This Monday's local stock market saw an immediate uptick in activity following South Korea's recent decision to ban short selling in stocks until next June. Additionally, the American depositary receipts (ADRs) of South Korean companies that were traded in the US saw an increase due to this policy change.
Despite the fact that South Korean stocks fell on Tuesday, it is still important to consider the potential effects of the regulators' action on trading tactics for stocks that are listed on foreign exchanges. The regulators reported that they had discovered "illegal naked short selling taking place in a more routine way," which offers an interesting perspective on how domestic policy decisions can have a ripple effect on global trade environments.
The Ban on Short Selling Does Not Apply to ADRs
The prohibition on short selling of South Korean stocks does not apply to ADRs, which are traded in the US like ordinary stocks.
A notable 2010 study clarified a fascinating ADR-related dynamic. It showed that short-selling activity for ADRs of companies with shorting restrictions in place in their home countries had increased by a significant 40%. The researchers, who are affiliated with Utah State University, the University of Mississippi, and North Carolina State University, posited that U.S.-traded ADRs function as a means of evading short-sale restrictions that are specific to individual countries. This enables investors to short-sell through ADRs rather than the restricted stocks directly.
An interesting finding of the study was that, even in the absence of prohibitions, ADR short sellers could predict negative returns in foreign companies. Furthermore, they performed noticeably better at forecasting returns from these stocks for businesses originating from markets where short sales are prohibited.
The potential impact on stock prices of the short sale ban is one of its consequential outcomes, along with the hypothetical upswing in ADR shorting activity.
The researchers uncovered an intriguing trading phenomenon associated with restrictions on short sales: trading patterns that align with the mispricing of the restricted stock in its home market can result when stocks are restricted in their home markets but their ADRs are left unrestricted. ADR trading is one way that short sellers can take advantage of this opportunity.
Investors who engage in short selling do so in an effort to profit from their prediction of a stock's price decline. Usually, to do this, shares are borrowed from a broker and then later purchased back at a discount. Nevertheless, when it comes to naked short selling, investors divest their short positions without guaranteeing that they will be able to borrow the shares, which puts them at risk of not being able to buy the shares when needed. After the 2007–2008 recession and financial crisis, this practice was outlawed in the US.
Concerned about the fair pricing function of domestic stock markets, the South Korean Financial Services Commission has discovered instances of illicit naked short selling by institutional and foreign investors. Notably, Bloomberg revealed in mid-October that regulators intended to fine BNP Paribas and HSBC Holdings for allegations of engaging in naked short selling.
It's important to remember that South Korean regulators have previously imposed limitations on short sales. In reaction to the effect of COVID-19 on the equity markets, a protective measure akin to this restriction was put in place in March 2020.
This action could have an important effect on South Korea's goal of being acknowledged globally as a developed financial market. MSCI, an index provider, has encouraged South Korea to lift previous restrictions on short selling that discourage foreign investment, and the country is actively working to be classified as a developed market.
Chairman of the Financial Services Commission Kim Joo-hyun has responded to these developments by expressing the government's resolve to improve the nation's short-selling system with the goal of restoring confidence to all investors.
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