[Free Speech Forum] Retail investors face an uneven playing field ... Short-selling reform is urgent

How many individual investors view short selling positively? In some quarters, calls to abolish short selling are even gaining traction. The reason they have come to see short selling as something evil is that equal opportunities to participate in the market have not been guaranteed. If political populism joins the backlash against short selling itself, we may lose the beneficial functions of short selling for good. That would mean a regression of Korean capitalism.

The short-selling ban, which was implemented after the COVID-19 pandemic on the grounds of preventing turmoil in the stock market, was lifted after an additional six-month extension. Individual investors do not seem pleased by the news. That is because they believe short selling causes stock prices to fall. Short selling is a trading method in which an investor borrows shares, sells them in advance in anticipation of a price decline, and later buys the shares back to return the borrowed stock. Because it is effectively a bet on falling prices, it has given rise to the misunderstanding that it itself drives prices down. There is also a widespread perception that short selling is a money game played by foreigners and institutions using shares they do not even own, and that individual investors suffer as a result.

However, contrary to what many people believe, short selling serves several useful functions in the stock market. First, it allows negative information about a company to be reflected in its price. This helps prevent bubbles and enables the price discovery function to operate efficiently. In addition, short selling supplies liquidity to the market, provides new investment tools, and can be used as a means of hedging risk. These are objective facts proven by empirical research. Nevertheless, people think negatively about short selling because the short-selling system is structurally unfavorable for individual investors to participate in.

Korean individual investors face difficulties from the very first step of borrowing the shares needed for short selling. This is because the channels through which foreigners and institutions borrow shares differ from those available to individual investors. Foreigners and institutions use stock lending transactions, while individuals use retail stock loans. The stock lending transactions used by foreigners and institutions involve borrowing shares directly from institutions such as Korea Securities Finance Corporation and Korea Securities Depository. By contrast, retail stock loans involve borrowing shares through securities firms.

Stock lending transactions are carried out through mutual contracts, often on a one-year basis, and it is relatively easy to extend the contract period, making long-term borrowing possible. By contrast, retail stock loans have a maturity of 90 days, and although extensions are possible, they may not be allowed depending on the securities firm, making them unsuitable for long-term borrowing.

In addition, stock lending transactions cover all of the roughly 2,000 listed companies, whereas retail stock loans are limited to KOSPI 200 and KOSDAQ 150 stocks. Even among those, most of the shares available for retail lending are concentrated in a small number of large firms, making borrowing even more restricted. There is also a very large difference in collateral requirements: 5% for stock lending transactions versus 40% for retail stock loans.

Because of this disadvantageous system, individual investors account for only around 1% of the short-selling market. Considering that individual investors make up more than 60% of stock trading, this figure is absurd. Even this is an increase achieved only after improvements were made to the short-selling system.

In Japan, which Korea referred to when improving its system, individual investors account for 20% of total stock trading, and they also account for 20% of short selling. This is because opportunities for individual investors in Japan to borrow shares are widely available.

Japanese individuals can freely borrow, without quantity limits, stocks in more than 70% of all listed companies through retail stock loans. This is because Japan Securities Finance fulfills all borrowing requests submitted by individuals through securities firms. If the amount requested by individuals exceeds the volume available in Japan Securities Finance’s retail lending pool, it borrows additional shares at the level of Japan Securities Finance and lends them out according to a pre-established system. In effect, this allows temporary naked short selling.

Since Korea prohibits naked short selling, it would be difficult simply to import Japan’s system wholesale, especially given how highly developed margin trading is in Japan. However, the fact that individual investors there can easily borrow shares and actively participate in the short-selling market is precisely why we should pay attention to Japan’s example.

Fair competition among market participants is what develops the market. That is why the tilted playing field between individual investors and foreigners and institutions in the short-selling market must be corrected. At present, as Korea shifts toward an advanced-economy structure, the size of the short-selling market is expected to grow much larger. If it grows only in scale while the unequal environment among market participants remains as it is now, negative public opinion toward short selling will only intensify.

To ensure fair competition in the short-selling market, it is urgent to implement more decisive institutional reforms that make share borrowing easier for individual investors. Individual investors, too, should be able to participate in short selling as fair competitors in the market. Through greater participation and competition, we must increase the efficiency of the stock market and build an advanced free-market system worthy of the nation’s elevated standing.

Sanghoon Shin, Intern Researcher, Center for Free Enterprise (CFE)

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Original title: [자유발언대] '개투'에겐 기울어진 운동장 ... 공매도 제도개선 시급

Author: Sang-hoon Shin

Date: 2022-04-08

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=free_opinion&pn=9&idx=24658