Korea's short-selling ban to have long-term consequences

Korea's short-selling ban to have long-term consequences

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The August stock market correction may have more long-term effects for Korea than any other country in the region. The South Korean stock market declined for six consecutive days, losing nearly 7.5% of its value over August 8 and 9 alone – but while the market will surely rebound the reaction of the regulator will take longer to overcome.

The (FSC) rapidly introduced a comprehensive, albeit temporary, short-selling ban. Whether it has a short-term stabilising effect on the market is debatable; its long-term effect on Korea’s status as a financial centre is negative.

The scale of the market fall made the move understandable. The KOSPI, having stood at 2172 on August 1, dipped below 1700 for the first time since July 2010. But, while the Korean market was hit worse than most, the stock market event was a global.

It was the result of a loss of confidence in the global economic recovery and the events of European debt contagion and US sovereign downgrade. Although Korea’s export-led economy is sensitive to global growth there was no evidence to suggest it was being targeted.

Foreigners and institutions
Nonetheless, the FSC said short-sellers, “mostly foreigners and institutions”, were responsible for spreading market anxiety. It imposed a temporary ban on the short-selling of all listed stocks in the Korea Exchange and Kosdaq markets for three months – from August 10 to November 9. It had already prohibited the shorting of financial stocks.

The FSC implemented the ban following a suggestion from the Korea Exchange. The FSC independently took the decision to proceed, without the influence of any other government bodies. FSC spokesman Ernst Lee says the intention of last month’s ban was twofold: firstly, to prevent any excessively speculative transactions and, secondly, to “give a psychological comfort to the market.”

The penalty for contravening the ban is a KRW50m fine and the FSC says it can also impose “other sanctions” on offending companies. It would not be the first time the Korean authorities took punitive action against foreign short-sellers. In February, Deutsche Bank's Korean securities and exchange-trading operations were slapped with a six-month ban for selling shares in the last minutes of trading with the purpose of making gains from “speculative” derivatives positions built in advance.

The global market turmoil also meant that the Bank of Korea was forced to delay plans to hike interest rates to combat surging inflation in the country, compounding pressure on the already volatile local market.

Market reaction
In the weeks after the ban was introduced, the short interest for the Korea Composite Stock Price Index (KOSPI) fell from 0.52% of market cap on August 9 to as low as 0.39% (see graph) according to DataExplorers. Korea short interest was 0.42% by August 29. This level is anyway low by international standards – 3% of the S&P 500 is typically out on loan – bringing into question the effect it was anyway having on prices.

DataExplorers notes that the ban does not require outstanding short positions to be unwound and may fluctuate up as well as down after the ban because people borrow for reasons other than short-selling, such as option market makers, provide liquidity to the market, borrow in order to cover shorts (but don’t take a direction). This is the case in other markets with bans such as France.

The bid/ask spread on buying credit protection against a Korean sovereign default widened by nearly 10% to hit an annual high on August 11 of 137/141bp on five-year credit default swaps, from a close of 127bp at market close on August 10 (it was 130bp by August 31), according to Markit.

Following the ban, equity prices were briefly supported, with the KOSPI closing at 1892 on August 17, but by August 22 the index finished at 1710. While the KOSPI then experienced a gentle rally to end the month on 1,880 (on Sept 1) there is no strong
evidence that it had the desired impact.

Limited success
Attempts by other countries to calm their markets in this way have met with limited success. General bans on stock shorting can actually increase market volatility, as they reduce liquidity.

France, Italy, Spain, Belgium and Greece are among those that also implemented short-selling bans last month but European bank stocks, the main target of their intended protection, continued to suffer, plummeting to their lowest levels since the credit crisis of 2008.

Nicholas de Boursac, managing director of the Asia Securities Industry & Financial Markets Association, says: “Broad brush bans of this nature don’t do any good. We support monitoring and penalising abusive short-selling, but we think short-selling in general is good for the markets.

“Short-selling makes sense for people who think an asset is overpriced in the same way anyone who thinks it is underpriced should be able to buy it. The empirical evidence suggests markets return to equilibrium the faster volatility is reduced and markets are generally healthier when short-selling is allowed.”

He adds that it was “perplexing” that short-selling of assets included in the KOSPI had been banned, yet participants could still sell the KOSPI short on the futures exchange. “If you want to take a significant short position the cheapest and quickest way is through the futures exchange, or through total return swaps that are not similarly restricted,” he says.

Such decisions to ban short-selling are often driven by politicians rather than regulators, says de Boursac, “as politicians feel they need to be seen to be ‘doing something’.”

Henry G Morris, advisor, North Asia, Triple A Partners, says the ban has “created complications for some portfolio managers, particularly at hedge funds which now would find it even more difficult to do onshore short sales and would very likely be charged an even greater premium for being enabled to do so from their prime brokers’ inventories.”

Shortage of interest
It is also questionable whether the action taken was proportionate given the relatively low level of short interest in the Korean market. The Korean government justified the ban on the basis the short interest had spiked well above its usual daily level of around KRW100bn ($93m) before the crisis in global equity markets, to KRW314bn per day between August 2 to 5 and around KRW430bn August 9.

But, Morris at Triple A Partners says: “Given that the equivalent of $400m in a market where daily turnover is on average $4-6bn is not very much, one can wonder why the authorities felt that the level of short interest was pushing the market down rather than more fundamental factors, such as the understanding amongst both domestic and international investors that the Korean market is very dependent upon global trade since the major Korean listed companies have high exposure to exporting.”

Morris adds it was “entirely possible that margin calls at the retail level also contributed to the large swings on the KOSPI. Retail investors became a bit agitated and could have been highly reactive.” He says retail investors in Korea are not long-term investors and, unlike other major OECD markets, the Korean market is "still dominated by the average punter, not by institutional players. Institutional trading in the Korean market averages 30-35% of daily volume and retail the balance, whereas in London or New York up to 80% would be institutional and 20% retail.” He adds the Korean market still trades in substantial volume and did not suffer significant loss of liquidity as a result of the ban.

Arrested development
There are currently no hedge funds based onshore in South Korea, although the Korean authorities are currently in the process of discussing the rules and regulations that will apply to domestic hedge funds in order to enable them to be launched. The FSC has said the absence of local hedge funds is detrimental to the country’s financial status as a major economy.

Indeed, when Korea’s financial condition has turned for the worse in the past capital outflows from foreign hedge funds have been blamed for foreign exchange market instability – if this is true, onshore hedge funds might be able to provide a cushion, acting as arbitrageurs.

Lee at the FSC said there is no fixed time line for the launch of domestic hedge funds, which will require revision of the Financial Investment Services and Capital Markets Act and the National Assembly’s approval. He adds: “It is difficult to predict when we will get the approval. All we can say is that we are trying very hard to give birth to domestic hedge funds by the end of this year.”

However, Peter Douglas, chief executive of GFIA, a Singapore-based fund research business looking at hedge funds and long-only funds investing into emerging markets, says the short-selling ban would be counterproductive to the aim of the Korean authorities, deterring entrants to any nascent domestic hedge fund market.

He says: “The bulk of what we see going on in onshore Korea at the moment is existing Korean financial firms working on setting up hedge fund units. I don’t think you’ll see firms leaving but you will see firms dropping projects, dropping business units – in particular Korean financial services firms that already have offshore entities. Those firms that have already been working on a Korean hedge strategy will move that from the onshore entity to the offshore entity.”

The ban is of course under review and Lee at the FSC emphasised its temporary nature, saying: “The Korean government is fully committed to open market policy. The maximum period of the ban we initially envisaged was until 9 November, but if the market situation normalises before then I think we will withdraw the ban on short-selling.” He adds this would be judged on criteria “mainly of volatility”.

Damage done
However, as Douglas at GFIA says: “Even if the ban is rescinded early the damage has been done. If you're thinking of setting up a hedge fund business in Korea, that’s a long-term commitment.

You’ve got to find enough capital for your license, you’ve got to find skilled people, you’ve got to find investors who invest in you, and you’ve got to get the right space. You're only going to do that if you’ve got a high degree of confidence you will be allowed to run your strategy.”

He adds that in conversations with Korean managers they had told him they were looking less at the short-term effects of the ban and taking a more long-term view “of what appears to be a policy U-turn.”

“In an environment where clearly the regulator feels that every now and again even for fairly brief periods they can stop you shorting, the degree of comfort that you can run your strategy consistently evaporates pretty quickly,” says Douglas. “From a direct ‘market’ point of view the issue is not more than near term inconvenience and increased volatility. But, from a ‘policy’ point of view it’s going to put people off investing in the infrastructure to run sophisticated strategies in Korea.

“I am pretty sure this will stop dead the development of the onshore Korean hedge fund industry and move it back offshore again, which is where it was to start with.”

 

 What prompted the ban?

Short sales averaged KRW100bn ($93m) per day in the first half of the year. In early August this figure rose to over KRW400bn, and from August 2 to 5, short-sellers sold an average of KRW314bn per day.

The previous record high was KRW234bn in September 2008. The FSC responded by banning short-selling of all listed stocks from 1 October 2008, subsequently lifting the ban on non-financial stocks from June 1 2009.

Last month, program trading on KOSPI shares was halted for five minutes each on August 8 and 9 after KOSPI 200 Index futures fell over 5% for more than a minute. Trading of shares on the Kosdaq Index was also stopped after the index fell more than 10% for over a minute, triggering automatic curbs.


 

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