• Bloomberg

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South Korea’s government has found a tool to keep the retail investors that are increasingly dominating the stock market happy: A short-selling ban that’s turning into one of the world’s longest and broadest.

In August, the government extended the ban the country imposed in March for another half a year, much to the consternation of institutional investors needing to short sell to manage risks. That ban was prolonged even though the benchmark Kospi has soared about 60 percent since its March swoon. The extension makes the ban one of the longest by any major market in the wake of COVID-19.

The rationale for this continued ban lies with the increasing importance of individual investors, who make up 70 percent of the stock market now, according to analysts and regulators.

The dilemma for Seoul is that with so many mom-and-pop investors entering the market this year, reintroducing short selling could cause a crash and upset an electorate that’s increasingly invested in the stock market’s performance.

Korean regulators are now discussing a partial lift of the extended ban when it expires on March 15 — only blue chip stocks could be allowed to be sold short, a senior official who isn’t authorized to speak publicly said. The Financial Services Commission, a regulator overseeing Korea’s short-selling rules, declined to comment on the issue.

The ban has frustrated institutional investors, both local and foreign, who have been put off from investing in South Korea. Their trading value has dwindled to just 35 percent of the Kospi’s total versus 52 percent at the end of 2019, according to the Korea Exchange. Institutional investors also have to battle a perception that short-selling can be used to manipulate the market, especially after the government in September fined four unnamed foreign firms for naked shorts — the illegal practice of selling shares without borrowing them.

While tech stocks have been buoyed by individual investors using apps such as Robinhood in the U.S., in South Korea it’s biotech stocks such as Mekics Co. and Shin Poong Pharmaceutical Co. — up 839 percent and 1,743 percent this year, respectively — that have captured retail punters’ imaginations.

A stock market where institutional investors are missing is more likely to be volatile and inefficient. Short sellers also play a large part in uncovering frauds: Muddy Waters famously helped expose accounting scandals like that of China’s Luckin Coffee Inc. early this year.

“Short-selling is necessary for markets,” said Chan H. Lee, managing partner at Petra Capital Management, a Seoul-based hedge fund focused on a long-only strategy. “Some of the bubble in the biotech sector could be due to the lack of short selling, which has allowed stocks to keep surging to high valuations.”

Another risk Korea faces from banning short-selling is an acceleration of the foreign sell-off in shares. If the ban is tightened or continued beyond March 2021, some international index providers such as MSCI Inc., which rates South Korea as an emerging market, could cut the country’s weighting in the MSCI emerging markets index, according to Erica Ko, Korea compliance head at Credit Suisse Group AG. MSCI didn’t reply to emails for comment.

In June, the index compiler warned Turkey that it would lower the MSCI Turkey Index’s status to a frontier market from an emerging market, citing “deteriorating accessibility.” After rushing to prohibit bearish bets to tame markets convulsed by the pandemic, the number of major markets that have maintained the ban has dwindled to Indonesia, Malaysia and South Korea.

“It’s shocking for an economy so advanced and a market that was once the darling of Wall Street to impose a ban like this for such a long time, especially since volatility has come down,” said Lyndon Chao, Hong Kong-based head of equities at ASIFMA, a regional financial industry association.

“We’ve seen retail investors rushing into the market in a big way to fill the void, but in a world where everyone is competing for capital, you can’t have a market operating with just retail investors.”

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