[Opinion] Five 'Facts' That Should Underpin the Short Selling Debate

Professor Seong Hee-hwal, Inha University School of Law

The short-selling situation is unfolding in an unusual way. In response to the unprecedented COVID-19 crisis, short-selling was temporarily banned for six months starting in March 2020. Last September, the ban was extended for another six months. However, as heated debates continue?ranging from politically driven calls for further extensions to investor petitions demanding a permanent ban?the issue of short-selling, which was initially a minor concern within the financial sector, has now become a political issue beyond the financial world. Furthermore, when the IMF recommended resuming short-selling, investors reacted strongly, calling it interference in domestic affairs. Across the Pacific in the United States, a large-scale short-selling of GameStop stock by hedge funds led to a war-like confrontation, with 2 million individual investors uniting to counterattack through buying, escalating the debate to congressional hearings. Having observed the securities market for over 30 years, I have never seen short-selling debates unfold on such a grand chessboard as now.

Whether the short-selling ban is extended, resumed immediately, or permanently prohibited, this debate could be a turning point for short-selling regulation. To ensure it does not lose its way and reaches a desirable outcome, it is essential that the discussion proceeds rationally based on fundamental facts that everyone can agree upon. Confucius said, “Even if many people hate it, one must examine it; even if many people like it, one must examine it” (Analects, Wei Ling Gong chapter). For a calm and rational decision, this article aims to present five ‘facts’ that should serve as the starting point and premise of the discussion.

First, the short-selling system has been sufficiently recognized for its role and function throughout 420 years of global securities market history. In fact, it is remarkable that short-selling is even allowed. Only short-sellers favor it; investors, companies, and governments all dislike it, yet it has persisted through a long history. Why is that? Because short-selling plays a significant role in targeting false information such as window dressing and stock price manipulation, and by acting as a counterbalance to margin buying, it helps maintain market equilibrium and contributes to rational price discovery. Rational price discovery is the fundamental reason for the existence of markets. Historically, not only the Netherlands, which was the first country to ban short-selling in 1610, but also the UK and France banned it for decades at times, yet all eventually reinstated short-selling after recognizing its positive functions. It is a system that has passed the test of time.

Second, short-selling is a globally widespread system. Almost all countries with securities markets allow short-selling, and during the COVID-19 crisis, most countries did not ban short-selling. Among those that did impose bans, only Korea and Indonesia have maintained them so far.

Third, if short-selling is not allowed, a significant portion of foreign investors may withdraw. Foreign investors have a major impact on our economy and securities market, which have experienced national default risks due to foreign exchange shortages. The government has made long and strenuous efforts to join major indices like FTSE and MSCI, which greatly help attract foreign investment. If Galapagos-style regulations that do not exist in major countries persist, foreign investor withdrawal could increase the Korea discount.

Fourth, above all, Korea is one of the most strictly regulated countries in the world regarding short-selling. Last September, the government and National Assembly agreed to extend the ban for six months on the condition of improving short-selling issues, and accordingly, the Capital Markets Act was passed, significantly strengthening penalties for short-selling violations. Now, violations can be punished with imprisonment of more than one year and fines ranging from three to five times the amount involved. Additionally, financial authorities have introduced administrative fines corresponding to the amount of short-selling orders, which are effectively more severe than penalties for unfair trading such as stock price manipulation. Under current law, short-selling using undisclosed information is treated as insider trading, and short-selling for price manipulation is punished as market manipulation. The newly established short-selling penalty provisions apply to simple short-selling orders made by mistake, but the penalties are harsh relative to the blameworthiness of the act.

Compared internationally, only Hong Kong imposes criminal penalties for naked short-selling, but even then, the sentence is light?up to two years. Japan only imposes a fine of 300,000 yen for illegal short-selling. The often-cited example of the United States, where penalties can be up to 20 years imprisonment, is misleading. The 20-year imprisonment clause in Section 32 of the U.S. Securities Exchange Act is a general provision setting the maximum penalty for all violations of the Act and is not specifically for short-selling violations. In fact, there are no known cases of criminal punishment for short-selling violations. Moreover, unlike Korea, the U.S. has essentially abolished the uptick rule (which prohibits short-selling at prices below the last traded price), an important mechanism to prevent price drops caused by short-selling orders.

Fifth, the opposition of individual investors to short-selling is also well-founded. Their hostility stems not only from a primal fear of price declines but also from dissatisfaction with unequal opportunities?where 1% have advantages over 99%?and the use of undisclosed information by institutions and foreigners. Therefore, the government should strive to expand short-selling opportunities for individual investors as much as possible and, through thorough investigations of large-scale short-selling just before significant disclosures, clearly determine whether undisclosed information was used, thereby restoring trust among individual investors.

David Hume said, “Reason is the slave of the passions,” and the current short-selling situation appears to be a passionate reaction. I hope that the overwhelming dominance of passion in this debate will be somewhat alleviated.

Seong Hee-hwal, Professor, Inha University School of Law