The Japanese derivatives market is really two distinct markets – financial derivatives, with three exchanges, and commodities, with four. But the apparent strength of these forces is not reflected in powerful results. Trading volumes for most of the exchanges, in fact, have been dire. Now both sectors have begun to grapple with the need for fundamental modernisation.
The financial derivatives market, with its own regulator and individual rules, is serviced by the Osaka Securities Exchange, the Tokyo Stock Exchange and the Tokyo Financial Exchange. This market is globally significant – though without roaring volumes.
Separately, there is commodity derivatives – peopled by the Tokyo Commodity Exchange, the Tokyo Grain Exchange, Kansai Commodity Exchange and the Central Japan Commodity Exchange. This market has shrunk at an alarming rate.
The OSE leads trading volumes in Japan, with 166m contracts traded last year, making it the world’s 19th largest exchange according to Futures and Options Intelligence. OSE has outstripped the TSE – Japan’s dominant stockmarket – through its suite of Nikkei 225 Index Futures, Options and Mini Futures, which account for virtually all its volume.
The TSE has been concentrating on winning the share trading race. Its volume of 26.2m contracts in 2009 was a sixth as much as OSE’s – its biggest product, Topix Index Futures, is just not as popular as the Nikkei contracts. TSE’s Ten Year Japanese Government Bond Futures also declined in volume last year, though the related options held up well.
The Tokyo Financial Exchange’s derivatives offering has virtually dwindled away. Trading of its Three Month Euroyen Futures on Japanese short term interest rates has shrunk from 39m contracts in 2007 to 13m last year. Only 3.15m contracts were made in the first four months of 2010. The bourse has had some success with its new spot FX service.
Japan’s commodity markets also have a tale of woe to tell. Tocom is the strongest exchange, though its volume has declined fairly steadily from 87m contracts in 2003 to 28.9m last year. The slide appears to have bottomed out, however, with 9.9m bargains in the first four months of 2010.
The pain is much worse at Tokyo Grain Exchange, where there were just 4.83m contracts in 2009, a quarter of 2007’s volume.
The decline of Japan’s commodity futures markets is no accident. An amendment to the Commodity Exchange Law, implemented in 2005, made soliciting individual investors difficult by putting curbs on aggressive sales techniques such as phone marketing or cold calling.
Brokerages, which represented retail investors, were forced to deposit their clients’ margin funds with the new Japan Commodity Clearing House, which led to a clearer separation between the accounts of customers and brokerages.
To make life even harder, the government recently passed new requirements that from 2011 will ban marketing commodities products to retail customers except through newspaper advertisements or specialist seminars – draining the once dominant retail sector from Japan’s commodity markets.
These legal changes hit some exchanges harder than others, especially the TGE, which had a large retail customer base.
So bad has the performance of the Central Japan Commodity Exchange been that news reports even suggested that it would cease trading – though a spokesperson for the exchange denied this.
However, while the commodity exchanges have been handicapped by changes in the law, they did little to help themselves.
New products, longer hours
The Japanese exchanges know they have a problem with falling volumes, and that they need to act before they are left further behind by global competitors. They have announced a string of initiatives to attract more trading.
The TSE has ambitious plans to double derivatives trading from 2007 by the end of the 2011 financial year next March. Because of the decline since then, that means it will have to raise volume by 153% from 2009 levels.
However, the exchange insists that by expanding its product portfolio, it can still meet the target.
On July 26, the TSE will introduce three dividend futures, hoping to capture trade that previously went on over the counter. They will be linked to the Nikkei Stock Average Dividend Point Index, the Topix Dividend Index and the Topix Core 30 Dividend Index.
Dividend futures are this year’s trendy contract for exchanges to launch, from Chicago to Frankfurt to Johannesburg.
Julien Le Noble, chief executive officer of futures broker Newedge Japan, says there is no reason why the product’s success elsewhere cannot be replicated in Japan.
Perhaps the busiest exchange, in terms of new measures to boost volume, is Tocom. The exchange will extend its trading hours to 4.30am from October, in the hope of luring trading firms that play the London and New York commodity markets. In March it introduced Nikkei-Tocom Commodity Index Futures.
The OTC sunrise
Besides new products and longer trading hours, perhaps the most intriguing development for the Japanese exchanges is the prospect of clearing over the counter derivatives.
The idea has been important to European and US exchanges such as NYSE Liffe and CME Group in recent years.
Japan is the first and so far only major nation to pass a new law since the financial crisis that mandates clearing of some derivatives. In Japan, standard yen interest rate swaps and credit default swaps linked to the iTraxx Japan index will have to be cleared by regulated clearing houses, probably from 2012.
TSE and TFX had both already begun work on creating OTC clearing houses, and are eager for the new opportunities created by the law.
Mitch Fulscher, a consultant with Melamed & Associates in Tokyo and chairman of the Futures Industry Association Japan, says that unlike the US, the Japanese have taken a measured approach to regulation since the global financial crisis.
He believes the market will benefit from more central counterparty clearing, though two exchanges offering the same service could be one too many, when the Japanese OTC market is not that large.
TFX seems to be thinking along the same lines. Masayuki Nakajima, executive officer at TFX, says that while no formal agreement is in place with TSE, one possibility might be that TFX offers OTC clearing for the interest rate swaps, while the stock exchange handles CDS.
Tocom is also examining the feasibility of an OTC clearing house, encouraged by CME Group’s success with ClearPort for commodities, says Mitsuhiro Onosato, executive officer for business planning.
Tech is the key
For an exchange, good technology can be a game changer. One reason why the OSE has been more successful than the other Japanese exchanges is that it listened to its clients by implementing Span, give-ups and colocation services.
Not content to rest on its laurels, the OSE has agreed a deal with Nasdaq OMX to upgrade its platform from the second quarter of 2011.
Several of the other exchanges have now embarked on technical upgrades.
TSE introduced a new options trading platform, Tdex+, in October last year, and will move its futures to it in the next few months.
TFX, which struck a deal with Liffe to license its exchange platform in 2005, will upgrade its technology in 2013. Nakajima says the exchange is “presently in the process of selecting” which firm will supply the new system.
In the commodities sector, too, the exchanges have finally begun to address their technical weaknesses, something Fulscher says is long overdue. They have continued to use archaic practices, such as an Itayose system, which prevented any direct market access orders.
In May 2009, Tocom finally went live with a new Nasdaq OMX trading system, which includes circuit breakers and allows the exchange to offer colocation.
TGE has also belatedly realised that good technology is important, striking a deal with Tocom to share its Nasdaq OMX trading and clearing platform from January 2011.
Fulscher says the IT upgrades show the exchanges have “finally” realised their technological offering was hindering their development.
“For a long time the leaders of the exchanges just didn’t get it, just didn’t understand the importance of providing technology that is demanded for getting the international participants to join and bring the liquidity that makes even the domestic markets more successful,” Fulscher says.
Le Noble says these measures have borne fruit: “The influx of prop trading shops and market makers in the last four years is a positive reflection of how much more conducive the market is now.”
For Fulscher, all the exchanges deserve credit for the efforts they have made to address this need, but Tocom has perhaps made the greatest strides. “Tocom has taken long-needed action to position itself to attract international players,” he says.
One way of seeking trading volume from overseas is a remote membership scheme – something that the OSE, TFX, Tocom and TSE have done. These allow overseas investors with no offices in Japan to become members.
Each scheme is slightly different. At the TSE, firms must establish some relationships physically in Japan, which includes having a designated clearing participant and a resident compliance representative.
With the TFX programme, remote members are only permitted to trade its Three Month Euroyen Futures and Options.
For its part, Tocom is hoping to capitalise on its upgraded technology by seeking approval from overseas regulators to offer direct market access internationally.
Several international firms have taken advantage of this new service. Fulscher says he himself has noticed an increase in the number of foreign firms now looking at Japan, though he advises them that there are still several issues that need to be addressed. As he puts it:“High frequency traders call upon me and ask, ‘Is now the right time to get into this market?’ I say ‘Almost’.”
Fulscher says that while Japan is making huge strides forward, it must still address problems with the tax position of international remote members. Firms that have any trading infrastructure in Japan are taxable, and the tax levels are much higher than those in other countries.
“Tax is already complicated enough – especially in Japan. Who wants to put servers close to the Japanese derivatives exchanges and then be hit by the Japanese tax authority?” asks one executive at a futures commission merchant in Singapore.
The TSE has worked hard to address this issue. Earlier this year, it reached an agreement with the National Tax Agency whereby overseas investors without a presence in Japan will be considered, on a case-by-case basis, for exemption from the country’s 40% ‘permanent entity’ tax.
It is not clear whether the other exchanges offering remote membership have secured similar agreements. Fulscher says FIA Japan is in the process of putting a working group together to tackle this issue with regulators.
A hotline to London’s liquidity
While international trading in Japan can be troublesome, that is not the case in London. NYSE Liffe plans to introduce Topix futures in the fourth quarter of this year, which will be fully fungible with the TSE’s contracts. Both exchanges hope to profit from the deal.
Listing the futures at Liffe will lengthen the trading day from the present seven hours to 19.5 hours. When trading finishes in London, open interest will be transferred to Tokyo.
Jonathan Seymour, director of equity derivatives at Liffe in London, says the new products will complement the exchange’s existing index futures and options, while also satisfying demand from clients for access to this index.
“Topix is very much an institutional benchmark product,” says Seymour. “It is used globally by institutions that have exposure to Japanese equities. Many of those institutions are based in Europe. Our listing of the Topix futures contract will provide the ability to trade that market in European and US trading hours.”
One country, seven exchanges
Choice is often a competitive driver. However, in Japan it may be hindering the development of derivatives trading. For a modest-sized market, Japan’s seven exchanges is a surprisingly large number.
Le Noble says the effect is to increase costs and barriers to entry for trading firms. “It’s hard to understand – when the government and the regulators are passing into law the possibility for exchanges to list all types of products, and even to merge or acquire one another – why so little is happening in this area.”
As a result, any firm interested in trading, say, long and short term Japanese interest rate contracts and the most liquid equity index contracts would have to connect to three exchanges. It would have to undertake due diligence three times, find brokers – not many connect to all the exchanges – establish relationships and so on.
“It’s very costly for Japan, not only in terms of higher trading and operating costs, but also the opportunity loss when participants shy away from such a fragmented and complex marketplace,” Le Noble concludes.
However, the exchanges have steadfastly refused to consider merging – even though the Commodity Futures Industry Association of Japan declared in February 2009 that the TGE should combine with Tocom. It said 80% of brokers surveyed by the association favoured a merger. The TGE rejected the notion.
An analyst at a Japanese trading firm in Tokyo says he believes the stubborn approach – particularly from TGE – is derived from its ownership structure.
While tax may deter bigger international players from entering Japan’s derivatives markets, there are a few other problems unique to the commodity sector.
Perhaps not surprisingly, since Japan has been a domestically focused market until now, its commodities exchanges have not been that attractive to international participants.
“The products were not really designed for international customers,” says Emmanuel Faure, head of business development and sales for futures at HSBC, and the issue is complicated by the large number of commodity exchanges.
For example, the TGE and Kansai Commodity Exchange have a very similar range of products, and many of the commodities, such as sugar, silk, coffee and soybeans, can be traded with much greater liquidity at exchanges elsewhere in the world.
Fulscher highlights another problem: what he calls the “desperate need” to upgrade the Japan Commodity Clearing House (JCCH).
The FIA Japan published a report on this point in February 2009, saying urgent action was needed in four areas: risk management, IT infrastructure, overall management, and a new business plan.
“The JCCH is far behind international standards,” agrees Le Noble, “and far behind with regard to its ability to serve market participants.”
The trade association even said that with things the way they are at the JCCH, a more radical approach may be needed.
“It would be very difficult to expect the existing clearing house to deal with the changes that we believe are required, due to its existing structure and the current financial status of the commodities futures industry in Japan,” the FIA Japan report read.
It recommended that Tocom, as the largest commodities exchange, should head the clearing house. However, it also offered a more radical suggestion: to create a single clearing house for both financial and commodity derivatives.
“Internationally, it is recognised that users need and demand a way to better manage their clearing funds and margin money, as well as to have transparency and to be able to measure the risk between each clearing participant as well as its offsetting positions and arbitrage,” the FIA Japan report said.
Le Noble says creating a single, multi-asset clearing house would be a great help for the Japanese market. “It would be as beneficial as if there was one single exchange in Japan,” he believes.
Faure agrees: “Anything that makes trading cheaper and easier for the clients is a good thing for the margin. If they were to merge the clearing house, at least you could pool margin requirements.”
One chance left
With Japan still the world’s second largest economy – if only a whisker ahead of China now – it is natural to expect that its derivatives market should be a global force. However, that view is too easy.
The Japanese market is in danger of being sidelined, as regional superpowers such as China and India emerge.
“For years and years, Japan was the only way to invest in Asia,” says Faure. “Over recent years other markets have opened, and now it looks as if other markets have more potential.”
Fulscher concludes that Japan should have taken its rightful place as the financial centre for Asia many years ago, but that inaction by the exchanges on a series of issues had let the country fall behind.
But market participants also agree that all is not lost. “I don’t see Japan as a dead market,” says Faure.
Le Noble stresses that Japan continues to be a force in the world’s markets, and still has all the really important ingredients to regain a leading role.
“Right now is probably the last chance for Japan to make a comeback and be a firmly established dominant marketplace in the Asia Pacific region,” says Le Noble. “Japan runs the risk of being left behind once other regional exchanges have developed and opened up. But that being said, there is still huge potential as the problems are more about cultural customs and domestic policies, rather than real expertise or a lack of infrastructure.”