OPINION
2022 Jul/26
Korea’s ELS Market: Current State and Risk Monitoring
Jul. 26, 2022
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- Summary
- Amid a decline in key stock indexes, Korea’s ELS market has remained stable in 2022. The outstanding issuance of ELS has been relatively low in size with stock market conditions being more favorable to issuers’ hedging activities compared to the previous market crisis. Still, however, a recent surge in the outstanding balance driven by a sharp drop in ELS early redemption volume, as well as growing uncertainties in the global stock and financial markets, has caused jitters in the ELS market, which requires caution of market participants.
Individual issuers should exert further efforts to control risks inherent in ELS issued by them and formulate a plan for stably issuing and managing ELS products by fully considering overall market conditions. ELS investors should maintain a proper weight of ELS in their investment portfolio as part of an asset allocation strategy. What is also needed is risk management by opting for a low knock-in structure that is less likely to generate losses. Furthermore, the financial authorities should closely examine and monitor destabilizing factors in the ELS market.
Current state of the 2022 ELS market in Korea
Korea’s equity-linked securities (ELS) market continued its growth in the wake of the global financial crisis before it began to contract due to the financial market unrest triggered by the Covid-19 pandemic in March 2020. As the stock markets of major economies recovered from a sharp decline, ELS early redemption was initiated in the second half of 2020. But with a decrease in new issuance, the outstanding balance of ELS slid to KRW 34 trillion in end-2021 from KRW 48.3 trillion in end-2019 (Figure 1). Such a decline can be attributable to the financial authorities’ regulation1) on risks arising from the ELS market as well as ELS issuers’ effort to curtail risks. Furthermore, it is estimated that amid active participation of retail investors in the stock market during the same period, the ELS investment amount, redeemed at or prior to expiration, was put into the stock market or other direct investment vehicles (Figure 2).
With this trend being reversed in the second half of 2021, ELS outstanding has gradually climbed to KRW 44 trillion as of end-June 2022, posting the KRW 10 trillion increase compared to the end of last year. The 2022 monthly average of ELS issuance amount (from January to June) stood at KRW 2.7 trillion, down 29% from the period between 2020 and 2021. However, such a decrease has been offset by a bigger drop in early redemption, thereby driving up the net amount of ELS issuance (issuance amount less redemption amount). As illustrated in Figure 2, the net ELS issuance resumed its growth in the second half of 2021 when Korea’s stock market entered into a correction phase and trading volume went down. As it is hard to expect a bullish stock market amid the correction of stock indexes, ELS investment seems to have been on the rise as an alternative to stock investment. Against this backdrop, this article intends to examine current risks in the ELS market, compared to the previous market crisis period.
Risk indicators of the ELS market
In Korea’s ELS market where step-down ELS on domestic and overseas stock indexes can be seen as the most prevalent type (Jang (2021)), the first critical factor for determining risks of the ELS market is the outstanding issuance of ELS. Based on a similar rate of return structure and identical underlying assets, ELS products tend to share hedging methods and are subject to the same conditions for investment loss.2) Thus, a plunge in the value of underlying assets could give a shock to the ELS market depending on the outstanding balance. Furthermore, indicators related to early redemption are of importance since step-down ELS are attached with a condition of early redemption. If early redemption is made smoothly without a sharp decline in stock indexes that serve as underlying assets for ELS, ELS issuers as well as investors are less exposed to risks and achieve higher returns. In contrast, if early redemption is delayed due to a drop in stock indexes, ELS investors are likely to suffer principal losses while issuers would be faced with greater hedging risks.
In the past, Korea’s ELS market experienced a crisis twice when HSCEI plummeted between 2015 and 2016 and Covid-19 broke out in March 2020. This article examines how the two risk indicators mentioned above changed before and after each crisis hit the market. The graph in Figure 3 depicts the changes in ELS outstanding and early redemption ratio (early redemption amount for the corresponding month divided by outstanding balance of the previous month). During the two crisis periods shown in Figure 3, the early redemption ratio fell sharply and ELS outstanding went up amid worsening market conditions, with the outstanding issuance of ELS reaching nearly KRW 49 trillion. Back then, the stock market was affected by a crisis amid the growth of the outstanding balance and ELS issuers suffered heavy losses from hedging activities. Although most ELS using stock indexes as underlying assets achieved returns as the stock market staged a recovery, ELS investors were at risk of losing principal at a time of crisis.
In the second half of 2018, the decline in the ELS early redemption ratio and ELS outstanding growth fell short of escalating into a full-blown crisis. The early redemption ratio sank but remained higher than that of other crisis periods (the upper part of the dotted line (3%)), which picked up again thanks to the stock market rally in 2019. This suggests even with the rising outstanding balance, the ELS market could be stabilized depending on the conditions of the stock and financial markets.
In addition to the two indicators, the pace of underlying asset price falls and the correlation between underlying assets matter to issuers engaging in issuance and hedging of ELS. A simultaneous plunge in the value of underlying assets (two to three indexes used by an individual ELS product) is one of the most challenging events. But if the stock market shows moderate changes, issuers could adjust hedging positions while properly responding to market conditions. It is also notable that in the step-down ELS structure, whether any product achieves returns (or incurs losses) is determined by the worst-performing index among a basket of underlying assets. Accordingly, the risk of hedging would be relatively alleviated if a poorly-performing underlying asset is determined based on a single index’s sharp decline.
Knock-in levels are equally important to ELS investors. If a fall in stock indexes used as ELS underlying assets delays early redemption and the value of underlying assets comes near to knock-in levels, this would raise the possibility of principal losses.
Monitoring risks of the ELS market
Key stock indexes have fallen more than 20% from the peak until June 2022 amid growing uncertainties over the stock market. Despite this situation, the ELS market seems to remain stable. In the past, massive falls in the stock market mostly triggered the ELS market unrest. In this respect, this article examines current risks in the ELS market compared to the previous crisis.
As shown in Figure 3, the outstanding balance of ELS amounted to KRW 44 trillion as of end-June 2022, lower than KRW 49 trillion reported when a previous crisis hit the ELS market. Figure 4 reveals that the ratio of ELS outstanding to equity capital for issuers as of June 2022 is lower than the level observed immediately before a crisis occurred in February 2020 (around 0.8 on the trend line in the right-hand graph). A 25% increase in issuers’ equity capital for two years along with a decline in outstanding balance seems to have a positive impact on market stabilization. Although the ELS market remains stable, ELS market participants should be cautious of the early redemption ratio as low as the previous level and the rise in outstanding balance.
Despite a plunge in stock indexes, the stock market conditions have become more favorable to ELS hedging in 2022, compared to the previous market crisis. Concerns were raised over the ELS market unrest observed between 2015 and 2016 when HSCEI fell about 50% from its 2021 high in March 2022. However, this hardly sent a shock to the ELS market. HSCEI-linked ELS stood at KRW 12 trillion as of end-June 2021 prior to a plunge in stock indexes, representing 35% of the end-2015 value of KRW 34.1 trillion (Table 1). ELS products with a knock-in level of 55% or higher amounted to KRW 5 trillion in June 2021, lower than KRW 18 trillion in 2015, indicating a relatively lower possibility of principal losses.3) As indicated by stock market conditions in Figure 5, indexes declined at a relatively moderate pace between 2021 and 2022, compared to the period between 2015 and 2016. HSCEI’s correlation with other indexes was not high because weaker HSCEI was attributable to China-specific issues.4) Notably, HSCEI that showed a 50% fall was determined as the poorly-performing index since other indexes dipped just 20% from their peak from 2021 until March 2022. Thus, the risk of hedging is estimated to have diminished during the period, compared to the period between 2015 and 2016.
Aside from HSCEI, other key indexes tumbled between March and June 2022. As demonstrated by the S&P500 index (Figure 6), the declining pace of other indexes during that period was more moderate compared to the 2020 crisis. Also, key stock indexes showed a low correlation during the same period (the right-hand graph in Figure 6). Despite a strong correlation between S&P500 and Eurostoxx50, the burden of ELS hedging seemed to be relieved as HSCEI dropped before other indexes and was selected as the low-performance index.
Conclusion
The ELS market has remained stable, although major stock indexes sank more than 20% from their highs until June 2022. The current ELS outstanding is smaller than the outstanding balance reported during the previous market unrest, which has helped stabilize the ELS market. Currently, the ELS market has seen stock indexes falling at a more gradual pace and the correlation between those indexes has become weaker, which contributes to easing the burden of hedging on ELS issuers. Still, however, a surge in the outstanding balance amid a sharp drop in ELS early redemption volume, as well as growing uncertainties in the global stock and financial markets, has caused jitters in the ELS market. This requires extra caution of market participants because a crisis may arise if market conditions unfavorable to ELS such as a plunge in the global stock market emerge amid the increased outstanding balance.
Individual issuers should exert further efforts to control risks inherent in ELS issued by them and formulate a plan for stably issuing and managing ELS products by fully considering overall market situations. ELS investors should maintain a proper weight of ELS in their investment portfolio as part of an asset allocation strategy. What is also needed is risk management by opting for a low knock-in structure5) that is less likely to generate losses. Furthermore, the financial authorities should closely examine and monitor destabilizing factors in the ELS market.
1) The financial authorities have strengthened the management of issuers’ liquidity and leverage ratio and introduced restrictions on diversified investment in hedging assets in an effort to control risks related to ELS issuance and hedging (Financial Services Commission, July 31, 2020).
2) The price level susceptible to investment losses may vary depending on the base price of ELS products determined at the time of issuance.
3) ELS with a knock-in level of 50% or lower can be classified as a low knock-in type. As the low knock-in products are unlikely to breach knock-in barriers, this article compares the size of ELS with the 55% knock-in level (a knock-in barrier is breached if the stock index falls over 45%). For detailed information on knock-in price levels for March this year, see Jeon (2022).
4) HSCEI plunged out of concern for the Chinese government’s regulation of tech companies and a possible property market bubble.
5) Despite a lower coupon rate, a relatively safe low knock-in structure could raise the expected utility (Choi, S.Y. et al., 2021, p183-192).
References
Financial Services Commission, July 30, 2020, How to build a sound marketplace for derivatives-linked securities, press release.
Jang, G.H., 2021, Korea’s ELS market: current status and future tasks, KCMI Capital Market Focus 2021-2.
Jeon, G., 2022, A critical examination of HSCEI-linked ELS, Samsung Securities.
Choi, S.Y., Kim, J.M., Jang, G.H.& Kang, H.J., 2021, Outlook for the low interest rate environment and countermeasures- of financial investment business entities, KCMI Research Series 2021-4.
Korea’s equity-linked securities (ELS) market continued its growth in the wake of the global financial crisis before it began to contract due to the financial market unrest triggered by the Covid-19 pandemic in March 2020. As the stock markets of major economies recovered from a sharp decline, ELS early redemption was initiated in the second half of 2020. But with a decrease in new issuance, the outstanding balance of ELS slid to KRW 34 trillion in end-2021 from KRW 48.3 trillion in end-2019 (Figure 1). Such a decline can be attributable to the financial authorities’ regulation1) on risks arising from the ELS market as well as ELS issuers’ effort to curtail risks. Furthermore, it is estimated that amid active participation of retail investors in the stock market during the same period, the ELS investment amount, redeemed at or prior to expiration, was put into the stock market or other direct investment vehicles (Figure 2).
With this trend being reversed in the second half of 2021, ELS outstanding has gradually climbed to KRW 44 trillion as of end-June 2022, posting the KRW 10 trillion increase compared to the end of last year. The 2022 monthly average of ELS issuance amount (from January to June) stood at KRW 2.7 trillion, down 29% from the period between 2020 and 2021. However, such a decrease has been offset by a bigger drop in early redemption, thereby driving up the net amount of ELS issuance (issuance amount less redemption amount). As illustrated in Figure 2, the net ELS issuance resumed its growth in the second half of 2021 when Korea’s stock market entered into a correction phase and trading volume went down. As it is hard to expect a bullish stock market amid the correction of stock indexes, ELS investment seems to have been on the rise as an alternative to stock investment. Against this backdrop, this article intends to examine current risks in the ELS market, compared to the previous market crisis period.
In Korea’s ELS market where step-down ELS on domestic and overseas stock indexes can be seen as the most prevalent type (Jang (2021)), the first critical factor for determining risks of the ELS market is the outstanding issuance of ELS. Based on a similar rate of return structure and identical underlying assets, ELS products tend to share hedging methods and are subject to the same conditions for investment loss.2) Thus, a plunge in the value of underlying assets could give a shock to the ELS market depending on the outstanding balance. Furthermore, indicators related to early redemption are of importance since step-down ELS are attached with a condition of early redemption. If early redemption is made smoothly without a sharp decline in stock indexes that serve as underlying assets for ELS, ELS issuers as well as investors are less exposed to risks and achieve higher returns. In contrast, if early redemption is delayed due to a drop in stock indexes, ELS investors are likely to suffer principal losses while issuers would be faced with greater hedging risks.
In the past, Korea’s ELS market experienced a crisis twice when HSCEI plummeted between 2015 and 2016 and Covid-19 broke out in March 2020. This article examines how the two risk indicators mentioned above changed before and after each crisis hit the market. The graph in Figure 3 depicts the changes in ELS outstanding and early redemption ratio (early redemption amount for the corresponding month divided by outstanding balance of the previous month). During the two crisis periods shown in Figure 3, the early redemption ratio fell sharply and ELS outstanding went up amid worsening market conditions, with the outstanding issuance of ELS reaching nearly KRW 49 trillion. Back then, the stock market was affected by a crisis amid the growth of the outstanding balance and ELS issuers suffered heavy losses from hedging activities. Although most ELS using stock indexes as underlying assets achieved returns as the stock market staged a recovery, ELS investors were at risk of losing principal at a time of crisis.
In the second half of 2018, the decline in the ELS early redemption ratio and ELS outstanding growth fell short of escalating into a full-blown crisis. The early redemption ratio sank but remained higher than that of other crisis periods (the upper part of the dotted line (3%)), which picked up again thanks to the stock market rally in 2019. This suggests even with the rising outstanding balance, the ELS market could be stabilized depending on the conditions of the stock and financial markets.
Knock-in levels are equally important to ELS investors. If a fall in stock indexes used as ELS underlying assets delays early redemption and the value of underlying assets comes near to knock-in levels, this would raise the possibility of principal losses.
Monitoring risks of the ELS market
Key stock indexes have fallen more than 20% from the peak until June 2022 amid growing uncertainties over the stock market. Despite this situation, the ELS market seems to remain stable. In the past, massive falls in the stock market mostly triggered the ELS market unrest. In this respect, this article examines current risks in the ELS market compared to the previous crisis.
As shown in Figure 3, the outstanding balance of ELS amounted to KRW 44 trillion as of end-June 2022, lower than KRW 49 trillion reported when a previous crisis hit the ELS market. Figure 4 reveals that the ratio of ELS outstanding to equity capital for issuers as of June 2022 is lower than the level observed immediately before a crisis occurred in February 2020 (around 0.8 on the trend line in the right-hand graph). A 25% increase in issuers’ equity capital for two years along with a decline in outstanding balance seems to have a positive impact on market stabilization. Although the ELS market remains stable, ELS market participants should be cautious of the early redemption ratio as low as the previous level and the rise in outstanding balance.
The ELS market has remained stable, although major stock indexes sank more than 20% from their highs until June 2022. The current ELS outstanding is smaller than the outstanding balance reported during the previous market unrest, which has helped stabilize the ELS market. Currently, the ELS market has seen stock indexes falling at a more gradual pace and the correlation between those indexes has become weaker, which contributes to easing the burden of hedging on ELS issuers. Still, however, a surge in the outstanding balance amid a sharp drop in ELS early redemption volume, as well as growing uncertainties in the global stock and financial markets, has caused jitters in the ELS market. This requires extra caution of market participants because a crisis may arise if market conditions unfavorable to ELS such as a plunge in the global stock market emerge amid the increased outstanding balance.
Individual issuers should exert further efforts to control risks inherent in ELS issued by them and formulate a plan for stably issuing and managing ELS products by fully considering overall market situations. ELS investors should maintain a proper weight of ELS in their investment portfolio as part of an asset allocation strategy. What is also needed is risk management by opting for a low knock-in structure5) that is less likely to generate losses. Furthermore, the financial authorities should closely examine and monitor destabilizing factors in the ELS market.
1) The financial authorities have strengthened the management of issuers’ liquidity and leverage ratio and introduced restrictions on diversified investment in hedging assets in an effort to control risks related to ELS issuance and hedging (Financial Services Commission, July 31, 2020).
2) The price level susceptible to investment losses may vary depending on the base price of ELS products determined at the time of issuance.
3) ELS with a knock-in level of 50% or lower can be classified as a low knock-in type. As the low knock-in products are unlikely to breach knock-in barriers, this article compares the size of ELS with the 55% knock-in level (a knock-in barrier is breached if the stock index falls over 45%). For detailed information on knock-in price levels for March this year, see Jeon (2022).
4) HSCEI plunged out of concern for the Chinese government’s regulation of tech companies and a possible property market bubble.
5) Despite a lower coupon rate, a relatively safe low knock-in structure could raise the expected utility (Choi, S.Y. et al., 2021, p183-192).
References
Financial Services Commission, July 30, 2020, How to build a sound marketplace for derivatives-linked securities, press release.
Jang, G.H., 2021, Korea’s ELS market: current status and future tasks, KCMI Capital Market Focus 2021-2.
Jeon, G., 2022, A critical examination of HSCEI-linked ELS, Samsung Securities.
Choi, S.Y., Kim, J.M., Jang, G.H.& Kang, H.J., 2021, Outlook for the low interest rate environment and countermeasures- of financial investment business entities, KCMI Research Series 2021-4.