Blank selling and short selling are two ways of profiting from a falling stock market. Essentially, the seller first sells the securities and then buys them back at a lower price, netting the difference. For instance, if you sell 500 shares of Hubco at Rs 32 and buy them back at Rs 30, you would have earned Rs 2/share.

While this may appear an interesting and harmless way of profiting, blank and short selling have often been held partially responsible for many a stock market crisis internationally. Blank selling is prohibited in every stock market while short selling is usually tightly regulated.

In our stock markets, blank and short are associated with virtually every crisis. They are particularly bothersome because our investor base is too narrow which increases the potential for manipulation. Often these two are confused with each other and their implications for market fairness and integrity are not well understood. The aim here is to clearly explain the concept of blank and short and the rationale for their regulation.

Concept: The distinctions among a sale, a short sale, and a blank sale are made by the “Regulations governing short selling in the ready market” that were implemented in 2002. Under these regulations, a sale is not subject to any special restrictions if (i) it is backed by ownership of shares or (ii) a buy transaction before a sell transaction. It becomes a short sale if you didn’t own the shares or hadn’t first executed a buy transaction but had arranged for borrowing the shares before you sold them. It becomes a blank sale if you hadn’t even borrowed the shares sold, i.e. you just sold in thin air.

Let’s take a simple example. On Monday, you sell the 500 shares of Hubco you own. You can tender delivery on Thursday, under the T+3 system and receive payment. Else you can square your position by buying 500 shares of Hubco later in the day. You are betting on the prices going down. You’d receive the profits on squaring if the price indeed fell. If you weren’t lucky and the price rose you’d have to pay the losses.

If you didn’t have the 500 Hubco shares, but you first executed a buy transaction of 500 shares, you’d still be fine because you had a claim on what you sold. You might have bought the shares fractions of a second earlier or even simultaneously; you might be carrying over your buy position using the Carry Over Financing; or you might have bought at one stock exchange and sold at another trying to arbitrage away the price differential. As long as the sale transaction is not before the buy transaction, it is legal and does not attract any special restrictions.

If you didn’t have the 500 Hubco shares, but you had first borrowed them before selling them, you’d be making a “short sale.” If you didn’t even borrow the shares, you sold blank. Practically, a blank seller squares his trade the same day while a short seller may tender delivery and buy back the shares later.

Law on blank and short: Under the regulations, blank selling is prohibited. Short sale is permissible, but it is subject to the following conditions: (i) a prior contractual borrowing arrangement and (ii) allowed in only specified liquid shares (currently 31 shares) and (iii) can be made only on an up-tick and (iv) the offer has to be identified as a short sale at the time of punching the offer in the trading system and (v) net outstanding short position shall be tendered by delivery.

In case of first violation, fines can be levied from Rs 25,000 or 1 per cent of the amount of short sale, whichever is higher and forfeiture of profits. For the second violation, Rs 50,000 or 3 per cent of the sale amount, whichever is higher, and forfeiture of profits. The burden of compliance rests with the broker and not on the clients because a broker is in a position to make his clients comply. Moreover, it is usually not feasible for the regulators to take action against individual clients.

Short is also subject to some additional conditions by the Companies Ordinance 1984.

Under section 219, following are not allowed to make a short sale in their company’s stocks: (i) director (ii) chief executive (iii) chief accountant (iv) company secretary (v) auditor and (ii) a beneficial owner with more than 10 per cent holding. The intention behind this law is to protect investors from insider trading and large scale short selling.

Under the SEC’s prohibitory order on blank selling issued in Sep 2001, a blank or short sale cannot be carried over using the Carry Over Financing.

Rationale for prohibiting blank: (i) It is wrong in principle because one cannot be allowed to sell something he doesn’t have but he might have to deliver. (ii) Blank seller steals away money from other investors by manipulating the prices. By putting in blank sales and creating selling pressure, the seller tries to mislead others into thinking that the prices are falling due to genuine selling so that others also start selling. Once the price drop is artificially magnified and accelerated, the blank seller squares himself at a profit. (iii) Blank seller exposes himself and the market to an increased risk of defaults. Unlike a genuine seller, blank seller faces substantial price risk because he doesn’t have the shares. If contrary to his expectations, market moves against a blank seller, he would have to square at substantial losses that he might not be able to bear. Moreover, if he is unable to offset his position, delivering shares that he never had can become very difficult. (iv) Blank selling artificially raises the volatility in the market and hurts its perception as a fair place. Bad perception scares away investors, thus narrowing the investor base and hurting the process of capital formation.

Rationale for restricting short: Unlike a blank sale, a short sale is acceptable in principle because the seller does arrange for the shares. In the absence of short selling, bears would not be able to profit from their analysis or expectations. Moreover, short sale helps in finding the fair prices and helps avoid buying euphoria. Short sale is subject to a number of restrictions because (i) it also has the potential of market abuse; and(ii) a short seller is exposed to substantial price risk and an added burden of cost of borrowing.

Experience in implementing the law: Perhaps, the single most effective measure in minimizing blank and short is the restriction on carrying over such a position, which has pulled the rug from under the feet of the blank sellers. Investigations under the regulations were carried out after the May 2002 crisis. A number of violations have been proven and fines levied. Futures, introduced in 2001, have also weakened the roots of blank selling. Due to a lack of Futures market, bears were selling blank in the ready market. Now the bears can sell Futures, where concept of blank and short do not apply, and profit if the prices fall. It’s difficult to quantify the extent of blank selling before and after the reforms. Clearly, data on blank selling is not available because it is a crime and nobody reports it. But trading patterns and views of market players suggest that blank selling is a dying phenomenon.

Following measures are suggested to further protect the investors and the market integrity from blank and illegal short selling: i. Entering a unique account holder’s identification number in the trading system at the time of trade must be made mandatory. This number would set an audit trail from the trade to the account on which the trade is carried out. Currently, either no identification number is put in the trading system, or it is not unique, due to which clever manipulators have a good chance of misleading the investigators by mixing up holdings, buying, and selling of different accounts.

ii. “Prior contractual borrowing arrangement” in the regulations should be defined as such that shares must be in the account of the seller before the sale. Due to ambiguity on borrowing contracts, it is possible to obtain a fake backdated plain paper statement as a valid borrowing contract.

iii. Short sale should be allowed regardless of uptick, zero tick, or downtick. The uptick rule is overly restrictive and not very logical either because it forces a seller to sell in a rising market. Market forces aided by tight downward circuit breakers should be sufficient to avoid a bear raid by short sellers.

iv. Random audits to check compliance should be introduced on a continuous basis. These audits should also focus on whether a manipulator was able to borrow the securities after making a blank sale. v. Index Futures and Options should be introduced to provide the bears with more and new ways of trading on their expectations. These new instruments would further weaken the culture of blank selling.

vi. Following the international practice, a centralized borrowing and lending intermediary should be set up using which the owners could rent out their securities to the short sellers.

Conclusion: In the past two years, our stock markets have come a long way in defining and regulating blank and short selling, thanks to the exchanges and the SECP. All such steps add up to achieving our ultimate aim of making our stock markets fair, efficient, liquid, and transparent so that they can eventually act as an economic agent and play their part in the economic progress of the country.

(The writer is an official of the Securities & Exchange Commission of Pakistan. The commission, however, does not necessarily subscribe to his views.)