The financial authorities have played a strong hand with a “full prohibition of short selling” to restore market trust. Unlike the global trend during the COVID-19 crisis, this time, South Korea alone has moved to prohibit short selling, drawing significant attention to the rationale behind this decision.
On Nov. 5, in an emergency meeting, the Financial Services Commission announced that “due to repeated detection of illegal, unwarranted short selling by foreign and institutional investors, concerns over the fair formation of domestic stock market prices are very high.” Thus, from Nov. 6 until June 30 of next year, short selling will be banned in all domestic stock markets, including the main Korea Exchange, the KOSDAQ, and the KONEX markets. The ban excludes certain cases, such as market makers and liquidity providers, where there is no concern about destabilizing the market. Additionally, the Financial Services Commission revealed on Nov. 6 that they have launched a “Special Investigation Team on Short Selling” to conduct a thorough investigation of global investment banks and strongly penalize any illegal short selling.
This prohibition marks the fourth time in the history of Korea’s stock market that short selling has been banned. The government first suspended short selling for eight months during the 2008 financial crisis, then halted it again for three months during the 2011 European fiscal crisis when the global economy was impacted. The third suspension came in March 2020, as markets plunged amid the COVID-19 crisis.
Authorities have been allowing short selling in a limited capacity since May 3, 2021, only for the KOSPI 200 and KOSDAQ 150 index stocks. This new comprehensive ban effectively pushes back the full resumption of short selling by over four years.
Originally, the authorities maintained that a full resumption of short selling was inevitable. The argument was that South Korea’s short selling regulations were more stringent than those of major overseas countries, and to align with global standards, a full resumption, rather than a suspension, of short selling was necessary.
However, the atmosphere changed when the Financial Supervisory Service recently uncovered intentional illegal naked short selling by global investment banks such as BNP Paribas and HSBC, involving tens of billions of won. This lent credibility to the long-standing claim that short selling has been an uneven playing field favoring foreign and institutional investors over individual ones.
Calls for a full ban on short selling began to grow once again. Over 50,000 individual investors petitioned the National Assembly for regulatory reform, and the ruling People Power Party began to drive the complete prohibition ahead of general elections.
Faced with intense pressure, the authorities rapidly shifted their stance. Kim Joo-hyun, chairman of the Financial Services Commission, said during the comprehensive audit of the National Assembly’s Political Affairs Committee on Oct. 27, in response to an inquiry by Yoon Chang-hyun, a member of the People Power Party, that a temporary full suspension of short selling is necessary. “We will pursue all necessary system improvements from scratch,” he declared, and this measure was announced less than ten days later.
The authorities have clarified that the ban was set in place because illegal short selling undermines fair market price formation and erodes trust. They added that the decision was made in consideration of whether the short selling was impeding market stability and fair price formation, according to Article 180 (3) of the Capital Markets Act.
Chairman Kim stated in a Q&A session following the briefing that “We cannot maintain trust in the Korean capital market by leaving the habitual illegal activities of major institutional investors unchecked. Rectifying this issue is our duty and could become a crucial turning point for the long-term development of our capital markets.”
Nevertheless, the industry is concerned that this measure might instead diminish the credibility of the Korean stock market and trigger an exodus of foreign investors. Critics also argue that this could further distance South Korea from the inclusion in the Morgan Stanley Capital International (MSCI) Advanced Country Index as it fails to ensure a free trading environment.
Chairman Kim responded, “While we of course consider global trends, it’s difficult for our country’s capital market to develop healthily without rectifying this unique situation. In the medium to long term, (after the prohibition and system improvements), this will actually be more beneficial for foreign investors.”