Short selling under fire again as stocks remain volatile
Short selling is under fire once again in Korea after dramatic falls in stock prices, and the financial regulators are taking aim.
They are going after illegal short selling and updating some definitions so as to better identify potentially dangerous speculation and stop it when the activity becomes too frothy.
Their efforts are fraught with peril as international investors need the practice to hedge positions and will often simply sell their shares if they are not able to sell short during times of volatility. The country also has to allow for short selling in order to be included in the MSCI Developed Market Index.
In August, the Financial Supervisory Service (FSS) started an inspection of Morgan Stanley, the biggest short seller of stocks in Korea, for illegal short selling.
"I believe situational inspections on organizations or brokerages where short selling transactions were concentrated during times of market declines are necessary," FSS Gov. Lee Bok-hyun told reporters on Aug. 16.
The inspections followed President Yoon Suk-yeol's message to Financial Services Commission (FSC) Chairman Kim Joo-hyun earlier in the month to "strictly monitor illegal short selling."
During his campaign, Yoon said that he would institute a circuit-breaker for short selling.
In August, the Korea Exchange said that it would start designating stocks as being overheated if short sold positions are equal to 30 percent of daily turnover. Once designated, shares in the companies will not be available for short selling for a number of days.
With short selling, traders sell stocks they borrowed on expectations that share prices will decline. When the prices fall, they profit by buying shares at a lower price.
The five stocks most sold short on Tuesday were Samsung Electronics, Hyundai Motor, Hanwha Aerospace, Doosan Enerbility and LG Energy Solution.
Illegal short selling includes naked short selling, the practice of short selling a tradable asset without first borrowing the asset.
Short selling, which is not in and of itself illegal, plays an essential role in the efficiency of capital markets by facilitating secondary trading of securities, improving liquidity and eliminating bubbles.
The practice has often been blamed by retail investors for the fall in stock prices, especially during times of volatility, and has been viewed especially negatively in Korea.
Short selling was temporarily prohibited in Korea in March 2020 as the market melted down following the pandemic outbreak.
The short selling of Kospi 200 and Kosdaq 150 index stocks was allowed again in May 2021. But short selling stocks outside of the indexes remains prohibited as the market continues to underperform.
The Kospi is down around 19 percent this year, and the Kosdaq 25 percent.
Last January, more than 200,000 people supported a petition demanding the "permanent eradication of short selling" on the Blue House petition website. Last May, a post requested the government improve the short selling system to offer a fairer trading environment for retail investors, calling the current system "an uneven playing field."
Institutional and foreign investors do almost all the stock short selling in Korea.
According to the Korea Exchange, "anybody that borrowed securities is able to short sell. But there are limits for retail investors because they are at a competitive disadvantage to institutional or foreign investors when it comes to borrowing securities due to having weaker credit and financing ability."
Investors are also provided different trading conditions for short selling.
The margin threshold for retail investors is 140 percent, compared to between 105 and 120 percent for institutional and foreign investors. Higher margin requirements allow institutional and foreign investors to borrow a larger number of stocks compared to the assets they hold.
Retail investors are required to repay the shares within 60 days, whereas foreign and institutional investors can borrow the shares for 90 days and extend the repayment period.
The FSC is lowering the margin threshold for retail investors to 120 percent starting in the fourth quarter. It has further vowed to allow retail investors to extend the repayment period.
Some retail investors want more and are demanding the financial authorities raise barriers for institutional and foreign investors to restrict short selling in general.
"There is a huge gap between foreign and institutional investors and retail investors," said Jung Eui-jung, CEO, Korea Stockholders Alliance. "Average daily returns of foreign and institutional investors from 2016 through 2019 was 39 times greater than that of retail investors," Jung added.
"That is plundering, not investing."
The regulators should "make it more inconvenient for institutional and foreign investors to reduce damage to retail investors" because lowering barriers for retail investors will only expose them to bigger losses by encouraging them to trade on unsecured loans, Jung added.
Retail investors complain of the weak punishment imposed on investors that illegally sell short.
Those found to be illegally short selling have to pay a fine equal to five times the profit unfairly gained and can be jailed for up to 1 year.
"Restrictions on illegal short selling are already at the highest level allowed by the capital markets law," the FSC argued in July. "Criminal punishment can be imposed on intentional short selling, and even if it was a mistake, a fine can be imposed within the range of the transaction amount."
The FSC added it will "make use of the fast-track investigation process centered around the joint investigation unit set up at Seoul Southern District Prosecutor's Office to impose punishments commensurate with the severity of the crime when the level of damages is severe and seek forfeiture of illegal profits and concealed properties gained through illegal short selling."
"In principle, short selling has many positive functions, like eliminating the creation of bubbles in the market and encouraging companies to better manage the business to avoid being short sold," said Won Chae-hwan, a finance professor at Sogang University. "The practice is also a step required for Korea to grow and become accepted as developed financial market, like getting accepted into the MSCI Developed Market Index."
New York's MSCI is an investment research firm that provides stock indexes. The indexes are divided into three categories: developed, emerging and frontier markets.
Korea has made attempts to be included in the developed market index since it was added to the current emerging markets index in 1992. But MSCI had asked Korea to make several changes, including those related to short selling, according to the annual MSCI Global Market Accessibility Review released in June last year.
Korea failed to make it into the watch list for the index in June. In an assessment in the same month, MSCI said Korea's financial market restricts short selling.
Regulators have not yet decided on the date of a full resumption of short selling of stocks outside Kospi 200 and Kosdaq 150.
Korea temporarily prohibited short selling during the global financial crisis in 2008, the eurozone debt crisis in 2011 and Covid-19 in 2020.
It was the only country that halted the practice in all the three crises, compared to seven other key markets: the United States, Britain, Germany, France, Japan, Hong Kong and Australia.
"A ban on short selling in Korea since 2008 has been the longest, and the scope of the stocks that were banned from short selling was very extensive," said Song Min-kyu, a senior research fellow at KIF, in a report in December.
But the ban hasn't always been successful.
Effects of "using short selling to prevent price falls only lasted several days, or the falls did not stop at all, according to the analysis of three past cases in which Korea halted short selling," said Song.
"It's difficult to say short selling is the direct driver pulling down stock prices because Korea applies an uptick rule that disallows short sales to be conducted at a lower price than the previous trade," according to the Korea Exchange.
It added that the price fall either preceded short selling or the two had no correlation, according to research conducted on the top 20 short sold Kospi and Kosdaq stocks in 2014.
"There were a lot of times when short selling was banned in Korea for political reasons," said Won from Sogang University. The ban becomes "particularly prevalent ahead of the election to gain more votes. Recently, political and economic elements have been significantly interlinked."
BY JIN MIN-JI [firstname.lastname@example.org]