2023-11-08 10:37:00
“If we completely ban short selling and also touch the market maker system, we will never be able to even reach the threshold of an ‘advanced country stock market’ once more.” (Executive in charge of IB at a securities company)
History repeats itself. Rumors are circulating in the securities market that market makers will be the targets following the total ban on short selling. Some investor groups have already begun protests, calling for the ‘abolition of the market maker system.’ Headlines misleading the reality by saying, ‘Despite the total ban on short selling, KOSDAQ short selling actually increased,’ are inciting anger.
On the 6th, in line with the total ban on short selling, the Korea Exchange sent an official letter to securities firms’ derivatives market makers stating, ‘We are exempt from market creation obligations this week.’ In effect, it conveyed the message not to engage in short selling. In fact, on the 6th, market maker short selling in the derivatives market was ‘zero’.
The market maker’s job is to submit quotes in both directions to reduce the gap between ask and sell prices, increase the possibility of transaction completion, and facilitate transactions. If you sign a contract with the Korea Exchange, you are called a market maker (MM), and if you sign a contract with a listed company or exchange traded fund (ETF), you are called a liquidity provider (LP).
It is important for market makers who must provide liquidity by submitting two-way quotations to have a ‘risk neutral’ position due to the nature of their work. Since you cannot build quotes in only one direction, you cannot bet on the direction of the market. To briefly summarize, there are many cases where liquidity for sellers is provided through buying, and liquidity for buyers is provided through (borrowed) short selling.
De facto banning their short selling is equivalent to saying that the exchange itself blocked the smooth trading function of the market.
Derivatives market makers are not the only problem. The stock market market maker function has already been paralyzed since September of last year. The average daily short selling volume of stock market makers this year was already ‘zero’. There was no short selling at all to ensure a smooth supply of quotes.
All problems started in September 2021.
At the time, the Financial Supervisory Service imposed a fine of close to 50 billion won on the market makers, saying they had engaged in ‘market disruption’. The financial authorities seemed to agree with the claim of some investor groups at the time that ‘even following a complete ban on short selling, market makers are still practicing short selling and are becoming a conduit for illegal short selling.’
This measure became unprecedented when the Financial Services Commission concluded that there were ‘no charges’ in July 2022. Although fines disappeared, securities companies that participated as market makers had no choice but to worry regarding regulatory risks.
The number of stock market makers, which was 14 each in KOSPI and KOSDAQ before the imposition of fines, decreased to 6 in KOSPI and 5 in KOSDAQ as of the end of the third quarter of last year. During the same period, the number of stocks subject to market making decreased from regarding 670 to regarding 540, and the transaction completion rate for market making stocks also plummeted from 60% to 48%.
In the first half of this year, Shinhan Investment & Securities gave up its market maker status, and Hi Investment & Securities also gave up its KOSDAQ market maker status. E-Best Investment & Securities is considering giving up as a market maker, but in the third quarter, the market creation obligation performance rate for both KOSPI and KOSDAQ was 0%, meaning it is virtually not conducting business.
The market maker system is a system that is being introduced in all advanced stock markets such as the US and the UK. It was also introduced in the domestic stock market in 2016. Domestic and international research results show that the market maker system ▲increases the possibility and efficiency of completing transactions and ▲significantly improves liquidity indicators.
It also increases the volatility of stock prices, but contrary to popular belief, this appears to be in a positive direction.
According to the Korea Institute of Taxation and Finance, the number of stocks subject to domestic market creation increased significantly from 82 to 574 in 2018. As a result of analysis of stocks newly subject to market creation during this period, the stock prices of these stocks rose by an average of 44%. As liquidity was supplied to the stock and trading increased, stock price volatility increased, but ultimately it worked in the direction of rising stock prices.
These results have been proven at home and abroad over the past several decades. A 1997 French study found that stocks subject to market creation achieved an average excess return of 5%. A 2013 Euronext study confirmed that the introduction of the market maker system generated excess returns of 3.5% on average. In the derivatives market, a 2004 study conducted on the Chicago Mercantile Exchange concluded that market makers have improved the speed and efficiency of price discovery.
The imposition of fines on market makers and the resulting contraction of market makers is already having a negative impact on the domestic stock market.
As a result of the Capital Market Research Institute’s analysis of the effects of the regulation of short selling during the COVID-19 period in February, the domestic stock market’s price efficiency, volatility, and liquidity did not recover to previous levels even following the resumption of short selling. As a background, the researcher suggested the possibility that the decline in market makers offset the positive impact of the resumption of short selling.
Despite this situation, the exchange has once once more taken measures to force market makers to engage in anti-market behavior. The possibility of additional regulations is also raised as the government and exchanges appear to be compromising with public opinion. There is a possibility of imposing stronger sanctions, such as the abolition of the ‘market maker securities transaction tax exemption’ policy, which has been controversial ahead of the election.
In the securities market, people complain of helplessness. The general consensus is that it cannot be trusted as a government policy that claims to be ‘pro-market’ and ‘liberal’.
The head of the stock management division of a mid-sized asset management company said, “The government has continuously introduced regulations since 2020 that discourage the activities of market makers, such as abolishing the transaction tax exemption for market-making stocks with a market capitalization of 1 trillion won or more and excluding stocks with a market capitalization of 10 trillion won or more.” “If we further neutralize the market maker system while losing the trust of domestic and foreign investors by completely banning short selling without justification, it is no different from a declaration to return to the way it was before the opening of the capital market in 1992,” he said.
For reference, it is false to say that KOSDAQ short selling increased even following the complete ban on short selling. The total KOSDAQ short selling amount on the 6th was 164.9 billion won, a 40% decrease from 274.4 billion won on the 3rd. Short selling by market makers and liquidity providers subject to exceptions to the uptick rule increased from KRW 77.2 billion on the 3rd to KRW 164.9 billion on the 6th, but this is believed to be due to the rapid increase in the overall trading value of KOSDAQ from KRW 6 trillion to KRW 11 trillion.
In particular, it is pointed out that the trading volume of ETFs such as KOSDAQ 150 Leverage and Secondary Battery Theme has increased explosively, and short selling by liquidity providers of the ETF has increased. The proportion of short selling proceeds among the total trading value of KOSDAQ decreased from 4.08% on the 3rd to 1.46% on the 6th.
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