[News Terms] Growing Losses in Hong Kong ELS... What is 'Nok-in (Knock-in)'?

Concerns are growing that investment losses amounting to trillions of won may occur related to Equity Linked Securities (ELS) based on the Hong Kong H-Share Index (HSCEI), leading major banks to temporarily halt ELS sales amid controversy. Investors who subscribed to ELS products when the Hong Kong H-Share Index peaked in the first half of 2021 will see maturities starting early next year, and if the index does not rise by 20-30% from its current level, investment losses exceeding 3 trillion won could occur.

ELS (Equity Linked Securities) are investment products issued based on underlying assets such as specific stock prices or stock indices, with returns determined by the movement of these underlying assets. If the price of the underlying asset does not fall below a certain level from the contract date until maturity, the product pays the principal and a pre-agreed return. Knock-in refers to the underlying asset breaching a predetermined threshold and entering a loss zone. In other words, if the price falls below the Knock-in Barrier, the principal is lost.

ELS underlying assets typically combine 2 to 3 stock indices, with many products linked to the Hong Kong H-Share Index. The Hong Kong H-Share Index is calculated as a weighted average of the market capitalization of 50 leading Chinese companies listed on the Hong Kong Stock Exchange with large market caps and trading volumes. It has been considered relatively low risk.

The problem lies in the options of these products. ELS are divided into Knock-in and No Knock-in types. For Knock-in types, if the underlying asset price falls below a certain level (usually 50% of the subscription price) even once, and at maturity the underlying asset price has dropped more than 30-35% from the subscription price, principal loss occurs. In contrast, No Knock-in types guarantee principal and interest if the underlying asset price decline at maturity is less than approximately 50-60%, regardless of the asset’s movement during the contract period. For the Hong Kong H-Share Index-based ELS maturing next year, most are Knock-in types that incur principal loss if the tracking index at maturity falls below 60-70% of the subscription price, so the investment industry explains that if the index remains at its current level, a 30-40% principal loss is expected.

The possibility of a rebound in the Hong Kong H-Share Index appears very low. The index, which was at the 12,000-point level in the first half of 2021 when the ELS were set, has fallen to around 5,600 points. Although conditions vary by stock, the market expects the Hong Kong H-Share Index to recover to about 8,000 points or higher, corresponding to 60-70% of the peak, by January or February next year to avoid principal loss.

Financial authorities are recently holding financial companies that sold ELS including the Hong Kong H-Share Index accountable. On the 29th of last month, Lee Bok-hyun, Governor of the Financial Supervisory Service, raised concerns about whether the "suitability principle" was observed when ELS were sold at bank counters, emphasizing the responsibility of sellers. Some interpret that it is difficult to consider all these ELS investors as "victims." ELS are products often reinvested in after successful investments. Since 90% of investors in ELS including the Hong Kong H-Share Index are reinvestors, they should be regarded as voluntary investors rather than victims.