From the 19th, ETF Tracking Error Management Will Be Tightened... Single-Stock Leveraged Paper Trading Will Be Mandatory

[Financial News] Starting on the 19th, the rules for managing tracking error in exchange-traded funds (ETF) and exchange-traded notes (ETN) will be tightened. Individual investors who newly invest in single-stock leveraged and inverse products will also be required to complete more than five hours of paper trading, in addition to a basic deposit of KRW 30 million and three hours of pre-investment education.
The Financial Services Commission (FSC) approved an amendment to the Korea Exchange Main Board operating rules at its first extraordinary regular meeting on the 12th. The move follows supplementary measures for single-stock leveraged products announced on the 16th and 29th of last month.
First, the tracking error range that securities firms must manage at the closing price for all ETFs and ETNs will be lowered. For domestic products, the current 3% threshold will be cut to 2%, while for overseas products it will be reduced from 6% to 5%. The calculation rules will also be clarified, including the use of absolute values when tracking error is calculated as a negative number.
Tracking error is an indicator that shows the gap between the market price of an ETF or ETN and its net asset value or index value. The further the market price deviates from the product's actual value, the greater the risk that investors will buy at too high a price or sell at too low a price.
The procedure for designating cautionary investment products will also be shortened. The current three-step process of removal, advance notice of designation, and designation will be reduced to two steps: removal and advance notice of designation, followed by designation.
If tracking error exceeds twice the management range, advance notice of designation will be issued at the same time as removal. That means 4% for domestic products and 10% for overseas products. If the same threshold is exceeded again within 10 trading days of the advance notice, the product will be designated as a cautionary investment product. If the threshold is exceeded for two consecutive days, designation can occur in as little as two days.
Once designated as a cautionary investment product, single-price trading will apply for three trading days. If tracking error falls back within the management range for three consecutive trading days during that period, the designation will be lifted. If the tracking error on the final trading day widens to at least three times the management range, trading will be suspended for one day before single-price trading resumes.
The Korea Exchange also plans to revise its enforcement rules to restrict new liquidity provision duties for liquidity providers (LP) that intentionally, through gross negligence, or repeatedly violate tracking error management obligations. The revision process is currently under way.
Entry requirements for single-stock leveraged and inverse products will also be tightened. From the 19th, individual retail investors seeking to newly invest in single-stock leveraged and inverse products listed in Korea or overseas must complete paper trading on the Korea Exchange.
The existing requirements of a KRW 30 million cash deposit and a total of three hours of pre-investment education will remain in place. The education consists of one hour of basic training and two hours of advanced training.
Paper trading must be completed over at least five trading days, for at least one hour per day and at least five hours in total. Investors do not need to log in every day. The system allows users to access the exchange website and trade with virtual funds based on same-day market prices.
The financial authorities said the paper trading requirement is intended to help investors experience the so-called "negative compounding effect," which can occur in leveraged products because they track multiples of the underlying asset's daily returns. When the underlying asset's price fluctuates repeatedly, long-term returns can differ from the simple leverage multiple.
Investors who newly buy single-stock leveraged products listed overseas will be subject to the same paper trading requirement. However, instead of building a separate paper trading system for overseas products, they will use a Korea Exchange system based on domestic data. The Korea Financial Investment Association is revising related rules for this purpose.
After the financial authorities raised the basic deposit to KRW 30 million in cash on the 31st of last month, trading in single-stock leveraged products dropped sharply.
According to FSC data, trading value in related products rose from KRW 10.4 trillion on May 27 to KRW 12.4 trillion on July 30, then fell to KRW 700 billion on August 11. That is about 5.6% of the July 30 level. From the 4th to the 10th, redemptions worth KRW 1.4 trillion occurred.
The FSC, the Financial Supervisory Service, the Korea Exchange, and the Korea Financial Investment Association plan to monitor market conditions and implement additional follow-up measures related to single-stock leveraged products announced last month.

[email protected] Kim Mi-hee Reporter