The Korean Equity Derivatives Market _ A Rising Star
Korea Head of the Equity Markets Group, Macquarie Securities Korea
Korea enjoyed astonishing economic growth and development over the past decades.
Rapid development in the labor-intensive manufacturing, textile, construction and heavy industries from the 70s through to the 90s was followed by rising supremacy in the semiconductor and high technology sectors, and more recently Korea's service industries have started to dazzle.
Macro growth, though temporarily subdued by the Asian financial crisis which struck with a jolt in 1997, regenerated as corporate governance structures were forcibly overhauled and, responding to hard lessons learned from the excessively generous lending practices of inexperienced credit card companies, improved risk management practices were induced.
These reforms stimulated competitiveness in higher-end industries and the Korean economy now has stronger fundamentals, displaying robust quality sustainable growth.
A timely expansion in the scope and depth of Korea's financial markets has also occurred.
With relatively high reliance by OECD standards on fixed interest investments, Korean individual investors had flocked to real estate for higher yielding leveraged returns in a prolonged low interest rate environment.
Property is a scarce resource in popular locations and prone to speculative bubbles, which the Korean Government has sensibly resolved to remedy through capital gains super taxes imposed for multiple investment properties. This has spurred an increase in local ownership of Korean equities and better access to a broader range of financial products including funds and derivatives. This note briefly touches on a real Korean success story, namely the local equity derivatives market.
Korea's foray into equity derivatives started with exchange traded KOSPI200 Index futures and options contracts listed in 1996 and 1997 respectively.
These markets now rank number five and number one in the world by volume and size, a proud achievement considering that derivative products have been traded in other advanced countries for over 20 years. At the end of 2006, the cumulative trading values for these KOSPI200 derivative instruments were approximately 4,700 trillion won and 170 trillion won respectively.
More recently, new equity linked products have been introduced, deepening Korea's financial derivatives market and providing investors with new pathways to invest indirectly in the Korea bourse.
First, the unlisted equity linked securities (ELS) market opened in 2003. ELS products quickly gained popularity with investors and since inception the ELS market has observed an eight-fold increase in annual issuance size, amounting to 25 trillion won at the end of 2006. The majority of products are sold to local securities company investors.
Some products are sold through banks in the form of equity linked funds (ELF), however bank customers tend to be more conservative and often prefer lower headline yield and capital protected products sold in the form of equity linked deposits (ELD) _ a successful market in its own right.
The ELS market thus far has been dominated by a small number of ``hit'' structures, the most recent example being the very complex ``Hi-Five'' structure and its numerous variations.
Issuers have tinkered with new structures, such as cliquets and Nikkei 225 Index and TSE-REIT linked products, but these have yet to demonstrate prolonged popularity.
Further innovation is necessary to avoid the current concentration of product types, which can be unhealthy for investors and issuers particularly from a risk management perspective. The introduction of simpler structures would reduce the risk that less sophisticated investors will misunderstand the potential pay-offs from their investment.
Next came the Equity Linked Warrant (ELW) market which first traded on the Korea Exchange in December 2005. Since then, the Korean ELW market has surged to rank fourth in the world by turnover value, trailing Hong Kong, Germany and Italy. At the time of writing, there are 2,129 ELWs listed with an average daily turnover value of between 200 billion won and 500 billion won, having exceeded at times 10 percent of the total KOSPI daily market volume.
The market is still young however, and must confront challenges before it can graduate to the next phase of development. The most visible problem is low open interest (ELWs actually held overnight by investors), which is currently less than 10 percent of issued product, although there are signs of recent improvement. This is indicative of a lack of awareness of ELWs by the broader potential investor set and a high participation of short-term opportunistic traders.
Education is needed to relay the message that ELWs, being geared proxies for shares, need to be held for a period in order to fully enjoy the potential benefits they offer. With proper education, traditional share investors may see ELWs as a means of getting exposure to their favorite blue chips for smaller premium investment with leverage selected according to their risk profiles, while enjoying compulsory liquidity provision by the issuer or other appointed liquidity provider (LP).
Investors in KOSPI200 Index futures and options can also view ELWs as an alternative way of obtaining exposure to the market without competing against professional traders or being subject to margin calls.
Under current regulations, issuers may list over 101 possible ELW underlyings, being the KOSPI200 Index and KOSPI100 constituents or baskets thereof. It is hoped that additional underlyings are permitted including major KOSDAQ stocks and overseas indices such as the Nikkei 225, HSI and HSCEI.
For the ELW market to attain world-class status, issuers, regulatory authorities and investors need to work together. Currently, there are 13 licensed issuers, only one of which has foreign experience (Macquarie Securities Korea). An issuer's role is to ensure the market gets fair and prompt liquidity, while issuing product responsive to investor needs.
To expand the market, ELW issuers need to focus on investor education while at the same time benchmarking successful overseas markets. For example, issuers of warrants in Hong Kong, the world's most active market, where retail derivative warrants have been around for over a decade, still hold regular public seminars that are well attended by retail investors.
Through such information sessions, local investors come away with a better understanding of the product, and are better equipped to utilize its investment characteristics. As the only issuer with successful prior experience overseas, Macquarie Securities Korea is determined to assume a leading role in educating the market about the characteristics of ELWs, their benefits and their risks, with a view to promoting market depth and awareness through a strategy of long-term commitment.
Regulatory reform could also assist the development of the ELW market. For example, an exemption from securities transaction tax for LPs when hedging ELWs would enable LPs to provide tighter and more responsive pricing. Also, allowing LPs to participate in the last month of trading would permit investors to realize their investment in that period and make it easier for them to assess which LPs will give investors opportunities to exit at fair prices in harder times.
The market eagerly awaits the introduction of share futures too, which if regulatory approval is obtained, will complement existing financial instruments while giving both issuers and investors a means to more easily hedge their portfolios.
Investors themselves should also take care to fully understand and carefully select equity derivative products that match their investment needs, and their attitude to risk. They should take advantage of analytical tools and educational materials when making investment decisions, such as, in the case of ELWs, websites like Macquarie Securities Korea's www.warrants.co.kr.
Growth in the quality of the ELW market should go hand-in-hand with growth in its size. The Korean economy has shown in the past that it can achieve this pairing. With each participant in the exciting equity derivatives sector doing their bit to help the market mature, the subsequent expansion of knowledge and quality products will generate better opportunities for everyone and go some way to helping Korea's financial markets achieve regional hub status.