New rules to limit sales of structured notes

Korean brokerages may face a funding squeeze as new rules curb their ability to sell structured notes.

Regulations outlined in December 2013 and that take full effect on Jan. 1, require brokerages to have a maximum asset-to-equity ratio of 13:1 or risk disciplinary action, including being required to dispose of nonperforming assets or curtail expenditure. Moody’s Investors Services says the introduction of such a limit could boost the cost of capital as firms raise funds elsewhere. Sales of equity- and derivative-linked securities in Korea, most of which are issued by brokerages, have averaged about $8 billion a month in 2015.

Despite regulatory efforts to consolidate the fragmented industry, there are still about 58 securities firms in Korea, down from 63 at the end of 2013. Profits are under pressure due to a stock-price slump and firms have been lowering their brokerage fees to compete. According to Moody’s, putting a cap on leverage should mitigate some of that downside.

“Specifically, it will help to reduce the industry’s overall leverage ratio,” Hong Kong-based Moody’s analyst Jeffrey Lee said. “Funding will improve as the newly introduced leverage regulation will likely prompt the industry to increase its use of equity for funding and decrease structured note issuance.”

Structured notes, often branded as wealth management products, offer investors a higher yielding alternative to bank deposits. The Bank of Korea kept its key interest rate unchanged at a record low 1.5 percent last week as it gauges uncertainties for the economy from China’s slowdown and a possible policy shift by the Federal Reserve.

Sales have averaged $8.3 billion a month this year and rose to a record high $10.7 billion in March, Korea Securities Depository data shows. Brokerages tapped clients for as much as 60 percent of total funding in 2014, as the higher yield of structured products appealed “amid the falling interest rate environment,” Moody’s said. Securities firms welcomed the stable fee income from selling wealth products.

Regulations that limit leverage will help relieve the strain structured note issuance has put on Korean brokerages’ funding profiles. The industry’s overall leverage ratio climbed to 743 percent in the first quarter from 468 percent in 2010 because of the jump in client-sourced funding.

Some securities firms still have a fair degree of headroom when it comes to such ratios, so at least in the short term equity- and derivative-linked product offerings will keep increasing, Gyun Jun, a Seoul-based analyst at Samsung Securities Co., said. Equity-linked issuance may be over 90 trillion won ($76.9 billion) this year, up 20 percent on 2014, he said.

What will probably have more of an impact on structured note offerings in Korea is market turbulence in China and the global commodities rout, Jun said. “Some equity-linked securities related to the Hang Seng China Enterprises Index have lost their chance of early redemption,” he said, referring to situations where investors are able to get their money back ahead of time upon a certain trigger event.

The measure of Chinese shares in Hong Kong has declined 33 percent from its peak this year in May. Korea’s benchmark Kospi gauge has fallen 9 percent from a high this year in April.

Korea’s won has weakened 6.8 percent against the greenback this year, including a 1.1 percent depreciation since China devalued its currency in August. Ten-year government bond yields have fallen 34 basis points to 2.296 percent since Dec. 31.

“Brokerages’ leverage has increased partly due to the sales of equity-linked securities,” Lee Chul-ho, an analyst at Korea Investment & Securities, said. “I don’t think the regulations will affect the demand of equity-linked securities significantly, but it’s a bit naive to expect the demand will continue to grow as fast.”

Bloomberg