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Preparing for Short Selling Spikes
Short selling is currently a hot topic in capital markets.
By definition, short selling is the sale of a security the seller does not own at the time of entering into the agreement, with the intention of buying it back at a later point in order to deliver it. When equity markets are down-trending, short selling can be a profitable trading strategy for financial institutions.
Short selling is not exactly a new phenomenon, having been around for more than 400 years. However, the practice has faced various iterations of regulation across different jurisdictions, with some regions maintaining more open regulatory stances than others.
As highlighted in our 30 August 2024 article, illegal short selling, also known as naked short selling, is coming increasingly under the regulatory microscope. In naked short selling, shares are sold without the custodian transferring ownership and without the investor ever lending the shares. The share owner, in fact, is unaware that their shares have been a part of any trading activity.
For example, in South Korea, the Financial Services Commission (FSC), South Korea’s financial regulator, imposed a total penalty of KRW 26.5 bn ($20.4 million) on two global conglomerates for naked short selling.
In light of this, in September 2024 the FSC announced revisions to Financial Investment Services and Capital Markets Act (FSCMA), the governance framework for securities transactions in South Korea, with the goal of improving short selling regulations. In particular, the FSCMA revisions will require institutional investors to set up their own electronic short selling processing systems and prepare relevant internal control standards. In addition, tougher monetary penalties will be put in place to help disincentivise illegal short selling practices.
There are two main reasons as to why naked short selling is problematic. If sellers cannot complete the transaction within the settlement cycle period and fail to deliver the shares to the buyer, the stock’s supply can appear inflated. In turn, this can negatively impact liquidity and depress prices. At the same time, naked short sellers are also known to disseminate false information about shares in order to cover their short positions at a reduced price and, as a result, generate greater profits.
Greater regulatory scrutiny has come at a time where short selling interest has reached record levels across equity markets, with traders expecting falling share prices. As highlighted by Markets Media Group, the short cover ratio for the entire S&P 500 reached a three-year high of 4.15 on 18 September, which gives an indication as to how many shares in the index are being ‘shorted’ relative to its trading volume.
On 3 October 2024, GreySpark Partners was pleased to reveal to Markets Media Group that one key reason for the observed increase in short selling may be the overvaluation of technology shares.
According to senior manager Rachel Lindstrom and subject matter experts Kelvin Lai and Ron Sung:
“The price of those [shares] has been going up for quite a long time now, since last year; so some investors may want to lock up their short sale activities. They want to rotate, they may look to another sector to relocate their portfolio. That drives up short selling activity.”
With a global regulatory crackdown in short selling afoot, it is imperative that financial institutions understand regulatory and governance requirements if it is to be conducted licitly.
GreySpark Partners has designed a proprietary model that will allow firms to prevent and identify instances of naked short selling. More information on this can be found here.
For further information, please do not hesitate to contact us at london@greyspark.com with any questions or comments you may have. We are always happy to elaborate on the wider implications of these headlines from our unique capital markets consultative perspective.