South Korea’s remarkable Kospi 200
Option is a mould-breaking product, unlike any other in listed
derivatives. Astonishingly, it is still growing fast. But
having climbed to a new peak, the Korea Exchange’s
way forward could lie up or down. KRX is linking up with the
world’s top exchanges, opening the prospect of yet
more liquidity. But at the same time, Korea may impose a tax on
derivatives trading. What would that do to the
Kospi’s legendary retail demand? Colin
Despite its short history, Korea Exchange has enjoyed
remarkable success since its inception as Daehan Stock Exchange
in 1956. KRX does not have as rich a history of derivatives
trading as the exchanges of Chicago, London or New York, but,
by number of contracts traded, it is the largest exchange in
Perhaps fittingly, it is based not in the capital Seoul, but
in the city that embodies the country’s
outward-facing, commercial side – Busan. At
Korea’s southeastern tip, Busan is the
nation’s second city, and the world’s
fifth largest port.
The derivatives exchange is on a similar scale. No less than
3.1bn contracts were traded at KRX in 2009, surpassing by 8.2%
the 2.86bn achieved the previous year. On that basis, this
exchange is about 91% as big as the entire European futures and
Such success is surprising, given the
exchange’s limited product range of 74 contracts
and the fact that South Korea’s economy, though
among the world’s 20 largest, is about the same
size as those of Mexico or the Netherlands.
What KRX does have is two Korean share index contracts so
successful that rivals can only admire, namely the Kospi 200
Future and Option, with the option leading the way.
When the Kospi 200 Option was introduced in 2004, KRX had
hosted 12.2m trades the previous year. Fast forward one year
– the exchange recorded 2.58bn trades.
Of those, the Kospi 200 Option accounted for 2.51bn, and
that roaring success has continued since then. In 2009, the
equity index product accounted for 94% of all KRX trades.
Remarkably, the product has not even reached a mature
plateau – in the first half of 2010 trading volume was
21% ahead of the same period last year.
The Kospi 200 futures contract is also extremely successful,
though it fails to match its sister product’s
staggering volumes. However, trading volumes of 83.12m last
year mean it is not an insignificant contract, accounting for
10.6% of all index futures trading in Asia.
Together, the Kospi 200 Future and Option generate 3bn
traded lots a year, 96.7% of KRX’s total
Even in cash terms the Kospi contract is impressive. Each
options contract is sized at W100,000 times the index, now
about 225. That means each is for a notional amount of around
Based on an estimated average of 183 for the level of the
Kospi index in 2009, the 2.92bn contracts traded last year were
worth a total of $41.9tr. That compares with $11.5tr for all
trading in Eurex’s Euro Stoxx 50 Index Futures
last year and $10.2tr for the Euro Stoxx 50 Options.
But KRX as a whole is only about half as big as Eurex in
cash trading terms.
Tailormade for retail
The brisk trading of Kospi 200 Futures and Options is no
accident, but as Alex Choi, broker at Daewoo Securities in
Seoul, concludes, the result of several factors. Most important
is the high participation of retail investors – about
30% in the Kospi 200 Futures and Options, Choi says, making it
unlike any other market in the world.
"Koreans are now financially well-educated enough to trade
futures and options, compared to other countries," Choi
His assessment that the average Korean with a bit of money
in the bank is more clued up on the benefits of derivatives
than retail investors in other markets is echoed by an
executive at a KRX member trading firm.
He says that compared to investors in other Asian markets,
Koreans are happier to take risk with their capital. He
describes the independent retail traders as sophisticated in
their understanding of derivatives and drawn to trading the
stock index option by the substantially higher returns its
leveraged nature makes possible.
The Kospi Options’ relatively small size also
makes them suitable for retail traders. The Kospi Futures are
five times bigger, as they are worth W500,000 times the
"The contract size is relatively small, so it is easy to get
into without large margin requirements, and with substantial
liquidity, it is easy to get out of a position too," says Kevin
Lee, managing director of Newedge Korea.
Emmanuel Faure, head of business development and sales for
HSBC Futures Asia, suggests another reason for the
options’ success – that with few
retail-friendly instruments available at KRX, the Kospi Option
became the default speculative instrument.
Lee also points to relatively low execution and clearing
fees, enabling local traders to provide the "critical
liquidity" underpinning the product’s success.
But perhaps the most powerful advantage KRX has lies in the
tax system. As Seong-Koo Cheong, attorney at Kim and Chang in
Seoul, explains: "Under Korean law, capital gains tax is not
imposed on the trading of any instrument listed at KRX."
Securities firms have not been slow to spot the opportunity,
marketing the Kospi 200 contracts very actively to their retail
Another factor in the market’s favour has been
Korea’s status as the country with the largest
number of internet connections per person in the world. About
80% of households are connected to the net, putting the
derivatives potentially in reach of a mass audience.
"High speed internet and investors’
friendliness to internet-based trading make individual
investors participate in the options market actively," Choi
concludes, adding that these retail investors’
understanding of software is as sophisticated as their
knowledge of derivatives.
It is wrong to think of Korea as a closed, purely domestic
market. Indeed, Choi says, foreign firms perform the largest
share of Kospi Option trading, about 36% in 2009. Retail
traders did 31%, institutions and securities/futures firms
about 16% each, and all other groups less than 1%. There are
regulatory obstacles to foreign participation, but compared
with some of its Asian neighbours, Korea is a land of
"The Korean government has over the last few years pressed
for more international firms to be active in its
exchange-traded markets," Cheong says. "To become a member of
KRX, either as a clearing member, non-clearing member, or a
non-clearing special member, a firm must obtain permission to
commence derivatives trading from Korea’s
Financial Supervisory Commission."
Faure says that despite this possibility, Korea remains a
"fairly restricted" market, though there are signs that may be
changing. "The regulators have been giving a lot of positive
signals over the last few years on trying to make the Korean
market a lot more accessible to foreign investors and more in
line with international markets," Faure concludes.
Such liberalisation is remarkable, given the closed markets
that have dominated Asia, notably those of China and India. Lee
says Korea’s relative openness has encouraged the
development of its derivatives market, especially the Kospi 200
Futures and Options.
"Although there are some limitations, investing in Korea is
relatively easy compared to other countries.
Korea’s regulatory system allows for international
firms to be active and to realise a profit," Lee says.
More complicated are the rules governing Korean
firms’ access to overseas exchanges.
"Generally speaking, Korean financial institutions and
non-institutional firms must hire brokers to trade outside
Korea, though there are some complicated exceptions," Cheong
Regulators have recently expressed a willingness to explore
relaxing the law to permit firms to become members of foreign
boards of trade. But Cheong says it is too early to say when
this might happen.
Open all hours
Because of the regulatory complications in the way of
foreign access to Korea’s financial markets
– and after all, it is only fairly recently that Korea
has bulked large on global investors’ radars
– the country’s flagship futures and
options have probably still not reached the pinnacle of what
could be achieved.
If there is likely to be more cross-border traffic in
future, foreign exchanges are eager to get in on the act.
Step forward Eurex, which has set up a connection with KRX
to offer futures on Kospi 200 Options to its own customers
during the hours when Korea’s market is shut.
The Frankfurt-based exchange will go live with the link on
August 30. Michael Peters, a member of Eurex’s
executive board, says it will benefit both existing Eurex
customers that do not have access to trade on the KRX, and
Korean investors, by enabling them to trade outside normal
The Eurex contract will begin trading when KRX closes. The
contract’s closing price in Busan will be
published to KRX and Eurex members. Trades will be matched and
settled in Eurex’s system and placed in its
clearing house. But at the end of each day, all contracts will
expire into open Kospi 200 Options positions at KRX.
"We decided to transfer the daily positions opened on Eurex
to KRX because we did not want to split the open interest,"
Non-Korean firms that are not members of KRX will be able to
trade the Kospi 200 Option without any regulatory constraint,
other than the ordinary rules at Eurex.
It will be more difficult for Korean firms. As Korean law
forbids them to join foreign exchanges, they will have to
execute through a Eurex member.
Eurex has high hopes for the new relationship, which it
hopes will grow trading in the contract by between 2% and 3.5%
over the next four years.
Meanwhile, CME Group has got its own cooperation project
with KRX, covering Kospi 200 Futures, not Options.
Since November 2009, the US exchange has offered after-hours
access to the contract, hosted on the CME Globex electronic
trading platform by routing orders to KRX’s
Unified System for Global trading (USG). Firms can trade the
contract only through firms that have KRX membership.
The USG also allows Korean KRX members, which are not
permitted to join international exchanges, to trade the Kospi
200 Futures at CME Globex.
The offering has been well received, with an average daily
volume of 4,910 contracts in June.
KRX and CME want to extend their partnership to a mutual
order routing deal, like the one CME has with BM&F Bovespa
in Brazil. However, this is subject to regulatory
Life beyond the Kospi
Although KRX’s other products are overshadowed
by the Kospi contracts, they are not insignificant.
Launched in 1999, the exchange’s US Dollar
Future has grown strongly almost every year, reaching an annual
volume of 6.4m contracts in 2008. Korea’s strong
economic links to the US and to international trade in general
ensured there was plenty of demand.
But in 2009 trading exploded, as 41m contracts were made.
The main reason, market participants say, was the savage fall
in the won in the second half end of 2008, when it fell from
around W1,000 to the dollar to about W1,500. Having recovered
somewhat, the won dived again early in 2009, reaching a depth
of nearly W1,600. Currency hedging was suddenly an urgent
In the end, that was as bad as it got – the won
recovered, first quickly, then steadily, to reach about W1,100
in May this year, though it has since taken another
This year’s volume in the US Dollar Future has
been even stronger, topping 30m contracts by the half year
mark. As each contract is for $10,000, that means $300bn of
trading, with nearly $8bn of open interest. The instrument is
regularly among the world’s top five most actively
traded FX futures and options.
KRX’s Three Year Korean Treasury Bond Future is
another contract that has grown strongly in recent years.
Bucking the global trend in which bond futures trading sagged
between late 2008 and early 2010, KRX’s contract
has grown in volume every year since 2007, to reach 12.6m
trades in the first six months of 2010.
Yet Faure says the KTB Future is never going to win the same
popularity as the Kospi 200 instruments because of its design.
"The three year bond future is quite a large contract," he
says. "It is used primarily by the banks and institutional
investors that want to hedge fixed income exposure." The
instrument’s denomination is W100m ($83,500).
Flirting with danger
With the Eurex and CME Group connections and the vast
domestic appetite for options trading, you could be forgiven
for thinking that there was not a cloud on the horizon for
Korea’s derivatives market.
You would be wrong. Over the last decade, Korea has
sometimes flirted with imposing a transaction tax on
derivatives trading, and the idea has resurfaced again.
In December, a committee of the National Assembly resolved
to impose a tax on derivatives including futures and options
from 2013. While the details are still being finalised, the
latest version of the draft put forward by the Finance Ministry
would apply a basic rate of 0.01% of the
The bill still needs to be approved by the
Assembly’s Legislation and Judiciary Committee and
to its plenary session.
Kevin Lee at Newedge is optimistic that the bill will not
become law. He says the idea has cropped up before as a way to
tackle the budget deficit, but that if it were passed, the
results could be disastrous.
"Slapping a tax on futures and options trading would
increase costs, forcing many investors to leave the market and
driving down the trading volume," Lee believes. "A tax could
reduce the liquidity in the Kospi futures and options which the
retail market provides and which is the foundation of the
Going for a clampdown
Another threat to the growth of derivatives trading concerns
the FX market. The government is worried by the recent
volatility of the won, and has tightened restrictions on
firms’ exposure to exchange rates.
Several national banks suffered from writedowns during the
financial crisis, and some blamed their losses partly on
The government has designed new rules to reduce systemic
risk and act as a safety net to avert a crisis.
Foreign banks must cut their currency derivatives holdings
to 250% of their equity and domestic banks to 50% of it. They
will have two years to comply with the new ceiling, which will
be re-evaluated, and possibly even lowered, every three
The limit on currency derivatives use by non-financial
companies has been lowered to 100% of their capital, having
previously been limited in 2009 to 125% of capital.
A brokerage executive in Seoul says the two year grace
period was welcomed by the market, as many had expected a
OTC market reform
Moreover, despite the robustness of Korea’s
derivatives markets, the country has not escaped the global
Since October 2008, the government has been forced to spend
W3.8tr ($3bn) bailing out exporters which had burnt their
fingers on over the counter currency options.
This was a very common problem for emerging market exporters
at the time, from Brazil to Poland. Before the crisis, they had
feared dollar (or euro) weakness, which would reduce their
foreign earnings. Many had hedged against a fall in the dollar,
sometimes with unwise options strategies.
When the US subprime crisis struck, paradoxically the dollar
soared, as investors pulled out of anything marked
'risky’, which included all emerging market
currencies. That left some hedges badly under water.
This is one reason why Korea has followed the global trend
and embarked on its own series of reforms to its fairly small
Unlike the US, European Union and Japan, Korea has not
immediately sought to demand the central clearing of
standardised derivatives – though that is on the
agenda. Instead, Korea passed the Financial Investment Services
and Capital Markets Act in 2009, which came into force in
A new clearing house for OTC transactions is scheduled for
2012, but no details on which contracts will have to be cleared
have yet been revealed.
At the heart of the Act was the establishment of the Korea
Financial Investment Association. This brings together the
Korea Securities Dealers’ Association, the Korea
Futures Association and the Asset Management Association with a
mandate to oversee Korea’s OTC markets.
Self-regulator advances, then retreats
One of the KFIA’s first acts was to announce
that it would pre-screen any new OTC product which any licensed
OTC trading firm wished to offer.
The association’s OTC Derivatives Review
Committee began reviewing new OTC products on June 9. It has
nine members, led by Woo Yeong Ho, the KFIA’s
chairman and chief executive.
The committee will check whether products provide
transparent price information on the underlying assets, are
appropriate hedging tools, and fully explain the risks.
However, the review process is self-regulatory –
companies do not have to abide by the committee’s
That has not stopped market participants complaining about
the pre-screening requirement, saying it will cause delays and
reduce the effectiveness of their business.
The International Swaps and Derivatives Association has led
the opposition. Keith Noyes, Isda’s Asia Pacific
regional director in Hong Kong, commented on the legislation in
December: "The bill places a misplaced focus on the product.
The problem is never with the products themselves, but rather
the way they are sold. Issues of misselling, and to who they
are sold. Issues of appropriateness and suitability."
The KFIA subsequently appeared to soften its position, by
saying that it would only concern itself with OTC transactions
offered to private investors, and based on underlying risks
concerning credit, the natural world, or economic affairs.
Banks, companies and other institutions defined by the
Financial Supervisory Commission as professional investors
would not be affected.
All to play for
Korea punches far above its weight in derivatives. The
country is neither the largest economy in the world, nor even
an up-and-coming financial hub like Shanghai and Mumbai. But
market participants believe the Korea Exchange will continue to
be the largest exchange-traded derivatives market in the world
– if it avoids self-harm.
Lee at Newedge says he is bullish about KRX’s
prospects, believing it will be propelled further by the
success of its Kospi 200 products. The Eurex link will open the
product to a large new group of trading firms, and can only
HSBC’s Faure shares this optimism, especially
about the Kospi contracts. "I think there is always room to
grow, especially when there is such a strong commitment from
the local players," he argues. "The foreigners have not yet
reached the level that they can achieve, and Korean
institutional customers can become more active, so I do think
there is more to come from Korea."