The new short-selling mechanism, the so-called stock lending-borrowing scheme (SLBS) that came into force last week, is likely to take a while to catch on. There are several holes in the current structure.

The SLBS received less attention than it would in most weeks. First, there was the settlement and second, there are the stream of FY 2007-08 results. Third, institutional investors are currently focused on the modalities of the new cash-margining system.

But the return of a short-selling lending borrowing mechanism has the potential to alter market-dynamics. For several years, in fact ever since the excellent ALBM (automated lending-borrowing mechanism) was shut down, the market has been inured to the lack of a shorting mechanism outside the F&O segment.

The SLBS doesn't change that immediately since it's currently F&O-focused. Within F&O itself, the absence of stock delivery on futures positions can lead to large arbitrage opportunities when there is heavy shorting.

In order to arbitrage a higher cash-price to lower futures-price situation, the trader must go long futures (no problem) and short in cash (major problem except with a prior stock-holding). The SLBS may help if its costs are lower than possible arbitrage profits.

The cash margin for institutional investors(IIs) is unusual and the official explanation is that it's intended to provide a level playing field vis-a-vis retail investors. Let me confess I'm a cynic. It's more likely to have been imposed due to some visceral fear of (II) defaults.

The reasons don't matter – it's done. What does matter is that institutional activity will slow till such time as IIs are confident about the new system. It may also inhibit hedge funds from taking cash-market exposures. Lack of volumes usually equals lower prices.

The SLBS has very complicated mechanics. There are several possible different margins that the exchanges may impose apart from borrowing charges – about 140 per cent could be payable upfront in short-margins.

Also, the stock-borrowing must be tied up in the morning SLBS session before the short is taken. In game-theoretic, that's a distortion. If everyone knows X shares have been borrowed (SLBS is screen-based), the short-seller is liable to lose a large proportion of potential profits before any sales are initiated.

It's unlikely that too many FIIs will go short, though they may be very interested in lending stocks. While the entire F&O segment is available under SLBS, focus will be on top volume counters. Deals are likely to be thin and the perspective is no more than T+ 7 sessions though rollover will surely be possible.

The classic "value" short remains impossible. That occurs when a shorter decides that a company is overvalued. He sells, borrows stock to offer delivery and holds the short for months if required, to squeeze out maximum profit. Eventually he buys back off the market and returns the stocks to the stock lender.

This set of transactions is a mirror-image of that made by a long-term value investor, who buys and holds undervalued stock for the long-term. Like the value-buy, a value short doesn't require any stock-market margins because the trades are delivery.

But it only works where there are many committed long-term stock lenders (index funds, pension funds, etc). The stock-lending market has to be deep and liquid to ensure stock-borrowing charges are not exorbitant.

Not true in India at the moment. Some institutions will lend stocks but banks and insurance AMCs cannot at the moment. Likely "Badla" charges are impossible to assess with near-zero volumes generated so far.

RIL for instance, costs Rs 11 to borrow for 7 sessions at around 2630. That annualises to 15 per cent. RNRL cost about 25 per cent. Given that these stocks trade above eight figures daily, total borrowings of 260 stocks is ridiculous.

In the given format, it's difficult to see SLBS taking off. Any wannabe shorter is more likely to take the simpler, cheaper stock futures route - paying lower margin, getting better leverage and avoiding borrowing costs.

What is useful is that it reintroduces the concept of shorting to the Indian market. Eventually the SLBS' parameters could be tweaked enough to make it workable.

A good model to examine and perhaps update would be that old warhorse, ALBM. It offered a combination of a screen-based (anonymous) system which allowed punters to borrow stocks or cash at transparent rates.