Selling Investors Short
by andrew@JijiniMarkets - Mon 26 Feb 2007
There have been recent reports in the Kenyan media about millions being made by brokers who are selling customers' shares when prices peak and redeeming these shares when prices fall back down, all without the knowledge or consent of the clients. The scam has been unveiled when some clients have noticed discrepant CDS statements or when brokers have been unable to buy back the shares in time or at affordable prices. Ironically the practice has been enabled by the new electronic platform on the NSE which doesn't require signed documents from clients before shares can be bought or sold by a broker.
Selling shares you don't own is not a new practice nor is it illegal in some markets. Indeed major global investment banks earn vast sums of money from departments specifically setup for this kind of activity. The name it is given is Short Selling and involves (a) if you think a share is overpriced and will fall in price soon, borrowing the shares -- at a fee -- from a current shareholder, (b) selling the shares in the market and (c) redeeming the shares to the original shareholder after the agreed period of time by buying them back from the market. The points to note are that the original shareholder is paid a fee for lending out his/her stocks and is also covered from risk through a collateral agreement made with the borrower. The difference between the price the shares were sold and re-bought -- less the borrowing fee -- constitutes the profit made by the short-seller. That the short-seller could lose money if the share price doesn't fall in the given time period doesn't affect the original shareholder.
The value of short-sellers in a market is debatable. Some markets have banned the activity outright claiming it drives down the value of stocks. In markets where the practice is allowed, short-sellers play a vital role in identifying overpriced and poor quality stocks. E.g. short sellers were one of the factors in exposing Enron's accounting scams. They also enable investors to not only make money when prices rise but also when they are falling by being able to sell high and buy low. Long term investors can also benefit as the fees received for lending shares can be a major source of income that supplements dividends.
Short-selling is not a regulated activity on the NSE nor do I believe it is legal yet. The problem shareholders face is that they are not compensated for the service of lending shares to brokers to sell short and they are not protected from risk in case the broker gets it wrong. It appears some clients of Francis Thuo Stockbrokers were victims of illegal short-selling and one only hopes the Capital Markets Authority will act swiftly to either curb or regulate its practice.
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