Short Selling in Trinidad & Tobago

15 March 2017

A Firstline Securities Limited Blog by: Jonathan Wilson 


Ever wondered why there is no short selling on the Trinidad & Tobago Stock Exchange (TTSE)?   Read on to learn about short selling’s current place on the TTSE; how it can deepen the securities industry; the way in which its regulation protects investors, and what determined investors may do right now to hedge, manage or profit from portfolios in this manner!

I regularly recommend the film The Big Short (2015); a comedy-drama adapted from the financial non-fiction novel by author Michael Lewis. In the movie, a handful of investors predict the 2007-2008 subprime mortgage crisis and eventually make a killing by betting against the American housing market.

It may be very long before these investors’ credit default swaps or other such derivatives are on local markets. Nonetheless, I question investors’ abilities to short on the Trinidad and Tobago Stock Exchange. Can local contrarians express themselves beyond buy, sell or hold?

The movie title is a pun of course, as ‘shorting’ or ‘short selling’ is effectively a bet that a security will fall in value. Ordinarily, an investor who expects a rise in a security’s value ‘goes long’ or buys that security, say ordinary shares, or purchases more for his/her existing position to capture the expected return. In anticipation of the shares going south, an investor may sell his/her existing position to realise any capital gain or limit losses. But that’s it.

An investor may buy as much as sellers are willing and able to offer, but cannot sell as much as buyers are willing and able to bid if demand exceeds what he/she has on hand. Short selling expands an investor’s limit: he/she borrows from a third-party investor however much of the shares he/she wants to offer, then sells them, buys them later—at his/her anticipated lower price—and returns them to said third party at an agreed upon time. ‘Buy low and sell high’ but simply in reverse.

Not so fast. Local stockbrokers do not accept these orders from investors yet. The local Exchange has rules for trading on its platform among other things. Since 2010, the Exchange obtained regulatory approval to include rules for short selling, except these are part of a wider approval for the Trinidad and Tobago Depositary Receipt (TTDR) Market. The Policy Framework details the mechanics among investors, brokers, custodians and issuers that have yet to actually make the market on the Exchange. Furthermore, the rule amendments for TTDRs were in the context of the Exchange’s former trading platform, Horizon, which has since been changed to GlobalVision and again to Avvento this February. For at least these two reasons, you will not yet find mention of TTDRs in the first hyperlink.


What Can Short Selling Mean for Our Market?

Irrespective of a TTDR market, my opinion is that short selling should apply to the present equity and debt securities on the local Exchange. The short selling rules are well recommended for the TTDR Framework, because the empirical benefits to markets where investors can short include increased liquidity that is measured by narrower bid-ask spreads, more efficient price discovery and less volatility.

Short selling invites more participants—sellers who otherwise would not be able to sell—whose market orders via brokers mean more bids and offers that make for more frequent trading and hence more liquidity. Secondly, enabling contrarians to act on negative news or information in this manner also tends to reduce overvaluations in securities that may exist, thus improving pricing efficiency.

Thirdly, as a corollary, less overvaluation, on average, makes for less severe price corrections or volatility. Researchers test in various ways for these favourable outcomes in developed and developing markets. The arguments among academics, practitioners and regulators generally do not dispute these benefits but rather, the appropriate regulation.

I suspect that local market sentiment among investors and regulators is that markets are too thin to attract short sellers. Thin markets denote the unfavourable conditions to those described above such as less trading, wider spreads and more volatility. That sentiment may explain why short selling for the Exchange’s listed securities has not reached the stages of rule amendments and market making.

It is clearly not to say that locally listed securities are thinly traded because there is no short selling, but the sentiment describes a textbook chicken-and-egg problem that has been solved before in various ways when making markets for similar investments or their platforms. In the case of the local market, the Exchange’s (listed securities’) liquidity depends on investors’ participation, which in turn, depends in part on that liquidity. The solutions involve kick-starting this market dependency into a virtuous cycle, wherein the favourable market conditions reinforce themselves once set in motion.

Logistically, who will lend their securities to short sellers? The most usual lenders of stocks are funds, investment banks, banks and wealthy individuals: lending is an opportunity to make additional profit on long term investments. Borrowing contracts may include premiums on the securities loaned that supplement income to offset unrealised capital losses. I have yet to verify whether local pension funds’ statutes explicitly speak to any such activity but general buy-and-hold portfolios such as these are top candidates in my opinion.

The Framework disallows brokers from executing short sales without a Securities Loan Agreement Form. This prevents what is referred to as naked short selling, where the short seller borrows or seeks to borrow only after the sale is made.

He who sells what isn’t his’n,
Must buy it back or go to prison
Daniel Drew

This topic is one example of what local regulators observed from the U.S. SEC short selling rule changes following the 2008 crisis. Besides naked shorting, the uptick rule and alternative uptick rule are frequently researched and debated.  The uptick rule allows shorting only on securities whose prices are up by one tick (usually one cent) from the last traded price.

In 2010, the U.S. SEC approved the alternative uptick rule. The rule stops shorting a given security that drops more than 10 per cent in a day; long investors, of course, may still sell.
Research teases out how much covered and naked short selling are responsible for negative outcomes like severe downturns or volatility, and measures how much of the favourable outcomes attributable to shorting are given up by the various regulations.

The rules mentioned here appear in the Framework and may well be expected to apply to local listings if shorting ever came to pass. There are volumes of empirical cost-benefit analyses; research on the U.S. SEC approvals; and rules in other developed markets but very little on emerging markets. Local stakeholders should consider the differences in development in their appraisal of the regulations and its supporting research.

An Alternative to Short Selling

Short selling may become impractical, for example, when uptick rules become restricting. Instead, investors can use options for synthetic shorting. An investor sells a call option on the security that he expects to decline and simultaneously buys a put option for that security—“synthetic” as this approximates the risk-reward profile that an actual short seller has.

An investor can enter into option agreements with local broker-dealers or through them to find counterparties who are willing to buy or sell securities in this manner. At least two counterparties are necessary: one that buys the call option from the investor and another to sell him a put option.

Synthetic shorting using over-the-counter or dealer options such as these does not, however, explicitly involve borrowing; so the investor may be expected to own the underlying security before entering the options depending on the contract negotiated. Exchange-traded options, on the other hand, are standardised and listed; the investor would be able to sell the option to close once the underlying fell. Listed options settle through clearing houses that require collateral deposits from members. Of course, this latter options market is yet out of reach locally.

Risk comes from not knowing what you’re doing.”
Warren Buffet

The risks of shorting that concern most investors come down to counterparty risk and market (price) risk. Buyers and lenders, respectively, face the counterparty risk that short sellers may fail to deliver on executing the sale and returning the borrowed shares, and as discussed above, regulators or legal contracts aim to protect investors from just that.

The latter, scarier risk is the unlimited loss potential if the security shorted rises in value. The investors in The Big Short understood these risks but this is why many others just say no. Local pension funds, for instance, regularly exclude derivative contracts like options from their Investment Policy Statements.

These concerns are important, but note that risk-return profiles, in isolation, should not determine investment decisions but rather how the decisions affect the total portfolio. A diversification process, for example, may be more efficiently managed from the inclusion of a single short position in an asset class, sector, or country (or combination of these exposures) than from increasing and decreasing several long exposures.

If short positions suit your objectives, desired risk-return profile and other investment criteria, then ask your broker-dealer about their willingness to arrange options, or talk to your Asset Manager about his/her investment process for your portfolio when the bears come to attack.

Have a question that you want answered?  Ask us in the comments below!

The views expressed are those of the author. As such, this post should not be taken as investment advice.


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