While India has a world class equities trading ecosystem, one of the last missing building blocks is a mechanism to borrow shares. Stock lending is important because it will improve the pricing of stock futures, and because it will enable expression of bearish views about non-derivatives stocks. A stock lending mechanism has been under development for a decade. In 2010, there seems to finally be some traction in this. If this works out, then one of the last missing pieces of the equity ecosystem would fall into place.
Divergent views of an array of participants are the essence of finance. If a person feels optimistic about a stock, he can borrow money and buy shares. What about the pessimist? When a share price is Rs 100, a pessimist borrows shares and sells them on the market. He is obliged to return the shares at a later date. If the pessimist is right, the share price goes down to, say, Rs 90. He then buys the shares back at Rs 90 and returns them, for a profit of Rs 10.
The ability to borrow shares is thus essential to a free and fair market: just as optimists can borrow money, pessimists should be able to borrow shares. While this is the right way to think about thousands of listed firms in India, there is a privileged set of 200 firms that are different. These stocks have stock futures trading. India is unusual by world standards in having achieved success with stock futures at NSE. Stock futures are cash settled, thus giving true symmetry between the optimist (who would buy the stock futures) and the pessimist (who would sell the stock futures).
While stock lending is not important for a healthy and balanced speculative price discovery to come about for these 200 stocks, there is still a vital role for it, in the process of arbitrage. Derivatives pricing is done by arbitrage. The futures price should reflect an interest cost of carry over the spot price. If the futures price on the market is too high, then arbitrageurs step in, who buy an equal quantity of shares on the spot market and sell the futures, thus making a profit while taking no risk.
But what happens if the futures price is too low? The arbitrage strategy then requires buying the futures (since this is too cheap), and simultaneously selling an equal quantity of shares on the