GameStop frenzy amid shorting debate in Korea

 Retail investors across the world, including South Korea, were captivated recently with the revolt targeting short selling by Wall Street hedge funds, which jacked up the stocks of a few firms, video game retailer GameStop in particular.

Shorting refers to transactions when an investor borrows stocks and sells them soon in hopes of buying back later at a lower price, taking advantage of perceived arbitrage opportunities.

In the case of GameStop, institutional short sellers got very greedy. They bet against the game retailer and hoped its price would plummet by shorting more stocks than were available through its float.

Frustrated at watching the manipulations by big fish to rake in moolah, retail investors banded together -- through online brokerage apps and anonymous social media messaging boards -- and drove the price higher through a short squeeze, in turn pocketing windfall profits. The financial institutions were forced to unwind their short positions, losing an estimated $20 billion.

Although a course correction is widely anticipated -- GameStop stocks have cooled down from a high of 140 percent two weeks ago -- with calls for a probe by regulators rising, the David vs. Goliath battle that rattled the US and European stock markets has now spread to Asia.

The uprising caught the attention of White House, even as retail investors, celebrities and lawmakers have decried any move to impose restrictions. Meanwhile, the Securities and Exchange Commission has vowed to protect individual traders and also promised to scrutinize the unfair actions of large brokerages.

This showdown between retail investors and FIs, which has peaked now, is not something new. Korea is no exception, and is in fact turning out to be the new battleground for this face-off.

During the global financial crisis in 2008, more than half the financial markets tightened their regulations to restrict shorting. The measures included a ban on naked shorting -- transactions without borrowing the asset from someone else or ensuring that it can be borrowed -- and short selling of financial companies’ stocks, and strengthened disclosure rules related to the practice.

When stock prices sharply fell, Korea banned covered and naked shorting of all stocks from Oct. 1, 2008.

This followed vehement opposition by many retail investors who stated that shorting increased unfair practices and would increase market volatility.

The stock market in Korea is perceived as being asymmetric due to the limited market access of retail investors. While foreign and institutional investors can borrow stocks for a year with lower fees, retail investors must pay hefty fees and sell borrowed stocks within 90 days, leading to an unleveled playing field.

As the financial crisis subsided, most countries eased or lifted their restrictions and Korea followed suit, allowing short selling of all stocks with exceptions.

Since then, the Financial Services Commission has continued to tighten regulations. However, retail investors have pointed out flaws in the system and the situation finally came to a head last year.

As a result, one of the world’s longest bans on shorting was imposed in March last year. Following a six-month extension which lapses on March 15, the financial regulator has announced that the temporary ban will be lifted in May, while pledging a stringent monitoring system to detect illegal shorting.

This has sparked an intense debate between FIs that have been severely hit by the ban, academicians, market analysts and retail investors. While retail investors are pushing for a total ban on shorting, the move does not find much support from other market players and experts.

The debate on shorting has political implications too.

With interest in trading equities growing and retail investors being the primary force for the bullish trend during the COVID-19 pandemic, more than 203,000 people have signed a petition imploring President Moon Jae-in to make shorting illegal -- a threshold of 200,000 compels him to officially respond.

The country’s benchmark Kospi hit a historic 3,000 points earlier last month, continuing a yearlong upward trend. Retail investors purchased a net 67.7 trillion won ($60.5 billion) worth of stocks on the country’s main Kospi and secondary Kosdaq markets last year. 

A market crash would bode badly for the ruling party in April by-elections to elect mayors for Seoul and Busan. But the FSC sees little justification to continue the current ban as the stock market has continued to outperform. The regulator has vowed to improve market transparency by enhancing monitoring and establishing additional safety nets by the time the cap is removed.

The regulator, meanwhile, plans to level the playing field and invite more retail investors to take part in shorting activities as they are mostly carried out by foreign and institutional investors now.

Even the International Monetary Fund has pitched in, urging Korea to end its shorting ban, saying it risks making the market less efficient.

Most economists are of the view that there is nothing wrong with shorting. They insist that a ban not only undermines market efficiency and quality, but also causes overpricing and substantial deterioration of market quality.

It is a vital investment strategy that responds to market fundamentals, facilitates efficiency, mitigates price bubbles and promotes risk management activities.

In fact, shorting is not all that bad and is a very useful scheme for individuals who know how to use it to their advantage. It can be an opportunity for retail investors to earn a profit when stock prices decline. They should equip themselves with sufficient know-how about the market and utilize the system for gains when appropriate.

As they say, the stock market is not for the faint-hearted. Unfortunately, in Korea most of the retail investors are ignoring the accompanying risks. And when they get blindsided they look for convenient scapegoats like shorting.

A total ban on the practice goes against international capital market practices and a more prudent approach is required for devising shorting regulations and setting the level of restrictions in the future.