Short-selling ban sparks biggest rally in Korean stocks since 2020

South Korean stocks soared after the country reimposed a full ban on short-selling, a controversial move that regulators said was needed to stop the illegal use of a trading tactic deployed regularly by hedge funds and other investors around the world.

The nearly eight-month ban may help appease retail investors who have complained about the impact of shorting — the selling of borrowed shares by institutional investors — ahead of elections in April, several market watchers said. However, it could deter participation by foreign funds in the $1.7 trillion equity market and complicate Korea’s bid to seek a developed-market status in MSCI Inc.’s indexes.

The Kospi ended the day up 5.7% to cap its biggest gain since March 2020 amid a surge in trading volumes. Overseas investors were big buyers on a net basis, indicating that funds were covering short positions. Stocks that had recently witnessed an increase in short selling — including LG Energy Solution and Posco Future M — were among the biggest contributors to the benchmark’s advance. The small-cap Kosdaq Index jumped 7.3%.

The Financial Services Commission said on Sunday that new short-selling positions will be prohibited for equities on the Kospi 200 Index and Kosdaq 150 Index from Monday through the end of June 2024. The decision doesn’t impact existing positions. While pandemic-era curbs on the practice had been lifted for those two gauges in May 2021, the ban had remained in place for some 2 000 stocks.

“This policy reversal with respect to short selling is unwarranted at the current time,” said Wongmo Kang, an analyst at Exome Asset Management. “Many people view it as a political move aimed at next year’s general election,” he said, adding that the Korean market tends to be “heavily influenced by retail investors.”

South Korea is set to conduct general elections for the National Assembly in April and public perception of short-selling remains deeply negative in the nation. Some ruling party lawmakers had urged the government to temporarily end stock short-selling in response to demands by retail investors, who have staged protests against the tactic from time to time and also made sporadic coordinated attempts to drive gains in stocks targeted by short sellers.

Most short-selling in South Korea is conducted by institutional investors. However, it accounts for a tiny portion of the market — about 0.6% of the Kospi’s market value and 1.6% of the Kosdaq’s, according to exchange data.

Naked shorts

Lee Bokhyun, governor of the Financial Supervisory Service, refuted the view that the ban was politically motivated, adding that the suspension was necessary to protect retail investors and improve the short-selling mechanism. The ban was “inevitable to introduce an advanced short-selling system,” he was cited as saying by Yonhap Infomax.

Sunday’s announcement comes just days after the financial watchdog said it plans a comprehensive probe into short-selling trades by global investment banks, with a view to root out the practice of naked short-selling, which is illegal in South Korea. Earlier in October, the FSS proposed the imposition of record fines on two global banks for “routinely and intentionally” engaging in naked short-selling.

The so-called naked variety of the trade involves shorting shares without borrowing them first.

The Kospi surged earlier this year on frenzied buying of electric-vehicle battery names and chip stocks related to the artificial intelligence theme. Concerns over geopolitical tensions and high interest rates reversed the rally in recent months, driving the benchmark into a technical correction and nearly erasing its gain for the year.

The gauge is currently up almost 12% in 2023 versus a 2.6% advance in the broader MSCI Asia Pacific Index. On Monday, the Kospi’s trading volume was 70% higher than the average over the past 10 sessions, according to NH Investment.

The latest ban is “unusual” as authorities are comprehensively prohibiting short selling at a time when there is no major external risk, said Huh Jae-Hwan, an analyst at Eugene Investment & Securities. South Korea had banned short selling during the Global Financial Crisis in 2008, amid the euro-zone debt crisis and the US sovereign downgrade in 2011, and then again during the start of the pandemic in 2020.

While regulators argue that naked short-selling inhibits fair price formation and hurts confidence, some observers say broad outright bans make the market less transparent and therefore less attractive. Some also say the restrictions may keep the market from being upgraded in MSCI indexes.

“It does compromise their status and certainly would hold them back from achieving developed market status,” said Gary Dugan, chief investment officer at Dalma Capital Management Ltd. “Given that there is an immediate ban there will be an initial sharp move higher in stock prices of companies that have had some short selling,” but the impact may be limited given low levels of short positions in the overall market, he said.

A spokeswoman for MSCI said the index provider does not comment on potential future reclassifications. South Korea needs to take the politically sensitive step of fully lifting curbs on stock short selling to ensure inclusion in a key global index, the head of the country’s securities exchange said in an interview earlier this year.

“There is a possibility that international investors may lose trust and opportunity in the Korean market,” Exome Asset’s Kang said. “Without the ability for investors to express a view that markets and individual stocks are ‘mispriced’ to the upside, stock markets lose long-term credibility on the world stage.”