Korea Capital Market Institute

Since inception in 2005, off-exchange retail foreign exchange transactions (also called FX or forex margin trading) in Korea have increased dramatically. In particular, trading volume in 2008 jumped by 540% compared to the previous year. The popularity of the FX margin trading is due to high volatility in the FX market, poor performance of traditional assets such as stocks and bonds, and low interest rates, all of which are associated with the recent global financial crisis. However, the vast majority of retail investors` accounts incurred huge losses and experienced margin shortages in a very short period of time. This led regulatory authorities to strengthen regulations on FX margin trading in order to protect retail investors. They raised margin requirements from 2% to 5%, and encouraged domestic FCMs to provide investors with bid/ask prices from multiple forex dealers. Unlike regulatory schemes in the U.S. and Japan, there are two major flaws in the domestic scheme for off-exchange retail FX transactions. One is that financial investment companies (FICs) such as securities firms and FCMs cannot engage in the FX dealing business because leveraged retail FX transactions are classified into “exchange-traded” derivatives in the Financial Investment Services and Capital Markets Act (hereafter “the Act”). Since FICs are only allowed to conduct brokerage businesses through the U.S. or Japanese forex dealers, retail investors pay unreasonably high transaction costs in terms of bid-ask spreads. If FICs receive bid-ask prices directly from the inter-bank market as overseas forex dealers do, they may be able to lower transaction costs for investors. The other major flaw is that investors are not allowed to trade the Korean won (KRW)?denominated currency pairs but cross-currency pairs. This policy aims to prevent domestic and foreign investors from speculating against the KRW and curb KRW exchange rate volatility. According to the Bank of Japan, however, FX margin traders tend to take positions against short-term market directions, and therefore may help reduce exchange rate volatility. Moreover, with KRW?denominated currency pairs, investors can easily perform carry trades and hedge against adverse moves in foreign exchange rates. For FICs to play as forex dealers, it is necessary to define off-exchange retail foreign exchange transactions as an OTC derivative product in the Act. At the same time, the Act, which currently permits retail investors to trade OTC derivatives only for the purpose of hedging, needs to be modified so that retail forex trading can be conducted for both speculative and hedging purposes. In addition, the regulations for financial investment businesses should be modified so investors can trade KRW?denominated currency pairs. This will not only enhance investors` convenience, control, and profitability of FX margin trading, but it may also help decrease exchange rate volatility.