The latest investigation follows an initial investigation by the South Korean financial watchdog in late 2023, which discovered management system issues in the sales of equity linked securities (ELS).
The Financial Supervisory Service (FSS) in South Korea has started an investigation today (Monday, 8 Jan.) which includes on-site inspections at a total of 12 banks and brokerage firms that sold ELS tied to the Hang Seng China Enterprises Index (HSCEI).
The scope of the FSS probe includes sales limit management and whether related laws, such as the Capital Markets Act, have been breached in the H-index-linked ELS sales process
Based on a probe of major sellers conducted last November and December, the Korean regulator revealed in a report released on Sunday (7 Jan.) that it had encountered management system issues among some ELS sellers including insufficient management of ELS sales limits, policies to drive sales of high-risk and high-difficulty ELS products according to KPI and failure to store contract documents.
Following the sluggish performance of the HSCEI over the past year, concerns over potential retail investors’ losses loomed over the Korean market as the total outstanding balance of ELS products linked to the HSCEI amounted to KRW19.3 trillion (US$14.66 billion) as of last November, according to the FSS’ data.
With 52% of these products, worth KRW10.2 trillion, set to mature in the first half of 2024 due to the failure of early repayment of three-year-tenor products sold in 2021, investor losses are expected.
‘Large investor losses are visible,’ the financial authorities stated.
Market guesses that the minimum level of HSCEI to avoid the ELS loss might be above 7,000 points - Gyun Jun, Samsung Securities
“Market guesses that the minimum level of HSCEI to avoid the ELS loss might be above 7,000 points,” Samsung Securities derivative analyst Gyun Jun told SRP. “At this stand, there are not many opportunities to avoid the loss, so retail investors on ELS have complained to the regulator and sellers.”
FSS pointed out that investors aged 65 and above purchased products totaling over KRW5.4 trillion. Among these, 8.6% were first-time investors with no past experience investing in derivatives-linked securities.
With the in-depth inspection, which starts with the two largest sellers KB Kookmin Bank and Korea Investment & Securities, the scope of the FSS probe includes sales limit management and whether related laws, such as the Capital Markets Act, have been breached in the H-index-linked ELS sales process. Civil complaint investigations will also be simultaneously conducted on these two companies, besides on-site inspection.
Other targeted institutions include four banks (NH Nonghyup, Shinhan, Hana, and Standard Chartered Bank Korea) and six securities houses (KB, NH, Mirae Asset, Samsung, Shinhan, and Kiwoom).
‘In case of confirmation of illegal activities, the policy will be strictly held,’ the financial watchdog stated. ‘In particular, the banking sector has taken steps to protect investors based on the premise of ‘customer interest protection-centered sales of high-level financial products (ELS), following the derivatives-linked fund (DLF) crisis in 2019’.
Despite the risk of potential investor losses, on the hedging side, issuers have not seen a significant impact on their trading books due to the fact that most autocalls expiring are relatively short-dated and are not exposed to implied volatility (Vega), as reported in December.
SRP data shows that there were 1,788 HSCEI-linked ELS, worth US$2.3 billion, issued in South Korea throughout 2023, soaring from 597 products worth US$1 billion in 2022.
According to Jun, the remaining products hit the knock-in barrier in 2022, so the hedging program of HSCEI-linked products focuses the long gamma hedging, such as linear delta trading. He also sees most of the hedging programs are not exposed to Vega.
“I found the HSCEI futures market has massive liquidity, so the impact of rewinding the hedging position would be limited to the HSCEI futures market,” he said.
Meanwhile, the FSS has also announced that it plans to manage dispute complaints by taking into account the principle of investor self-responsibility in a balanced manner, along with actual compliance with the sales principles set forth in relevant laws and regulations.
‘We plan to quickly proceed with a series of procedures ranging from ‘inspection to dispute resolution to review of system improvement’ through organic collaboration between relevant departments and consultation with the Financial Services Commission (FSC),’ stated the FSS.
Click the link to read the full Financial Supervisory Service report (in Korean) on the on-site inspection of major Hong Kong H-share index-linked ELS sellers.