Side Effects of Tax Benefits for Market Makers
Securities transaction tax exemptions for domestic institutional investors, which have been adopted to activate stock trading, has the side effect of fueling their short stock selling.
Institutional investors sold more than 2.34 trillion won (US$2 billion) worth of stocks on the main KOSPI market from Jan. 1 to May 3 this year, according to Korea Exchange (KRX) on May 6. Of the total, 1.44 trillion won (US$1.23 billion) worth of stocks were sold through arbitrage trading in program trades.
Arbitrage is the simultaneous purchase and sale of an asset to profit from an imbalance in the price. It is a trade that profits by exploiting the price differences of spots and futures. It means that institutional investors made a large-scale arbitrage trading by purchasing futures and selling spots through computer programs this year. In this case, most of spot selling deals are short selling. In short, an increase in sell arbitrage means a jump in short selling by institutional investors.
The most remarkable aspect here is that institutional investors have consistently recorded large-scale net sales of arbitrage trading, regardless of fluctuations of the KOSPI index, or price changes between spots and futures. Their net sales amounted to 244.80 billion won (US$209.23 million) in January, 211.70 billion won (US$180.94 million) in February, 446.60 billion won (US$381.71 million) in March and 491.40 billion won (US$420 million) in April. This stands in stark contrast with foreign investors who went on a buying spree and selling spree back and forth over the same period.
The problem is that such a trend stood out after 2015 when the government began to give seven South Korean securities companies designated as liquidity suppliers, or market makers, exemptions from securities transaction taxes on their arbitrage trading to promote their transactions. The size of net sales surged to some 8 trillion won (US$6.84 billion) in 2017.
Some point out that the transaction tax exemptions pushed institutional investors toward pursuing a thoroughly pro-sale policy. An official from the investment banking industry said, “One of the problems is that the government did not set the hedge ratio in the process of introducing the transaction tax exemptions.” In other words, it made institutions sell more spots at their discretion than losses from futures purchases. He also said, “It is necessary to thoroughly consider the side effects of the securities transaction tax cuts as they are highly likely to lead to active arbitrage trading by institutional investors.”