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2017 Feb/23
Financial Risks from Increasing ELS and DLS: Diagnosis and Implications Research Papers 17-04 PDF
As the low interest rate and low growth trends prolong, the market for ELS and DLS grew steeply for a short period of time. The remarkable growth of the two securities was backed by their higher expected returns compared to bank deposits, shorter maturities that enable easier reinvestments, and among others, their selection of banks as the main distribution channel. Although the market’s growth is rapid-paced and remarkable in terms of quantity, some adverse effects in terms of quality are observed to cause major risks. More concretely, the risks include the unfair trade risk, mis-selling risk, systemic risk due to the losses from ELS and DLS hedging. Abundant literature exists on the risks of unfair trade and mis-selling practices related to ELS and DLS, alongside with the supervisory authorities striving to eradicate those illicit practices with a number of regulatory improvements. However, the impacts of the rapid increase in ELS and DLS on the capital markets and financial institutions have yet grabbed sufficient attention of researchers and regulators. If the increase in ELS and DLS significantly heighten capital market volatility, and losses in one financial institution spill over to other financial institutions, this could adversely affect the real economy as well. This study assesses the risk factors where the increase in ELS and DLS could affect the capital markets and financial institutions, and presents how to improve risk management to prevent the related financial risks from expanding further. 
This study comprises of three parts. The first part estimated the gains and losses from ELS and DLS hedging of 23 Korean securities firms for the past 30 quarters, and then carried out a panel data analysis on the factors affecting the gains and losses. The result of the empirical analysis found a significant negative impact of the 10-year KTB yield. However, the gains and losses from hedging were not affected by the KOSPI200 return and the return volatility, the Hong Kong H-shares return and the return volatility, FX rate changes, CDS premiums, etc. Although a rate hike tends to increase the loss from valuation of debt securities held for hedging, it also cut the present value of liabilities to be paid out to investors, from which securities firms could reap gains from hedging. The factors affecting the gains and losses from ELS and DLS hedging were found to be similar across large and small to mid-size securities firms, with large players showing a slightly higher sensitivity as compared to small to mid-size players. This suggests that large players may suffer higher losses than small to mid-size players when the interest rate rises in the future, requiring large players to be more thorough in managing the interest rate risk. In the latter half of 2015 and in the second quarter of 2016, ELS and DLS hedging incurred heavy losses, mostly in large securities firms seemingly because the dividend yields of underlying indices suddenly fell, as well as because the major underlying indices such as Hong Kong H-shares abruptly plummeted to the level nearly close to the knock-in barrier. This possibly leads to the interference that Korean securities firms failed to manage the tail risk in a systematic manner. 
Second, I analyzed the impacts that Korean securities firms’ increased ELS and DLS hedging impose on the equity, government debt, credit card loan, and other capital markets. First of all, an increase in ELS issuance at normal times was found to increase the demand for selling volatility and thereby affect the volatility in returns though the effect is not statistically significant. Caution is necessary because stock price volatility lowered due to the increase in ELS and DLS issuance at normal times could rise at crisis times when ELS and DLS hedging activities increase. As an increase in ELS and DLS hedging activities requires more debt purchases, this could push down the yields of government bonds, credit card loans, and other debt instruments. The empirical analysis found that an increase in ELS and DLS issuance had no significant impact on the government bond market, but did significantly bring down card loan yields. This implies a possibility where card loan yields could rise dramatically if a contraction in the ELS and DLS market leads to a cut in the demand for card loans.
Third, I looked at whether an increase in ELS and DLS in one financial institution would increase the linkage to other financial institutions. The result showed that an increase in ELS and DLS significantly pushed up outstanding repo contracts. This is because securities firms, more than before, use the debt securities held for hedging ELS and DLS as repo collateral. If a domestic securities firm suffers devastating losses from ELS and DLS hedging activities to face a short-term liquidity crisis, this could potentially raise the credit risk of repo counterparties. Lastly, this study examined the linkage between securities firms and credit card companies that internally hedge ELS and DLS. According to the result, although the risk of securities firms suffering losses from any credit event in credit card companies was found to decrease, the financing risk of credit card companies rose as securities firms cut the issuance of ELS and DLS. 
Taken altogether, financial risks arising from increased ELS and DLS have not yet reached a serious level with related risks slightly on the rise, though. Hence, a preemptive action is necessary to contain the risks that could arise from the increase in ELS and DLS. Issuers should be well aware of the danger where an increase in ELS and DLS could further expand the volatility in the equity and debt markets, based on which to systematically manage any changes in returns in underlying indices, as well as the threat arising from the tail risk. More concretely, they should formulate their own guidelines that help abate any concentration in a certain underlying index, while at the same time carrying out a stress test on a regular basis for setting up their crisis management plan against any tail risk. Supervisory authorities should carefully review whether to improve the formula for the leverage ratio and NCR, so as to help the prudential measures more accurately reflect any increase in ELS and DLS. Also necessary are prompt actions to introduce an early warning system and a trade repository that could enable thorough monitoring on the risk where losses from ELS and DLS hedging activities could spill over to the repo and credit card loan markets.