Two global investment banks based in Hong Kong face the biggest-ever fines and possibly criminal charges in South Korea for their alleged illegal short selling activities, which sparked calls from retail investors for tougher rules and heavier penalties against such practices.

The Financial Supervisory Service said it was seeking to impose its largest-ever fine on the two IBs for what is called “naked short selling,” FSS Gov. Lee Bok-hyun said in a parliamentary inspection that criminal punishment seems possible in the case.

Naked short selling refers to the practice of short selling stocks without first making borrowing arrangements, and the Korean financial watchdog deems it illegal.

The Hong Kong-based units of two global investment banks routinely conducted naked short selling in 2021 and 2022, the FSS said, without officially disclosing the banks' names. Local media outlets later claimed the two involved were HSBC and BNP Paribas. The firms did not confirm the reports.

According to the FSS, one of the investment banks placed orders to short sell 101 listed stocks, including Kakao, valued at 40 billion won ($29.8 million) between September 2021 and May 2022, even though it knew it would not be able to borrow the shares sold.

The other firm is accused of engaging in illegal short selling worth 16 billion won between August and December of 2021, involving shares such as those for Hotel Shilla.

FSS officials said the banks intentionally shorted stocks without borrowing over a long period, given that it is difficult to assume that they did not understand the local financial rules.

The latest crackdown on the two foreign firms is expected to help restore some trust in the Korean financial market where experts and retail investors alike have long called for more stringent rule implementation against such illegal activities.

But it should be noted that the FSS’ move came only after it set up an investigation team to prevent illegal short selling in August 2022. The crackdown should have been implemented much earlier, given the disturbing increase in illegal short selling activities in recent years.

Despite the stern warnings from Korean financial authorities, the number of illegal short selling cases jumped from four in 2020 to 16 in 2021 and 32 in 2022.

The underlying reason lies in the nominal and negligible amount of fines imposed on violators. The average fine for illegal short selling stood at a meager 180 million won over the past four years -- a small amount compared with huge profits violators usually reap. No wonder, then, that such illegal activities show no sign of abating.

Another trend that should draw attention from regulators is that foreign firms tend to engage in naked short selling, suggesting that there might be persistent problems with related rules and oversight.

According to Financial Services Commission data submitted to Rep. Yun Ju-kyung of the ruling People Power Party, over 10.7 billion won in fines were meted out to firms as a result of 45 cases of illegal short selling in the first eight months of the year. Of the 45 cases, 23 involved foreign firms. Notably, regulators imposed 9.89 billion won in fines, which is equivalent to 92 percent of the total, on foreign firms.

Aside from illegal short selling, there is a serious gap between regulators and retail investors when it comes to the impact of short selling on the stock market. Although the Korean government currently allows short selling for Kospi 200 and Kosdaq 150 stocks, investors hold a view that the practice adds to volatility in share prices and they are likely to suffer losses as a result.

In contrast, an official from the FSS investigation team downplayed the effect of the unlawful activity on the local bourse, saying the volume of stocks involved was small.

Regardless of the number of stocks involved, however, financial authorities and lawmakers should work together to introduce stronger restrictions against illegal acts that could erode public trust in the market.