The South Korean financial authorities are launching an official probe into the misselling of equity-linked securities tied to Hong Kong's benchmark index, with massive principal losses set to occur starting this month.

On Monday, the Financial Supervisory Service is set to open an on-site investigation over 12 financial institutes suspected of violating rules while selling ELS products tracking the Hang Seng China Enterprises Index.

An ELS is a type of fixed-income derivative that pays out a return based on the performance of certain equities. Conversely, if the price of a certain stock on the index falls below a predetermined level, the investors lose the principal.

While HSCEI was known as a relatively stable gauge, it experienced a sharp decline since hitting its peak at 12,000 points in February 2021, dropping more than 50 percent to below 5,000 in October 2022 and fluctuating at around 5,600 recently.

The on-site probe will be a follow-up investigation of the regulatory body's preliminary inspection conducted between November and December, during which the FSS revealed it discovered some serious rule violations by the firms.

Among the problems detected were eased internal control in ELS sales in early 2021, when it should have been tightened, given the instability of HSCEI due to China's economic difficulties and the geopolitical tensions with the US.

In addition, some banks were found to have encouraged their employees to sell more ELS products despite lingering risks, for instance, by factoring in ELS sales outcomes of the workers as a big part of their performance appraisal.

Some companies were also discovered to have misplaced important documents related to contracts.

The FSS revealed it plans to take a thorough look into the overall management system of the financial firms as well during its on-site inspection of the 12 firms starting Monday.

First to be examined are KB Kookmin Bank and Korea Investment and Securities, the top-selling bank and securities firm of ELS products, respectively. The financial watchdog said it will extend the probe over other major banks, including Hana, Shinhan, Woori and NH NongHyup, as well as six other key brokerages, within January.

According to the FSS data, the outstanding balance of Korea's ELS products underlying the Hong Kong index amounted to 19.3 trillion won ($14.66 billion) as of November. Of them, some 52 percent -- 10.2 trillion won -- are set to mature in the first half of the year, followed by another 5.2 trillion won in the latter half.

Among the total, around 17.8 trillion came from retail investors, with over-65s accounting for 5.4 trillion won.

The financial authorities pledged strict punishment for any illegal acts discovered, especially as this is not the first time the banks have failed to protect their customers' money.

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

“While it is a basic principle that investors invest at their own risk, it will be inevitable for the firms to take liability over their actions, if they made only superficial efforts and neglected their responsibility to protect the customers even after experiencing the DLF incident,” FSS Gov. Lee Bok-hyun said Thursday in a press conference.

Under the circumstance, the financial authority in December launched a new task force in charge of investigating and responding to the HK-linked ELS sales situation.

"We have quickly initiated an on-site inspection as financial damages are expected to continue in the coming days," the FSS official heading the task force said, adding, "As soon as we resolve (problems) rising from the misselling and other illegal acts, we will promptly draw up guidelines for compensations."