Sacrificing the innocent or punishing the evil?

By Kim Da-ye

For brokerage houses operating in Korea, March 12, 2012, heralds fear.

The third round of measures to regulate Korea’s equity-linked warrant (ELW) market kicks off that day. Industry insiders say that the third set of regulations will be the deadliest among the three ― they will deal blows not only to brokerage houses but also to retail investors known here as individuals or ants.

The first series of regulations demanded those investing in ELWs to be properly educated, and the second required investors to keep a minimum balance of 15 million won in order to trade the complicated warrants.

The third set will limit the active participation of liquidity providers (LPs) in the market as the regulator believes they rip off retail investors using their “monopolistic” pricing power.

Liquidity providers, mostly brokerage houses that issue the warrants, exist to vitalize the ELW market. Formed in 2005, the market initially targeted retail investors for whom trading options and futures could be too risky and difficult.

Because the market consisting of individuals could suffer from the lack of liquidity ― many equity options that are highly similar to ELWs are rarely traded ― LPs, which have to make bids and offers to reduce the gap between a bid price and an asking price, were introduced to eventually help investors to trade the warrants when they want to. When the spread is too wide, investors wouldn’t be willing to trade or be forced to trade at a loss.

The current regulation demands LPs to make bids or offers within five minutes when the “market spread ratio,” the portion of the gap between an asking price and a bid price against the bid price, exceeds 20 percent.

The Financial Supervisory Service (FSS), however, announced Dec. 1 last year that LPs aren’t carrying out their duties faithfully but actively competing against individuals by making bids and offers too frequently rather than when it is necessary. In short, the regulator indicated that individuals’ loss is LPs’ gain.

The evidence provided by the authorities said that LPs frequently traded warrants when the spread stayed at merely 7 to 9 percent. Their duty is trading more than 100 warrants in case of a lack of liquidity, but they sometimes traded 80,000 warrants at a time, the FSS said.

This way, it’s LPs versus investors, not investors versus investors as it was originally planned. And such competition isn’t fair because LPs have the pricing power, the regulator said.

As of October 2011, the volume of warrants traded among investors accounted for only 11.2 percent of the total turnover, the FSS added.

Under the new regulation kicking off in March, LPs will be able to make bids and offers only when the spread exceeds 15 percent. More importantly, the minimum spread for LPs’ bids and offers must be 8 percent, meaning that without active participation by investors, the spread won’t shrink below 8 percent.

One official from a brokerage house, who spoke on the condition of anonymity like every other source because criticizing the regulator is a taboo in Korea, said that retail investors now have to trade ELWs at greater costs and that doesn’t match the regulation’s core purpose of protecting investors.

“It’s unprecedented globally that a regulator asks to widen the dense spread, not shorten the wide spread,” he said.

Are retail investors willing to trade in such the market? An ELW trader, who uses the name Putnanke in the stock information site Paxnet, wrote that limiting LPs’ bids and offers will make trading warrants inconvenient, recommending others to trade options instead of ELWs.

“It’s like burning down a house to catch a mouse. From March 12, individuals will have to make the price without LPs. Does that make any sense?” Putnanke wrote.

The biggest question among some LPs who have done their jobs of educating the investors and providing reasonable services is why ELWs have become the regulator’s target.

They feel that the enforcement of three sets of regulations specifically on ELWs between October 2010 and March 2012 is too harsh, considering that similar risks exist in the derivatives and stock markets, especially the KOSDAQ division.

“I guess when you lose money with ELWs, you know who you traded with _ LPs. In the derivatives market, you don’t know who you trade with. Maybe it is easier to point a finger at someone when you trade ELWs,” the brokerage house official said.

Are LPs really monopolistic?

The third series of the regulations originates from the belief that LPs are monopolistic in pricing warrants.

Once ELWs are issued, LPs acquire them and begin trading them. Investors initially buy from LPs and eventually trade among themselves, in theory. But because most investors day trade, LPs end up buying most of them back, keeping its monopolistic status, an independent study by FSS officials titled “A Study on Price Behaviors in the Korean ELW Market” says.

Liquidity providers argue against the accusation, saying that there are too many competitors offering similar products. If certain LPs provide bad services in terms of products as well as liquidity provision, investors would abandon them, they say.

As of Feb. 8, 6,642 kinds of ELWs were listed on the Seoul bourse and 1,717 of them were linked to equity indices.

Another criticism against ELWs is directed at their prices.

The study by FSS officials found that ELWs are 24 percent on average more expensive than equity options with similar conditions attached. It claims that retail investors buy the expensive ELWs partly because they aren’t aware of such disadvantages without receiving adequate education on the products.

The warrants are highly similar to option contracts, which give their holders the rights to buy or sell underlying assets at pre-determined prices on certain dates.

The differences between two instruments include the followings: ELWs are listed on the stock market; they are sliced into small units _ they are often priced under 10,000 won while the minimum trading unit for options is 500,000 won; and investors cannot be the seller of ELWs, meaning their losses are limited to losing the principal.

For brokerage houses, the price gap between ELWs and options is only natural because the former is designed for retail investors and the latter is for wholesalers like institutions.

In fact, the prices of ELWs include many unseen costs including the fees to get them listed on the bourse.

Another official from a brokerage house says that a big part of the cost comes from hedging. When an investor buys an ELW, the LP buys its underlying asset in case the holder exercises his right at the expiration date.

For example, if an investor buys warrants linked to Samsung Electronics stocks that give him or her the right to buy the stocks at promised prices, the LP has to buy those securities. That process also incurs trading taxes.

Liquidity providers have also been condemned for their relationships with scalpers. The high frequency traders make profit by acting before LPs do. When the price of a stock rises, LPs would raise the price of the warrant linked to that particular stock. Before LPs take that action, scalpers buy the ELW and sell it once its price is up.

Scalpers are, in fact, competitors of LPs, but a friendship between them has been unavoidable. Investors prefer highly liquid ELW products, and scalpers, who trade in huge volumes, provide liquidity to the products, making them look attractive to retail investors.

The prosecutors charged last June that current and former CEOs of 12 local brokerage houses performed special favors or scalpers. They said that those brokerages provided a separate route to some scalpers, their VIP clients, in placing orders, making the competition among investors unfair.

The securities industry argued against the charge in that the provision of separate trading routes to VIP customers is nothing new and that scalpers aren’t competing against ordinary retail investors for their goals and in executing their trading methods.

In foreigners’ eyes

Back in June 2011 when 12 CEOs of local securities firms were prosecuted, one British national who had resided in Korea for over decades told this reporter that brokerage houses feared that the government seemed determined to shut down the ELW market.

In a recent meeting with industry insiders, they said that such fears linger especially with the third set of regulations to take effect soon.

“We do not know what the regulators are really thinking. They may say that they aren’t going to get rid of the market, but from our side, we fear that they may eventually do so. It is our worst-case scenario,” one industry source said.

A senior FSS official acknowledged by phone that the third round of the regulations would be the most damaging to LPs. While the first two sets were aimed at retail investors, the third targets LPs and scalpers, he said.

The official said that the Korean ELW market, the world’s second largest by turnover, has grown somewhat abnormally as a result of scalpers being too active ― the FSS said last December that scalpers accounted for 81.2 percent of the entire trading of ELWs by retail investors.

“It had to be done once to refine the market. It was unavoidable,” he said, adding that the authorities are aware of LPs’ complaints.
When asked if the authorities are determined to kill the market, he said that the measures are intended to encourage the market in the long term. As the market develops, he said, the authorities may lift some regulations or introduce new ones, suggesting that harsh measures may go away one day.

For foreign securities firms, the sense of fear and uncertainty seemed more evident.

There are eight foreign LPs operating at the Seoul bourse ― Goldman Sachs, Nomura, Macquarie, Merrill Lynch, Standard Chartered, Citigroup, Credit Suisse and J.P. Morgan.

One foreign executive said that becoming an LP requires a vast amount of capital investment ― approximately 200 billion won ― as well as hiring locally and setting up infrastructure.

When asked why foreign LPs still operate in the Seoul bourse despite so much regulation, the executive said that they all entered the market expecting a long-term presence and that the investment was too huge for them to abandon the business.

“To put money into such a venture, you need to be very optimistic on the return on the investment in the long run. We are positive that the market will continue to develop and that a lot of investors will stay loyal to the market. We hope that the market does return to the former glory,” he said.