The secondary market advisory committee of the Securities and Exchange Board of India has recommended that short sales should be monitored at the time of delivery in the settlement, while such sales would be regulated by an efficient lending and borrowing mechanism.

The panel, which met in July this year, has made its recommendations to Sebi. Short sales will also be defined as failure to deliver securities at the time of settlement.

According to the committee lending and borrowing of securities would entail borrowing of securities by the clearing corporation or house for meeting settlement shortfalls. The return of the borrowed securities by the clearing corporation house would be independent of the normal settlement.

According to the panel, in the Indian context shortages at the time of settlement affects settlement efficiency, so in order to avoid this regulation should focus on genuine shortages at the time of settlement.

Settlement shortages can be made up by borrowing securities while short sales may be regulated indirectly by regulation of securities lending and borrowing.

The current mechanism of auctions and close-outs adds to the inefficiency in settlements according to the committee.

In case of borrowing of securities it would be made at a pre-determined fixed rate which may be linked to Mibor. The borrowed securities would be delivered to the buyer along with the normal pay-out.

However, where the securities cannot not be borrowed, financial closure would be made. In case of margin trading the advisory committee has recommended that banks and Reserve Bank of India-registered non-banking finance companies would finance margin trading and brokers would merely act as facilitators.

The broker would only be bringing the borrowers (clients) to the lenders for financing and will be mediating and such borrowing would not be reflected in the balance sheet of the broker.

The SMAC felt that this model can be launched immediately since it does not require any legal amendments or clarifications and margin trading may be immediately started with this model.

The committee has also recommended that the market can soon migrate to the model whereby brokers finance their clients, which would require legal amendments and clarifications.

However this model would require some modifications.

According to the modifications suggested by the committee only corporate brokers may be allowed to participate in margin trading.

The net worth of such brokers should be at least Rs 3 crore (Rs 30 million) and it should be computed as per Sebi formula.

Brokers can use funds for margin trading by borrowing only from banks and NBFCs registered with RBI and other qualified institutions approved by Sebi but cannot use funds of other clients or individual investors.

The margin trading should be available in respect of the securities in group 1 of the risk management circular relating to T + 2 rolling settlement. These securities have an impact cost of less than 1 per cent.

The initial margin and maintenance margin may be 50 per cent and 40 per cent, respectively.

This means that the client places 50 per cent of the purchase value in cash with the broker and the broker arranges the balance 50 per cent to meet full settlement obligations.

The margin calls will be made when the balance in the client account reduces to 40 per cent.

The total indebtedness of a broker shall not exceed five times his net worth.

The committee did not recommend exchange traded model of margin trading.

On securities lending and borrowing, the panel has recommended that the model of securities lending for handling settlement shortages by clearing house or the corporation may be considered for introduction.

The return of the borrowed securities by the clearing corporation should be independent of the normal settlement.