November 21, 2024

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An electronic board shows the benchmark Kospi starting at below 2,500 at a dealing room of the Hana Bank headquarters in Seoul on Monday. (Yonhap)

While South Korean regulators maintain a wary eye against short selling, the prolonged ban and imposing stricter guidelines on the practice could drive foreign investors away from the local equity market, experts said.

Following heavy market fluctuations, local regulators enforced a complete ban on short selling in November. The halt, initially set to last until June, has been prolonged to March next year with a complete reform on the system.

Though the ban did not lead to a massive capital outflow, the local stock market remains volatile. Foreign investors pulled out 4.76 trillion won ($3.55 billion) from the Kospi in August and the first week of September. Coupled with the rising uncertainties in the US economy, the Kospi plunged to as low as 2,491.3 points during intraday trading Monday.

The chief of the Financial Services Commission, the top regulator here, assessed that foreign investors “understand” the halt on short selling, and the reform could lead to a better investment climate.

"Foreign investors understand the prolonged ban on short selling," FSC Chairman Kim So-young told the press in June. "They could increase their investments if a transparent market order is maintained after the reinstatement of the short selling practice.

Pressure on foreign investors

Though the execution of the short selling ban did not result in a massive exodus of foreign funds, the limit still puts pressure on foreign investors.

“No system can be operated perfectly,” Kim Dong-eun, head of wholesale at Korea Investment & Securities, said at an event in June.

“Many hedge funds in Korea have already left the local market to use the long-short strategies,” she said. Long-short equity strategies involve buying long positions in stocks expected to increase in value and short selling stocks expected to depreciate.

“As it has been a while since they pulled out of the Korean stock market, it could be overwhelming for them to return to the local market.”

The short selling ban also hinders Korea’s push to win a stock index upgrade from Morgan Stanley Capital International to secure capital flow from global institutional investors. The index operator commented that sudden changes in market rules are not “desirable,” referring to the short selling ban.

“Short selling is a tool that has its merits on the stock market,” a local researcher said on condition of anonymity. Short sellers are considered to contribute to price discovery by reducing divergence from fundamental values.

"The practice is somewhat misunderstood here," the researcher said. "Changes in the short selling measure make the local stock market unreliable for foreign investors."

Reform in March

In August, the FSC released detailed guidelines on short selling, requiring institutional investors to keep up with the measures to participate in trading when it resumes.

Under the new guidelines aiming to “level the playing field,” institutional investors must set up their own electronic short sale processing systems. They have to manage the balance of stocks available for short sale in real-time to prevent naked short sale orders.

The Korea Exchange, the country's sole bourse operator, is to set up a central monitoring system to monitor all sell orders placed by institutional investors.

The new guidelines also require all institutional and corporate investors to designate a division to monitor compliance with short sale activities.

'Excessive' hostility

Though the short selling practice is set to return in March, local authorities have yet to lower their guard against the practice.

For instance, Paris-based asset manager Kepler Cheuvreux was accused of a naked short selling charge for a sales order placed in 2021. Though the foreign asset manager claimed the order was mistakenly placed, a fine was assessed by the Securities and Futures Commission under the FSC in 2023.

Kepler Cheuvreux filed a lawsuit concerning the penalty, and the local court ruled in favor of the asset manager in August, recognizing the order was mistakenly placed. The FSC is to appeal.

“A misplaced order could be considered as naked short selling here, which is associated with a heavy fine and sanctions," a foreign investor said in a report issued by the Korea Capital Market Institute in June.

"The regulations are to protect investors and ensure market stability, but from the perspective of foreign financial firms, the extent is excessive.”

Kepler Cheuvreux did not respond to a request for comment.

Another official from a global investment bank said it is not easy for investors to speak up about the system, as short selling is considered a sensitive subject here.

“Short selling is a controversial topic in Korea. Different groups of investors have very different perspectives on the subject,” the official said.

By Im Eun-byel (silverstar@heraldcorp.com)