Korea equity derivatives reform fails to impress dealers

The Korean Wave was coined to describe the popularity, since the late 1990s, of South Korean culture, including TV dramas and music like K-pop. And national champions such as Samsung have proudly stepped forward to showcase the country's tech savvy. But Korea's financial markets seem to be bucking the trend as equities stagnate and policy-makers struggle to revive the sector's flagging fortunes.

In 2014 the benchmark Kospi 200 was the worst performing major benchmark in Asia, down more than 5% (see charts below). In contrast, the Shanghai composite soared 50% and the Nikkei rose 9%. Moreover, the Kospi 200 has made no progress since hitting a post-crisis peak of 291 in April 2011. It currently stands at 250.

Korean authorities are concerned, especially when neighbouring Japan is attempting reform via prime minister Shinzo Abe's radical brand of economics and China has shaken off an equity market slump that was present until last year. This concern has led Korea's Financial Services Commission (FSC) to announce a swathe of policy measures to invigorate ailing markets. Its proposals fall into three categories: expanding the range of investment products; improving market infrastructure and the trading system; and increasing the participation of institutional investors.

This isn't the first time the regulator has launched a raft of rule changes and initiatives designed to revive the markets. In June 2014 the FSC announced its 'Roadmap for a derivatives market', which included some new products but also greater barriers to entry for retail investors. In November 2013 the FSC revealed its '10-10 value-up plan' to use financial services to raise GDP by 10% in 10 years in which it spoke about relieving regulatory barriers. But the damage may have already been done in 2012 and 2011 when the FSC introduced enhanced monitoring and stricter margin requirements for investors in the successful equity-linked securities, derivatives-linked securities and equity-linked warrants markets.

Given this string of recent initiatives, what is different this time? Very little, says John Sung, head of single stock flow and exotics at UBS in Hong Kong.

"These are incremental efforts and nothing is immediately a home run that will revolutionise the market."

Productive ideas

As part of the FSC's first measure, intended to extend the range of investment products, the regulator will consider introducing mini futures, renminbi futures, V-Kospi options, and futures based on exchange-traded funds (ETFs).

Sung believes that a mini version of the Kospi 200 futures contract could increase volumes. "If mini futures can reduce the hurdle for retail participation that will be helpful for the market. In the past, negative measures for liquidity like adjusting the options multiplier to 500,000 won ($460) has increased the hurdles for retail."

The options multiplier used to have a threshold of just 100,000 won which was increased to 500,000 in 2012, putting the brakes on a market that had grown in the preceding years to become the biggest equity index options market globally.

The standard Kospi 200 futures contract is currently 500,000 won and while the FSC has not provided any further details about the size of the mini, market participants suggest it could be one-fifth the size.

But a lack of consistency on the margin required of retail investors could act as a barrier, says Yeonchoo Kim, head of equity derivatives trading at Korea Investment & Securities. While the FSC requires investors trading Kospi 200 futures to hold 30 million won of initial margin, those trading V-Kospi futures must have 50 million won up front.

"Even if they release mini futures still the minimum margin is 30-50 million won so they won't harmonise with each other; that's not a reason to buy a mini futures," he says.

Indeed the Korean regulator's wish to expand its market often collides with its equal if not greater concern to protect consumers, especially when it comes to derivatives. This conflict has been evident in previous policy announcements.

Sungjeh Moon (pictured), senior equity derivatives trader at NH Investment & Securities (formerly Woori Securities) in Seoul, expects the balance to remain in favour of consumer protection.

"New listings can be discussed but Korean regulators will keep their strict policy on derivatives markets especially for retail customers. Tight regulation such as increasing margin required, mandatory education, was introduced from last year-end. With a high degree of concern on the issue of financial customer protection, I expect such a strict view of regulation to persist for a considerable time," he says.

Utility of volatility

Another product in the pipeline from the Korean regulator is V-Kospi options, but again market participants are sceptical given that the newly launched (November) V-Kospi futures market has low trading volume. On January 23, for example, only 20 contracts were traded.

"V-Kospi futures are already not popular and I'm struggling to make decent volume each day so how can I expect V-Kospi options to be popular – it's too early to list it," says Kim who acts as a market-maker on volatility futures. "It's more important to make V-Kospi futures successful first."

As for the FSC's proposed ETF futures, Kim is unconvinced. "There are only a few ETFs that are popular like Kospi 200 ETF so Kospi 200 listed options and futures could be enough for investors. While there should be some need for ETF futures I don't think it will help to revitalise the market."

Moon says there is also the issue of "cannibalisation" between Kospi futures and other ETF futures products.

Dealers agree that the Kospi 200 remains the most important and liquid index in Korea given the active futures and options market. Most ETFs track the Kospi 200 with total assets under management (AUM) of those ETFs standing at around $6.6 billion while active funds that track MSCI Korea have total AUM of around $20 billion.

In a move that mirrors some of the policies that have emerged from Japan recently, the FSC also wants to create a new index of stocks, called the KTOP 30, that better represent Korea's economic and industrial sector – reminiscent of the JPX Nikkei 400 index created in 2014.

Moon describes it as a "naïve idea" but says that if it is introduced then related exchange-traded products or listed derivatives should accompany it.

There are already a plethora of indexes in the Korea market and dealers struggle to see why a new one would gain more traction than the existing set. A derivatives dealer at a Seoul-based securities firm describes the idea as "symbolic" and doubts whether it would gain traction especially as this was also done in the past when the Kosdaq Star index of top 30 names was launched and the whole market suffered volume declines as a result.

There is also speculation among securities companies that the new index is an attempt to motivate companies to do a stock split because the cost of some blue chip stocks makes it hard for retail customers to invest so they wouldn't be good candidates for the new index. A single Samsung Electronics share, for example, costs 1.4 million won.

Lifting the barriers

Under the banner of increasing the participation of institutional investors, the FSC plans to abolish the rule prohibiting public funds from investing more than 10% of assets in any one issuer's securities. The market has welcomed the move as positive as it better allows mutual funds to meet their benchmark and will increase demand for Korean equities.

With some stocks such as Samsung Electronics representing more than 10% of the index, artificially restricting funds to a 10% limit for certain issuers means that funds can't replicate the index performance if those stocks outperform. The restriction was conceived to limit issuer risk for public funds.

The FSC has also proposed moving the daily stock price limit from +/–15% to +/–30% but dealers don't believe this will have much effect.

"For small caps, increasing the limit can change market behaviour, but the Korean stock market has been in historically low volatility periods for more than three years, so I consider a 15% price limit far enough," says Moon.

Kim says that even among traders there is controversy about this rule as while it has the potential to make the market price more efficient, most stocks rarely touch the existing 15% limit. "Another problem is that if the price limit moves higher, the margin required from individual investors will also increase which could have the opposite impact to what was intended," he says.

Strike force

Market participants have given a lukewarm response to some of the regulator's proposed measures, and dealers say that other improvements to the options market would be more welcome: for example, more strikes listed for Kospi options. Compared to the Nikkei 225 or HSCI, Kospi 200 puts on the downside are often 90% of spot whereas in the Nikkei 225 they are 30% or 40% of spot, says David Best, head of index flow and exotics at UBS in Hong Kong.

"Having a broader range of strikes gives more confidence to the market and allows us to see more clearly what the variance price of the index should be. If we can only see 90% there is a risk of not having any more listed strikes to hedge with if the market crashes more than 10% on a single day."

A Kospi index trader at BNP Paribas says the daily liquidity of Kospi 200 options is about $200 billion but it's mainly on the front month.

Best cites an example of a recent measure that was well received by the market. In September 2014 KRX launched off-exchange block trades for Kospi 200 options in the interbank market, which has increased liquidity at the longer end of the curve.

"This is key in hedging long-dated skew and volatility risk in the Kospi 200. It facilitates transaction between counterparties and helps to address credit risk as banks can cross in the market," he says. "In longer-dated Kospi 200 options the natural liquidity comes from exotics books and from the variance swap market used by hedge funds to express their view rather than with vanilla options."

But Kim at Korea Investment & Securities says that it's not creating new products that will kick-start the market, rather it is removing some of the existing barriers peculiar to Korea.

"Removing weird rules like individual investors putting up 50 million won in margin and requiring individual investors to have experience in trading index futures for one year before they can trade listed options – those rules are so ridiculous and no other country except Korea has these as far as I know," says Kim.

Nick Ronalds, head of equities at trade association Asifma, says it's not uncommon in Asian markets generally to see the temptation to tweak and fix and when that happens over a number of years it results in lots of rules and complexity, but bad rules are not necessarily annulled while new rules are developed.

"When Korea introduced various restrictions on equity-linked warrants a few years ago it had a dramatic shrinking effect on futures and equities. The symptom that you don't like is excessive speculative trading so you introduce a rule but the consequence is bigger than intended and a few years later you are trying to fix problems created by the last fix," says Ronalds.

It is clear that post-crisis, the regulatory climate in Korea has been characterised by caution towards derivatives and a preference to protect retail investors above all else, but the knock-on effect has been stagnation of its markets. Unless the balance is redressed the impact of new products may be nullified.

"[Rule-makers] think they should prevent individual investors from trading derivatives and if that basic view doesn't change it will be very hard to revitalise the derivatives market," says Kim.