South Korean Investors Reel from Downturn in China Equity Derivatives

An unexpected plunge in a prominent Hong Kong stock market index this month has left South Korean retail investors grappling with substantial losses. The downturn has particularly impacted investments linked to about 15.4 trillion won ($11.50 billion) worth of index-linked derivatives set to mature within the year. As of January, major South Korean banks reported that from the 432.6 billion won of combined products that have reached maturity, there have been recorded losses amounting to 216.4 billion won.

The financial strain stems from the downturn of the Hang Seng China Enterprise Index (HSCEI), which benchmarks the performance of mainland China-based companies listed in Hong Kong. The index’s decline below the “knock-in” level, a threshold unique to each product, has triggered the losses. The structured notes, which are designed to mirror the HSCEI’s performance and offer bond-like returns unless the index falls below a specified level, are now in jeopardy. The HSCEI has tumbled more than 50% since its peak in February 2021, leaving $11.5 billion worth of securities vulnerable amidst waning investor confidence in Chinese and Hong Kong shares.

The situation has prompted the South Korean financial watchdog to initiate a probe on January 8 into 12 local banks and securities firms involved in the sale of these equity-linked securities. The Financial Supervisory Service (FSS) has raised concerns over potential misconduct in sales practices, including the pressure on bank employees to market these high-risk, complex financial products to retail investors.

The gloomy outlook for Chinese assets has been described as a “vicious cycle” by Lee Hyo-seob, the head of the financial services industry at the Korea Capital Market Institute think tank. Lee noted that the skepticism surrounding the HSCEI index is escalating as it continues to plummet, prompting brokers to hedge, which further intensifies the downward spiral. As the majority of these securities are slated to mature in the first half of the year, market analysts anticipate increased sell-off pressure, particularly as March and April approach.

This development is particularly concerning given that more than a quarter of the total 19.3 trillion won worth of such notes sold in South Korea were purchased by individuals aged 65 or older, highlighting the potential significant impact on a vulnerable segment of investors.

As the situation unfolds, stakeholders are closely monitoring the market’s response and the potential ramifications for both South Korean investors and the broader financial ecosystem.