Derivatives Spot. Third round of LP restrictions making its mark. March 21, Overview

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1 March 21, 212 Derivatives Spot Analyst Trisha Sung Gyun Jun ETF RESEARCH ELW market risk and opportunities Third round of LP restrictions making its mark Overview As announced in December, a third round of restrictions on the ELW market was put into effect on Mar 12. As a result, liquidity providers (LPs) are now: 1) required to submit bids or offers when bid-ask spreads exceed 15%, not 2% as before; 2) only allowed to supply liquidity when spreads exceed 15%, having previously been able to submit bids or offers below such a limit; and 3) not allowed to submit bids or offers when LP-related bid-ask spreads are below the minimum limit of 8%. Burdened by concerns over these liquidity supply restrictions, the ELW market has seen trading volume plummet. Analysis shows that out-of-the-money (OTM) options trading at 4-6% and 6-8% of parity levels have seen trading volumes balloon 99% and 5%, respectively, since the third round of restrictions were put in place. This has caused some to worry that the recent measures may be fueling speculation and risk in the ELW market. We, however, consider such concerns overblown, as the trading volume of very-otm options is insignificant, while slightly-otm and at-the-money (ATM) options are being traded in considerable volume. This and the fact that most such options do not have LP-related ask prices, suggest that bid-ask spreads may widen, providing new profit-generating opportunities. Key factors to consider should be: 1) the return of conservative investors to the market; 2) the timing of a trading volume recovery; and 3) a shift in focus toward liquid products. The secondary ELW market now comprises individual investors, LPs, and foreign investors, vs only the former two previously. The change in investor composition should boost pricing efficiency in the market, despite the shrinkage in overall ELW trading volume caused by last week s LP restrictions. Since the reforms, the LP portion of average daily trading value has fallen to 29% (vs 44% in 211), while as many as four securities firms have been rated F by the KRX. If large LPs decide to exit, both market structure and ELW pricing efficiency would suffer. To prevent the market from qualitative deterioration, measures are needed to encourage LPs that now face restrictions on their hedging and profit-seeking activity. The limitations placed on LPs' market making power are sure to cause a further contraction in the ELW market, possibly pulling trading volume down to 5% of last year's level. As a result, the proportion of ELW hedging by securities firms should also fall this year, from its current percentage in the low 3s to one in the high 2s. All material presented in this report, unless specifically indicated otherwise, is under copyright to Samsung Securities. None of the material, nor its content, nor any copy of it, may be altered in any form or by any means, transmitted, copied, or distributed to any other party, without the prior express written permission of Samsung Securities. This memorandum is based upon information available to the public. While we have taken all reasonable care to ensure its reliability, we do not guarantee that it is accurate or complete. This memorandum is not intended to be an offer, or a solicitation of any offer, to buy or sell the securities mentioned herein. Samsung Securities. shall not be liable whatsoever for any loss, direct or consequential, arising from any use of this memorandum or its contents. Statements, if any, relating to affiliates of Samsung Securities. are also based upon information available to the public and do not necessarily represent the views of the management of such affiliates. This report has been prepared without any undue external influence or interference, and accurately reflects the views of the analyst(s) covering the company or companies herein. Samsung Securities (Korea)

2 March 21, 212 ELW market risk, opportunities, and outlook Tighter regulations on LPs causing market to contract Third round of ELW market restrictions limiting active market participation by LPs ELW trading in freefall due to stricter market regulations As announced in December, a third round of restrictions on the ELW market was put into effect on Mar 12. After raising entry barriers for the ELW market by demanding that individual investors must be properly educated (the first round of restrictions in Nov 21) and maintain a minimum balance to trade in ELWs (Jun 21), the third round of reforms place direct limitations on active market participation by liquidity providers (LPs). LPs are now: 1) required to submit bids or offers when bid-ask spreads exceed 15%, not 2% as before; 2) only allowed to supply liquidity when spreads exceed 15%, having previously been able to submit bids or offers below such a limit; and 3) not allowed to submit bids or offers when LP-related bid-ask spreads are below the minimum limit of 8%. As the new restrictions limit participation by LPs the biggest ELW traders reductions in liquidity supply are making it harder for investors to buy or sell ELWs at preferential prices, causing a downturn in overall trading in the market. Weighed down by rising concern over tightening market regulations, ELW trading began to fall in Dec 21. By Feb 212, trading volume and value were down a respective 24.3% and 47.4% from Nov 21 levels to 3.8b contracts and KRW89.6b per day. Market trading has subsequently fallen at an even faster pace since the third round of restrictions began limiting LP participation on Mar 12. Since the latest restrictions, ELW trading volume and value have dropped to 4m contracts and KRW58.6b per day, less than 1% of last year s daily averages of 4.9b contracts and KRW1.28t per day. ELW trading volume and value trends (Mil contracts) 7, 6, 5, 4, (KRWb) 2,5. 2,. 1,5. 3, 2, 1, Trading value (RHS) Trading volume (LHS) Dec 5 Jan 7 Feb 8 Mar 9 Apr 1 May 11 Note: Shows average daily trading figures for each month 1,

3 March 21, 212 Trading volume plunging but portions stable Concerns over market distortion overblown Despite sluggish trading, new profit-making opportunities emerging The table below shows how ELW trading volume has changed since the third round of ELW market reforms was put into effect. Although overall trading volume plummeted almost 8% on Mar 15 (from its Mar 9 level), out-of-the-money (OTM) options trading at 4-6% and 6-8% of parity levels have seen trading volumes balloon 99% and 5%, respectively, since implementation of the latest restrictions in stark contrast to declines of more than 6% in trading volume of other products with parity levels above 8%. This has caused some to worry that the recent measures may be fueling speculation and risk in the ELW market. In reality, however, the trading of very-otm options now accounts for only.18% of total trading volume, while the slightly-otm portion is a whopping 28% despite an 86% decline in related nominal trading volume. It is also natural that ITM investors, which are relatively more conservative than other investors, have taken a wait-and-see approach amid high uncertainty in the market. The rise in trading volume of certain OTM options can be partially attributed to: 1) speculative demand on the prospect of price distortion caused by a drop in liquidity; and 2) investor inertia based on the belief that there would be cheap products, for which LPs can set ask prices. The considerable trading in slightly-otm and ATM options and the fact that most such options do not have ask prices set by LPs suggest that bid-ask spreads may widen, providing new profit-generating opportunities. Key factors to consider should be: 1) the return of conservative investors to the market; 2) the timing of a trading volume recovery; and 3) a shift in focus toward liquid products. If history is any guide, some products will see price distortion, which should not be considered a side-effect of the third round of reforms unless it is overly frequent. ELW trading volume before and after third round of market reforms, by parity level Parity level (%) Mar 9 Mar 15 Changes Trading volume Proportion (%) Trading volume Proportion (%) Trading volume (%) Proportion (%pts) , , ,927,7.23 7,417, ,179,361, ,71, (73.3) ,538, ,177, (85.86) (15.216) ,291, ,78.15 (78.53) (.1) ,52. 7,96. (64.65) ,6. 2,21. (9.81) (.1) Above (85.71) (.) Total 2,115,587, ,223,95 1. (78.34) Note: Parity is 1 for ATM options, less than 1 for OTM options, greater than 1 for ITM options Source: FnGuide, Samsung Securities KOBA ELW trading was sluggish even before introduction of thirdround of ELW market restrictions Even before the introduction of third-round restrictions on the ELW market, KOBA ELW trading was more sluggish than ELW trading as a whole. The products have received little attention from investors, as their tick values are relatively high all components are ITM stocks and the options are not exempted from LP quotation limitations. The average daily trading volume and value of KOBA ELWs have steadily fallen from 43m shares and KRW461.7b in Sep 21 (when they were listed) to 12.94m shares and KRW8b in Mar 212. At end-sep 21, 89 stocks were traded from a total of 21, but on Mar 15 this year only 8 stocks were traded from a total of 15. Despite being launched as a product with minimal speculative characteristics, KOBA ELWs have failed to become popular, while trading in the products has thinned considerably since the recent round of restrictions. 3

4 March 21, 212 KOBA ELW trading trends (Mil contracts) Trading value (RHS) Sep 1 Jan 11 May 11 Sep 11 Jan 12 Note: Shows average daily trading figures for each month Trading volume (LHS) (KRWb) Implications of structural change in ELW investors Investor composition shifting to individuals, LPs, and foreign players ELW trading value, by investor type Having been dominated by individuals and LPs, the secondary ELW market has seen a change in investor composition, with foreign investors now a major force. The value of LP trades has plunged following recent restrictions on their market-making power, while trading by individual and other investors has followed suit amid related concerns. Over Mar 12-16, LP trades accounted for only 19% of the secondary ELW market, less than the 2% for foreign investors the individual investor portion rose from 49% to 6%. In sum, the composition of the market has shifted from a two- to three-horse race as foreign investors have entered the fray. The change should boost pricing efficiency in the market, despite the shrinkage in overall ELW trading volume caused by last week s LP restrictions. Portions of ELW trading value, by investor type (KRWb) (%) 3, Brokerages (LPs) 7 2,5 6 Brokerages (LPs) 2, 1,5 Retail investors Retail investors 1, 2 5 Foreign investors 1 Foreign investors Jan 6 Jan 26 Feb 15 Mar 6 Jan 6 Jan 26 Feb 15 Mar 6 4

5 March 21, 212 Many still concerned that LPs will flee ELW market Incentives needed for LPs As of Mar 15, LPs' ELW holdings accounted for 97.16% of all listed ELWs, having remained above 97% since December. In contrast, the LP portion of average daily trading value stood at only 29% (down from 44% in 211) as a result of third-round reforms. Faced with restrictions on their market-making power and potential profit-generating difficulties, LPs are increasing their ELW holdings and minimizing liquidity-providing activity (both voluntary and forced). The regulatory uncertainty has made them more conservative, but if larger LPs were to exit the market, both the structure of the ELW market and pricing efficiency would suffer considerably. For reference, as many as four securities firms were rated F by the KRX in 4Q11, up sharply from one in 2Q11, and none in 3Q11. Competent LPs have been the driver behind past upturns in the Korean ELW market, enabling investors to trade at desirable prices. Losing them would be detrimental. To prevent qualitative deterioration in the market, measures are needed to encourage LPs that now face restrictions on their hedging and profit-seeking activity. LP portions of trading value and holdings (%) (%) 1 55 LPs' trading portion (RHS) LPs' holding portion (LHS) 8 Jan 8 Jan 9 Dec 9 Dec 1 Jan 12 Note: Shows daily figures at market close from Jan 2, 28 to Mar 15, Trading portions of five largest LPs (%) Jan 11 May 11 Sep 11 Jan 12 Macquarie Mirae Asset Woori Daewoo Goodmorning Shinhan Note: Shows daily data from Jan 3, 211 to Mar 15, 212; LPs shown have the most listed ELW products 5

6 March 21, 212 ELW market and proprietary trading by securities firms in decline Contraction in ELW market a major factor in drop in futures trading, especially at brokerages The declines in Kospi 2 futures liquidity and proprietary trading by securities firms were prompted, in our view, by a contraction in the ELW market following the introduction of stricter regulations and subsequent decline in hedging by ELW issuers and LPs. As most brokerages use Kospi 2 futures when hedging index products using ELWs, the drop in ELW trading led directly to a decline in index futures trading by securities firms. Kospi 2 futures trading value vs contribution from securities firms Restrictions may cut ELW market liquidity in half (KRWt) (%) Securities firms' portion (RHS) Total trading value of Kospi 2 futures (LHS) Jan 1 May 1 Oct 1 Mar 11 Aug 11 Jan 12 The limitations placed on LPs' market making power are sure to cause a further contraction in the ELW market, possibly pulling trading volume down to 5% of last year's level. As a result, the proportion of ELW hedging by securities firms should also fall this year, from its current percentage in the low 3s to one in the high 2s. That said, while the market may contract further, positive changes in investor composition and restrictions on LPs market making power may open up new trading opportunities. Measures aimed at encouraging LPs are essential though, if the dampened market is to stabilize or recover

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