Seoul wants fast success in hedge funds

Industry upbeat on opportunity, while complaining of entry barrier

By Cho Jin-seo

Will the introduction of hedge funds be the “completion of Korea’s investment industry” as touted by the nation’s chief financial regulator? Or is it just another daydream without substance?

The financial industry, as well as its regulators, is upbeat that allowing hedge funds in Korea will open a new era in investment in Korea. Many believe that in this sophisticated field of money management, Korea can replicate the success of its manufacturing sector — that it can fast catch up with established names in the West or even outperform them in a short period of

time, as the country did so in making TVs and mobile phones.

“Korea has the best shot in the hedge fund field in that we can become one of the top 10 nations,” said Kim Hyoung-tae, the president of Korea Capital Market Institute (KCMI), a think tank.

“In the hedge fund industry, the incumbents have relatively weak dominance. It is a field where you can rapidly rise to success if you have good ideas.”

The Korean government plans to allow financial firms to set up hedge funds as early as late this year. Kim Seok-dong, the chairman of the Financial Services Commission (FSC), the chief regulator here, said he would drive the plan ahead “like a tank,” against expected objections from left-leaning NGOs and politicians at the National Assembly.

The FSC Chairman Kim is leading the initiative. The FSC overseas financial regulations but it’s also responsible for the industry’s growth. So, in a public conference last week, he said he “would do anything” to see a hedge fund in action as soon as possible.

His trick is that despite the FSC not having the authority to rewrite the Capital Markets Act, it is capable of making amendments to the Act’s individual clauses. So if he adds or takes out a few sentences in the section on private equity funds, the FSC chairman says, he can effectively set the legal ground for hedge funds regardless of what happens in the National Assembly. This bypass is possible because the definition of “private equity” is different in Korea and is more closer to that of hedge funds in other countries (See related article).

Kim believes that the absence of Korean-based hedge funds is actually discrimination against its own financial firms, as foreign-based hedge funds, especially ones from Hong Kong, have long been active in trading Korean stocks, bonds, real estate and other assets. It has also been an obsession of the government that while Korea’s manufacturing firms are world-class, financial firms are almost non-existent outside the country.

Entry barrier

A hedge fund is the most liberal form of a collective investment instrument, as managers enjoy maximum freedom in deciding where, when and how to invest the customers’ money (see article in the box). It is currently the ultimate form of free-market capitalism with higher risk and higher expected return.

During the recent financial crisis in the U.S. and Europe, hedge funds were deemed detrimental to the stability of the economy because they borrowed heavily from banks and other financial institutions and this led to a “domino effect” in the times of credit squeeze. Criticism on hedge funds is still strong as they are suspected to have driven up the prices of everyday commodities such as oil, silver, coffee and cocoa all over the world, for speculative purposes.

But with the global economy almost back on its pre-crisis track, especially in East Asia, Korea wants to tap the market.

In the hedge funds initial launching, the FSC wants to set up some entry barrier to prevent any spectacular collapse of the market. The regulators have already seen how ordinary citizens with little knowledge in modern-day finance can easily be drawn into highly leveraged derivative products, as in the case of the Equity-Linked Warrants (ELW) market. So the regulators are contemplating a 500 million to 1 billion won ($1.1 million) minimum investment requirement for individual investors, and a leverage limit of 400 percent for the fund as a whole.

The implication is simple — if a person invests more than 500 million won in a hedge fund, he or she must be a person with a cool head and knows the risk of doing this. Noh Hee-jin, a researcher at KCMI, the think tank, says that the barrier is actually too high compared to other countries such as the United States, where the requirement for hedge fund customers is usually $1 million in assets, not investments. This means that many middle-class Americans can meet this requirement with the value of their homes, savings and other possessions.

“Korea’s hedge fund industry can succeed only when the related regulations are designed well,” Noh says. “The high entry barrier and cumbersome regulations will kill the creativity of the fund managers.”

The government first contemplated the introduction of hedge funds when the Capital Markets Act became effective in 2007. But the outbreak of the financial crisis in the U.S. has put the scheme in the closet. It was only late last year that the discussion has begun to make progress, with the FSC’s Kim, who was appointed this January, speeding up the process.

Optimism abounds

Creativity was the scariest word in the financial industry during the crisis, but it’s now the most coveted word among Korea’s hedge fund enthusiasts.

“Koreans are well known for our fast adaptation to changing environment,” said Noh, the researcher at KCMI. He cites the example of various equity-derivative markets, where the country has become one of the world’s largest market in terms of trading volume within 10 years from the start.

“Hedge fund will be the same. Once it is allowed, then we will soon be able to see creativity sprouting from Korean fund managers.”

One remaining worry is that Korea lacks big investment banks that can do chores for hedge funds, such as introducing customers, providing loans and executing trading orders. The so-called “prime brokerage” business is one weakness of the domestic financial industry, so hedge funds may have to rely on Western investment banks, Noh says.

But in the end, the prime brokerage industry, or the “sell side,” will also grow fast once the “buy side” of their services such as hedge funds prospers, says Kim Gyung-rok, CEO of Mirae Asset Capital.

“The financial industry revolves around information, and information will come to you when you have the power to distribute the money,” he said.