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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.
- 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]
- 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.
- Securities Sector’s Financial Soundness in Korea Presented through Comparison with Foreign Regulatory Frameworks [22-01]
- Senior Research Fellow Lee, Hyo Seob / Feb. 21, 2022
- Although securities firms have played a pivotal role in the development of capital markets, in-depth research on financial soundness regulations that have the greatest impact on their business activities has rarely been undertaken. Since its first introduction to Korea in 1997, the previous Net Capital Ratio rule had been in place for about 20 years. In 2016, the financial authorities decided to adopt the new Net Capital Ratio approach (new NCR) with a view to enhancing global competitiveness and expanding risk investment capabilities. However, a systematic analysis of how the introduction of the new NCR has affected Korea’s securities sector has not been sufficiently conducted. In this regard, this report intends to take a look at financial soundness regulations on the securities industry in major economies like the US, Europe, and Japan, countries with a long history of the capital requirements regulation, and to examine changes that the adoption of the new NCR has brought about to Korea’s securities sector. In addition, it would analyze regulatory divergence between Korea and other advanced countries, aiming for presenting directions for regulatory improvement in the prudential framework to which Korea’s securities firms are subject.
As shown in the analysis of regulations on the securities sector’s financial health in major economies, the US NCR has evolved based on the philosophy of company liquidations-related liquidity requirements with a top priority of protecting customers’ assets in case of an insolvency event. The US introduced the NCR in 1934 when the Securities Exchange Act came into effect, and established the current capital requirement formula after undergoing several revisions such as the 1975 introduction of the Uniform Net Capital Role. The current NCR approach can be classified into three types: the basic method, the alternative method, and the alternative net capital method. European countries including the UK use a Basel-style approach that has emphasized the importance of preventing bankruptcies of securities firms under the regulatory philosophy of the going concern-based prudential framework. The previous Basel-based regulation on the securities sector is similar to the capital requirements to which commercial banks are subject. Europe is expected to significantly improve regulations on the securities industry’s financial soundness from the second half of 2021. This means that in practical terms, European countries would shift towards the US NCR approach.
Amid the worsening financial health of securities firms in the mid-1990s, Korea introduced the previous NCR rule in April 1997 by benchmarking Japan’s capital requirements framework. The previous NCR rule laid the foundation for the regulatory framework for the securities sector’s financial health, which helped securities firms overcome the 1997 Asian financial crisis and the 2008 global financial crisis. Since the new NCR was implemented in 2016, Korea’s securities industry has seen a sharp increase in equity capital amount, expanded into overseas markets, and considerably increased profitability in IB businesses. Given this performance, the new NCR appears to have achieved its policy objectives. On the other hand, some brokerage firms have seen a surge in the issuance of derivative-linked securities and the debt guarantee value over the same period, which increased prudential risks in some segments. Furthermore, small securities firms have suffered reduced investment capabilities and worsening profitability. This highlights that the impact that the new NCR approach had on the securities industry varied by size of firms.
Additionally, this report undertook a comparative analysis of capital adequacy requirements for the securities sector in both Korea and major economies. The analysis reveals that in terms of calculating the capital adequacy ratio, the net operating capital, and gross risks, Korea’s regulatory regime is more stringent than those of other countries. Korea is not much different from its counterparts when it comes to the calculation of capital adequacy ratios. However, its regulatory scheme can be considered more rigorous given that Korea is applying a single capital adequacy ratio to brokerage firms regardless of their size. What is also notable is that it is hard to find any government around the world that has adopted a leverage ratio regulation as part of the prompt corrective action system. Against this backdrop, the introduction of the leverage ratio regulation to the securities sector appears to be a somewhat stringent regulatory measure.
The following suggestions should be taken into consideration to improve Korea’s regulatory framework with respect to the securities industry’s financial soundness. First, the financial authorities need to provide more flexibility to the application of capital adequacy ratios depending on the size and function of securities firms. For instance, it may be desirable to apply the Basel-style capital requirements to IB securities giants and to allow small- and medium-sized brokerage firms to choose between the net capital ratio and the Basel-based approach. Second, the net operating capital and gross risks should be calculated in proportion to economic risks. Third, it is necessary to keep to a minimum the use of capital requirements for achieving policy objectives. Lastly, in the long run, the leverage ratio system should be employed only to curb systemic risks. In this regard, the potential systemic risk of the securities sector needs to be assessed on a regular basis, and if the risk assessment shows that the risk level remains low, the regulatory threshold of leverage ratios should be reduced.