Hong Kong is the world's biggest warrants market. Average daily turnover in the city for warrants (and its close kin, the callable bull/bear contract) clocks in at a thumping HK$19.3 billion, according to figures from HSBC. As to why the product is so popular, Shirley Kwok, head of exchange-traded solutions sales for Hong Kong and Singapore at BNP Paribas, says simply: 'Hong Kong people like to gamble.' The warrants market does have casino-like features. Warrants contain an option to buy or sell a security - typically, equities. If a share goes up or down enough in value such that the option can be exercised, an investor can recoup several times the amount of their investment. If not, it expires worthless. The leveraging effect of warrants, their ease of use and the all-or-nothing aspect of returns is reminiscent of gambling, where punters risk losing their entire stake for the chance to win big. There are 22 warrant issuers in Hong Kong who listed 7,826 warrants last year - a record rate of issuance and an 85 per cent increase year on year, according to Hong Kong Exchanges and Clearing (HKEx). But recently, developments involving two issuers - Deutsche Bank and Goldman Sachs - have highlighted some of the risks in this highly geared derivatives market. Last month, several people were arrested - including two Deutsche Bank executives - as part of an investigation by the Independent Commission Against Corruption. The two bank staff are suspected of conspiring to accept bribes from a stock investor and others for quoting favourable prices to them, enabling them to make profits. Those arrested are suspected of conspiring to defraud the bank and the investing public by creating a false or misleading appearance of active trading in derivative warrants. That followed a trading halt of four warrants issued by Goldman that were linked to the Nikkei 225 Index. There was a typographical error in the original listing documents. The error was in the formula used to calculate the cash settlement amount once the warrants matured. The warrants had not matured by the time the error was detected and corrected. Goldman announced a plan three weeks after trading was halted to buy back the warrants at a premium, ensuring investors would not lose money, according to the bank. The return investors received from the buy-back offer, however, varies depending on the amount they paid for the warrants. There are still investors who have not accepted the offer. Like all investment decisions, choosing to invest in warrants depends on a person's appetite for risk. But Edmond Lee, director, global equity flow, Societe Generale - Hong Kong's biggest warrants issuer - says SG routinely cautions pensioners to stay out of this market: 'Retirees should not invest in this kind of high-leverage, short-term product. The risk is too high. We always mention this to people.' Warrants are a technical product that are difficult to price - to extend the gambling metaphor, the odds of a payout are hard to calculate. 'Pricing [on warrants] is complicated because it's based on Black-Scholes and binomials and trinomials. You are up against PhDs at the investment banks who have a lot more brain power,' says Robert Jones, head of FCL Advisory, which advises wealthy families on investing. 'Retail investors are least equipped to deal with complicated derivative products - they would have better luck going to Macau.' The complexity is compounded by the fact that there is a lot going on behind the scenes that sometimes creates the impression among investors of an unfair market. Because warrants' pricing is difficult to understand, retail investors overwhelmingly favour the most heavily traded warrants, with the view that these securities most robustly reflect fair market value. However, a November 2005 report by the Securities and Futures Commission on the warrants market found that issuers used inducements such as cash, gift vouchers and holidays to encourage people to trade warrants, thereby inflating the turnover of a particular issue. The commission found that cash was typically paid in the form of broker rebates, and that the biggest rebate paid by an issuer to an investor to trade a warrant was HK$2.5 million. The commission noted further that, under the arrangement: 'Two persons could actively trade with each other for no other purpose than to claim the rebates' - thus inflating turnover. The SFC banned the rebate practice in 2006. At the same time, it implemented rules requiring each issuer to make a market in the warrants by providing liquidity so that each security could be traded within a tight bid-offer range. By ensuring all warrants could trade and, therefore, be bought at a fair price, the commission was trying to get investors comfortable with buying the less traded warrants (to no avail - investors still overwhelmingly prefer popular warrants). After that, investors complained that market makers indiscriminately flooded the market with new warrants, depressing warrants prices in the process. The new market-making rules didn't make investors feel more secure about buying warrants; they just added to suspicions that institutions manipulated warrants' supply and demand. And yet, for all the complexity and risk of warrants, there is virtually no one lobbying for greater regulation of warrants, or to in any way restrict retail investors' access to this product. There are arguments in favour of warrants, with most of these falling under the view that informed individuals can take responsibility for their investing choices. Also, warrants are battle tested. The exchange-listed variety has been trading in Hong Kong since 1989 and they are consistently popular. 'A lot of investors in warrants understand the product well,' says Keith Chan, head of listed products sales, wealth management sales, HSBC Global Markets. 'It's regulated, it's listed on the exchange and it's accessible.' Warrants are also easy to buy and trade. Unlike shares, which generally have to be bought in expensive lot sizes, a warrant can be bought for pennies, at a fraction of the price of the underlying asset. Warrants are also cash settled. If a position pays out, an investor can expect payment in cash within three days, with no need to sell shares via a brokerage with embedded charges such as stamp duty. Finally, and most importantly, warrants have that juicy lure of built-in leverage. 'They [warrants] are cheap exposure. You get to bet small amounts of money and still get the exposure to gains that are substantial,' says Mark Dickens, head of listing at HKEx. Dickens adds that the exchange received no complaints about warrants even through the wretched markets of 2008-09, when investors surely lost a lot of money trading the instrument. Although warrant pricing is highly complex, the concept behind the instrument is simple and intuitive: if a security hits a certain price threshold, the warrant pays off. Warrants are popular with retail investors, and there are substantial industry interests stacked in favour of the product. HKEx is a key regulator of warrants. The exchange generates about one quarter of its trading volumes from warrants and CBBCs, thus earning healthy fee income from the product. The big banks do not break down how much money they make from warrants issuance. However, it is telling that large, institutionally oriented firms - such as Deutsche Bank, Goldman Sachs and JP Morgan - are active warrant issuers, and this is about the only place they are active in the retail market. Banks make money selling warrants and in making a market for warrants. They also do good business reselling the risk of the instrument - in particular, equity volatility - to institutional clients such as hedge funds. 'There is a good two-way market for volatility. The spreads are so wide that banks make a significant amount of money on it,' says Todd James, head of wealth management services, north Asia, BSI Bank. And, with wide investor demand and deep industry support on its side, the fair bet is that warrants are here to stay. What are they? Warrants give investors the right to buy or sell a given security at a pre-set price. Warrants issued by third parties for trade on the Hong Kong exchange are called derivative warrants. There are two types: put or call warrants, the former offering the right to sell and the latter the right to buy. Warrants trading in Hong Kong are usually European style - they are cash settled and the option to buy or sell can only be invoked on the exercise date. Risk factor: high - investors stand a good chance of losing their entire initial investment. Returns: high - instrument is designed to pay out multiples of original investment.