The Korean government approved a long-awaited amendment to the presidential decree to the Securities and Exchange Act in February, which will permit certain qualified securities companies in Korea to enter the over-the-counter derivatives business, starting from this July. Although KOSPI (an index for Korean companies) index futures and options and certain currency and other futures products have been traded on the Korea Stock Exchange and the Korea Futures Exchange for years, OTC derivatives have been off limits to securities companies in Korea, except in very limited circumstances. This is in sharp contrast to the treatment of commercial banks in Korea that have engaged in various OTC derivatives transactions. Foreign securities and commercial banks with a large capital base and expertise in foreign currency related products also have been active in this business, although they were subject to foreign exchange regulatory approvals or reports. Such favorable treatment of commercial banks and foreign companies over domestic securities companies has been a source of complaint. By opening up this market to securities companies, such criticism will be lessened. In addition, the Korean government hopes that the competitiveness and profitability of securities companies is enhanced and their customers better served in their financing and risk management needs.
The Process
However, the Korean government intends to deregulate the OTC derivatives market gradually, in light of its potential impact on the stability of both the financial system in Korea and the transaction parties in particular. First, eligible securities companies will be limited to those with a comprehensive securities business license (i.e., all of the brokerage, underwriting and dealing licenses), satisfying the minimum capital ratio of 300% with the minimum capital to be set by the ministry of finance and economy. It is expected that the minimum required capital is KRW300 billion. They must also employ directors and employees who are experts in derivatives on a full-time basis and must comply with risk management and internal control guidelines of the Financial Supervisory Commission. Because of the stringent financial criteria, only a few companies are expected to satisfy the above requirements and no Korean branches of foreign securities companies are expected to qualify. Although European banks have in general both securities branches and banking branches in Korea and, therefore, they can continue to engage in derivatives business through their banking branches, the U.S. securities companies which do not have banking branches in Korea will find it difficult to compete.
In addition, the types of OTC products that would be permitted have not yet been fully determined. The February amendment delegates authority to determine the types of permitted products among those related to currencies and securities and indices based upon them to the ministry. Credit-linked derivatives will not be allowed, because they are similar to guarantees. Under the Securities and Exchange Act, securities companies are prohibited from issuing guarantees or similar instruments.
Thirdly, counterparties to OTC derivatives will be limited to institutional investors and the companies listed or registered with the Korea Stock Exchange or the KOSDAQ. Due to the high risks involved in such products, individuals are expected to be prohibited from directly investing in OTC derivatives.
The total risk exposure of a securities company to OTC derivatives is also expected to be limited to a maximum net position (for example, to a certain percentage of its capital).
The Korean government also plans to strengthen its monitoring and supervisory functions over OTC derivatives by requiring periodic disclosure in the security companies' annual or other reports of derivatives transactions and the profits and losses from such transactions, requiring use of standard terms and conditions for certain standardized products and setting up a monitoring team within the Financial Supervisory Service. Such measures are critical for maintaining the stability of the financial system in Korea.
The Impact
The February amendment is merely a first step toward deregulation of OTC derivatives to securities companies. As discussed above, detailed implementation measures need to be adopted before July. It remains to be seen whether this partial deregulation will achieve the intended results of making Korean securities companies more competitive and profitable, and if so, how soon. Given that the risk management system of Korean securities companies is not yet sophisticated and there is a shortage of derivatives experts in Korea, although this deregulation is a welcome development, thorough preparations and gradual deregulation appears to be the right approach.
This week's Learning Curve was written by Jong-Goo Yi, a foreign legal consultant at Shin & Kimin Seoul, Korea.
