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Will Sebi's stock borrowing scheme work?

November 05, 2008

It should be no surprise that the original stock lending and borrowing scheme announced by the Securities and Exchange Board of India about seven months back failed to take off. The reason was simple; the borrowed shares had to be returned in seven days, which gave the punter a very small window within which to make money. If the price did not move appreciably during the week, it would be difficult to even recover costs.

Now that this time limit has been increased to 30 days, the scheme becomes more practicable, but it may not be enough to tempt punters -- because they can always go short in the stock futures segment where trading is possible in more than 200 stocks, most of which are liquid. After all, the SLB is applicable for the very same set of stocks. So, there is no need to go through the cumbersome and time-consuming process of borrowing shares, selling them in the cash market and then reversing both the transactions, especially since the SLB does not give any advantage with regard to duration.

Stock lending and borrowing are important, and make a big difference in markets (like the US) where single stock futures are not traded. In India, it remains simpler, and perhaps cheaper, to go short in the F&O segment; all one needs to do is to pay the daily mark-to-market margins and roll over the contract when it is about to expire, if one wishes.

If the SLB scheme is to take off, the duration for which stocks are lent needs to be much longer; in Western markets, stocks are loaned for as long as six months and are far more flexible, with put and call options built in. In other words, the lender and the borrower can call for the shares or the money, even before the contract ends.

Here too, contracts need to be made more flexible; an arbitrageur should be allowed to return shares within the 30 day period if s/he so wants. Otherwise, s/he could end up borrowing the shares for longer than needed.

For SLB to take off, the big holders of stock (like insurance companies and mutual funds) need to participate. The biggest holder of stocks in the country today is Life Insurance Corporation; unless LIC [Get Quote] lends, the supply of shares will be limited and arbitrageurs will not be able to borrow stock even if they are willing to pay for it.

Then, the cost of borrowing needs to be reasonable, otherwise the trader will not make money and the scheme will languish. Besides, as of now, not all institutions are allowed by their charters to lend stocks, and they will need to get the necessary permissions.

It is not enough to be able to borrow stock; the system has to facilitate the borrowing and lending of money too, on flexible terms. That was possible, to some extent, in the alternate lending and borrowing mechanism system on the National Stock Exchange.

Over-all, a well-structured SLB is an asset for the market; it helps price discovery and liquidity and consequently lowers impact costs. But unless the system is flexible and convenient, especially with regard to the duration of contracts and also the sequence of the pay-in and pay-outs, there will be few takers even for the amended version of the scheme as proposed now.



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