Korea autocalls pose risk to structured products market

Crazy about autocalls


Investors in South Korea remain devoted to autocallable structured products based on the Kospi 200, the country's benchmark index. The flat to downward movement of the Korean stock market, matched with low volatility - both of which are in sharp contrast to stock markets rising in Japan - have failed to deter investors. Fierce competition between local securities houses and international banks has coincided with government intervention that has almost completely killed off the local warrants market, denying an outlet for the recycling of risk created when producing these derivatives-based investments.

Autocallable structured products based on the Kospi 200 or the Hang Seng China Enterprise Index (HSCEI) account for nearly 70% of equity-linked notes, says Won Jun Hwang, manager of the equity derivatives team at Wooribank, in Seoul. Considering the range of structures and underlyings available to investors, it is wildly disproportionate, and is a cause for concern. "The outstanding size and concentration on the same structures causes an imbalance between the supply and demand of volatility and correlation, which puts pressure on volatility and makes hedging these products more difficult," says Hwang.

The concentration of products on only a few underlyings is not unique to Korea. "This is true all across Asia. It's a natural result of the fact that most trades are quite similar, because while retail flows are huge, the institutional market is nearly non-existent," says another Hong Kong-based banker.

There are more than 20 houses competing in the South Korean market, including local and regional banks such as Woori Investment & Securities and Daewoo Securities, while international banks such as Merrill Lynch and BNP Paribas are major hedge providers. "The pricing was more aggressive because of competition, especially from local securities firms," says one structured products banker in Hong Kong.

At the same time, there was and is a lack of counterparties to which you can offload risk. "This makes for a little bit of danger... typically these products stay on [the bank's] shelf for two years," says another Hong-Kong based banker. The problem is so bad, the banker believes, that the financial regulator needs to modernise the market.

As it stands today, warrants volumes have dropped significantly

The historical and implied volatility of the Kospi and its component stocks has been decreasing for several years and the volatility risk premium of Kospi is much smaller than any other Asian indexes, even though a considerable portion of the economy depends on information technology, auto and construction, which are strongly influenced by the business cycle. "Amazingly, the volatility level of the Kospi is similar to that of FTSE 100," says Hwan.

Kospi autocalls have already lost banks money. With the market having been flat, and looking to remain that way, the low-volatility market, even with longer tenor products, means structurers cannot make money, especially if they have placed their bets on the kick out. While a rising Nikkei 225 in Japan meant similar products kicked out, the same did not happen in Korea. "You need to manage this risk carefully because of the complex risk scenario activities. Everyone was selling and no-one was buying, including the locals," says the Hong Kong-based structured products banker. "When the market went down, everyone sold at the same time, and as a result they had to sell at a discount, which was something they had not anticipated." As a result, a few banks lost a lot of money, although that has not stopped the resuscitation of the same business.

Regulatory intervention is part of the problem, according to Brian Chan, head of equity derivatives Asia-Pacific at Credit Suisse in Hong Kong. "Since Korean regulators effectively shut down the exchange-linked warrants market, the ‘demand' side of the underlying vega, for single stocks in particular, has disappeared," says Chan. "This led to an imbalance, which means that, for smaller names especially, the providers will have to warehouse the vega sourced from selling the exchange-linked security products."

Despite the problems with hedging, autocalls remain particularly popular with investors, says Charles Firth, head of market structuring, equity derivatives, Asia-Pacific at Credit Suisse in Hong Kong. With terms typically of three years, Korean tenors are a little longer than those of products offered in neighbouring countries, so an autocallable that fails to redeem early when the market has dived has more opportunity to do so when the market recovers over the following few years. "Many investors have had good experiences with these products," says Firth. "They were keen to come back to the market and do more."

Only a decade ago, Korean interest rates were in double digits, but in the past five years interest rates in Korea have fallen from 7% to 3%, inspiring a demand for yield. "Korea has a low interest rate but the market has good liquidity," says Chang Hyung Lim, general manager at Wooribank in Seoul. "Because of this, clients need various products that meet their target yield. That's why the development and sale of structured products has become very active."

Hwang says: "The over-the-counter business has been entering a more mature phase in Korea, and investors have experienced a good rate of return, creating a virtuous cycle in investing in structured products." Investors also piled into structured notes when other investments went wrong. "Some sectors such as shipbuilding and construction dropped sharply and triggered knock-in options with big losses. And then, notes backed by stock indexes grew in popularity," says Hwang.

The part of the South Korean market that is not based around Kospi and HSCEI autocalls includes range accruals and steepeners based on interest rates, as well as autocallable structures based on gold and silver - although demand has fallen since precious metal prices plummeted earlier this year, says Hwang. Commodities do still hold a certain appeal for investors, however, says Jerry Won, manager of derivatives at Mirae Asset Securities in Seoul. "In Korea, investors tend to stick to certain, high coupons, of 9%, 10% or 11%, but since we've seen massive collapse of volatility in equity, investors have changed their direction from equities to commodities to see the high coupons," says Won.

"The S&P 500 has partly replaced the HSCEI as an index underlying of choice now that the US market is recovering, while the Nikkei 225 and FTSE 100 have recently begun to be tapped by institutional investors," says Hwang.

Yet the overall choice of underlyings remains narrow. For example, Europe as a region is not part of the mainstream. "The value investors among client advisers appreciate Europe is cheap because it's gone down so much, but if more problems come out investors will be asking their advisers what they thought they were doing given Europe's continuing problems are so well publicised," says Firth. "Professionals outside Europe are not incentivised to take that career risk."

As well as structured products, the exchange-traded fund (ETF) market in Korea has been so popular this year that there were more ETFs listed in Korea than on the Tokyo Exchange, including at least seven commodity ETFs listed based on the S&P GSCI. "Synthetic ETFs were listed on the Korean stock exchange for the first time this year, and "the Korean ETF market is expected to keep growing in both quality and quantity", says Hwang. Both institutional and retail investors are becoming increasingly keen on the ETF market, says Hikaru Ogata, chief executive, corporate and investment banking, Asia-Pacific at Société Générale (SG) in Hong Kong, with domestic asset managers issuing these funds, as well as looking at issuing synthetic ETFs. To be a market-maker within ETFs, SG would need another licence, but this is on the team's radar, he says.

Box: Will regulation erode derivatives competitiveness?

The Korean government has proposed a tax on derivatives transactions a number of times, although it backed down in the face of widespread market opposition. But this time the government appears to be serious, at least according to local commentators.

The proposal put forward by the finance ministry includes a 0.001% tax on turnover value per futures trade and 0.01% on options dealing. "If the government pushes ahead with the plan to impose a tax on derivatives trading in the future to increase tax income, I'm afraid that it will significantly dampen liquidity and erode competitiveness in the Korean derivatives market," says Won Jun Hwang, manager of the equity derivatives team at Wooribank, in Seoul. The government estimates that a transaction tax could generate up to 120 billion won ($110 million) every year.

It is not the first time that the government has tried to curtail derivatives. In 2012, the Financial Supervisory Service limited liquidity providers' activity to the extent that the trading volume of warrants fell by 90%. It was introduced to protect the rights of shareholders, according to a structured products lawyer in Seoul. "Naked stock warrants may infringe shareholders' pre-emptive right. Korean legislators have been in a hostile position to the introduction of such warrants."

Although there were rumours that this restriction will be relaxed, the lawyer does not believe this to be the case. It was thought that Korean legislators considered the introduction of naked stock warrants in connection with the amendment to the Financial Investment Services and Capital Markets Act (FSCMA), with amendments finalised on August 29, but they did not. "The regulator is still very stubborn. That's why the market has collapsed and there were traders who lost their jobs," says Jerry Won, manager of derivatives at Mirae Asset Securities in Seoul.

"The regulators have looked to curtail the development of the market due to some losses that retail investors have suffered and as the market was deemed too speculative," says Hikaru Ogata, chief executive, corporate and investment banking, Asia-Pacific at Société Générale (SG) in Hong Kong. "As it stands today, warrants volumes have dropped significantly." According to Wooribank's Hwang the Korean stock exchange has been looking at ways of revitalising the warrants market.

Recent amendments to the FSCMA now stipulate that large securities firms will be able to expand their corporate financing, which will only add to the competition, says Hwang.



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