[Public Voices] Overlooked Issues in the Hong Kong H Index ELS Crisis

Structural Issues in Securities Firms' Product Sales
High Potential for Conflicts of Interest with Investors
Authorities Urged to Prioritize Investors' Interests

Lee Byung-sam, Advisor at Law Firm K1 Chamber Yeouido Office, Former Deputy Director of the Financial Supervisory Service

The Hong Kong H Index equity-linked securities (ELS) incident, with estimated losses of about 6 trillion won, starkly reveals the current state of financial consumer protection. The Financial Supervisory Service's inspection confirmed that sales companies did not provide sufficient explanations about the possibility of principal loss and forcibly recommended high-risk products like ELS to investors who could not bear the risk of principal loss. The Financial Supervisory Service points out that this was not merely a deviation by some employees but a company-wide issue at sales firms that encouraged performance competition. I believe that the discussion needs to go further to fundamentally address the design and sales structure of the Hong Kong H Index ELS product.

Why did this happen? First, let's look at the sales structure. In the case of securities companies, which are another important sales channel besides banks, the possibility of conflicts of interest is prominent. This is because the Hong Kong H Index ELS is designed, issued, and the sales proceeds are incorporated into the securities company's proprietary account. This differs from the most representative financial investment product sold by securities companies, namely fund beneficiary certificates (collective investment securities). Securities companies sell funds, but the sales proceeds are transferred to a fund trust company and managed by another financial institution, the asset management company (collective investment business operator). Investors are likely unaware of this difference between fund products and ELS products sold by securities companies.

The structure in which securities companies sell the Hong Kong H Index ELS product raises concerns from a conflict of interest perspective. In any product, sellers want to set prices high, and buyers want to set prices low. It is possible that the Hong Kong H Index ELS product was priced unfavorably for investors. Since the issuance proceeds of the Hong Kong H Index ELS are incorporated into the proprietary account, securities companies have a greater incentive to offer higher compensation to sales staff. This creates an environment where sales staff may forcibly recommend high-risk products without considering customers' investment tendencies or risk tolerance.

The possibility of conflicts of interest is also found in the structure of the Hong Kong H Index ELS product itself. If the Hong Kong H Index is above the agreed redemption reference price, investors receive investment returns higher than market interest rates. This is a burden for securities companies. Conversely, if the Hong Kong H Index meets the Knock In condition, investors suffer significant principal losses, but securities companies only need to repay a minimal amount relative to the principal. Unless one is a seasoned financial expert, investors are likely to misunderstand that securities companies distribute profits earned from managing investment funds, in other words, that the interests of investors and securities companies align.

Korea's unique private banker (PB) system in the financial market seems to exacerbate the problem. Investors often do not expect securities company PBs, with whom they have built trust over a long period, to recommend structurally conflicted products.

The U.S. Securities and Exchange Commission (SEC) regulations and self-regulatory organization rules (FINRA) impose strict rules regarding conflicts of interest. Broker-dealers must clearly disclose whether they are intermediating financial products or selling their own products. Since securities companies selling products they themselves issue can be a source of conflicts of interest, this must be emphasized and explained clearly.

The Hong Kong H Index ELS inherently contains a high possibility of conflicts of interest due to the nature of the product and its sales structure. At the very least, the possibility of conflicts of interest must be sufficiently explained to serve as a basis for investment decisions. Financial institutions should recognize the possibility of conflicts of interest at the ELS product design stage and strive to mitigate them, and when conflicts arise during the management stage, they must prioritize investors' interests in decision-making. To establish these principles, strict sanctions against violations are also necessary.

Byung-sam Lee, Advisor at Law Firm K1 Chamber Yeouido Office, Former Deputy Director of the Financial Supervisory Service