The Financial Supervisory Service (FSS) has uncovered common illegal short selling practices by a global investment bank (IB) for the first time.
According to the announcement from the FSS on Oct. 15, a Hong Kong-based global IB, hereinafter referred to as Company A, submitted short selling orders without borrowed shares worth approximately 40 billion won (US$29.55 million) for 101 different stocks, including Kakao, during the period of September 2021 to May 2022.
Short selling involves borrowing shares, selling them, and then buying them back to repay the loan. Selling shares without borrowing them first, a practice known as “naked short selling,” is illegal under current regulations.
This is the first time regulatory authorities have uncovered systematic and deliberate illegal short selling, rather than mere errors or mistakes. The illegal short selling amount identified across the two IBs is estimated to be worth 56 billion won, resulting in the largest-ever anticipated fines in history.
Another Hong Kong-based company, Company B, submitted naked short selling orders worth approximately 16 billion won (US$11.82 million) for nine different stocks, including Hotel Shilla, during the period of August 2021 to December 2021.
This case differs from previous instances of discovery in the sense that it involves an extended period of illegal short selling by global IBs. While prior uncovered naked short selling was attributed to one-time errors or mistakes made by end investors such as foreign institutional investors and hedge funds, this time it reveals intentional illegal activities by global IBs that facilitate short selling operations for these end clients.
These global IBs operate as Prime Brokerage Service (PBS) providers, mediating orders from end investors looking to engage in short selling. PBS offers comprehensive financial services to clients, including individuals, institutions, and hedge funds, involving securities lending, borrowing, intermediation, credit provisioning, and over-the-counter derivative contracts. When foreign institutional investors seek to short sell domestic stocks, they often enter into swap agreements with IBs.
From an IB perspective, submitting sell orders directly would expose them to risks related to price fluctuations. To manage the risks, they appear to have submitted short selling orders in the same quantity in the market. In this process, it seems they have continued with illegal naked short selling, where they short sell without initially borrowing shares and subsequently cover by borrowing the next day. This is possible due to the three-day settlement system, allowing trades to be completed as long as they are bought back by the next day after the trading day.
Company A borrowed stocks through internal interdepartmental lending. It did not retain records of the borrowed stocks. It submitted sell orders based on an overstated balance from the double-counting of owned stocks. Even though the company realized the shortage in settlement quantity on the day following the trading, it did not take corrective action and continued to follow the traditional post-borrowing method, essentially allowing the illegal activity to go unaddressed.
Company B engaged in short selling based on the “quantity available for borrowing” rather than “confirmed borrowed stock quantity” in an effort to manage the risks associated with sell swap agreements for foreign institutional investors. It forcefully proceeded with short selling based on this. The company also followed the practice of confirming borrowing agreements based on the final short selling quantity after the fact, essentially allowing the illegal activity to persist.
It has been revealed that not only global IBs but also domestic securities firms that handle their orders have tolerated illegal short selling. The foreign securities company based in South Korea, affiliated with Company A, continued to execute Company A’s naked short selling orders.
The company consistently shared information on the consigner, short selling prices, and borrowing details daily. Despite ongoing balance shortages during the settlement confirmation process, it continued to press for settlement. Throughout this process, it did not take steps to investigate the root causes or implement preventive measures.
The FSS anticipated that the largest fines would be imposed on global IBs since the introduction of the penalty system. The exact amount of the fines will be determined through the deliberation and decision of the Securities and Futures Commission under the Financial Services Commission (FSC).
The FSS has emphasized its serious stance regarding global IBs that, despite a clear understanding of domestic regulations, allowed illegal activities to persist over an extended period. Furthermore, the FSS has outlined plans to strengthen inspections not only for IBs conducting similar activities but also for domestic securities firms that receive orders from global IBs.
The FSS is currently investigating certain IBs for violating the Capital Markets Act, such as selling more shares than their ownership quantity before the market opens, for a long time. In the case of domestic securities firms, there is a possibility that their relationships with affiliate companies and fee income could lead to tolerating the illegal actions of clients. Therefore, the FSS plans to examine the process of short selling order execution and assess the ability to identify illegal short selling orders.
The regulatory authorities have expressed their willingness to cooperate with foreign supervisory agencies when necessary. The FSC and the FSS have recently collaborated with the Securities and Futures Commission (SFC) in Hong Kong, actively engaging in international cooperation by sharing information and verifying the sources of funds. A representative from the FSS stated, “Despite efforts to create a favorable investment environment for foreign investors, we have detected violations and we need strict measures and prevention of further incidents.”