The SC recognises that shortselling enables hedging and arbitrage activities in both cash and futures markets to be developed, and is an important step to ensure the development of complete capital market. This has led to the formation of a Working Group in 1994 which has been responsible both for the development of shortselling as well as securities borrowing and lending in Malaysia. In December 1995, a set of guidelines was issued by the SC which governs the practice of securities borrowing and lending in Malaysia. In respect of shortselling, amendments were made to both the Futures Industry Act and the Securities Industry Act which came into force on 25 of November 1995 and 7 March 1996 respectively. These amendments enable rules of the stock exchange to be made to regulate shortselling. Together with the KLSE, the SC has actively worked towards formulating an appropriate regulatory framework for shortselling to be reflected in the Rules of the Exchange.
While recognising the contribution of shortselling to the development of the capital markets, it must be balanced with the need to ensure market integrity, and to protect investors. In this connection, the policy objectives in formulating shortselling are to ensure:
- Transparency: All shortsales must be identified at the time of the order and must be reported expeditiously
- Security: A member company who executes the shortsale must be responsible for ensuring that a Securities Borrowing and Lending ("SBL") arrangement is in place so that there are no undue risks placed on the stockbroking companies, which could result in systemic disruption
- Integrity: Shortsales will only be permitted on the most liquid companies so as to ensure that shortselling activities would not result in adverse disruption in the market place
- Investor protection: Investors involved in shortselling must be informed of the risks involved, and brokers executing short orders must know their customers, and their capacity for taking risks.
In brief, the means to achieve these objectives are as follows:
- Every shortsale must be identified at the time the order is made. It is incumbent on the stockbroking company to make the necessary enquiries to identify whether any order is a shortsale or not.
- A securities borrowing arrangement must be in place at the time of the shortsale. This requirement is vital in order to ensure that the shortselling client does not carry out a naked short sale and that he is able to deliver the securities when he is required to do so. By imposing such a requirement, it is believed that undesirable speculative shortselling activities are minimised. For this purpose, efforts have been taken to ensure that a securities borrowing and lending market is developed locally.
- The member company is duty bound to inform the Exchange of all short sales on a periodic basis. This information will then be utilised by the Exchange to determine the outstanding short sales that exist ("short interest") and such information will then be disseminated to the market in an expeditious manner.
- Investors engaging in short sales, be it for arbitrage or speculative purposes, must be aware of the risks they run, and brokers must ensure that their clients have the financial capacity to assume such risks.
Features of the shortselling regime
List of approved securities
The concern that shortselling should not lead to cornering of the market of a particular security, or permit market participants to manipulate the price of the security, is reflected in the need to have a list of approved securities for which shortselling is permitted. If shortselling is permitted for illiquid securities, the likelihood of "short squeezes" or manipulation is increased. Therefore, it is necessary to ensure that the securities on which shortselling is allowed are carefully selected. In this context, the relevant features are high market capitalisation, wide distribution of shareholders and high proportion of shares being freely traded on the market. For a start, it is proposed that the list of approved securities for the purpose of shortselling be similar to the list of securities on which call warrants may be issued. The criteria are as follows:
- average daily market capitalisation of more than RM2.0 billion for the past 3 months;
- at least 100 million shares in public float;
- average monthly share volume traded of more than 2 million for the past 12 calendar months;
- at least 2000 registered shareholders; and
- 5 years uninterrupted after-tax profit track record.
However, it is expected that the list of approved securities would be expanded over time to enable arbitrage and trading strategies in respect of index futures contracts and stock option contracts. Based on research undertaken by the SC, a portfolio of the above-mentioned securities possesses a high correlation with the KL Composite Index, and will enable baskets of securities to be sold to encourage arbitrage between futures and the cash markets. As and when stock option contracts become available, these contracts will likewise be based upon securities for which shortselling is permitted.
To ensure liquidity conditions are maintained, the list of securities will be reviewed once in six month, and dovetailed with the process of approving futures contracts.
Price at which shortselling should be carried out
Another issue relevant to formulating an appropriate structure for shortselling is that of determining the price at which shortsales can be carried out. While the SC does not support market intervention, and believes in allowing the unfettered interaction of market forces, it recognises that the practice of regulated shortselling is new to the market. As such, it is concerned that the introduction of shortselling should not introduce more volatility into the market. In the event of a market break, there is also the concern that systemic stability be preserved, and that shortselling should not encourage panic selling. On the other hand, it is aware that permitting shortselling improves market efficiency, and enables large, downward price movements to be avoided.
Hence, unlike some jurisdictions which allow shortselling without regard to the condition of the market, the SC has adopted a balanced approach at the outset of shortselling and approved a pricing model using the last done (last transacted) price as a point of reference. In brief, a shortsale may be carried out at a price equal to or higher than the last done or last transacted price. This serves to dampen large, downward swings in prices and gives the market time to react in the event there are large gaps in price formation. The last done price is used as a reference because it best indicates the intentions of a buyer and seller who meet at arms length and wish to deal with each other on that basis.
This is in preference over the last bid or last ask price. If a bid or ask price is utilised, such a point of reference may be manipulated by arbitrageurs or speculators who wish to shortsell and who may deliberately place bid or ask prices to suit their intentions. Secondly, bid and ask prices may not be totally current or accurate as intended. This is especially the case when the market moves very quickly and the volume of trades done are very high, or when there are large gaps in price formation owing to an imbalance in the order flow. In such cases, bid and ask prices that are placed may not be current and shortselling should not be on the basis of "stale" prices.
The "Know your client" rule
At the onset of shortselling, it is prudent to re-iterate the time honoured "know your client" rule. While recognising that arbitrage and speculation improve efficiency and liquidity in the market, these activities carry with them an inherent risk. Investors engaging in shortselling must have the financial means to honour their short positions. Hence, it is incumbent on stockbroking fraternity to carry out up-to-date credit evaluations of their clients to assess their capacity to take on risk. The broker must continuously review the trading track record of clients, and be in a position to pose such questions as-
- Is it a long or a short sale?
- Do you have securities available for delivery?
- If so, where are the securities kept?
- What are the arrangements the borrower has made for delivery?
- If there is no SBL arrangement in place, which brokers have been appointed to effect delivery?
In addition, in order to ensure that a member company which takes shortselling orders is in a position to arrange for a securities loan in order to meet delivery requirements, only a member company which is authorised by the SC under its Guidelines on SBL as an authorised borrower, lender or both may carry out shortselling activities for its customers or for their own account. This would ensure that such member companies would be in a position to arrange for borrowing of securities when their clients wish to carry out shortselling activity.
Monitoring of shortselling activity and dissemination of relevant information
Prescribed information pertaining to shortselling must be given by member companies to the KLSE on a daily basis. This information enables the total accumulated shortsale positions which have been entered into by the particular member company in respect of a particular security to be known.
The daily shortselling position report of a member company must be submitted to the Exchange not later than 6.00 p.m. of the next market day after the shortselling took place. Following this, the total net short sale positions will be calculated by the Exchange. The process of verifying this information will continue until the following trading day and at the end of that trading day, the total net short sale positions will be disseminated to the market. It is important that this information is made available to the market as it increases the transparency in the market and indicates the prevalent trends in the market.
These disclosure requirements impose specific functional requirements for the infrastructure of the exchange the stockbroking companies which would take some time to be developed. However, all involved are aware that they are being held to a tight schedule. As and when the infrastructure is in place, the Exchange will notify the SC, and the public will be notified accordingly.
