The early 18th Century in Japan was a time of great upheaval. A series of poor harvests combined with restrictions on trade had led to a collapse in the price of rice. Rice was essential to Japan not only because it was the staple food, it was also the commodity by which much of the population was paid. Riots met the rise in rice prices. In response, rice brokers on the Dōjima Rice Exchange in Osaka began guaranteeing forward prices of rice. The concept of futures was born.
For three hundred years, Japan pioneered the derivatives industry and remained a derivatives powerhouse right up until the turn of the century. In 2001, over 118m contracts were traded in the country, representing a 55% share of exchange traded futures and options in Asia and a 3.4% share of the global market.
Japan as a derivatives trading market trailed only the US, France, Germany and the UK in trading volumes. The exchange landscape was populated by a host of successful exchanges, led by the Tokyo Commodity Exchange with almost 56m trades in 2001, followed by the Tokyo Grain Exchange with 23m trades.
By 2010, while volumes on Japan’s derivatives market had more than doubled totalling over 260m contracts, its Asian market share had fallen to just 2.7%, while the global share fell to 1.1%. The exchange landscape has also changed with the Osaka Securities Exchange emerging as the clear front runner in derivatives trading, with 191.78m contracts traded, a 73% market share in volume and way ahead of Tocom and the Tokyo Stock Exchange.
Outdated silos
To understand the roots of the substantial decline in the fortunes of Japan’s derivatives markets, one has to consider its market structure. Japan still has three different regulators each overseeing different products. With three watchdogs come three different regulatory requirements so those firms that trade across different asset classes have different rules and reporting standards.
For customers, it wasn’t any easier. They needed separate accounts and often separate brokers. As a result, most domestic and international traders focused on one product and trading migrated to more investor friendly markets when they became available.
With each product having separate regulation and often different market participants, it is perhaps not surprising to observe contrasting fortunes in performance. The equity derivatives market is dominated by the OSE and the TSE. Today, the OSE is far and away the largest and most vibrant equity derivatives market, offering Nikkei 225 futures and options, and mini futures.
Colin MacFarlan, head of futures, Asia Pacific at Credit Suisse, describes the contracts as “a global success story”, with a deep pool of liquidity.
Volumes in the Nikkei 225 contracts have grown consistently year-on-year, peaking last year at 22.48m for the futures and 43.79m for the options contracts. While these volumes may not be groundbreaking, each contract has a national value of 1,000 yen multiplied by the index. The national value of the Nikkei 225 options in 2010 was approximately $130tr, comparing favourably with most successful equity index contracts.
The success in financial derivatives has not been replicated in commodities. Legislative changes and pressure from regional competitors has taken its toll on the sector. Trading in commodity futures slumped 26% in 2010, the sixth successive annual fall.
Tocom is now the market leader, with trading at TGE having dropped dramatically over the past decade, while the Central Japan Commodity Exchange ceased operations in January amid the collapse of commodity derivatives trading and its market share falling to less than 5%.
Without doubt the biggest contributing factor to the slump came with the amendments to the Commodity Exchange Law in 2005, which limited speculative trades and banned aggressive sales techniques on commodity contracts by Japanese brokers as well as limiting access to the markets.
The laws also moved to counter concerns over the activity of brokerages. Those brokers that represented retail investors were forced to deposit their clients’ margin funds with the new Japan Commodity Clearing House, clarifying what many saw as a grey area between the accounts of customers and brokerages.
In 2011, Japan tightened regulation for offshore commodity traders. All brokers must now be licensed by both the Ministry of Agriculture, Forestry and Fisheries (Maff) and the Ministry of Economy, Trade and Industry (Meti) as Commodity Derivatives Business Operators.
MacFarlan describes the action as “well needed” in terms of improving market governance, though he adds that they “shot themselves in the foot in terms of volumes”.
Economics have hit fixed income trading. Back in 1996, TFX was Japan’s largest exchange but by 2010, the exchange was a fourth. The decline of Japan’s largest fixed income derivatives market can be attributed to one thing: the country’s economy.
Interest rates in Japan have been below 0.5% since September 1995 and at 0% for most of the 00s. TFX volumes hit more than 37m in 1994 before dropping to just 4.1m in 2003. While volumes picked up with movements in interest rates in 2006 and 2007, hitting an all time high of 42.6m in 2007, volumes have since fallen substantially with just 11m trades last year.
Winds of change
Volumes in IR trades will pick up when interest rates start to move but Japan faces a more fundamental challenge in its bid to return to its former status: the derivatives market structure, which has long been a barrier to growth. The Liberal Democrat Party government took few steps to revitalise the markets, and as participants become ever more frustrated, Japan’s derivatives market share shrank.
However, in 2009, the Democratic Party of Japan took power, ending the LDP’s 54 year tenure. There were signs of change with the new government. Last year the government announced plans to restore Japan’s standing as a financial sector, with plans to boast derivatives trading at the heart.
Key to the plan was the breakdown of market silos, even proposing a single exchange that would offer both financial futures and options alongside commodity derivatives. This idea, called the East Asia Exchange, is part of Japan’s effort to develop its futures and options markets. The plan will also alter the regulation of derivatives markets.
Yoshio Kuno, president of Newedge Japan, says that while the financial exchanges continue to be profitable, users would like to see consolidation. “From a users’ point of view, we want to see consolidated exchanges, provided that it makes users’ lives easier,” he says.
While Kuno hails the benefits of consolidation among the exchanges, perhaps even more so in the commodity markets, the Newedge executive says it must be in conjunction with regulatory harmonisation.
Mitsuhiro Onosato, executive officer at Tocom agrees with the assessment of the need for regulatory harmonisation. “We think that unified market regulation and surpervision are more rational and instrumental in enhancing convenience for the market participants,” he says.
The proposal for a single market has been welcomed by market participants. While it is still in the early stages of planning, and the details are far from finalised, there is a clear set of objectives: a one stop shop for products, the regulatory harmonisation between Japan’s numerous watchdogs, and making business easier by establishing a solution to the tax issues that plague Japan’s drive to encourage remote trading – more on this later.
Come together
While Japan’s derivatives markets have shrunk as a percentage of global trading, surprisingly the drop in global share has not been reflected by a similar drop in the number of exchanges. In 2010, when Japan’s derivatives volumes accounted for less than 2% of global derivatives trading, the country still housed five main exchanges and the regional Kansai Commodity Exchange.
While the world has been gripped by bids and rumours of exchange consolidation, there has been little action from Japan. However, Japan’s commodity exchanges have moved to partner up motivated by financial pressures. In addition, Tocom took over the trading of the C-Com futures contracts after it closed its doors.
While of course financial pressures may force consolidation there is a question of how important a reduction in the number of exchanges is for the market as a whole. Peter Jaeger, managing director for futures and options Japan at JPMorgan, says the harmonisation of exchanges is perhaps more important than reducing the number of bourses.
“An outside observer could be forgiven for finding Japan's mix of five futures exchanges overly complex. Agriculturals, industrials and financials all trade on different exchanges. The two major stock index futures trade on different exchanges. Only one exchange lists a bond contract. Another exchange lists the only short-term interest rate contract. Each exchange has different rules and is subject to different regulators,” Jaeger says.
“A mechanical consolidation alone would not boost trading volumes, but it stands to reason that members and clients would benefit if the end product had one set of rules, one set of regulators, one technological environment, and one clearinghouse. “
Japan’s leading exchanges also appear to share Jaeger’s view. There are also signs the leading exchanges may also consider mergers, but they are not in a rush as many of them are rumoured to be planning to float. In March, TSE President Atsushi Saito said his exchange was interested in possibly merging with the OSE, just months after the exchange had denied it was talking with Tocom over a possible partnership.
Akira Tagaya, executive manager, business development at the TSE, says the exchange is open to a merger but there is currently “nothing that can be disclosed”.
While Tocom’s Onosato won’t be drawn on possible mergers or timetables, he does admit the exchange is open to partnerships, but, as the Tokyo-based exchange has told the working group forming the government’s plan, it must be a merger to improve the marketplace.
“Tocom is open to discussing the possibility of consolidation if it leads to a revitalisation of the commodity market and our heightened corporate values. We are ready to consider all possibilities for exploring effective solutions to achieve these two goals,” Onosato says.
“We have emphasized, however, to the officials of the regulatory bodies and the government that what we are striving to achieve is not the consolidation of organisations, but the improvement of market convenience and the revitalisation of the Japanese market.”
Tsunami changes priorities
While the Japanese government may have made the restoration of Japan’s financial stature a priority, the devastating Tsunami in March set them back. Trading on Tocom spiked in the month of the earthquake with monthly volumes over 50% above their norm. However, one of the long term impacts of the earthquake will be on the pace of legislative change.
Indeed Onosato says the working group’s meetings have been suspended, probably delaying the introduction of the universal exchange project initially scheduled for 2013.
Speaking on the progress, Kuno says there have been several rounds of talks but the tsunami “has changed everything” and he expects the proposals to be put on hold until the disaster recovery efforts have been completed.
Tetsuya Kudo, deputy manager at Yamawa Securities, adds that another consequence of the earthquake and Tsunami is the impact on local brokerages. The Tokyo-based executives says the devastation has meant the retail sector have been unable to pay margin requirements to their clearers, leaving many brokerages with substantial losses.
Technological partnerships
With no exchanges currently committed to a merger and the government now rightly focused on the disaster recovery efforts regulatory harmonisation discussions are on the backburner. As such the market must look elsewhere for harmonisation.
One area that is currently being explored is linking the technologies of the exchanges. In January, Tocom licensed its trading system to TGE, allowing a bridge between the two exchanges.
Kuno says that the wishes of the government to see the breakdown of silos, market demand, and the realisation that technological expenses can be cut by aligning systems with compatriots, may all combine to encourage these “softer alliances” whereby one exchange offers its matching engine to another.
In February, the OSE went live with J-Gate, the Nasdaq-supplied trading platform, which is also used by Tocom, fuelling speculation that a similar agreement to the one with TGE might be reached.
Neither Tocom nor the OSE has confirmed the speculation but already participants are excited. “While commodity trading and financial instrument trading on the same exchange is common in the US and other countries, in Japan the gulf between the two is severe,” Mitch Fulscher, chairman of the FIA Japan says. “But this is exactly in line with the thinking of the political leaders and would clearly be welcomed by domestic users of the markets and international players.”
Tax issues
International participants may welcome the ability to trade numerous products through one connection but there remain tax issues that need resolving if Japan is to regain ground on its regional and international rivals.
Under current legislation, if a market firm wants to trade remotely, then any gains made from these trades will be liable for tax in Japan, even though that firm will not have staff/infrastructure in Japan. Compare this to most countries will tax income depending on where the business books its revenue. The situation is also complicated by the fact that Japan’s tax rates are higher than most other nations, meaning many firms have been put-off remote trading in Japan.
Some trading firms, through the TSE primarily, have been able to sort out tax arrangements so that they pay lower tax rates, but it is still an issue.
“Tax policy is one of the strategic tools countries employ to compete in the international business arena,” Jaeger says. “It affects all industries and has a long-term influence on how businesses formulate their deployment strategies. In Asia, Japan competes with venues like Hong Kong and Singapore which have long-established pro-trade policies, and the exchange traded derivatives market is no exception.”
Too little, too late?
While nothing can be certain, the success of Japan’s equity markets looks set to continue, but is it too late to revive its derivatives industry.
Japan’s financial derivative market is almost certain to continue to suffer from the Tsunami. Interest rates will remain low and the news last month that Japan has slipped back into negative GDP growth, threaten to perpetuate this. MacFarlan says that because Japanese interest rates show no sign of increasing, he pessimistic for the fixed income derivative market.
Japan’s largest commodity exchange Tocom has recorded volume growths since the low of 2003 but with Japan geographically straddled by China and India, can it retain its significance in the regional market?
Overall Kuno says he is optimistic that Japanese derivatives volumes will continue to grow despite a slowdown after March’s high volatility. The Newedge executive cites interest from overseas in the products as well as services such as co-location.
Jaeger too shares Kuno’s optimism, believing that Japan’s underlying economic problems will afflict all global economies in the future. “One of the biggest drags on Japan's economy has been her aging population, but most of the world's major economies will encounter similar demographic issues over the next generation. In relative terms, therefore, I am confident that Japan can outperform again,” Jaeger says.
While the devastation has meant chaos to many, MacFarlan says there may be some light at the end of the tunnel for Japan’s economy, with large scale investment from the Japanese Government serving as a boast to the country’s financial markets.