[‘Hot Potato’ Short Selling] ③ Unified Call to Establish a System to Completely Block Illegal Short Selling

Financial Supervisory Service Increases Penalties Including Fines
Individual Investors Demand "Stronger Punishments to Curb Rampant Activity"

Editor's NoteThe Financial Services Commission temporarily banned short selling on all KOSPI and KOSDAQ stocks on March 16, 2020, to reduce stock price volatility caused by the COVID-19 crisis. As the market stabilized, in May 2021, short selling was allowed only on 350 large-cap stocks included in the KOSPI200 and KOSDAQ150 indices. After more than two years since the partial resumption, the Financial Services Commission has indicated its intention to fully resume short selling. The Financial Supervisory Service and Korea Exchange have also voiced a unified opinion that a full resumption of short selling is necessary for the advancement of the capital market. Although authorities have stepped back somewhat due to strong opposition from individual investors, their determination to fully resume short selling remains strong, and the controversy is expected to flare up at any time. Meanwhile, last year’s short selling transaction value reached an all-time high, and the first quarter of this year has also been significant, further increasing dissatisfaction and distrust among individual investors.

Despite intense debates over the pros and cons of short selling, both market experts and individual investors agree that illegal short selling must be completely blocked. Recently, the Financial Supervisory Service detected cases of illegal short selling involving intentional sell orders aimed at driving down stock prices and imposed the first fines. Short selling is an investment strategy where an investor sells stocks they do not own, then buys them back at a lower price to return to the lender, profiting from the price difference. This 'borrowed short selling,' where stocks are borrowed before selling, is not problematic. However, 'naked short selling,' where stocks are sold without borrowing them first, violates the Capital Markets Act and is illegal.

According to the Financial Supervisory Service, the Short Selling Investigation Team, established in August following the launch of a dedicated short selling investigation task force in June last year, has investigated 76 cases of naked short selling and completed actions on 33 cases. The remaining 43 cases will also be sanctioned under a zero-tolerance policy. For 31 cases before the amendment of the Capital Markets Act, fines totaling 2.1 billion KRW were imposed, and for 2 cases after the amendment, penalties amounting to 6 billion KRW were levied. The two cases after the amendment represent the first instances of fines being imposed, marking a significant increase in punishment severity compared to previous fines and warnings.

Although regulators are intensifying efforts to detect and increase penalties for naked short selling, distrust among individual investors remains unresolved. The number of naked short selling violators this year has reached the highest level since 2018. As of the 31st of last month, there were 52 cases of naked short selling violations. Considering that the total number of violators last year was 34, this is a substantial figure. Moreover, the proportion of domestic institutions among violators increased from 10% last year to 27% this year, placing them at the center of the controversy.

The Korea Stock Investors Association (KSIA) estimates that the number of detected naked short selling cases was likely higher in the past. This is because the domestic electronic system automatically executes short selling orders whenever foreigners or institutions press the sell button, and securities firms cannot verify whether a short selling order is borrowed short selling on a case-by-case basis. Jeong Eui-jeong, the KSIA representative, stated, "They claim to have detected naked short selling aimed at driving down stock prices for the first time, but this result is hard to understand," emphasizing, "Our country’s short selling electronic system is structured in a way that makes it difficult to prevent institutions’ naked short selling, so there were likely many such cases before."

KSIA has proposed that for the full resumption of short selling, the following are necessary: ▲investigation of profits from short selling accounts over the past 10 years ▲unification of collateral ratios by investor type ▲standardization of short selling repayment periods ▲establishment of a system to detect naked short selling. Jeong Eui-jeong said, "In 2018, the Financial Services Commission chairman announced plans to establish a naked short selling detection system by the first half of 2019, but even after more than four years, it has not been built," criticizing, "The financial authorities use the excuse that it would cost an astronomical amount, but they have not disclosed the scale of the cost."

There are opinions that the system could be built if the financial authorities had the will. It is suggested that the already operating Foreign Investor Management System (FIMS) could be utilized. This system automatically cancels orders that exceed foreigner limits. However, the financial authorities argue that even if blocked systemically, human intervention can cause errors. A financial investment industry official said, "Building a system to filter out naked short selling involves many cost considerations, so it inevitably takes time," adding, "Strengthening penalties first could be an alternative." However, the official added, "If the illegal gains exceed the fines, it will be difficult to expect the eradication of illegal short selling."

There is also a strong call to strengthen post-transaction penalties because no country currently has a system to preemptively filter naked short selling, and it is impossible to monitor all transactions. Hwang Se-woon, senior researcher at the Korea Capital Market Institute, said, "It is better to block illegal short selling transactions in advance, but monitoring and tracking all transactions is impossible and extremely costly," adding, "Like overseas, penalties should be severe and sentencing standards higher when violations are detected after the fact." Assemblyman Yoon Young-duk urged, "The supervisory authorities must enforce stricter crackdowns to prevent naked short selling, which is prohibited by law, from occurring."