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.