Regulation tightening squeezes ELW sellers

By Cho Jin-seo

An upcoming series of regulatory changes is likely to squeeze profit margins and possibly kill the fast-growing market for speculative stock derivatives, called equity-linked warrants (ELWs).

Financial regulators announced the changes in late May, which include a minimum account balance of 15 million won (around $14,000) for ELWs. The stock exchange says this entry barrier will be enough to deter students, housewives and other novice traders from entering the speculative market, where some 1.6 trillion won ($1.4 billion) change hands every day.

And this change also means 30 banks and securities companies including Macquarie, Nomura, Goldman Sachs, JP Morgan, UBS and Citi will see their income fall in this zero-risk business from August.

“This means that a college student cannot trade options with his pocket money of 1 million won anymore. Currently there are many such retail traders in this market,” an official at the Korea Exchange, the trading bourse, said. He doesn’t want to be named. “There will be a dramatic change. The ELW market will not be the same.”

Macquarie, an Australian investment bank, has been the leading seller of ELWs in Korea for years. So it will also feel the impact of the shrinking market by the greatest degree. The firm’s ELW marketing team declined to comment last week.

The foreign banks have prospered in the ELW market in Korea with more experience in dealing with these kinds of complex financial products than their Korean counterparts have.

Hedging and gambling

An ELW is an option contract that makes bets on stocks or stock indices. Korea has the second largest ELW market in the world, next only to Hong Kong.

The Korea Exchange, the solitary stock market operator, oversees the market’s operations, while the aforementioned 30 firms are designated “liquidity providers” (LPs).

The LPs create and sell ELW contracts at a certain price they want. They have the responsibility to provide liquidity at any time. The risk is hedged by offsetting contracts at the regular options market or by positions in underlying stocks in the KOSPI market. For perfect hedging, these positions are continuously rebalanced, thanks to modern finance techniques and super-fast computers. In the process, the LPs add margins between the option price and ELW price, on top of the usual buy-sell spread margin.

A good LP knows how to hit the balance in setting the price of ELWs. If it is priced too cheap, then its margin is low. If it is priced too high, then retail investors won’t buy it.

Risk-free business

From retail investors’ perspective, the ELW market in Korea is easy to access and highly speculative. Some see it like a legitimate casino where people with little financial knowledge can make bets on the movement of KOSPI stocks and the KOSPI200 index. They can win big money if they get it right — often the price of ELWs can rise more than 10 fold in a single day, while they can lose everything if they get the direction wrong.

According to the financial regulators, there are about 40,000 active ELW accounts held by home traders, who benefit from Korea’s high-speed Internet lines and convenient PC trading systems. Their average balance is only 4-5 million won.

With investors being players, the investment banks and stock brokers take the role of the casino house. In most cases, they are not engaged in proprietary (profit-oriented) trading. Rather, they play the role of liquidity provider and price setter, and make safe profits from the spread between the selling price and the buying price and other margins.

In 2009, the most recent available data, the 30 firms made 179 billion won ($164 million) by selling ELW products to retail investors in Korea. The amount may be small compared to the global investment banks’ total worldwide sales. But this ELW market has been a cash cow for them, as it was virtually a risk-free business.

Other gainers were professional “scalpers” or “flash traders” who use automated computer programs. Meanwhile, retail investors lost 518 billion won in the same year and more than 1 billion won between 2006 and 2009.

Like the U.S. subprime mortgages market before the financial crisis, the banks do not carry risks on their shoulders and let their customers carry them. Most of the customers are aware of the high risks and high commissions included in the price. But they — including students, housewives and pensioners — still trade ELWs because they like the high leverage and they like the thrill, just like the Las Vegas roulette game. And most of all, it is legal, while casinos are illegal in Korea except for Gangwon Land Casino.

Reason for its existence

The ELW market is popular because the ordinary options (non-ELW) market already has a minimum balance requirement of 15 million won. So retail investors with smaller funds who could not trade in the options market were drawn into ELWs. They are basically the same as options but are more expensive because of the brokers’ margins.

Therefore, when the same minimum deposit is enforced in the ELW market, retail investors have little motivation to prefer expensive ELW over ordinary options, the official at the Korea Exchange said.

This can bring a self-destruction to the market. If the LPs cannot make high margins, they will become less active in the ELW market. Without active LPs, retail investors will have to trade among themselves.

In theory, this shouldn’t matter. the ELW market should help retail investors hedge their direct investment in the stock market. But in reality, many people only trade in the ELW market without owning the underlying asset.

Korea Exchange acknowledges the speculative nature of this market.

“Because there is no deposit requirement, retail investors are easily drawn into speculative trades in the ELW market,” said Kim Min-kyo, a layer working for the exchange, in a report.

Protests

The LPs have defended the need for less regulation. They argue that an active ELW market makes the underlying KOSPI stock market more liquid (larger trading volume) and thus benefits the broader economy.

They also say that ELWs offer an opportunity to invest in blue chip companies even to people with small pockets. For example, not everyone can buy Samsung Electronics stock because one share costs more than 800,000 won ($700). But even the poorest people can buy ELWs on Samsung Electronics as these are priced at only a few hundred won, or less, per contract.

Thus, the setting of minimum deposit requirement seems contradictory to the ELW’s market’s reason for being to many bankers and academics.

“Once the minimum requirement is set, retail investors will have no incentive to use the ELW market to hedge. So only the most speculative traders will remain in this market,” said Lim Byung-hwa, researcher at Korea Economic Research Institute, a free-market think tank.

The financial regulators are determined. The regulatory changes were planned last year but were postponed because of protests from the LPs, the official at the Korea Exchange said. But now, their patience has run out.

“By raising entry barriers such as the introduction of a basic deposit, the indiscriminate investment by retail investors will be contained,” the Financial Supervisory Service said in an announcement.