[The Editors' Verdict] System Reform, Design, and the Resumption of Short-Selling

There are various opinions regarding the temporary resumption of the short-selling ban. On one hand, some argue that since stock prices have risen sufficiently, short-selling should be resumed; on the other hand, some believe that before resuming short-selling, several issues need to be addressed. The government seemed inclined toward resuming short-selling but recently there are signs of extending the ban. So, why do individual investors fear short-selling?

When prices surge dramatically in some short-sold stocks, the entities that short-sold suffer significant losses. Conversely, short-selling continuously pushes prices down, which may fail to reflect fundamentals and future value, thus impairing the price discovery function. The overall domestic stock market has risen rapidly amid the resurgence of COVID-19, raising concerns about overheating. However, considering South Korea’s economic growth rate over the past decade, it is not a bubble.

The decision to resume short-selling must be designed with systems and regulations suitable for the domestic market. There are several points to review. First, South Korea’s short-selling system uses a T+2 settlement cycle. It allows short-selling of stocks not held, provided settlement occurs within two days, which prevents issues. This system does not exist in the U.S. In the U.S. and Canada, the settlement date is the same for stocks and foreign exchange markets. Since global financial markets operate 24 hours with time zone differences, the settlement dates in the U.S. and Korea cannot be the same. Therefore, the solution must come from systems, technology, and collective intelligence.

Second, the current South Korean short-selling system allows short-selling without margin requirements, which can be improved through regulation. That is, by imposing margin or certain qualifications, individual participation could be allowed for fairness. However, individuals who meet these qualifications tend to be “super ants” rather than ordinary investors. Therefore, the current short-selling system should introduce a margin system while keeping the individual investor proportion small and gradually expanding it.

Third, South Korea’s short-selling has no fixed repayment period, whereas the U.S. does. In South Korea, the short-selling repayment period is two months for domestic investors and one year for foreigners. This period can be extended through agreements with the lending institutions. Consequently, foreigners account for a high proportion?65%?of short-selling transactions in the domestic stock market, which may harm individual investors.

Individual investors are aware that despite the current short-selling ban, many stocks are still being short-sold. This is due to the market maker system that supplies liquidity to stocks with low trading volume. Although the total amount of market maker activities is being reduced, in 2020, market maker stocks numbered 666 in KOSPI and 173 in KOSDAQ, totaling 839 stocks. However, institutions also incur costs and thus do not prefer this. If individual investors also dislike short-selling, it may be necessary to boldly reduce or even abolish certain stocks.

Post-processing of illegal short-selling must also be institutionalized. Individual investors frequently witness illegal short-selling, but it is rarely detected or penalized. Recently, penalties for illegal short-selling have been imposed within the range of the short-selling order amount, and criminal penalties have been introduced, but the severity is relatively low. In the U.S., illegal short-selling can result in up to 20 years imprisonment, and in France, fines can be up to ten times the unfair gains. Mistakes or errors causing market disruption should also be included.

Professor Kim Sang-bong, Department of Economics, Hansung University