Seoul Food for Thought

By Alan Ewins, Partner, Allen & Overy, and Head of Allen & Overy’s APAC Regulatory Group, Hong Kong (02/06/2010)

The Korean financial services industry holds a great deal of fascination for market participants, and for observers like myself. There is a feeling of Korea trying to work its way through difficult market infrastructure issues, struggling between making the domestic market safe and secure while taking a full part in the global financial reforms process.

Korea has not been content simply to be one of the members of the G20, together with the other Asian members, China, India, Indonesia and Japan. The most immediate and tangible evidence of its continuing urge to play a full part in the international financial community's moves to reshape the financial industry is Korea having achieved the coup of hosting the November 2010 G20 summit. That is the next one after Canada  has had its turn in June, and the final one before the process switches to annual meetings next year (starting in France). So, Washington, London, Pittsburgh, Canada, and then Korea: the first Asian nation to have the honour of holding this event.

This is in addition, as part of the overall process, to Korea being earmarked to host the Financial Stability Board Plenary Session just before the G20 meeting.

As the G20 host in November, Korea will not merely have a seat at the table in relation to international reforms but, for the lead up to and duration of the G20 conference in November, it will have the chance to have a real influence on the dishes and how they are served.

On that, Korea has already on the face of it embraced that challenge, indicating its desire to ensure that financial first aid kits are made available for developing countries, that it will take a leading part in the pursuit of financial reform and setting international standards, and that the summit is recognised as an opportunity for Korea to "become a genuinely advanced country".

This opportunity follows on the back of Korea's membership of ASEAN Plus Three (the ASEAN countries plus China, Japan and Korea) and the implementation of the Korean ‘Big Bang’ early last year which, notwithstanding the extraordinarily unfortunate timing in the midst of the market turmoil, was designed to demonstrate the forward thinking nature of the Korean financial market. That legislation included moves away from the rigid system of institutions only being permitted to sell financial products insofar as those products fell within the expressly allowed ‘bucket’.

This seemingly bright moment, set down by the Financial Investment Services and Capital Markets Act (FSCMA) became somewhat dimmed by the furore over the KIKO derivatives litigation, which led to questions as to the size of the modernisation challenge for this country. KIKOs - Knock-In/Knock-Out options - are contracts which were sold by banks on the basis that they reduced potential risk from fluctuating forex rates.

The product created an enormous problem for counterparties (such as small and medium-sized Korean corporates) that, when the foreign currency in question rose sharply, it triggered huge losses for those counterparties. The tide of disputes has to some extent been stemmed by the Korean Court's decision in a case earlier this year that there had been no mis-selling by the relevant bank. Before then, there had been dangerous moments for the Korean system, with claims being made that foreign banks had entered into transactions which could only benefit them, and where they had not properly explained the risks of the products. 

The level of concern has again risen sharply as a result of the arrival of the ‘NPA’ provisions of FSCMA.  

The NPA for these purposes is not to be confused with the Korean National Police Agency. However, these ‘new product approval’ requirements seem to put the clock back to earlier times, and they do conjure up images of stern guardians of the Law rather than 21st Century business-minded reform.

Any new OTC derivative products with underlying credit, natural, environmental or economic risk (forex, interest rate, equity and commodity underlyings would not appear to be covered), or which are offered to ‘general investors’, are required to be essentially pre-approved by the New Product Approval Committee under the Korea Financial Investment Association (KOFIA). The provisions may be relatively short-lived, having a built-in ‘sunset’ provision which will mean that they will fall away (unless extended) at the end of next year.

Some products may be entitled to exemption from the review process, under a Presidential Decree. A great deal of caution needs to be used to ensure that this regime does not end up in more or less the same position as the pre-FSCMA legislation, where essentially a ‘menu’ of products was allowed to be marketed. That would undermine the concept of disclosure-based regulation which has been adopted by most of Korea's major competitors.

The Securities and Futures Commission in Hong Kong, in relation to the distribution of structured products to retail investors, have gone out of their way to say that product approval is not on the table in Hong Kong, and that they would prefer to rely on disclosure-based sales processes.

Although the committee is on the face of it manned by industry experts and designed only to add a layer of protection to general investors, the initial stage of clearing a new product, and the responsibility that places on the reviewers (particularly if the product ever proved disastrous) has the distinct danger of strangling, or at least significantly slowing, financial innovation. That is notwithstanding any moves to simplify or ‘streamline’ such decision-making.

There lurks the additional danger of the regulators being viewed as having ‘signed off’ on the product which potentially creates significant hazards for the investing public, in that they may inadvertently rely upon such perceived approval, regardless of the steps taken to inform them of the true position. That has been a constant challenge for Hong Kong regulators even where the regulatory regime is clear on the face of it.

All of this makes it a very difficult balance for Korea to strike in terms of the G20 dinner guests arriving in Seoul. It needs to be seen to be firm and committed, proportionate and taking the lead on measures that will improve the post-turmoil regulatory environment.  This all needs to be viewed in the context of the current, and somewhat more immediate, political and other challenges for the country. 

Indeed, given Korea's position in November at the head of the table of the international financial community, it needs to be able to apply gleaming knives of meaningful regulatory and monetary reform, and be seen to choose the perfect vintage of global debate, while not being viewed as having stale offerings in its larder.