🚨 Short Selling Returns After 5 Years, Between Foreign Capital Inflow and Market Volatility
Today Korean Economic News | 2025.03.28
📌 Short Selling Returns After 5 Years, Between Foreign Capital Inflow and Market Volatility
💬 Short selling will be fully resumed in the domestic stock market from the 31st. The system has been improved and the computer system has been reorganized to enhance fairness and prevent illegal activities, and expectations for foreign capital inflow are also growing. However, in the short term, some stocks may experience selling pressure and increased price volatility, requiring caution.
1️⃣ Easy Understanding
Short selling is being fully resumed in the domestic stock market after 5 years. I'll explain what short selling is, and what the meaning and impact of its resumption are.
Short selling is an investment method where you borrow stocks without owning them, sell them first, and then buy them back later when the price falls to return them. In other words, it's a strategy to make a profit when stock prices fall by 'selling high and buying low.' For example, if an investor expects Company A's stock, currently at 100,000 won, to fall, they can borrow Company A's stock from a securities firm, sell it at 100,000 won, and if the stock price actually drops to 80,000 won, they can buy it at 80,000 won and return it to the securities firm, making a profit of 20,000 won.
In Korea, short selling was completely banned in March 2020 during the market crash caused by COVID-19, and after going through partial permission and re-prohibition, it will be fully resumed on March 31, 2025, after 5 years. This resumption is not simply returning to the past system but comes with several system improvements. In particular, system reorganization has been carried out to improve the 'short selling inequality' issue between individual investors and institutional/foreign investors.
The positive aspects of resuming short selling include enhancing market efficiency. Short selling plays a role in guiding overvalued stock prices to appropriate levels and provides liquidity to the market. Also, since it's a preferred investment strategy for foreign investors, increased foreign capital inflow is expected with the resumption of short selling. In fact, some global investment banks are forecasting that the attractiveness of the Korean market will increase.
On the other hand, there are concerns as well. In the short term, stock price volatility may increase due to selling pressure from short sellers in some stocks. In particular, companies with high valuations or weak financial conditions may become targets for short selling. Also, since there have been some cases of illegal/unfair short selling in the past, market concerns remain.
The government and financial authorities have prepared measures to strengthen surveillance of illegal short selling and increase sanctions for violations with the resumption of short selling. For example, penalties for naked short selling have been significantly increased, and real-time monitoring systems have been improved.
Investors need to prepare for market changes due to the resumption of short selling. In the short term, caution regarding volatility is needed, and investment strategies focusing on corporate fundamentals and long-term growth have become important. Also, while short selling is a strategy that bets on stock price declines, paradoxically, stocks with excessive short positions can experience rapid increases due to a 'short squeeze' (large-scale buying by short sellers) when positive news occurs, requiring an understanding of bi-directional volatility.
2️⃣ Economic Terms
📕 Short Selling
Short selling is an investment strategy where you borrow stocks you don't own, sell them, and then buy them back when prices fall to make a profit.
- It is used when expecting stock prices to fall and contributes to market efficiency and price discovery.
- It is a high-risk strategy with the possibility of unlimited losses, and has various regulations and restrictions.
📕 Liquidity
Liquidity refers to the ease with which an asset can be quickly converted to cash without loss of value.
- Market liquidity lowers transaction costs and price volatility, contributing to efficient asset price formation.
- Short selling plays a role in increasing market liquidity by providing additional selling and buying opportunities.
📕 Market Efficiency
Market efficiency refers to the degree to which stock prices quickly and accurately reflect all available information.
- In an efficient market, overvaluation or undervaluation of assets is quickly adjusted to converge to fair value.
- Short selling enhances market efficiency by exerting downward pressure on overvalued stocks.
📕 Short Squeeze
A short squeeze is a phenomenon where stock prices soar as short sellers engage in large-scale buying to limit losses.
- It occurs when unexpected positive news or buying pressure enters stocks with many short positions.
- Short sellers are exposed to unlimited loss risk, so sequential buying to limit losses during price increases can occur.
3️⃣ Principles and Economic Outlook
💡 Background of Short Selling Resumption and System Improvements
Let's examine the background of the full resumption of short selling in the domestic stock market and the contents of system improvements made so far.
First, it's necessary to understand the progression of short selling bans and resumptions. In March 2020, amid the global financial market crash due to COVID-19, Korean financial authorities completely banned short selling to stabilize the market. Initially planned for 6 months, it was extended several times considering market conditions and demands from domestic investors. In May 2021, short selling was partially resumed for KOSPI200 and KOSDAQ150 index components, but it was banned again in 2023 due to continued controversy over illegal short selling and fairness issues. After a preparation period for system improvements and reorganization, it will be fully resumed on March 31, 2025. This marks the end of a 5-year short selling restriction period and is an important turning point for the Korean stock market to move toward meeting advanced market standards.
Second, it's necessary to understand the main criticisms and problems regarding short selling. The biggest criticism of short selling was the 'inequality' issue between individual investors and institutional/foreign investors. Individual investors had limited access to stock lending and higher costs, making it difficult to practically use short selling strategies, while institutions and foreigners could use short selling with relatively favorable conditions. There were also criticisms that surveillance and sanctions for illegal activities such as 'naked short selling' were insufficient. Naked short selling is an illegal act of short selling without borrowing stocks, and some cases of violations by foreign securities firms have been detected in the past. Additionally, information asymmetry in the short selling process, the possibility of market manipulation, and distortion of corporate values were concerns.
Third, let's look at the system improvements made ahead of this short selling resumption. Financial authorities presented ensuring institutional fairness and establishing an illegal prevention system as preconditions for short selling resumption. First, to increase individual investors' access to short selling, the stock lending brokerage system was improved, and measures were prepared to secure stock lending volume dedicated to individual investors. Securities firms agreed to expand short selling services customized for individuals and adjust lending costs to reasonable levels. Additionally, the computer system for monitoring illegal short selling has been advanced, and real-time monitoring and post-verification systems have been strengthened. Sanctions for illegal short selling have also been strengthened, with penalties for naked short selling raised from 30% to up to 100% of the selling amount. Short position reporting standards have also been strengthened to enhance market transparency, requiring daily reporting when holdings exceed 0.5%.
Fourth, it's worth noting the system reorganization and preparation process for short selling resumption. The Korea Exchange and the Korea Financial Investment Association completely overhauled the short selling computer system, strengthening the pre-check function for all short selling orders. A 'pre-borrow system' that verifies actual borrowing at the order stage has been introduced, establishing a system that fundamentally blocks naked short selling. Securities firms have also strengthened internal controls related to short selling, conducting employee education and system checks. Financial authorities have also conducted mock tests with market participants, checking potential problems in advance after resumption. Along with this, investor education and information provision have been expanded to enhance understanding of the principles and risks of short selling and related regulations.
Through these system improvements and reorganization, the resumption of short selling is expected to take place in a more fair and transparent manner rather than simply returning to the past system. In particular, an improved environment has been created in terms of enhancing fairness between individual and institutional/foreign investors, preventing illegal short selling, and strengthening market transparency compared to the past. However, continuous monitoring and evaluation will be needed after the resumption to see if these system improvements actually work effectively in the market.
💡 Impact of Short Selling Resumption on the Market and Investors
The resumption of short selling is expected to have various impacts on the overall market and investors.
First, let's look at the impact on market efficiency and price discovery function. Short selling essentially plays a role in enhancing market efficiency. Investors who judge that a particular company is overvalued relative to its fundamentals exert selling pressure through short selling, promoting the process of price adjustment to appropriate levels. This is called the 'price discovery' function and is an important market mechanism that helps the efficient allocation of resources. During the short selling ban period, this adjustment function may have been weakened, possibly allowing some stocks to maintain an overvalued state relative to their fundamentals. The resumption of short selling may lead to price adjustments in such stocks, which may act as downward pressure on stock prices in the short term but contribute to more rational price formation in the long term.
Second, the impact on market liquidity and volatility is also important. Short selling has the effect of increasing market liquidity by providing additional trading opportunities. Especially in a one-directional market centered on buying, short selling can alleviate liquidity shortage problems by supplying additional selling volume. This leads to reduced transaction costs and narrowed bid-ask spreads, enhancing market efficiency. However, in the short term, there is a possibility that selling pressure due to the resumption of short selling may increase volatility in some stocks. In particular, companies with high valuations, weak financial conditions, or questioned growth potential may become targets for short selling. However, there are research results suggesting that short selling actually reduces volatility in the medium to long term, so a more stable market environment is expected after initial adjustments.
Third, different impacts are expected by investor type. Institutional and foreign investors tend to actively use short selling, so they are likely to view the resumption positively. Especially for foreign investors, short selling is an important tool for risk management and arbitrage strategies, and the resumption of short selling can be a factor that increases the accessibility and attractiveness of the Korean market. There is also a possibility that participation in the Korean market by some global hedge funds or investors using quant strategies may expand. On the other hand, individual investors have some concerns about the resumption of short selling. This is because there have been experiences in the past where short selling concentrated on stocks preferred by individual investors, causing losses. However, with this system improvement, individual investors will be able to access short selling more easily, enabling diversification of investment strategies.
Fourth, industry and stock-specific impacts will also be differentiated. Short selling does not affect all stocks equally, and companies with certain characteristics are more likely to be significantly affected. In particular, the following stocks may be major targets of short sellers: ① High-valuation growth stocks, ② Companies with weak financial structures or insufficient cash flow, ③ Companies with weakening performance momentum, ④ Sectors with deteriorating competitive environments or negative industry outlooks, ⑤ Companies with questioned governance or accounting practices. Conversely, value stocks with high and stable dividend yields, large-cap stocks with solid financial structures, and defensive stocks are expected to be relatively less affected by short selling.
Overall, while the resumption of short selling may lead to increased volatility and stock price adjustments in some stocks in the short term, it is expected to contribute to enhancing market efficiency and soundness in the medium to long term. Along with the positive effect of increased foreign capital inflow, it will serve as an opportunity to provide investors with various investment strategies and risk management tools. However, continuous system improvements and monitoring are needed to prevent illegal short selling and protect investors, and investors need to fully understand the principles and impacts of short selling and prepare response strategies.
💡 Potential Foreign Investor Inflow and Medium to Long-term Market Outlook
Let's analyze the impact of short selling resumption on foreign investor inflow and the medium to long-term market outlook.
First, let's examine the correlation between short selling resumption and foreign capital inflow. Short selling is a strategy actively used by global investors, especially hedge funds and institutional investors, and restrictions on it have acted as a factor lowering the investment attractiveness of the Korean market. According to analyses by global investment banks (IBs), short selling is used as a basic investment tool in major advanced markets, and Korea's ban on short selling has been perceived as a regulation deviating from global standards. Some global index providers have also pointed out short selling restrictions as a negative factor in assessing the accessibility of the Korean market. Therefore, the resumption of short selling is expected to enhance the global coherence of the Korean market and improve accessibility for foreign investors. In fact, several global investment banks are recommending increasing investment weightings in the Korean market after the resumption of short selling and projecting an expansion of net foreign capital inflow.
Second, the impact in terms of Korean market valuation and investment attractiveness should also be considered. The Korean stock market is evaluated as being relatively undervalued in global comparisons. As of March 2025, the KOSPI index's 12-month forward P/E ratio (price-to-earnings ratio) is about 10x, lower than major advanced markets such as the US (19x), Europe (15x), and Japan (16x). In this undervaluation situation, the resumption of short selling can provide foreign investors with both 'buying opportunities' and 'short covering (buying to close short positions)' opportunities. Especially with the entry into a global rate cut cycle, improved investment conditions in the Korean market can act as a catalyst for foreign capital inflow as funds to emerging markets expand. However, some high-valuation growth stocks or theme stocks may also become short selling targets, so stock-specific impacts are expected to be differentiated.
Third, medium to long-term market structure and investment environment changes can also be anticipated. Beyond short-term market volatility, the resumption of short selling is expected to affect the structure and culture of the Korean market in the long term. First, as the price discovery function strengthens and the gap between corporate value and stock price narrows, it can be an opportunity for companies to focus more on creating real value and shareholder returns. This can also contribute to resolving the 'Korea discount,' which has been pointed out as a chronic problem in the Korean market. Additionally, individual investors' investment strategies may diversify. Moving beyond simple buy strategies, more diverse approaches such as long-short strategies, pair trading, and hedge strategies may be attempted. Furthermore, the investment decision-making of market participants is expected to become more fundamentals-centered. Companies will pay more attention to strengthening financial soundness, improving governance, and transparent information disclosure to avoid becoming targets of short sellers, which will be a factor enhancing the transparency and efficiency of the entire market in the long term.
Fourth, potential risks and response measures should also be considered. While the resumption of short selling is expected to bring positive effects such as foreign capital inflow and enhanced market efficiency, there are also several potential risks. First, market instability may increase in the short term due to aggressive selling by short sellers. Especially if short selling is resumed during a period of high global volatility, its impact may be amplified. Second, there is still a risk of illegal short selling or market manipulation, and the effectiveness of the surveillance and sanction system needs to be verified. Third, there is still a possibility that individual investors may be placed in a relatively disadvantageous position due to information asymmetry and resource disparities among market participants. To respond to these risks, financial authorities need to strengthen market monitoring and take prompt measures against unfair trading. It is also important to expand education and information provision for individual investors to enhance their understanding of short selling and response capabilities.
Overall, the resumption of short selling is expected to be an important opportunity to enhance the global coherence and investment attractiveness of the Korean stock market. It is particularly expected to contribute to improving accessibility for foreign investors and strengthening market efficiency and price discovery functions. However, to maximize these positive effects and minimize side effects, fair and transparent trading environments must be created, and strict surveillance and sanctions against illegal activities must continue. Investors need to prepare for short-term volatility brought by the resumption of short selling while focusing on the positive aspects of market advancement and efficiency enhancement from a medium to long-term perspective.
4️⃣ In Conclusion
Short selling, which will be fully resumed after 5 years from the 31st, is expected to be an important turning point for the Korean stock market. It is being resumed in a differentiated environment from the past in that it has enhanced fairness between individual and institutional/foreign investors and strengthened measures to prevent illegal short selling through system improvements and computer system reorganization.
Short selling has positive aspects of enhancing market efficiency through the 'price discovery' function that guides overvalued stock prices to appropriate levels and the role of supplying additional liquidity to the market. Also, since it's a strategy actively used by global investors, the resumption of short selling is expected to increase the global coherence of the Korean market and promote foreign capital inflow.
However, in the short term, there is a possibility that selling pressure may increase in some stocks, expanding stock price volatility. Particularly, companies with high valuations, weak financial conditions, or weakening performance momentum may become major targets of short sellers, requiring caution. Investors need to monitor short selling trends in their holdings and establish risk management strategies if necessary.
From a long-term perspective, the resumption of short selling can be seen as a positive change contributing to the advancement and maturation of the Korean market. As the price discovery function strengthens, the gap between corporate value and stock price may narrow, potentially promoting companies' value creation and shareholder return efforts. It may also lead to diversified investment strategies and strengthened fundamentals-centered decision-making for investors.
Financial authorities and market participants should continue to create fair and transparent trading environments through continuous monitoring and system improvements even after the resumption of short selling. In particular, there is a need to enhance the effectiveness of illegal short selling surveillance and sanctions and strengthen efforts to resolve information asymmetry. It is important for investors to accurately understand the principles and impacts of short selling and maintain investment strategies focused on corporate fundamentals and long-term growth potential rather than short-term volatility.