Harnessing benefits of short-selling

IS short selling a boon or a bane for the stock market? News headlines tend to frame short selling as a manipulative tool that triggers market volatility and instability.

An incident that made international headlines is the GameStop short squeeze saga, where in January 2021, retail investors from the Reddit community (r/wallstreetbets) drove up the price of GameStop shares, which are listed on the New York Stock Exchange.

The collective aim of the retail investors was to force the hedge funds, which had heavily shorted the stock, to cover their positions, leading to a short squeeze.

GameStop’s share price skyrocketed from around US$20 to over US$400 at its peak, causing significant financial losses for short sellers, primarily the hedge funds.

What are the learnings for us in Malaysia? Should we therefore conclude that short selling is indeed a bane for the stock market, and should not be allowed in Malaysia’s stock market?

A deeper examination of short selling in Malaysia’s stock market reveals a different story – that short squeeze on a particular stock is unlikely due to robust regulations governing short selling.

Bursa Malaysia’s mechanisms require investors to borrow securities before short selling.

Furthermore, only selected securities, known as Approved Securities, are eligible for short selling, and these are subject to rigorous criteria and regular reviews.

Bursa Malaysia also has controls such as price and volume limits. For instance, short-selling orders must be placed at the same price as the last traded price, and the total gross short position is limited to 10% of the total number of listed shares of a particular Approved Security.

These measures ensure a controlled and orderly market, significantly reducing the risk of a short squeeze, like in the case of GameStop.

To proactively ensure market stability during exceptional events, the Securities Commission and Bursa Malaysia have introduced a temporary suspension on short-selling activities.

This decision was made after closely monitoring market conditions and observing similar measures by other jurisdictions to curb market volatility.

During the Covid-19 pandemic, Regulated Short Selling (RSS) and Intraday Short Selling (IDSS) were suspended in March 2020 and were gradually lifted from January 2021 [Note: Permitted Short-Selling (PSS) was unaffected]. These measures were aligned with action by major global markets to preserve market confidence and ensure fair and orderly trading conditions during a period of unprecedented uncertainty.

Orderly increase

Since the gradual lifting of RSS and IDSS suspension from January 2021, short-selling traded value as a proportion of market capitalisation on Bursa Malaysia has more than doubled to 0.98% in 2024, from 0.51% in 2021, underpinned by growth in total market capitalisation of the bourse during this period.

Bursa Malaysia’s updated Approved Securities list3 as at Dec 31, 2024, increased to 469 stocks from 441 stocks in the previous list with total market capitalisation of RM1,821bil. This expansion reflects a 0.3% increase in market capitalisation of the Approved Securities list.

It’s important to note that there is a correlation between short-selling traded value and the number of Structured Warrants (SW) issuances. Short selling allows product issuers such as SW issuers to hedge their market exposure effectively and is a critical tool for them to manage their risks efficiently.

Alongside the rise in short-selling traded value, the number of SW issuances increased by 24% to 1,804 in 2024 from 1,451 in 2021.

Hindrance to development of capital market

Any suspension or the lack of short-selling mechanisms can hinder the development of the capital market.

A review of academic literature by the World Federation of Exchanges found evidence pointing unanimously towards bans “being disruptive for the orderly functioning of markets, as they are found to reduce liquidity, increase price inefficiency and hamper price discovery”.

This results in wider bid-ask spreads which leads to increased trading costs.

Index providers, such as FTSE and MSCI, include the existence of a well-functioning short selling and securities lending market in their criteria for a country’s inclusion in their developed market indices.

The regression of a capital market’s short selling and securities lending facilities may trigger the index providers to consider downgrading the country’s status, as in the case of Turkey and MSCI in 2020.

After a series of short-selling bans, MSCI considered launching a reclassification for the MSCI Turkey Index to Frontier Markets or Standalone Markets status.

As highlighted in the MSCI 2020 Market Accessibility Review, “the accessibility level of the Turkish equity market has been adversely impacted by the introduction of short selling and stock lending bans in October 2019 and February 2020, respectively.

These bans severely restrict the ability of institutional investors to express active investment views and hedge portfolio risk.” (Update: Turkey’s short-selling ban on shares in the BIST-50 index, comprising the largest 50 companies on its stock exchange, was lifted on Jan 2).

Development of short-selling regulations

To meet the needs of different sectors of market participants, short selling in Malaysia has evolved over the years whilst preserving investor confidence and a fair and orderly market.

Since its inception in 1996, RSS has been a cornerstone in providing investors with essential hedging tools, enabling them to manage their risk effectively.

The temporary suspension of RSS during the 1997 Asian financial crisis was meant to mitigate heightened market volatility.

However, its reintroduction in 2007 underscored the importance of such mechanisms in maintaining a balanced and resilient market environment.

Building on this foundation, the introduction of PSS in 2008 marked yet another milestone, allowing for the short selling of exchange-traded fund (ETF) units to facilitate ETF market making, ensuring tighter spreads and better price discovery.

In 2018, the launch of IDSS further democratised access to short selling, enabling all investors to engage in short-selling activities with the requirement to close their positions within the same trading day.

This innovation has facilitated greater market vibrancy by allowing for more dynamic trading strategies and improving price discovery processes, while being carefully controlled to ensure market stability and prevent excessive volatility.

These strategic enhancements reflect a commitment to addressing investor needs while preserving market confidence. By providing robust mechanisms for risk management and fostering a more vibrant trading environment, these measures contribute to the overall health and stability of the Malaysian capital market.

Key mechanism for market stability, efficiency

Amidst the noise and confusion on short selling, we need to revisit the essence of a well-regulated short selling: a key component of a well-functioning capital market, contributing to price discovery, market vibrancy and efficiency, and risk management.

Price Discovery: Short selling plays a crucial role in the price discovery process.

By allowing investors to express negative views on overvalued stocks, short selling helps correct inflated prices and ensures that securities are more accurately valued based on their underlying fundamentals.

This mechanism is essential for reflecting the true value of assets, thereby enhancing overall market transparency and integrity.

Market vibrancy and efficiency: The ability to short sell contributes to market vibrancy by increasing trading activity and liquidity. Enhanced liquidity ensures that there are sufficient buyers and sellers in the market, facilitating smoother and more efficient transactions.

This vibrancy is vital for the functioning of capital markets, allowing for a broader range of investment strategies and opportunities.

Risk management: Short selling is a vital risk management tool. It supports various investment strategies, including market making activities, hedging existing positions, and active portfolio management.

By providing a means to hedge against potential losses, short selling enables investors to manage risk more effectively, contributing to the stability and resilience of financial markets.

In conclusion, short selling can be harnessed to benefit our stock market. Key to achieving this lies in well-regulated short-selling frameworks, such as RSS, PSS and IDSS.

These frameworks are essential for balancing market vibrancy with stability, ensuring that short-selling activities are conducted in a controlled and transparent manner, while preserving market confidence and preventing excessive volatility.