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During the COVID-19 pandemic that began in 2020, the short selling regulations in the Korean stock market has undergone many changes. As there are still many controversies regarding the short selling regulations, it is very meaningful to investigate how the short selling regulations affects the stock market, and it can provide important implications for the future regulatory directions. This report reviews major changes in the short selling regulations during the COVID-19 pandemic, and conducts empirical analyses on the effects of the changes in the short selling regulations on the price efficiency, market liquidity, and return volatility. 

In March of 2020 when the market plunged by rapid spread of COVID-19, short selling for all listed shares was banned in Korean stock market. Though market makers were exempted from the ban, even market makers minimized short selling activities. As the stock market rebounded and market sentiments was stabilized, in May of 2021 the short selling ban was lifted for constituents of KOSPI200 and KOSDAQ150. The short selling would not be allowed for non-constituents shares until the regulator amend the regulation policy for the short selling.    

Empirical results are consistent with theoretical prediction and previous empirical analysis on short selling ban in general. First, price efficiency decreases, the return volatility and the frequency of extreme returns increase, and liquidity decreases after short selling ban. Particularly, volatility of positive returns and the frequency of extreme positive returns increases remarkably, which implies that short selling ban might fail to eliminate overvaluation. However, interestingly, while short selling ban expels institutional investors and raises the proportion of retail investors who are limit order traders, quoted spread decreases. 

Second, return volatility and the frequency of extreme returns decrease and turnover increases after the partial lift of short selling ban. Results for price efficiency vary with efficiency measures and quoted spread is widened due to the decrease of retail investors after the partial lift of the ban. Because short selling activity is lower in the post-ban period than in the pre-ban period, the results of the lift of the ban might not be as strong as those of the ban. 

Our results in Korea stock market reconfirm the adverse effect of short selling ban shown in the previous empirical and theoretical studies. Short selling ban might deteriorate price efficiency, increase return volatility, and reduce liquidity. To design the regulation of short selling, the regulator has to consider the role of short selling in the market and the possible negative impact of short selling ban on the market efficiency. It is desirable to design step-wise regulation and to prohibit illegal activity than to call a market-wide ban on short selling.