South Korea’s financial regulators are planning to launch a joint investigation into banks, securities companies and asset managers within this month as investors who purchased derivatives-linked fund (DLF) products based on the interest rates of major countries are highly likely to lose up to 95 percent of their principal.
According to the Financial Supervisory Service (FSS), banks and securities companies sold a total of 822.40 billion won (US$680.18 million) worth of DLF products and derivatives-linked securities (DLS) as of Aug. 7. Individual investors bought 732.60 billion won (US$605.81 million) worth of the products, accounting for 88 percent of the total. It means that each retail investor invested about 200 million won (US$165,370) in such products.
The FSS said on Aug. 20 that it will first look into how financial institutions, including banks, came to sell the foreign interest rate-linked derivatives products, which have a complex structure and a high risk of losing money, to a considerable number of retail investors.
DLF and DLS products are derivatives linked to the interest rates of major countries. Banks sold DLF products in the form of private equity funds investing in derivatives-linked securities. Securities firms directly sold DLS products. These products guarantee an annual return rate of 3.5 percent to 4 percent if the interest rates remain at a certain level until maturity. However, they start losing money if the interest rates fall below the baseline. In the worst case scenario, investors can lose all of their money.
The FSS said most of the products were sold in the form of DLF through private bankers at banks. It intends to focus on the appropriateness of the product design and allegations of incomplete sales by bank officials.
Woori Bank and Hana Bank will be the first targets of the joint investigation as they were most active in selling the controversial DLF products. Woori Bank sold 401.20 billion won (US$331.79 million) worth of DLF products, taking up 48.8 percent of the total, while Hana Bank sold 387.60 billion won (US$320.57 million), or 47.1 percent.
The financial regulator is also planning to check if securities companies properly designed the products sold by banks. An FSS official said, “It is hard for investors to understand the products. Some products have a high level of leverage so some investors are expected to lose up to 90 percent of their money at the expiration. We will look closely into whether financial institutions intentionally did not run their internal control systems simply to earn sales commissions.”
The financial regulator has come forward as most of the products sold by financial institutions have entered a loss section. Out of the 822.40 billion won (US$680.23 million) worth of the products sold, 695.80 billion won (US$575.52 million) is linked to the U.K. pound 7-year constant maturity swap (CMS) rate and the U.S. dollar 5-year CMS rate as an underlying asset. As the CMS rates in the United Kingdom and the United States have decreased, 597.30 billion won (US$494.96 million) worth of the two products, or 85.8 percent of the total, have entered a loss section.
Of the products linked to the U.K and U.S. CMS rates, 49.20 billion won (US$40.69 million) will come due this year, 614.10 billion won (US$507.90 million) next year and 32.50 billion won (US$26.88 million) in 2022. Investors cannot avoid taking losses unless interest rates rebound before maturity. The expected loss rate stands at 56.2 percent if interest rates remain at the current level until maturity. The figure goes up further if interest rates go down. If one of the two underlying assets becomes 0 percent at maturity, investors will lose the total amount of principal. The rate of return will be -96.5 percent if investors receive the coupon rate at maturity.
In particular, 126.60 billion won (US$104.72 million) worth of the DLF products based on the interest rate of Germany's 10-year government bonds has already entered a 100 percent principal loss section as the relevant interest rate has fallen below -0.7 percent. The expected loss rate is 95.1 percent. The products linked to Germany’s government bonds will mature in September to November this year.