Both Market Price and Book Value at Will... Widespread Illegal Activities in Wrap Product Management

Ambiguity in Evaluation Criteria for Bonds Included in Lab and Trust Products
KB and Hana Securities Suspected of Illegal Activities in Money Market Lab and Trust Product Management

KB Securities and Hana Securities are under suspicion of engaging in illegal activities during the management of Money Market Lab (MMW) and trust products. The Financial Supervisory Service (FSS) has detected illegal acts by the two securities firms and announced plans for a focused inspection.

The allegations against the two securities firms involve investing in bonds with maturities different from those stated in the product prospectus, followed by engaging in wash trades to prevent losses caused by the decline in bond values. The securities industry has responded that these suspicions are not surprising. The ambiguous evaluation standards for lab and trust assets and the entrenched bad practices in the Yeouido securities market are pointed out as the core issues.

KB Securities Headquarters in Yeouido, Seoul. Photo by Yonhap News

Suspicion of Collusion Between Bond Brokers and Lab·Trust Management Personnel

According to the financial investment industry on the 25th, the core of the current suspicion lies in the ambiguous evaluation criteria for bonds included in lab and trust products. Although the management entities differ, funds with the same nature as lab products have been required since July 2000 to evaluate bond assets at market prices. This means that market conditions and changes in the creditworthiness of issuing companies must be reflected when calculating bond prices. At that time, the financial authorities established regulations reflecting concerns that if investors requested redemption due to excessive discrepancies between market prices and book values (the purchase price at the time of acquisition), most of the losses could be passed on to investors.

However, lab and trust products were not included in the scope of these regulations. As a result, securities firms were free to decide whether to evaluate assets at market price or book value when managing lab products.

Consequently, securities firms arbitrarily exploited the ambiguous regulations. In practice, securities firms implicitly included long-term bonds or commercial papers (CP) with maturities over one year in short-term three-month lab trust accounts and used the higher yields during periods of falling interest rates to boost institutional sales. Since the included bonds were recorded at book value, securities firms could covertly receive long-term bonds through bond brokers instead of short-term products and include them in lab products without customers noticing.

An anonymous financial investment industry insider said, "This is a bad practice deeply rooted in the Yeouido bond market," adding, "Because book value evaluation was possible, a collusive relationship naturally developed between bond brokers and lab·trust management personnel." Another industry insider explained, "When securities firms generate profits, it is linked to individual performance bonuses. Since customer acquisition ultimately comes down to interest rate competition, securities firms likely devised ways to offer higher interest rates to attract more customers."

The problem surfaced during the period of rising interest rates. When bond yields rise sharply, bond prices traded in the market inevitably fall rapidly. In October last year, as the short-term financial market tightened due to the Legoland incident, CP rates soared to the 5% range, and long-term bond yields rose to levels comparable to the 2008 global financial crisis. As the market valuation of bonds shrank, lab products including long-term bonds or CPs recorded significant losses.

KB Securities is suspected of illegal wash trading at this point. To cover losses incurred by customers, it is alleged that KB Securities purchased the loss-making bonds at book value into its trust account at Hana Securities, thereby ensuring no losses for customers. Under the Capital Markets Act, securities firms are generally prohibited from repeatedly trading securities through internal accounts. Industry insiders believe that as bond losses ballooned with the sharp rise in interest rates in the second half of last year, other securities firms may have engaged in similar practices as KB Securities.

KB Securities maintains that there is no illegality because it informed customers that assets with different contractual periods could be included. Furthermore, it denied that the internal account transactions were intended to cover losses, asserting they were aimed at supporting liquidity for small and medium-sized corporations. A KB Securities representative stated, "When providing liquidity support from late November to early December last year, we prioritized liquidity supply mainly to small and medium-sized corporations facing difficulties in payroll or final payment due to short-term funding liquidity issues," adding, "The timing of recognizing losses through market valuation coincided with the year-end accounting settlement, so there is also a timing difference."

FSS: “Sequential Inspections of Securities Firms to Proceed”

The Financial Supervisory Service plans to complete the inspection of Hana Securities by the 26th and then launch an ad hoc inspection of KB Securities. Additionally, it intends to sequentially inspect other major securities firms selected as inspection targets. Market participants believe that since similar practices are widespread in the securities industry, the scope of inspections may be expanded.

Earlier, the FSS announced that it had selected thematic inspections of unhealthy sales practices in the lab and trust markets as a major inspection plan for 2023 and would conduct on-site inspections. The FSS aims to closely examine whether there are unhealthy sales practices or risk factors such as bond parking or wash trades within the lab and trust markets. An FSS official said, "Some securities firms have included high-interest long-term bonds in short-term lab products to achieve excessive target returns," adding, "In such cases, if a funding market crunch or large-scale redemptions occur, there is a high possibility that the included assets will be disposed of through illegal or illicit methods, which is legally prohibited."

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