Korean regulator allows synthetic ETFs

Issuance of South Korean ETFs to remain largely from local managers despite changes to allow synthetic ETFs

The decision by the Financial Services Commission (FSC) to allow synthetic ETFs in Korea is a positive move, but issuance of new synthetic ETFs will largely be from local ETF managers, says one ETF provider.

On February 26, the FSC announced that it had passed a revised bill that was submitted by the Korea Exchange (KRX) to trade synthetic ETFs on the local exchange. A synthetic ETF tracks the underlying investment via a derivative such as an interest rate swap with a counterparty, as opposed to a traditional ETF which physically invests in a basket of stocks or bonds.

Counterparties for synthetic ETFs are mandated to meet certain eligibility requirements including being approved for trading over-the-counter derivatives by the FSC and having a credit rating higher than AA–, the FSC said. The minimum trust amount required to list an ETF was also raised to 7 billion won ($6.44 million), up from an initial 5 billion won.

Marco Montanari, head of passive asset management, Asia-Pacific for Deutsche Bank in Hong Kong, says the move will allow ETF managers to bring products into the market that were not possible before.

However due to tax laws on foreign firms operating in Korea, Deutsche Bank will not be able to directly cross-list its synthetic ETFs in Korea as in Hong Kong and Singapore, says Montanari.

"As a foreign provider, there are still some tax disadvantages as compared to a local ETF provider so I would expect local ETF providers to continue to be the ones driving the growth of the new synthetic ETF market until there is a change in tax regulations which would make it more attractive for foreign ETF providers to directly cross-list their ETFs in Korea," he says.

Despite this, Montanari says synthetic ETFs will fill a gap in the local ETF market, with most Korean ETFs focused on domestic underlyings.

"The Korean market has always been among the most innovative – there are already leveraged and short ETFs, but there are still many products missing. There are only 137 ETFs in Korea whereas Germany has over 1,000 ETFs. Synthetic ETFs will allow Korean managers to outsource the tracking of certain indexes linked to Latin American or South-east Asian countries for example, as they may not have had the capability to track those markets previously," he says.

Within Asia-Pacific, Hong Kong, Singapore, Australia and Japan all currently allow the listing of synthetic ETFs. The 137 physically backed ETFs listed in Korea represent $13.8 billion under management, according to Deutsche Bank figures.