Onshore derivatives and Korean corporates

Phenomenal GDP growth rates of 10% plus in 1999 saw foreign investors rushing back into the Korean market. Koreans, a nation of keen students, have learnt many lessons from the crisis and have transformed those lessons into a more efficient domestic financial market.

On the brink

Two years ago, along with most Asian nations, Korea was on the brink of bankruptcy. Once admired for its economic prowess, the Asian currency contagion dealt a severe blow to its financial architecture. Financial markets were in disarray, foreign exchange reserves were nearly depleted and the currency, the Won, was spiralling into oblivion.

A fledgling domestic derivatives market had been obliterated. Capital markets once dominated by the top five chaebol or conglomerates died a painful death leaving precious few sovereign issues to fill the void. Korea learnt the hard way that an inefficient financial system was a weakness that was too critical to be ignored.

Fortunately, the Korean authorities have not ignored this reality and have spent the last two years swallowing the IMF's medicine. The recently formed Financial Supervisory Commission and its sister body, the Financial Supervisory Service has been at the helm of the government's efforts to restructure the ailing financial sector.

Strict timetable

Strict adherence to a timetable of reform has allowed Korea to enjoy a comeback unimaginable two years ago. But this exceptional recovery has not been without its hiccups. The near bankruptcy of the nation's second largest business empire, the Daewoo group, and the subsequent liquidity squeeze was one such hiccup that had many economists touting a W-shaped recovery. Timely intervention and unwavering support, however, for the financial markets saw the authorities avoid any systemic risk that was inherent in the Daewoo induced liquidity squeeze.

The program of reform has extended to the capital markets where the authorities are in the midst of a complete overhaul of the domestic bond market. Government debt securities, pre-crisis almost non-existent, have become the benchmark for the market, giving market participants instruments necessary to form yield curves for longer term products.

Concurrently, liquidity in the secondary market has been steadily increasing. Authorities have been implementing measures necessary to enhance liquidity. A constant supply of government bond issues and the establishment of a primary dealer system has helped bolster liquidity in the secondary market.
The majority of the hard work in reforming the bond market has been completed. However, the government needs to take further measures in order to completely reform the bond market and bring it to world class levels. For now, the Korean government is showing every sign of finishing the job but the proof remains to be seen.

Local involvement

Its efforts to date, however, have not escaped the attention of market participants with foreign banks increasingly setting up operations in the newly formed onshore derivative market. More importantly, local Korean banks are becoming involved in the market with price making operations in Seoul. Local banks, led by Kookmin Bank, are developing the technology to act independently of foreign banks, tailoring innovative hedging solutions for Korean corporates.

The basic building blocks of complex derivative transactions have been developed. Kookmin Bank, for instance, now offers products such as currency options (both plain vanilla and exotic), long-term foreign exchange, cross-currency swaps, interest rate swaps and overnight index swaps.

Local banks with intimate knowledge of the domestic market are using their local competitiveness to their advantage. Banks like Kookmin, Korea's largest commercial bank (with a customer base of 12 million), consider themselves to be in a better position to understand domestic credit than international competitors. In addition, local banks are also not subject to the so-called "country risk" (that is the risk international institutions face when operating in a jurisdiction that is different from their own) when dealing with local corporations. These two factors allow local banks to be more aggressive when pricing credit.

For some customers this may mean the difference between success or failure in securing a credit line, while for others, it may translate into a longer tenor for a transaction. In either scenario local corporations are given greater access to the onshore derivatives market and cost of credit is typically cheaper.

Risk management

The developments in the underlying financial markets have also allowed participants to develop sound risk management techniques. Risk management systems have been established and banks are increasingly designing new products specifically tailored to the Korean market. These techniques have enabled banks to perform true price-making functionality for the first time.

Previously, all hedging had been done via offshore banks, with local banks only standing in between corporate and foreign bank to "credit wash" the transaction. These new developments have increased the liquidity in the domestic market allowing corporates greater access to deliverable derivative products and more efficient pricing.

With the recent development and implementation of these new risk management systems locally, corporates have greater flexibility in terms of hedging their Korean risk. Banks are now providing a raft of services from protection for clients, to creating sophisticated options structures. In-house experts also now work with clients to tailor solutions designed to meet clients specific needs. Having a complete onshore presence also means local banks can now be far more responsive to a client's onshore needs as their is no need for approval from offshore head offices.

Technology use

Advances in technology combined with sounder market fundamentals have also made it possible for corporates to hedge sizeable exposures. Many transactions in the Korean market have a tenor of three years and can reach $100 million in size. As the market develops further this year participants can expect longer tenors and transactions that frequently surpass the $100 million mark. Longer tenors give corporates a chance to smooth out the effects of volatility over time. They also give greater clarity over future cashflows, allowing corporates to concentrate on their core business.

Whilst some corporations are taking advantage of longer tenors to smooth out the market volatility, some corporates are entering into interesting transactions which take advantage of shorter term volatility. Innovative structures are being developed allowing customers to continually take advantage of short term volatility in the market to achieve long term goals.

It is clear that the onshore derivatives market developed rapidly over the last year. It is even clearer that the market will continue to develop, giving Korean corporate treasurers and investors more avenues to hedge their market risks.

Onshore hedging

Prior to the currency crises, there was very little onshore hedging done in Korea. Treasurers and investors kept unwavering faith in the government's ability to protect them. Even worse, the seemingly steady state of the US$/Won lured some corporates and investors into speculative FX derivative transactions, while others elected to borrow US$ to "reduce" interest servicing cost. The negative outcomes from such practices have subsequently become clear to all. Practitioners learnt via the bitterest of experiences just exactly what a financial market exposure was.

Although credit was freely available pre-crisis, many Korean corporate treasures were reluctant to hedge. Most feared reprimand from senior management for entering into transactions that happened to be "out of the money" at balance dates. This was a major cultural boundary that many Koreans charged with the responsibility of managing financial risk faced. If their hedges were "in the money" they received little or no recognition of performance. If their hedges were "out of the money" they could expect to be reprimanded.

Recent experience has taught many lessons to those operating in the Korean markets. Management is now no longer berating treasurers for entering into hedging programs, but in stark contrast to the past, is encouraging them to utilise hedging products now available. Unfortunately, post-crisis corporate Korea is still suffering from a substantial credit shortage which has become a barrier to the hedging of longer term financial exposures.

Korean onshore hedgers are facing more favourable hedging conditions then they have ever before. They have a wider range of onshore products with a larger number of institutions providing them. There are still some problems facing the Korean hedger but these are rapidly disappearing. The Korean onshore derivatives market has come a long way in a short period and many anticipate the market will flourish in the future.

Nick O'Kane is chief dealer, structured products, with Korea's Kookmin Bank.