CSE unveils new market opportunities with regulated short selling and stock borrowing & lending

Colombo Stock Exchange Chief Regulatory Officer Renuke Wijayawardhane delves into the proposed new frameworks for Regulated Short Selling (RSS) and Stock Borrowing and Lending (SBL) and their benefits, measures to safeguard the rights of lenders and stabilizing the market during downturns.

Can you elaborate on the Regulated Short Selling (RSS) and Stock Borrowing and Lending (SBL) frameworks to be implemented by the CSE?

Wijayawardhane: These mechanisms provide the investors with opportunities to navigate the securities market while maintaining adequate safeguards. Regulated Short Selling (RSS) enables investors to profit from potential market price fluctuations by allowing them to sell borrowed shares. RSS is permitted under two methods: borrowing the shares through SBL first and then short selling or initiating a short sale first and then borrowing shares via SBL before the conclusion of trading on the same trading day. However, in both these scenarios, an SBL Agreement must be in place.

The introduction of short selling offers a range of benefits to the stakeholders and the market. Lenders, often holding dormant portfolios with no immediate trading plans, gain an opportunity to earn a fee by lending their shares. Borrowers can harness market fluctuations through short selling and profit from a falling market.

From a wider market perspective, short selling enhances market efficiency and the market microstructure of CSE. It improves the price discovery process by incorporating the views of the short sellers in determining the share price; effectively bringing the share price of an overvalued stock closer to its fundamental level. It also narrows bid-ask spreads and minimizes the impact cost which ultimately results in improving the liquidity of the market.

What would be the basis for selecting shares eligible for RSS and SBL?

Wijayawardhane: The selection criteria for the RSS and SBL hinge on key factors, with a strong emphasis on liquidity. These criteria undergo quarterly reviews to maintain their relevance and effectiveness.

Shares eligible for SBL and RSS must meet a minimum liquidity threshold, determined by an average trading volume of at least 100,000 shares and a minimum of 100 average daily trades. Additionally, the shares must have a minimum public holding of 15%. Shares eligible for SBL must also fall under the ‘low to medium’ volatility criteria, as defined by CDS. High-volatility shares are automatically excluded. Volatility is assessed by the CDS using the Value at Risk (VaR) metric.

What are the measures to be adopted by the CSE to ensure that the rights of the lenders are protected under SBL and RSS?

Wijayawardhane: Firstly, only a limited basket of highly liquid shares will be eligible for SBL and RSS to ensure liquidity and minimize risk. To protect the lenders, we have implemented stringent margining and collateral requirements for the borrowing participant. Daily mark-to-market valuations of collateral provide an additional layer of security if the borrower fails to return the shares. It is the borrower’s responsibility to return the borrowed securities on the return date. Any non-compliance with this rule results in the collateral being utilized to compensate the lender. The borrower is also responsible for passing all corporate benefits arising during the lending period to the lender. When there are corporate actions or voting events during the lending period, lenders have the option to recall the shares lent by providing 3 market days’ prior notice to the borrower.

These transactions involve regulated market participants such as stockbrokers and custodian banks. Certain enforcement actions will be taken against the borrowing participant in the event of any rule breaches.

Since the lenders bear the primary risk in SBL and RSS, our comprehensive approach prioritizes lender protection while upholding the integrity of the mechanisms.

What is the rationale behind the ‘uptick rule’ in short selling and how is it expected to stabilize the market?

Wijayawardhane: The rationale of the uptick rule is to mitigate the acceleration of steep declines in prices due to short selling, especially during downward market sentiments.

If the price of an eligible share for RSS drops more than 10% within a single day, all incoming short-selling orders will be validated with the uptick rule. This means that all new short-selling orders submitted thereafter must be at least one tick size higher than the last traded price of that share.

Additionally, if the price drop exceeds 20% or more, short selling for that particular share will be suspended for the remainder of the trading day unless the share price recovers back to the permitted range.