Policy Priorities to Bring Professional Investors to Korea s Derivatives Market

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Ira Thornton
6 years ago
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1 Policy Priorities to Bring Professional Investors to Korea s Derivatives Market Lee, Hyo Seob The recently released plan for developing Korea s derivatives market is inviting heated debates due to the entry requirements for retail investors. It is regrettable that the controversy could kill the more important agenda of nurturing professional investors as a main investor pool. I propose three policy priorities regarding this. First, it is necessary to lure large-scale professional investors such as the National Pension Service (NPS) to the derivatives market. Second, the regulations over how securities firms and asset managers use derivatives in asset management should be eased. Third, an incentive-compatible market microstructure should be designed for professional investors, for example, introducing the market maker system and the block trade system. Recently, Korea s financial authority unveiled its plan to develop the derivatives market by enhancing investor protection and nurturing professional investors as a main investor pool in the market. The plan intends to allow only qualified retail investors to trade exchangetraded derivatives and to list diverse types of derivatives in order to improve the market s risk management function. To become a qualified retail investor, one should take a 30-hour trading program and a 50-hour mock trading session. In addition, qualified retail investors must deposit at least KRW 30 million in a margin account to trade futures. For option trading, they should have at least one year of futures trading experience and at least KRW 50 million in a margin account. All opinions expressed in this paper represent the author s personal views and thus should not be interpreted as Korea Capital Market Institute s official position. Ph.D., Research Fellow, Derivatives Department, Tel: , hslee@kcmi.re.kr 1

2 The plan faces immediate opposition by the financial investment industry. The industry is raising concerns that limiting the entry of retail investors would contract trading activity in Korea s exchange-traded derivatives market, which has already fallen abruptly due to the increased option multipliers and dwindling volatility. But the financial authority thinks otherwise: Retail investors make up a high portion in KOSPI200 futures and options markets and investor protection should be strengthened to prevent their losses. The two parties agree on the purpose of the plan but differ widely on how to accomplish it. If the sound growth of Korea s derivatives market is to be achieved, the industry and the authority should narrow the differences through effective communication. A more serious problem, however, is that the controversies and heated debates over the entry requirements for retail investors are killing the much more important agenda of making Korea s derivatives market more oriented towards professional investors. When the Financial Investment Services and Capital Markets Act (FSCMA) took effect in 2009, one of its main objectives was to list new financial vehicles under the motto of financial innovation. But for the past five years since then, mini gold futures have been the only newly listed derivatives product. It is time to seek substantial ways to develop the market, e.g., providing risk management tools for professional investors. In this regard, the recently released plan is significant. Above all, this plan includes several measures providing hedging tools for professional investors (e.g., listing futures on the volatility index, the sector index, long-term government bonds, and commodities) and facilitates futures and options on individual stocks. This is expected to substantially reduce the excessively high proportion of retail investors in the KOSPI200 futures and options markets. In this article, I point out concrete policy priorities to nurture professional investors as a main investor pool in Korea s derivatives market. First, more large-scale investors (e.g., NPS) should be encouraged to participate in the market. Second, the regulations on how professional investors manage assets through derivatives should be eased. Third, I propose the use of a more incentive-compatible market microstructure for professional investors, e.g., a market maker system and a block trade system. Bring large-scale investors to the derivatives market Until just a few years ago, Korea s institutional investors represented over 30% in the KOSPI200 futures and options markets. But the figures have continued to decline since the 2

3 regulation was tightened (e.g., option multipliers were increased) in The proportion of institutional investors in the KOSPI futures and options markets recently stood at the upper 20% and 10% ranges, respectively. On the other hand, foreign investors dramatically increased their presence in these markets to about 50% and 60%, respectively. This stemmed from many internal and external factors: less market volatility, the reduction in proprietary trading of domestic institutional investors, and the contraction in program trading. The problem is that the massive foreign capital outflows in the derivatives market under the situation will significantly expand the overall volatility in Korea s capital markets. This is the very reason why it is necessary to encourage large-scale professional investors such as the NPS and Korea Post to invest more in the derivatives market. Another important reason to use derivatives as a hedging tool is the NPS s increasing exposure to domestic equity. According to the NPS s estimation, the NPS assets are projected to reach the peak of KRW 2,500 trillion in 2043, and then go down to negative territory in Given that the NPS invests about 20% of its assets in domestic stocks, its stock exposure is estimated to amount to over KRW 500 trillion, meaning that a 20% fall in the KOSPI by a temporary market shock would lead to a KRW 100 trillion loss. Also, the NPS s high presence in KOSPI market capitalization exposes the NPS to the short-fall risk, adding to the sense of urgency for the creation of tools (e.g., KOSPI200 futures) to hedge the risk of stock price declines. Although the NPS s internal regulation allows for the trading of exchange-traded derivatives, in practice the NPS barely invests in derivatives. Derivatives investments are possible as long as they are approved by the risk management committee and chairman of the NPS. It is necessary to encourage the NPS to trade exchange-traded derivates for the purpose of hedging and arbitrage. Above all, the NPS and Korea Post should be exempted from stock transaction taxes so that the concentration on foreign investors in the arbitrage market can be reduced. Some concerns exist that the tax exemption will decrease Korea s tax revenues, but the reduction will be dwarfed by the tax revenue increase that is expected when the NPS participates in the arbitrage market and increases the stock trading volume. If the NPS generates stable returns through arbitrage, the benefits will go directly to the public. This will help catch three rabbits: ease the concentration in the capital markets, increase the tax revenue from more market activity, and increase the expected rate of return of the national pension. 3

4 Ease the rules for managing assets through derivatives Transforming the derivatives market to be led by professional investors requires more than listing diverse derivatives for professional investors, e.g., futures on the volatility index and the sector index. If professional investors largely represented by asset managers and securities firms face hurdles in using derivatives in asset management, all these innovative products would be useless. The biggest hurdle asset managers face in this aspect is the 100% value at risk (VAR) rule for derivatives, under which the VAR for the derivatives held by one fund cannot exceed 100% of the fund s net asset value. For example, if a fund invests roughly 10% of its fund assets in futures, it is almost impossible for the remaining 90% to be invested in risky assets. The 100% VAR rule also constrains the adoption of simple strategies like the covered call strategy through which the risk of stock price plunges are hedged by selling call options. Easing this rule will enable asset managers to design diverse low-leverage, mid-risk, mid-return financial products. Other rules that are regarded as hindrances to the development of ELS, DLS, and hedge fund industries include the 30% cap applied when a publicly placed fund invests in DLS, and the 400% leverage limit for hedge funds. Also noteworthy is the deep out-of-the-money rule securities firms are obligated to use to calculate the VAR for derivatives. Global risk assessment models including the Basel guideline take into account only three factors: delta (first-degree sensitivity), gamma (second-degree sensitivity), and vega (sensitivity to volatility). But Korea s net capital regulation (NCR) calculates the risk of being deep out-of-the-money, which is completely unprecedented under the global standard. Furthermore, securities firms need to meet NCR, yet another hindrance, in order to issue DLS. The higher the regulatory arbitrage between Korea and the global financial markets gets, the more distant Korea s hope to create a Korean wave in finance becomes. Design an incentive-compatible market microstructure It is important to facilitate the participation by large-scale professional investors like the NPS and to ease the regulations for derivatives in asset management. And equally important is designing a market that enables professional investors to participate actively. Because professional investors place more weight on hedging and arbitrage as opposed to speculation, they prefer a highly efficient, liquid market microstructure. 4

5 The introduction of the market maker system is highly recommended to develop the derivatives market into one led more by professional investors when the entry of retail investors is limited. Professional investors are reluctant to invest in an illiquid market that has high transaction costs. Hence, most bourses in the US and Europe have adopted the market maker system where market makers are obliged to provide liquidity. Already in the KOSPI200 future and options markets, some market participants provide liquidity as the de facto market maker, but their activity sits outside regulations and thus is often misconceived as price manipulation or other unfair trading. The market maker system should be in place for all exchange-traded derivatives, and market makers should be given both carrots (lower transaction costs) and sticks (liquidity provision obligations). As observed in the success achieved in the primary dealer system for Korea Treasury Bonds, offering even trivial incentives to liquidity providers will be of tremendous help to market development. However, it may be difficult to boost trading of some derivatives on foreign currencies or commodities by professional investors at the early stage. Providing a block trade system to banks and other entities buying and selling foreign currencies and commodities will boost market activity and help financial investment firms dealing with relevant orders. Also helpful is improving the market microstructure (e.g., decreasing the tick size as well as option multipliers), which would enhance market efficiency and liquidity and make the market led more by professional investors. Conclusion Korea s derivatives market today lies on an inflection point where its main investor pool is shifting away from retail to professional investors. If the regulations in place to attract more professional investors contract the level of trading activity, then this will be penny-wise and pound-foolish. It must not happen. On the other hand, it is even more undesirable to neglect the protection of retail investors while facilitating derivatives trading. Today s goal for Korea s derivatives market is to make professional investors the main investor pool, not to attract more leverage-based, speculative trading. To accomplish the goal, it is essential to lure more large-scale professional investors like the NPS and loosen regulations on the use of derivatives in asset management. Additionally, providing a more incentive-compatible market microstructure for professional investors will help significantly. 5

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