The Korean Mistake: A Warning for India's Derivatives Market

As Indian regulators discuss potential changes to the derivatives market, including possibly removing weekly expiries, history offers a powerful cautionary tale from another Asian powerhouse: South Korea.

Years ago, South Korea tried to “protect” its market by severely restricting retail access to derivatives. The experiment backfired spectacularly, forcing regulators to reverse course to revive a market they had inadvertently destroyed. This story is a crucial lesson for every Indian trader, investor, and policymaker.

A Derivatives Giant’s Rise and Spectacular Fall

In the late 1990s and early 2000s, South Korea was a global force in derivatives. With the launch of KOSPI 200 futures in 1996 and options in 1997, the market exploded. Retail and institutional participants flocked to these products, making Korea one of the largest and most active derivatives markets in the world.

However, this success story began to unravel. Growing concerns about speculation culminated in a major scandal. On November 11, 2010, a massive sell order in the final minutes of trading caused a sudden 2.7% crash in the index, wiping out option sellers. The manipulation was traced back to Deutsche Bank, which was subsequently penalized.

This event triggered a regulatory panic. In 2011, authorities brought down the hammer with a series of harsh restrictions:

• Retail access was severely curbed with high entry barriers.
• Margin requirements were tightened significantly.
• The variety of available products was limited.
• A “suitability test” was introduced, effectively blocking many retail traders.

The Unintended Consequences: A Market on Life Support

The results were swift and devastating. Trading volumes plummeted. The vibrant ecosystem built over a decade vanished almost overnight.

The downsides were numerous:

• Retail Exodus: The retail traders who provided crucial liquidity disappeared. They didn’t stop trading; they simply moved to other arenas like cryptocurrencies and overseas markets.
• Foreign Dominance: The remaining market became dominated by foreign institutions, making it shallower and more susceptible to large, concentrated moves.
• Economic Stagnation: The broader capital market lost its dynamism. The main index, the KOSPI, delivered muted or negative returns for years, failing to attract new investors. The enthusiasm that once defined the market evaporated.

The attempt to protect investors had backfired, strangling the market’s growth and making it less attractive for everyone.

The Painful Road to Recovery

By the mid-2010s, the damage was undeniable. Korean regulators acknowledged their mistake and began the slow, arduous process of undoing it. They started easing restrictions, inviting retail participants back, and introducing new products to breathe life back into the markets.

In a move that shows just how far they’ve come, Korea has now gone full circle. In recent years, they have introduced more frequent expiries, such as Monday weekly options, to complement the existing Thursday ones. They have also broadened their offerings to include KOSDAQ 150 weeklies, ETF futures, and sector futures, all in an effort to regain their lost vibrancy.

Lessons for India

The Korean saga offers clear, undeniable lessons as India stands at a similar crossroads.

1. Over-regulation Kills Liquidity, Not Risk. The primary lesson is that heavy-handed regulation doesn’t eliminate risk; it just kills the market. Liquidity, provided by a diverse base of retail and institutional participants, is the lifeblood of any healthy market. Driving away participants creates a shallow, illiquid market that is actually more dangerous and less efficient.

2. Punish the Manipulator, Not the Product. The Korean clampdown was triggered by a manipulation scandal. However, the response was to cripple the product instead of strengthening surveillance and punishing the culprits more effectively. Insider trading is a known problem in equity markets, but no one suggests banning stocks. The same logic should apply to derivatives. The goal must be to ensure a fair and level playing field, not to shut the field down.

3. Capital Will Always Find an Outlet. Banning or restricting derivatives won’t stop people from speculating. It will only push them into less regulated, often more dangerous, avenues like offshore markets or cryptocurrencies. This not only leads to a loss of capital and tax revenue for the country but also removes any chance of regulatory oversight.

Some argue that India’s cash market is strong and doesn’t need a vibrant derivatives segment. This view misses the symbiotic relationship between the two. Derivatives are essential for hedging, price discovery, and providing liquidity to the underlying cash market. Others suggest that moving to only monthly expiries is a soft touch, but it would still drastically reduce volumes and hurt the entire ecosystem of brokers, traders, and fintech platforms built around the current market structure.

History is whispering a clear warning. While the intention to protect retail investors is noble, the path chosen by Korea in 2011 led to a dead end. India should learn from this mistake, not repeat it. The focus should be on robust surveillance, investor education, and strict penalties for manipulation—not on blunt instruments that could cripple one of the world’s most dynamic equity derivative markets.