The Korean financial market’s reputation will be undermined with local and international asset owners if the local watchdog gives in to retail investors and permanently bans short selling, after recently extending an existing ban on the practice, warn experts.

The country’s ban on short selling was imposed in March last year when its market fell amid the coronavirus pandemic. The Financial Services Commission originally scheduled for the ban to expire on March 15 this year, but extended it until May 3 after it received protracted pressure from retail investors who believe the practice works in the favour of large investment institutions.

Short selling involves an investor borrowing shares from a peer and selling them, with the expectation their price will fall. If this happens the investor can repurchase the shares and return them to the lender, while pocketing the price difference.

If done successfully, the short seller can benefit from price drops or use shorting positions to hedge their stock positions against broader market drops. But investors who short aggressively risk losing money if share prices rise instead of fall, because they have to buy the shares back at the higher valuation to return them.

Ironically, the the extension also follows a very healthy year for the Kospi index, South Korea’s stock-market benchmark. The market ended up rising by 30.8% across 2020 despite the market drop in March, marking its biggest annual jump in more than a decade and makin it one of the world’s top performing stock markets.

Assuming the short-selling ban is not further extended, the FSS allow stocks on the benchmark Kospi 200 Index and the small-cap Kosdaq 150 to be shorted once more from May 3. However, executives at local asset owners are nonplussed by both the initial ban and the FSS's decision to extend it further. 

“The short-selling ban is not good for the market eventually. Psychologically, people think that the ban can prevent a market collapse, but eventually the market is the market; there must be a price discovery mechanism,” the chief investment officer of a Korean pension fund told AsianInvestor on condition of anonymity.

HEDGING LIMITATION

Other Korea market participants argue the most important consequence of the ban on short-selling has been its impact on investor confidence in the country’s stock market.

Most of the country’s asset owners do not like the ban because it prevents them from hedging in preparation for any potential market collapse. While individual options exist for most large-cap stocks, they are not available for every listed Korean company, said the CIO.

In addition, global investors like to invest into liquid, predictably regulated capital markets that offer hedging tools. Korea's shorting ban risks undermining its stock market appeal because it has removed a useful tool. Global investors have sold a net W18.3 trillion ($16.26 billion) since the ban started, according to the Financial Times.

In addition, the CIO argued that the decision to enact and then extend the ban was “arbitrary” and conducted less for market efficiency reasons than to placate Korea’s increasingly dominant retail investors (who are also voters).
Elizabeth Oh, Mercer:
shorting impact is limited

Indeed, Elizabeth Oh, head of investment advisory for Korea at consulting firm Mercer, told AsianInvestor there is little evidence that short selling has weakened stock valuations. She pointed to research from the Korea Capital Market Institute that scored the correlation between short-selling trading volumes and the Kospi index's price from July 2008 to October 2016 at -0.0389, meaning it was very small.

“As we can refer to the low correlation, some of asset owners believe that the influence of short-selling to the stock market might be relatively limited," she said. “[Korea’s] macro economy, industry fundamentals and [financial] performance, forecasts etc. are influencing [stock] market prices over the factor of short-selling allocation."

Seoul’s willingness to maintain the ban in the face of available evidence is likely to decrease investor confidence in the stock market, the pension CIO added. Additionally, even if the short-selling ban is partially lifted for Kospi 200 and the Kosdaq 150 stocks on May 3, another 2,037 other stocks will remain banned for short selling.

Rhee Keeyoung, KDI:
Against the ban

Rhee Keeyoung, research fellow at Korea Development Institute (KDI), agrees that banning short-selling ban has had unintended consequences.

He told AsianInvestor that plenty of academic research details the benefits of short-selling to efficient price discovery, as it provides stock markets with more information. Rhee added that market regulators are unwise to give mixed signals about the role of short-selling to the public.

“If short-selling improves efficiency in stock trading, why did they ban it at a time of increased uncertainty in which the market desperately needed more information about solvency of listed firms?” he said.

“NAKED SHORT-SELLING”

Rhee believes the FSS has focused on the wrong issue with the blanket short-selling ban, arguing that it should instead have focused on instead on naked short-selling.

The practice of naked short-selling derives from a regulatory blind spot, he noted. Financial regulators in most countries require short-sellers to bring evidence that they have borrowed underlying stocks from other investors, but if a clearinghouse does not prudently monitor the short-sellers’ reports on their stock borrowings they can sometimes falsely report they have borrowed shares when in fact they have not, he noted. This loose book-keeping offers predatory short-sellers a loophole for naked shorting. 

Korean authorities have prohibited naked short selling since 2000. However, the market is still seen as a hotbed for the practice, given that a violation of the rule carries a relatively light penalty.

Of the 101 cases of naked short selling uncovered by financial authorities here between 2010 and late 2019, 94 were committed by foreign investment companies. Forty-five firms were slapped fines, while the remaining 56 were simply warned, according to the Korean Herald

 

The best approach the financial regulators could have taken to alleviate individual investors’ misgivings about short-selling would have been to take some visible actions such as introducing stricter book-keeping requirements, but they have not done so, Rhee added.