South Korea's derivatives decline threatens equity trade South Korea's derivatives market, once the world's largest by trading volume, is suffering a sharp drop in liquidity as stricter regulations damp appetite and drive investors to neighbouring markets in China and Japan. The country was the world's top derivatives trader until 2011 thanks to heavy retail investor activity in equity derivatives. Last year it fell to fifth ranked in the world, and is now not even in the top 10 as retail investors deserted the market after regulators raised the entry barriers against them. IN Developing Markets & Asia The country's derivatives trading volume has plunged nearly 70 per cent to 430m contracts in the first half of this year while elsewhere global derivatives trading has increased 15 per cent to 11.2bn contracts. Financial regulators have tightened rules - including raising the minimum trading unit of index-linked options, putting a quotation limit on liquidity providers of equity-linked warrants, and raising the amount of collateral for forex margin trading. These regulations have been introduced over the past two years to address concerns over the mounting losses of individual investors in the highly speculative market, but traders are angered that such excessive regulations have crippled growth in the once vibrant market. "Blocking investors" access to the market like this is not desirable," says Lee Jung-ho, analyst at Tong Yang Securities. Trading volume has plunged because of the regulations but this does not mean that the market has been cleaned up. Equity derivatives trading has continued to shrink over the past two years with Korea's portion of global derivatives trading falling from 15.7 per cent in 2011 to just 3.7 per cent in the first half of this year. Trading volume of Kospi 200 options and futures dropped 76 per cent and 17 per cent respectively in the first half, while that of Japan's Nikkei 225 Mini futures and China's CSI 300 futures have more than doubled from a year ago. "Investors are leaving for China and Japan as they find it difficult to hedge risks here," says Kim Jae-joon, vice-president at the derivatives market division of Korea Exchange. It is regrettable that we are losing strength in the derivatives market, the only area where we used to get the global spotlight. Leveraged bets from private traders made the country's derivatives market the world's busiest for three years from 2009. But the government recently began to crack down on the market by raising trading units for Kospi 200 options by five times to Won500,000 and requiring investors to make an initial deposit of Won15m before trading equity derivatives or ELWs. The regulations are sapping the vitality of our capital markets, by undermining the derivatives market's role for risk hedging and price discovery Nam Gil-nam, researcher at the Korea Capital Market Institute The country's ELW market, which was the world's second-largest behind Hong Kong in 2010-2011, is now in danger of extinction after regulators repeatedly imposed stricter regulations to cool the overheated market. The market's average daily turnover has decreased to around Won110bn from Won2tn in 2010 with most foreign brokerages pulling out of the market. Regulators say such strict measures were needed as the market had become the playground for speculation and improper trading practices. "Our market was dominated by loss-making retail investors, while it is mainly professional traders that drive other foreign markets," says Kim Yong-beom, financial policy director at the Financial Services Commission. We had to adopt such rules to protect retail investors, but some of them may have been excessive. We may ease some of the regulations depending on the market situation. Traders complain that the shrinking derivatives market would also have a negative impact on liquidity in the country's stock market by depriving investors of hedging tools such as arbitrage trading. The average daily turnover of the country's 200-largest stocks fell 13 per cent in the first half to Won3.2tn. "The regulations are sapping the vitality of our capital markets, by undermining the derivatives market's role for risk hedging and price discovery," says Nam Gil-nam, researcher at the Korea Capital Market Institute. A shift in regulatory stance is needed for the market's recovery. It wouldn't be helpful for raising tax revenues either by slashing trading at both the spot and derivatives market Kim Jae-joon, Korea Exchange Experts say new products should be introduced for the market's balanced development as it is currently geared too heavily towards equity derivatives, which account for 77 per cent of trade. Only 15 derivative products are listed on the KRX, compared with CME's 1,619 and Eurex's 294. The KRX plans to introduce a market for spot gold next year and an exchange for carbon emissions rights in 2015 while it is also considering listing Korean volatility index derivatives and sector index futures. But it is feared the proposed tax bill on derivatives trading, if passed in parliament, will deal a further blow to the already shrinking derivatives market. The government is planning to introduce a transaction tax of 0.001 per cent on Kospi 200 futures and of 0.01 per cent on Kospi 200 options in 2016 to raise tax revenues. "Such a move is against the global trend and would have a deleterious effect on liquidity," says Mr Kim at KRX. It wouldn't be helpful for raising tax revenues either by slashing trading at both the spot and derivatives market.