Impact of short-selling bans: Market dynamics during COVID-19

This study investigates the impact of the COVID-19-driven short-selling ban on the Korean stock market, with a specific focus on changes in market dynamics such as liquidity, volatility, and turnover. While conventional financial theories and prior international evidence suggest that short-selling bans tend to reduce market efficiency and trading activity, empirical findings from Korea indicate a counterintuitive outcome: market dynamics actually improved during the ban period. Using a comprehensive dataset covering the KOSPI and KOSDAQ markets between 2019 and 2021, this study analyzes mean-median comparisons, daily trends, and firm-fixed effects regressions to assess the magnitude and significance of these changes. The analysis reveals that key market variables—such as Amihud illiquidity, bid-ask spreads, price range, and turnover ratio—showed substantial improvement during the ban. This anomaly is explored through the lens of investor composition, particularly the surge in participation by individual investors. The study theorizes and empirically tests a causal relationship between reduced short-selling and increased individual investor activity, using both Granger causality tests and structural equation modeling (SEM) over a decade-long period (2010–2021). Findings confirm that decreases in short-selling activity Granger-cause increased trading by retail investors, who view short selling as destabilizing. Their increased activity during the ban helped enhance liquidity and trading volume, contrary to global precedents. The paper contributes to the literature by showing that investor composition—especially the dominance of retail investors—can significantly mediate the effects of market regulations. It offers policy implications for emerging markets with similar structures, suggesting that short-selling bans may not always hinder market performance if they align with investor sentiment. These insights highlight the importance of tailoring regulatory policies to local market characteristics rather than importing global standards wholesale.