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28. What is ‘short selling’ and what is the role of repo?
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Short-selling
is the sale of a borrowed security. In due course, the short-seller will have to buy the borrowed security back from the market, in order to return it to the lender. Between selling and then buying back the security, the short-seller is said to have a short position. If the price of the security falls before it is bought back from the market, the short position will yield a capital gain (and vice versa). Short-sellers can borrow securities in the repo or securities lending markets.

Short-selling performs essential functions in the financial market:
  • Market-making. Short-selling allows a market-maker to continuously quote prices for securities that he does not hold. If an investor buys one of these securities, the market-maker can be sure of being able to deliver, because he knows he can borrow it, if he is unable to immediately buy that security from someone else in the market. The liquidity thus provided reduces risk for investors by allowing them to buy on demand, which in turn reduces the cost of borrowing for issuers. Several debt management agencies offer special repo facilities to market-makers to allow them to borrow whenever the available supply in the market is inadequate.
  • Hedging. A long position in one security can be hedged by a short position in a similar security, so that, as prices fluctuate, changes in the value of one position will be substantially offset by opposite changes in the value of the other. Hedging allows the underwriting of new bond issues and is therefore essential to primary market liquidity.
  • Traders take short positions in assets they believe are over-priced. This is essential to efficient price discovery and the prevention of asset price bubbles.
Short-selling incurs significant risks and costs. It is therefore undertaken cautiously.  
  • Risk. The price of a security sold short may rise, in which case, it will have to be bought back at a price higher than that at which it was sold, which means a capital loss. Since the price of a security can only fall to zero, there is a limit to the possible capital gain on a short position. However, in theory, there is no limit to where the price of a security can rise, so the possible capital loss is potentially unlimited.
  • Running cost. A daily loss will accrue on a short position at a rate equal to the coupon on the security sold short (since the daily accrual of coupon interest on the security will add to the eventual cost of buying it back) less the repo rate on the cash lent in the reverse repo through which the security has been borrowed. This differential is known as the ‘cost of carry’.
  • Penalty cost. A short-seller who is unable to buy back a security from the market and return it to the lender will be penalised for failing to deliver.
Borrowing to cover short positions can be arranged before or after a short sale is agreed, but should be done before delivery is due. Short-selling without borrowing before delivery is said to be uncovered or naked. Concern is sometimes expressed that uncovered short-selling permits unlimited selling of a security, allowing speculative forces to massively leverage negative sentiment and manipulate the market. However, many, if not all, uncovered short positions are either temporary and/or unintentional. Temporary uncovered short positions are usually only intraday and arise because it is more convenient to borrow after a short sale has been agreed. Unintentional uncovered short positions arise when it is difficult to borrow securities in the market because of lack of supply, or because lenders fail to deliver (which is often due to inefficient clearing and settlement, particularly of cross-border transactions).

Uncovered short-selling becomes a market abuse in the case where a seller has no intention of borrowing and delivering the securities that he has sold short. However, in contrast to the equity markets of the past, this is difficult to do in fixed-income markets, given that it will always result in failure to deliver a security, which incurs costs and penalties, and would be unacceptable to the counterparties expecting delivery. Anyone who has failed to receive a delivery of bonds that he has purchased in the cash market also has recourse to buy-ins, which allow him to buy the bonds from a third party and pass any extra costs (which can be significant) to the seller who has failed to deliver.

In the EU, the EU Short Selling Regulation which came into force in November 2012 prohibits uncovered short-selling of government bonds or listed shares in Europe, other than by market-makers or banks involved in the issuance of government bonds.


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