Seoul eyes Hong Kong-style flexible leverage structure for single-stock ETFs

The government has proposed Hong Kong's "flexible leverage" structure as an additional measure for single-stock leveraged ETFs. The move comes as volatility has intensified sharply in the Kospi and Kosdaq markets — with circuit breakers triggered on two consecutive days — and losses for retail investors in leveraged ETFs have mounted, prompting authorities to pursue a legal framework to address the situation.

According to the financial investment industry, the government decided Thursday to establish a legal basis that would allow financial authorities to take market-stabilization measures in emergency situations, drawing on Hong Kong's flexible leverage ratio model. The decision came out of an emergency market review meeting held Wednesday at Government Complex Seoul, attended by Deputy Prime Minister and Minister of Economy and Finance Koo Yun-cheol, Bank of Korea Governor Shin Hyun-song, FSC Chairman Lee Eok-won and Financial Supervisory Service Director General Lee Chan-jin.

Hong Kong's Securities and Futures Commission announced Friday that it would apply a flexible leverage structure to leveraged and inverse products whose capacity fluctuates significantly with market conditions, allowing the target leverage ratio for the next trading day to be adjusted daily depending on market and operational conditions.

Under the revised rules, fund managers may set the next trading day's target ratio within a range of up to 2x for leveraged products and up to -2x for inverse products. Managers must disclose the applicable target ratio for the following trading day on their own websites and on the Hong Kong Stock Exchange website after each market close. Product names must also indicate both the flexible leverage feature and the maximum leverage ratio.

Hong Kong-based CSOP Asset Management announced Monday that it would change the investment objectives and names of its single-stock leveraged and inverse products in line with the SFC's revised rules. CSOP was the first asset manager in the world to launch single-stock leveraged products tracking Samsung Electronics and SK Hynix, doing so last year.

CSOP will apply the flexible leverage structure to its single-stock leveraged products starting Monday. The company said that under normal market conditions it targets 2x leverage for leveraged products and -2x for inverse products, but that it could lower the ratio if operational constraints or cost burdens arise. "In extreme market conditions, leveraged products can be adjusted down to a minimum of 1.1x, and inverse products to a minimum of -1.1x," it said.

The SFC said the revision is intended to improve investors' understanding of product characteristics while enhancing issuers' operational flexibility, contributing to sustainable market development.

This approach differs from the ratio-reduction proposal put forward by domestic political circles. The Democratic Party of Korea's special committee on the "Korea Premium K-Capital Market" said July 22 that it was reviewing a plan to lower the target leverage ratio for single-stock leveraged products from the current 2x to 1.5x or similar.

That fixed-ratio approach would reduce the target multiplier of existing 2x products to 1.5x and hold it there permanently. Its advantages include a narrower range of profit-and-loss swings regardless of market conditions and a target ratio that is easier for investors to understand. The Hong Kong-style flexible leverage model, by contrast, maintains the existing 2x structure under normal conditions but lowers the target ratio when market shocks intensify or when operational conditions — such as the liquidity needed for rebalancing or futures and options position limits — deteriorate. Because the ratio can be raised back to 2x once markets stabilize, the approach offers considerably greater operational flexibility.

Given that the government explicitly cited the Hong Kong case, some observers suggest the focus may shift toward a variable approach that allows financial authorities or fund managers to adjust leverage ratios flexibly in emergency situations.

However, both approaches require a unitholder meeting vote, since they involve changing the target ratio of already-listed products. Under Article 188, Paragraph 2 of the current Financial Investment Services and Capital Markets Act, any material change affecting unitholder interests must go through a unitholder meeting. A change requires the approval of a majority of voting rights held by unitholders present, as well as the consent of at least one-quarter of all issued beneficiary certificates outstanding.

The government's reference to "establishing a legal basis" is widely interpreted as an effort to remove this institutional barrier. For any change to take effect, the adjustment of a leveraged product's target ratio would need to be either exempted from the unitholder meeting requirement or given a separate legal basis.

"The industry has long interpreted changes to investment strategy — including target ratio adjustments — as subject to a unitholder meeting vote," said one official in the asset management industry. "There is debate over whether this requires a legislative amendment or can be resolved through an authoritative interpretation, but given that the government mentioned establishing a legal basis at Wednesday's meeting, it appears to view this as a matter requiring a change in law."

The push for additional measures, even as the government has already announced and pursued supplementary steps for single-stock leveraged products, reflects the extreme volatility gripping domestic markets. Circuit breakers were triggered simultaneously in both the Kospi and Kosdaq on Tuesday and Wednesday, and sharp declines in Samsung Electronics and SK Hynix are estimated to have significantly widened losses for retail investors in single-stock leveraged ETFs.

In an Asia trading strategy report released Wednesday, Citigroup said the balance of domestic underlying-asset leveraged ETFs had fallen from a peak of $52.5 billion on June 22 to $19 billion. "Notably, $6.2 billion in new subscriptions flowed in even as losses were mounting," Citi said. "Factoring that in, cumulative losses sustained by retail investors in leveraged ETFs are estimated at approximately $38.7 billion."

Retail investors dominate the market by a wide margin. Financial Supervisory Service Director General Lee Chan-jin said at a press briefing last month that retail investors hold approximately 92 percent of single-stock leveraged products.

The financial investment industry has also moved to respond. The Korea Financial Investment Association held an emergency meeting Wednesday to discuss voluntary measures for market stabilization and investor protection. The meeting was attended by the heads of asset management firms running single-stock leveraged products and by executives from securities firms serving as liquidity providers.