Analysis of the Effect of Short Selling Regulations and Its Policy Implications[17-06]
Seiwoon Hwang
The date
08 March 2017
Capital and Financial Markets
Despite the long history in which its positive economic functions have been recognized, criticism against the short selling transactions has been strongly raised in Korea, mainly by individual investors. The short selling plays an important role in maintaining the price efficiency of the stock market by acting on the main route through which negative information is reflected in the stock price. It also provides a critical instrument that prevents excessive formation of stock price bubbles. Considering these positive functions, if the regulations on short selling are excessively strengthened, negative cost factors such as decline in the market liquidity and price efficiency might be even larger than the benefit factor of stabilizing the market price. Therefore, strong regulations such as banning short selling transactions could be a reasonable policy choice if and only if the market function does not operate properly as a result of a large economic crisis. It is necessary to develop short selling regulations in the direction to maximize the benefit from the operation while minimizing side effects.
Short sale transactions in Korean stock market are gradually increasing. This trend is commonly observed in both the KOSPI market and the KOSDAQ market, and changes in the market condition seem to affect the increase in short selling transactions. As the stock price index is trapped in the narrow band for a long time, various investment strategies are needed to improve the portfolio performance. It is expected that the short selling would be more actively utilized by institutional investors and foreign investors in order to make gains even with the price downturns. Considering that short selling finds more value among institutional investors, it is desirable to design the regulation mechanism focusing on the market efficiency enhancement.
Immediately after the global financial crisis in 2008, many countries including the US, EU members and Japan took measures to temporarily prohibit short selling transactions. This was because it has been confirmed that short selling could amplify stock price declines at times when it is difficult to make reasonable investment decisions as the market is in panic. However, in many countries where short selling transactions were prohibited, it was only for companies financial industry, and the period of banning was short in most cases. The domestic policy responses to the crisis in 2008 seem to be the same as the overseas policy approaches, alleviating excessive market volatility and over-reaction.
The short selling regulation in the foreign markets after the global financial crisis is featured by strengthening information disclosure system to improve the market transparency. The information disclosure requirements on short selling have been adopted in many countries in Europe and Asia. The disclosure systems are positively evaluated as they support investors to make reasonable investment decisions by disclosing information on how actively the short selling transactions in the market are taking place.
Short selling regulations that appear not to be useful for improving market efficiency are abolished boldly. The abolition of the up-tick rule is a typical case. Many Asian countries are still maintaining the up-tick rule to alleviate downward price pressure from short selling. However, in the United States and Europe, negative views are prevailing over the effectiveness of the up-tick rule. The cases of repealing or operating it in a very limited manner are increasing. In Korean stock market, it would be needed to re-evaluate the utility of the up-tick rule in the future.
In the empirical analysis on the effect of the short selling prohibition, the possibility of falling market liquidity, decreasing volatility and stock price efficiency were found. Analysis of the effect of the three-month short selling ban is conducted for the period of the down-grade of the US sovereign credit rating and European fiscal crisis in 2011. It is estimated that the market liquidity and volatility decreased during the prohibition period. The market liquidity diminished overall, but the volatility in stock returns was higher in companies for which bypassing route over short selling prohibitions was open. Price predictability also became stronger for stocks that can bypass short selling prohibitions.

With the results of empirical analysis of the short selling prohibition, we were able to confirm the positive roles the short selling. The results suggest that while it improves the market liquidity to allow short selling, it can also amplify the volatility. These results are consistent with previous researches. Keeping both brighter and darker side of the short selling in mind, we will have to revise the regulatory system in a way that minimizes side effects. Although the information disclosure system on short selling has positive aspects for market transparency, it should be borne in mind that the excessive level of information disclosure can reduce trading activities.
It is also important to recognize the limit of the market in short selling. Similar to general stock trading, the information asymmetry clearly exists in the short sale transactions. For institutional investors, foreign investors, and individual investors, there are many cases where significant differences are seen in terms of information accessibility and information processing among investor groups. Individual investors have more weakness than the other investor groups. The information asymmetry is not likely to disappear completely even if market infrastructure improves. Information asymmetry will ultimately lead to disparity in the profitability among investor groups and individual investors are more likely to realize relatively lower returns. Revising the regulations on short selling, policy makers should take this aspect into account for better-functioning market.