On February 3rd, the short selling ban, which was scheduled to end on March 16th, was extended again until May 2nd. Short selling is the act of borrowing stocks that are expected to fall in price and selling them, then actually buying them at a lower price later on. Earlier in March, 2020, the Financial Services Commission (FSC) imposed a six-month ban on short selling to lower market volatility in the pandemic and extended the period by six months in September. “The FSC agreed that the resumption of short-selling is inevitable. But we agreed on inducing a soft landing by beginning with a partial lifting,” the financial regulator said in a statement on Feb 3rd. Those who support the ban say that short selling, which has been the main culprit of the fall in stock prices, should be banned and the boom in the stock market should continue. While those against want short selling to be resumed, assuming its positive impact and the local stock market’s current situation. What is the answer to the short selling measure? Let's take a closer look at both sides' arguments and think about it.
Korea’s stock market was one of the world’s top performers last year and continues to boom in 2021 as the Korea Composite Stock Price (KOSPI) broke above the 3,000 mark for the first time. The major drivers of the boom were abundant liquidity brought by the economic stimulus and heavy buying by retail investors. However, the effect of short selling ban was also significant. KOSPI plunged as low as 1,457 in March last year but bounced back fast, recovering 2,000 in two months after the short selling ban. Choi Yoo-joon, a researcher from Shinhan Investment, said in June last year, “The stimulus effect of the short selling ban is estimated to be around 9% based on the price earning ratio (PER) at the time of prohibition of short selling in 2008 and 2011.” This result shows that short selling has caused a lot of damage to the stock market in the past. Short selling still has many problems, which especially damages retail investors. Therefore, it is premature to resume short selling and the stock market should be protected from short selling for the time being.
First, short selling is an unfair system that put retail investors at a disadvantage. Many people, especially small investors, have described short selling as an “uneven playing field.” In fact, according to the “Financial Investment Services and Capital Market Act”, anyone can make a short sale. But the reality is quite different. Short selling by retail investors and by institutional investors does not take place under equal conditions. To make a short sale, borrowing stocks is the first step. The method of borrowing stocks is divided into securities lending for institutional and foreign investors and stock lending for individuals. The problem is that the latter’s lending conditions are at a disadvantage from the former. Lending periods for securities lending are usually six months to one year, while for stock lending are only 30 to 90 days. On the contrary, lending fees are higher in stock lending (5% or more) than in securities lending (1~4%). This means that while institutional investors pay fewer fees and earn profits by short selling transactions within a long period, individuals are likely to not be able to sell borrowed stocks due to the short lending period while paying higher fees. Also, prospecting a fall in stock is more difficult for retail investors whose funding and information power are much lower than institutional investors. As a result, the share of individual investors in short-selling transactions is minimal. According to the data from the Korea Exchange, the proportion of retail investors in short selling transactions in Korea’s stock market in 2020 is only 1.2%. In short, short selling in Korea is exclusive to institutional and foreign investors.
Second, short selling has many side effects, but regulations on them are weak. The first problem is price manipulation. Unlike general transactions, short selling is profitable when stock prices fall. This structure can lead some investors to intentionally manipulate the entity’s share price. The Nasdaq-listed hydrogen truck company Nikola Corporation saw its share price plunge after a short seller Hindenburg Research revealed serious allegations of fraud at the company. This has led to heavy losses for Nikola stock investors. The second problem is default risk. The borrowed stock should be redeemed. But if the stock price does not fall but rather rises after the short sale, the repayment burden of short sellers may increase since their loss has increased. The default risk increases when it is naked short selling. Naked short selling refers to short selling without borrowing stock. In other words, the short seller deals with the buyer based only on the possibility that one “can borrow the stocks later.” Because of its high risk, naked short selling has been prohibited since 2000 in Korea. However, it is difficult to prevent naked short selling due to weak surveillance and punishment. First of all, there is no real-time monitoring system to monitor illegal short selling. Democratic Party lawmaker Park Yong-jin pointed out that “There were 14,000 suspected cases of illegal short selling in August last year. But the system for monitoring illegal short selling is still not computerized and adheres to traditional handwriting methods such as messengers. So, it is difficult to determine whether they are illegal.” Meanwhile, punishment for illegal short selling is insufficient. If the illegal profits from violating the Capital Markets Act are less than 500 million to 5 billion won, they will be punished with up to three years in prison and more than five years in prison if they are more than 5 billion won. However, punishment for illegal short selling is only up to one year in prison or a fine equivalent to three to five times the illegal profit.
Third, resuming short selling cools the local stock market, which negatively affects the overall national economy. If short selling resumes, stock price volatility increases, which damages retail investors. As the popularity of stock investing has increased recently, retail investors, called “gaemi,” or ants, are now more powerful than ever before in the stock market. However, one danger is that the credit loan, which invests in stock through debt, is also increasing. Credit loans reached a record high of 21.2 trillion won as of January 6th. Such leverage investments pose a significant risk of increasing the investor's repayment burden if the share price falls due to the resumption of short selling. At the macro level, the decline in stock prices due to the resumption of short selling dampens investor confidence. What’s good about a boom in the stock market is that more people are willing to invest in stocks, and the money flocks into the capital market. If market liquidity is injected into productive investments, not unproductive things such as real estate, corporate activities will be promoted, which can lead to job creation, and finally develop the national economy. This is why the government and many people celebrated KOSPI’s closing above 3,000 points for the first time. If the stock market falls due to a hasty resumption of short selling, however, it could reduce public investor confidence and will eventually stagnate economic development.
Short selling has many problems, and many things need to be improved. Fixing the problematic system comes first. It is not right to simply reimplement it as it was. In particular, if the most essential problem of the "uneven playing field" that alienates retail investors is not fixed, the resumption of short selling will continue to face a lot of opposition in the future. It is contradictory to maintain a system that is disadvantageous to people while encouraging them to participate in the capital market for national development. It is not too late to resume short-selling when the capital market, which has risen so rapidly, becomes more stable and the effect of improving the short-selling system is revealed.