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Our Survey Paper provides a focused review on financial policies as well as management cases to present insights on financial market development.
- Market Accessibility of Korean Capital Markets: Viewpoint of Foreign Institutions [24-02]
- Senior Research Fellow Choi, Soon Young / Jun. 28, 2024
- This paper introduces the perspective of foreign investors and intermediaries regarding the market accessibility of Korea’s capital markets. Korea’s capital markets, by quantitative measures, belongs alongside developed markets. However, in major market indices, mainly the MSCI stock market index and FTSE Russell bond market index, Korea is classified as an emerging market. The discrepancy between the quantitative and qualitative aspects of Korea’s capital markets comes from the market accessibility assessment, used by MSCI and FTSE Russell.
In both the MSCI and FTSE Russell market accessibility assessments, foreign financial institutions play an important role in providing feedback that is used as input for market classification. To better understand why Korea’s market accessibility is regarded as being below developed country standards, interviews were conducted with major financial firms that invest and intermediate investment in Korea. The group includes global asset managers, banks, custodians, boutique investment banks, hedge funds, market makers, system traders along with ASIFMA and GFMA. The results of the interview reveals that various issues related to market accessibility are interconnected. In particular, areas of market accessibility that Korea falls behind in are not just rules and regulation, but process and practice. Interview participants emphasize that in order to improve Korea’s market accessibility, rules and regulations need to be applied more transparently and consistently. In addition, the most effective measure suggested to enhance Korea’s market accessibility is to improve communication between Korea’s financial regulators and industry with the foreign investor community.
- Analysis of Pension Tax Systems: Characteristics and Directions for Improvement [24-01]
- Senior Research Fellow Kim, Kab Lae and others / Mar. 14, 2024
- The swift advancement of aging populations combined with declining birth rates is increasingly highlighting the critical role of pensions. Growing skepticism about the long-term viability of public pension systems is fueling a shift toward reinforcing private pension schemes. This shift is notably evident in key nations including South Korea. A pivotal factor in bolstering private pensions is the structure of the pension tax system. Indeed, tax incentives are the primary motivators for private pension plans. The configuration of this tax system profoundly affects how individuals allocate their pension assets and can also influence the evolution of capital markets.
In South Korea, the pension framework is broadly categorized into public and private systems. The public pension system encompasses national pensions and occupational pensions, while private pensions comprise employer-based retirement plans such as Defined Benefit (DB) and Defined Contribution (DC) schemes, along with individual retirement plans like IRP and pension savings. The taxation approach for pensions predominantly adheres to the EET method. This method entails exemption (non-taxation) at the contribution phase, exemption on earnings at the management phase, and taxation at the pension income distribution phase.
Challenges within the domestic private pension tax system include a lack of diversity in tax-advantaged pension plans, insufficient tax incentives to encourage the pensionization of retirement benefits, and relatively low limits on income deductions (or tax credits) compared to overseas, with inflexible limit adjustments.
This study undertook a comparative examination of pension tax systems in key international jurisdictions to investigate the evolving trends in these systems. Through the analysis of pension tax systems in the United States, Japan, Australia, and Germany, it was confirmed that various tax incentives are being provided for the development of the private pension market. A critical observation from studying these international pension tax systems is the recognition that the essence of an effective pension tax system hinges on the strategic design of tax benefits for pensions. In the case of private pensions, while there are some retirement plans where enrollment is compulsory like retirement pensions, many retirement plans operate based on the voluntary will of the subscribers. The most powerful incentives to induce voluntary subscription of the participants are tax benefits.
This study of international pension systems suggests several key legislative measures to develop the domestic pension tax system. Firstly, bolstering private pensions requires increasing the limits on tax benefits. Legislative reforms should allow for periodic adjustments to these limits, using economic indicators like the growth rate, inflation, and average wage increases. Secondly, to discourage the trend of opting for lump-sum withdrawals of retirement contributions, there's a need to consider higher tax rates on such lump-sum withdrawals. This approach would promote the receipt of retirement income in the form of pensions. Thirdly, the mechanism for offering tax benefits on pension contributions should shift from a tax credit method to an income deduction method. Fourthly, a variety of methods for providing tax benefits ought to be allowed. Specifically, introducing a TEE pension system could offer a new framework, where contributions are taxed, but earnings and withdrawals are exempt. Lastly, it is recommended to consider implementing a refundable tax credit system or a matching subsidy scheme for pension contributions made by socially vulnerable groups, ensuring a more inclusive and equitable pension system.
- Implementing Best Execution Obligations in the Face of Market Fragmentation in the Korean Securities Market [23-02]
- Senior Research Fellow Kang, Sohyun / Dec. 14, 2023
- The domestic trading market is on the brink of a significant shift from a monopolistic exchange-centric system to a competitive regime among multiple trading markets. The concept of best execution, which establishes the criteria for order execution in a complex trading market environment, forms the basis for creating a fair competition system among trading markets and protecting investors. Despite the importance of best execution, the domestic trading market has maintained a single exchange-based trading structure for an extended period, causing best execution to have limited practical impact and be perceived as a relatively less urgent topic.
However, with NextTrade planning to launch an Alternative Trading System(ATS) by early 2025, it is evident that a multi-trading market structure will soon emerge in South Korea. Consequently, each financial investment company is facing the need to establish policies and procedures for best execution and swiftly build a best execution system.
Furthermore, since the introduction of a broad legal framework regarding best execution in the Financial Investment Services And Capital Markets Act(FSCMA) in 2013, specific discussions on implementation methods have not taken place. As a result, there is an absence of concrete guidelines concerning the obligation of best execution, making it challenging for financial investment firms to establish detailed criteria and methods for compliance.
In light of these developments, this report compiles eight key issues related to the obligation of best execution in the domestic trading market, along with proposing specific implementation measures based on international regulations and guidelines.
First and foremost, it is essential to have a clear understanding of the meaning of best execution. Given the complexity of market structures and various trading methods, determining the best course of action is not straightforward. There is no one-size-fits-all approach to best execution, as judgment may vary based on market conditions, order characteristics, investor preferences, and trading methods. It's important to note that achieving the best execution does not guarantee the best outcome for clients; instead, it means establishing appropriate procedures to ensure that the best possible results are obtained for clients, without guaranteeing the best results.
Second, it should be recognized that the entity that must comply with the best execution obligation cannot be a trading market. This responsibility falls on financial investment traders or investment brokers. In the United States, by the way, marketplaces are required to perform order routing under the Order Protection Rule(OPR). However, this complements the best execution obligations of financial investment firms and enhances overall market fairness and investor protection, but it cannot replace the unique obligations of financial investment firms.
Third, the FSCMA limits the securities that can be traded on an ATS to equity securities and equity-related depository receipts. Therefore, it is reasonable for securities subject to best execution to follow these restrictions. However, when using Smart Order Routing(SOR), financial investment firms may need to decide which securities to apply SOR to at their discretion.
Fourth, choosing the trading market where orders will be executed is at the discretion of financial investment firms, based on overseas regulations and guidelines. Like the Japanese case, however, if only exchanges are considered, the expansion of investor choice and the development of the domestic trading market may be delayed. Therefore, it is necessary to devise practical integration measures and regulatory incentives to encourage financial investment firms to consider selecting ATSs as execution markets without reluctance.
Fifth, to enhance the convenience and efficiency of best execution for financial investment companies and investors, it is necessary to distinguish between individual customers and professional customers and establish separate best execution standards. The primary reason for distinguishing individual customers and setting different best execution standards is to simplify the best execution criteria in a complex trading environment, making it more suitable for investor protection. Additionally, due to the nature of individual investors who trade in small quantities of high liquid stocks, there is less need to consider complex variables. Individual customers can request to consider other factors through separate instructions if they wish, so blocking customer choice is not the objective.
Sixth, when determining best execution, the definition of the best outcome can vary depending on factors such as customer type, order characteristics, market conditions, and any specific instructions provided by the customer. Therefore, best execution policies should be established, taking into account various factors. However, for individual customers, as previously mentioned, the benefits of simplifying criteria are higher, so criteria should be restricted to factors like prices and transaction costs.
Seventh, it is essential to note that merely satisfying a customer's specific instructions during order execution does not fulfill a financial investment firm's best execution obligation. While satisfying specific instructions should be prioritized, additional measures should be taken to ensure that the best possible choice is made, considering other requirements.
Finally, as market structures become more complex, risk of conflicts of interest increase due to the interest between trading markets and financial investment firms and unclear order execution processes . However, the domestic trading market is currently in the early stages of market fragmentation, with limited concerns about conflicts of interest arising from practices such as Payment for Order Flow(PFOF) or the opaqueness of SOR. As market maturity and complexity increase, discussions on concrete measures to address conflicts of interest will become more substantial.
Defining best execution and specifying the means to fulfill this obligation require a flexible approach that considers market conditions and the preparedness of market participants. Since specific guidelines have not yet been established in the domestic market, in-depth discussions are required on various topics, including the eight issues mentioned earlier. It is a critical moment where regulatory authorities, financial investment firms obligated to comply with the best execution obligation, and investors evaluating whether orders are being executed in their best interests must collaborate. Regulatory authorities should establish mandatory requirements through guidelines following extensive discussions among market participants. Additionally, they should facilitate the development of criteria by financial investment firms to make the best judgments in the interest of their clients, beyond the specified requirements. As the South Korean trading market progresses into a multi-trading market system, it is hoped that this report contributes to enhancing investor protection and establishing the foundation for a stable and efficient market environment.
- Exploring relationships between climate risks and asset prices: A survey [23-01]
- Research Fellow Park, Hyejin / Jan. 19, 2023
- This report examines the implications climate risk on capital markets and asset prices. Climate change is one of the most important issues in our generation and may have significant impacts on the economy. This report provides a comprehensive literature review on the relationship between climate risk and asset prices and conducts an empirical analysis to test whether transition risk is associated with stock returns in Korea. This reports aims to advance our understanding of the financial risks linked to climate change and its implications on asset prices.
The report begins by providing an introduction to financial risks caused by climate change. It explains the two main types of climate-related financial risks: physical risk, resulting from the natural disasters and weather changes due to climate change, and transition risk, resulting from the transition to a decarbonized economy. It discusses how physical and transition risks impact companies and transmit to the economy and financial markets.
The second chapter then surveys the literature on the relationship between climate risks and asset prices. The chapter reviews the rapidly growing literature that studies the effects of climate risk on asset prices, and finds that climate risks have substantial effects on the prices of assets that are exposed to such risks. This chapter then turns to discussion of scenario-based climate risk assessment methodologies and presents examples of climate stress testing by central banks.
Finally, the third chapter examines whether climate-related risks, in particular, transition risks, are priced in Korean stock market by using the compliance with the Korean emission trading scheme as a proxy for transition risks. The result shows that stocks of firms that are subject to the emission trading scheme, or relatively more exposed to transition risks, tend to have higher abnormal returns and this pattern is more pronounced after the Paris Agreement. This result thus indicates that transition risk may have significant effects on asset prices, and emphasizes the need to make efforts to understand the financial implications of climate risk and develop methodologies to assess the impact of climate risks.