Why Is Short Selling Illegal in Some Countries? (2024)

Short selling—when investors sell borrowed stocks expecting their price to decline—is often unpopular with the general public and has been banned in some countries. The premise of the strategy, which is typically a form of insurance in a portfolio, strikes many as wrong since it seems to profit from the problems of others. The banning of short selling in various jurisdictions over time can also be attributed to economic, regulatory, market-specific, and social factors.

Each country's approach to short selling is based on its financial market's dynamics, regulatory philosophy, and economic policy objectives. Understanding the reasons behind bans or limits to short selling requires knowing the specific concerns about market stability and national economic interests where they occur.

Historical Examples of Short Selling Bans

Historically, there have been important instances when short selling was banned in various countries, usually in response to financial crises. Here are occasions when banning short sales was part of an emergency response to stabilize markets and protect the economy:

• The Great Depression (1930s): In the wake of the 1929 stock market crash and during the Great Depression, the U.S. implemented regulations to control speculative short selling. For instance, the Securities Exchange Act of 1934 introduced rules governing short selling and established the Securities and Exchange Commission (SEC) to enforce them.
• Global financial crisis (2008): During the 2008 financial crisis, several countries temporarily banned short selling to protect their financial markets. In the U.S., the SEC temporarily banned short selling in financial stocks in September 2008. Similar measures were taken in the United Kingdom, Australia, Canada, and several European countries to safeguard financial institutions and restore market confidence at a perilous time.
• Eurozone debt crisis (2011): During the eurozone debt crisis, countries like Spain, Italy, France, and Belgium imposed temporary bans on short selling certain stocks in the banking and financial sectors. These actions aimed to stabilize and protect the banking systems.
• COVID-19 pandemic (2020): The pandemic led to extreme market volatility, prompting several countries to implement short-selling bans or restrictions. Countries like Spain, Italy, France, South Korea, and Greece enacted such measures to curb market declines and maintain financial stability during the health crisis.

These examples underscore a pattern: short selling bans are typically enacted during periods of severe economic distress or market turmoil. The rationale is to prevent these sales from exacerbating market declines, protect critical economic sectors, and maintain investor confidence. However, economists and financial experts debate the effectiveness and long-term impact of such bans.

Countries Where Short Selling is Illegal

Some countries restrict but do not ban short selling. China has stringent regulations on short selling. The Chinese government has been known to impose temporary bans or restrictions on short selling, especially during periods of market volatility. It allows the practice, but it's limited to a select list of stocks.

Short selling is banned in South Korea until at least June 2024. The ban was part of the fallout from investigations into naked short selling by institutional investors. In early 2023, South Korea's financial regulators fined five foreign companies, including Credit Suisse, for naked short selling. This is an often-illegal form of short selling where an investor shorts stocks without first determining if they can be borrowed.

Malaysia has long had a cautious approach to short selling. Following the Asian financial crisis in 1997-1998, Malaysia banned short selling. Although the ban was lifted almost a decade later, restrictions were reintroduced in various forms over the years, especially during market downturns.

Indonesia has had temporary bans on short selling, usually in response to significant market downturns. The Indonesian Financial Services Authority has the power to impose and lift such bans. Also, both Greece and Turkey have had temporary bans on short selling, also in response to extreme market conditions.

In India, short selling is allowed but within stringent regulations. The Securities and Exchange Board of India regulates the practice, which must meet margin and disclosure requirements.

All these regulations are subject to change based on market conditions and regulatory decisions.

Why Is Short Selling Illegal in Some Countries?

Short selling is illegal or heavily restricted in some jurisdictions. Here are the major reasons why:

• Market stability: Short selling can exacerbate market downturns. In a declining market, short sellers can contribute to price declines as they sell borrowed shares, hoping to buy them back at a lower price. This can cause a snowball effect, which can then lead to panic selling and market crashes. Banning short selling is defended as a means of averting these spirals.
• Preventing market manipulation: Short selling has been used in market manipulation schemes like bear raids, where traders short a stock and then spread negative information to drive the stock price down. The practice is illegal.
• Maintaining investor confidence: Short selling could undermine investor confidence during economic uncertainty. Investors might perceive increased short selling as a sign that something is fundamentally wrong with the market or specific companies, leading to reduced investment and economic slowdown. The turmoil could then send jitters through the wider economy.
• Protecting companies: Short selling can pressure companies, especially those already struggling. A decline in stock prices because of short selling would negatively affect a company's ability to raise capital and maintain its operations, potentially leading to layoffs, reduced investment, and other problems for the firm.
• Regulatory and oversight challenges: In some markets, the regulatory framework may not be robust enough to monitor and regulate short-selling activities effectively. This could lead to illegal practices like naked short selling. Such practices can distort market functioning and lead investors to believe the market is operating unfairly. Banning the practice entirely is seen as the better alternative.
• Economic policy considerations: The decision to ban or restrict short selling could align with broader economic policies. For instance, during a financial crisis, governments might take a range of measures to protect their economies, and controlling short selling is sometimes part of this tool kit.

While it is important to note that short-selling bans might provide short-term market stability, they can also have negative long-term effects, such as reducing market liquidity and reducing price discovery mechanisms.

Why Is Short Selling Legal in the US?

Short selling is legal in the U.S. for several reasons, reflecting the country's regulatory approach and philosophy toward financial markets. One reason is market efficiency and liquidity. Short selling is said to contribute to market efficiency. By allowing investors to sell stocks that are perhaps overvalued, short selling helps correct market mispricings. As such, investors should find more prices that reflect the true value of a company based on available information. Additionally, short selling increases market liquidity, making it easier for investors to buy and sell securities.

Another reason short selling is legal in the U.S. is price discovery. Short selling allows the market to incorporate negative information into stock prices, not just positive. This should lead to a healthier market since prices will more likely reflect both the good and the bad news.

Additionally, short selling is valuable for hedging and managing risk. Investors and portfolio managers use short positions to hedge against downside risk in their portfolios, not unlike a person taking out car insurance. This could be particularly important in volatile markets or during economic downturns.

The U.S. also has a robust regulatory framework that governs short selling. The SEC has rules to prevent abusive practices, such as the uptick rule and its ban on naked short selling. These regulations are designed to prevent market manipulation and ensure fair trading.

The legal status of short selling in the U.S. also reflects a broader economic view favoring minimal intervention in the market. The idea is that markets, when left to operate independently, are the best mechanism for allocating resources and ensuring economic growth and stability.

While short selling is often controversial, especially during market downturns, there is a general understanding among U.S. investors and regulators that short selling is a legitimate investment strategy. This acceptance is partly because of the education and transparency around market practices in the U.S.

What is Naked Shorting?

The SEC banned naked short selling in 2008 after the financial crisis. Before this ban, the SEC amendedits Regulation SHOto limit naked shorting by taking away some loopholes. Regulation SHO requires the SEC to publish lists of stocks with unusually high rates of failing to deliver, a sign of naked shorting.

In naked short selling, the investor sells shares without first ensuring that they can be borrowed. Essentially, it involves selling short shares that the seller does not own and has not confirmed can be gotten should they be needed. As a result, the seller may fail to deliver the shares to the buyer within the standard settlement period or may be fraudulently selling shorts on stocks that the seller never intended to trade for.

Naked shorting can be used to manipulate the market. By selling a large volume of nonexistent shares, a trader could artificially increase the supply of a stock, driving down its price. This could harm companies and investors, especially in smaller or less liquid markets.

Also, naked short selling can lead to failures to deliver on settlement dates, disrupting normal market operations and leading to a chain reaction of trading and liquidity issues.

The Bottom Line

The legality of short selling varies globally because of diverse regulatory philosophies, economic conditions, and market structures. Key reasons for its prohibition or restriction in some jurisdictions include concerns about market stability and the prevention of market manipulation. Short selling can amplify market downturns, particularly during periods of economic stress, leading to panic selling and destabilizing financial markets. Additionally, it could be used in manipulative trading practices, such as spreading false information to profit from declining stock prices, which requires regulations to protect investors and maintain market integrity.

Moreover, short-selling bans or restrictions could align with broader economic policies or national interests, such as safeguarding key industries or companies during vulnerable periods. In markets with less developed regulatory frameworks, effectively monitoring and regulating short-selling activities can pose significant challenges, making bans or restrictions a more practical solution.