The Question of Short Selling

Bans on short selling of stocks in China and South Korea have ignited debate regarding whether Hong Kong should follow suit.

This polarizing topic inevitably pits two camps against each other, the supporters who see the ban as an indirect stimulus, providing the stagnant market with a floor, while the critics are of the opinion that such move would scare away investors and reduce liquidity.

South Korean stocks soared after the country reimposed a full ban on short-selling, a controversial move that regulators said was needed to cease the illegal use of a trading tactic deployed regularly by hedge funds and other investors around the world.

Shanghai and Shenzhen stocks have also lifted since mid October, so on the surface it could be argued that a short-selling ban does correlate to bullish sentiments.

Like Korea, it is illegal to short-sell without any stocks in Hong Kong, so short sellers usually borrow shares from brokerages before selling them in the market and then buy them back at a lower level.

Some proponents of a complete short-selling ban have compared short-sellers to robbers and highlight the commonly-used short selling tactic, when extreme, results in market disruptions. Others argue it will be useless to outlaw short-selling if the main purpose is to prevent shares from falling, shares may just fall a little slower than they usually would but prices would eventually move back to equilibrium driven by supply and demand. Some analysts reckon that a short-selling ban is not worth the effort in Hong Kong.

There has been no shortage of research into the effects of short-selling as regulators across the globe have engaged in it at some point, typically during times of economic stress and crises. Europe’s Centre for Economic Policy Research (CEPR) has studied temporary short-selling bans in several European countries in response to crises, such as the 2008-09 Financial Crisis, the 2011-12 European Debt Crisis, and – most recently – in the initial phase of the Covid-19 pandemic in the spring of 2020.

It was found that the bans produced a significant reduction in spreads overall, and led to an improvement in liquidity of high-spread stocks but would primarily increase order processing costs and raise spreads for low-spread stocks. Other studies conclude that short-selling improves market efficiency and that restricting this activity with a ban only harms liquidity.

Both proponents and critics agree that these bans restrict trading activity and may cause prices to deviate from fundamentals, yet the two sides diverge on whether this is a desired effect or an unnecessary distortion, and whether bans improve or harm markets overall.

In Hong Kong, there are restrictions to limit malicious short-selling. Short sellers are typically required to place around 20% of the face value of the stocks’ to be shorted as well as having the full amount of cash from the disposals in a margin account with a brokerage, in addition to notifying the Securities and Futures Commission and HKEX.

Moreover, the selling price of stocks in a short sale order cannot be below the prevailing ask price, therefore it is unlikely that panic selling is tiggered by setting a low selling price, and the order may be hard to fulfil if there are not enough purchases.