Short Selling Bans Talking Points:
- South Korea has recently imposed a short selling ban on Korean equities until June of next year, in order to promote a ‘level playing field.’
- This has led to some calls for a similar move in the United States, and given the pressure seen in equities since July, that could seem logical. But history suggests that short selling bans don’t work and may exacerbate the issue, per the Federal Reserve. I explore further below.
- I’ll be discussing these themes in-depth in the weekly webinar on Tuesday at 1PM ET. It’s free for all to register: Click here to register.
South Korea is in the news to start the week as regulators have re-instated a short selling ban on equities until June of next year. This has been applied with the logic of promoting a ‘level playing field,’ and given the scorn that short sellers receive, particularly in falling markets, this can seem sensible.
Financial Services Commission Chairman Kim Joo-hyun said that the move was ‘aimed at fundamentally easing the ‘‘tilted playing field’’ that exists between institutional and retail investors.’ Again, this sounds like a positive development.
This isn’t the first time that we’ve seen something similar: The prior short selling ban was lifted in May of 2021 and allowed short selling in large caps included in the KOSPI200 or KOSDAQ150 indices.
And one look at the KOSPI shows why South Korean regulators may want to make such a move right now. From the below chart, we’re looking at the KOSPI monthly chart and notice how the index topped just a month after the short selling ban was lifted in May of 2021.
From July of 2021 into September of last year the index dropped by -35.57%; and it was around the time that equities in the US began to bounce as buyers started to return, running a bullish move into August of 2023, at which point sellers came back into the picture.
It was a brutal three-month-stretch for the index that saw as much as 14.7% taken-out.
So far, November has started on a much brighter note; but the question remains – do short selling bans work? And is there something similar coming to the United States?
KOSPI Monthly Price Chart (indicative)Chart prepared by James Stanley; data derived from Tradingview
Do Short Selling Bans Work?
If you look at the above chart it might be simple to walk away with the idea that lifting the short selling ban in Korea at least contributed to the KOSPI’s sell-off that started in 2021. But this is a single anecdote, so it can be dangerous to draw too much from one individual instance.
If we look at the logic, again, that can make sense, right? If prices are falling fast, just remove the short sellers from the equation and that should at least soften the blow, right? Because then we should only see selling from current longs, which should remove some of the downside pressure in those falling market environments?
Unfortunately, history seems to suggest otherwise; and short selling bans may actually make the problem worse. Because if you remove the ability for shorts to buffer bullish runs, then topside moves can begin to take on a feast or famine mode where strong surges (made stronger by a lack of short sellers on tests of fresh highs) are followed by aggressive declines (as profit taking from longs removes demand from the market).
And if there is a weak fundamental backdrop, those aggressive declines can be enticing for longs to close their positions, which can add even more supply to the market.
While the simple explanation would seem that banning short sales could be helpful, it also avoids the very real aspect of market behaviors where almost every move or change has a repercussion of some type.
But this isn’t just my theory. The United States has tried short selling bans before, and the results aren’t great. The Federal Reserve has opined on the matter multiple times.
In September of 2008, the U.S. banned short selling in financial stocks. This was the depths of the financial collapse, so a move of that nature made sense. In 2011, the Federal Reserve had this to say about the matter:
“Evidence suggests these bans did little to stop the slide in stock prices, but significantly increased the costs of liquidity. In August of 2011, the U.S. market experienced a large decline when Standard and Poor’s announced a downgrade of U.S. debt. Our cross-sectional tests suggest that the decline in stock pries was not significantly driven or amplified by short selling. Short selling does not appear to be the root cause of recent stock market declines. Furthermore, banning short selling does not appear to prevent stock prices from falling when firm-specific or economy-wide fundamentals are weak, and may impose high costs on market participants.”
You can read the entire study at the Federal Reserve Bank of New York’s website, and the PDF is linked at the bottom of that page.
In another study from the New York Fed, there’s a bit more of a threatening factor offered from short selling bans:
“A new look at the effects of such restrictions challenges the notion that short sales exacerbate market downturns in this way. The 2008 ban on short sales failed to slow thee decline in the price of financial stocks; in fact, prices fell markedly over the two weeks in which the ban was in effect and stabilized once it was lifted. Similarly, following the downgrade of the U.S. sovereign credit rating in 2011- another notable period of market stress-stocks subject to short selling restrictions performed worse than stocks free of such restraints.”
The link for that study can be found at the following page from the New York Federal Reserve, with the PDF linked at the bottom for the full study.
Is a short selling ban coming to the United States?
Given evidence, it would seem that the Fed would be opposed to such a policy. But, this is also the type of item that can fast become political in nature and if Congress is calling for a short selling ban, it may still happen. The bigger question is whether something like that would help and given the data and evidence, any such bans that are imposed could invite additional risk into the matter.
The 2008 GFC was certainly not the first ‘crash’ seen in U.S. markets, and short sellers have continuously been blamed for these types of scenarios, including the market crash in 1929 that preceded the Great Depression. That’s what led to the initial implementation of the ‘uptick rule,’ which meant that short positions could only be opened on an uptick and not on a downtick, designed to mitigate the slides in price from successive short sellers offering supply. This was in effect until 2007 when it was removed by the SEC; and it came back in a modified form known as a ‘short sale restriction’ that was adopted in February of 2010.
So, this is far from the first time that the world has heard of short selling bans; and despite evidence continually pointing to their lack of effectiveness and, perhaps even their ability to exacerbate selloffs, market regulators and politicians desperate for answers have continually went back to what seems like a simple answer.
--- written by James Stanley, Senior Strategist