EAI Fellows Program Working Paper Series No.41
 

Author

Myung-koo Kang (MA, PhD, University of California, Berkeley) specializes in international and comparative political economy, especially focusing on financial crises and government’s macroeconomic policy responses, and financial regulatory reforms, both cross-national and Asia-specific context. He has published articles on financial and fiscal crises and reforms in Japan and Korea. He has published articles in Comparative Political Studies, Asian Politics and Policy, Asian Survey, and others. He is currently finishing up a book manuscript that explores the historical origins, development, and transformation of the Korean financial system in response to financial globalization, comparing with the Japanese case. His next research agenda is to conduct research on global financial imbalances and government policy options, focusing on U.S.-Asia economic relations. Before joining Baruch College, he taught 4 years at Claremont McKenna College; held a post-doctoral fellowship from the Asia Pacific Research Center at Stanford University in 2006-08; was affiliated to the Ministry of Finance of Japan as a visiting scholar in 2003-04 and to the Institute for Advanced Study as a visitor from January to August of 2010.

Introduction

Uncertainty is one of the endemic features of financial transactions (Minsky 1982; Knight 2006; Arrow 1984): “Each financial instrument is created by exchanging ‘money today’ for commitments to pay ‘money later’.” (Minsky 1982, 19). As a result, “underlying all financing contracts is an exchange of certainty for uncertainty. The current holder of money gives up a certain command over current income for an uncertain future stream of money” (Minsky 1982, 20). New financial instruments introduced to the derivatives markets for the past two decades were primarily for mitigating the inherent investment risks resulting from the intertemporal uncertainty.

The global financial crisis of 2008-2010, however, clearly demonstrated that unrestrained speculative activities in financial derivatives markets can cause a systemic crisis in the entire financial system. In the wake of the crisis, the way of regulating financial derivatives markets has become one of the critical regulatory agendas in the Group 20 regulatory authorities. Scholars and policy makers have commonly pointed to a regulatory failure as one of the critical underlying causes of the crisis (Financial Crisis Inquiry Commission of the U.S. Congress 2011; Roubini and Mihm 2010; Buckley and Arner 2011). Under the intellectual context, policy makers and scholars have debated concerning proper supervisory and regulatory frameworks towards financial derivatives markets (Wymeersch, Hopt, and Ferrarini 2012; Grant and Wilson 2012; Delimatsis and Herger 2011). As a result in the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act (July 2010) set forth enhanced regulatory and supervisory standards targeting financial derivatives. In the European Union (EU), the European Market Infrastructure Regulation (EMIR), which came into effect in August 2012, required all firms entering into any form of derivatives trade to report their transactions to trade repositories. Of various regulatory issues, regulating over-the-counter derivatives (OTCD) was one of the critical regulatory issues, as they are highly opaque and leveraged ones.

These ongoing debates and regulatory reforms provide good policy lessons to those regulators in emerging markets in that they should not deregulate (or allow) financial derivatives in a rushed way, especially OTC derivatives, without institutionalizing safeguards against them. However, existing debates have primarily focused on regulating OTCD. They do not provide good policy references for emerging markets that need to create new financial derivatives markets from scratch. Many emerging markets do not have any OTCD markets at all, and the liquidity of derivatives traded in exchanges is often limited. An immediate concern for those regulators in emerging economies is often to enlarge the volume of derivatives traded in exchanges. In this context, the Korean experience for the past decade or so provides a great reference case for emerging markets in terms of enhancing the volume of exchange-traded derivatives (ETD).

Financial derivatives markets did not exist at all in South Korea (hereinafter Korea) until 1996. KOSPI200 futures were only introduced in May 1996, and a year later in July 1997, KOSPI200 options followed. But in the few years from 2001 to 2003, both trade volume and value of these two derivatives grew in a explosive way and have remained on the rise for the past decade. The volume of equity index derivatives traded on the Korea Exchange (KRX, the former Korea Stock Exchange) has been the world largest since 2002. The KRX accounted for about 70 percent of equity index derivatives traded in exchanges worldwide in 2011, primarily owing to the exceptional high trade volume of KOSPI200 options (Davydoff and Naacke May 2009). KOSPI200 options traded in the KRX were over 3.6 billion contracts in 2011, and it accounted for about 93 percent of KRX-traded derivatives for the year. More remarkably, the trade value of KOSPI200 futures and options went over 436 trillion won and 11,113 trillion won, respectively in 2011. The combined trade value of these two derivatives went over about 11 times of stock market capitalization (the total value of listed companies’ shares in the KRX) and about 9.3 times of Gross Domestic Product (GDP) for the year...(Continued)