Option expiration shock, Nov 11, 2010 and follow-up measures and system implementations

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On November 11, 2010, option expiration shock occurred in South Korea due to unfair trading and risk management status of financial investment companies in relation to the selloff, which sparked the stock market plunge. On the next day, Korea Exchange (KRX) and the Financial Supervisory Service (FSS) organized an investigation team to carry out unbiased and reasonable investigations. According to the investigation result, it turns out that financial investment companies violated prohibition on market manipulation through the link between spot and futures and neglected the management and supervision of internal control system against market manipulation. As the investigation team figured out the market manipulative transaction, the regulators set a long term plan to reform and stabilize the current market system. Here are some measures and guidelines under consideration by regulators for November 11, 2010.

Strict settlement risk management

1) Tightening the margin rule

The regulator will consider evaluating the settlement risk of a qualified institutional investor and determine the grade to impose margin requirements on the investor prior to trading when it fails to meet certain grade requirements. Currently, qualified institutional investors are allowed to deposit margins on a post facto basis.

2) Setting a daily order limit for each qualified institutional investor

The regulator will consider setting a daily order limit for each qualified institutional investor based on total margin amount.

Reform of trading system

1) Implementing the random end rule for single price trading

If the gap between the expected matching price at 14:50 (currently at 14:55) and the tentative market price (closing price) is 5% or more, the deadline for submitting quotations will be extended within 5 minutes to prevent sharp price movements. Industrialized countries such as Germany, the UK and France already introduced such a rule to mitigate steep fluctuations in matching prices.

Sound derivative markets

1) Setting derivative position limits

The regulator will consider setting limits for the maximum positions that may be taken for derivatives including option contracts through a thorough analysis of global practices. Currently, the regulation only sets forth how many contracts a speculative investor may hold for futures (5,000 contracts for an individual investor and 7,500 contracts for an institutional investor) in Korea, but US and Hong Kong implemented position limits for both futures and option contracts.

2) Reporting large holdings

The regulator will consider a reporting duty for large holdings of derivatives. Currently, holders of commodity derivatives (based on gold and pork) are required to report on large holdings and change in holdings above certain volume. In the US and Hong Kong, reporting for large holdings of option contracts is mandatory.

These are system implementations and the investigations conducted in a thorough and comprehensive manner without delay by regulators. The task project team consisting of experts, relevant institutions and the industry will discuss system reforms currently under consideration to ensure sound derivatives market. So people expect these measures to strengthen settlement risk management, reform the trading system and make sound derivative markets in Korea.

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