KOREA CAPITAL MARKET INSTITUTE

Business models of global exchanges have undergone a shift from securities trading towards infrastructure for trading, clearing, and settlement of derivatives. Demand for exchange-traded derivatives has been on the steady rise due to their lower transaction costs, higher liquidity, and usefulness in hedging and arbitrage transactions. Meanwhile, the need for clearing and settlement infrastructure services has been growing fast in the over-the-counter derivatives market amid the post-crisis overhaul of regulatory regimes, e.g., mandatory central counterparty (CCP) and mandatory reporting and record keeping of trade repositories (TR). On top of persistent growth of exchange-traded derivatives and growing needs for new OTC derivatives infrastructure, global derivatives exchanges in the developed markets have prospered, enjoying high profitability and growth.

Nevertheless, Korea’s derivative exchange industry has faced a crisis. Recently, Korea’s trading volume of exchange-traded derivatives drastically fell due to slowed volatility, institutional investors’ flight, tightened regulation, etc. This is a stark contrast to Asian competitors such as China, India, Russian, Hong Kong, Singapore, and Japan where derivatives exchanges keep evolving by launching new products. Rather, Korean investers increased their share in derivatives listed on foreign exchanges while foreign investors’ holdings in Korea have steadily risen, raising concerns about the tail wagging the dog. Also worrisome is that Korea is behind the race for introducing OTC derivatives infrastructure. Korea’s won-denominated interest rate swap is the only product requiring mandatory CCP clearing. But KRX’s delay in becoming an ESMA-authorized qualified CCP is deterring market participation by foreign institutional investors.

Against the backdrop, this study examines leading derivative exchange operators with the focus on their development history and business models in order to seek development strategies that fit Korea. First of all, I analyze the development history of the top four global players in terms of profitability and growth (CME, Deutsche Borse EUREX, ICE, and LSE), and their business models. CME, EUREX, and ICE have centered on derivatives exchange, generating most of their revenues from trading services for exchange-traded derivatives, and from clearing and settlement services for OTC derivatives. Notably, ICE recently acquired the world’s largest stock exchange NYSE, a timely reminder of the exchange industry reshuffle leaning towards derivatives infrastructure. On the other hand, LSE initially began their business as a stock exchange, but recently acquired LCH.Clearnet to expand to derivatives business. As a result, derivatives data, index ownership and infrastructure took hold as LSE’s core revenue source.

One thing common among derivatives exchange groups in developed countries is their business diversification to swiftly adapt to the rapidly changing global market and regulatory environment. In their traditional area of exchange-traded derivatives, they try to enhance competitiveness by listing new products, advancing into emerging markets, and merging or acquiring other exchanges. On top of this, they have pushed for expanding their core business to other areas such as derivatives-related market indices and IT services. Regarding the global financial crisis as a new business opportunity, they preemptively invested in back office infrastructure such as CCP and TR, which eventually paid off. Backed by the success, they are seeking new business models such as market data, custodian, collateral, IT-based electronic trading platform services. More recently, they carried out massive investments in  interbank settlement and OTC trading infrastructure with Blockchain technology.

Last, this study attempts to propose the direction in which Korea’s derivatives exchange should head based on the aforementioned development history and innovation strategies of global derivatives exchanges. I recommend that Korea achieve economies of scope via business diversification, which according to global players’ cases is a crucial element. Toward that end, Korea’s derivatives exchange must follow the development path already trodden by global players; shifting towards demutualization to form a holding company, go for an IPO, and eventually to become a profit-seeking company. More concretely, it is desirable for the KOSPI and KOSDAQ operators and KOSCOM to work together to establish subsidiaries each of which specializes in derivatives trading, derivatives clearing and settlement, ETFs and retail structured products, and data service. The clearing and settlement subsidiary must accumulate equity capital and funds sufficient enough to meet the global standard in order to manage settlement risk and prevent CCP from defaulting. Also necessary for enhancing competitiveness of Korea’s exchange-traded derivatives are regulatory compatibility, more new products, and trading services for institutional investors. Furthermore, this study suggests plans to enhance clearing and settlement infrastructure for OTC derivatives, to expand IT services, and to strengthen competitiveness of back office infrastructure. Additionally, it is advisable for Korea to export its superb derivatives IT infrastructure to emerging markets such as Southeast Asia.