Concerns are looming large over the loss of principles in equity-linked securities products underlying Hong Kong’s slumping benchmark index with over 8 trillion won ($6.1 billion) in ELS products sold by Korean banks set to mature in the first half of next year.

The size of ELS products tracking the Hang Seng China Enterprises Index maturing next year and sold by Korea’s five major banks exceeds 13 trillion won. Of them, some 8.4 trillion won worth of ELS products are facing maturity in the first six months of 2024, according to data from Korea’s Financial Supervisory Service.

By size, Kookmin Bank holds the largest amount standing at 4.77 trillion won. Nonghyup Bank holds 1.48 trillion-won worth of ELS products while those for Shinhan Bank, Hana Bank and Woori Bank amount to 1.37 trillion won, 752.6 billion won and 24.9 billion won, respectively.

ELS is a derivative product that pays a certain amount of profit if an individual stock or index stays within a certain range. Conversely, if the price falls below a predetermined level, investors lose the principal. As the index has experienced a sharp decline since 2021, when the derivative products were sold, a loss of principal is inevitable.

Chinese shares listed on the Hong Kong bourse have fallen sharply this year, placing the HSCEI among the world’s worst-performing gauges.

The HSCEI dropped more than 50 percent from the range of 10,000-12,000 points in the first half of 2021 to below 5,000 at the end of October 2022, and has recently been fluctuating in the 6,000 range.

The HSCEI was known as a relatively stable index with little fluctuation but it started to rattle on China’s weak economic recovery, property crisis and geopolitical tensions with the US.

Experts predict that if the Hong Kong index fails to rebound and maintains its current level, there will be a loss of approximately 40-50 percent of the principal.

In fact, among the products already sold by Hana Bank, a principal loss of 8.3 billion won, or 45 percent of the 18.1 billion won that recently reached maturity, occurred.

Applying the calculation to the five major banks, it is estimated that the related principal loss will exceed 3 trillion won in the first half of next year.

Since last week, the FSS has opened its investigation on banks and securities firms that have been selling ELS products that track the HSCEI. The watchdog announced that it will begin an on-site inspection into Kookmin Bank, which has the largest sales volume, to be completed by Friday.

“We are checking the sales status and the bank’s response to complaints,” an FSS official said.

"The FSS plans to conduct a written inspection into other sellers such as Hana, Shinhan, Woori and NH Nonghyup," the official added.

Among securities companies, some five companies, including Mirae Asset Securities and KB Securities, are also set to face inspection.

“If losses actually occur next year, we plan to take an additional look at it at the supervisory authority level, " the FSS official added.

The regulator will look into whether the financial companies violated the Financial Consumer Protection Act by insufficiently explaining to their customers the possibility of a loss of principal and that derivatives are high-risk products.

KB Kookmin Bank declined to comment on the matter as the inspection is still ongoing. A Woori Bank official said the lender sold the "minimal amount" of the product in question and offered financial items focused on "high stability rather than high returns."

Both Kookmin and Woori have been informing customers of the status of subscribed ELS products including fair value and price of underlying assets and provides information on the Hong Kong market status to investors via mobile text messages, they said.

With the potential loss of ELS products tied to the HSCEI, fear among retail investors over "irresponsible marketing" of high-risk financial products has resurfaced.

In 2019, the FSS ordered local financial firms including Hana Bank and Woori Bank to return to their investors up to 80 percent of the losses they suffered from high-risk derivatives linked to the interest rates of overseas countries.

Blaming financial firms’ excessive profit-seeking strategies and lack of internal regulations, the regulator ordered the highest rate of compensation seen in any dispute deriving from local financial investment.

In 2022, Shinhan Bank, Hana Bank and NH Investment & Securities came under fire for misselling funds run by now-defunct Lime Asset Management, which caused trillions of won in financial damage to investors.