South Korea's exchange-traded fund (ETF) market is approaching 450 trillion won ($328 billion), but the performance ratings of brokerages serving as liquidity providers (LPs) have deteriorated. Analysts say that as both trading volume and the number of products grow simultaneously, the increasing difficulty of quote management is creating cracks in the market's price formation function.
According to the Korea Exchange on Tuesday, seven of the 26 domestic brokerages evaluated as LPs in the first quarter received a C grade, up five from two in the previous quarter. This marks the highest level since the second quarter of 2020, with LS, DB, IBK, iM, Daishin, Yuanta, and Hana Securities among those downgraded. Most firms (18) received a B grade, while Bookook Securities was the only one to secure an A grade for three consecutive quarters.
LPs present bid and ask quotes in ETF trading to narrow the gap between market price and indicative net asset value (iNAV). The Korea Exchange conducts quarterly evaluations based on obligation fulfillment (40%), activeness (20%), average spread (20%), and average quote quantity (20%). Based on these criteria, each brokerage's LP performance is classified into four grades: A (excellent), B (good), C (average), and F (poor).
The rapid expansion of the ETF market has sharply increased the burden on LPs, which is cited as the reason for the downgrades. The recent surge in thematic and active ETFs has complicated the pricing structure of underlying assets, while hedging costs have also risen. With brokerages forced to simultaneously manage even low-volume products, profitability relative to risk has declined, making quote provision more passive.
In fact, ETF deviation disclosures in the first quarter totaled 1,359, an 88% increase from 723 a year earlier. The rise is attributed to the combination of expanded trading volumes and periods of heightened volatility in products such as crude oil ETFs, driven by geopolitical risks in the Middle East. The burden on LPs responsible for price formation has grown, and their pace of adjustment has failed to keep up during sharp market swings.
With the introduction of single-stock leveraged ETFs scheduled for the 22nd of this month, the burden on LPs is expected to grow further. Given the structure tracking double the volatility of individual stocks, both hedging difficulty and volatility risk rise simultaneously. Industry observers say that instead of responding uniformly to all ETFs, brokerages may increasingly adopt a "selective quote provision" approach, focusing on higher-margin products.
There is significant concern that a weakening of LP functions will lead to direct investor harm. If quotes are not sufficiently provided, the gap between ETF market prices and net asset values widens, potentially causing investors to buy at prices higher than actual value or sell at lower prices. The industry points out that the gap between the market's external growth and liquidity supply infrastructure is widening. "The number of personnel moving from the ETF industry to the brokerage LP market is actually on the rise," an official at one brokerage said. "Nevertheless, whenever the size and volatility of the stock market grow, the liquidity supply system supporting it fails to keep pace."
