In the aftermath of the SG Securities scandal, some argue that CFDs should be removed from the market. CFDs are OTC derivatives based on private contracts. If investment in CFDs is prohibited, investors may flock to new types of OTC derivatives, such as TRSs and new margin trading, which could cause a more serious problem. As Korea has tightened the regulation on OTC derivatives’ market entry since 2010, investors tend to herd toward speculative financial instruments by increasing their exposure to high-risk instruments such as virtual assets, FX margins, overseas leveraged products, and CFDs. It is noteworthy that eliminating the CFD from the market has limitations in preventing the SG Securities scandal and fundamental regulatory improvements are needed to eradicate a range of unfair trade practices involving OTC derivatives. First, transparency in OTC derivatives trading should be enhanced through the reform of the KRX trade repository (TR) reporting system and the Suspicious Transaction Report (STR). Second, the market surveillance system should be upgraded to swiftly detect and investigate new types of unfair trade practices using OTC derivatives in advance. It is also necessary to expand the personal information disclosure for criminals and restrict their participation in the capital market in order to wipe out unfair trading. Third, the financial authorities should prohibit financial services firms from inducing investors to register as individual professional investors to recommend high-risk OTC derivatives, with the aim of preventing potential mis-selling. In addition, the duty of explanation should be imposed on financial services firms that recommend OTC derivatives for individual professional investors. Fourth, the financial authorities should actively induce financial services firms to overhaul the internal control and the compensation system to improve their sales behavior of recommending high-risk financial instruments with high sales fees attached to boost short-term performance.
Types of illegal transactions involving over-the-counter (OTC) derivatives
Derivatives are like a double-edged sword. Derivatives such as futures and options give investors leverage opportunities while providing them with a means of risk management and price discovery. But if the price of underlying assets moves against expectations, derivatives investors can sustain huge losses, and if the volume of derivatives is excessively large, it gives rise to the “wag the dog” phenomenon, resulting in greater fluctuation in the price of underlying assets and threatening financial stability. Unlike exchange-traded derivatives that are listed and managed on the exchange, OTC derivatives can inflict extensive damage to investors or trigger systematic risk, due to high leverage and lack of trading transparency. OTC derivatives are known to be the main culprit of the 2008 global financial crisis and the KIKO scandal that caused financial damages to several Korean SMEs in the mid-to-late 2000s.
Worse yet, OTC derivatives using stocks as underlying assets, such as a Contract for Difference (CFD) and a Total Return Swap (TRS), are prone to misuse for a wide range of illegal transactions such as unfair trading, potential mis-selling, tax avoidance, and unconventional corporate governance.1) The CFD and TRS have the advantage of providing the function of risk management and price discovery, depending on the needs of investors. But the advantage is outweighed by their disadvantage of being used for various illegal trading activities. In the case of the CFD or TRS, it is hard to identify the main entity of orders and thus, it is easy to gain unfair profits or avoid losses. Furthermore, financial services firms can exploit OTC derivatives such as CFDs and TRSs as a means of mis-selling. Under the Act on the Protection of Financial Consumers (the “Financial Consumer Protection Act”), when encouraging individual professional investors to enter into an OTC derivatives contract, financial services firms may exempt from key sales regulations, including the duty of explanation, the principle of suitability and the principle of appropriateness which apply to ordinary investors. It is problematic that financial services firms are likely to induce ordinary investors to change to individual professional investors to obtain high fees from the opening of CFD and TRS accounts. If the firms ask ordinary investors to register as individual professional investors to recommend high-risk OTC derivatives such as CFDs and TRSs, this practice could be regarded as an act of mis-selling in a broad sense.
In addition, CFDs, TRSs and other OTC derivatives can be used as a tool to avoid tax such as controlling shareholders’ capital gains tax and gift tax. As prescribed by the current tax law, an investor who holds listed stocks worth KRW 1 billion or more or whose ownership share exceeds a certain level is subject to requirements for a controlling shareholder and thus, ought to pay a 20% to 25% tax on capital gains from stock trading. If the controlling shareholder uses the CFD and TRS, the tax on capital gains can be reduced because the owner of underlying stocks cannot be identified. On top of that, if the controlling shareholder designates his or her child as the counterparty of the CFD or TRS and induces a loss in the underlying index, OTC derivatives can be abused as a means of avoiding gift tax in the form of matched orders.
By taking advantage of the CFD or TRS, it is possible to establish unconventional corporate governance that enables evading the duty of disclosure and exercising shareholder rights to a company without a voting right. Under the Financial Investment Services and Capital Markets Act (the “FSCMA”), a person who holds five percent or more of stocks of listed companies should disclose stock holdings and any change in holdings, the purpose of holding stocks and details of any change.2) But if the person acquires stocks indirectly through the CFD and TRS, he or she may evade the duty of reporting large-volume stock holdings. The Monopoly Regulation and Fair Trade Act (the “Fair Trade Act”) applies a strict set of fair trade regulations to a business group designated as the business group subject to limitations on cross shareholding. If the CFD and TRS are used, it is possible to bypass limitations on cross shareholding.
As such, OTC derivatives such as CFDs and TRSs can be exploited for various illegal trading purposes, including unfair transactions, potential mis-selling, tax avoidance, funds concealing, evasion of the duty of disclosure, and avoidance of fair trade regulations. Against this backdrop, this article intends to present regulatory improvements for eradicating illegal transactions involving the CFD and TRS.
Enhancing transparency in OTC derivatives transactions
To prevent the CFD and TRS from being misused for illegal trading, the monitoring of the main entity of orders should be reinforced. As the 2009 G20 summit reached an agreement that all OTC derivatives should be reported to a trade repository (TR), Korea also designated the Korea Exchange (KRX) as the TR for OTC derivatives. Accordingly, financial investment firms are required to report trading information regarding OTC derivatives to the KRX TR starting from April 2021.3) As for OTC derivatives based on underlying assets such as interest rates and currencies, the main entity of transactions, trading volume and information on contract execution should be reported to the KRX TR. In the case of the CFD, the initial margin, the maintenance margin and criteria for liquidation, in addition to the main entity of transactions, should be reported. But as CFD-linked account information is excluded from reporting requirements,4) the CFD can make it easy to hide the main entity of transactions. In this respect, it is worth considering beefing up the reporting system of the KRX TR by expanding the reporting scope regarding the CFD and TRS.
When financial services firms enter into an OTC derivatives contract or provide brokerage services, the financial authorities need to require them to report suspected illegal transactions to Korea Financial Intelligence Unit (KoFIU). Under the Act on Reporting and Using Specified Financial Transaction Information (the Specified Financial Information Act), if there are reasonable grounds to believe that a counterparty engages in money laundering, such as illegitimate financial transactions, financial services firms must immediately report the fact to the Commissioner of KoFIU.5) As money laundering crimes are on the rise globally, the authorities should revamp the red flag system for detecting suspected transactions and conduct thorough monitoring to wipe out money laundering crimes involving virtual assets and OTC derivatives.
The CFD and TRS can be easily used to conduct major unfair trade practices, including market manipulation activities such as matched orders and the use of undisclosed material information (insider trading), due to difficulty in identifying the main entity of orders and high leverage. Since CFDs and TRSs can put a bet on falling prices of underlying assets, they can also be used as a tool to avoid short selling regulations. As such, they are prone to abuse for various unfair trade practices and thus, market surveillance should be stepped up for stocks used as underlying assets. As demonstrated by the downward trend in stock prices arising from the SG Securities scandal, unfair trading methods have become more elaborate and sophisticated. For this reason, it is hard for the current market surveillance system to detect unfair trading methods related to CFDs and TRSs which have been put into use for a long time. To quickly detect and investigate new types of unfair transactions that have used OTC derivatives for a long time, it is necessary to upgrade the KRX market surveillance system by hiring more talent specializing in AI and big data and expanding large-scale IT infrastructure. Additionally, prior disclosure should be mandatory for insiders who sell shares in large volume to uproot the use of undisclosed material information based on OTC derivatives.
To eliminate elaborate unfair trading activities, sanctions against those engaging in unfair trading should become more rigorous. To this end, Korea needs to promptly introduce the unfair trading penalty system adopted by major advanced economies such as the US, the UK and Japan and to enhance the calculation method of unfair gains (or avoided losses) that serve as the basis for calculating the penalty. As unfair traders in the capital market are highly likely to reoffend, the authorities should work on lowering the reoffending rate to minimize damages to investors. As part of the effort, they need to expand the disclosure of unfair trade practices and sanctions imposed on unfair traders by referring to cases of the US, Canada and the UK. What is also needed are restrictions on unfair traders’ participation in capital market transactions.
Eradicating mis-selling linked to OTC derivatives
When selling investment products to ordinary investors, the seller should comply with key investment solicitation regulations, such as the duty of explanation, the principle of suitability and the principle of appropriateness. Notably, the company selling high-risk OTC derivatives to individual professional investors is exempt from such regulations. The problem is that financial services firms are likely to ask ordinary investors to change to individual professional investors to facilitate the sale of high-risk OTC derivatives and they may recommend such OTC derivatives without fully explaining relevant risks as soon as the change in investor type is completed. In this regard, it is worth considering permitting firms to recommend high-risk OTC derivatives only for investors who have registered as individual professional investors for a certain period of time.
The mandatory duty of explanation should be imposed on financial services firms that recommend high-risk OTC derivatives for individual professional investors. Countries like the US and Hong Kong prohibit individual investors from investing in CFDs. On the other hand, Europe permitting the investment in CFDs has classified CFDs into the highest risk 7th-rating category, among categories of seven risk ratings, and has made the duty of explanation mandatory to require the firms to fully explain the risk of loss by revising the regulation of packaged retail investment and insurance-based products (PRIIPs). Under the FSCMA, CFDs sold to individual investors fall under the high-risk financial instrument category6) and financial services firms soliciting the CFD investment are obligated to provide individual professional investors with a summary prospectus specifying the risk of loss. For this reason, it is necessary to consider imposing the duty of explanation—the minimum investment solicitation regulation--on financial services firms that encourage individual professional investors to invest in OTC derivatives, with the aim of achieving regulatory consistency with high-risk financial instruments.
Tightening internal control of OTC derivatives
The Act on Corporate Governance of Financial Companies (the Corporate Governance Act) stipulates that financial service firms have an obligation to establish risk management standards necessary to recognize, evaluate, monitor and control risks arising from business conduct in a timely manner, along with the duty of preparing internal control standards.7) In this respect, the Financial Investment Services Regulation specifies a set of internal control rules for business conduct and trading of derivatives. Without making distinction between ordinary investors and individual professional investors, the rules obligate the derivatives sales manager to periodically examine the suitability of transactions, the appropriateness of size and frequency of transactions by type, and excessive concentration of portfolio positions, in light of investors’ purpose.8) As such, the internal control standards of financial services firms specify requirements for not only the sales stage of high-risk products but also the post-sale follow-up stage. But it is notable that internal control rules are defined in abstract terms and they are ineffective due to ambiguity in supervisory responsibilities. For the effective operation of the internal control by financial services firms, the supervisory responsibilities of the CEO and the board of directors should be defined distinctly through the revision to the Corporate Governance Act, while incentives such as sanctions relief should be given to ensure that executives and employees of the firms can faithfully comply with internal control rules.
Given that financial services firms can receive higher sales fees by selling higher-risk instruments, they are likely to recommend high-risk OTC derivatives to maximize short-term profits. Since CFDs and TRSs sold to individual professional investors are not subject to regulations under the Financial Consumer Protection Act, including the duty of explanation and the principle of appropriateness, there is a possibility that financial services firms aggressively engage in the sales activities of CFDs to boost short-term performance. To address this problem, the compensation system adopted by financial services firms should be overhauled to induce a shift from the current short-term sales performance-oriented compensation system towards the long-term compensation system focusing on customer-related performance.
In the aftermath of the SG Securities scandal, some argue that CFDs should be removed from the market. CFDs are OTC derivatives based on private contracts. If investment in CFDs is prohibited, investors may flock to new types of OTC derivatives, such as TRSs and new margin trading, which could cause a more serious problem. As Korea has tightened the regulation on OTC derivatives’ market entry since 2010, investors tend to herd toward speculative financial instruments by increasing their exposure to high-risk instruments such as virtual assets, FX margins, overseas leveraged products, and CFDs. Although OTC derivatives such as the CFD and TRS play a positive role as derivatives, they can be abused for unfair trading, potential mis-selling, tax avoidance, and unconventional corporate governance, thereby causing a range of side effects. To prevent the recurrence of the SG Securities scandal, fundamental regulatory improvements are needed to enhance transparency in OTC derivatives trading and eliminate unfair trade practices and potential mis-selling related to OTC derivatives. Above all, it is crucial to encourage financial services firms to focus more on long-term returns of investors, rather than short-term returns through the reform of the internal control and performance-based compensation systems. 1) For details of types of unfair trade practices involving OTC derivatives, see Jung & Lee (2014) and Lee (2016).
2) See Article 147 of the FSCMA (Report on Stocks Held in Bulk).
3) For the agreement on the OTC derivatives regulation reached by the 2009 G20 summit, see Nam (2010).
4) See the enforcement rules for the trade depository regulation of the KRX.
5) See Article 4 Paragraph 1 Subparagraph 2 of the Specified Financial Information Act.
6) CFDs sold to institutional investors are excluded from the high-risk financial instrument list.
7) See Article 27 Paragraph 1 of the Corporate Governance Act.
8) See Section 2 Article 27 of the Financial Investment Services Regulation.
Nam. G.N., 2010, A Study on US OTC Derivatives Regulations: Implications of the Dodd-Frank Act and its Impact, Korea Capital Market Institute Survey Paper 2010-05.
Lee, J.D., 2016, A Study on Matters Concerning Stock-based OTC Derivatives Trading, The Korean Journal of Securities Law Volume 17-1, 203-245.
Chung Y.M. & Lee, H.S., 2014, A Study on Regulations for Unfair Trading in Korea’s Derivatives Market, Korea Capital Market Institute Research Paper 2014-02.