South Korea’s remarkable Kospi 200 Option is a mould-breaking product, unlike any other in listed derivatives. Astonishingly, it is still growing fast. But having climbed to a new peak, the Korea Exchange’s way forward could lie up or down. KRX is linking up with the world’s top exchanges, opening the prospect of yet more liquidity. But at the same time, Korea may impose a tax on derivatives trading. What would that do to the Kospi’s legendary retail demand? Colin Packham reports.
Despite its short history, Korea Exchange has enjoyed remarkable success since its inception as Daehan Stock Exchange in 1956. KRX does not have as rich a history of derivatives trading as the exchanges of Chicago, London or New York, but, by number of contracts traded, it is the largest exchange in the world.
Perhaps fittingly, it is based not in the capital Seoul, but in the city that embodies the country’s outward-facing, commercial side – Busan. At Korea’s southeastern tip, Busan is the nation’s second city, and the world’s fifth largest port.
The derivatives exchange is on a similar scale. No less than 3.1bn contracts were traded at KRX in 2009, surpassing by 8.2% the 2.86bn achieved the previous year. On that basis, this exchange is about 91% as big as the entire European futures and options market.
Such success is surprising, given the exchange’s limited product range of 74 contracts and the fact that South Korea’s economy, though among the world’s 20 largest, is about the same size as those of Mexico or the Netherlands.
What KRX does have is two Korean share index contracts so successful that rivals can only admire, namely the Kospi 200 Future and Option, with the option leading the way.
When the Kospi 200 Option was introduced in 2004, KRX had hosted 12.2m trades the previous year. Fast forward one year – the exchange recorded 2.58bn trades.
Of those, the Kospi 200 Option accounted for 2.51bn, and that roaring success has continued since then. In 2009, the equity index product accounted for 94% of all KRX trades.
Remarkably, the product has not even reached a mature plateau – in the first half of 2010 trading volume was 21% ahead of the same period last year.
The Kospi 200 futures contract is also extremely successful, though it fails to match its sister product’s staggering volumes. However, trading volumes of 83.12m last year mean it is not an insignificant contract, accounting for 10.6% of all index futures trading in Asia.
Together, the Kospi 200 Future and Option generate 3bn traded lots a year, 96.7% of KRX’s total volume.
Even in cash terms the Kospi contract is impressive. Each options contract is sized at W100,000 times the index, now about 225. That means each is for a notional amount of around W22.5m ($18,800).
Based on an estimated average of 183 for the level of the Kospi index in 2009, the 2.92bn contracts traded last year were worth a total of $41.9tr. That compares with $11.5tr for all trading in Eurex’s Euro Stoxx 50 Index Futures last year and $10.2tr for the Euro Stoxx 50 Options.
But KRX as a whole is only about half as big as Eurex in cash trading terms.
Tailormade for retail
The brisk trading of Kospi 200 Futures and Options is no accident, but as Alex Choi, broker at Daewoo Securities in Seoul, concludes, the result of several factors. Most important is the high participation of retail investors – about 30% in the Kospi 200 Futures and Options, Choi says, making it unlike any other market in the world.
“Koreans are now financially well-educated enough to trade futures and options, compared to other countries,” Choi explains.
His assessment that the average Korean with a bit of money in the bank is more clued up on the benefits of derivatives than retail investors in other markets is echoed by an executive at a KRX member trading firm.
He says that compared to investors in other Asian markets, Koreans are happier to take risk with their capital. He describes the independent retail traders as sophisticated in their understanding of derivatives and drawn to trading the stock index option by the substantially higher returns its leveraged nature makes possible.
The Kospi Options’ relatively small size also makes them suitable for retail traders. The Kospi Futures are five times bigger, as they are worth W500,000 times the index.
“The contract size is relatively small, so it is easy to get into without large margin requirements, and with substantial liquidity, it is easy to get out of a position too,” says Kevin Lee, managing director of Newedge Korea.
Emmanuel Faure, head of business development and sales for HSBC Futures Asia, suggests another reason for the options’ success – that with few retail-friendly instruments available at KRX, the Kospi Option became the default speculative instrument.
Lee also points to relatively low execution and clearing fees, enabling local traders to provide the “critical liquidity” underpinning the product’s success.
But perhaps the most powerful advantage KRX has lies in the tax system. As Seong-Koo Cheong, attorney at Kim and Chang in Seoul, explains: “Under Korean law, capital gains tax is not imposed on the trading of any instrument listed at KRX.”
Securities firms have not been slow to spot the opportunity, marketing the Kospi 200 contracts very actively to their retail customers.
Another factor in the market’s favour has been Korea’s status as the country with the largest number of internet connections per person in the world. About 80% of households are connected to the net, putting the derivatives potentially in reach of a mass audience.
“High speed internet and investors’ friendliness to internet-based trading make individual investors participate in the options market actively,” Choi concludes, adding that these retail investors’ understanding of software is as sophisticated as their knowledge of derivatives.
It is wrong to think of Korea as a closed, purely domestic market. Indeed, Choi says, foreign firms perform the largest share of Kospi Option trading, about 36% in 2009. Retail traders did 31%, institutions and securities/futures firms about 16% each, and all other groups less than 1%. There are regulatory obstacles to foreign participation, but compared with some of its Asian neighbours, Korea is a land of opportunity.
“The Korean government has over the last few years pressed for more international firms to be active in its exchange-traded markets,” Cheong says. “To become a member of KRX, either as a clearing member, non-clearing member, or a non-clearing special member, a firm must obtain permission to commence derivatives trading from Korea’s Financial Supervisory Commission.”
Faure says that despite this possibility, Korea remains a “fairly restricted” market, though there are signs that may be changing. “The regulators have been giving a lot of positive signals over the last few years on trying to make the Korean market a lot more accessible to foreign investors and more in line with international markets,” Faure concludes.
Such liberalisation is remarkable, given the closed markets that have dominated Asia, notably those of China and India. Lee says Korea’s relative openness has encouraged the development of its derivatives market, especially the Kospi 200 Futures and Options.
“Although there are some limitations, investing in Korea is relatively easy compared to other countries. Korea’s regulatory system allows for international firms to be active and to realise a profit,” Lee says.
More complicated are the rules governing Korean firms’ access to overseas exchanges.
“Generally speaking, Korean financial institutions and non-institutional firms must hire brokers to trade outside Korea, though there are some complicated exceptions,” Cheong explains.
Regulators have recently expressed a willingness to explore relaxing the law to permit firms to become members of foreign boards of trade. But Cheong says it is too early to say when this might happen.
Open all hours
Because of the regulatory complications in the way of foreign access to Korea’s financial markets – and after all, it is only fairly recently that Korea has bulked large on global investors’ radars – the country’s flagship futures and options have probably still not reached the pinnacle of what could be achieved.
If there is likely to be more cross-border traffic in future, foreign exchanges are eager to get in on the act.
Step forward Eurex, which has set up a connection with KRX to offer futures on Kospi 200 Options to its own customers during the hours when Korea’s market is shut.
The Frankfurt-based exchange will go live with the link on August 30. Michael Peters, a member of Eurex’s executive board, says it will benefit both existing Eurex customers that do not have access to trade on the KRX, and Korean investors, by enabling them to trade outside normal hours.
The Eurex contract will begin trading when KRX closes. The contract’s closing price in Busan will be published to KRX and Eurex members. Trades will be matched and settled in Eurex’s system and placed in its clearing house. But at the end of each day, all contracts will expire into open Kospi 200 Options positions at KRX.
“We decided to transfer the daily positions opened on Eurex to KRX because we did not want to split the open interest,” Peters says.
Non-Korean firms that are not members of KRX will be able to trade the Kospi 200 Option without any regulatory constraint, other than the ordinary rules at Eurex.
It will be more difficult for Korean firms. As Korean law forbids them to join foreign exchanges, they will have to execute through a Eurex member.
Eurex has high hopes for the new relationship, which it hopes will grow trading in the contract by between 2% and 3.5% over the next four years.
Meanwhile, CME Group has got its own cooperation project with KRX, covering Kospi 200 Futures, not Options.
Since November 2009, the US exchange has offered after-hours access to the contract, hosted on the CME Globex electronic trading platform by routing orders to KRX’s Unified System for Global trading (USG). Firms can trade the contract only through firms that have KRX membership.
The USG also allows Korean KRX members, which are not permitted to join international exchanges, to trade the Kospi 200 Futures at CME Globex.
The offering has been well received, with an average daily volume of 4,910 contracts in June.
KRX and CME want to extend their partnership to a mutual order routing deal, like the one CME has with BM&F Bovespa in Brazil. However, this is subject to regulatory approvals.
Life beyond the Kospi
Although KRX’s other products are overshadowed by the Kospi contracts, they are not insignificant.
Launched in 1999, the exchange’s US Dollar Future has grown strongly almost every year, reaching an annual volume of 6.4m contracts in 2008. Korea’s strong economic links to the US and to international trade in general ensured there was plenty of demand.
But in 2009 trading exploded, as 41m contracts were made. The main reason, market participants say, was the savage fall in the won in the second half end of 2008, when it fell from around W1,000 to the dollar to about W1,500. Having recovered somewhat, the won dived again early in 2009, reaching a depth of nearly W1,600. Currency hedging was suddenly an urgent priority.
In the end, that was as bad as it got – the won recovered, first quickly, then steadily, to reach about W1,100 in May this year, though it has since taken another bump.
This year’s volume in the US Dollar Future has been even stronger, topping 30m contracts by the half year mark. As each contract is for $10,000, that means $300bn of trading, with nearly $8bn of open interest. The instrument is regularly among the world’s top five most actively traded FX futures and options.
KRX’s Three Year Korean Treasury Bond Future is another contract that has grown strongly in recent years. Bucking the global trend in which bond futures trading sagged between late 2008 and early 2010, KRX’s contract has grown in volume every year since 2007, to reach 12.6m trades in the first six months of 2010.
Yet Faure says the KTB Future is never going to win the same popularity as the Kospi 200 instruments because of its design. “The three year bond future is quite a large contract,” he says. “It is used primarily by the banks and institutional investors that want to hedge fixed income exposure.” The instrument’s denomination is W100m ($83,500).
Flirting with danger
With the Eurex and CME Group connections and the vast domestic appetite for options trading, you could be forgiven for thinking that there was not a cloud on the horizon for Korea’s derivatives market.
You would be wrong. Over the last decade, Korea has sometimes flirted with imposing a transaction tax on derivatives trading, and the idea has resurfaced again.
In December, a committee of the National Assembly resolved to impose a tax on derivatives including futures and options from 2013. While the details are still being finalised, the latest version of the draft put forward by the Finance Ministry would apply a basic rate of 0.01% of the contract’s value.
The bill still needs to be approved by the Assembly’s Legislation and Judiciary Committee and to its plenary session.
Kevin Lee at Newedge is optimistic that the bill will not become law. He says the idea has cropped up before as a way to tackle the budget deficit, but that if it were passed, the results could be disastrous.
“Slapping a tax on futures and options trading would increase costs, forcing many investors to leave the market and driving down the trading volume,” Lee believes. “A tax could reduce the liquidity in the Kospi futures and options which the retail market provides and which is the foundation of the contracts’ success.”
Going for a clampdown
Another threat to the growth of derivatives trading concerns the FX market. The government is worried by the recent volatility of the won, and has tightened restrictions on firms’ exposure to exchange rates.
Several national banks suffered from writedowns during the financial crisis, and some blamed their losses partly on currency derivatives.
The government has designed new rules to reduce systemic risk and act as a safety net to avert a crisis.
Foreign banks must cut their currency derivatives holdings to 250% of their equity and domestic banks to 50% of it. They will have two years to comply with the new ceiling, which will be re-evaluated, and possibly even lowered, every three months.
The limit on currency derivatives use by non-financial companies has been lowered to 100% of their capital, having previously been limited in 2009 to 125% of capital.
A brokerage executive in Seoul says the two year grace period was welcomed by the market, as many had expected a tighter deadline.
OTC market reform
Moreover, despite the robustness of Korea’s derivatives markets, the country has not escaped the global downturn.
Since October 2008, the government has been forced to spend W3.8tr ($3bn) bailing out exporters which had burnt their fingers on over the counter currency options.
This was a very common problem for emerging market exporters at the time, from Brazil to Poland. Before the crisis, they had feared dollar (or euro) weakness, which would reduce their foreign earnings. Many had hedged against a fall in the dollar, sometimes with unwise options strategies.
When the US subprime crisis struck, paradoxically the dollar soared, as investors pulled out of anything marked ‘risky’, which included all emerging market currencies. That left some hedges badly under water.
This is one reason why Korea has followed the global trend and embarked on its own series of reforms to its fairly small OTC markets.
Unlike the US, European Union and Japan, Korea has not immediately sought to demand the central clearing of standardised derivatives – though that is on the agenda. Instead, Korea passed the Financial Investment Services and Capital Markets Act in 2009, which came into force in January 2010.
A new clearing house for OTC transactions is scheduled for 2012, but no details on which contracts will have to be cleared have yet been revealed.
At the heart of the Act was the establishment of the Korea Financial Investment Association. This brings together the Korea Securities Dealers’ Association, the Korea Futures Association and the Asset Management Association with a mandate to oversee Korea’s OTC markets.
Self-regulator advances, then retreats
One of the KFIA’s first acts was to announce that it would pre-screen any new OTC product which any licensed OTC trading firm wished to offer.
The association’s OTC Derivatives Review Committee began reviewing new OTC products on June 9. It has nine members, led by Woo Yeong Ho, the KFIA’s chairman and chief executive.
The committee will check whether products provide transparent price information on the underlying assets, are appropriate hedging tools, and fully explain the risks. However, the review process is self-regulatory – companies do not have to abide by the committee’s recommendations.
That has not stopped market participants complaining about the pre-screening requirement, saying it will cause delays and reduce the effectiveness of their business.
The International Swaps and Derivatives Association has led the opposition. Keith Noyes, Isda’s Asia Pacific regional director in Hong Kong, commented on the legislation in December: “The bill places a misplaced focus on the product. The problem is never with the products themselves, but rather the way they are sold. Issues of misselling, and to who they are sold. Issues of appropriateness and suitability.”
The KFIA subsequently appeared to soften its position, by saying that it would only concern itself with OTC transactions offered to private investors, and based on underlying risks concerning credit, the natural world, or economic affairs.
Banks, companies and other institutions defined by the Financial Supervisory Commission as professional investors would not be affected.
All to play for
Korea punches far above its weight in derivatives. The country is neither the largest economy in the world, nor even an up-and-coming financial hub like Shanghai and Mumbai. But market participants believe the Korea Exchange will continue to be the largest exchange-traded derivatives market in the world – if it avoids self-harm.
Lee at Newedge says he is bullish about KRX’s prospects, believing it will be propelled further by the success of its Kospi 200 products. The Eurex link will open the product to a large new group of trading firms, and can only boost volumes.
HSBC’s Faure shares this optimism, especially about the Kospi contracts. “I think there is always room to grow, especially when there is such a strong commitment from the local players,” he argues. “The foreigners have not yet reached the level that they can achieve, and Korean institutional customers can become more active, so I do think there is more to come from Korea.”