CD-rate rigging scandal threatens Korean financial market

With commercial banks suspected of collusion to artificially fix interest rates on certificates of deposit, or CDs, the derivatives market of CD rate-based assets worth 4,600 trillion won (4,030 billion U.S. dollars) will likely take a hit as well.

Since an investigation by the Fair Trade Commission will take more than two months, the Korean financial market will likely be reeling from a highly chaotic situation for the time being.

According to the Korea Financial Investment Association on Friday, derivatives products based on CD rates amounted to 4,587 trillion won (4,020 billion dollars), including 4,332 trillion won (3,800 billion dollars) in interest rate-based swaps, 5.1 trillion won (4.5 billion dollars) in interest rate forwards, and 250.3 trillion won (219 billion dollars) in interest rate options.

If banks are found to have colluded to fix CD rates, the market could see a rush toward liquidation or early repayment of CD rate-based derivatives products.

A source at the association said, “Interest rate swaps and structured notes have an average maturity of 10 years, and include products with a maturity of 20 years,” adding, “If banks are found to have colluded to fix the CD rate or if such products are scrapped due to controversy over collusion, a situation could arise in which the entire volume of such products will be contracted all over again.”

Interest rate swaps are settled every three months, but interest rate forwards or option contracts are designed to see prices changes every day. So if a CD rate is not publicized even just for one day, settlements cannot be made, which in turn could cause massive confusion for not only domestic financial institutions but also financial companies overseas, including those in Hong Kong and Singapore.

If such a situation occurs, the external credibility of Korean derivatives products and structured notes will significantly deteriorate, and the Korean financial market will also suffer a setback in credibility. Also, those who suffer damage could pursue international lawsuits en masse, as in the case of the scandal surrounding the London Interbank Offered Rate.

A senior Korean official said Friday, “As an investigation has started due to the abnormal movement of CD rates, which serve as the benchmark for bank lending rates, the main target of the probe into the suspected collusion will be banks.” The CD rate fell Friday for the fourth consecutive day to 3.21 percent.

buddy@donga.com weappon@donga.com