Short Selling

Short selling, the practice of selling borrowed securities with the intention of repurchasing them at a lower price, plays a significant role in financial markets by enhancing liquidity and enabling price discovery. However, due to its potential to amplify market volatility and the risks associated with naked short selling – selling shares without ensuring their availability for settlement – regulators worldwide have implemented stringent frameworks to oversee and control short selling activities.

Global regulators have intensified scrutiny, imposing strict rules and heavy penalties on firms failing to meet compliance standards. Despite financial services firms implementing robust controls, recent enforcement actions highlight persistent challenges and gaps in regulatory adherence.

This article outlines developments in short-selling regulation and measures firms can put in place to help achieve compliance.

Increasing Regulatory Complexity and Divergence

Firms operating across jurisdictions must navigate a web of differing short selling regulations. For example:

In the EU, the Short Selling Regulationopens in a new tab (SSR) mandates that all short sales of shares and sovereign debt instruments be covered, effectively prohibiting naked short selling. The regulation also requires investors to notify authorities of significant net short positions and, in certain cases, disclose them publicly. Exemptions are provided for market-making activities and authorized primary dealers. Additionally, the SSR grants authorities intervention powers to address exceptional situations that may pose systemic risks or threaten financial stability.

On leaving the EU, the UK converted EU SSR into domestic law. A review of the UK SRR has resulted in some small immediate changes in the new Short Selling Regulation 2025opens in a new tab. The regulation also granted the FCA powers to set more detailed rules to complete and implement the new regime responding to industry feedback to HM Treasury’s earlier Call for Evidenceopens in a new tab. The FCA plans to consult on these new rules in Q3 2025.

In the United States, the Securities and Exchange Commission (SEC) enforces regulations to prevent abusive short selling practices. Notably, the SEC’s alternative uptick rule, established in 2010, restricts short selling when a stock’s price experiences a significant decline, aiming to prevent potential market manipulation. The SEC also mandates transparency through regular reporting of short positions by institutional investors.

South Korea and Hong Kong  (SAR), China have some of the strictest short selling rules, including outright bans during market stress. The Financial Services Commission (FSC), South Korea’s market watchdog, has imposed substantial fines on financial institutions for violations. For instance, in July 2024, the FSC levied a combined fine of approximately $19.6 million on two firms for executing naked short selling orders involving over 160,000 shares of multiple listed firms.

Staying compliant across these varied regimes requires significant resources, frequent policy updates, and real-time monitoring.

Controls and Compliance Measures

Firms have implemented various controls to comply with short selling regulations and mitigate associated risks:

• Pre-Trade Verification: Ensuring that securities are available for borrowing before executing a short sale to prevent naked short selling.
• Real-Time Monitoring: Utilizing advanced surveillance systems to detect and address irregular trading activities promptly.
• Automated Trading Controls: Incorporating safeguards within trading algorithms to prevent erroneous orders, such as size limits and validation checks.
• Regulatory Reporting Systems: Establishing processes to accurately report significant net short positions to relevant authorities within mandated timeframes.

Despite these measures, recent enforcement actions indicate that firms continue to face multiple challenges in meeting regulatory expectations. Common deficiencies include inadequate system controls, insufficient oversight of algorithmic trading, and failures in timely and accurate reporting of short positions.

Technology and Operational Risk – Many regulatory breaches stem from system failures, inaccurate trade markings, or algorithmic trading errors. In May 2024, the UK’s Financial Conduct Authority (FCA) fined a large financial institution close to £28 million due to failures in trading systems and controls. The FCA emphasized the necessity for firms engaged in trading activities, including algorithmic trading, to implement effective systems and controls to prevent such errors. Similarly, in April 2023, the Financial Industry Regulatory Authority (FINRA) fined a US bank for mislabelling millions of short sale orders due to a coding error.

Institutions must invest in their trading systems and controls, such as automated validation systems, real-time error detection, and stress testing algorithms to minimize such risks.

Compliance with Short Position Reporting – Regulators demand accurate and timely disclosure of short positions. However, many firms struggle with:

• Threshold inconsistencies: Some jurisdictions require disclosure at a 0.1% net short position, while others mandate it at 0.5%.
• Real-time aggregation: Accurately aggregating short positions across multiple books and asset classes is complex, particularly for global trading desks.
• Data integrity: Ensuring high-quality data to prevent false or incomplete disclosures is an ongoing challenge.

Market Abuse and Regulatory Scrutiny – Activist short selling, where firms bet against stocks while publicly criticizing companies, has drawn increased regulatory attention. Hedge funds backing short reports now face scrutiny, with regulators investigating potential coordinated market manipulation.

Strengthened internal surveillance, trade justification processes, and market abuse monitoring will help firms mitigate regulatory exposure.

Resource Constraints and Compliance Costs – Implementing and maintaining effective short selling controls require substantial investment in technology, personnel, and legal expertise. Many firms struggle with keeping up with regulatory changes requiring constant policy updates, hiring skilled compliance professionals due to high demand and limited supply, and managing costs of fines and remediation from enforcement actions.

Change ahead – The UK, EU and Switzerland will follow the US moving to T+1 settlement in October 2027. With the settlement period compressed, firms are likely to move to greater automation of their securities lending processes and controls so that they don’t end up with uncovered short sells.

Bridging the Compliance Gaps

To meet regulatory expectations, firms can:

• Enhance automated trade surveillance to detect improper short selling activities in real time.
• Invest in tools for accurate trade marking and reporting.
• Strengthen governance frameworks with clear accountability and escalation protocols for trading errors and compliance breaches.
• Educate trading and compliance personnel on the latest regulatory requirements.
• Implement cross-border compliance programs to align global short selling policies.
• Monitor regulatory developments to stay ahead of evolving requirements and enforcement trends.

By addressing these challenges, firms can reduce regulatory risk, enhance market integrity, and maintain investor confidence in an increasingly complex short selling environment.

KPMG in the UK has experience working with firms to develop ways to more effectively mitigate regulatory risk and to embed sustainable change in front office, oversight functions, surveillance and key support teams.