[Opinion] We Must Uncover Phantom Derivatives

A ghost has been haunting our capital markets in recent years. The ghost of Total Return Swaps. Both corporations and financial companies have been fascinated by this mysterious ghost, forming a sacred alliance and venerating it as the Holy Grail of the capital market.

As the Lime Fund scandal worsens, Total Return Swaps (TRS) have come to the center of controversy. It is suggested that the suspension of redemptions, which could have been limited to the Lime Fund, has spread across the hedge fund industry because of TRS. However, even before this incident, in recent years, several conglomerate affiliates such as Kumho, Doosan, Lotte, Kolon, Hanjin, Hyundai, Hyosung, SK, and hedge funds like Elliott Management, both domestic and international, have been subjects of controversy related to TRS.

TRS, along with Credit Default Swaps (CDS), is a representative credit derivative product that has greatly developed since the 1990s. This TRS, which seems both unfamiliar and familiar, was the nightmare that caused enormous losses of about 1 trillion won to several domestic financial institutions that traded with J.P. Morgan during the 1997 foreign exchange crisis. At that time, the underlying assets of the transactions were bonds, but in recent years, TRS with stocks as the underlying assets has rapidly expanded and become a major focus of interest and controversy in capital markets including South Korea.

TRS with stocks as the underlying assets is an over-the-counter derivative contract where the swap buyer (total return receiver, mainly corporations or hedge funds) transfers specific stocks (including treasury stocks) to the swap seller (total return payer, mainly financial companies) or has the swap seller purchase them. The capital gains or losses (total return or total loss) arising from changes in the value of these stocks and dividends are entirely borne by the swap buyer, while the swap seller, who holds the stocks, receives a fixed agreed interest or fee.

The important point here is that although the legal owner of the stocks is the swap seller, the financial company, and thus the voting rights also belong to the financial company, in practice, through side agreements or customary practices, the swap buyer, the corporation, can exercise control over these stocks. For corporations, this allows them to easily secure voting rights while avoiding legal regulations, which is called 'de facto voting rights' or 'hidden voting rights.'

Several phenomena caused or potentially caused by stock TRS are as follows. First, corporations can easily secure voting rights by evading regulations under the Commercial Act and Capital Markets Act related to treasury stocks. Second, they can evade the 5% reporting obligation under the Capital Markets Act because the voting rights secured through TRS are not explicitly included in the 'de facto ownership' that triggers the 5% reporting obligation. Third, investors can evade the short-selling balance reporting obligation because the party required to report the short-selling balance is the financial company that actually conducts the short sale under the TRS agreement, not the actual short seller such as a hedge fund. Fourth, if a hedge fund becomes the swap buyer, it can acquire 100% of the stocks through a financial company by posting less than 100% margin, thereby nullifying the leverage limit regulations under the Capital Markets Act designed to prevent systemic risk. Fifth, major shareholders can evade capital gains tax on stock transfer profits. If a shareholder holds a certain amount of shares in a listed company, they are considered a major shareholder and subject to capital gains tax, but indirect ownership through TRS enables tax avoidance. Additionally, evasion of Fair Trade Act regulations is also a significant issue.

These results occur because the essence of stock TRS is close to nominee transactions (nominee holdings), yet current related laws fail to encompass this new financial instrument. Looking at cases in major countries, most lack clear regulations, and the positions of the industry, regulatory authorities, and courts differ. The market is uncertain and chaotic due to these ghost-like derivatives, creating a very high regulatory risk. Consequently, on one hand, there are controversies over illegal acts, and on the other hand, the legitimate development of derivatives is hindered. It is necessary to promptly amend related laws to clarify the substance of this ghost. It is desirable to strictly regulate unacceptable illegal nominee transaction types while removing legal uncertainties so that legitimate derivatives can freely develop.

Seong Hee-hwal, Professor, Inha University School of Law

This content was produced with the assistance of AI translation services.