Do you think a firm’s share price will fall? The hunch could earn you cash

By Otiato Guguyu | Published Tue, March 14th 2017 at 08:05, Updated March 14th 2017 at 08:07 GMT +3

The three-year stock market slump could have provided an opportunity for investors to make money. That is, if Kenya had a product that allows investors to bet that stocks would decline.

Making this bet is called shorting, and it could become an option in a matter of months if the Capital Markets Authority (CMA) has its way.

“The framework itself is with the Treasury awaiting passage, and we remain hopeful that it will be adopted as part of the Budget Statement, which will be read in a matter of weeks as we know the Budget cycle is a bit shorter this year,” CMA boss Paul Muthaura said last week.

Close position

This is how it would work: you do not have to own shares of a company, but are allowed to borrow them to trade with before returning them.

If you spot a company whose stock price you believe will fall, you approach a broker and can ask to borrow 100 shares at Sh10, for instance, each. You can then sell these shares in the market at Sh10 each, making Sh1,000.

When the share price falls to Sh5, you can decide to close your position. This would require you to go back to the market and buy the 100 shares you owe at Sh500 and give these back to the broker. You will have made Sh500, excluding commissions and interest on the margin account.

This could have seen market players make billions of shillings from the current market bear run at the Nairobi Securities Exchange (NSE). As it is, four of the 12 companies on the NSE 20-Share Index that held initial public offerings (IPO) between 2000 and 2016 are trading below their introductory prices.

Mumias Sugar, KenGen, Eveready and Stanlib Fahari I-Reit, which made a debut in the market in October 2015, are all negative of their listing prices.

The shorting product is set to be very attractive as it does not come with the additional cost of taxation.

“Tax neutrality will make sure that as we introduce this new product that will result in the transfers of securities, we can manage the tax cost of these transfers of securities so there is no additional tax expense,” Mr Muthaura said.

Accounting issues

He added that securities made available for trading in the interim period would not be charged an additional tax so as to create a commercially viable product for the securities lending and borrowing platform.

“We are not trying to introduce new tax incentives that give opportunities for tax leakages; it is just to make the product viable,” Muthaura said, speaking on the sidelines of a Financial Services Volunteer Corps and Bloomberg conference on deepening Kenya’s capital markets.

Shorting can expose a seller to the risk of price gains, but it can also be helpful in spotting companies with accounting issues, corporate governance problems or stocks that are overvalued.

Short sellers are also called vulture investors – they circle a company, look carefully and meticulously at distressed companies to detect oversold securities or even specific kinds of accounting problems.

When they short firms, then they can help those who have gone long on a company (invested in the actual shares hoping the firm will perform well and rally in the long term) become more analytical of their investments.

Further, if a company ends up being dissolved, CMA will ensure the short sale is protected from the insolvency.

Muthaura added that once a security is moved, it will not be transferable back to the company by the receiver, which is the case in other transactions in the run up to insolvency.

There are certain provisions in new insolvency legislation that allow for the claw-back of transactions that are effected in a certain period leading up to the insolvency of a company

“We are working with the Attorney General’s office to introduce selling finality ... due to the vibrant nature of securities transactions, it is necessary to introduce certainty that once a security has moved it will not be unwound by whoever is co-ordinating insolvency,” Muthaura said.

However, CMA has banned naked short selling, which is where a player shorts without first borrowing the security and cannot deliver the shares on time. There were claims that this kind of aggressive short selling played a role in the failure of US financial giant Lehman Brothers.

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