Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Using options to evade futures position limits

What happens when a Briton, a Frenchman and an Australian in Hong Kong conspire with an American in New York and a Korean in Seoul to make money for the German financial giant for whom they all work? The answer according to the Financial Services Commission (FSC) of Korea is that the Korea Stock market index drops 2.79% in the last ten minutes of trading and Deutsche Bank’s Korean securities unit makes $40 million of profit.

According to the press release put out by the FSC yesterday, Deutsche Securities Korea created a large short position in the index derivatives market and then sent massive ($2.2 billion) sell orders into the cash market in the last 10 minutes of trading on expiry day (November 11, 2010). Position limits in the index futures market would have prevented them from establishing such a large short position, but for some strange reason, the Koreans did not have any position limit in the options market.

Deutsche Securities Korea therefore created synthetic short futures positions by simultaneously buying put options and selling call auctions. By put call parity, this combination is economically equivalent to a short futures position. In addition, they also bought put options, but unlike the synthetic futures, these options would have incurred a cost in terms of the upfront premium.

Belatedly, the FSC has realised that position limits are required as much in options as in futures. Last month, the FSC announced new rules establishing a position limit in index options roughly equal to a quarter of the position that Deutsche Securities Korea held on November 11, 2010. Hedging and arbitrage activities are exempted from this position limit, but this exemption is not available on expiry day.

FSC also banned Deutsche Securities Korea from trading shares and derivatives for its own account for six months. The individuals concerned will be prosecuted separately.

Compared to other investigative orders that I have read (from the US, UK, India and Australia), the Korean order appears to me to be short on detail. I think that in matters like this, it is important for the regulators to provide detailed information not only to increase their own credibility, but also to strengthen private sector surveillance and discipline.

For example, the FSC says the stocks that were sold in the cash market in those 10 minutes had been purchased through index arbitrage trading. Since there were position limits in the futures market, stocks purchased through index arbitrage could have accounted for only a small fraction of the total sales. Where did the remaining sales come from? If these were sold short, how was the short covered? Moving the market with a large trade is easy; making money out of this after getting rid of the resulting position (“burying the corpse” as we often call it) is harder. The FSC does not explain how this was done.

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