[Q&A] What Is the Significance of a 24-Hour FX Market and Offshore Won Settlement System?

On September 26, the Ministry of Economy and Finance announced its plan to establish a '24-hour operation system' and an 'offshore won settlement system' in the foreign exchange market by the first half of next year, aiming to have the Korean stock market included in the Morgan Stanley Capital International (MSCI) Developed Markets Index. The government made this announcement at the 'Korea Economic Briefing (IR) Investment Summit' after President Lee Jaemyung rang the opening bell at the New York Stock Exchange (NYSE) that morning.

We spoke with an official from the Ministry of Economy and Finance to understand the current state of Korea's foreign exchange market, the reasons behind the government's push for foreign exchange market reform, and whether these changes could pose any foreign exchange-related risks.

Q. What is the current structure of Korea's foreign exchange market?

A. Currently, Korea's foreign exchange market only has an 'onshore market' and no 'offshore market.' In other words, the won can only be exchanged for foreign currencies and officially traded within Korea.

The foreign exchange market is where the supply and demand for foreign exchange (the won) meet. In Korea, this can only happen through two brokerage firms: Seoul Money Brokerage Services and Korea Money Brokerage Corporation. When banks place orders with these brokers, the brokers match buyers (bids) and sellers (offers) to facilitate transactions.

Not everyone can buy and sell foreign exchange through these brokers. Only foreign exchange banks, which are licensed by the government, are allowed to do so. Woori Bank, Hana Bank, Shinhan Bank, KB Kookmin Bank, and IBK Industrial Bank have all received licenses as foreign exchange banks. Korea Development Bank and Export-Import Bank of Korea are also licensed. Since last year, foreign financial institutions licensed in Korea can also participate. Because foreign firms are not granted brokerage licenses, Korea only has an onshore market.

Additionally, if a U.S. investor wants to buy Korean stocks, they need Korean won. However, it is not possible to buy won directly in New York. They must enter the Korean market and exchange their currency through a bank account in Korea. Trading hours are also limited to Korean time. The Korean foreign exchange market operates from 9 a.m. to 2 a.m. the next day, Korean time. Therefore, if U.S. or European investors want to buy won during their own business hours but the Korean market is closed, there is no way for them to trade.

Q. What are the differences compared to overseas markets?

A. Overseas, there are no special brokerage licenses required, and trading takes place freely across countless platforms. In Korea, the onshore platform is fixed, and only certain institutions can participate. Overseas, there is no distinction between the interbank market and the customer market.

For example, U.S. dollars, Japanese yen, and euros can be traded 24 hours a day, virtually anywhere in the world. In major financial hubs like London, New York, Hong Kong, and Singapore, dollars and yen can be bought and sold freely, and final settlement is safely completed through each country's central bank payment systems.

For instance, if a German investor wants to buy Asian stocks and needs yen, they do not need to open an account in Japan. They can exchange for yen directly at a bank in London, and settlement is smoothly handled through the Bank of Japan's global system. In contrast, Korean won is different. Foreign investors cannot exchange for won directly in London or New York; they must go through a bank counter in Korea to complete the transaction.

Q. What problems arise from having only an onshore market?

A. First, it has resulted in the somewhat distorted development of the NDF (Non-Deliverable Forward) market. Since foreigners cannot directly settle in won, they have created a workaround. NDFs are contracts where, instead of actually exchanging won, only the difference resulting from exchange rate fluctuations is settled in dollars in offshore markets. For example, if an investor in Singapore believes the won-dollar exchange rate will rise from 1,300 to 1,350 won, they can enter into an NDF contract. If the rate does rise to 1,350 won, the counterparty pays the difference in dollars. This allows investors to speculate on the won's exchange rate without actually using won. There is demand for won from foreigners, but because of regulations, such a market has developed.

Q. How will things change going forward?

A. The goal is to allow foreigners to exchange for won directly in New York when buying Korean stocks. There will be no need to wait for the Korean market to open, and exchange rate risk management can be handled immediately. This could increase foreign investment demand for Korean stocks and bonds.

This does not mean a complete opening of the offshore market. The core is to establish an offshore won settlement system to substantially resolve the inconvenience foreigners face in trading won. Resolving these inconveniences means ensuring that banks can settle enough won among themselves and that each bank can create won deposit accounts. The aim is to allow banks in New York to open won accounts. This will create incentives for 24-hour trading, and foreign investors will be able to freely trade, hold (deposit), and procure won among themselves.

Q. Why was this not possible until now?

The biggest reason is the experience of the 1997 foreign exchange crisis. At that time, the value of the won plummeted as overseas speculators massively sold off the won, deepening the crisis. Because of this experience, authorities prevented foreigners from holding won. There were concerns that if foreigners held won (deposits) and sold them all at once, the value of the won would collapse. Therefore, through the Foreign Exchange Transactions Act, foreigners were barred from holding won, and the system was designed so that they could temporarily bring in dollars, exchange them for won for securities investment, and then take the money out after the investment. The aim was to prevent foreigners from freely trading won overseas.

Q. Why is it possible now?

A. The most important reason is that Korea's external soundness has become very robust. This is also thanks to the power of the so-called 'Seohak Ants' (Korean retail investors investing abroad). From January to July this year, overseas investments in securities and other assets exceeded Korea's current account surplus by 20 billion dollars. Net external assets (as of the end of the second quarter this year) stand at a staggering 1.0302 trillion dollars. No matter how much Korea exports, if domestic investors are investing overseas to this extent, the exchange rate is bound to rise. If outbound investment is easy for 'Seohak Ants' but inbound investment (from overseas) is too difficult, the exchange rate will go up. The authorities believe that maintaining a stable exchange rate is best. Korea's foreign exchange reserves are also considered sufficient. Simply put, authorities believe Korea is no longer as vulnerable to attacks from foreign speculators as it was during the foreign exchange crisis. Furthermore, as the foreign exchange market expands, it becomes less susceptible to manipulation by any single entity.

Q. Has overseas demand actually been confirmed?

A. Yes. The government has met with MSCI investors and confirmed sufficient demand. As investors themselves have indicated a need, demand is expected. Additionally, since the NDF market is estimated to be two to three times the size of the spot market, there is presumed to be demand for won. The Bank of Korea has also confirmed actual demand through consultations with major global investment banks and asset management companies.