South Korea this week re-imposed a prohibition on short-selling stocks. Should it have done so? And should South Africa follow suit?
Last Sunday, 5 November 2023, the South Korean Financial Services Commission (FSC) decided to ban the short selling of stocks listed on the main KOSPI, the small-cap KOSDAQ and the startup KONEX exchanges, with immediate effect. The ban is set to remain in place until the end of June 2024.
Both markets have since pared their gains for the week to 2.5% and 2.7%, respectively, by close of trading on Thursday.
Still, it’s a significant reversal in markets that have trended largely downwards since their peaks on 1 August and 25 July, respectively, with the KOSPI having lost 14.6% and the KOSDAQ 21.7% by the end of October.
This might suggest that the popular view of short selling – that it is something evil speculators do to bet on failure and drag companies down – is correct.
Short selling is the process by which an investor sells shares in a company that they do not own. The short sale is considered covered if the shares are first borrowed from a broker, or their availability to be borrowed is at least established.
If the shares are not first borrowed, and a short seller uses a credit scheme from their broker to sell shares they may not be able to produce upon demand, the short sale is described as naked.
Naked short selling is illegal in many countries, including South Korea and South Africa. That this is so is controversial in some free-market circles, but it’s a complex matter, and sometimes the very same economists who previously opposed regulations against naked short selling change their minds about it later.
Let’s return to the case of ordinary short selling.
Buying shares (‘going long’) signals confidence that the value of a company will increase, and that its shares are undervalued. The buyer can earn a potential profit only if the performance of the company is such that its value actually does increase.
An investor who considers a share to be overvalued has no means to act upon that information, however, unless they are already invested in the company.
This is where short selling comes in. By borrowing shares and selling them at today’s price, the short seller stands to make a profit if those shares, at any time before the settlement date, can be bought on the open market at a lower price in order to return them to the lender.
If the share price does not decline, but rises instead, the short seller loses the difference between the price at which they repurchase the shares and the price at which they sold them.
There is an inherent risk to short selling that doesn’t exist with other types of trading. An investor who goes long stands to lose at most the amount that they invested, if the company in which they bought shares collapses entirely and the share price goes to zero.
For an investor who goes short, however, there is no limit on the potential amount they can lose, since there is no upper limit on how high the price can go before the borrowed shares have to be returned. If the short seller cannot cover this loss, this can also affect the broker from which they borrowed the shares.
Such failure to deliver can affect the stability of markets, which is why short selling is routinely regulated, and short sellers are typically expected to maintain collateral to ensure that they can cover their shorts.
Short selling is not only used as a tool for speculation. It is widely used, especially by institutional investors, as a hedge. Hedging is a trading strategy that can get very complex, but essentially sacrifices some potential upside in order to limit the potential downside of a trade.
Of course, the very act of selling shares, whether borrowed or otherwise, places downward pressure on their price, just like buying shares places upward pressure on their price.
Company managers and other shareholders are invested in seeing share prices rise, so they frown upon actions that seem designed to achieve the opposite.
These aren’t the only people with a vested interest in seeing share prices rise, however.
In the case of South Korea, the FSC claims that the short-selling ban was needed to curb illegal naked short selling. It also claims that the ban is needed to ‘level the playing field’ between institutional and retail investors.
Both these justifications are highly questionable. Many countries successfully prohibit naked short sales without prohibiting covered short sales. And why a regulation that levels the playing field is only needed for eight months is a mystery.
A far more likely explanation is that the South Korean ruling party, the People Power Party, is feeling a little fragile ahead of elections in April 2024. The fact that stock markets have been falling does not reflect well on their economic management, and banning short selling is a quick fix.
Few people have much sympathy for short sellers, because few people have a direct interest in watching shares fall, so banning short selling is an easy political win.
A prohibition on short selling is likely to deter foreign investors in the South Korean stock market. It is also likely to threaten South Korea’s reclassification by MSCI from a developing equity market to a developed equity market, which expects market regulations to cater for stock lending and short selling.
Short selling performs a vital function in capital markets. Not only does it play a role in risk management (hedging), but in the same way that investors allocate capital to companies that they believe are, or will be, successful at producing what society needs or wants, short sellers disallocate capital from companies they believe will not be successful.
After all, a core principle of free markets is not only to reward successful companies with profit and successful shareholders with capital appreciation, but also to punish unsuccessful companies and ensure that they fail.
Resources, including capital, assets, managerial skills, intellectual property, licences and permits, commodities, and labour are scarce. Markets exist to optimally allocate resources to the most productive uses.
Company failures help to free up the resources tied up in them, so they can be more productively employed in more successful businesses.
Short sellers simply speed up this process, making capital reallocation more efficient. They merely reduce the price of a stock sooner than it otherwise would have fallen.
Far from hoping that bad things will happen, or betting on failure, short sellers are eagle-eyed traders who watch companies like hawks, uncovering fraud, mismanagement or strategic blunders long before regulators even get around to take action.
How often have corporate share prices collapsed before governments instituted legal or criminal action against companies and their managers? Thank short sellers!
It is for this reason that companies that complain the loudest about short sellers often are found to be hiding either poor trading prospects or ‘accounting irregularities’, to put a euphemistic shine on corporate fraud.
Short sellers increase the amount of information in the market. They contribute to efficient price discovery.
Allowing short selling gives investors an incentive not only to pick and reward winners, but also to identify and punish losers.
They don’t cause the failure of companies; they are early indicators of company failures that would have happened in the long run anyway. They don’t change reality, but they help to align market beliefs more closely with that reality.
Short selling is not even unique to stock markets. It happens in all sorts of businesses. A farmer selling crops that they have yet to grow is a short seller. Developers selling housing units they have yet to build are short sellers. Car manufacturers taking pre-orders are short sellers. In none of these cases would one argue that the actions of the short seller are somehow inimical to the interests of the market at large.
South Africa is itself a developing equity market, according to MSCI’s classification. It presently permits short selling, and although the Financial Services Conduct Authority (FSCA) is considering new regulations to improve disclosure and transparency of short sales, it is not openly considering a prohibition on short selling stocks.
Yet. As in South Korea, the Johannesburg Stock Exchange has also not performed well lately. Since the end of January 2023, the All-Share Index has lost almost 10% of its value.
The ruling ANC has few reasons to crow ahead of next year’s general election as it is. Agitating against short sellers, and perhaps engineering a short-term stock market rally, may well prove to be politically profitable for politicians desperate to retain power.
Don’t fall for their rhetoric. Government restrictions on markets rarely make them more efficient, and do not reliably protect investors, either.
Short sellers are far more likely to sniff out and punish corporate malfeasance than the FSCA, the National Prosecuting Authority, or the Financial Intelligence Centre are.
It is easy to make short sellers seem like financial vultures, but, like vultures, they perform a critical financial ecosystem function, recycling the carcasses of dead and dying companies.
[Photo: Christian Bale in the film The Big Short /flickr]
The views of the writer are not necessarily the views of the Daily Friend or the IRR.
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