How the Korea Exchange Vaulted to Top, a Case Study

How did the Korea Exchange come to be amongst the world's largest derivatives exchanges?  The main factors in its strong growth were 1) the strength of its equity derivatives market, 2) the role domestic retail investors played during its early years, 3) the lifting of the cap on investment for foreign investors in 1992, and 4) the more recent rise of institutional investors.

Korea Exchange's rise to the top is due disproportionately to domestic retail (and later, foreign investor and institutional) participation in its equity derivatives market (specifically, its Kospi 200 options, which were until recently the most actively traded derivatives contract in the world), rather than due to any outstanding strength in its exchange-traded T-bond, currency, or commodity derivative markets.

In 2011, the Korea Exchange was at the top of the rankings in contract volume, with 3.748 billion, 93% of which was equity index options.  In 2012, the Korea Exchange fell a little in the rankings, but still fully 86% of the 1.835 billion in volume that year was equity index options.  Of those equity index options, roughly 28% could be attributed to retail traders, while 42.3% could be attributed to foreign entities, and 29.7% to institutional investors (as of April, 2012; 27% retail and 43% foreign in 2011).

• As a developing country, Korea initially lacked institutional investors (hedging demand), but developed strong retail (speculative) demand.  Developing markets often lack natural hedging demand, as they do not yet have enough institutional investors who can make long-term investments and manage their risk.  Retail investors originally comprised 2/3 of the equity derivatives market, driving its growth and making Korea stand out (along with India and Taiwan) from most other developing markets, which have weak equity derivative markets.  Since then, institutional players have steadily increased their presence in the derivatives market.

• Until recently, it was relatively cheap for retail investors to buy options on the index, making the equity options index key to the exchange’s rise, and key to its recent dip.  The index multiplier was low ever since the contract launched in 1997, making it cheap for retail speculative investors to trade.  The main reason the Korea Exchange recently dropped in the rankings is because regulators quintupled the nominal size of their Kospi equity index contracts, making them more expensive and damping excessive retail speculation.  Korean exchange-traded derivatives also tend to be concentrated in short-term contracts.  Long-term contracts are not even listed, meaning it is difficult to manage risk and hedge in the long-term. 

• Furthermore, widely available internet (94% of people have high-speed connections) made it easier and cheaper for retail investors to participate in the markets.  Combine that with online broker competition, low transaction costs and commission fees, the proliferation of market research sites, and a cultural enthusiasm for trading like that in Japan, and you have the makings for very active retail investor participation (and in seeking opportunities for arbitrage or speculation).

• Capital control liberalization also lifted the investment ceiling for foreign investors, enabling them to be the contributors to Korea’s capital markets that they are today.

• Fourth, consolidation and partnerships played a role in Korea Exchange’s growth, as it often does in the wider industry.  As a product of the Korean Stock and Futures Exchange Act, three markets merged to form the Korea Exchange in 2005, accelerating the growth of Korean capital markets.  Then, in 2009, Korea Exchange partnered with Eurex, enabling its contracts to be traded in Europe and the U.S., when the Korean market is closed. 

• The growth in Korea’s economic fundamentals, its integration into the global community, and value as a high beta investment play has been an underlying driver for its capital markets. 

Credit Rating Reform, Part II: Forging a Hybrid Model

Regulators tasked with reforming the credit rating industry have been hesitant to rock the ship, taking great pains to explore every possible option.  Furthermore, the fact that structured products are the main target of scrutiny, yet have been the most profitable line of business for credit rating agencies presents a considerable headwind for reforms.  As a result, talks have slipped beneath the waters, floundering along in slow motion.

Recently, we discussed a prominent “rating clearinghouse” proposal that has raised industry objections.  For a brief review of the options before regulators up to this point, please see Table 1.

Table 1: Fixing the Credit Rating Industry

Source: SEC.

The debates of the last few years have put a spotlight on the weaknesses of a range of proposals.  With that in mind, the challenge for the SEC will be to construct a model that effectively erases the conflict of interest problem, yet avoids regulatory overreach.  It must further be operationally feasible and affordable to implement.  By identifying the vulnerabilities shared by the various reform proposals, regulators may forge a more effective model from their midst.  Whatever the eventual model, it should take heed of those design constraints. 

First, it needs to effectively prevent conflicts of interest and “rating shopping,” in which issuers seek out the agency that offers the most favorable appraisal.  In order to do that, it must actually be utilized, unlike the inert Rule 17g-5 program, an early effort which failed to motivate agencies and investors to participate.  Also, solving one conflict of interest could create new ones if incentives are not managed carefully.  The investor-owned models run this risk, as investors have an interest in seeing certain rating results, just as issuers do.  One important distinction to make, when designing a solution, is whether the conflict of interest stems more from the payment mechanism (i.e., who pays the agency), or from the selection mechanism (i.e., who selects the agency).  

In the process, it should take care to avoid regulatory overreach.  As is often the case with legislation and regulation, policies can be too ambitious or aggressive, and have unintended consequences.  In this case, investors’ traditionally free access to ratings should be preserved, competition within the industry should not be undermined, and issuers should not be overly burdened. 

Third, it should be operationally feasible.  The complexity of rating deals under the new regime should not overwhelm regulators’ capacity or an assigned agency’s expertise.  Without the requisite experience, a central clearing party, or assigned agency in any one deal could cause delays, and the quality of service could decline.  Therefore, whatever system is put in place must speedily and efficiently handle the deal type and flow, and adequately compensate the rating agencies.  Preferably, it wouldn’t require legislation to enumerate new powers in order for it to work.  Questions of cost and feasibility have tended to plague the section 15E(w) program, as well as the stand-alone and designation models.    

Last, it should be affordable to implement.  Overly prohibitive costs could include the extensive resources required to form a new oversight body, or even a serious loss in market efficiency.  Even increasing the size of a regulatory agency may be undesirable at a time when government is generally trying to do the opposite.  

One approach that could effectively marshal these lessons is a hybrid model, in which issuers and investors are both stakeholders of a fund that is only responsible for collecting fees from new issuances (from issuers) and secondary transactions (from investors), and for disbursing payments to selected agencies.  Unlike the clearinghouse model, the fund would have no active role in selecting the agencies.  Rather, agencies would simply initially be placed in a continuous queue to receive rating assignments, unless they were unable to rate a particular issue.  

Along with randomization, an agency’s capacity for rating complex structured transactions would be built into the process and determined at the time of NRSRO eligibility, rather than decided later by a centralized body.  In the future, assignments would be ruled by performance.  

Chart 1: Severing the Links that Create Conflict of Interest

This solution would cover quite a few of the constraints listed above, and takes a step towards satisfying the question of feasibility.  It separates many of the links between issuer, agency, payment, and selection that typically generate conflicts of interest; and by bringing together issuers and investors as stakeholders, it balances the various conflicts of interest between raters, issuers, and investors. 

 Although it might tradeoff deal speed and volume because it would be blind to individual NRSRO competencies, it also avoids the burden of having to create a new government oversight board or clearinghouse responsible for determining assignments.  Queuing up agencies that are pre-qualified to rate structured deals would still achieve the random assignment effect.  

Though imperfect, such a hybrid model would be a step forward in a dormant effort, with strengths that reformers can build upon.

Credit Rating Reform, Part I: The State of Credit Rating Reform

Since the Dodd-Frank Wall Street reform bill became law in 2010, government efforts to cure what ails the credit rating industry have completely stalled in some areas, while inching ahead in others. In recent months, the Department of Justice initiated a lawsuit against Standard & Poor’s, accusing it of inflating its ratings and misleading investors, and the SEC convened a roundtable to contemplate the industry’s future. Yet aside from these events, the silence of the last three years has been deafening.

The core issue remains conflicts of interest.  This refers to the incentives generated by the industry’s pay structure, in which issuers compensate the agencies to rate their securities. Multiple agencies may submit ratings, but in the end, issuers select – and pay -- only one firm to grade their deals. Consequently, agencies have a huge incentive to relax their standards and submit favorable ratings to gain business, especially during a fight for market share. During the boom years leading up the 2008 financial crisis, issuers would frequently pressure the rating firms to influence outcomes.

“It would be like a figure skater bribing the judges, and they’re all giving 10s,” said Sen. Al Franken, Democrat of Minnesota.

Franken’s clearinghouse model, which is the main alternative to this way of doing business, involves creating an independent supervisory board to randomly assign and rotate work among agencies. Over time, however, performance and accuracy would determine which agencies received more work in the future.  That idea got a very cool reception at the roundtable, where some participants, including regulators and financial executives, were reticent to overhaul the system and failed to reach consensus on the pay structure question. Critics argued that a clearinghouse would run counter to the government’s objective of reducing investors’ reliance on credit ratings, and that random assignments would overlook the contours of each deal as well as each firm’s area of expertise. The view that it would infringe on the agencies’ First Amendment rights was also aired.

The lone area of regulatory progress seems to be the SEC’s effort to dismantle institutional reliance on rating agencies such as S&P, Moody’s, and Fitch (e.g. formally known as nationally recognized statistical rating organizations, or NRSROs). In the 1930s, and again in the 1970s, regulators shaped the industry’s landscape for decades to come by mandating that institutional investors must rely on the NRSROs’ ratings. Now, removing references to credit ratings from the regulatory infrastructure is intended to weaken that linkage and encourage investors to conduct additional, independent due diligence and credit analysis.

Although Franken’s proposal has become mired in a web of indecision, efforts in this area continue to plod ahead. And the SEC has not been alone in its undertaking: The Federal Reserve, the Treasury Department, and the Federal Housing Finance Agency have all proposed and adopted rules to remove references to NRSROs. This takes rulings on the industry full circle – regulators are now trying to transform what they created long ago.

One factor limiting the SEC’s ability to implement Dodd-Frank, a complex and comprehensive law, has been its chronic understaffing at all levels. Reformers also doubt the ability of recently appointed SEC Chairwoman Mary Jo White, a former Wall Street defender, to lead the process forward. The SEC “embraced the classic D.C. strategy of kicking the can down the road,” law professor Jeffrey Manns of George Washington University said about the slow progress. “The concern would be that the longer the SEC takes, the less political will there would be to see this through. The sense of urgency is not as pronounced as it has been.”

Although the SEC sometimes uses this tactic to delay rules that it considers poorly designed, the clearinghouse model deserves timely consideration. The conflict of interest issue, which Franken’s plan is designed to address, is fundamental, inescapable, and relatively self-evident compared to other problems in the financial industry, so working around its edges is a strategy that falls short. Other ideas, such as improving NRSRO governance, paring back reliance on ratings, increasing disclosure, and lowering the industry’s barriers to entry, are relevant but secondary. The longer regulators chase those half-measures, the more they risk missing the issue that truly matters.

As Sheila Bair, the former FDIC chairman, remarked during the Dodd-Frank approval process: "This stuff doesn't get any better with time.  The longer you wait to finalize the rules, the more they get watered down, the more exceptions that get built in, people's memories about the crisis start to fade, and the pressure isn't there."

Comparing the Benefits of OTC and Exchange-Traded Derivatives

Price discovery and transparency mechanisms are typically better in exchange-traded markets than in OTC markets.  This is to be expected, as electronic communication networks (ECNs) in exchange-traded markets allow for complete and immediate transactions and pre-trade price data.  Despite the presence of active brokers in OTC markets, electronic media (e.g. Reuters, Bloomberg, Markit), post-trade price reporting through TRACE, and dealer runs, OTC markets are relatively opaque.  For not only do buyers and sellers in OTC markets privately negotiate terms in relative isolation from the prices and trades occurring elsewhere in the market, but also dealers prefer at least some market opacity.  Too much price transparency would increase competition and put pressure on bid-offer spreads to a point where dealers are discouraged from intermediating.  It has been suggested that due to their undisclosed nature, dark pools may detract from heightened price transparency in exchange-traded markets.
Which market allows for more effective risk management is actually two separate matters: which is better at managing counterparty risk, and which has better at hedging risk (e.g. cash flow, fair value, or net investment risk).

It is unclear which market has the edge in terms of reducing counterparty risk.  It is crucial to understand that clearinghouses and exchanges are not the same thing—that it is a clearinghouse that allows better counterparty risk mitigation by mutualizing losses from failures, netting trades, requiring parties to post collateral, and centralizing trade reporting.  Central clearing also reduces the need for trade participants to formulate complex in-house models to manage counterparty risk.  Many large U.S. derivatives exchanges also have their own clearinghouses, so it just happens that most exchange-traded derivatives are also cleared through the exchange’s clearinghouse.  Now that regulators are enforcing central clearing in OTC markets, the balance is less clear.  It used to be that the inherent opacity of OTC derivatives and limited post-trading infrastructure hampered risk management.  Because of the private nature of OTC markets, it was difficult to assess how different institutions were interlinked and how risk exposures were distributed.

It should be noted that having central counterparties does not completely eliminate systemic risk, as the risk is simply shifted to the clearinghouse.

In terms of hedging power, it could be said that OTC markets offer greater flexibility to meet individual buyers and sellers’ risk management needs.  Due to the lack of a standardization authority, parties have greater flexibility in the terms of the trade, latitude to negotiate, customizability, and ability to use non-standard products.  OTC markets are also better testing grounds for customized products before they are standardized.

Transaction costs in exchange-traded markets are competitive with, if not lower than those in OTC markets.  This is because regulations have pushed up OTC derivative trading costs, and the greater transparency in exchange-traded markets supports more competitive pricing.  Certain listed products have huge trading volumes (economies of scale), trades are fully automated (technology), and greater trade uniformity.  In the past, OTC derivatives had a clear cost advantage over exchange-traded derivatives, due to lower fees and taxes, and the lack of margin requirements.  It was often more costly to do business on an exchange rather than off-exchange, because of the substantial margin/collateral (in the range of 5-15% of the total notional value of the transaction) requirements for clearing or trading on exchanges.