The Korea Herald


[Editorial] Naked short selling

Measures to block naked short selling necessary for fairness in stock market

By Korea Herald

Published : May 8, 2024 - 05:30

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The nation’s financial regulator said it has found suspected cases of illegal naked stock short selling at five more global investment banks, bringing the total number of suspected institutions to nine.

The Financial Supervisory Service has been inspecting 14 global investment banks with the largest short selling transactions here after it found last year that BNP Paribas and HSBC had placed naked stock short selling orders worth 55.6 billion won ($40.3 million) between 2021 and 2022.

The FSS, along with the Financial Services Commission, has since imposed a temporary ban on short selling, which is due to expire on June 30.

In January, the FSS said it found illegal short selling orders by another two investment banks.

The combined size of naked short selling orders made by the nine global institutions amounts so far to 211.2 billion won. That amount could rise as the inspection remains ongoing.

The FSS said it has "completed imposing fines (26.5 billion won) on the first two companies that engaged in illegal stock short selling, worth 55.6 billion won, and referred them to the prosecution."

A short seller borrows a stock, sells it and when the stock price falls, buys the stock to return it to the lender. The short seller profits by buying the stock back at a price lower than it had previously been sold for.

Naked short selling refers to the illegal practice of short selling a tradable asset without first borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale.

Naked short selling increases uncertainties in the stock market as failure to borrow the shares under a contractual obligation with the stock lender and the subsequent failure to settle the transaction could cause damage to those who attempted to buy shares from the short seller.

As for the reasons of placing naked short selling orders, the global investment banks cited human error in their balance management systems and a lack of understanding of Korean regulations.

This is what they have been saying for years. One of the reasons the banks keep doing it, either unintentionally or intentionally, is because the fines are not high enough to keep them from seeking huge profits through the illegal activity. There have been calls for heavier penalties on naked short selling and enhanced oversight over securities lending transactions by improving computerized systems.

Naked short selling can be prevented if the contract details when a short seller borrows a stock are recorded in the computerized system.

The FSS last month unveiled a plan to require institutional investors to set up a system where they can place short selling orders only if they have actually borrowed the stocks, with all orders verified by a centralized system. For this to be implemented, the law has to be revised and new systems need to be built, which would take about a year. The lifting of the ban on naked short selling is therefore likely to be deferred.

The FSS also said it plans to hold a meeting with global investment banks in Hong Kong before the end of this month to explain Korea's stock short selling system and possible changes to take place when the temporary ban is lifted.

Stronger penalties are also necessary.

By law, those who attempt illegal naked short selling are subject to a prison term of one year or more, or a fine of up to five times the undue profits gained through the illegal activity. However, there were only fines imposed and no criminal penalties in the 174 cases of illegal short selling identified between 2010 and August last year, 156 of which were committed by foreign investors. An average of about 30 percent of the amount of naked short selling orders have been imposed as fines.

Countries like Canada, Australia and Japan partially or fully restrict naked short selling. It is not banned in the US, UK and China, but their financial authorities are seeking ways to raise the transparency of short selling.

There is no doubt that measures to block naked short selling would raise efficiency and fairness in Korea's stock market and help upgrade its capital markets.