Retail boom

Korea's retail sector looks set to expand substantially over the coming year. Joseph Radford looks into the reasons behind its growth

Demand for derivative-style products from Korea's retail sector is set for further growth over the next year, driven by regulatory changes and the increasing sophistication of individual investors.

Most notably, in late July the Financial Supervisory Commission (FSC), which along with the Financial Supervisory Service (FSS) makes up Korea's principal financial regulator (see profile on page 33), announced that warrants could be listed on the Korea Exchange (KRX) – a move which has been widely perceived as potentially giving a significant boost to the retail sector.

"The introduction of listed warrants is very positive at this juncture, as investors generally need more instruments to enhance their current [financial] performance," says Ross Gregory, head of structuring for the Korean equity derivatives business formed by an alliance between Macquarie International and Woori Bank. "Retail investors [in Korea] tend to be more aggressive than institutional investors."

The move, which had been anticipated for some time, is expected to allow retail customers to compete more fairly with institutional investors. For example, Gregory says the tools will be far easier to use for individual investors than exchange-traded futures and options. "Currently, retail investors are competing against professional traders in buying Kospi 200 futures and options," he explains. "They're at an inherent disadvantage because those are standardised contracts which all professional banks use to hedge their positions and it's hard for retail investors to gain access to the same breadth of information, and they of course lack the balance sheet strength to always sustain positions."

KRX is expected to launch the market around the beginning of November, and although retail customers in Korea are increasingly sophisticated, market participants say there is a need for an educational drive from securities houses and the exchange itself. Initially, only registered securities companies with a domestic derivatives dealers' licence will be able to issue warrants.

Indeed, senior officials from several international financial companies operating in Korea tell Asia Risk that education will play an extremely important role in the development of warrant markets and other derivative markets in Korea. "Over the past year, banks have provided a raft of seminars, there have been a lot of brochures and people are getting more exposure to [derivatives] markets," says an unnamed Seoul-based worker from an international bank.

Gregory adds that education via the internet is increasingly important. He explains that Macquarie's Australian site has a lot of information detailing the specifics of financial instruments, including warrants and exchange-traded options. Woori and Macquarie formed their joint equity derivatives business in Korea in 2003.

But some participants predict that, with the right education, the warrants market could see high volumes very soon. "It's got great prospects, and the sophistication of retail traders, their preparedness to actively trade positions, and their uptake of internet-based home-trading systems means they've created incredible liquidity in the Kospi 200 options and futures contracts – there is every chance they will establish just as much depth and liquidity in well-structured warrants," Gregory says.

Another potentially significant regulatory change is that regulators have said exchange-traded options can be cash settled. This is a move that should help the development of overall markets, and should be particularly good news for retail investors. "Exchange-traded share options will be able to be cash settled instead of settled by physical delivery," explains Gregory.

The Korean regulator is also increasing the number of shares that can have options on them from around seven to around 30, meaning that most Korean blue-chip stocks will have an option and a warrant as well. Indeed, a member of KRX's staff who asked not to be named warns that this means there will be an element of conflict between these options and warrants when it comes to winning liquidity. "There would be some competition in terms of liquidity between the warrants market and equity options market if maturity on a warrant is short," he says.

Derivatives demand

The retail sector also looks set to continue growing on the back of demand for structured products, which is predicted to go from strength to strength over the next year or so. Though some players warn that banks will need to be quick to develop new kinds of equity-related products to ensure this sector maintains its momentum.

"Equity derivatives have become very popular for retail distribution these days," says an official from another international bank operating in Korea. "This has a lot to do with the fact that interest rates have been very low and stable. Retail investors have been through thick and thin as far as investing directly into equity markets is concerned, so they are very happy putting their money into a structure where they can get some upside potential of the equity market and then get protected on the downside."

The equity derivatives market for retail investors has developed rapidly in Korea. Macquarie's Gregory says that while the market began with plain vanilla deposits, funds and notes, more creative structures have become increasingly common. For example, market participants say that during the past year the so-called Hi-Five structure has been very popular.

The official from the first international bank says the company had helped construct Hi-Five products with a three-year tenor based on a basket of two stocks. The products were offered by local banks to retail customers. On an observation date every six months, if the worst-performing share remains above a trigger level, the option will terminate early with a coupon payment of around 5%. However, if it doesn't terminate early the coupon is rolled over to the next six-month observation period, and so on throughout the life of the product.

This means that if the worst-performing share closes above the trigger level after three years, the client gets a 30% coupon with 100% of the notional returned as well. If this doesn't happen, but neither share falls to a knock-in barrier level during the observation period, the client receives 100% of the notional. However, if either share falls below the knock-in barrier level at anytime during the observation period, the client receives the notional amount multiplied by the performance of the worst-performing share, where this performance is defined as the difference between final price and initial price.

"The risk assumed by the investor [with these kinds of products] is that if the market suffers a very significant drop then they become exposed to the market. So it's like buying the market, but only if it drops by 35% or 40%," says Gregory.

But some observers say that investors are looking for new structures in which to put their money. Gregory explains that when a new product takes off in Korea it generally becomes dominant very quickly. "Products here tend to boom or bust," he says. "The current popular Hi-Five product could be knocked off its dominant position if somebody comes up with a well-structured product that also has a trendy appeal."

And Gregory predicts that new products will need to be based on a larger number of underlying stocks than the one or two that are commonly used at the moment. He also believes they will need to involve an element of correlation. Right now it is very difficult to manufacture yield without using correlation models, he explains.

However, some market participants point out that the image of derivatives in Korea has been harmed by several recent scandals (see box), and say this could possibly dampen the enthusiasm of some retail investors for these products. Though most players agree that even with this slight setback the retail space is likely to maintain its strong growth. "This market is really taking off," says the official from the second international bank. l

Watchdog snaps at banks

The Financial Supervisory Commission (FSC) last month reprimanded three international banks operating in Korea for derivatives trading irregularities. BNP Paribas, Barclays Bank and Deutsche Bank were all criticised for conducting "improper" over-the-counter derivatives contracts with state-owned companies.

The FSC, a sister organisation of the FSS charged with disciplining regulatory abuses, said in a written statement that these banks offered "non-standardised derivatives" designed to reduce clients' interest payments on foreign currency loans, without thoroughly explaining the risks entailed.

"The foreign bank branches… failed to adequately disclose material information on the potentially substantial financial losses and other downside risks… despite the complex nature of the transactions involved," the FSC said.

Deutsche received the harshest dressing down; punishments included a one-month suspension for the head of its Seoul branch and the recommended sacking of another staff member. "Deutsche Bank accepts the decision of the Korean regulators, and we remain committed to the further development of our business in Korea," said a bank spokesperson.

BNP Paribas's Seoul chief received a so-called 'censure' from the regulator, and the French bank was told it should impose a three-month pay reduction on another employee. The watchdog also recommended reduced pay for a Barclays worker.

BNP staff did not respond to requests for comment, but Barclays issued a statement saying: "No institutional sanction has been imposed on Barclays. [The bank] is co-operating fully with the FSS on the implementation of measures designed to strengthen and improve its business model in Korea."