Citing reckless management and a clause in the nation’s constitution, South Korea’s finance ministry has effectively nationalized the Korea Stock Exchange by categorizing it as a public institution. A CME Group spokesperson said, at this time, an agreement to list the KRX’s Kospi 200 futures on CME Globex later this year is unaffected. See HYPERLINK "http://futuresmag.com/cms/futures/monthly%20issues/Issues/2009/03/Editorial/Departments/Trendlines/Trendlines-KRX" Trendlines for the full story.
In-Soo Kim remembers his first trip to Chicago in 1995, when he worked in training and research for the Korea Stock Exchange (KSE). “There was no futures and options market in Korea back then,” says Kim, who in April of 2008 became executive director of the futures market division for the three-year-old Korean Exchange (KRX). “There was no KRX, no Kospi success story, and no real expectation that we would do anything like what we’ve done.”
A year after that first visit to the Windy City, however, KSE launched futures on the Kospi 200 stock index, with options following in 1997. By 1999, the Korea Futures Exchange (Kofex) was up and running and in 2003, the government forced Kospi futures and options off of KSE and onto Kofex as part of a process that led KSE and Kofex to merge into the combined cash and futures platform KRX in 2005.
By then, the Kospi 200 options contract had established itself as the world’s most successful derivatives contract in volume terms, although its relatively small underlying value (about $10,662 per contract at today’s exchange rates) led many to dismiss it at first.
GOING GLOBAL – INCH BY INCH
In October, FTSE reclassified Korea as a developed market, and Samsung Securities analyst Gyun Jun expects MSCI to do the same between now and June.
The FTSE decision came just three months after KRX launched futures on lean hogs and one month before it committed to a timeline for listing Kospi futures (but not the more popular options) on CME Group’s Globex system by September of this year.
Kim says both developments symbolize the exchange’s efforts to broaden and internationalize its business, but the CME Group deal is far from broad-reaching. To begin with, it includes only the Kospi 200 futures, which traded 66.4 million contracts in 2008, which pales in comparison to the options volume of 2.7 billion. Even factoring in the 5:1 difference in contract size, the options are a four-times-bigger chunk of trading than are futures (see “Number one in volume”).
What’s more, the CME Group contracts will be cleared and settled on KRX, meaning that anyone looking to trade Kospi will have to open an account with a clearing member of KRX and convert his margin to Korean won. “Options are the number one product in the world,” Kim says. “We’re concerned that offering the market overseas would actually reduce the volume in Korea.”
So they’re treating the futures foray as an experiment that will make it possible to offer 24-hour trading (they will trade on Globex from 2 a.m. to 3 p.m. Chicago time) and receive global reach. There are, however, no plans to list Kospi options on Globex as well.
For its part, CME Group gets a telecommunications hub in Seoul to complement the hub it set up in Singapore in 2005.
TRADING THE KOSPI
It’s been a wild ride for stock indexes around the world and the Kospi is no different, plunging to below 1,000 in late 2008 from 2,085 in November 2007. Samsung’s Gyun Jun expects the market to trade between 750 and 1,450 through the first half of 2009, and believes traders with a fundamental bent should focus on three key factors: the success or failure of efforts to restructure the Korean construction sector, the exchange rate of the won relative to the dollar and the state of Korea’s export market.
“The Korean market is very highly influenced by the economic condition of advanced countries, because Korea has a small, open economy,” he says. “Consumption in major export destinations and raw material prices are also very important variables, because the earnings of large-caps — including Samsung Electronics, Hyundai Motor, and POSCO — are based on both domestic and overseas markets.”
Foreign investors remain minority participants in the Korean stock market, but U.S. and European investors account for roughly 60% of those foreigners who do participate, with the rest being hedge funds and Asian managers, including Japanese funds.
It also pays to keep an eye on China, which accounts for more than 30% of Korea’s international trade.
Not surprisingly, Korea’s two major stock indexes, the Kospi and the Kosdaq, have become more correlated with stock markets in major importing countries amid the current economic crisis as investors look to them as a bellwether for Korea’s own export market (see “Keeping up with the Joneses”). The correlation and common time zone have made pair trading between Kospi 200 futures and Nikkei 225 futures a popular play, but that’s where international arbitrage on a grand scale ends — for now.
NO LONGER THE ‘KOSPI EXCHANGE’?
The exchange lists 15 products, but more than 95% of the volume is concentrated in the Kospi 200 options, leaving KRX in the same boat Eurex was in just a few years ago, when critics dubbed it “The Bund Exchange” for its reliance on one flagship contract.
A series of initiatives are underway to change that, including the introduction of market-making, the relaxation of position limits on hedging positions and the introduction of commodity futures, with lean hogs being the first.
Targeted to farmers and patterned on the CME Group’s successful benchmark contract, the KLX version hopes to attract arbitrage activity from Chicago, although the contract is not listed on Globex.
“The volume is not great,” concedes Kwangil Ji, head of derivatives sales for Korean brokerage NH Investment & Futures. “We’re seeing volume of about 100 to 200 contracts per day, and my company trades the lion’s share — roughly 90%.”
But he believes that will change gradually over time as farmers come to understand hedging. And his company is well positioned to capitalize on that as a subsidiary of NH Bank, an entity that evolved from agricultural cooperatives and thus has a strong background in agricultural finance.
“We’re sort of like the Korean version of France’s Credit Agricole,” he says.
The diversification doesn’t stop there. In May, KRX launched single stock futures, and volume has improved steadily, peaking at 3,625,026 contracts in December. The exchange also lists Asia’s second-largest government debt contract: the three-year Korean Treasury bond, which finished 2008 with 16 million contracts traded: respectable, but hardly a blockbuster.
“The lean hog contract was three years in the making and also involved amending the law to get it listed in July,” he says. “Yes, it’s not very active, but if we can provide the investors with a risk management tool, we have diversified our product line.”
He says the exchange also is taking steps to begin clearing over-the-counter instruments. They’ve also met with Chicago Climate Exchange boss Richard Sandor about setting up carbon emission reduction contracts once a post-Kyoto accord is hammered out in 2013, and are looking at a slew of other contracts such as volatility indexes, gasoline, and non-Korean stock indexes.
“All of this takes time,” says Kim. “We don’t even have a cash market for gasoline right now and have to build that up first.”
He points out that the Kospi took 10 years to launch and was by no means an overnight success.
“In the early stages, there was not very much trading,” he says. “But with consistent marketing and education, ... Korean investors became accustomed to the markets and the new technology. They traded actively, and gradually institutional investors came as well.”
The country also is slated to implement a key aspect of the Capital Market Consolidation Act this year: the breaking of the barriers between securities firms and futures firms.
NH Futures can trade all futures products and they are not allowed to trade securities. Firms like Samsung Securities (part of the conglomerate that makes consumer electronics) can’t technically trade futures, though it does have a futures affiliate. For all intents and purposes, futures and securities operations are kept separate — but once the new act kicks in, NH Futures will be able to trade equities, while Samsung Securities will be able to trade currency futures, interest rate futures and commodities.
Designed to help Korean firms compete on the world stage and to participate in a more diverse range of financial instruments, the act has been slowed by a fear that an influx of foreign capital and competition will steamroll smaller, less sophisticated Korean banks.
Indeed, regulatory hurdles appear to be Korea’s greatest impediment. U.S. authorities initially green-lighted the Kospi contracts three years ago, but a Korean law preventing the sharing of domestic client information with foreign entities prevented the exchange from taking the final step. That law was amended in 2007, making it possible for Korean and U.S. regulators to communicate with each other and clearing the last hurdle for November’s green light.
Meanwhile, both Kim and Ji say they’re looking to forge relationships with international brokers and exchanges. “I want to find out more about which competitors could be our partners and what they are doing with their businesses,” says Kim. Ji, meanwhile, is reaching out to U.S. FCMs, institutions, and retail clients, all of whom will need a Korean gateway to access Kospi products, including the futures listed on Globex. Global exchanges and brokerages have been salivating over the potential to tap into the success of the Kospi 200 Index for several years and Korea appears on the cusp of opening itself up to the wider trading world. Stay tuned.