In today’s Finshots, we tell you why South Korea keeps banning short-selling and if these bans are justified or not.

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The Story

South Korea just banned short-selling. Again!

We say ‘again’ because they did it when the pandemic struck in 2020 and their stock market nosedived. They did it when the global financial crisis in 2008 led to a massive drop in the market. And they even imposed a ban in 2011 during the European Debt crisis.

South Korea simply does not seem to like short-selling.

But wait…what’s this short-selling we’re going on about?

Okay, let’s say you’re feeling pretty positive about the economy and by extension the stock market. You think companies will improve earnings quickly and their share price will zoom.  What will you do? You’ll simply buy the stocks you prefer, right? It’s simple.

But let’s say you’re feeling pretty gloomy about the economy. You sense that a fall in stock market is imminent. You might choose to withdraw your investment and sit on the sidelines. That way you can protect yourself from a loss. But how do you profit from this? Well, that’s where the practice of short-selling comes to the fore. All you need to do is borrow the stock from brokers and sell first. If and when the price falls, you simply buy it back at a lower price, pocket the profit and give the stock back to the broker. If the prices rise instead and your bet turns sour, well, you lose money. But hey, that’s the risk you take when you trade.

Now we get why regulators might want to ban a practice like this during a financial crisis. The stock markets will be imploding and most investors will be losing money hand over fist. If you give short-sellers a chance to indulge in their trades, it could exacerbate the collapse even further. The bloodbath could continue. So to slow down the crash, regulators might step in with these special bans.

But why on earth is South Korea doing it now? And why is the ban in place till June 2024?

Well, they’re claiming that they’re doing it to prevent an illegal practice ‘naked’ short-selling. Now naked short-selling is pretty much the same as short-selling but with a difference — in this case, the broker doesn’t check whether the stock is available for borrowing in the first place. He just assumes it is available. And things can get quite messy when it comes time for the traders to buy back the stock and return it. They’ll have to scramble to find the requisite quantity of stock. If not, the risk might even fall on the broker.

Now most countries don’t allow such a practice anyway because of this risk. But, sometimes people might still end up taking such trades. And as per South Korean financial regulators, some global investors seem to be indulging in such a practice. They claim it is an intentional effort to hurt the stock market.

But not everyone thinks that’s the real reason. After all, there’s no financial crisis brewing even with these naked short-sellers. So why not just find them and fine them?! Well, we don't know. This is why some people believe the ‘naked’ short-selling rationale might just be a smokescreen. Rather, they claim it could be a politically motivated move.

You see, South Korea’s gearing up for its election in April. And as per Reuters, retail investors have become a key voting bloc. Retail stock trading accounts have doubled in the past half a decade. And today, 1 in 5 Koreans have a trading account. Now the thing is, most retail investors don’t like short-sellers. It’s usually the big institutional investors who do most of the short selling and that could put the retail investors on the back foot. They’ve protested against these short-sellers in the past too. Also, people believe that short-sellers are betting against the success of a company or even the country. And no one likes that. So by banning short-selling, the regulator simply seems to be playing to popular sentiment.

But this begs the question — are short-sellers really a toxic presence in the stock markets?

Well, the short answer is No!

Remember the collapse of Enron, the American energy giant? Well, it was Jim Chanos, a popular short-seller who pointed out that there could be an accounting fraud brewing at the company. And that led to the company’s downfall. Now Chanos could do it because he had an incentive — he could short-sell the stock and make massive profits if proven right. But if the entire practice of short-selling is banned, no one will bother to do the hard work and unearth fraudulent practices at companies. And the dubious company could keep fleecing naive investors.

Now that’s just a singular example. Think of this on a larger level. Without people shorting the market and asking questions, the market simply could keep rallying or heading north. Eventually, it could create bubbles. And that will only hurt retail investors even more when the eventual crash comes. Heck, in 2021, even the IMF asked South Korea to rethink its short-selling ban. The IMF basically said that short-selling is required so that “investors are more sensitive to risks.” Or put another way, markets need short-sellers so that investors don’t get complacent about a market rally and that they don’t burn their fingers.

Maybe South Korea needs another reminder about this from the IMF now?

Until then…

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