SEBON Chairman Dr. Gopal Bhatta Unveils Plans for Covered Short Selling in Nepal: A Game Changer for Market Modernization

The Nepal Stock Exchange (NEPSE) is on the cusp of a significant transformation, with the newly appointed Chairman of the Securities Board of Nepal (SEBON), Dr. Gopal Bhatta, announcing ambitious plans to introduce "Covered Short Selling." In a recent interview with 'Mero Lagani,' Dr. Bhatta emphasized that this move is crucial for modernizing the capital market, specifically opting for a 'covered' model to mitigate high market risks, as opposed to 'naked' short selling. While the term might be new to many Nepali investors, covered short selling is a well-established and integral practice in developed international capital markets. This initiative promises to fundamentally alter how investors engage with the market, offering new strategies for profit and risk management.

At its core, short selling is an investment strategy that allows investors to profit from a decline in a security's price. Unlike traditional investing, where one buys low and sells high, short selling involves selling a security first, with the expectation of buying it back later at a lower price. If an investor believes a company's share price is likely to fall, they can sell shares they do not own, a practice known as "shorting." The profit is the difference between the initial selling price and the subsequent repurchase price, minus any associated fees.

Dr. Bhatta's insistence on the 'covered' aspect is critical. There are two primary forms of short selling:

1. Naked Short Selling: In this highly risky practice, an investor sells shares without first borrowing them or even confirming their availability for borrowing. This can lead to settlement failures if the shares cannot be delivered on the due date and can artificially inflate the supply of shares in the market. Consequently, naked short selling is prohibited in many developed countries due to its potential for market manipulation and systemic risk.
2. Covered Short Selling: This is the model Dr. Bhatta intends to implement in Nepal. Here, an investor must first ensure they have borrowed the shares (or have a firm commitment to borrow them) before executing a sell order. This guarantee of timely share delivery for settlement makes it 'covered' or safer, significantly reducing the risks associated with settlement failures and market instability.

The process of covered short selling, as practiced internationally, typically involves five key steps:

1. Securities Lending and Borrowing (SLB): The investor first borrows the desired shares through an SLB mechanism. This involves paying a fee to the lender (often institutional investors or long-term holders) for the use of their shares.
2. Market Sale: The borrowed shares are then sold in the open market at the current price. For instance, if an investor sells 100 shares at NPR 500 each, NPR 50,000 is credited to their account.
3. Anticipation of Price Decline: The investor then waits for the share price to fall, validating their initial bearish outlook.
4. Short Covering (Repurchase):): If the price drops to, say, NPR 400, the investor buys back 100 shares from the market for NPR 40,000.
5. Share Return: Finally, the repurchased shares are returned to the original lender. In this scenario, the investor realizes a profit of NPR 10,000 (before deducting SLB fees and other transaction costs).

For covered short selling to function effectively, robust infrastructure is paramount. As Dr. Bhatta highlighted, the SLB mechanism is the "heart" of this system. It provides a platform for long-term investors to lend their idle shares, earning additional income, while simultaneously enabling short sellers to access the necessary securities. Alongside SLB, a stringent margin system is indispensable. Short selling carries significant risk; if the share price rises instead of falling, the investor could face substantial losses. The margin system requires short sellers to maintain a certain amount of collateral in their accounts, and brokers issue "margin calls" if the collateral falls below a specified level, demanding additional funds to cover potential losses.

While some might perceive short selling as a bearish activity that could depress market prices, economists generally agree on its numerous benefits. It significantly increases market liquidity by adding more trading activity. Short sellers also play a crucial role in price discovery, helping to correct overvalued stocks by exerting downward pressure when prices become irrationally high. Furthermore, sophisticated investors often use short selling as a hedging tool to protect their portfolios against potential market downturns or specific stock risks.

However, covered short selling is not without its risks, the most prominent being a "short squeeze." This occurs when a stock that has been heavily shorted suddenly experiences a rapid price increase. As short sellers rush to buy back shares to cover their positions and limit losses, this buying pressure further accelerates the price surge, leading to potentially massive losses for those who were short. Dr. Bhatta's emphasis on "risk-based supervision" and "pilot testing" underscores his commitment to managing such risks effectively.

Dr. Gopal Bhatta's roadmap for implementation is characterized by urgency and a phased approach. He stated that all necessary documentation is ready and has been submitted to the Ministry, declaring, "I will not wait for Ashoj; every second is important to me." His sequential plan involves first streamlining margin lending, followed by the introduction of intra-day trading and the SLB mechanism, before finally rolling out covered short selling. Crucially, his strategy includes an initial "pilot testing" phase, where covered short selling will be permitted only for a select group of strong, stable companies. This cautious approach aims to prevent systemic risk and allow the market to adapt gradually to this new instrument.

The introduction of covered short selling represents a historic leap for the Nepali capital market. It will transform NEPSE from a predominantly "one-way" market (profiting only from rising prices) to a "two-way" market, where investors can potentially profit from both upward and downward price movements. If Dr. Bhatta's "sadhana" (dedication) and "bullet-speed" work ethic succeed in establishing the necessary international-standard infrastructure, the Nepali share market is poised to become genuinely modern and mature, offering a broader range of strategies and opportunities for all participants.