Short-selling is the sale of a security which the seller has not yet purchased. In due course, the short-seller will have to buy the borrowed security back from someone else in 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 allows essential functions to be performed in the financial market:
- Market-making. Short-selling allows a market-maker to continuously quote prices for securities that he does not hold in inventory. 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 or unwilling 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 or securities lending 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 market-makers in the secondary market to hedge the interest rate risk on inventory and temporary long positions accumulated through buying. It also allows the underwriting of new bond issues and is therefore essential to the primary market both for government bonds and corporate bonds.
- 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.
- 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. In theory, there is no limit to where the price of a security can rise, so the possible capital loss on a short position is potentially unlimited. On the other hand, since the price of a security can only fall to zero, there is a limit to the possible capital gain on a short position. In this respect, taking a short position can be compared to the risky practice of writing a call option.
- 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 (borrowing a security in a reverse repo means investing cash and earning the repo rate). This differential is known as the cost of carry. Coupons are usually higher than repo rates because bonds are longer-term and repos are short-term, which means the cost of carry is typically a loss to a short-seller.
- Penalty cost. A short-seller who is unable to buy back a security from the market and return it to the lender may be penalised for failing to deliver and may have to compensate customers in order to keep their business.
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. There are different fail management mechanisms in the repo market (see question 25).
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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