Korea Capital Market Institute

As the global financial crisis progressed, the confusion in both the global and domestic financial markets became pervasive and the instability in the domestic swap market deepened. In this report we review the current state of the swap markets in Korea. We explore the factors that negatively impacted on the stability of the domestic swap markets. We offer some suggestions to improve the stability of the swap market. The usual relationship between the bond markets and the swap markets represented mostly by a rational risk premium structure has collapsed in recent years. The risk premium inversion known as the swap spread inversion characterized by treasury yields exceeding IRS rates(fixed rates in an interest rate swap) had a beginning in 2002, persisted thereafter and aggravated through the global financial crisis. The swap spread inversion where the IRS rate is lower than the treasury rate appears to be caused by the financial institutions` preference for fixed interest rate, increase in the issue of structured notes among others. Banks have issued bonds which pay fixed interest rates to fund their loan portfolios. Since their loan portfolios, especially the mortgage loans, receive floating interest rates, banks often hedge the floating rate loans by takin gthe IRS receive position. The heavy demand of the IRS receive position from banks has exerted a severe downward pressure on the IRS rates. There is yet another type of a swap market anomaly, an arbitrage opportunity for foreign banks. The arbitrage operations between the swap markets and the bond markets, which became very prominent during the global financial crisis, is structured as follows. Foreign investors take the CRS pay position in a cross currency interest rate swap, where they pay the fixed rate on the funds in Korean currency they receive, that is, pay the CRS rate and receive the LIBOR rates for the funds in the US currency they lend. The funds in Korean currency are invested in the Korean treasuries as is often the case, the foreign investors realize the arbitrage profits, which is the difference between the treasury rates and the CRS rates. Through the currency swap, the foreign investors can purchase Korean treasuries and lock in the arbitrage profit. If the foreign investors invest the Korean funds they borrow at the CRS rate in CD rate products instead and hedge the CD rates by taking the IRS receive position, then foreign investors realize the arbitrage profits, which is the difference between the IRS rates and the CRS rates. The Korean exporters have also played a role in creating the arbitrage opportunity for the foreign banks. The exporters sell the future receipts in the US dollars forward to hedge the exchange rate risk. In the process banks often have to sell the US dollars in the spot market to meet the regulatory limit on the net foreign currency holdings. Banks fund the US dollar requirement by entering into the currency swap with the Korean branches of foreign banks. This creates demand on the CRS receive position pushing the swap rate down. Similar trades occur when offshore funds managed by Korean fund management firms try to hedge the proceeds from the foreign investments adding to the demand on the CRS receive position. We make the following suggestions to help develop the swap markets. Presently domestic financial institutions are not true swap banks and act primarily as liquidity demanders in the swap markets. They need to play a market making role providing liquidity to the swap market. Korean swap markets are yet comparatively small so that they tend to show a large increase in volatility in times of a severe market disruption. To improve the stability in the swap markets, Korean swap markets must grow in size. Improvement in the trade execution system for the swap markets is necessary. The straight through process(STP) needs to be developed so that the entire trade system is completely automated. In order to increase the trade completion, we recommend that the central counter party(CCP) system be examined. There is a difference between the current repo market practice and the repo market that is adapted to the swap market. In order to facilitate the repo market operations required for the swap banks the treasury repo market specifically for the swap banks needs to be introduced. In order for swap banks to hedge embedded options, new types of options need to introduced. In short, all major markets linked with the swap market such as bond markets, derivatives markets, foreign currency markets and money markets need to be developed even further.