Regulated Short Selling and Securities Lending and Borrowing in Sri Lanka – The Regulatory Framework in a Nutshell

What is Short Selling?

  • A “short sell”, in its essence, is a transaction for the sale of securities where the seller does not own the entirety of the securities that are sold under such transaction.
  • The Trading Rules of the Colombo Stock Exchange (“CSE”), which enabled short selling to be carried out within the framework of such Rules with effect from 6th November 2023, defines a “short sell” transaction to mean a sell trade carried out by a seller which will result in a short position as at the end of trading day of such trade.
  • As per the Clearing House Rules of the Central Depository Systems (Private) Limited (“CDS – Clearing House”), a “short position” is created in relation to a sell trade when the aggregate of (i) the cleared balance of the relevant securities in the client account through which the trade is executed and (ii) the number of securities under pending buy trades relating to the same client account, is less than the aggregate of (i) the securities sold under such sell trade and (ii) the number of securities under pending sell trades in relation to the same client account, as at the end of the trade day.
  • In short, this is a position that will result in the seller failing to meet its delivery obligations in full on the settlement date, unless the shortfall is procured by the settlement date.

Regulated Short Selling

  • The Trading Rules permit a short sell transaction to be executed on the Automated Trading System of the CSE (“ATS”), only where the seller (i) has borrowed the shortfall through a Securities Borrowing and Lending (“SBL”) transaction, prior to placing the short sell order, or (ii) borrows the shortfall through an SBL transaction by the end of the trade day (the shortfall should be fully credited to the client account by end of trading on such trade day).
  • A short sell transaction that is executed on the ATS as permitted by the Trading Rules, is a “Regulated Short Sell (RSS)”.
  • No sell trade can be executed on the ATS if the client account relating to the trade shows a short position as at the time of the order, unless the sell trade is specifically flagged as an RSS.
  • Where transaction is flagged as an RSS, the trading participant of the seller should ensure that the transaction does not result in a short position within the meaning of the Clearing House Rules as at the end of trading on the date of the trade.

Key matters of note

  • An RSS can be carried out only in respect of listed securities specified by the CSE and published on its website.
  • The ‘Uptick Rule’ will apply if the price of a security declines by 10% from the previous closing price. In such scenario, an RSS order in respect of such security should necessarily be entered to the system at least one tick size above the last traded price.
  • If the price of the security declines by 20% or more from the previous closing price, an RSS in respect of such security is not permitted until the price appreciates above the 20% threshold.

Securities Borrowing and Lending

Framework for Borrowing and Lending of Securities

  • Section 7 of the Clearing House Rules of the CDS – Clearing House set forth the regulatory framework for the SBL transactions.
  • The borrowing and lending of securities under an SBL transaction is effected by way of a transfer by the lender of the relevant securities (“Borrowed Securities”) to the borrower subject to a simultaneous agreement by the borrower to transfer to the lender on an agreed date, an identified number of securities in settlement of the SBL transaction (“Settlement Securities”). The borrower pays the agreed lending fee to the lender at the time of settlement.
  • The framework allows clearing members to collect borrowing and/or lending requests from several investors seeking to borrow/lend securities and place a cumulative borrowing order or lending order on the SBL module of the CDS.
  • SBL transactions are effected through separate CDS accounts of clearing members designated specifically for the purpose of facilitating SBL. The investors who wish to borrow or lend securities should enter into an agreement their clearing members (in form prescribed by the CDS – Clearing House) to record the terms and conditions pertaining to the SBL transactions between the parties.

Salient requirements for SBL transactions

  • An SBL transaction can be carried out only in respect of listed securities specified by the CDS – Clearing House and published on its website (“Eligible Securities”).
  • The quantum of Eligible Securities of a particular listed company that can be subject to outstanding SBL transactions at any given time, is limited to a maximum of 5% of the total number of Eligible Securities in issue in such company.
  • CDS – Clearing House imposes margin requirements on borrowing clearing members and such clearing members should maintain adequate collateral to maintain the minimum margin requirement determined by the CDS – Clearing House. If the collateral maintained is inadequate to meet the total margin requirement of a borrowing clearing member, additional margins are imposed on the clearing member. The margin requirements in respect of ongoing SBL transactions are adjusted on a daily basis to reflect marked to market value of the SBL transactions, and the clearing members should provide more collateral if those already provided is inadequate to meet the adjusted requirement. All margin requirements are calculated by the CDS – Clearing House and communicated in writing to clearing members.
  • The collateral that can be provided by clearing members to meet margin requirements are (i) cash, (ii) irrevocable and unconditional bank guarantees and (iii) listed securities determined by the CDS – Clearing House from time to time.

Execution of SBL transactions

  • The minimum information to be entered on the SBL module to carry out an SBL transaction are the relevant CDS account, Eligible Security, quantity, borrowing/lending period and borrowing/lending rate.
  • The quantum of Eligible Securities subject to the SBL transaction should be in the relevant CDS account at the time entering the lending order.
  • The SBL transaction entered on the SBL module are matched based on the details entered to the SBL Module by the respective clearing members.
  • The Borrowed Securities are deemed to be transferred on delivery of the Borrowed Securities to the borrower’s account in the manner set out in the Clearing House Rules. Such transfer takes place immediately. The borrower will become the owner of the Borrowed Securities upon the receipt of such securities to its account.

Settlement of SBL transactions

  • An SBL transaction is settled by (i) the delivery and transfer of the Settlement Securities to the designated lending account and (ii) the payment of the lending fee by the borrower to the lender, in the manner set out in the Clearing House Rules on the agreed settlement date. The lender will become the owner of the Settlement Securities upon the receipt of such securities to its account.
  • The Settlement Securities should be (i) securities of the same company that has issued the Borrowed Securities, (ii) of the same class as the Borrowed Securities and (iii) be equivalent to the number of the Borrowed Securities, However, the quantum of Settlement Securities will be different to the quantum of Borrowed Securities if there was a sub-division or consolidation of the Borrowed Securities after the SBL transaction was executed.
  • The lender can require the delivery of the Settlement Securities on a date prior to the settlement date (early recall) in the manner set forth in the Clearing House Rules in order to be eligible to a corporate action or vote at a shareholders meeting. An early recall should however be in respect of all but not part of the Settlement Securities.
  • The borrower can settle the SBL transaction by delivering the Settlement Securities on a date prior to the settlement date (early settlement) in the manner set forth in the Clearing House Rules. An early settlement should be in respect of all but not part of the Settlement Securities.
  • An SBL Transaction can be foreclosed by the CDS – Clearing House in the instances specified by the CDS – Clearing House and made available on its website. In the event of a foreclosure, the delivery of the Settlement Securities and the payment of the lending fee should take on a date specified by the CDS – Clearing House.
  • The lending period of an SBL transaction can be extended by the borrower or the lender with the agreement of the counterparty.
  • Any SBL transaction that is not fully settled by the delivery of all of the Settlement Securities to the lender, is deemed to be a defaulted SBL transaction and the default provisions in the Clearing House Rules will apply. If the lending fees are not fully paid, the collateral provided by the borrowing clearing member will be utilized to ensure full payment.
  • Where the listed company carries out any corporate action that is relevant to or affects the Settlement Securities prior to the settlement of the SBL transaction, the borrower should make available to the lender any securities arising from such corporate action or provide sufficient cleared funds (as applicable) based on the instructions provided by the CDS – Clearing House from time to time.

Authors

BuwanekaBasnayake
Partner