Korea derivatives road map gets lukewarm reception

FSC to boost investor participation in derivatives but faces industry scepticism


An overhaul of Korea's derivatives market is facing criticism from dealers for being overly restrictive for new products and failing to remove any of the existing impediments that stop the market from growing.

On June 17, the Financial Services Commission (FSC) released a road map for developing the country's derivatives market, in which it outlined various new products it plans to introduce. The latest announcement adds more detail to a strategic blueprint released last November, which sought to raise the contribution of the financial industry to 10% of South Korea's GDP over the next 10 years – its so-called "10-10 Value-Up plan". The financial industry currently accounts for around 7% of GDP, according to the FSC.

The FSC's road map sees the exchange-traded derivatives (ETD) market becoming a market for professional investors, with the derivatives-linked securities (DLS) market becoming the market of choice for retail investors. It envisages an extended range of products, with the introduction of equity volatility futures, sector index futures and the overnight trading of US dollar futures by the end of 2014. It is also reviewing the introduction of short-term interest rate futures based on the Korean interbank offered rate, foreign exchange futures and commodity futures.

In its road map, the Korean regulator notes the ETD market has been restricted for many years. While only 15 products are listed on the Korea Exchange (KRX), 274 products are listed at Frankfurt-based Eurex and 1,303 are listed at Chicago-based CME Group.

In the DLS market, it plans to expand the range of products from exchange-traded funds (ETFs), equity-linked securities and equity-linked warrants (ELWs) to include exchange-traded notes (ETNs). Meanwhile, the FSC says it will standardise ELWs and improve disclosure and sales methods, making it easier for investors to compare and choose between products.

But market participants say ETNs face bigger challenges in other areas – most notably, the way they are taxed. "Securities companies couldn't persuade Korean tax authorities to give tax benefits to ETNs to boost the new market, so it will be difficult for ETNs to compete with ETFs. Currently, for domestic equity underlyings, it's tax-free, but for foreign stocks the whole gain is treated as dividend income," says Wonjae Chang, chief risk officer at Samsung Securities in Seoul.

Because ETFs and ETNs cover the same products, the lack of any tax advantage leaves investors with little reason to choose an ETN, says an equities source at another securities firm. Unlike ETFs, ETNs do not represent a claim on a pool of underlying assets, so leave investors exposed to counterparty risk. "If a tax break was given to ETNs with exposure to foreign underlyings, the market would have a greater chance of success. Leverage as a differentiating factor is also prohibited, so we are not sure that the market will take off," he says.

Although the FSC is hoping to attract more retail investors to the derivatives markets – a central tenet of its plan to increase the stability of the derivatives sector – observers say the regulator has failed to lift the onerous barriers to entry for retail investors.

During the second half of 2014, the FSC plans to introduce a qualified retail investor scheme which has two stages. The first stage allows retail investors to trade simple futures products, such as Kospi 200 index futures, provided they have margin of 30 million won ($30,000) and have completed 30 hours of investor education and at least 50 hours of mock trading.

Only once they have passed the second stage will investors be able to trade complex futures and options products, such as V-Kospi 200 futures that allow investors to trade volatility. To achieve that, investors must provide 50 million won in margin and achieve a year's trading experience.

"The FSC is trying to revitalise the derivatives market, but the method isn't very helpful. There are too many barriers for retail investors," says Samsung's Chang.

Chang adds that the existing structure of the ELW market doesn't encourage investor participation. One example of this is the minimum 8% bid/offer rule. Among dealers, the rule is partly blamed for causing the market to shrink to a tenth of its size from a peak of 2 trillion won ($1.9 billion) in October 2010.

"They should get rid of the 8% rule for bid/offer spreads, which is the biggest obstacle for the ELW market," says Chang.

The proposed standardisation of the ELW market is also being viewed with dismay by some market participants. According to one source at a securities firm, standardising the terms of ELWs will create more competition among issuers by limiting the overall choice of products. That could lead to even lower margins for dealers, who will then be forced to compete on price. A former equity derivatives trader at a foreign bank says thinning margins in the industry mean "it's too little, too late".

The FSC did not respond to questions about the factors holding back the market.

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