The Establishment of Alternative Trading System in Korea: Issues & Considerations

Finance VIP Series Vision, Insight and Policy 2012-02 www.kif.re.kr May 2012 The Establishment of Alternative Trading System in Korea: Issues & Considerations Min-Kyu Song Taehoon Youn

Author Min-Kyu Song Research Fellow 02-3705-6371 mksong@kif.re.kr Taehoon Youn Research Fellow 02-3705-6377 tyoun@kif.re.kr

Summary Summary 02 Ⅰ. Introduction 10 Ⅱ. ATS (Alternative Trading System) 12 1. Definition and Recent Trend 2. Classification 3. ATS & Stock Exchange III. Cases: US and EU 21 1. Development 2. Key Factors of Growth IV. ATS Industry in Korea 27 1. History 2. Effects of the ATS in the Domestic Market V. Considerations 33 1. Advanced Structure of the Best Execution 2. Independent Clearing House and Market Surveillance 3. Transparency of Information & Fair Trade 4. Regulations on the Tick Size and Market Stability 5. Transaction Fees 6. Development of the Dark Pool 7. Mid-to-Long-term Plans for the ATS Industry 01

The Establishment of Alternative Trading System in Korea: Issues & Considerations I. Introduction On the recently proposed FSCMA (Financial Investment Services and Capital Markets Act) revision, the introduction of ATSs (Alternative Trading System) is positively being considered to be adopted so as to boost the domestic securities markets competition. Ⅱ. ATS (Alternative Trading System) An ATS is an trading system where brokers, dealers, and investment banks participate to use as an electronic trading. An ATS makes a trade on behalf of the stock exchange, so called as alternative trading system. Advance in information and communication technology has fostered the ATS industry in the US and Europe. Asian countries had the difficulty in adopting the system due to its regulations, even though the system is widely accepted currently in the region. According to the regulations, the type of securities, and trading information, an ATS itself has many different forms. In terms of the mechanism of execution and price discovery, ATSs can be classified into 1 bulletin board, 2 crossing system, 3 quote-driven system, and 4 order-driven system. 02

Summary Not only the stocks, but also the bonds and FX position are actively traded on the ATSs. Based on the degree of investors public information, ATSs are divided into lit pools and dark pools. In terms of managing agents, type of securities, listing services, and market surveillance service, an ATS is different from the stock exchange. Investment banks, brokers, and dealers serve a role for the managing agents in ATSs. While only the listed securities are traded in the stock exchanges, ATSs include unlisted securities. The stock exchange has the power to list companies but an ATS has no authority. The stock exchange is responsible for monitoring in order to protect investors from such as unfair trades in the market but such role is rather limited for the ATS. 03

The Establishment of Alternative Trading System in Korea: Issues & Considerations Ⅲ. Cases: US and EU 1. Development In the US, the ATS industry has been growing after the legislation of the Order Handling Rule, Regulation ATS, and Regulation NMS (National Market System). In Europe, MiFID (Markets in Financial Instruments Directive) was adopted in 2007 so as to induce best execution and officialize the business playground of ATSs. 2. Key Factors of Growth Low transaction costs, shortened execution time, and less market impact are the key factors to the success for foreign ATS. In efforts to compete with the stock exchange, ATSs have reduced their explicit costs. ATSs have also reduced implicit costs which include timing cost and market impact. ATSs provide more advanced data processing facilities than those of the stock exchanges so as to reduce the execution time. Some crossing systems or dark pools take the orders of block trades taking trading prices given from regular exchanges so as to reduce the market impact. 04

Summary ATSs involve various securities and flexible trading hours so as to secure convenience to investors. Not only the stocks, but also the bonds and FX position are traded on ATSs to fulfill the trading demand that the stock exchange may not cover. Also, the stocks from different countries can be traded within an unified system which may facilitate investors to proceed global investment. The trading hours in ATSs are more flexible than those of the stock exchange. Diversified execution system is also one of the main reasons for the growth of ATS as a whole. For those investors who are engaged in block trades may prefer quote-driven system rather than the order-driven system; for those who want to be anonymous may prefer dark pool; and those investors who only want to reduce the transaction costs and extend the trading hours usually prefer order-driven system. Ⅳ. ATS Industry in Korea The adoption of ATS in Korea may contribute to advancing domestic capital market, reducing transaction costs, along with the fulfillment of the market participants various needs. 05

The Establishment of Alternative Trading System in Korea: Issues & Considerations Customized transaction fees and faster executions play an important role in competing with the existing stock exchange. The improvement in the execution speed and reduced transaction costs is likely to be crucial in meeting the customer needs in the market. However, ATSs might bring some side effects in terms of market segmentation, transparency of information, and investor protection. Especially individual investors may be hurt more due to low transparency of information. HFT (High Frequency Trading) is widely used with the growing ATS industry thus may rise sharply. In the US and Europe, those side effects are being mitigated with the help of best execution, advanced IT industry, information disclosure, etc. If there is a price difference between an ATS and the stock exchange, the best execution allows investors to have the most favorable price which may reduce the gap between the prices and protect the investors who cannot have direct access to the ATS. In order to practice the best execution, ATSs and the stock exchanges need to search the best order price through SOR (Smart Order Routing) or ITS (Intermarket Trading System). MiFID reinforces ATSs to disclose their information and Regulation ATS also requires to disclose more information as trading volume increases. 06

Summary Ⅴ. Considerations Advanced structure of the best execution If a single security is traded on different trading systems, practical standards on the best execution should be established. In general, best execution not only denotes the best order price, but also assures favorable timing, certainty, and explicit/implicit costs so as to fully meet the customer needs. And it may need to take a further consideration into how and to whom the best execution responsibilities will be applied. Independent clearing house and market surveillance It may cause various conflicts of interests if the stock exchange takes the roles for clearing and market surveillance; therefore needs to have an independent form of a clearing house and market surveillance. As the fact that the ATS industry has to compete with the existing stock exchange, the clearing service fees would be imposed based on the cost price and the service will eventually need to have an independent form of a clearing house. Transparency of information & fair trade In order to efficiently manage and monitor the securities markets, both pre-trade and post-trade information need to be released appropriately. 07

The Establishment of Alternative Trading System in Korea: Issues & Considerations Policy measures need to be brought beforehand so as to minimize the side effects that arise different trading systems such as unfairness between investors. Regulations on the tick size and market stability A dual trading system may incur unnecessarily excessive competition in reducing the tick size, so it always needs to carefully examine its costs and benefits for adequate regulations. However, too much reduced tick size may induce excessive HFT (High Frequency Trading) which could lead to negative effects in pricing. ATSs may also need some kind of a control system such as a circuit breaker in the stock exchange. Transaction fees When ATSs co-exist with the stock exchange, it needs to be considered how each market will charge the transaction fees. Development of the dark pool The dark pool may cause several issues in terms of fairness; the financial regulatory authorities should provide various measures in order to prevent or mitigate such problems. A certain level of transparency needs to be effectively guaranteed in order to maintain effectiveness and fairness in the market. However, it may need to keep in mind that too high transparency sometimes reduces the volume of block trades. 08

Summary All of the market participants need to be fully notified about the advantages and disadvantages that they may get from differences in transparency between the regular exchange and ATSs. Mid-to-long-term plans for the ATS industry. Considering that the main purpose of adopting ATSs is to boost competition in the secondary markets, it needs to bring specific plans and schedules to incur actual competition. 09

The Establishment of Alternative Trading System in Korea: Issues & Considerations Ⅰ. Introduction On the recently proposed FSCMA (Financial Investment Services and Capital Markets Act) revisions, the introduction of ATSs (Alternative Trading System) is positively being considered to be adopted. An ATS is different from a stock exchange in a sense that various types of securities are being traded within the system. Also an ATS is different from the regular stock exchange in terms of the listing service and its regulations. Proposed FSCMA defines an ATS as a financial investment agent which needs to be approved by the financial authorities. Currently, listed stocks are the target instruments, however, other securities will be taken under the review on the revised enforcement ordinance. * A person can hold up to 15% of stocks of an ATS and financial institutions can hold up to 30% of an ATS if approved by the FSC. * The stock exchange is allowed to find an ATS as a form of wholly owned subsidiary. Internationally, development of the ATS industry has brought competition in the secondary markets and also effectiveness in the financial markets as a whole. In the US and Europe, ATSs already takes 40% and 30%, respectively, in the stock markets. 10

Ⅰ. Introduction As competition between ATSs and the stock exchanges rises, we may expect more effective capital markets, reduced transaction costs, and fulfillment of the customer needs. * Also, various forms of the ATSs promote customer-centered transaction fees and shortened time of execution. Unlike the ordinary stock exchanges, the dark pools are also growing where information on the prices or orders is not fully disclosed. In addition, some of the ATSs (e.g. BATS, Direct Edge) have transformed into the stock exchanges so as to bring competition among the stock exchanges. Proposed FSCMA would change the laws on the establishment of a stock exchange to a permit system thus another stock exchange can be established with an approval from the FSC. If any ATS has grown enough to be transformed into a stock exchange then we may have a dual regular exchanges. In this paper, it looks into the roles of ATSs, international cases, institutional and functional characteristics along with key factors in order to adopt the ATS domestically. 11

The Establishment of Alternative Trading System in Korea: Issues & Considerations Ⅱ. ATS (Alternative Trading System) 1. Definition and Recent Trend ATS involves many different types of the securities markets. An ATS is a trading system where brokers, dealers, and investment banks participate to use as an electronic trading. * The US SEC denotes ATS as an automated trading system which is not registered as a stock exchange to the SEC. 1) * The European CESR(Committee of European Securities Regulators) denotes an ATS as an automated trading system which is not regulated under the same conditions as the stock exchange. As an stock exchange, an ATS also provides services of executions where there are buyers and sellers. * Makes a trade on behalf of the stock exchange, so called as alternative trading system. Advance in information and communication technology has fostered the ATS industry in the US and Europe. In the US, development of Regulation ATS in the late 1990s has promoted the ATS industry and as of September 2009, ATS accounted for 36% of total stock trading in the market. 2) * As the ATS industry grows rapidly, NYSE Euronext s share of the European listed stocks trades has decreased from 79% in 2005 to 23% in March 2010. 1) SEC release No. 34-38672. 2) Concept Release on Equity Market Structure, SEC, 2010. 12

Ⅱ. ATS (Alternative Trading System) In the Europe, establishment of MiFID in 2007 has promoted growth of the ATS industry, accounting for about 25% of total European stock trading. * As of January 2010 Chi-X Europe, the largest ATS in Europe, took third place in Europe to follow NYSE Euronext in trading volume, and accounted for 18.4% in total European stock trading as of April 2010. * On the other hand, the stock trading volume of the LSE in the UK, the largest regular stock exchange in Europe, has decreased from 75% in January 2009 to 53% in February 2010. <Figure 1> ATS Stock Trading in the US(2009.9) <Figure 2> ATS Stock Trading in Europe(2009) Note : The US stock exchange includes NASDAQ, NYSE, NYSE Arca, BATS, NASDAQ OMX BX, etc. Source : Concept Release on Equity Market Structure(SEC, 2010), FESE Asian countries had the difficulty in adopting the system due to its regulations, even though the system is widely accepted currently in the region. 13

The Establishment of Alternative Trading System in Korea: Issues & Considerations In Japan, JSCC (Japanese Securities Clearing Corporation) began its clearing service on ATSs 3) in July 2010 and Chi-X established Chi-X Japan to begin its securities trading. In the case for Australia, the ASX (Australian Stock Exchange) has a similar monopoly system such as Korea s KRX, but Chi-X Australia, Liquidnet, and AXE-ECN already or are planning on to provide their services. In Hong Kong, the dark pool-centered BlocSec, Liquidnet, and Sigma-X already provide their services actively. In Singapore, Chi-East plays a role. In Korea, recently FSCMA is proposing to allow ATS to be adopted and some international ATS companies already take under the review to enter into the Korean securities market. * The systems of just matching the order of buying and selling already has been observed in Korea ECN and KoreaCross. * And the ATS which is thought to be adopted in recently proposed FSCMA denotes where both execution and price discovery are possible. 2. Classification According to the regulations, the type of securities, and trading information, an ATS itself has many different forms. In terms of the mechanism of execution and price discovery, ATSs can be classified as follows. 3) Called PTS(proprietary trading system) in Japan. 14

Ⅱ. ATS (Alternative Trading System) Bulletin board: Provides a network where investors can start negotiating through an electronic system. But execution service is not provided. * Doesn t provide the execution service but helps directly, so classified as a type of ATS. * e.g. European TradeCross, WETRA Crossing system: When an order has been taken, it makes a trade with the price made from other stock exchanges or the market. * Execution is possible but price discovery function is not. * e.g. POSIT, Liquidnet, E-Crossnet Quote-driven system: A dealer, who is the market maker, offers quotes to make trades with investors. * Both execution and price discovery function are possible. * e.g. CTAS-OS, Tradelink, EuroMTS Order-driven system: Each investor offers an order and competitive bidding takes place. * Both execution and price discovery function are possible. * In the US, most of the ATSs, so called ECN(electronic communications network) are the order-driven systems. * e.g. Instinet, BondVision, TradeWeb 15

The Establishment of Alternative Trading System in Korea: Issues & Considerations <Table 1> ATS Function Price discovery Execution Bulletin board Crossing system Quote-driven system Order-driven system Not only the stocks, but also the bonds and FX position are actively traded on the ATSs. Instinet and BATS are for stock trade, Tradeweb and Marketaxess are for bond trade, and Currenex and Hotspot FX are for FX trade. Based on the degree of investors public information, ATSs are divided into lit pools and dark pools. As the regular stock exchanges, information on the price, order, brokers, and other related factors are opened in the lit pools. In the dark pools, trades are made with some parts of the information missing. * Liquidnet, Pipeline, POSIT, and BIDS are the dark pools. * A certain crossing system only takes the order and use the price that is made from outside the market, therefore can be classified into the dark pool. 16

Ⅱ. ATS (Alternative Trading System) The dark pools have developed so as not to give market impacts on the prices, where block trades are made outside the regular markets. <Figure 3> ATS Classification ATS(Alternative trading system) Bulletin board Crossing system Quote-driven system Order-driven system Trade Cross E-Crossnet CATS-OS Instinet WETRA POSIT Tradelink BATS Liquidnet Bondscape Direct Edge Pipeline EuroMTS BondVision BIDS COREDEAL TradeWeb CreditTrade Eurex Bonds Currenex MarketAxess Hotspot FX Stock ATS, Bond ATS, FX ATS 2) DB Research 3. ATS & Stock Exchange In terms of managing agents, type of securities, listing services, and market surveillance, an ATS is different from the stock exchange. 17

The Establishment of Alternative Trading System in Korea: Issues & Considerations Investment banks, brokers, and dealers serve a role for the managing agents in ATSs. While only the listed securities are traded in the stock exchanges, ATSs include unlisted securities. * MiFID doesn t put any limits on the securities. The stock exchange has the power to list companies but an ATS has no authority. * The stock exchange takes both listing and trading but an ATS takes only trading. * So there is no listing requirements nor its regulations under the ATS. * An ATS doesn t take the process of evaluating companies for listing, which is an debatable issue in considering that whether ATS needs to pay for the listing service to the stock exchange or not. The stock exchange is responsible for monitoring in order to protect investors from such as unfair trades in the market but such role is rather limited for the ATS. * MiFID requires the role of market supervising but the US Regulation ATS doesn t. * But the US SEC cooperates with the FINRA (Financial Industry Regulatory Authority) and the stock exchanges so as to protect from any unfair trades and frauds in the markets. 4) 4) SEC release No.34-40760, "Regulation of Exchanges and Alternative Trading Systems" 18

Ⅱ. ATS (Alternative Trading System) <Table 2> The Stock Exchange and ATS Stock Exchange Securities Listed securities * Mostly listed stocks ATS No restrictions. Includes listed securities, non-listed securities, foreign currencies, etc. Listing 1) Market surveillance Comparatively strong Comparatively weak Self-regulation Comparatively strong Comparatively weak Degree of regulations from the supervisory authorities Comparatively strong Comparatively weak Note: 1) If ATS transforms into a stock exchange, then acquires the function of listing. In the US, an ATS can transform into a stock exchange by registering at the SEC; the scope of their business expands but it has to take additional responsibilities. When ATS is transformed into a stock exchange, it can provide listing service and share profits which came from selling data through registering at the CTA (Consolidated Tape Association). But, becomes subject to the direct regulations of the SEC. The ATS should not violate the roles of transparency and also provide a reasonable level of transaction fees. In addition, it has to hold the function of market surveillance and is not allowed to enact anti-competitive rules. 19

The Establishment of Alternative Trading System in Korea: Issues & Considerations If an ATS registers as a broker or dealer then Regulation ATS is likely to handle more responsibility as trading volume expands. If any of a single transacting security takes below 5% of the countrywide trading volume, the ATS has to report its business contents to the SEC quarterly and cannot use the name exchange or stock market in its business. If any of a single transacting security takes above 5% then the ATS has to disclose its order price and follow the rules as a member of the stock exchange. If any of a single transacting security takes above 20% then the ATS is regulated in the same way as the stock exchanges. * The ATS needs to obey market fairness and implement some contingency plans as well. 20

Ⅲ. Cases: US and EU Ⅲ. Cases: US and EU 1. Development In the US, the ATS industry has been growing after the legislation of the Order Handling Rule, Regulation ATS, and Regulation NMS (National Market System). ECNs (Electronic Communication Network) began their services in 1997 where investors were able to directly trade with each other and not necessary to go through market makers of the stock exchanges. * In the US, an ECN is referred to as an order-driven ATS where information on the electronic trading system is continuously disclosed. 5) In 1998 establishment of Regulation ATS allowed existing ATS to register at the SEC thus the ATS became a legitimate securities market in the country. Establishment of Regulations NMS in 2007 reinforces transparency of the ATS and effectiveness of best execution so as to capture investors confidence on ATSs through Order Protection Rule or Trade-through Rule. 5) SEC Release No.34-39884(Regulation of Exchanges and Alternative Trading System), 1998. 21

The Establishment of Alternative Trading System in Korea: Issues & Considerations Regulation NMS 6) Implements unified rules so as to lead free-competition between markets. Rationalizes Order Protection Rule, which is applied mainly to automated order prices so as to be more strict on the best execution. Other than the existing ITS (Inter-market Trading System), allows private linkage system. If the order price is higher than $1, adjusting the price by less than 1 is prohibited so as to protect from delay of a trade. Sets upper limit on the access fee so that non-members don t have to pay excessively high costs of transaction fees. Such as the stock exchange, an ATS is also required to disclose its information. In Europe, MiFID (Markets in Financial Instruments Directive) was adopted in 2007 so as to induce best execution and officialize the playground of ATSs. The European regulatory authorities suggested MiFID in 2004 in order to expand investors choices of trading systems. 7) * MiFID refers an ATS as a MTF (multilateral trading facility). 6) KCMI release, "U.S. Securities Market Restructuring due to Regulation NMS," 2007. 7) MiFID was officially announced in 2004 by EU, acknowledged for advancing ISD (Investment Service Directive). MiFID is not a form of law but enacted in each country in 2006. 22

Ⅲ. Cases: US and EU MiFID treats ATSs on the basis of same-function-same-regulation, thus the roles of disclosing information is reinforced to ATSs. This effort aims advanced customer protection and reduces inefficiency from market segmentation. * As the market is divided into the stock exchanges and ATSs, inefficiency of market segmentation is the economic costs which indicates different price discoveries or spreads enlarging in the markets. The roles of disclosing information are reinforced so as to bring friendly environment for best execution. MiFID Regulations on ATSs Organize trading rules to lead stability in the systems. The supervisory authorities should re-check the trading rules and price discovery function. Provide market surveillance. Reinforce transparency for both before and after a trade. Set conditions on ATSs capital to lead overall financial stability. No limits on the kinds of securities so that various financial instruments can be traded. 23

The Establishment of Alternative Trading System in Korea: Issues & Considerations 2. Key Factors of Growth Key factors to the growth of foreign ATSs are 1 reduced transaction costs, 2 more flexible trading settings, and 3 diversified trading systems. First, low transaction costs, shortened execution delay, and less market impact are the key factors to the success of ATSs. In efforts to compete with the stock exchange, ATSs have reduced their explicit costs. ATSs have also reduced implicit costs which include timing cost and market impact. * Timing cost is the cost that arises from delay of a trade. * Market impact is the additional cost that has to be paid by traders when a large order changes price in the market. For instance, average execution price may be higher than initial order price if a block trade is involved. <Table 3> Securities Transaction Costs Explicit cost Transaction fee Brokerage fee Implicit cost Timing cost: Cost if trade delays. Market impact: Additional cost if execution price changes. Opportunity cost: Cost if execution fails due to lack of liquidity. 24

Ⅲ. Cases: US and EU ATSs provide more advanced data processing facility than that of the stock exchange so as to reduce the execution time. * For those investors who prefer fast execution system can benefit from the ATS which is very suitable in quantitative strategy, hedge fund, proprietory trading, etc. Some crossing systems or dark pool ATSs take the orders of block trades so as to reduce the market impacts. Secondly, ATSs involve various securities and flexible trading hours so as to secure convenience to investors. Not only the stocks, but also the bonds and FX position are traded on ATSs to fulfill the trading demand that the stock exchanges may not cover. Also, the stocks from different countries can be traded within an unified system which may facilitate investors to proceed global investment. * Instinet can trade stocks of 40 different countries. The trading hours in ATSs are more flexible than those of the stock exchange. * May proceed a transaction if new information comes out after the regular trading hours. 8) * Especially for those global investors may benefit from reducing the gap between the trading hours due to time difference. * CiticATS: 8 a.m.~10 p.m., Tradelink: 8 a.m.~11 p.m., Liquidnet: 2 a.m.~6 p.m. 8) Barclay, Michael and Terence Hendershott (2003, The Review of Financial Studies) Price Discovery and Trading After Hours". 25

The Establishment of Alternative Trading System in Korea: Issues & Considerations Lastly, diversified execution system is also one of the main reasons for the growth of ATS as a whole. Investors may choose various mechanism in price discovery and execution. For those investors who are engaged in block trades may prefer quote-driven system rather than the order-driven system; for those who want to be anonymous may prefer dark pool; and those investors who only want to reduce the transaction costs and extend the trading hours usually prefer order-driven system. 26

Ⅳ. ATS Industry in Korea Ⅳ. ATS Industry in Korea 1. History In Korea, monopoly of KRX has hindered the way of developing ATS industry but there have been instances of infant stage ATSs. They use the price from the KRX thereby not violating the regulations of prohibiting other exchanges than KRX. Usually they only take orders and their prices are made from the outside; which is a crossing system. A. Korea ECN (2001~2005) In efforts to develop the overall trading system and to meet investors various needs, Korea ECN was established in 2001. Listed stocks are traded during the after-hours (4:00 p.m. ~ 8:00 a.m. next day). Clearing/execution service is provided from the KSD. Korea ECN doesn t have the price discovery function and use the price from the KRX. Besides the trading hours, there is no distinct difference between the KRX and also it doesn t have the price discovery function, Korea ECN closed its business in 2005. 27

The Establishment of Alternative Trading System in Korea: Issues & Considerations B. KoreaCross (established in 2008) KoreaCross takes an order before the regular trading hours (7:00 ~ 8:45 a.m.) and makes execution after the regular trading hours (3:00 ~ 6:00 p.m.) with a value weighted averaged price(vwap) from the KRX. It doesn t have the price discovery function and use the price from the KRX; also another type of a crossing system. KoreaCross is widely used by foreign investors who are engaged in the Korean stock market. Due to different trading hours between the domestic markets and foreign markets, foreign investors used to encounter some difficulties but KoreaCross has provided a solution to the matter. It uses VWAP so as to reduce market impacts. C. Korea ATS (2011 Proposed FSCMA) Recently proposed FSCMA is suggesting to adopt order-driven system of ATS in Korea. ATS may well be defined as a form of Financial Investment Agent which needs to be approved by the authorities. Clearing and market surveillance service will be provided from the KRX. 28

Ⅳ. ATS Industry in Korea Trading securities are set to listed stocks but on the review to be changed with revised enforcement ordinance. If the size of ATS industry grows to a certain point, it may be switched over to a regular stock exchange and will be allowed to have a multiple-exchange system in the market. The regulations on various functions will be adopted based on the add-on method. If approved to become a regular stock exchange then it has to carry out the roles of listing and market surveillance services. <Table 4> Domestic ATS Korea ECN KoreaCross Korea ATS Period 2001~2005 2008~Present 2011 FSCMA Trading rules Crossing system Crossing system Crossing system Order-driven system Quote-driven system Price discovery Execution Price discovery Execution Price discovery Execution Trading hours 4:00 p.m.~8:00 a.m. (next day) Order: 7:00~8:45 a.m. Execution: 3:00~6:00 p.m. No specific limits Trading securities Listed stocks Listed stocks No specific limits 1) Note: 1) Listed stocks will be used in the early stage. 29

The Establishment of Alternative Trading System in Korea: Issues & Considerations 2. Effects of the ATS in the Domestic Market The adoption of ATS in Korea may contribute to advancing domestic capital market, reducing transaction costs, along with the fulfillment of the market participants various needs. Customized transaction fees and faster executions play an important role in competing with the existing stock exchange. The improvement in the execution speed and reduced transaction costs is likely to be crucial in meeting the customer needs in the market. The dark pool may cover the customer needs that the existing stock exchange couldn t meet. Such as BATS or Direct Edge, if an ATS switches over to a regular stock exchange, it may bring competition between exchanges. As in foreign cases, ATSs could consider to switch over to a regular stock exchange so as to expand their business scope and make larger profits. ATS could act as a catalyst to boost positive competition and lessen monopoly of the current stock exchange later on. However, ATSs might bring some side effects in terms of market segmentation, transparency of information, and investor protection. 30

Ⅳ. ATS Industry in Korea Market segmentation is the inefficiency that arises when a single market is divided into multiple markets, which is defined as overall problems on ineffective price discovery and different pricing among the markets. For block trades, an ATS provides low-transparent transactions in order to reduce market impact, but this may lead to some disadvantages to a group of investors. * For those investors who prefer transparency of information may get losses. Especially individual investors may be hurt more due to low transparency of information. * For instance, ATS s low transaction fees to large traders could be a problem on price discrimination but could also thought to be as a new opportunity to enhance market efficiency. HFT (High Frequency Trading) is widely used with the growing ATS industry thus may rise sharply. * There could be a problem on flash order which is a service to provide order price to specific traders before opening up to regular investors. * Especially individual investors or small-sized investors may have to bear some losses. In the US and Europe, those side effects are being mitigated with the help of best execution, advanced IT industry, information disclosure, etc. If there is a price difference between an ATS and the stock exchange, the best execution allows investors to have the most favorable price. 31

The Establishment of Alternative Trading System in Korea: Issues & Considerations Which may reduce the gap between the prices and protect the investors who cannot have direct access to the ATSs. In order to practice the best execution, ATSs and the stock exchanges need to search the best order price through SOR (Smart Order Routing) or ITS (Intermarket Trading System). MiFID reinforces ATSs to disclose their information and Regulation ATS also requires to disclose more information as trading volume increases. To sum up, it should definitely need to find legitimate measures beforehand to make sure the overall conditions of information disclosure or the effects on individual investors are appropriate in the current market circumstances. 32

Ⅴ. Considerations Ⅴ. Considerations In order to stabilize the securities market where the stock exchange and ATS co-exist, the financial authorities need to assure transparency of information and protect investors from any unfair acts. 1. Advanced Structure of the Best Execution If a single security is traded on different trading systems, practical standards on the best execution should be established. The new proposed FSCMA revision enforces best execution to financial invetment agents thus the investors are able to compare order prices in the markets. In general, best execution not only denotes the best order price, but also assures favorable timing, certainty, and explicit/ implicit costs so as to fully meet the customer needs. * As for best execution, the US aims at the best order price while Europe covers overall related conditions. In order to carry out the best execution, SOR and ITS have been widely used abroad, thus the criteria of best execution is to be defined in terms of practical and technological perspectives. And it may need to take a further consideration into how and to whom the best execution responsibilities will be applied. 33

The Establishment of Alternative Trading System in Korea: Issues & Considerations In the US the roles of best execution are enforced to exchanges, ATSs, and brokers. * To do so, SOR, managed by brokers, and ITS, a system among stock exchanges and ATSs are being used at the same time. It is necessary to clarify the responsibility on structuring and managing the system in advance. Considering that brokers in the ATSs and the stock exchanges may be different, current regulations of the US are thought to be appropriate. If best execution is violated, a considerable amount of fines must be charged. * For instance, BNY Mellon made fraudulent practices related to best execution for 8 years, then was imposed $2.4 million fine and also the board of members were prohibited from getting a job in all of securities companies. Also there should be concrete measures to take care of errors which could be made on the prices between ATSs and the stock exchanges. An error can arise from many different factors such as the price range, tick size, different trading hours, etc. If the price on a same security is different between ATSs and the stock exchanges, rearranging time, price adjustment, and correcting bodies are to be delineated first. * This is because if the price is different, ATSs, the stock exchanges or some brokers may earn risk-free profits. 34

Ⅴ. Considerations In addition, computing rules on the NAV(net asset value) of funds needs to be re-examined. 2. Independent Clearing House and Market Surveillance It may cause various conflicts of matters if the stock exchange takes the roles for clearing and market surveillance; therefore needs to have an independent form of a clearing house and market surveillance. For the efficiency point of view, recent proposition designated the stock exchange to take the roles of clearing house and market surveillance services. As the fact that the stock exchange has to compete with ATSs, it may be unfair to ATSs if the exchange sets clearing service fees and takes charge of surveillance services. The clearing service fees would be imposed based on the cost price and will eventually need to have an independent form of a clearing house. 3. Transparency of Information & Fair Trade In order to efficiently manage and monitor the securities markets, both pre-trade and post-trade information need to be released appropriately. 35

The Establishment of Alternative Trading System in Korea: Issues & Considerations A unified monitoring system is necessary on the investors who are engaged in both ATSs and the stock exchange so as to protect from any unfair trades such as manipulation, unfair trades, etc. * The information includes all the related contents in the markets such as order price, execution price, trading amounts, etc. In the US, such a role is being taken by Consolidated Tape System which integrates most of trading information and orders, then usually FINRA monitors the markets on the basis of the information. * SEC is also developing Audit Trail System which could monitor trading orders and execution in real time. Policy measures need to be brought beforehand so as to minimize the side effects that arise from different trading systems. If an ATS is adopted and brings competition, welfare of investors would be upgraded as a whole, but the magnitude of upgrade will be different among investors. Especially in case that a sort of ATS allows only specific traders or forms of trades, there should be a clear criteria to decide legitimacy of the trades. 4. Regulations on the Tick Size and Market Stability A trading system may incur unnecessarily excessive competition in reducing the tick size, so it always needs to carefully examine its costs and benefits for adequate regulations. 36

Ⅴ. Considerations An ATS will likely to reduce the tick size in efforts to predominate over the stock exchange and vice versa. Reduced tick size brings competition, thins spread, and cuts transaction costs. However, too much reduced tick size may induce excessive HFT (High Frequency Trading) which could lead to negative effects in pricing. * In the Europe, too much competition over reducing the tick size has brought a voluntary negotiation(2009) of uniting the tick size of most securities. ATSs may also need some kind of a control system such as a circuit breaker in the stock exchange. Considering the domestic market characteristics, a review on implementing adequate control system covering ATSs and the exchange together should be made. Internationally, adopting such control system is different from place to place. * In the US, the circuit breaker system is used in all of the markets including ATS. * In the Europe, few countries follow the routine of the US but most countries use different control system according to their trading markets; thus if a transaction has stopped in one market the same transaction could keep proceeding in another market. 37

The Establishment of Alternative Trading System in Korea: Issues & Considerations 5. Transaction Fees When ATSs co-exist with the stock exchange, it needs to be considered how each market will charge the transaction fees. Different services and transaction fees between ATS and the stock exchange could influence overall trading behavior in the market. * For instance a maker/taker way of pricing, which optimizes the transaction fees in response to supply of liquidity, may have a chance to change the order timing of market participants. Also it needs to take a review on the after-effects of potential price differentiation in the stock exchange and ATSs. Internationally, diversified transaction fees after adopting ATS is reputed as being very complicated and frequently changed compared to that from the past. * Graduated pricing: Lowers transaction fees as trading volume increases. * Price differentiation based on order characteristics. (e.g. proprietary vs. client account) * Maker/taker pricing: Lowers transactions fees for later orders and impose higher fees for prompt orders. 6. Development of the Dark Pool It is necessary to consider allowing the dark pool in the domestic market. 38

Ⅴ. Considerations It has been observed that competitive auction trading of listed securities in order-driven ATSs is basically not different from the regular stock exchange. Development of expertise investments such as hedge funds has increased the proportion of dark pool in the market. It is predicted that an expertise-centered dark pool may be established in Asia later on. The dark pool may cause several issues in terms of fairness; the financial regulatory authorities should provide various measures in order to prevent or mitigate such problems. IOI (indication of interest) is being used to find transacting participants without leaking out one s information but may have the problems on fairness. * Since IOI is not distributed to everyone in the market, those participants who haven t received the IOI would get disadvantages. * EC, the US SEC, and Canadian Securities Administrators disclose actionable IOIs to all market participants in efforts to keep transparency of information. Sometimes unified trading data service is provided but some participants are not allow to access on the system thus they cannot affect price discovery properly. Also if development of the dark pool causes the size of lit pool to shrink, it may bring some inefficiency in price discovery. 39

The Establishment of Alternative Trading System in Korea: Issues & Considerations Regulations on transparency and execution should be made in case the dark pool is adopted. A certain level of transparency needs to be effectively guaranteed in order to maintain effectiveness and fairness in the market. * Here, transparency includes both pre-trade and post-trade information. However, it may need to keep in mind that too high transparency sometimes reduces the volume of block trades. Thus a moderate degree of transparency needs to be enforced in each market and also reasonable standards or explanation should be prepared if the requirements of transparency are being differentiated in those markets. * The supervising authorities of each country differentiate the requirements between lit pools and dark pools, but at the same time, they put every efforts to keep effectiveness and fairness among the markets. IOSCO (International Organization of Securities Commissions) gives priority to transparent orders whether the orders are from lit or dark pools. All of the market participants need to be fully notified about the advantages and disadvantages that they may get from differences in transparency between the regular exchange and ATSs. 40

Ⅴ. Considerations 7. Mid-to-Long-term Plans for the ATS Industry Considering that the main purpose of adopting ATSs is to boost competition in the secondary markets, it needs to bring specific plans and schedule to incur actual competition. For instance, it is not suitable if the stock exchange establishes ATS on its own in the early stage but will be acceptable when proper competitive circumstances are settled as a whole. In case that international ATS is adopted into the domestic market in coming days, it needs to take an additional review. 41

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