[La Deok-yeon Gate] This Time It Exploded with CFD... The Tail Shakes the Body in the Over-the-Counter Derivatives Market

CFD Forced Liquidation, SG Securities-Triggered Crash Acts as a Catalyst
"You Never Know When or Where Something Will Explode... Beware of Risks and Leverage"

The Financial Services Commission, the Financial Supervisory Service, and the Korea Exchange are conducting a focused inspection on approximately 3,400 Contracts for Difference (CFD) accounts held by 13 domestic securities firms and 5 foreign securities firms, targeting market manipulation, unfair trading, and transactions suspected to be similar to the Soci?t? G?n?rale (SG) Securities incident. The Korea Exchange plans to begin reviewing transaction records from these CFD accounts starting next week, covering the period from January 2020 to last month, and aims to complete the inspection within two months. Typically, investigations into abnormal transactions take about 3.5 months, but this time, a special inspection team has been formed within the Korea Exchange Market Surveillance Committee to expedite the process.

In response, capital market experts unanimously agree that authorities need to assess risks across all over-the-counter (OTC) derivatives. Derivatives, which Warren Buffett described as "financial weapons of mass destruction," are increasingly viewed as potential time bombs in the domestic capital market amid global financial market instability. Derivatives, originally designed to diversify capital market risks, have instead become weak links in the capital market, amplifying investors' anxieties.

The Crisis Originates from Derivatives... OTC Derivatives Market Size is About Eight Times GDP

Derivatives are financial products whose prices are determined by the value fluctuations of underlying assets such as stocks, bonds, and currencies. These include futures, options, equity-linked warrants (ELW), equity-linked securities (ELS), equity-linked funds (ELF), and foreign exchange arbitrage, among others. Among these, exchange-traded derivatives (futures, options, etc.) cleared and settled on exchanges carry relatively lower counterparty default risk. The OTC market is where non-standardized derivative financial products are traded directly between market participants without going through an exchange. Swap products like interest rate swaps and forwards are OTC derivatives traded between corporate or bank contract parties. Options exist in both exchange-traded and OTC derivatives.

The domestic securities firms’ CFD account trading balance, which acted as the trigger for the recent SG Securities crash, stands at approximately 2.7 trillion KRW, which is very small compared to the 1,700 trillion KRW balance of domestic OTC derivatives trading. As of the end of March, the domestic OTC derivatives trading balance reached 1,671.6 trillion KRW, about eight times the country's gross domestic product (GDP) last year. In the first quarter of this year, an average of 9,924 transactions were conducted daily. By product category, interest rate derivatives accounted for 1,341.9 trillion KRW (80.3% of total trading balance), followed by currency derivatives at 305.1 trillion KRW (18.3%). More than 98% of the OTC derivatives market is used for hedging (risk avoidance). Mainly financial institutions or institutional investors use them to manage investment risks. Most problems tend to arise from products other than CFDs.

Financial companies have exercised caution even in relatively low-risk transactions. For example, domestic Bank A decided in the fourth quarter of last year to restrict the handling of OTC derivatives for customers, limiting OTC derivatives sales. This was a risk management response to soaring interest and exchange rates.

Individual Transactions Between Financial Firms and Between Financial Firms and Corporates

OTC derivatives, which have complex product structures and are difficult to manage, lie outside the regulatory surveillance network. These are individual transactions between financial firms, or between financial firms and corporations. Derivatives are originally intended for hedging (risk avoidance). Mainly financial institutions or institutional investors use them to manage investment risks.

However, the problem lies with investors who treat derivatives intended for hedging as speculative instruments. They jump in hoping to make large profits at once and sometimes engage in unfair trading. Authorities have raised entry barriers and reduced leverage to prevent individuals from participating recklessly and to curb speculation, while the industry has argued that stricter regulations would reduce liquidity and shrink the market.

OTC derivatives are contracts concluded individually between financial firms and companies or between financial firms themselves, rather than through public institutions like exchanges. Since OTC derivatives are one-to-one contracts, they are confidential transactions between contracting parties and carry counterparty risk. If someone abuses them as leverage to generate leverage without underlying physical transactions, they can become weapons that destroy financial markets, as Warren Buffett warned. The chief investment officer of Institution B said, "Derivatives always cause problems during crises," adding, "You never know where or what will explode, and once it does, it cascades like a chain reaction, which is the most frightening."

The biggest characteristic of derivatives is that they allow the use of leverage (borrowing). Large transactions can be made with relatively small amounts of money. Derivatives require only a portion of the transaction amount as margin to trade large sums. This greatly amplifies the return on equity by leveraging other people's money. If bets are successful, large profits can be made in a short time. However, failure means having to pay large sums, so the risk is equally high.

The bankruptcy of the hedge fund LTCM in 1998, which terrified Wall Street, vividly demonstrated the risks of investment behavior that excessively increased leverage in OTC derivatives trading. The bankruptcy of Lehman Brothers, one of the triggers of the 2008 global financial crisis, was also due to high leverage. The CFD that triggered the recent SG Securities crash is also an OTC derivative where investors do not directly own underlying assets such as stocks but settle only the price difference, allowing up to 2.5 times leverage.

The Size of the OTC Derivatives Market is Measurable... Risk Factors Need to be Examined

Korea held the undisputed top position among global exchanges in derivatives trading volume from 2001 to 2011. The derivatives market becoming excessively large compared to the stock spot market or economic scale has been criticized as evidence that the Korean stock market has degenerated into a speculative playground or a playground for foreigners.

Incidents targeting the derivatives market for quick profits have occurred repeatedly. These include the 'Deutsche Option Shock' in November 2010 and the 'Gangnam Express Bus Terminal Homemade Bomb' incident in May the following year. These were cases where investors in derivatives that profit from falling stock prices induced stock market crashes.

As criticism grew that the derivatives market had turned into a 'speculative arena,' authorities have worked to strengthen regulations. A positive aspect is that the size of the domestic OTC derivatives market is now measurable through the Korea Exchange's Trade Repository (TR), established in April 2021. The TR is a financial market infrastructure that collects, stores, and manages detailed information on OTC derivatives transactions. Currently, 275 users including domestic and foreign banks, securities firms, insurance companies, and asset management companies are registered and report data.

The chief investment officer of Institution C said, "During the 2008 financial crisis, even if derivatives exploded, the amounts could not be grasped," adding, "Still, after the CFD incident occurred this time, seeing the immediate grasp of the damage amount was somewhat reassuring." The CEO of Securities Firm D said, "The biggest responsibility for this incident lies with the stock manipulation forces, but authorities' failure to manage the system and financial firms' insufficient detailed customer management are also areas that require deep reflection and improvement." Although the financial authorities recognized the risks of CFDs in the past, their failure to prevent recurrence indicates that this incident is not a one-off caused by stock manipulation forces but a crisis of the overall derivatives management system of the authorities.

The chief investment officer of Institution E said, "Derivatives are absolutely necessary for hedging, but individual investors investing for speculative purposes and excessive reliance on leverage can lead to mutual destruction in unstable financial markets," adding, "Private bankers (PBs) at financial firms or private equity funds should refrain from recommending derivatives to individual investors, and authorities should examine whether there are any risk factors."

According to 'Domestic Investors' Domestic and Overseas Derivatives Investment Status' submitted by the Financial Supervisory Service to Kim Byung-wook, a member of the Democratic Party of Korea, the size of individual investors in the derivatives market was 2.2156 trillion KRW in 2017, 2.834 trillion KRW in 2018, 2.8095 trillion KRW in 2019, and 3.9633 trillion KRW in 2020.

Experts point out that to protect investors, it is necessary to operate the derivatives market in a way that preserves its original purpose. In unstable financial market conditions, they recommend significantly raising entry barriers for individual investors, strengthening information collection and monitoring related to trading entities, and improving exchange market surveillance systems to block unfair trading.

※The recent SG Securities stock price crash has sounded an alarm for the order of the capital market. Readers’ reports will be a great help in uncovering the truth. We welcome any reports regarding investment damage cases, suspicions of stock manipulation and asset concealment by the Radukyeon group, details related to the large-scale sales by major shareholders of Dow Data and Seoul Gas, or any other content (jebo1@asiae.co.kr). Asia Economy will do its best to establish a transparent capital market order.

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