Are Nepalese Regulators Afraid to Allow Short Selling?

Many investors need to learn money can be made even when the market declines. It might surprise you, but yes! money can be made both in a bull market and a bearish one. How? By Short Selling or Going Short. 

Short selling is one of the investment strategies where experienced traders and investors try to make money when the market is falling. An investor predicts the downtrend of a particular stock, borrows it from a broker or other market participants, and sells it; later, he buys the same stock and gives it back to the lender. But how can one make money from that? Well, here is an example; 

One of the experienced traders predicts that the price of XYZ company will fall by 25%, which might be due to declining sales or any other qualitative factors, and he decides to take a short position. The current price of that company is Rs. 1000, which means it will fall to Rs. 750. 

Let’s assume a perfect mathematical situation for our trader going for a short position at XYZ company. He will borrow 1000 units of the company at Rs. 1000 and sell it at Rs. 900. It seems like he is at a loss, but it’s unrealized. 

The trader decides to repurchase it at Rs.750 and give it to the lender, so how much is his profit, or is he on losses?

Initial Borrowing And Selling 

Initial Borrowing= 1000*1000 = Rs. 10,00,000

Initial Selling = 1000*900 = Rs. 9,00,000

Loss = 10,00,000 – 9,00,000 = Rs. 1,00,000 (A)

Repurchasing at a Lower Price

Total Repurchase Amount = 1000*750 = Rs. 7,50,000

Realized Profit = 10,00,000 -7,50,000 = Rs. 2,50,000 (B)

Profit at the End = B-A = Rs. 1,50,000

Our trader’s profit is the difference between when he borrowed the stock and returned it to the lender, which is Rs. 1,50,000. 

Isn’t it surprising? Yes, it is; despite the downfall in the market, our trader earned a reasonable profit. Likewise, other market participants, such as brokers, also benefit. The regulators can also get a good amount on fees, and the government can also earn amounts from taxes. Despite that, it is illegal in countries like Nepal, but why? 

Short selling is legal in many countries, such as the United States, United Kingdom, Canada, Australia, Japan, India, and many more. Why are short selling legal in these countries? 

Short selling has been a debatable and controversial topic for a very long. It is assumed that the short selling stabilizes the market through increased liquidity. Also, it helps investors bet against overvalued stocks, which helps in the appropriate valuation of the stock’s value and managing risk. 

Digging into financial history, we find traces of short selling from 1609. Short selling was likely invented in 1609 by Isaac Le Maire, a Dutch East India Company shareholder.

At various times, the government banned or restricted it due to the financial crisis or bubbles it caused.  Short sellers were blamed for the Wall Street Crash of 1929, and the regulations governing short selling were implemented in the United States in 1929 and 1940. Likewise, countries like Spain, Italy, and France put restrictions on short selling during the Covid-19 pandemic. This also shows that short selling can bring negative results in the market. 

Likewise, in short selling, there is an infinite risk for traders. In the above example, what if the stock price increased instead of decreasing? If the above company’s cost increases by Rs.10, our trader will already have a Rs. 1,000 loss. But still, banning is not an option. The government should allow short selling for the market’s growth and regulate it simultaneously. 

The regulators can put a limit or restriction to avoid the potential impact that the short sellers can bring to the market. The USA has implemented regulations such as the uptick rule, a ban on naked short selling, put option, and many more to regulate short selling. 

The effective short-selling market needs advanced technologies, human resources, and other regulatory reforms. But are Nepalese regulators, such as the Securities Board of Nepal (SEBON) and Nepal Stock Exchange (NEPSE), ready for it? Is the government of Nepal ready for it? Are Nepalese investors prepared for it? These questions must be addressed before starting short selling. 

In my conversation with some of the employees in SEBON, they claim that if short selling is allowed, then the government should make some regulatory reforms, hire an expert workforce in regulatory bodies, and provide the advanced technology for regulators required to regulate the market. Or else the market might have to face the next bear market. I think now is the right time for Nepalese regulators and the government to rethink short-selling.  

References: 

How Does Short Selling Help the Market and Investors? (investopedia.com)

Why Is Short Selling Legal? A Brief History (investopedia.com)

https://en.wikipedia.org/wiki/Short_(finance)#:~:text=The%20practice%20of%20short%20selling,Compagnie%20or%20VOC%20in%20Dutch) 

How an Investor Can Make Money Short Selling Stocks (investopedia.com)