Evolution of derivatives
World’s most liquid market seeks diversity, stability and efficiency
By Kim Da-ye
The Korean derivatives market carries pride as well as a stigma: It is the home to the world’s most liquid derivatives while it has been blamed as the “graveyard of ants” meaning losses suffered by individual investors.
While industry insiders fear the society’s indiscriminate contempt against derivatives and the potential political actions could shrink or even destroy them, the market is evolving.
In Korea, 85 percent of exchange-traded derivatives are equity-based in terms of balance, compared to 10 percent based on interest rate and five percent on currency, as of June, 2010.
Globally, in contrast, the interests rate derivatives account for 92 percent of the exchange-traded instruments. The portion of the equity-based is merely seven percent.
The derivatives market division of the Korea Exchange (KRX) finds opportunities such the imbalance. It aims to develop more accessible derivatives linked to interest rates, currency and even commodities ― ultimately to promote the balanced growth among them and big shots like the KOSPI 200 Options.
One example is a “remodeled” version of a U.S.-dollar option contract under development.
Instead of delivering actual dollars at a promised foreign exchange rate, the new option will pay out the difference between the promised rate and the actual rate on the exercise date. The trading unit could also get smaller for a wider range of investors.
“Foreign exchange rates and interests rates are, in fact, more relevant to the economy as well as to companies and individuals,” Kim Jin-gyu, the president of the KRX’s derivative market division, said in an interview with Business Focus.
“They tend to fluctuate, and there is surely the desire to hedge against their volatility.”
History
Korea’s official derivatives market was formed in May 1996 with the launch of the futures contracts linked to the KOSPI 200 index which consists of 200 largest companies listed in the Seoul bourse.
In the following year, the KOSPI 200 option was introduced, and would become the world’s most traded equity index option in 1999 and retain that title until now.
Its trading volume reached 3.53 billion contracts last year ― significantly more than 529.8 million contracts of the second most traded S&P CNX Nifty Option on India’s National Stock Exchange.
In 1999, a futures exchange was set up with the addition of U.S. dollar futures and three-year-government-bond futures.
The new millennium saw derivatives more accessible for retail investors listed in the stock market division of the KRX.
Exchange-traded funds (ETF) ― literally mutual funds sliced and listed ― entered the stock market in 2004, followed by equity-linked warrants (ELWs), which works very similar as equity-based options, in 2005. Before the crackdown on the big players earlier this year, Korea’s ELW market was the world’ second largest after Hong Kong.
In 2009, the KOSPI 200 futures got listed on CME Globex, the electronic trading platform of the world’s largest exchange CME Group, allowing after-hours access globally to the liquid instrument. Last year, the Eurex, Europe’s leading derivatives exchange, developed the Eurex KOSPI Product, a daily future contract derived from the KOPSI 200 Option, in cooperation with the KRX, basically enabling the option traded during European trading hours.
“I believe the development of information technology played a pivotal role,” Kim of the KRX said regarding the fast growth of the derivatives market.
“And cultural factors must be there ― the dynamic Koreans.”
Stigma
The negative vibe attached to the word “derivatives” since the global financial crisis in 2008 does affect the reputation of the domestic market, Kim admitted.
In the U.S., mortgage-backed securities, which financial firms issued to fund mortgages for borrowers with poor credit history, were mixed with safer assets to create collateralized debt obligations (CDOs), whose risks were insured against by credit default swaps (CDSs).
The burst of housing bubbles put mortgage firms into trouble, soured CDOs and smashed the issuers of CDSs.
Most importantly, the CDOs and CDSs were over-the-counter (OTC) derivatives ― traded among financial institutions in the absence of an exchange. The regulatory body couldn’t track how massive the trading volume had become, so couldn’t prevent the debacle.
Such the credit derivatives rarely existed in Korea ― 98 percent of OTC derivatives are based on currencies and interest rates, according to the KRX data. And the popular instruments like the KOSPI 200 Options and ELWs are exchange-traded ― the KRX and the regulatory bodies keep a good track of them.
One controversy came from the Knock-In-Knock-Out (KIKO) options when it dealt a huge blow in 2008 to small- and middle-size exporters who bought to hedge against foreign exchange volatility.
When the value of the Korean won against the U.S. dollar crashed at the downturn of the global economy, the exporters had to buy expensive dollars to pay them back according to the terms of the KIKO options.
The KIKO options, however, were OTC derivatives that were traded between exporters and financial institutions, and didn’t affect external parties.
It wasn’t until Nov. 11, 2010, when the public became aware of the dangers of the derivatives.
Deutsche Bank’s securities unit sold off stocks worth 2.5 trillion won, causing the KOSPI fall by 2.5 percent. Investigations found the firm had bought equity index options that yield profit at a bearish turn.
The case clearly showed that the derivatives market can shake and move the spot market, and both could be manipulated.
Individual traders had long been complaining among them that future, options and ELWs are their graveyards, but the notion became public only recently.
The following crackdown on the ELW market in May worsened the reputation of derivatives.
The Seoul Central District Prosecutors’ Office charged 12 former and current chiefs of securities firms for giving special favors to high frequency traders called scalpers to help them trade ELWs faster than ordinary individuals.
With the high frequency traders counting more than 38 percent of the ELW trading volume, industry insiders quietly voiced their fears that the financial authority is determined to wipe out the market.
“They shouldn’t kill the derivatives market. The KOSPI would be staying at 1,200 points without it,” an official from the Market Oversight Commission of the KRX said, explaining the role of derivatives’ attracting of foreign investors who hedge risks in their spot investment with options and futures.
Evolution
In the current climate sensitive toward protection of retail investors and negative toward any exotic instruments, the KRX continues developing new derivatives to create balance among various types.
With the equity index options and futures dominating the market, the KRX focuses on those linked to currencies and interest rates although
In the long term, Kim said, derivatives could be made from anything whose volatility creates demand for hedging and that can be standardized. CME Group, for instance, has derivatives based on weather including snowfall futures and options.
About 11 percent of all derivatives across the world are perceived “successful” ― the trading volume is 10,000 contracts a day or more ― and the success rate or new products have dropped to five percent in the last five years, according to the KRX.
“The upgraded versions of the existing products are more likely to do well,” Kim said.
The remodeled dollar option will be one of them. Kim Jae-jun, a derivatives division executive of the KRX said that the KIKO options have nearly disappeared after the controversy, and the new exchange-traded derivative would make a good replacement.
The KRX had applied a similar change to the payment plan for 10-year-government-bond futures in October last year. Within a year, the trading volume jumped 40-folds from 500 contracts a day to 20,000.
The exchange is also increasingly paying attention to commodities.
Last year, it launched the mini gold future that trades 99.99-percent-pure gold bar by 100 grams instead of 1 kilogram. It now plans to launch a spot market for gold by 2012 and expands the product portfolio to rice, crude and petroleum product by 2014.
If the commodities division succeeds, the KRX would consider by 2015 spinning it off as an independent market.