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. Short selling is a trading strategy that involves borrowing and selling stocks expected to decline in price.

The halt, initially set to last until June, has been prolonged to March next year. The regulators are to enforce a complete reform of the system to "level the playing field" between retail and institutional investors.

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, falling below 2,500. It wrapped up at 2,535.93, down 8.35 points or 0.33 percent from the previous trading day.

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 nation's short selling ban may not have led to an immediate exodus of foreign funds on the stock market, the limit still puts pressure on foreign investors, experts said.

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

Kim explained many hedge funds have already left the local market to use long-short strategies, an investment tactic that involves short selling.

“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."

System reform

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 after the ban slated to last until March.

Under the new guidelines, 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 oversee all sell orders placed by institutional investors.

The new guidelines also require both institutional and corporate investors to designate a division dedicated to monitoring compliance with short sale activities.

Excessive hostility?

Though the short selling practice is on pause, 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 company claimed the order was mistakenly placed, an over 1 billion won fine was assessed.

Kepler Cheuvreux filed a lawsuit concerning the penalty, and the local court ruled in favor of the asset manager in August. 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.