Korea Post Resumed Arbitrage Trading: Evaluation and Implications

Transcription

1 Korea Post Resumed Arbitrage Trading: Evaluation and Implications Lee, Hyo Seob Since Korea Post resumed arbitrage trading at the end of April 2017, the KOSPI200 and derivatives markets surged in trading value. This led to not only a significant reduction in disparate ratios in KOSPI200 futures and ETFs and the resultant improvement in capital market efficiency, but also a marked reduction in foreign investors herding in the arbitrage market. Among others, this evidently triggered an increase in the KOSPI spot transactions, which is expected to give the government KRW 1.12 trillion revenues from securities transaction tax by the end of All of those developments make it worth considering the following measures. First, it would be wise to extend the temporary securities transaction tax exemption on arbitrage trading that will end in December 2018, and to make the exemption a permanent one. Second, the range of arbitrage trading should be broadened to cover options and ETFs as well. Certainly, such measures must accompany thorough monitoring aiming to prevent the arbitrage market from undermining financial stability. Arbitrage is a trading strategy profiting from the difference in prices between the spot and derivatives markets. This is known to not only enhance price discovery in the derivatives market, but also help stabilize volatility in the overall capital markets. Furthermore, active arbitrage trading could lead to a significant increase in trading value in the spot equity and derivatives markets, and thus invigorate the capital markets and contribute to fiscal health via more revenues from securities transaction tax. This was what actually occurred while arbitrage was 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, Financial Services Industry Department, Tel: , hslee@kcmi.re.kr 1

2 active between 2007 and During the period, arbitrage trading recorded the annual average of KRW 50 trillion, accounting for 3% to 4% of the spot equity market. Korea Post represented more than half of arbitrage trading as shown in Figure 1. However, the 2013 tax revision began to impose securities transaction tax on Korea Post, which quickly led to an abrupt contraction in arbitrage trading. In 2016, Korea s arbitrage trading plummeted to KRW 4.7, only one-tenth of the peak or 0.4% of the spot equity market of the year. Another change brought by the 2013 tax revision is the greater clout of foreign investors whose proportion in arbitrage trading steeply rose from the 20% to 30% range to the 60% to 70% range. This is problematic because herding by foreign investors in arbitrage trading may lead to higher volatility in the capital markets when there are large arbitrage orders in times of crisis. Fortunately, Korea Post s arbitrage trading got exempted from securities transaction tax again from April 2017, and the exemption will last until the end of Such an exemption came amid high expectations for the resumption of Korea Post s arbitrage trading to do something about the prolonged slump in Korea s stock market and the stagnated trading value in the spot and derivatives market. This article explores how the exemption affected the liquidity, efficiency, and volatility of the Korean capital markets, and derive the implications for the tax regime and relevant policies. Figure 1. Annual arbitrage trading Source: KOSCOM (CHECK) 2

3 Evaluation After Korea Post resumed arbitrage trading, the spot equity as well as derivatives markets saw their trading value rising significantly. In the 3-month post-resumption period between April 28, 2017 and July 31, 2017, the daily average trading value in the KOSPI200 shot up 31.7% to KRW 4.5 trillion, as compared to KRW 3.4 trillion in the 3-month pre-resumption period, as illustrated in Figure 2. During the same period, a similar trend was also observed in the KOSPI200 futures and options that climbed 16.3% and 18.5% to KRW 16.5 trillion and KRW 0.5 trillion, respectively. A municipality presumed to be Korea Post traded KRW 200 billion on daily average via arbitrage buying and selling strategies during that period. Simply put, an increase by KRW 200 billion in arbitrage trading led to an addition of over KRW 1 trillion liquidity to the KOSPI200 and the derivatives markets. 1) Especially notable was the virtuous circle in liquidity: Korea Post s recent arbitrage trading mostly using ETFs boosted trading of KOSPI200-tracking ETFs by more than 30%, which created arbitrage opportunities between ETFs and spot index portfolios, leading to another increase in KOSPI200 spot trading. As such, arbitrage trading induces participation of not only arbitrageurs, but also their trading counterparties, and thus serves a positive function in providing liquidity to the capital markets. As significant as the increased trading value in the equity and derivatives markets was the improved capital market efficiency. The disparate ratio between the KOSPI200 spot and future prices had been at 12.5bp on daily average before Korea Post resumed arbitrage trading, but fell to 9.1bp in the post-resumption period, a 27% decrease from that of the 3-month preresumption period. This implies that derivatives on equity indices saw their price discovery function substantially improve after Korea Post s resumption of arbitrage trading. Also found was a significant fall in the disparate ratio of major ETFs. In the past, major KOSPI200-tracking ETFs had observed their disparate ratio hover around 20bp to 30bp, which clearly dropped to the 0bp to 10bp range after Korea Post began trading those ETFs for the purpose of arbitrage trading. As securities transaction tax exemption on Korea s equity ETFs led to a cut in the disparate ratio of ETFs, concerns are being raised about some foreign investors with low financing costs trying to avoid securities transaction tax by using ETFs. However, such concerns stem from the difference in financing costs between foreign and domestic investors, and thus only a small portion of trading 1) It is judged that the KOSPI rising out of its long-standing boxed range during that period also imposed a positive impact on the increase in trading value of the KOSPI200 spot and derivatives markets. 3

4 seems to be actually related to tax avoidance. Rather, Korea Post s arbitrage trading appears to have a positive impact on the ETF market by making the ETF value closer to the market price. Figure 2. Daily average trading value before/after the resumption Source: KOSCOM (CHECK) Lastly, since Korea Post resumed its arbitrage trading, there has been a significant abatement in herding by foreign investors in the market. When the 2013 tax revision began imposing securities transaction tax on Korea Post s arbitrage trading, Korea Post de facto stopped arbitrage trading, which markedly pushed up the share of foreign investors to 70% to 80% in the KOSPI arbitrage trading market. The problem is that foreign investors were often blamed for executing a large scale of program selling that could only exacerbate the market s downward spiral. Also notable are unfair trading practices where foreign investors scramble program selling orders on futures and options expiration dates to artificially cause price declines in the stock market. Fortunately, Korea Post s resumption of arbitrage trading effectively brought down the percentage of foreign investors to 20 to 30%, while that of domestic institutional investors increased to 70% to 80% in the market. Domestic institutional investors include a variety of entities such as securities firms, insurers, municipalities, etc. As they are less likely to execute large-scale program selling orders, their increased clout in arbitrage trading helps alleviate volatility in Korea s capital markets. Indeed, the stock index volatility has remained stable although program selling has dwarfed program buying since the resumption of arbitrage trading. Rather, the KOSPI finally escaped the boxed range to rise further, showing more stabilized volatility in the capital markets. 4

5 Policy implications First, it is wise to perpetuate the securities transaction tax exemption on arbitrage trading that would otherwise end in December Despite the exemption, the overall revenue from securities transaction tax is expected to pick up because of the immense increase in trading value in the stock market. Since Korea Post resumed arbitrage trading in April 2017, the daily average trading value of the KOSPI200 has increased by KRW 1.1 trillion, of which KRW 900 billion appears to be the net increase as KRW 200 billion is from increased arbitrage trading. Imposing 0.15% securities transaction tax plus 0.15% special tax for rural areas on the KRW 900 billion would translate to a tax revenue increase of KRW 1.12 trillion for one year and eight months between April 2017 and December Given that the revenue from securities transaction tax was the highest when arbitrage trading was active between 2010 and 2011, the exemption is expected to make a positive impact on the rise of the spot equity market, which could eventually buoy tax revenues. Second, it is desirable to broaden the range of underlying assets whose arbitrage trading is subject to the securities transaction tax exemption. Currently, the exemption targets only KOSPI200 spot and futures (mini-future) markets, KOSPI150 spot and futures markets, individual stocks and futures, etc. However, arbitrage opportunities often occur not only between spot and futures, but also between more diverse facilities, e.g., spot-options, futures-options, optionsoptions, spot-etf, ETF-derivatives, etc. This requires for a broadened scope of arbitrage trading affected by the exemption to a wider range of markets including options and ETFs. Third, close monitoring on any herding of program selling is necessary to prevent arbitrage trading from undermining financial stability. As mentioned above, arbitrage trading has many positive functions, e.g., improving capital market liquidity and efficiency, abating herding by foreign investors, etc. However, there were some past cases where large program selling orders clustering on futures and options expiration dates or in times of crisis did temporarily amplify capital market volatility. To address this, external asset managers of Korea Post should be subject to stricter compliance, while regulators should bolster monitoring on any herding of program selling in the arbitrage market. 5