[Endless Short Selling Controversy] ② Volatility Mitigation Benefits vs Prior Institutional Reform Before Full Resumption

Stock Market Volatility Increases, Calls for Full Resumption of Short Selling Grow
Capital Market Research Institute: "Short Selling Ban Increases Stock Price Volatility and Frequency of Sharp Declines"
Issues Like 'Tilted Playing Field' Favoring Foreign and Institutional Investors Persist

As volatility in the domestic stock market increases, voices advocating the necessity of short selling are gradually growing despite fierce opposition from individual investors. Experts unanimously agree that a full resumption of short selling is necessary to allow its positive functions to operate, based on empirical analysis results showing that market volatility increased after a complete ban on short selling but partially decreased after its partial resumption. However, there is also a strong call for institutional reforms to establish a rational market structure before this can happen.

Most Stocks Related to Price Crash Incidents Were Subject to Short Selling Ban

As stock prices plummeted amid the spread of COVID-19, financial authorities completely banned short selling of listed stocks on March 16, 2020. Subsequently, as the market rebounded and volatility eased, short selling was resumed only for stocks included in the KOSPI 200 and KOSDAQ 150 from May 3, 2021.

However, as market volatility increased this year due to price crash incidents in some stocks and concentration in theme stocks, calls for a full resumption of short selling have grown. Most of the stocks that experienced price crashes were subject to short selling bans. On June 14, five stocks?Dongil Industry, Daehan Textile, Manho Steel, Banglim, and Dongil Metal?that hit their lower price limits were all banned from short selling. Earlier, during the La Deok-yeon gate in April, among the eight stocks that hit their lower price limits en masse, five stocks including Daesung Holdings, Sebang, Samchully, Seoul Gas, and Daol Investment & Securities were also banned from short selling.

Experts believe that if the positive function of short selling operates on stocks that steadily rise without special reasons, it can somewhat curb excessive price surges. This implies that if short selling had been fully allowed, price manipulation groups would have felt burdened. In fact, during the La Deok-yeon gate, among the eight stocks hitting their lower price limits, Daou Data and Harim Holdings, which were allowed short selling, had fewer occurrences of hitting the lower limit and recovered their prices faster than other stocks.

Short selling refers to borrowing stocks that one does not own and selling them, then buying the actual stocks after a certain period to return them. It is a method of borrowing stocks expected to decline in price, selling them, and then repurchasing them at a lower price to earn a profit. Because of this, short selling has the positive function of preventing bubbles in overvalued stocks and helping find appropriate prices. Junseok Kim, Senior Research Fellow at the Korea Capital Market Institute, explained, "Short sellers discover negative information and reflect it in stock prices, thereby reducing the possibility of accumulation of negative information," adding, "Short selling has predictive power for stock price declines, and easing short selling restrictions has been analyzed to reduce the likelihood of stock price crashes."

Short Selling Ban Lowers Price Efficiency and Increases Volatility

Recent research has shown that the ban on short selling during the COVID-19 period lowered price efficiency in the domestic stock market and shrank market trading. This provides grounds for emphasizing the importance of strengthening detection of unfair trading such as naked short selling rather than banning short selling outright.

The Korea Capital Market Institute conducted an empirical analysis of the effects of short selling regulations by comparing the top 20% and bottom 80% of stocks by trading volume during 120 days before and after the full ban on short selling. The results showed that "price efficiency consistently declined regardless of the measurement indicator after the full ban on short selling, and volatility and the frequency of extreme returns increased." It added, "Especially, the increase was significant in volatility and the frequency of extreme positive returns when returns were positive, suggesting that short selling restrictions failed to effectively resolve stock overvaluation."

Before the short selling ban, the top 20% of stocks generally had higher price efficiency, lower volatility, and higher liquidity than the bottom 80%. However, after the ban, the difference between the two groups narrowed or reversed. Stocks with a high proportion of short selling experienced increased volatility and frequency of extreme returns more than other stocks after the ban. Additionally, volatility and frequency of extreme negative returns increased simultaneously when returns were negative.

The Korea Capital Market Institute stated, "After the partial resumption of short selling, volatility and the frequency of extreme returns decreased in resumed stocks, and turnover rates increased," adding, "Short selling restrictions did not effectively control stock overvaluation, and the claim by proponents of the short selling ban that 'the ban could reduce the possibility of stock price crashes' was contradicted by the results." Junseok Kim emphasized, "The findings that short selling bans reduce price efficiency, increase volatility, and shrink market trading are consistent with empirical analyses of short selling regulations reported overseas."

Considering the Positive Functions of Short Selling, "Continuous Institutional Improvement"

However, the majority of experts agree that institutional improvements must come first for a full resumption of short selling. The reason the domestic short selling system is criticized as a 'tilted playing field' is that individuals are disadvantaged compared to foreigners and institutions in standards such as collateral ratios and stock repayment periods. Although the Financial Services Commission has supplemented the short selling system, many opinions say it is still insufficient. The financial authorities lowered the collateral ratio for individual investors from 140% to 120%, extended the repayment period from 60 days to 90 days, and allowed maturity extensions. The collateral ratio for foreigners and institutions ranges from 105% to 120%. However, individual investors consider this slight lowering of the threshold ineffective.

The short selling market itself is so dominated by foreigners that it is often called a playground for them. During the approximately 14 months before the full ban on short selling (January 2, 2019?March 13, 2020), foreigners accounted for 57.86% of short selling trades in KOSPI and 74.09% in KOSDAQ. During about one year after the partial resumption of short selling (May 3, 2021?May 11, 2022), foreigners accounted for 74.81% in KOSPI and 66.94% in KOSDAQ. During the same period, individual investors' share was only 1?2%. As of the 13th, foreigners accounted for 70.87% and individuals 1.41% of short selling trades in the KOSPI market. In the KOSDAQ market, foreigners accounted for 75.47% and individuals 1.06%.

The Korea Stock Investors Association pointed out, "(Foreigners and institutions) have virtually unlimited short selling repayment periods, so they can wait until stock prices fall and make guaranteed profits," adding, "Their collateral ratios are also more favorable than those of individuals."

Senior Research Fellow Sewoon Hwang said, "Rather than extreme approaches like a full ban on short selling, the system should be improved to maintain its functions while minimizing side effects," adding, "Detection and punishment of violations or unfair trading should be strengthened, and accessibility should be improved." Professor Junseo Lee of Dongguk University's Department of Business Administration said, "It is necessary to resolve unfairness between individuals and institutions and establish measures to monitor excessive price suppression through short selling." Professor Jun-kyung Ha of Hanyang University's Department of Economics also said, "Short selling has positive functions, but issues like the tilted playing field should be improved by referring to advanced countries' cases." Democratic Party lawmaker Byungwook Kim said, "The discriminatory short selling mandatory repayment period set at a maximum of 90 days for individuals but unlimited for foreigners and institutions should be improved," adding, "In Japan, collateral ratios are the same for all investor types."

Although financial authorities have stepped back due to individual investors' backlash, their stance on the full resumption of short selling remains unchanged. Vice Chairman Soyoung Kim of the Financial Services Commission said, "The full resumption of short selling should be done in the mid to long term," adding, "However, the exact timing of resumption will depend on ongoing market conditions." Deputy Director General Jeongtae Kim of the Financial Supervisory Service's Disclosure and Investigation Division said, "We are well aware of the various controversies regarding the necessity of short selling and its impact on the market, and the authorities are carefully considering and reviewing issues related to the resumption of short selling," but added, "Illegal short selling must be eradicated, and efforts to improve investors' perceptions should precede."