Foreign investors have been strong buyers of South Korean stocks such as tech groups Samsung Electronics and SK Hynix, pouring more than $4.4bn into the market in November © EPA

South Korea plans to jail and levy hefty fines on traders that illegally bet against the country’s stocks as part of a broader campaign against short selling that has annoyed hedge funds.

Investors who break rules that outlaw so-called naked short selling could be imprisoned for at least a year or have to cough up financial penalties of up to five times any profit they make on a trade, South Korea’s top regulator the Financial Services Commission said on Thursday.

Short sellers profit from successfully betting that a security’s price will fall. Naked short selling refers to doing this without first borrowing or owning the underlying security.

The beefed-up punishments come after regulators in August extended a ban on all short selling by another six months. The initial prohibition was implemented during a sharp sell-off in equities sparked by coronavirus early in the year. 

Restrictions on short selling have confounded hedge funds, particularly as the benchmark Kospi Composite has surged nearly 90 per cent from its low in March on expectations of a swift economic recovery in South Korea.

“Sending someone to prison for short selling sounds extreme,” said Albert Yong, head of Petra Capital Management, a South Korean hedge fund. “It is nonsense that they still maintain a short-selling ban in the booming market. Stocks like Tesla have gone up so much despite heavy short selling.”

Mr Yong added that the ban on short selling has had a negative impact on South Korea’s image as a capital market. It is one of three countries in the world that maintains such a ban, along with Malaysia and Indonesia.

Regulators are considering lifting the embargo on short selling when its current extension expires in March, although naked short selling will remain off limits.

Retail investors have generally been strong supporters of restrictions on funds taking bearish bets, which may have contributed to buoyant stock prices. The Kospi Composite is now trading at almost 14 times its projected earnings for the next 12 months — a near decade high.

Foreign investors have also been strong buyers of South Korean stocks such as tech groups Samsung Electronics and SK Hynix, pouring more than $4.4bn into the market in November — the highest monthly inflow in seven years. Foreign investors own more than a third of the country’s stock market.

The tougher restrictions on short selling are due to take effect three months after they are approved by South Korea’s cabinet, which is likely within the next two weeks.

They also require that investors keep a record of all their short-selling transactions for five years. Regulators also plan to improve their monitoring systems alongside the country’s stock exchange to ferret out illegal short selling.

The regulations were part of wider reforms of financial markets and investments that South Korea’s parliament passed on Wednesday. They also include tighter regulations designed to improve corporate governance among big businesses.

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