New Financial Products and Their Impact on the Asian Financial Markets

1. New Financial Products and Their Impact on the Asian Financial Markets 7 April, 2009 2008/2009 ASEAN+3 Research Group 3

2. Ⅰ Potential Merits and Drawbacks of New Financial Products Ⅱ Introduction of New Financial Products: Korean Experience Ⅲ Current Status of New Financial Products and the Effects of the Current Financial Turmoil on ASEAN+3 Ⅲ Implications from the Korean Experience and Policy Recommendations

3. Potential Merits and Drawbacks of New Products • Regulations and supervision should be based on broad understanding of the products and should pursue sound development and expansion of financial products - Potential Merits - - Potential Drawbacks - • Widening financing and investment options • Providing risk management tools • Increasing investment opportunities and market liquidity • Contributing the development of financial industry • Boosting economic growth • More complicated and risky products for investors • More difficult to assess the risk for credit rating agencies • More difficult for regulation • 3 -

4. Ⅰ Potential Merits and Drawbacks of New Financial Products Ⅱ Introduction of New Financial Products: Korean Experience Ⅲ Current Status of New Financial Products and the Effects of the Current Financial Turmoil on ASEAN+3 Ⅲ Implications from the Korean Experience and Policy Recommendations

5. Expected effects Strong investor protection • Protecting investors from misfeasance or negligence on the part of financial investment services • Increase in customer dispute cases • Reduce profitability from fee-for-service • Promote not only innovation of financial investment products and services but also competition among financial investment services • Corporations can secure capital in the most appropriate way via various structured products in addition to stocks and bonds • New financial products featuring various combinations of risks and yields allow assets to be tailored according to investor needs Higher competition • Accelerate money move toward securities and fund market • - but has a defect of possible settlement failure and • systematic risk Permit securities companies to run a retail payment service Expected Effects from CMCA • Financial Investment Services and Capital Markets Act(aka, CMCA) is effective from February 4th, 2009 consolidating six statutes governing the capital market, includingthe Securities and Exchange Act, the Indirect Investment and Asset Management Business Act, the Futures Trading Act, and Trust Business Act.

6. CMA and Change in Asset Allocation • Cash Management Accounts with payment and settlement capacity shifted the large funds from banks to securities companies, resulting in extreme fund shortage in banks, higher interest rates, and fierce competition across sectors. - Trend of CMA Balances - (Unit: Tril. Won)

7. SME Financing in Bond Market: P-CBO Program in Korea • P-CBO resolves the credit mismatch and high cost problems • P-CBO pools bonds with different levels of risk and with sufficient number of firms, the overall risk as well as transaction costs decrease. • Credit enhancement further reduces the credit risk of CBO. • SBC’s cross-border P-CBO in 2004 • 46 Korean SMEs participated in the P-CBO issuance in Japan in 10 billion yen with credit guarantees by IBK and JBIC • Subordinate tranche issued by the domestic SPC was purchased by SBC, providing additional credit enhancement • Senior tranche was acquired by the foreign SPC established in Japan and then distributed to investors in Japanese market - Basic Structure of P-CBO Issuance - - Cross-Border P-CBO Issuance -

8. Foreign Equity Investment Funds • Tax exemption on foreign equity investment was adopted in June 2007 • 15.4% tax was levied on profits from foreign fund investment • Korean won remained strong until 2007 • Tax exemption was expected to weaken Korean won • If strong Korean won persisted, it would have a negative impact on exports. • The increase of forwards and futures trading was partly due to the increase of transactions for hedging purpose • If foreign investment funds fully hedged foreign exchange risk through forwards or futures, there was no impact on foreign exchange market from tax exemption. • Korea experienced current account deficit in 2008 so that won/dollar exchange rate increased sharply. • Since Foreign Equity Investment funds hedged against exchange rate risk, investors could not reap gains from won/dollar exchange rate soar.

9. Knock-in & Knock-out(KIKO) Fiasco • KIKO forward is a structured forward with both a lower knock-out barrier and upper knock-in barrier • The regular type is a combination of buying a put option with low barrier and selling one or more call options with upper barrier. • It allows the holder to sell dollars at a preset exchange rate(option exercise price) when the exchange rate moves within the lower and upper barriers. • If the exchange rate falls below the low barrier(knocked out), it is worthless. • If the exchange rate surpass the upper barrier(knocked in), subscribers should sell dollars worth two to three times more than the contracted amount of the put option. • When the call option is knocked in, companies with overhedged position have to buy extra dollars from the spot market and sell them to the counterparty who exercised the call option at the predetermined strike price below market rate. • There were 68 SMEs with overhedged position of $3.1 billion at the end of June 2008 with accumulated realized loss of 149.2 billion won. • As losses from KIKO forwards rise with surging won/dollar rate, firms are on the verge of collapse. • Many corporate executives insisted that they were ill-informed of potential risks implicit in the KIKO contract • 9 -

10. Ⅰ Potential Merits and Drawbacks of New Financial Products Ⅱ Introduction of New Financial Products: Korean Experience Ⅲ Current Status of New Financial Products and the Effects of the Current Financial Turmoil on ASEAN+3 Ⅲ Implications from the Korean Experience and Policy Recommendations

11. Global CDOs and CDSs • Interest rate swaps have had the largest share in global derivatives transactions over the last 10 years • The boom in the U.S. housing market had encouraged financial institutions to manage their credit-default risk and to seek profits through CDOs and CDSs • Global CDO Market Issuance - • Credit Default Swaps Outstanding - (unit: USD million) Source: SIFMA(2008) Source: ISDA Market Survey

12. Status of new financial products in Asia • There are 5 main derivatives products that are traded in East Asian markets, such as foreign exchange products, interest rate derivatives, equity derivatives, commodity derivatives, and credit derivatives. • Asia has accounted for only a small proportion of the global CDO market • Global derivatives markets have grown extremely fast over the past 10 years. • Size of CDS market is about USD 1.37 bn, 7.6% of global CDS market, by the end of 2005(Source: HK Monetary Authorities)

13. CDSs and CDOs in Asia • There were a total of 921 CDS names in Asia that were traded in the CDS markets as of early Jan. 2008 • Among ASEAN+3, Japan dominates the market. • The first Asian CDO deals were balance sheet CDO…After 2002, the focus of the CDO markets in Asia shifted from the traditional balance sheet CDOs to the synthetic arbitrage CDOs and more recently to the single-tranche arbitrage CDOs • The growth in Asia’s CDO market peaked in 2006, whereby Japan and Korea accounted for more than half of the region’s deals in 2005-2007. • Asia’s CDS - • Asia’s CDO - Source: BIS Quarterly Review(2008)

14. Effects of the Recent Financial Turmoil on ASEAN+3: Financial Markets • The problem of CDOs and CDSs caused the massive recapitalization of financial institutions. • The private financial institutions suffered from their losses and inability to payback their claims ⇒ Central banks in many countries did liquidity injection. • The effect of subprime crisis has passed on to developing countries through capital markets. • Risk-averse investors have been pulling their money out of Asian equity markets to make sure that they would have some money as their financial guarantee if anything goes wrong in their domestic markets. • ASEAN+3 countries seem to get less impact from the U.S. subprime crisis compared to other developed countries, especially U.S. and Europe. • The reason is explained as they have less development in financial innovations, thus less connection to the financial risks.

15. Effects of the Recent Financial Turmoil on ASEAN+3: Capital Markets Source: IMF Finance and Development 2008)

16. Effects of the Recent Financial Turmoil on ASEAN+3: Real Sector • The current crisis will have a negative impact on the real sector in Asian countries. • Japan is expected to experience current account deficit while the group of 8 East Asia countries would still have a positive current account due to the economic growth in China • Except for the East Asia countries, other countries are expected to experience negative real GDP growth in 2009 • Effects on the Real GDP - • Effects on the Current Account - Source: FPRI World Economic Model (as of 2 Feb 2009) Source: FPRI World Economic Model (as of 2 Feb 2009)

17. Ⅰ Potential Merits and Drawbacks of New Financial Products Ⅱ Introduction of New Financial Products: Korean Experience Ⅲ Current Status of New Financial Products and the Effects of the Current Financial Turmoil on ASEAN+3 Ⅲ Implications from the Korean Experience and Policy Recommendations

18. Policy Recommendations • Need to consider that innovative efforts should not be discouraged • Regulations should take into account merits of new financial products along with their risks • When a policy makes certain financial products attractive, the overall effect of the policy should be taken into account. • As CMA became popular, banks’ funding costs rose, and banks became conservative in lending. • Supervisory system should gather information on new financial products popular in the market. • Supervisory authority should collect information to detect potential risk caused by new financial products • Reducing information asymmetry in financialmarkets is crucial for market transparency. • Risks should be distributed to investors who can deal with risks best • Since some complex derivatives are exotic and illiquid and traded OTC, uncertainty in the market increases • Disclosure and providing information to market participants as well as regulators are important for market transparency

19. Policy Recommendations • Regulation on conflicts of interest • Credit rating agencies are important in reducing information asymmetry, but they have grown with conflicts of interest • Regulations on conflicts of interest are needed to prevent them from mis-rating new and exotic financial instruments • Setting up clear rules and not over-relying on market discipline • Over-reliance on market discipline may cause poor monitoring, hence credit risk is transferred to those least able to understand and manage it • Reliance on market discipline is useful to deal with financial innovation and regulatory arbitrage, but we need to set up clear rules that adhere to the principle-based regulation and supervision • Extending clearing house-based transactions in OTC products • The instruments traded in clearing house-based exchanges lower counterparty risk because they are subject to margin requirements and appropriate mark-to-market on a daily basis • Standardization of financial instruments also reduces operational risk

20. Policy Recommendations • Building appropriate consumer protection rules • A gov’t needs to protect general investors by mitigating information asymmetry • Especially, general investors are unlikely to fully aware of the potential risks in new and complex instruments ⇒ risks implicit in the instruments should be notified in an appropriate way • Macro-prudential supervision • Without a comprehensive perspective, the contagious nature of a crisis can be underestimated • New financial products made it easier to transfer risk across the financial system so that they may be an element to enlarge systemic risk • Development of early warning systems, conduct of macro-stress testing, and other macro-prudential regulations on leverage, risk concentration, etc. are necessary • Macro-prudential supervision should closely complement micro-prudential supervision • The macro-prudential authority should have access to micro-prudential information, and vice versa • International cooperation • Regulatory arbitrage may lead financial intermediation to move to jurisdictions with lighter regulations • Considering increasing cross-border trading, sharing information and building a statistical database are needed

21. Policy Recommendations (International and Regional Levels)

22. Policy Recommendations (National Level: Public Sector)

23. Policy Recommendations (National Level: Private Sector)

24. EOD