Securities firms have been caught engaging in illegal “bond shuffling” practices, transferring bond losses, sometimes amounting to as much as 500 billion won (US$383.44 million), to other clients in an attempt to preserve investment returns for certain institutions and corporations. These activities were recently uncovered in comprehensive inspections by the Financial Supervisory Service (FSS).
On Dec. 17, the FSS announced the results of concentrated inspections on nine securities firms regarding bond-type wrap account (wrap) and specific monetary trust (trust) operations. The inspections revealed various illegal activities, including self-trading, as well as instances of inadequate internal controls.
Wrap and trust are financial products where securities firms manage assets through one-to-one contracts with investors. The principle of these products is not to guarantee the principal as performance-based dividend products. However, securities firms have traditionally been selling them as if they were principal-protected, engaging in a competitive race for returns.
According to the inspection results from the FSS, all nine securities firms were found to have participated in illegal self-trading, transferring losses from one investor’s account to another multiple times. One prevalent example involved selling investment assets such as commercial paper (CP) from customers whose investments had matured to another securities firm at a higher price than the market value. In return, the securities firm purchased other CP from the selling firm at an inflated price using the accounts of customers whose investments had not yet matured.
One securities firm engaged in “bond passing” practices for about a year, starting from July of the previous year, through approximately 6,000 linked and substituted transactions with another securities firm. Ultimately, this resulted in transferring losses totaling 500 billion won (US$383.44 million). In the process, some investors incurred losses. The losses transferred through such practices vary for each securities firm, ranging from tens of billions to hundreds of billions of won. There are speculations that the overall industry-wide scale could be in the trillions of won.
Bond-type wrap and trust products are typically subscribed to by corporations and institutions looking to roll over short-term excess funds for a period of three to six months. Securities firms need to include short-term liquid instruments in their assets to ensure the timely redemption of investment funds. However, there has been a prevalent industry practice where securities firms manage these products by including long-term bonds with maturities of three to five years or low-liquidity instruments like CP. This practice, known as “maturity mismatch management,” has been adopted to guarantee high returns for corporate clients.
This management practice had not been a significant issue in normal circumstances. However, the situation changed dramatically in the second half of last year when the so-called “Legoland incident” occurred. With the incident, bond interest rates surged and trading was suspended, leading to trillions of won of losses in the bond-type wrap and trust products due to valuation losses resulting from maturity mismatch management. The securities firms, facing substantial losses and unable to return the investment funds, are suspected of using various means, including self-trading and corporate assets, to preserve the returns for corporate clients. This suspicion has prompted investigations by the FSS since May of this year.
The financial regulatory authorities are taking a firm stance on this matter. Given that these transactions were originally prohibited, they plan to use this inspection as an opportunity to tighten control. The FSS intends to report the main allegations against the nine securities firms and around 30 operators responsible for the profit and loss transfer transactions to the investigative authorities. The FSS views their abnormal trading of assets at inflated prices, resulting in passing on losses to customers, as a serious breach of duty in the course of their work.
The possibility of administrative sanctions against owners has also been raised. The FSS previously indicated its intention to hold owners directly accountable for unethical business malpractices. Ham Yong-il, vice chairman of the FSS, stated, “If any department, including compliance, risk management, and audit, fails to prevent illegal activities related to wraps and trusts, it is a serious issue indicating that the overall internal controls were not functioning. The ultimate responsibility for internal control lies with the top management, and it cannot be considered unrelated to them.”