"Resumption of Short Selling: Prioritizing Consensus on Positive Functions and Institutional Improvements"

Publication of Report by Hana Financial Management Research Institute
Short Selling Has a Stabilizing Effect on Stock Prices... Countries That Resumed It Show No Significant Index Decline
Before Resumption, Need to Address 'Tilted Playing Field' Between Individuals and Institutions First

The Korea Stock Investment Association (KOSIA), a private investors' group, is operating buses displaying phrases such as "Abolish Short Selling" and "Dissolve the Financial Services Commission" to campaign against short selling. (Provided by KOSIA) [Image source=Yonhap News]

[Asia Economy Reporter Minwoo Lee] To resume short selling, a system must be established to address the 'tilted playing field' issue between individual and institutional investors that arises in operation, along with building consensus on the positive functions of short selling, according to an analysis.

Hana Financial Management Research Institute diagnosed this in its report titled "The Meaning and Implications of the Stock Investment Boom and Short Selling Controversy." Given that the KOSPI recorded the highest global index growth rate last year and a stock investment boom is sweeping the majority of the public, it argues that preconditions must be resolved before resuming short selling.

"Resuming Short Selling Does Not Lead to Index Decline"

First, it predicted that the market impact of resuming short selling would not be significant. It is difficult to find correlations between stock price fluctuations and the timing of past short selling bans and resumptions, and even in sectors with high short selling ratios, this does not lead to a decline in returns.

In 2009, after the short selling ban was lifted, short selling was concentrated in shipbuilding, utilities, communication services, transportation, and automobile sectors for three months, but except for shipbuilding (-7%), the top four sectors all saw stock price increases. The automobile sector rose 36% during this period, more than double the KOSPI's 15.2% increase. In 2011, short selling was concentrated in shipbuilding, utilities, communication services, hotel & leisure, and transportation sectors for three months after the ban was lifted. Except for communication services and hotel & leisure, all sectors saw stock price increases. Despite having the highest short selling ratio, the shipbuilding sector rose 17%, significantly outperforming the KOSPI's 4.4% increase during the same period.

Kim Wanjung, a research fellow at Hana Financial Management Research Institute, explained, "This reflects that institutions and foreigners actively employed long-short strategies using short selling, not merely 'selling' strategies, but selectively taking long and short positions within sectors, thereby realizing the positive function of short selling as a 'market price discovery mechanism.' Economic and industrial fundamentals and individual company prospects influenced stock prices more than the presence of short selling, and a high short selling ratio did not lead to lower returns."

The report continued this argument by citing overseas cases. As of last month, only South Korea and Indonesia currently prohibit short selling. European countries such as Greece, Belgium, Spain, Austria, Italy, and France banned short selling for about two months around March last year and then resumed it. On the day of resumption, all European stock indices surged. Malaysia also resumed short selling on December 31 last year.

Concerns Over Long-Term Short Selling Ban Side Effects... Need for Consensus on Positive Functions

Moreover, the prolonged short selling ban caused a persistent price gap (basis) between spot and futures markets, increasing profits for arbitrageurs such as financial investors and pension funds, while losses for other market participants like individuals expanded. Considering that large-cap stocks recently heavily bought by individuals can be invested in for price declines through futures, the impact of resuming short selling is judged to be limited. Rather, with individual market participation at an all-time high and strong self-fulfilling expectations, excessive anxiety about resuming short selling itself could increase market volatility.

Research fellow Kim said, "The prolonged short selling ban could distort the market's price discovery function and exacerbate market concentration. Ultimately, the controversy over short selling in Korea is not a market-wide problem but stems from information asymmetry between individuals and institutions, imbalances in securities lending and borrowing markets, and operational system flaws."

Therefore, he emphasized the need for consensus on the positive functions of short selling and communication with market participants for institutional improvements to resume short selling. Due to the weakening of market-making and liquidity supply functions caused by the short selling ban, the 'backwardation' phenomenon (when futures prices are lower than spot prices) in index and individual stock futures has prolonged, increasing volatility and destabilizing price formation processes, underscoring the necessity of resumption.

Resolving the 'Tilted Playing Field' Between Individuals and Institutions Is Essential

On the morning of April 30, 2019, in front of the Government Seoul Office Building, participants from organizations such as the Citizens' Coalition for Economic Justice and the Hope Sharing Shareholders' Solidarity shouted related slogans at a press conference urging a full investigation and eradication of illegal naked short selling.

However, he pointed out that improvements to the current short selling system are essential. Despite regulations against naked short selling (selling without borrowing stocks) and violations of the 'uptick rule' that restricts short sale quotes to above the last transaction price, lax management has led to continued damage cases, necessitating strong institutional measures to eradicate illegal activities.

He particularly stressed the need to address the 'tilted playing field' issue between individuals and institutions in the short selling operation system. Although short selling is not legally restricted for individuals, they conduct lending transactions through securities firms rather than the securities lending transactions used by institutions, resulting in relatively unfavorable lending conditions.

Research fellow Kim explained, "Institutional investors have overwhelming performance compared to individual investors based on cost advantages, a wider selection of stocks, and information power. Concerns that institutions and foreigners would appropriate the gains from individual-led stock price rises upon resuming short selling are also reasons for individuals' opposition. Recent research shows that although short selling transactions are about half the amount of margin trading, the average daily profit was 1.25 billion KRW, approximately 39 times higher, and profits were realized regardless of stock price trends."

This content was produced with the assistance of AI translation services.