Leveraged ETFs act as an amplifier of volatility in the South Korean stock market! $6 billion mechanical selling causes chaos in the market.

After South Korean regulators indicated that they are studying measures to curb the risks posed by leveraged exchange-traded funds (ETFs) tracking the stock of Samsung Electronics and SK Hynix, leveraged ETFs tracking these two storage chip giants may have collectively sold about $6 billion worth of stock on Tuesday to maintain their leverage ratio. Data shows that the selling of these leveraged ETFs on Tuesday accounted for about 14% of the daily trading volume of Samsung Electronics and SK Hynix. Financial Supervisory Service Chief Lee Chan-jin said at a press conference on Monday that regulatory authorities are considering enhancing monitoring of trading patterns and exploring other market stability measures to limit the potential impact of these ETFs' sharp fluctuations. These leveraged ETFs invest in the underlying securities with leverage through instruments such as derivatives and swap contracts, allowing investors the opportunity to achieve returns that are significantly higher than the underlying asset's price appreciation. While these ETFs can amplify investment returns, concerns about their potential to further exacerbate market volatility are on the rise. Lee Chan-jin pointed out, "The vast majority of investors are middle-class and salaried individual investors, and this could have a significant impact on the household sector during market fluctuations." Given the rapid expansion of these leveraged products and their increasing role in amplifying volatility in the South Korean stock market, their rebalancing mechanism is under close scrutiny. As these funds must rebalance daily to maintain a fixed leverage ratio, they are forced to buy when the market rises and sell when it falls. The volatility in the South Korean stock market on Tuesday vividly reflects this phenomenon. On that day, SK Hynix and Samsung Electronics' stock prices both fell by over 12%, leading to the most severe selling spree in the Korea Composite Stock Price Index (KOSPI) since the outbreak of the Middle East war. Currently, these two companies collectively account for over 55% of the weight of the KOSPI index. Bloomberg Intelligence ETF analyst Rebecca Sin said, "Yesterday was not a redemption-driven story. The selling pressure came from the mechanical rebalancing of these products to reset their daily two-times leverage exposure. This mechanism further amplifies the market trend when stocks that already command half the indexs weight drop." A report from Goldman Sachs' sales trading department also pointed out that the hedging demand of leveraged ETFs likely drove the sharp decline in SK Hynix and Samsung Electronics' stock prices on Tuesday. The report stated, "Weve previously noted that the mechanical daily rebalancing needs of these leveraged products create a kind of trend-following cycle. When the ETF's net asset value drops, the ETF needs to sell the underlying assets it holds, further reinforcing the downward trend." Sin added that around $170 million in net outflows were observed for the leveraged ETFs tracking South Korean stocks on Tuesday, although some products also saw inflows. She said, "These flows could be attributed to investors taking profits on SK Hynix and Samsung Electronics' strong performance so far this year, while Tuesday's sharp drop provided an opportunity for other investors to buy on the dip." "We continue to see strong inflows and high interest from investors in the chip, AI, and tech sectors." South Korea Central Bank Strengthens Hawkish Turn, High Probability of Rate Hike in July It is worth noting that the financial imbalances caused by leveraged investments have also become one of the reasons for the South Korean Central Bank to strengthen its hawkish stance. The Bank of Korea said in its biannual Financial Stability Report released on Wednesday that despite increasing uncertainties at home and abroad, the country's financial system has overall remained stable due to robust economic growth, resilient financial institutions, and strong external payment conditions. However, the report also warned that with accelerating rise in property prices in Seoul and surrounding areas, and investors increasingly relying on leverage to purchase assets, financial imbalances may further accumulate. The central bank also pointed out that while banks and other financial institutions maintain capital and liquidity buffers, credit risks of fragile borrowers and companies are rising. Meanwhile, data from the South Korean Statistics Office showed that the country's inflation rate in May reached 3.1% year-on-year, the highest since early 2024. Based on this, South Korea has raised its inflation expectations across the board. The central bank forecasted that consumer price growth in the second half of this year will remain around 3% while core inflation is expected to stay in the high range of 2%. Additionally, the South Korean Central Bank recently cautioned that even if the Middle East conflict ends and international oil prices fall, rising consumer demand and wage increases could lead to sustained high inflation in the future. The report predicted that the thriving performance of IT companies will further boost consumer momentum, and the ongoing trend of rising salaries in the IT industry may spread to the entire industry, intensifying upward pressure on prices. The central bank pointed out that usually, employee bonuses do not bring significant demand pressure, as they are not a permanent increase in income. However, the wave of "substantial exceptional bonuses" is expected to last at least until next year. With inflation continuing to rise, the July or September monetary policy meetings of the South Korean Central Bank are seen as important windows for a rate hike by external observers. Market analysis indicates that wage-driven inflation tends to have stronger stickiness, making it difficult to come down quickly, and the central bank may need to continue hiking rates to suppress demand. According to CME rate futures and predictions from several investment banks, the likelihood of a rate hike by the South Korean Central Bank in July is as high as 80% to 90%. Many market views suggest that South Korea will enter a tightening cycle. Analysts generally believe that the central bank will adopt a strategy of moderate tightening and managing inflation expectations early by attempting a small rate hike, instead of entering a sustained cycle of significant rate hikes. Analysts point out that there are three factors constraining the South Korean Central Bank's rate hike at the moment. Firstly, the heavy debt burden on the residential sector makes it highly sensitive to interest rates, and continued rate hikes may dampen domestic demand. Secondly, the economy is heavily reliant on exports and the semiconductor cycle, and excessive tightening may amplify the fluctuations caused by weakening external demand. And thirdly, the real estate and construction sectors are still fragile, and rapid rate hikes may trigger financial stability risks. Therefore, the central bank needs to strike a difficult balance between inflation control, growth maintenance, and financial stability.