Seoul to allow naked short selling of bonds

South Korea plans to allow naked short selling of bonds next year in an effort to attract more foreign participation in the country’s underdeveloped and illiquid bond market.

The move comes as South Korea seeks inclusion in Citigroup’s World Government Bond Index, which is widely tracked by global bond investors, to expand liquidity and reduce volatility of the market.

“We plan to set up guidelines for bond short selling, which has been banned for stronger risk control at banks, after discussion with relevant ministries,” Kim Jong-chang, governor of the Financial Supervisory Service, said on Friday.

Last year Seoul introduced rules for naked short selling – whereby a financial instrument is sold without being borrowed first – but transactions have been effectively blocked by the authorities and banks have been reluctant to take any risks due to the absence of clear guidelines.

An FSS official said the new guidelines would be set up next year, allowing institutional investors to sell bonds that have not yet been borrowed.

The move sent bond prices higher on Friday.

Foreign investors including Citigroup have been calling for reforms to the country’s bond market such as allowing short selling and activating a repurchase market.

The government has taken some steps to attract foreign investors by scrapping a 14 per cent withholding tax on sovereign bonds and adopting international settlement systems. It also plan to improve the trading system, which currently relies on closed messenger services or calls, to open the door wider to foreign investors.

The country expects Citigroup to add it to the World Government Bond Index in the near future as it took these reform measures to qualify as an index component. Officials said more foreign participation would add depth to the market, although analysts said allowing short selling could make the market more volatile in the short term.

South Korea’s bond market has grown rapidly since the 1997 financial crisis, with trade volume rising more than 20 times to $2,152bn this year.

Earlier this year, South Korea lifted its temporary ban on short selling of non-financial stocks, which was imposed in October last year in the wake of Lehman Brothers’ collapse. But it still maintains the ban on financial stocks. However, covered short selling is allowed.

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