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Pre-examination of OTC derivatives

The Financial Investment Services and Capital Markets Act (the FISCM) of Korea, which became effective on April 1 2009, emphasises following four regulatory areas: (i) the concept of financial investment products defined on the basis of a negative system (where related actions are allowed unless expressly prohibited), (ii) regulation of financial investment businesses according to function, (iii) expansion of the scope of financial investment businesses, and (iv) modernisation of the investor protection system.

The FISCM thus far has been amended a number of times, with a few additional amendments proposed. In particular, the Proposal on the Adoption of Pre-examination of OTC Derivatives before the National Assembly is drawing attention and controversy. The Proposal was submitted by 16 Assemblymen on April 10 2009, and is before the National Policy Committee, a standing committee within the National Assembly. In Korea, many disputes arose in the second half of 2008 between small and medium-sized companies and banks over certain synthetic currency option derivative products with knock-in knock-out conditions sold by the banks (the so-called Kiko cases), and it is understood that the Proposal was submitted in order to prevent similar future cases.

The rationale behind the Proposal is as follows: (i) although the FISCM systematically defines financial derivative products and provides a regulatory framework to respond to rapidly changing financial markets by expanding the scope of underlying assets, the FISCM still lacks preventative means of regulation and supervision to deal with uncertainties and risks of the OTC derivatives, and (ii) the Proposal introduces pre-examination of OTC derivatives by a self-regulatory body in order to preventatively control potential adverse effects caused by newly developed OTC derivative products and to enhance the protection of ordinary investors. The main points of the Proposal can be summarised as follows: (i) OTC derivative products, of which underlying assets are difficult to accurately evaluate because their markets have not yet been properly formed (products based on credit risks or risks from natural, environmental, or economic conditions), and new OTC derivative products for ordinary investors, except for certain cases, shall be pre-examined by the OTC Derivative Products Examination Board, and (ii) the Board shall be formed within the Korea Financial Investment Association to pre-examine such OTC derivative products.

Such an apparently redundant regulatory structure may raise the following issues: (i) the key to investor protection does not lie in the products themselves, but with having transactions entered into by fully informed parties – and the FISCM already provides sufficient protective measures for ordinary investors; (ii) under the FISCM, the concept of a professional investor in OTC derivative transactions has been narrowed, and the so-called appropriateness rule has been adopted in addition to the general principles of the regulation of solicitation (know-your-customer-rule, suitability rule, and duty to explain) even in cases where there are no solicitations for investment; (iii) the FISCM requires financial investment companies to confirm ordinary investors' intention to hedge when selling OTC derivative products to them and prescribes other provisions regulating the qualifications of salespersons or other personnel handling derivative products; and (iv) the FISCM takes other strict measures to regulate the integrity of the financial investment companies selling OTC derivative products, and there are also restrictions on credit or exotic derivatives in terms of foreign exchange regulation.

Furthermore, the following objections to the Proposal can be raised regarding unbalanced regulation and unintended consequences: (i) unnecessary securities could be issued excessively, and it could be viewed as unbalanced regulation in the case of derivatives-linked securities, since these could be exempted from pre-examination even though they are guaranteed-sale products; (ii) since almost no country has a pre-examination system, this could invite regulatory arbitrage between domestic and foreign companies, leading to reverse discrimination against domestic financial investment companies; (iii) despite the fact that most OTC derivative products are sold by banks, pre-examination will be conducted by the Korea Financial Investment Association, which is to a certain extent in a de facto competitive relationship with banks; (iv) the meaning of the phrase, "new OTC derivative products for ordinary investors," is ambiguous, and thus, a substantial number of OTC derivative products could be subject to pre-examination; (v) the entity conducting the examination may not be properly qualified to provide the requisite expertise, promptness in determination and confidentiality; (vii) the examiner might be held responsible for its examination on an ex-post facto basis by those that suffer damages; (viii) the principle of self-responsibility could be undermined as investors rely on the pre-examination rather than their own judgment, and increased costs may actually undermine investor protection; (ix) as the pre-examination is likely to be managed conservatively, it could result in delays and reduced number of transactions; (x) launching of OTC derivative products based on new underlying assets could become difficult, causing a reduction in scope of the OTC derivative products contrary to the fundamental purpose of the FISCM; (xi) regulation could lead to reduced market activities in the OTC derivative products with reduced participation by hedging parties, which could in turn lead to reduced market activities for exchange-traded derivatives; (xii) appeal procedures against pre-examination results are not clear; and (xiii) the risk-return structure of OTC derivatives cannot be definitely evaluated until the status of a counterparty's underlying assets is confirmed, which suggests that an examination system on an ex-post facto basis under certain conditions should be considered if any examination system is required.

Given these issues, it will be interesting to see whether or not the Proposal becomes law, or whether any supplementary provisions will be presented.

By Soonghee Lee

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