HSCEI Korea structured product losses spark regulatory fears

Potential losses for global banks and local firms estimated at $300 million

Heavy falls in China indexes linked to Korean structured products have hit dealers' hedging programmes hard with losses estimated at around $300 million across the Street and potentially the threat of regulatory intervention.

On August 3 the Hang Seng China Enterprises Index (HSCEI) – which tracks China firms listed in Hong Kong – stood at 11,009 and has now fallen precipitously to 9,400. This is a problem for the autocallable market where retail investors are selling put options because a significant percentage of products were issued earlier this year when markets were trading at more than 14,000. If the HSCEI falls 10–15% below current levels then issuers will scramble to hedge their positions and retail investors stand to lose some of their principal if knock-in barriers are breached.

A large proportion of the equity-linked securities (ELS) market in Korea consists of autocallable structures linked to the worst performance of two or more underlying stocks or indexes. A typical ELS note has a three-year initial tenor subject to an automatic call every six months if the reference entity exceeds a specific knock-out level, which then gives investors their principal back plus a coupon. The product also has a knock-in barrier usually observed daily and set at around 55% of the initial spot price.

The HSCEI has been a popular reference benchmark for Korean retail investors over past 18 months because it has a higher volatility than the Kospi 200 and therefore a higher return. The recent HSCEI fall prompted the Korean Financial Services Commission (FSC) to issue a statement at the end of August. "The FSC expresses concern that ELS issuance has been heavily concentrated on certain indexes such as the HSCEI, which could increase market volatility with the recent global stock market downturn."

In total 20 Korean securities companies issue ELS products with the five largest accounting for a 70% market share. According to Morgan Stanley research, NH Investment & Securities (formerly Woori Securities) is the worst affected securities house and is nursing losses of around 90 billion won ($76 million), compared with 20 billion won for both Samsung Securities and KIH.

FSC figures show that HSCEI ELS issuance was 36.3 trillion won ($30.5 billion), accounting for 38.5% of the total issuance of ELS products worth 94.4 trillion won, as of end-June 2015. The five market sources Risk.net spoke to all agreed that total losses so far for all dealers would be around $300 million, split roughly equally between Korean firms and international players.

In its August statement, the FSC said it could consider some restrictions on HSCEI products if concentration risk heightened. Dealers active in the Korean ELS market say the regulators have held private discussions to persuade them to stop issuing HSCEI-linked ELS products in the public market from September 14. Private issuance continues.

Interventionist stance

The Korean regulator has previous form for intervening in its derivatives markets to protect retail investors. In 2012 it effectively killed the equity-linked warrants market after imposing strict hurdles such as a minimum deposit and education test before allowing retail investors to participate. The FSC cited retail losses and scalpers using speed to gain price advantage to justify the measures. One equity derivatives source says attention may now be turning to the ELS sector.

"They are trying to get things under control without scaring the market by making big pronouncements about restrictions; instead they are taking securities firms behind closed doors and encouraging them to take certain steps. It is being presented by the market as a self-imposed moratorium so dealers are doing it voluntarily but with pressure by the regulator," says the source.

This view was confirmed by Hyo Seob Lee, researcher at the Korean Capital Markets Institute, who says regulators have intervened over fears that firms are facing major losses from their volatility exposures.

"FSC asked Korean securities companies to stop new issuance of ELS linked to HSCEI as it thinks this is too large to be properly hedged. Korean securities houses manage their volatility exposures by selling a large amount of put options with short-term maturities in exchange-traded or over-the-counter markets. Unfortunately, the short-term volatility of HSCEI rose fast and many hedging books have a big loss in the process of volatility hedging," he says.

International and local dealers in the Korean ELS market confirmed that the regulator had asked participants to act with caution when issuing further HSCEI-linked ELS products. One trader at a local securities house says the FSC has made efforts not to leave a paper trail. "It's not in a written document, it was delivered by phone call," he says.

But in an email exchange with Risk.net, the FSC flatly denied any market intervention with regard to HSCEI structured products. "There has been no restriction, formal or informal, on HSCEI-linked ELS issuance. There is no consultation that the FSC is conducting with the market on the ELS market," says a spokesman representing the capital markets division of the FSC in Seoul.

Whether regulators have intervened or not, issuance is falling: September data from two dealers shows that securities firms have issued far fewer notes while ELS issuance in general is on track to reach $3 billion notional for September compared with $4.3 billion in August, which was already the lowest level of issuance since November 2014.

Indeed, on August 21, HSCEI volatility stood at 19.4% but had risen to 28% by August 30 and currently registers 36.7% reflecting a degree of uneasiness should the index fall further.

The FSC is not just concerned about losses sustained by securities firms hedging ELS issuance during a volatile period but also by losses to retail investors. Dealers say that so far just 1% of ELS products outstanding have hit knock-in barriers causing losses to investors but there is nervousness in the market that a further bout of market turmoil could lead the HSCEI much lower and trigger a greater volume of lower barriers. Dealers say that between the 8000–9000 point range, 30% of ELS could knock-in on the HSCEI.

If this scenario occurs market participants expect that formal regulatory changes may be set in motion by the FSC.

"Right now there is still issuance from Korean retail with HSCEI in the baskets but less than before, so issuance hasn't stopped but it is significantly lower. More importantly we are still waiting for the regulator to give guidance on how much China products they will allow in those baskets going forward," says the equity derivatives source.