Leverage, Inverse ETFs Fuel South Korean Market Volatility, Prompting Regulatory Scrutiny

South Korea's stock market is grappling with extreme volatility, largely driven by leveraged and inverse exchange-traded funds (ETFs) linked to major tech companies like Samsung Electronics and SK Hynix. These products have begun to "cause predictable accidents," according to the Hankyoreh.

One stark example involved a leveraged product from Korea Investment Trust Management. When SK Hynix shares fell 8%, the ETF's closing price surged 50%, a stark deviation from its expected 15-16% drop. This anomaly is attributed to the fund manager's obligation to supply liquidity by placing buy and sell orders, especially when trading volume is low. In this case, a market-price buy order was executed just before the market close, leading to a massive discrepancy between the actual value and the quoted price.

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The leveraged product launched by Korea Investment Trust Management saw its closing price soar 50% even as SK Hynix shares fell 8% on the 8th of last month.

The "gap rate", the difference between a product's actual value and its quoted price, can cause investors to lose money by trading at inflated or deflated prices. While a normal gap rate is around 1-2%, deviations of tens of percent in the opposite direction are considered "accident level." In the past month alone, there were 57 instances where single-stock leveraged products exceeded the 1% gap rate threshold.

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The gap rate between the actual value and the quote, if widened, means investors trade at prices higher or lower than actual value, suffering losses accordingly.

Financial authorities are contemplating regulatory actions, recalling a past instance in 2020 when they raised entry barriers for oil-leveraged products after a surge in retail investment. The current "10 million won deposit and 1-hour mandatory pre-education" rule for Samsung and SK Hynix leveraged products stems from that period. However, simple entry restrictions are deemed insufficient.

Suggestions circulating in the market include "legal" methods to disrupt trading, such as limiting the quantity of rebalancing by fund managers late in the trading day or widening bid-ask spreads to make order execution more difficult. However, calls for the "bold delisting" of these ETFs to stabilize the market seem unlikely to materialize. Delisting is typically considered when the underlying asset's proportion or trading volume drops to minimal levels, whereas these problematic ETFs are experiencing explosive trading volumes. A unilateral delisting by securities firms would likely trigger significant investor lawsuits.

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There were 57 cases of exceeding the gap rate (over 1%) for single-stock leveraged products last month.

Authorities are reportedly leaning towards a "soft landing" approach, gradually reducing the trading proportion and volume of leveraged products. Imposing stricter regulations amid ongoing debates about a potential peak in the semiconductor market could further trigger capital flight and market decline. Therefore, the focus is expected to remain on implementing supplementary safety measures, such as stabilizing the gap rate, increasing the basic deposit requirement, strengthening investor education, and prohibiting additional leveraged products. The article concludes with a rhetorical question, "Can spilled water be gathered again?"

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Simple entry regulations alone are insufficient.