Short-selling and the problem of market maturity in Latin America

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Short-selling and the problem of market maturity
in Latin America
Miguel Díaz-Martínez and Emmanuel Fragnière
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Reading Questions

• Is portfolio theory and optimization techniques
  equally relevant when evaluating the integration
  of short positions in asset allocation strategies
  in Latin American stock markets as they are in
  developed economies?
• If not, is it possible to adjust such techniques
  by adding variables related to specific-country
  imperfections to make them applicable in Latin
  America?
• What are the main issues that we should consider
  when considering short sales in Latin America?
• What conclusions can be drawn from a comparative
  analysis of short sales in Latin American
  countries?

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Context

• Latin American countries have particular
  structural features that complicate the
  regulatory environment of capital markets and
  affect the effective execution of short sales.
• Specifically, Latin American capital markets are
  characterized by
• Reduced liquidity
• Limited price formation
• Unavailability of information
• Small economic size
• Factors affecting country risk perception from
  the international investor perspective
• All this makes it difficult to assess the
  appropriateness of short sales norms

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Review of national regulatory regimes

• Brazil Naked short selling is not allowed.
  Punitive rules that inhibit the non-delivery of
  stocks at settlement (T3). Some authors argue
  that The rules in place have limited leveraged
  speculation therefore avoiding the expansion of
  the crisis.
• Peru Short selling can only be made with the
  shares listed at the Tabla de Valores
  Referenciales 1 and 2, two lists that include the
  most liquid securities traded on the Lima Stock
  Exchange. There are also price restrictions
  through the uptick rule.
• Mexico Short selling is allowed but there is an
  uptick rule. The Secondary Legislation (Circular
  Única) establishes that short selling is only
  allowed through a Stock Exchange, and for only
  highly liquid and semi-liquid stocks.
• Chile The government has issued a manual that
  contemplates the mechanics, conditions and
  restrictions of short selling operations and
  stock brokers have developed standard formats to
  engage customers in short sales. However, short
  selling in the stock market is not very developed
  and it is limited to a small number of stocks.
  Naked short selling is not allowed.
• Argentina With some specific restrictions
  subject to the companies or securities traded,
  non-naked short selling is allowed

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Previous studies about short selling in Latin
America

• Literature is very limited and essentially
  derived from from analysis conducted for the
  entire set of emerging countries
• Bris et al. (2007) Studied 46 countries, and
  found evidence that prices incorporate negative
  information faster in countries where short sales
  are allowed and practiced.
• Charownrook and Daouk (2009) Created a
  short-selling feasibility indicator to analyze
  stock market indices around the world. Their
  findings suggest that aggregate returns and
  liquidity are better when short-selling is
  possible

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Previous studies about short selling in Latin
America

• There is also a range of studies evaluating
  specific aspects in individual countries and
  governmental studies assessing short-selling
  policies. Among these
• Torres et al. (2004) sustain that portfolio
  building methods are based on hypothesis that are
  not real in emerging markets
• Agudelo et al. (2010) have undertaken a
  comparative analysis of the Chilean and North
  American markets and concluded that, where legal
  frameworks do not allow them, short sales can be
  implemented through a temporary stock transfer
  contract
• Likewise, there is a range of government
  publications and newspaper articles, but these
  are not theoretically conclusive

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Previous studies on short selling in Latin America

• Due to the inconclusiveness of short selling
  articles and the lack of research, it is worth
  analyzing more general studies of financial
  markets and economic assessments from
  academicians and monetary authorities, such as
• Feldstein (1999) examined the actions of
  speculators and the macroeconomic events during
  the 1997-98 global financial crisis
• The Bank of International Settlements (BIS, 2002)
  published a series of papers about the
  development of bond markets
• Regarding equity markets there are various
  studies that give an insight of stock market
  capitalization and emerging countries efficiency
  (e.g. Bekaert and Harvey (2000))

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Short selling in Latin America

• As explained earlier, Latin American markets are
  structurally different making short selling more
  limited
• To look beyond such limitations, we analyzed the
  relationship between global capital flows and a
  wide range of financial instruments traded in
  emerging countries
• Our findings suggest that market liquidity and
  economic size are the fundamental aspects
  allowing the development of short sales
• This allowed us to identify the characteristics
  of short sales at three levels
• Currency markets these are normally big and
  very liquid
• Debt markets these are relatively big and
  liquid
• Equity markets these are normally not as liquid
  as currency and debt markets

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Short selling in Latin American Currency Markets

• The possibility of short sell depends on the
  existence of a fixed or a floating exchange rate
  regime
• If the currency floats freely, investors can
  borrow local currency, sell it for foreign
  currency, and then invest the foreign currency
  they then expect to sell their foreign currency
  after the local currency's fall and repay the
  original debt with cheaper currency
• The elements usually considered by investors to
  evaluate short sales against an emerging
  countrys currency are
• The countrys current account deficit
• Aggregated balance sheet imbalances in the
  banking sector
• Banking implosions, and their consequent
  contagion turbulence
• These elements provide an indication of the
  expected devaluation.

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Short selling in Latin American Debt Markets

• The possibility of short sell depends on the
  existence of secondary markets, and repo and
  funding markets
• If a speculator wants to short sell, he may sell
  a bond in secondary markets, receive the money
  from the sale, and then lend this money and
  receive a bond as payment guarantee. The bond
  received as guarantee is transferred to the
  buyer.
• At the maturity date of the lending the
  speculator will receive back the money lent and
  use it to buy another bond with exactly the same
  characteristics of the one he sold. This bond is
  given to the money borrower (i.e. the original
  bond holder)
• In Latin America and Eastern Europe, debt markets
  are relatively liquid and deep in Brazil, Chile,
  Czech Republic, Poland, Mexico, Colombia, Peru
  and Hungary

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Short selling in Latin American Equity Markets

• Even though countries have developed regulations
  on the topic, this table shows that short selling
  in equity markets is not feasible in the great
  majority of countries analyzed
• In the analysis of debt and currency markets, we
  found that short selling is very feasible, and
  investors often elaborate selling mechanisms in
  the absence of regulation
• Also, a statistical analysis of stock market
  indexes shows low correlations which is partly
  explained by the hazardous political environment
  and lack of development in Latin America
• Therefore, we hypothesize that the development of
  short sales is a determined by the maturity of
  markets
• Regulation should come as a way to regulate
  trading activities were markets are mature

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Discussion and Conclusions

• Global capital flows are one of the main drivers
  determining the depth of Latin American capital
  markets
• Market liquidity allows investors to balance risk
  and return, which is essential for the
  integration of short sales in portfolios
  strategies
• The evaluation of short selling policies is
  complicated in Latin America where markets are
  inefficient
• The comparison between developed and Latin
  American markets allows to bring interesting
  hypotheses
• In developed countries, it is possible to
  evaluate correlations of stock prices, build
  efficient portfolios and compare their returns to
  risk free returns
• In Latin America, correlations are strongly
  biased depending on political and economic events
• Therefore, in less Latin American economies
  sovereign risk becomes the most evident variable
  to evaluate against return

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Further thoughts

• It would be worth studying global portfolio
  strategies involving several securities within
  different Latin American markets to help
  increasing the understanding of this topic
• It is worth noting the lack of public statistics
  to provide any reasonable quantification of short
  selling in Latin America
• We believe that theory about short sales in Latin
  America is not complete. This short article
  intended to contribute to the creation of
  theoretical grounds in this topic