The Financial Services Commission announced the finalized version of short sale reform measures on June 13, which include plans to establish a completely electronic short sale processing system until March 2025, limit the length of stock repayment period for both institutional investors and retail investors to maximum 12 months, and strengthen the severity of penalties on illegal short sale activities when the amount of unfairly gained profits is KRW5 billion or more.
In November 2023, the FSC decided to ban short selling in domestic stock markets (until the end of June 2024), because authorities became concerned about naked short selling activities taking place routinely, which could potentially disrupt domestic stock markets’ fair pricing function. Since then, public debates and discussions have taken place to make improvements to the short selling system, and the ruling party and the government held a consultative meeting to announce the finalized set of reform measures on June 13.
Background
On November 16, 2023, the FSC introduced its plan to seek short sale reform measures at the meeting held with representatives from the private sector, the ruling party of the National Assembly, and related authorities. The issue of developing an electronic short sale processing system, which was discussed multiple times previously, has been thoroughly dealt with in taskforce meetings jointly led by the Financial Supervisory Service (FSS) and the Korea Exchange (KRX). After having active communication with market participants, including foreign investors, the authorities have come up with a set of practical measures for developing an electronic short sale processing system. In addition, the authorities have had a series of meetings and discussions with experts, industry representatives, and the public to collect wide-ranging opinions on the overall stock short sale system before arriving at this finalized set of reform measures.
Meanwhile, the authorities have continued to make efforts to inspect, uncover, and bring penalties to illegal short sale activities. The investigation into global investment banks revealed that 9 companies had engaged in naked short selling, which amounted to some KRW211.2 billion, for which further investigation is ongoing. For two of these companies, the Securities and Futures Commission (SFC), a sub-commission within the FSC, decided to report their wrongdoings to the prosecutors’ office and impose penalty surcharges amounting to some KRW25.62 billion. For the other seven companies, appropriate sanctions procedures are currently under way.
During the short sale restriction period, the FSS has carried out inspections on liquidity providers as they were exempted from the short sale ban and found no rule-breaking instances where illegal short sale or profiteering was involved.
Short Sale Reform Measures
The short sale reform measures have been prepared with aims to protect investors and establish a sound order in market transactions. Key measures include (a) establishing a rigorous electronic short sale processing system to stamp out naked short sale activities of institutional investors, (b) making the stock borrowing conditions equal for both institutional investors and retail investors, and (c) strengthening penalties and sanctions on illegal short sale activities.
I. Prevent Naked Short Sale through Electronic Short Sale Processing System
First, institutional investors—corporate investors with net short position balance of 0.01 percent or more, market makers, and liquidity providers who collectively make up about 92 percent or more of all short selling activities in domestic stock market—will be required to set up their own electronic short sale processing systems. As of November 2023, there were 21 foreign companies and 80 domestic companies that will be subject to this requirement.
In this regard, institutional investors subject to this requirement will need to set up their own balance management system to ensure electronic and real-time management of balance of stocks available for short sale, so that they can prevent naked short sale orders in advance.
In addition, all sell orders placed by institutional investors will be effectively monitored by a central monitoring system (NSDS: Naked Short-selling Detection System) set up at the Korea Exchange (KRX). The NSDS will receive information about the status of stock balance and over-the-counter (OTC) transactions from institutional investors and compare it with their order history stored at the KRX to monitor and ensure detection of naked short selling activities within three days of orders being placed. The KRX is currently working on developing the NSDS and plans to complete it by the end of March 2025.
Second, all institutional and corporate investors will be required to prepare internal control standards intended to prevent naked short sales. Even when they plan to place short sale orders in small amounts or only for once, institutional and corporate investors are required to set up internal control standards. The internal control standards should include details about the division that will be charged with overseeing short sale activities within the organization, operational rules regarding short sale activities, and the record keeping and management duties (for five years) on information about their internal control activities.
Third, the verification duty of securities companies will be strengthened upon receiving short sale orders from investors. Currently, the role of securities companies in preventing naked short sales is very limited in that they are only being notified about the fact that short sale orders have been placed with borrowed stocks. However, securities companies will be obligated to check and verify the electronic short sale processing system of institutional investors and the internal control standards of all institutional and corporate investors at least once a year and report their findings to the Financial Supervisory Service (FSS). Securities companies should process short sale orders only from the institutional and corporate investors that have been verified to have established their own electronic short sale processing and internal control systems.
Institutional investors that have failed to establish an electronic short sale processing system, institutional and corporate investors that have failed to set up internal control standards, and securities firms that have failed to comply with their verification duty will be subject to monetary penalties even when there is no occurrence of naked short selling activities.
II. “Level the Playing Field” by Making the Stock Borrowing Conditions Equal
The conditions for borrowing stocks will be made equal for both institutional investors and retail investors to level the playing field.
First, for short sale orders, the stock repayment period can be extended for 90 days each time for a total of 12 months. For stock lending to institutional and corporate investors, lenders may continue to issue a notice of recall upon which borrowers are required to immediately return their borrowed stocks. However, a minimum 90-day repayment period is guaranteed for retail investors.
Second, the cash collateral ratio for retail investors when borrowing stocks will be set at 105 percent, the same level currently observed for institutional investors. Currently, institutional investors are subject to different levels of collateral ratio (105 percent for cash and 135 percent for KOSPI200 stocks), while retail investors are subject to the flat rate of 120 percent regardless of the type of collateral. The reform measures will bring changes to this by reducing the cash collateral ratio of retail investors to 105 percent, which is the same level currently observed for institutional investors, while keeping their current collateral ratio for KOSPI200 stocks unchanged at 120 percent. This change will make the stock borrowing conditions for retail investors more favorable than they were previously.
III. Strengthen Penalties and Sanctions on Illegal Short Sale Activities
While continuing to make efforts to uncover and investigate illegal short sale activities, the authorities will significantly strengthen the severity of criminal penalties and sanctions on illegal short sales.
First, the severity of monetary penalties will be raised and an aggravated penalty introduced for imprisonment to strengthen criminal punishment. The level of fines imposed on illegal short sale will be increased from the current level of 3 to 5 times of the amount of unfairly gained profits to 4 to 6 times of the amount of unfairly gained profits. When the total amount of unfairly gained profits is KRW500 million or more, an aggravated penalty will be applied for imprisonment to make the penalty systems on both illegal short sale and unfair trading activities identical.
Second, the availability of sanctions mechanisms will be diversified to ensure more effective enforcement of administrative sanctions and boost market confidence. Those found to have engaged in illegal short sale or unfair trading activities will be prohibited from trading financial investment products in domestic market and from serving as an executive for financial companies or listed companies for up to 10 years.
IV. Other Reform Measures to Improve Transparency
Apart from these measures, the disclosure standards on net short position balance will be strengthened to ensure transparent disclosure of information about investors’ short positions. The net short position balance reporting standards will be tightened from the current level of 0.5 percent or more of total issuance volume to 0.01 percent of total issuance volume or KRW1 billion or more.
Moreover, investors who have placed short sale orders will be prohibited from acquiring the convertible bonds (CBs) or bonds with warrants (BWs) issued by the same company from the time the information about their CB or BW issuance plan is disclosed to the public until the time their convertible price is announced to prevent convertible arbitrage.
Further Plan
The FSC plans to promptly carry out follow-up measures to ensure speedy progress in implementing the reform measures.
First, the FSC will closely work with the National Assembly and support the legislative process to seek revision of relevant laws that is required for the implementation of the reform measures within this year. Until the third quarter of this year, the FSC plans to make relevant changes to subordinate regulations to lower retail investors’ collateral ratio and to strengthen disclosure requirement on net short position balance.
Regarding the balance management system and internal control standards that are required to be set up by institutional and corporate investors, the FSS will introduce guidelines to facilitate compliance from institutional and corporate investors from this year. The naked short selling detection system (NSDS) currently under development by the KRX is expected to be set up by the end of March 2025. Making upgrades to the securities lending system to limit institutional investors’ stock repayment period is expected to be completed by the third quarter of this year.
The government and related organizations will make utmost efforts to effectively implement the reform measures to ensure prevention of illegal and unfair short selling activities. These measures will help to alleviate the concern about the potential of illegal short sale activities disrupting stock market’s fair pricing function. Through these measures, the authorities will work to foster a sound market environment where short selling can be used as a proper trading strategy that can help to facilitate market’s price discovery function. The authorities also expect that these measures will help to contribute to ensuring fair market order and trust for all market participants.
* Please refer to the attached PDF for details.