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2023 Dec/14
Implementing Best Execution Obligations in the Face of Market Fragmentation in the Korean Securities Market
Survey Papers 23-02
PDF
- Research Topic Capital Markets
- Page 102
- Summary
- 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.