The Short-Selling Regulatory Landscape in Korea: Implications for Investors

Part of the efforts to resolve problems related to the short-selling system will involve gathering information on investors, including global investment banks and foreign hedge funds that invest in domestic listed securities from overseas. The Financial Supervisory Service (FSS) further announced on 5 February 2024, in its press release on supervisory priorities for 2024, that “the FSS will do its utmost to maintain order in financial markets” and that it would “take stern measures against market disruptions such as illegal short sales, unfair trading and accounting manipulation”. Specifically, the FSS announced that it would investigate illegal short-selling activities of investors located overseas and would work with the financial supervisory authorities in the relevant jurisdictions to this end.

In response to the financial authorities’ announcement, foreign investors have expressed concerns over loss of market liquidity resulting from restrictions on their ability to hedge efficiently. The FSC and FSS appear to be conscious of these market implications, and full-fledged regulations of short selling are a recent phenomenon. Since the introduction of the penalty surcharge system for illegal short selling in 2021, the FSS uncovered what it viewed as deliberate naked short selling by global investment banks for the first time in 2023. Eventually, the Securities and Futures Commission imposed penalty surcharges of KRW7.5 billion and KRW19 billion on each of two major investment banks, the largest fines to date.   

The tension between financial regulators in Korea and global investors stems in part from a difference in opinion regarding the seriousness of illegal short selling. For example, the FSS provided an almost immediate response to Bloomberg’s article released on 15 January 2024 – which reported that the alleged naked short selling by four global investment banks was equivalent to merely 0.001% of the total value of local shares traded in 2022 and 2023 – by stating that “the violation rate exceeded 20% in some cases” when looking at individual stocks.  

Another factor that explains the differing approaches is the difference in the legal systems, such as the subject of disclosure obligations and the application of law in terms of restrictions on short selling. 

Article 180 of the Financial Investment Services and Capital Markets Act (FSCMA) prohibits naked short selling, but it does not specify whether this restriction applies to end investors. In the context of a Total Return Swap (TRS), which is the primary method by which overseas investors, including institutions and hedge funds, engage in short selling, this raises questions as to which entity is responsible when naked short selling occurs. Responsible parties have been sanctioned or punished from time to time for unfair trades resulting from short selling, but there has not been an instance where an investor who opens a short position through TRS has been directly sanctioned for short-selling violations.   

Further, in a recent short-selling sanction case, the financial supervisory authorities appear to have opted for a wider interpretation and application of Article 180 of the FSCMA. From a legal perspective, a more restrictive interpretation may be necessary considering the current legal text and strengthened penalties. 

In addition, while any person who has borrowed and sold listed securities in compliance with legal requirements is subject to reporting and disclosure obligations to the FSC and the Korea Exchange if the net holding balance is negative and exceeds a certain percentage of issued stocks, the net holding balance of end-investors that actually hold or sell listed securities through TRS is not considered. This is unlike the model adopted in the EU, for example, where the net holding balance of end investors is reported when the reporting threshold has been met. 

Against this backdrop, the plan to amend the short-selling system as announced by the financial supervisory authorities on 15 November 2023, entails the following: (i) uniform application of short-selling conditions for individual investors as well as institutional and foreign investors; (ii) mandatory computing system to prevent naked short selling; (iii) expanded scope of investigations and sanctions; and (iv) expansion of short-selling disclosure obligations. The feasibility of such measures has been questioned by foreign investors, particularly in the context of whether implementing a mandatory computing system would in fact enable pre-order checking.  

Legislative bills intended to strengthen short-selling regulations are currently pending in the National Assembly. Any new regulations will likely address overseas end investors – for instance, by revising the FSCMA or subjecting overseas end investors to disclosure obligations. To the extent such amendments or guidelines are established, it will assist both regulatory authorities in Korea and foreign investors by enhancing access to information such as official guidelines in English.  

As the substance and extent of any new regulations remain to be crystallised, we will closely monitor the financial supervisory authorities' activities in the first half of 2024, so as to determine the regulatory trends and implications for investment in the Korea market. In the meantime, it is advisable that investors keep track of their own short-selling practices, which will help identify areas that are subject to regulations, and minimise the risk of unexpected large-scale violations.