The country's first futures exchange is struggling...and facing new competition.

By Erik Helland

Foreign investors are confused about the nature of Korea's commitment to derivatives markets and other forms of advanced capitalism-and with good reason. The government itself seems to be of two minds.

President Kim Young-Sam wants desperately to have Korea join the world's elite economies. Opening the country's equity futures markets is a key part of his strategy. At the same time, however, the government is trying to keep a firm grip on its currency and interest rate futures markets, for fear of losing its ability to control the value of its currenc, the won.

Slow start

The Korean derivatives market is developing in fits and starts. The cornerstone of the Korean equity market is the Korean Stock Price Index (KOSPI) 200, which is traded at the Korean Stock Exchange (KSE). Index futures on the exchange began trading at the KSE on May 3, 1996. The stock market base is well-capitalized, and ranks 10th or 12th in the world economies. Yet most trading analysts insist that ignorance has caused the index to be underutilized thus far, showing only moderate success. "The problem is that there really are few people in South Korea who understand futures," said Tae Yoo, systems vice president with Chicago-based Sakura Dellsher Futures & Options Worldwide.

Trading on the KSE has been dominated for the most part by hedging and speculating done by domestic firms, and a smaller number of U.K. and Malaysian firms looking to hedge their investments. In December 1996, traders engaged in only about 95,000 futures contracts worth about W3,475,699 million.

Despite this mediocre performance, the KSE has announced plans to expand into options. On July 7, the KSE will open the KOSPI 200 index options market, which is currently undergoing mock trading to acquaint industry members with the system-a form of on-the-job training.

Even stranger are the plans for a second futures exchange-the Korean Financial Futures, which started mock trading in early February and is set to open in October 1998. The new exchange will be developed and operated under the watchful eye of the Ministry of Finance and Economy (MOFE). The Korean Financial Futures Association (KOFFA)-an association of domestic banks, investment and finance corporations, merchant banks, and leasing and insurance companies-was originally given charge over the market development by MOFE, but is now charged with educating its members on stock and derivatives trading issues. It has handed over the development reins for the new exchange to the Preparatory Organization for the Korea Futures Exchange, made up of MOFE officials, university professors and senior executives from related organizations, which itself was started December 20, 1996.

Why two futures markets on the same underlying stock market? The KSE was formed in November 1987 by MOFE under the restrictive Securities & Exchange Act. All of its activities, including the futures and planned options markets, are governed by the act, which limits the number and type of products and the size of contracts and prohibits equity index contracts altogether. MOFE planned the new futures exchange in submission to the requirements of the Organization for Economic Development and Cooperation. Putting the new exchange under a separate roof also better places it under the MOFE's intense scrutiny. That was deemed critical by MOFE bigwigs who were afraid that the growth of interest rate futures would inhibit their ability to control currency fluctuations and capital flow.

The Korean Futures Exchange will have the advantage of being regulated by the much more liberal laws adopted recently. "The Korea Futures Exchange will be established under the Futures Trading Law, which allows a list of all kinds of futures products, including stock index futures," says S.Y. Yoon, manager of the policy development team of the preparatory organization for the Korea Futures Exchange. This Futures Trading Law came into affect in December 1995, after the KSE's development. "Therefore, it will be expected that there are two stock index futures."

Why is Korea so terrified of foreign bankers? "The government is afraid that opening the door to foreign investment will allow foreign companies to come in and reap the profits, since these foreign companies are far more experienced in trading in stocks and futures," said Stephen Marvin, head of research at Ssangyong Investment & Securities.

Many domestic firms and government agencies are also leery of problems arising from incompetent market speculating and rising inflation. Cha indicated that some industry officials will not be happy to see a currency index start, especially if it is abused by speculators. This is another reason why the government wanted to make sure the currency and interest rate futures would be traded in a carefully controlled environment.

Short leash

These fears have become particularly important since the partial deregulation of the country's currency. In October 1996, South Korea allowed its currency to align itself with the Japanese yen and the U.S. dollar. Although the currency contracts must still meet regulatory approval through the Korean Financial Telecommunications & Clearing Institute, the partial unleashing of the currency has opened up OTC spot markets and hedging activity on the domestic front and in Hong Kong. MOFE has also continued to monitor currency trading through its traditional leverage with seven or eight of the country's most powerful banks, including the Korea Exchange Bank.

Thus far, the currency market has found a variety of users-individuals are using it to speculate, domestic trusts to hedge, and domestic insurance companies to hedge and speculate. The remaining activity is linked to hedging contracts coming from foreign entities primarily in Hong Kong, the United Kingdom and Malaysia. Cha says foreign companies have been active hedging their investments by trading won. "Although foreigners sometimes have difficulty with availability of products and contract amounts, they are very keen on hedging," he says. "This is especially true of Hong Kong-based investment management firms."

Despite the relatively low level of activity, the deregulation of the won shows promise. "Deregulation seems to be on track," said Paul Wilkenson, head of the SPC Warburg Singapore division of the Swiss Bank Corp. "The market opportunity is considerable because of the size of the economy, the number of players and the demand for hedging investment products. The won is highly volatile, so both corporations and institutions need to hedge."

High ceilings

There are also some signs that Seoul will encourage greater foreign involvement in the market. The government has allowed aggregate foreign investment limits to rise from 18 percent to 30 percent of average daily open interest for the previous three months. The individual limit has been raised from 3 percent to 5 percent. And, the aggregate investment ceiling will continue to be raised in 3 percent increments annually until it reaches 29 percent in 1999. The entire ceiling is expected to be abolished by 2000.

Although foreigners make up only 5 percent of total futures trading, they are important players. The news that the foreign investment ceilings would be raised boosted market confidence and pushed stock prices upward. "In May, when the futures market was launched, the volume of the contracts stood at around 1,000," said Hong

In-kie, CEO and chairman of the KSE. "But with the enlarged foreign investment ceiling and their interest, the participation of the futures market by foreigners has become active, pushing up the contract volume to 9,000 a month."

Futures trading strategies used by these foreign entities are diverse. But futures traders at Morgan Stanley & Co. in Seoul-a KSE member security firm-said many securities companies tend to create a basket that follows the KOSPI 200 stock index in order to hedge their underlying market options. They said their philosophy is simply to buy stock and sell futures when the stock is undervalued. If there is a deep spread between cash and futures, they buy stock and sell futures.

Success on the world financial stage and at home will take more than creating new derivatives exchanges. Although President Kim may have been successful in slowly initiating his basic deregulation plans, he has yet to provide the necessary capital needed for the country's massive infrastructure plans. "The move in futures is good news, but it is really nothing significant in terms of its impact on the Korean economy," said Marvin. "The market needs more confidence from domestic companies and the government to allow more freedom for foreign companies to jump in."