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Japanese markets: Preparing for the next wave

In recent years, Japanese markets have witnessed increased retail and online trading, as well as foreign investment. They are learning to adjust to global competition and are making considerable progress in adapting their technology and regulatory framework to meet international standards.

Traditionally, Japanese markets have been order-driven, without market-making or special services to accelerate trading and increase liquidity.

Nevertheless, the large size of the Japanese economy has been enough to inject plenty of liquidity into its markets, where there are now more than 3,000 stocks listed.

In recent years, liquidity and volume have increased considerably, due to Internet trading from retail investors and because the government has introduced incentives for investing in the stock markets to generate greater investment returns.

The liberalization of the stock markets began in the late 1990s. More recently, the markets have undergone major regulatory changes to enhance fairness and transparency. In the short term, this has created a downturn in turnover, especially for the commodities exchanges, but analysts regard the changes as necessary and are confident that Japan’s markets will benefit in the long term.

“There has been a clear strengthening of the regulatory environment both on the financial and the commodities markets,” says Julien Le Noble, Managing Director of the French brokerage firm Fimat in Japan.

Julien Le Noble, Managing Director of the French brokerage firm Fimat in Japan

In 2006, a new legal framework was introduced, abolishing and consolidating four laws into the new Financial Instruments and Exchange Law (FIEL). Changes were made to the definition of securities, the scope of derivative transactions, disclosure rules and tender offer rules, along with other significant provisions.

“We welcome the new law,” says Le Noble, “since it will strengthen the Japanese financial marketplace, increase transparency and raise its international position.”

The recent growth in the Japanese stock markets also derives from continuous demands from foreign investors, who have started to trade heavily in Japanese markets.

»I would not be surprised if in three to four years’ time, Japan has only four or five exchanges.«

Both domestic retail investors and foreign investors depend on high quality technology systems, since many of them use program trading techniques such as algorithmic trading.

Exchanges in Japan were among the first in the world to use electronic exchange systems, but these systems have not been developed significantly for the past 10 years, due to the bearish equity markets. So while trading has increased, it has led to incidents among exchanges such as system delays, suspended trading, program bugs and capacity problems.
“People may think that Japan is a technology-driven country, but at the exchanges sometimes not even fundamental technology works,” says Kenichi Ohmae, Managing Director and founder of Ohmae and Associates and a leading management consultant and global business strategist.

OHMAE SAYS that the main reason for the delay in technology development is that most exchanges have been operated mainly from a regulatory perspective as government or semi-government organizations and, as such, tried to protect individual investors from being exposed to risks associated with modern financial assets or trade practices.

Another obstacle is the ownership structure of exchanges. Japanese exchanges are mostly owned by associations of brokerage firms and commodity trading firms, many of which are small and middle sized traditional local firms that are not particularly interested in introducing modern practices. Limited resources in, for example, management with good industrial knowledge and language capabilities also make it difficult for Japanese exchanges to communicate with foreign marketplaces.

The Tokyo Stock Exchange lists 2,416 companies with a market capitalization of more than USD 4 trillion.

One exception is the Osaka Stock Exchange (OSE), which is the only listed Japanese exchange. The OSE listed on its own Hercules market for startups in April 2004. Being a publicly listed exchange automatically leads to greater transparency and makes management more aware of the need to look for new opportunities.

“We can see now that the OSE is talking about improving its technology and finding new business models,” says Ohmae.

The success of the OSE listing has led its major rival, the TSE, to plan its own listing in 2009 when its new domestic system is implemented.

There is talk in Japan that the number of exchanges may be significantly reduced. The government seems to have adopted this idea, while market participants are more cautious and say that competition is necessary.

The Japan Securities Dealers Association is said to be considering a proposal to merge the TSE and five other stock markets and reorganize them into several new bodies under a holding company by 2009.

“We can see a trend that the government and members of financial and commodity industry associations encourage mergers,” says Ohmae. “It is something that the markets welcome, and they would also like to see the exchanges listed to improve transparency.”

“I would not be surprised if, in three to five years’ time, Japan has only four or five exchanges,” concludes Le Noble.

However, it seems clear that both the OSE and JASDAQ – a securities exchange headquartered in Tokyo that operates an electronic trading system similar to NASDAQ in the US – want to keep their autonomy and not be placed under, for example, the TSE.

TSE and the Japanese exchanges are increasingly looking for regional and global partnerships. In 2002, the TSE signed a memorandum of understanding (MoU) with the NYSE, which was followed up by a strategic alliance agreement early this year. TSE recently signed a partnership agreement with the LSE regarding product development and technology sharing. TSE also has MoUs with the Korea, Shanghai, and Taiwan stock exchanges and other exchanges around the world.

Kenichi Ohmae, Managing Director of Ohmae and Associates.

From a technology point of view, Japanese exchanges use solutions mainly from Japanese system providers. The solutions are tailor-made for the market and are difficult to adapt and integrate with international marketplaces. However, marketplaces in the region are looking into competing on the Japanese market by bringing in foreign technologies.

“Foreign exchanges can bring in different cultures and different market models to Japan,” says Ohmae. ”It would be welcomed if they should try to open their own exchanges in Japan and improve Japanese financial markets. They already have relations with investors abroad, and they have proved that their market models work.”

»...at the [Japanese] exchanges sometimes not even fundamental technology works.«

An interesting development is the Proprietary Trading System (PTS), which was introduced in 1998 and is a private broker-to-broker market. “I would not be surprised if the PTS market would gather liquidity with superior technology to the level to compete with traditional exchanges,” says Ohmae.

For the commodities futures markets, a new Commodity Exchange Law was put in place in 2005. The main purpose was to make the market more reliable and established and to ensure that all assets deposited by customers are protected and segregated as properties belonging to customers.

The 2005 law clamped down on certain sales techniques, such as cold-calling, and asked for clearer separation between the accounts of customers and brokerages. With the establishment of the Japan Commodity Clearing House, brokerages were forced to deposit clients’ margin funds with a central authority.

“The purpose of establishing the clearing house was to protect customer interest and enhance market integrity,” says Yasuo Mogi, Senior Executive Vice President of Himawari Securities in Tokyo. “It is time for Japan to create a modern structure and invite international participants. The goal is that our trading shall not rely on speculators. We have to make moves for the markets to be more professional.”

Following the new law, commodities futures market activities have sharply declined, since these markets had largely been driven by speculators. It has also led to a reshuffle among brokerage firms, since the new law also stipulates deregulated fees and new costs.

In Le Noble’s view, the benefits of the new law will outweigh the costs, since in a couple of years international investors will look at Japanese markets with much more confidence and willingness.

By Jan Hökerberg Photos Getty Images

MarketView 2007:1

The Tokyo Stock Exchange (TSE) is the second largest stock exchange market in the world after the NYSE by monetary volume. It currently lists 2,416 companies, and the total market capitalization is more than USD 4 trillion.

The Osaka Securities Exchange (OSE) is the second largest exchange in Japan. The Nikkei 225 Futures, introduced in 1988, is an internationally recognized futures index. The OSE lists 1,072 companies, but corporations often opt to trade their stocks on both the TSE and the OSE. The OSE is the leading derivatives exchange in Japan and the only Japanese exchange that has gone public.

The Tokyo International Financial Futures Exchange (TFX) is another specialized exchange for derivative products.

JASDAQ is a new securities exchange that operates an electronic trading system similar to NASDAQ in the US. NASDAQ and JASDAQ markets are unique in their use of market makers to quote prices, rather than being order-driven.

Three smaller stock exchanges, in Nagoya, Fukuoka and Sapporo, operate only on their local markets.

One effect of the regulatory changes is the ongoing consolidation process among commodities exchanges in Japan. Compared with seven in early 2006 and 16 in 1989, there are now four commodities exchanges in Japan: the Tokyo Commodity Exchange (TOCOM), the Central Japan Commodity Exchange (C-COM), the Tokyo Grain Exchange (TGE) and the Kansai Commodity Exchange (KEX).

Ever since the bubble economy burst in 1990, Japan has been on a path to recovery. Today, the nightmare seems to have ended, and corporate earnings are on the rise.

It has not been an easy ride for the world’s second largest economy. For more than a decade, Japan has been struggling to make a comeback, trying to wake from the nightmare caused by the bubble economy in the late 1980s, when real estate prices and stocks skyrocketed due to heavy speculation.

When the bubble burst in 1990, the country’s banking system was crippled by bad debts. In the aftermath, companies experienced negative cash flow, asset prices fell, consumers held onto their money, deflation ruled and the economy stalled.

“However, since 2002, Japan’s economy has witnessed a record-long expansion period,” says Kenichi Ohmae, Managing Director of Ohmae and Associates. “Companies have started to reinvest, and many industries have undergone necessary consolidations.”

In 1999, the Bank of Japan cut interest rates to zero, and they are still the lowest in any industrial country. In 2001, the central bank adopted a policy of quantitative easing of the money supply and backed up the banking system with cash injections in an attempt to get banks lending again.

The injections seem to have worked. Corporate earnings are on the rise, and in 2005, the Nikkei index was up 40 percent with continued growth in 2006.

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