Korea: Feeding the Growing Addiction
When asked why the Korean derivatives market is one of the largest and most liquid in Asia, one investment banker joked, “Because they are all mad.” It seems that a growing number of retail punters and corporates are willing try their hand at a number of derivative products in Korea.
The exchange-traded market of futures and options and equity-linked products feed off huge retail demand for derivative products. A handful of Korean bankers attribute the success of this market to the ‘gambling culture’ of Korean retail investors. With the lowest interest rates in Asia at 3.5 per cent, including a 25 basis point cut by the Korean central bank in August 2004, retail investors are hungry for more yield but unwilling to put too much cash directly into the equity markets, despite a nearly 20 per cent return over the past 12 months. They deem equities to be too risky as they can get similar returns from capital-guaranteed products such as equity- and option-linked notes.
“[It is] like the early stage of the credit card bubble,” says Kang M. Lee, senior vice-president of risk management at Hana Bank. “[You have a] new product with substantial volatility, which for a very small group of people gives a huge profit potential. [And like] a gambling habit they are joining the market with substantial exposure to futures and options.” But he adds, “Not many people are surviving in this volatile market.” According to the Fimat Group, a subsidiary of Societe Generale, on a combined basis the trading volume on the KOSPI 200 future and options market now outranks the S&P 200 and the Nikkei 225. Korean retail investors are active day traders and often invest in out of the money options, along with equity-linked products.
But the size and liquidity of the Korean exchange-traded, as well as the OTC market, is also the result of other, more important, factors. According to a bulge bracket banker in Hong Kong: “It is one of the most liquid indices in the world and the Korean market is a big market. It has to do with the government policy that encourages structured products, futures and options compared to other places in Asia.” Gyemyung Choi, head of the futures company supervision team at the Financial Supervisory Service (FSS), the country’s banking and financial services watchdog, says: “The derivatives market should be dependent on the market mechanism rather than regulation or supervision interference.” With this attitude, the Korean derivatives market has become one of the deepest in Asia—making it the investment area of choice for retail investors looking to make money.
But these days it is not just return-junkie retail investors who are looking to derivatives to enhance yield. Corporates are also eyeing the potential of exotic, highly structured derivatives in the OTC market, including FX, interest-rate and hybrid products. In May, New York-based Emerging Market Traders Association reported that the South Korean credit derivatives market was the most active among emerging markets, accounting for 12 per cent of the US$197 billion emerging markets credit derivatives market in 2003.
According to one Singapore-based options trader, these products are gaining popularity in Korea because Korean corporates like to, in his words, be seen to be using cutting-edge financial engineering.
While the swaps market in Korea is one of the most liquid in Asia for corporates, exotic and highly structured products are also developing rapidly in terms of liquidity and availability. And with this development observers are now whispering concerns about the ability of the users of these structured products to actually manage their risks. Corporates must carefully manage these products in their balance sheet to ensure that positions are adequately hedged and losses are limited to prevent blow-ups. This can be a complicated and difficult task and can result in substantial losses if not done correctly. Derivatives can protect a balance sheet and hedge risk, but like any other financial instrument they can also create problems.
For now, banks and corporates are finding these products offer a much needed yield boost. The National Agricultural Co-operative Federation (NACF), a major bank in Korea, now invests up to 20 per cent of its US$800 million treasury portfolio in structured products for both hedging and yield-enhancement purposes. Sangwook Lee, its head of fixed-income investment in the international banking department, explains his thinking behind his use of structured products. “Our main goal is we choose the banks that give us [products with] the highest yield and that depends on the market situation.” The range on offer includes: range-accrual notes; constant maturity swaps and snowballs.
The snowball is a structure that gets a lot of attention and makes many people nervous if it ends up in the wrong hands. It is an interest-rate or quanto swap structure that can be locked in for up to 10 years. The structure is a step-up, where the first coupon is a fixed rate, and subsequent coupons are determined by the previous coupon benchmarked against Libor, so making it sensitive to interest rate movements. Such a product allows the end-user to take a view on where they think interest rates are heading in the long term. It doesn’t take a genius to point out that pitting mid-level CFOs in Asia against the next move from US Federal Reserve chairman Alan Greenspan over the long term is a risky business. It could be more difficult to predict interest rate movements than they think – considering they are based on a complicated entanglement of micro and macro economic factors.
This kind of structure brings into question what the role of a CFO is actually meant to be. As one investment banker in Hong Kong asks: “Is it prudent for a corporate treasurer to be taking this kind of [interest rate] view, or should this be left up to investors?” Several high profile derivatives disasters through the years are a result of corporate treasurers stepping off the reservation and lax internal regulations, including the US$102 million loss by Proctor & Gamble in 1994. One banker adds: “If a CFO gets it right, he will get a raise. If he gets it wrong, he will lose his job.” And investors will get hammered.
In-sup So, head of structured product investments at the NACF’s international banking department, says that products such as the snowball are simply too unpredictable for the NACF’s portfolio. He also interestingly points out that if interest rates are moving in favour of the structure and the company begins making money, the selling bank can call the product, based on a target yield or call option by the issuer, putting an end to its profit-making potential. About three months ago, investment banks including a handful of French banks, began aggressively trying to sell the snowball structure to the NACF. So says: “But I expressed my opinion about the snowball and I don’t like the directional market [view it requires].” Instead, he invested into constant maturity swaps and AA-rated collateralized debt obligations (CDOs). This isn’t the case with other corporates elsewhere in the country. According to an options trader at a Korean bank, products such as snowballs are becoming increasingly popular in Korea, with corporates calling up and requesting prices for them despite their ‘very risky’ nature.
While the NACF may be using aggressive structures to make money, it seems to be taking the right approach to risk management by implementing worst-case scenario modeling and strict risk managment practices. But according to the NACF’s Lee, the FSS is getting a bit nervous about the use of structured products by banks and securities houses for treasury management and is recommending enhanced scrutiny for both risk analysis and pricing before purchase. Junghoon Hwang with the international cooperation team at the FSS confirms that the Derivatives Supervision Team sent out precautionary measures in trading of structured derivatives products in August 2004, but it is “far from prohibiting financial institutions from buying structured derivatives products”. The letter was intended to assist banks with risk management of swaps and options as well as risk issues in purchasing structured derivative products, to disclose these risks and to help them adopt the proper precautionary measures internally.
But despite these concerns the willingness of some corporates to use such products in their search for yield mean foreign investment banks are making a fortune in offshore structured products in Korea—one of the few investment banking product lines that still demands decent margins. Joonkee Hong, managing director and head of Korea debt markets at Merrill Lynch, tries however to put the increase in the use of these products into perspective. He says: “For [corporates] they are not going to put 100 per cent into structured products. If they have a huge balance sheet with US$1 billion in cash with low returns, they may throw US$20 million into structured products,” says Hong. “They are testing the market to see the opportunity for higher yield.” He also warns that corporates need to be careful about how they use these products.
While US$20 million may be a drop in the ocean compared with the overall balance sheet, it is still a substantial chunk of change that could be at risk if the product is not fully understood. Kiwon Chang, manager for the treasury department at Shinhan Bank, warns that not every Korean company using these products has the necessary skills to manage them. “It depends on the company. If they are a company such as Samsung Electronics, they are very confident about managing their risk and they do know the mechanics of the complex structured products.” But he adds in other cases, such as quasi-sovereigns, they may not have the same understanding of the market.
Yong-Hoon Roh, deputy general manager for treasury at Shinhan, adds: “Most Korean banks understand better about derivative structures, but for corporates it is sometimes difficult to understand the risk of that derivatives structure.” He adds that corporates can get more yield and are more and more interested in complicated structures, but still hesitant to take that kind of risk, which can be difficult to monitor and manage risk after the transaction.
Other bankers suggest too that Korean quasi-sovereigns may not fully understand the risks. But the head of one of the largest quasi-sovereigns in Korea, defends their attitude to these products and says: “Yes, sometimes I see very complicated structures presented by the banks but we don’t want to take that serious risk and our structure is very simple.” This particular organization uses a series of foreign and local currency issues, which are swapped according to where their foreign exchange/won liabilities and asset ratios need to be. This is done using plain vanilla swaps, which are inexpensive, one-time transactions.
Sung-uk Hong, head of international funding at Kexim, the Export-Import Bank of Korea, says that highly structured products always look good on the surface, but the risks can be hidden at the back — often unbeknownst to the user. And global investment banks cannot always fully disclose those risks. According to the European bank that created the snowball nine months ago, an explanation and reverse inquiry is provided if the client asks, with more “nitty-gritty” details revealed depending on how sophisticated the client’s knowledge of derivatives is. This approach may seem backward, but some clients simply do not have the knowledge to fully understand the product, even if the bank is willing to explain it. Yet the ongoing search for yield keeps driving sales.
With the recent interest-rate cut in Korea people are asking about a lot of products for yield enhancement, says Jee Yun Hong, senior officer for the financial options team and financial engineering at The Korea Development Bank. She adds that although certain structured products can be risky, clients who do not use derivatives, especially plain vanilla forwards, to hedge FX risk could be facing losses as well.
Aside from the fact that some corporates do not fully understand the potential pitfalls, there are serious pricing issues as well. “We don’t have any model to price those products,” says Lee at the NACF. “If they do have one, the sellers [have it], not the buyers.” He adds that the best way to ensure fair pricing is to get the banks to bid against each other. But this bidding process can make proprietary structures, such as the relatively new snowball, public knowledge after just a few trades. According to one bulge-bracket options trader: “Clients in Korea have no concept of secrecy and take any term sheet and send it around. They don’t work one-on-one, but involve a securities company or another bank. So they don’t treat these ideas with great confidence.”
Charles Park, chief of treasury and asset liability, at Korea East-West Power, explains that the company will only agree to look at a product, whether its proprietary or not, if it is allowed to price it with other banks in order to ensure the best cost. As Kang M. Lee, VP of Hana Bank explains, the price of the product is not disclosed on the retail and corporate derivative products, but based on an all-in-cost structure. And considering this, it is still up to the end-user to decide if they want to buy these products or not.
Hong at Merrill Lynch believes there is a method to this madness. “This business is high risk for investment banks, not like bonds where you make a commission after the bonds are sold,” he says, adding that if a bank enters into a 10-year swap, it has to manage it for 10 years. “If there is a mistake made along the way by a trader or someone else, you lose money. The market is already thin for the competition and this business will disappear if it comes into a bidding system and is fee-based because fees can be bid down so much that no one will have the incentive to develop any more technology.” He adds that clients are “shooting themselves in the foot” if they want a more transparent bidding system in an illiquid emerging market as bidding will move the market against them much more than the savings they can achieve by competitive bidding – they often end up getting a lot worse pricing.
Even with the expense of coming up with newer, more competitive structures, domestic banks are looking to get more involved in the OTC markets. KDB has one dedicated person on its options desk working on product structuring for clients. The bank can also make more money by selling these products directly to clients, instead of just taking a spread on selling them through the foreign investment banks, says KDB’s Hong. Lee at Hana Bank says, “We are providing the products that are basically provided by established [foreign] houses and we just get some spread.” But he adds that the bank is looking to squeeze more profits out of selling structured products to its clients. “From this year onwards we are structuring our own products.” Domestic often replicate the structures that are passed to them by the global investment banks, rather than innovating with new products, because they have just one or two staff members working on structures, compared with an army of derivative specialists at most global banks. But domestic houses have much less leeway and scale to sell these products than the bulge brackets. Their options book is much smaller with much less liquidity than banks such as UBS, Citigroup or Deutsche Bank—and they are, therefore, limited to the number of transactions they can safely hedge.
Hana Bank is creating its own in-house options book, but it will be a slow and steady build-up to ensure it understands all the risks and can safely hedge each transaction. But the corporate sector may not be taking such a gradual approach to introducing derivatives to its balance sheet. While bankers agree that most corporates are pragmatic about highly structured products, they also agree that some could be heading for disaster if their CFOs do not fully understand how they work and how to properly hedge them. Or, they may be simply wasting money on products they don’t really need. But in the mean time, domestic players have joined the bulge brackets as they continue to sell structured products in one of the most profitable markets in Asia. And considering the potential to make money in this market, maybe it is not madness after all.