March 6, 2021

High & Low Finance: Korea Clamps Down on Traders for Playing Games

It should be something else entirely. Finance ought to provide an economy with an efficient means of allocating capital. It should provide a means of price discovery of assets, whether real or financial. It should provide a safe and reliable payments system. Financial innovations are worthwhile if, and only if, they help in those areas.

All too often, players see financial innovations as providing ways to manipulate the system and make money off less savvy traders. If the players are caught, the scheme is usually deemed too complicated and wrongdoing too hard to prove to justify any more than a civil case. That ends in a fine — sometimes a large one — but perhaps one that may be seen as a cost of doing business.

In South Korea, they seem to be adopting a different attitude.

This week prosecutors in Seoul announced indictments on market manipulation charges of a Korean affiliate of Deutsche Bank and of four Deutsche Bank employees who were blamed for intentionally causing a sudden collapse in Korean stock prices last November.

In a separate case in June, two former Credit Suisse employees were indicted by Korean prosecutors on charges of manipulating stock prices.

People could go to prison for playing market games.

The Deutsche Bank case sounds like a classic example of people knowing how to profit from a game and having no appreciation at all of the larger dimension of what they planned to do. The game caused the Korean stock market to tumble in the last few minutes of trading last Nov. 11. That happened to be the same day the leaders of the Group of 20 nations were meeting — in Seoul.

Having its market crumble for no apparent reason with world leaders and world press in town was more than a little embarrassing to the Koreans, and they began immediate investigations.

The names of the Deutsche Bank employees involved have not been publicly disclosed. But only one of them is based in Korea, with three in Hong Kong. The Koreans sent a letter to the Securities and Exchange Commission about another Deutsche employee, who is based in New York, but he was not indicted.

The traders probably paid little attention to the plans for the Group of 20 meeting. They chose Nov. 11 because it was a day when stock index options and futures expired. They had a way to make a lot of money with little if any financial risk.

The strategy did not involve taking positions based on expectations of corporate performance, or the path of the Korean economy, or interest rates, or anything that matters to the real economy. In other words, it had nothing to do with the legitimate functions of finance.

Here’s what prosecutors claim took place. The Deutsche Bank traders established a huge index-arbitrage position, and placed a huge side bet on prices falling. Then they closed out the arbitrage position in a way designed to cause prices to collapse. They cleaned up.

In the more formal language that Korean market regulators used in their report, the traders “constructed speculative derivatives positions in advance through the combination of short synthetic futures and long put options.” Then in the final 10 minutes of trading on Nov. 11, they sold $2.2 billion worth of stocks, selling every stock in the Kospi 200 index, which includes all major Korean stocks.

That selling had a huge impact. The Kospi 200 index fell 2.8 percent in those 10 minutes, providing $40.5 million in what the Koreans called “illegal profits” on the derivatives position, which settled based on the closing prices.

Ten minutes before the close, the Korean stock market was down only a very small amount from the previous day. At the close, it was the worst day in nine months.

Index arbitrage is supposed to be a neutral strategy. A trader buys stocks and sells the equivalent amount of stock index futures, taking advantage of small discrepancies in prices in the two markets. Or he sells the stocks and buys the future. Either way, at expiration, the two positions will be worth the same, and a small profit will be realized. The strategy used by Deutsche appears to have amounted to index arbitrage done in a way that local regulators might not see coming. A synthetic future uses options or forward contracts to replicate the financial position of normal futures contracts. Going synthetic can cost more, but it may also avoid margin requirements and regulatory disclosure rules on large positions.

Floyd Norris comments on finance and the economy at

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