Korea's stock market has been forced to pause 41 times this year. All of 2008 had 26.

On July 24, Kospi fell 5.72% and set off a sell side sidecar at 11:23 a.m. Korea time, and Kosdaq set off one of its own at 11:47 a.m. For Kospi, it was the 41st sidecar of the year, and the year is not yet seven months old.

Between January 2 and July 24, the Kospi market set off 41 sidecars, 20 on the buy side and 21 on the sell side, according to Korea Exchange figures compiled by Seoul Economic Daily on July 25. In all of 2008, the year of the global financial crisis, Kospi set off 26. In all of last year, it set off only 3.

What a sidecar is, and what it is not

A sidecar is not a full stop. When futures move 5% or more from the previous day's close and stay there for a full minute, the exchange freezes program trading for five minutes, the automated orders that fire off baskets of stocks all at once. Ordinary buying and selling keeps going. The idea is to take the machines out of the market for a moment and let the humans catch up.

The circuit breaker is the serious one. That halts trading on the entire market for 20 minutes, and Korea has fired 7 of them this year. Since the system was introduced in 2000, there have been 13 in total, so more than half of all the circuit breakers in its history have happened this year.

July has been the worst stretch. Since July 15, Kospi has gone without a sidecar on only one trading day. In the week ending July 24 it set one off on four of the five sessions, on the 20th, 21st, 22nd and 24th. The exception was July 23, and even that day did not pass quietly, because Kosdaq set off a buy side sidecar of its own at 2:27 p.m. Korea time. All the times here are Seoul times, and a Korean trading day runs overnight for anyone watching from the United States, so Friday's Seoul session ends before New York opens on Friday morning.

Analysts keep pointing at the same two stocks

On May 27, Korean asset managers listed a set of exchange traded funds that track two times the daily move of a single company, and the two companies were Samsung Electronics and SK Hynix. There have been 41 trading days since that listing. Seoul Economic Daily counts a sidecar on 23 of them, which is 56% of the days.

Park Woo-yeol, a researcher at Shinhan Investment Securities, said the structure of the Korean market is what makes these products dangerous here in a way they are not elsewhere.

"In the US, where the single stock leverage ETF market is active, a single stock makes up about 8% of a product, so the effect on the whole index is not large," Park said. "But in our country, Samsung Electronics and SK Hynix come to 65% of Kospi 200 market value, and the leverage ETFs that hold only those stocks carry a lot of liquidity."

Shin Hyun-yong, an analyst at Yuanta Securities, explained why the effect feeds on itself. "The larger the price swing in the underlying stock, the more the rebalancing expands to maintain the leverage, which amplifies the volatility of that stock again," Shin said. "The effect this product has on volatility is going to be bigger in the future than it is now." A fund that promises two times a stock's daily move has to buy more of it when the stock rises and sell more when it falls, every single day, and the bigger the move the bigger the trade it is forced to make the next morning.

Park Sang-hyun, a researcher at iM Securities, said the change shows up in how much of the market’s daily activity the two chipmakers absorb. "The two stocks’ share of trading value was around 30%," Park Sang-hyun said of the period before the funds listed, adding that after they were introduced the trading share became abnormally high.

The Bank of Korea put numbers on that in a written answer it submitted to parliament on July 5. Samsung Electronics and SK Hynix together made up 36.1% of Kospi market value at the end of last year and 55.3% by June 24. Their share of trading value went from 27.9% to 63.5% over the same stretch. The bank warned that with the two already worth more than half the market, wider investment in single stock leverage ETFs could deepen that concentration.

One institute says everyone is blaming the wrong thing

Not everyone in Korea accepts that reading. The Capital Market Research Institute, a state funded research body, published work at the end of June concluding that the leverage ETFs had only a limited direct effect on volatility and that global conditions did more of the damage. That was before the worst of July.

Jang Geun-hyuk, a senior research fellow at the institute, said the timing made the ETFs an easy target. "While ETF rebalancing may have had some effect, various factors including geopolitical risks in the Middle East and global monetary policy uncertainty operated together," Jang said.

The institute's own numbers show SK Hynix's annualized volatility rising from 90% to 101%, a real increase, but a smaller one than several US chip stocks and indexes recorded over the same period. Jang still told investors to watch for risks intensifying after price rallies and for concentration risk in specific stocks.

The government is now deciding what to do

On July 10, presidential policy director Kim Yong-beom said the government would convene a market assessment meeting bringing together the Finance Ministry, the Financial Services Commission, the Financial Supervisory Service and the Bank of Korea to examine whether changes are needed. Kim said officials would carefully review the market impact over the month and a half the products had been trading before deciding on next steps.

Since then the Financial Services Commission has tightened the rules on those funds, raising the cash deposit required to trade them and setting a minimum order size. Retail investors pushed back hard on that rule, arguing it squeezes individuals and leaves the firms that created the products alone.

Meanwhile, the borrowed money is leaving

The other thing happening underneath all this is that Koreans are unwinding the debt they used to buy stocks with. Credit trading balances stood at 32.75 trillion won ($22.3B USD) on July 23, the lowest in three months. Short term margin debt fell to 945.4 billion won ($645M USD), the first time it has been under that mark since April 23.

So the leverage is draining out of the market. The volatility has not gone with it.

Sources

• Seoul Economic Daily (Korean language): Kospi has set off 41 sidecars in half a year, more than during the global financial crisis, July 25
• Seoul Economic Daily (Korean language): a shaken market, a sidecar every day but one since July 15, July 24
• Jeonnam Ilbo (Korean language): Capital Market Research Institute says global factors acted together, June 30
• Herald Business (Korean language): the Bank of Korea’s written answer to parliament on Samsung and SK Hynix concentration, July
• Seoul Economic Daily (Korean language): Kim Yong-beom says leverage ETFs will be adjusted if needed, decided at the market review meeting, July 10

Figures are from South Korean market reporting as described above, converted to US dollars at 1,466.6 won to the dollar, the July 24 close. This is general market commentary and not investment advice. Always do your own research and consider speaking with a licensed financial professional before making any investment decision.

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