[ELS Pinset Solution]① "Entering the battlefield without a shield... Individuals used as risk diversification tools"

ELS is a derivative product that diversifies market risk
Institutional investors eliminate risk by investing in opposite positions
ELS issuing securities firms also diversify risk through delta hedging

"Individuals entered the battlefield without shields. Institutional investors always hedge their risks by holding opposite positions when investing in high-risk products. Selling Equity Linked Securities (ELS) as a 'national wealth management product' is something that cannot happen overseas. High-risk derivatives like ELS are not products for general investors to subscribe to."

An institutional investor interviewed by Asia Economy described the large-scale loss incident involving Hong Kong ELS as an absurdity unique to the Korean capital market. Recently, as a massive principal loss in ELS products based on the Hang Seng China Enterprises Index (HSCEI, Hong Kong H Index) has become inevitable, subscribers' sense of crisis has reached its peak. ELS (Equity Linked Security) is a high-risk financial product whose returns vary depending on the movements of stock indices and individual stocks. Although it varies by design, generally, if the stock index or individual stock remains within a predetermined range, an annual return of 4-6% can be earned, but if the price falls beyond that range, principal loss may occur.

The ELS currently causing problems is linked to the Hong Kong H Index, which is at a dismal level. The H Index, which rose to 12,000 points in 2021, has now halved and remains in the 5,000-point range. The maturity of ELS is usually three years, and products maturing in the first half of this year alone amount to 10 trillion won.

This institutional investor pointed out, "There is nothing wrong with the emergence of various high-risk products including ELS due to the diverse cash flows and needs in the capital market, but I cannot understand selling these to individuals," adding, "Compared to the size of the capital market, derivatives are too active in our country." He further emphasized, "ELS itself is not a fraudulent product like Optimus or Lime, but since it is sold to individuals in a naked sell position (without hedging risk), individuals should not invest in it."

ELS is a derivative product... Investing without a hedge position is risky

When institutional investors invest in derivatives like ELS, they do so with a hedge position. For example, when investing in a derivative product structured with the right to sell again at KOSPI 2500 in three years, since future conditions are unknown, they also secure the opposite right to buy again at KOSPI 2500 in three years in advance.

When investing in derivatives, one must eliminate the price fluctuations of risky assets, but it is not easy for individuals to consider such risks in their investments. Therefore, experts point out that recommending such derivatives to individuals is an irresponsible sales practice by financial investment firms, and the authorities' negligence in approving the products and sales for widespread distribution to individuals is also significant.

According to expert analysis, principal non-guaranteed ELS generally have a 10% probability of more than 50% principal loss and a 90% probability of an average 6% return, making them high-risk products. Once losses begin, they become uncontrollable, so overseas sales of ELS to general investors are rare. However, they are uniquely popular in Korea. Since ELS products were first introduced in Korea in 2004, their issuance volume has steadily increased, surpassing 100 trillion won in 2019.

Currently, financial authorities are framing the large-scale ELS loss incident as a procedural fault of financial companies failing to properly explain the products, i.e., an 'incomplete sale' issue. However, experts believe the fundamental responsibility lies more with the financial authorities that approved the products and sales of such high-risk ELS.

In particular, most of the problematic ELS products were sold in 2021. In January 2021, the Trump administration issued an executive order banning investments in Chinese Communist Party-owned or controlled Chinese companies. Given this situation, the financial authorities bear significant responsibility for approving the products and sales of high-risk ELS based on the Hong Kong H Index and failing to properly monitor the sales situation.

10 trillion won worth of Hong Kong ELS maturing in the first half of the year... Where did all that money disappear?

Hwang Se-woon, a research fellow at the Korea Capital Market Institute, explained, "Derivatives inherently function to transfer risk like a 'zero-sum game.' Investors who wanted to eliminate the risk of the Hong Kong H Index falling are on the opposite side of those who suffered large losses this time," adding, "This Hong Kong ELS is a derivative product structured so that such investors make money."

When the underlying index collapses, individuals suffer losses, but the securities firms issuing the ELS hardly incur losses. For example, when 10 billion won worth of ELS is issued and investors' money flows into the securities firm, generally 50-60% is invested securely in bonds.

The remaining funds are used for delta hedging. Through continuous trading, the portfolio is adjusted to a state unaffected by price changes of the underlying asset (Hong Kong H Index). This method eliminates risk, and the more they sell, the more certain the commission profits. For index-type ELS, securities firms receive about a 1% upfront fee. For a 10 million won subscription, this is about 100,000 won. Banks receive about a 1% upfront fee and about a 1% trust fee, totaling around 200,000 won for a 10 million won subscription.

Considering this comprehensively, in the entire system operating ELS products, only general investors are thrown into market risk without safeguards. From the perspective that derivatives are products created to diversify market risk, relatively less knowledgeable individual investors have been used as a means of risk diversification in a game set up by institutions. This is why the argument that the financial authorities should have strengthened product and sales approval standards from the outset, rather than approaching this incident as incomplete sales, is gaining traction.

A senior official from a pension fund said, "Approaching this as a procedural issue like incomplete sales makes it difficult to prevent repetitive occurrences of similar cases due to the nature of sales and management businesses," adding, "This should be an opportunity to re-recognize that high-risk, high-return products are not suitable for retail investors and that policy changes are necessary."

Baek Ju-seon, chief lawyer at the law firm Daeyul, said, "Derivatives are gambling permitted by law. Therefore, the Capital Markets Act includes special provisions stating that selling such products does not constitute gambling," adding, "The essence of derivatives is betting with conditions, essentially similar to gambling, so it can be partially allowed for those well-versed in it, but it should be clear that it is not something to be encouraged for the entire population."

A senior official from B Mutual Aid Association said, "Selling so much to individuals is a peculiar phenomenon unique to our country, and it is related to the tenure and moral responsibility of financial company executives," adding, "In foreign countries, financial company executives have long tenures of 10 to 20 years and expect that a major financial crisis may occur during their term, so they do not sell such products. We need to carefully consider why such incidents occur uniquely in Korea."