Saudi Arabia’s introduction of short-selling to its stock exchange was a regionally historic moment. Despite the elevation of Qatar and the UAE to MSCI Emerging Market status in 2013, none of the exchanges in the Gulf had introduced the concept before the beginning of 2017. The issue has been on the developmental agenda of exchange authorities for years, but a number of concerns combined to delay its implementation. A desire to protect retail investors – who account for more than 70% of liquidity in some GCC markets – from the costs and risks associated with short-selling stocks was paramount among these considerations.
Cause For Concern
A central issue is that short-selling is essentially carried out using borrowed money: investors borrow stocks from a broker and immediately sell them at the current market price, with the proceeds going into investors’ margin accounts. In order to repay the borrowed stocks to the broker, the investor buys the stocks back at a later time, hoping to obtain them at a cheaper price than they were sold for. This practice generally carries greater expenses than a traditional long purchase of stock. Most long purchases are carried out using cash accounts, but short-selling is undertaken with borrowed funds via margin accounts, which means that interest charges apply.
Some shares are difficult to borrow due to demand or volatility, and are therefore frequently subject to hard-to-borrow fees, which can range from a fraction of the trade’s value to more than 100%. Lastly, short-sellers are liable for dividend payments on shorted stocks, to be paid to the broker, and are exposed to the possibility of charges related to share splits, spin-offs and bonus share issues.
In Saudi Arabia, the borrowing component of a short trade also raises concerns regarding sharia compliance. The sharia prohibition on speculation is frequently cited as one of the reasons why a number of trading tools, such as derivatives, have yet to emerge in GCC exchanges. The debate regarding short-selling is a long and complex one, but primarily revolves around varying interpretations of a hadith, which may prohibit the sale of what one “does not own” or what one “cannot deliver”.
Beyond the possibility of higher costs and incompatibility with sharia, there are a number of elevated risks associated with the practice of short-selling. The most fundamental of these is that a short trade runs counter to the generally upward long-term trend of markets, meaning that a simple buy and hold approach is unrewarding.
Timing a short trade is therefore an advanced skill. Popular, difficult-to-borrow short stocks are also prone to the so-called short squeeze, defined as the surge in the stock price after a broker closes out a large number of short positions. The most obvious risk in the context of a market dominated by retail investors, such as the Tadawul, is the scale of losses that can be accrued on an unsuccessful short trade. In long trades, both losses and gains are limited to the value of the stock; however, with short trades there is no limit to either of these, meaning that both losses and gains can theoretically be infinite.
The Case For Saudi
Despite the risks associated with short-selling, there is a strong case for its introduction to the Tadawul. While short-selling is prohibited around the Gulf, investors have succeeded in bypassing the regulatory block in some markets using offshore swaps.
In Saudi Arabia, however, banks are keen to avoid such regulatory disapproval, and by establishing a regulatory framework for short sales, the Capital Market Authority (CMA) has pre-empted its arrival.
In addition to removing a regulatory vulnerability, the advent of short-selling in Saudi Arabia serves to deepen market functionality. Recent years have seen a debate in advanced markets about the rising costs of short-selling, making the practice less enticing to hedge fund managers. However, despite the increased use of lower-cost alternatives, such as put options and inverse exchange-traded funds, short-selling remains an essential tool for investors engaged in hedging activity, or those simply wishing to act on a bearish view of a stock or sector.
Short-selling brings other advantages beyond its role as an important stock market tool: by selling shares, short-sellers add liquidity to the market, which helps to compress bid-ask spreads and lowers the purchase price of stocks. The Tadawul may be the most liquid exchange in the MENA region, but low oil prices and market uncertainty have made liquidity a central issue throughout 2017.
In a broader sense, short-selling is also seen as an essential balancing force in any market, acting as a brake on the powerful upswings characteristic of long-only exchanges. During periods of rampant market optimism, short-sellers adopt a contrarian approach, seeking out opportunities that run counter to the long-term trend, which enhances price discovery. Moreover, identifying short opportunities requires large amounts of due diligence, the accumulation of which greatly improves market transparency. Short-sellers, therefore, can act as a useful early warning signal for market problems.
Local Model
In introducing the new short-selling function to the exchange, the authorities have sought to balance the desire to deepen the market and attract liquidity with the necessity of protecting investors and minimising market risk.
To reduce the chance of destabilising the market, the practice of short-selling has been limited to institutional investors, such as funds. The CMA has also established a number of investment limits for short-selling activity: for example, total short positions must not exceed 10% of the issued securities of any issue, and the Tadawul reserves the right to specify which securities might be made available for short-selling transactions.
These prudential measures mean that the take-off in short-selling volumes is likely to be slow. Indeed, one month after the new framework was introduced, the exchange had yet to register any short trades.
“People like to see the systems in place for a while; it takes a little time,” Kaushik Chaudhury, chief investment strategist of Saudi Fransi Capital, told OBG. “The market needs some time to settle down and adapt. Managing a long-short fund requires a certain competency, and liquidity can be erratic, which is also a significant problem. So, while we have seen no new long-short funds yet, we can expect them to roll out in due time.”
Sharia Compliance
For demand to grow, it is important to resolve any remaining concerns regarding sharia compliance. For sharia-compliant investment houses, the distinction between the principles of hadith regarding the selling of what one “does not own” or what one “cannot deliver” is significant. After consulting with sharia scholars, the Tadawul believes that it has produced a short-selling model in line with sharia requirements. It has not, for example, approved naked short-selling – shorting stock without first borrowing the shares or ensuring that they can be borrowed – and has therefore limited short-selling to covered shorting.
OBG understands from its conversations with a number of sharia-compliant institutions in Saudi Arabia that their sharia boards have so far granted preliminary approval to the practice as defined by the CMA. While the effects of Saudi Arabia’s new stock shorting capacity have yet to be seen on the Tadawul, its quiet introduction is an important regulatory advancement – as is the CMA’s pre-emptive governing framework – and one that will aid the exchange in developing the more complex instruments by which it intends to deepen the market.
