Balancing between equality and efficiency
By Kim Da-ye
Stability and efficiency are the two rabbits Kim Jin-gyu wants to secure during his term as president of the Korea Exchange’s (KRX) derivatives market division.
“The market has already grown much in quantity. It now needs to improve in quality,” Kim, who was appointed to his role in May, said Wednesday in an interview with Business Focus.
In Korea’s derivatives market, an unusual place where individual investors account for one third of trading volume, stability and efficiency are, in a way, clashing values.
Individuals ― equally influential as institutional and foreign investors in terms of trading volume ― often lose in the zero-sum games because of inferior access to quality information. Many of them aren’t even professional investors, and trade derivatives without having underlying assets. They end up making speculative bets that are unlikely to be won ― ironically, that speculative behavior makes the market.
Creating too many regulations to protect retail investors could leave the market inefficient while little attention to them would spread a negative perception of derivatives.
Kim said that the KRX and the regulatory body ultimately want to lead individuals away from direct to indirect investment.
But as long as individuals stay in the market, the best way to achieve both stability and efficiency would be adequate education for individuals, Kim said.
“In China, in order to invest in derivatives, you have to pass exams. That is perceived quite a backward method.”
Korean investors are fortunate enough to skip those exams, but Kim wants to let them know that not everyone wins in the derivative market.
In the spot market, investors can profit altogether at a bullish turn and lose at a bearish one. In the derivatives market, winners and losers coexist.
“Investing in derivatives always carries the risk of a loss. Individuals need to aware of that.”
Some suggest raising the minimum amount for investment to deter small-scale retail investors. Kim pointed out at a side effect that those barred may seek unofficial, private routes that could be even riskier.
He also briefly mentioned making the structure of the financial instruments more complicated so that individuals find it difficult to approach them although he wouldn’t discuss details.
In the meantime, the KRX is mulling ways to make the whole industry more stable.
The KRX has been chosen as the central counterparty (CCP), which the G20 meeting has identified as the main method to manage risks from derivatives trading. A CCP clears and settles market transactions.
The over-the-counter market is nearly nine times as large as that for exchange-traded derivatives in Korea.
Kim Jin-gyu said that the KRX will begin clearing interest swaps as early as by the end of this year.
“Regardless of the counterparty’s credit rating, financial institutions can depend on the CCP in trading OTC derivatives. That could vitalize and develop the OTC market,” Kim said.
The OTC market has recently come under much spotlight. The Financial Supervisory Service (FSS) warned in 2009 that 99 percent of investors in foreign exchange margin trading were individuals and 90 percent lost money.
Equity linked security (ELS) is another OTC derivative that caught the interest of retail investors because of its guarantee of capital preservation depending on the risk the investor is willing to take.
Another way is reducing volatility on the exercise date of the KOSPI 200 Options. As the maturity date nears, the prices of derivatives fluctuate, affecting the spot market consisting of underlying assets.
Such vulnerability was evident when the Seoul bourse fell by 2.5 percent on Nov. 11, 2010, when Deutsche Bank’s securities unit sold off 2.5 trillion won in stocks to profit from its investment in the equity index options.
The KRX has outsourced a research project to find ways to reduce the volatility on the exercise date, and will pick one by the end of the year.
Kim refuses to discuss details, but hinted the most likely approach is altering the mechanics of calculating a settlement price.
The KOSPI 200 index ― the de facto settlement price for the KOSPI 200 Options ― is based on simultaneous bids and offers in the final ten minutes of trading hours between 2:50 and 3 p.m.
According to Youn Tae-hoon, a researcher at the Korea Institute of Finance, the settlement price for derivatives based on the FTSE Eurotop 100 is the average of 57 figures ― 81 gathered every 15 seconds between 11:40 a.m. and 12 a.m. minus the highest 12 and the lowest 12.
While such a method may help stabilize the securities market, Kim raises concerns over the latest information not being fully reflected in the final settlement price ― in short, inefficiency.
“There is no perfect product or system in this world. It’s all about market participants’ homework to maximize the strengths and remove the weaknesses,” Kim said.