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Asia-PacificMarch 30 2010

Tokyo advances in global trading race

Tapping into high-frequency: TSE's Arrowhead system is as fast as those of New York and LondonAfter five years plagued by setbacks, the Tokyo Stock Exchange has raised its game with the launch of its Arrowhead trading system in January. The exchange's next goal is to successfully accommodate the increased flow of alternative trading in order to cement its position as a rival to the more established centres in the US and Europe. Writer Charles Smith
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Tokyo advances in global trading race

The Tokyo Stock Exchange (TSE), once the world's largest exchange with 40% of global stock market capital during a brief euphoric period at the end of 1980s, used to be a bastion of 'Japan Incorporated', with chief executives regularly emerging from the Ministry of Finance and a membership system skewed in favour of Japanese brokerages. Now the once-mighty exchange is trying its best to keep up with the rest of the world.

The TSE no longer boasts of its market capitalisation, although by a narrow margin it still ranked second on this measure in March 2009. Instead, it is struggling to adapt to a slew of changes in the global securities industry that include hyper-fast sub-second trading and the rise of so-called competing proprietary trading systems (PTS) that offer lower fees, finer price differentials or anonymity that is not available on conventional stock exchanges.

Japan has not yet felt the full force of the PTS storm. A vast majority of the economy's more-than 300 licensed brokerages still accept orders by telephone, and licensed PTSs (excluding dark pools operated within individual brokerages) account for less than 1% of stock market volume turnover. But the TSE is gearing up to face a future where almost anything goes in the field of securities transactions. On the first trading day of 2010 it launched its long-awaited Arrowhead platform for trading cash securities, which boasts a 'latency' time of just two milliseconds, compared with two to three seconds on the final trading day of 2009.

Atsushi Saito, the first CEO in the TSE's history with a private sector financial background, admitted in pre-launch interviews with Japan's financial media that he was counting on the system's success. In late January, he said TSE volumes had risen by a daily average of 15% to 20% since the launch and estimated that it could double within a year. "Market participants from all over the world have looked at Arrowhead and told us that they expect to have systems in place to deal with us by mid-year," says Mr Saito.

In a burst of what some might consider excessive optimism, Mr Saito suggests that the relationship between the TSE and most kinds of hyper-fast proprietary trading is a case of 'win-win'. He believes that the TSE is fast enough to have a chance of taking 60% to 70% of the business that results from the rise of arbitrage and other high-frequency trading firms attracted to markets featuring multiple high-speed venues. The TSE will certainly have to compete with the alternative, high-speed trading systems, says Mr Saito, but if the exchange did not have its own high-speed alternative platform comparable with systems in London and New York, high-frequency prop houses and hedge funds would not come at all.

Profit on its way

Mr Satio believes that the TSE can expect a reasonable return on its $142m investment in Arrowhead and will be ready to offer its own shares to the public, possibly during 2011, following two previous postponements in 2006 and 2009. The exchange lost money in the fiscal years ending March 2008 and 2009 due to poor markets and a variety of mishaps that were partly of its own making. For the year ending in March 2010, a profit is expected, but net profit could still be negative because of extraordinary items including a $10.7m payment of damages to Mizuho Securities, which sued the TSE successfully for mishandling an attempted cancellation of a botched share order in 2005.

Going public is the subject of what one senior executive calls a 'hot debate' within the exchange itself. Unlike most Western stock markets, and increasingly many Asian markets that have become listed companies, the TSE is not only a platform for trading securities. It also undertakes what it calls a 'self-regulatory' operation, which means that it shares with the government's Financial Services Agency the task of monitoring stock market trading and imposing, partly through its listing system, increasingly demanding rules of transparency and corporate governance on its listed companies.

Mr Saito admits that there may be a conflict of interest between this role and the need to make a profit if the TSE is listed, but he feels that the organisation must be able to fund future technological upgrades and does not want it to depend on bank loans. In the meantime, the TSE has attempted to adjust to its dual role by turning itself into a holding company. At the top of the organisational triangle is the Tokyo Stock Exchange Group Inc, which owns the profit-seeking trading entity Tokyo Stock Exchange Inc and the non-profit Tokyo Exchange Regulation. This structure was created in August 2007, two months after Mr Saito become president. The theory is that because it does not aim to earn profits, the regulatory arm of the group would not need to influence investors' judgement on the performance of the holding company and would not itself be subject to commercial pressures.

With a state-of-the-art trading system and a possible decision to go public within the fiscal year ending March 2012, Japan's biggest exchange (there are five others, but together they account for less than 10% of market volumes) might seem to be almost, if not quite, on a par with huge state-of-the-art rivals in Europe and the US. But if the TSE has won a place at the top table of global stock exchanges in terms of service quality and is catching up fast in terms of product range, that is partly because it was shocked into action by a series of setbacks and disasters that could have sunk lesser entities than Japan's flagship stock exchange.

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Forced to resign: Takuo Tsurushima, former president of Tokyo Stock Exchange

Challenging times

The TSE began an annus horribilis in November 2005 when its trading system failed to start as the result of a glitch in its operating system that resulted from a misunderstanding between Fujitsu, the systems designer, and Tosho Computer Systems, the TSE subsidiary which looked after day-to-day operating problems.

The five-hour delay caused a severe loss of face for then-president Takuo Tsurushima (the first TSE career president following six successive CEOs supplied by Japan's Ministry of Finance). But it was nothing to the upheaval which occurred five weeks later when the TSE failed to cancel a botched order by Mizuho Securities that ended up costing the securities firm Y40bn ($441m) and was eventually traced to yet another TSE systems failure, not to Mizuho's failure to use the correct cancellation procedure as the TSE initially claimed.

Nor was the Mizuho affair the last episode in this litany of disasters. There was another incident in January 2006 when the TSE's operating system could not cope with a flood of panic selling orders caused by a government raid on Livedoor Company, a software firm accused of market manipulation. But it was the Mizuho affair that marked the nadir in the TSE's reputation and at the same time sparked its recovery. The affair forced the resignation of Mr Tsurushima and led to the appointment of as interim CEO and chairman Taizo Nishimuro, a former CEO of the Toshiba electronics group.

Mr Nishimuro lacked a background in finance, but he was quick to spot a lack of IT competence as the crucial weakness behind all three of the TSE's disasters. He created the thus-far lacking post of chief information officer to run the IT side, who was given the job of organising the development of the radically new operating system that eventually became Arrowhead. It was ironic that Arrowhead's debut on January 4, 2010 occurred less than one month after a Tokyo court awarded Mizuho Securities more than Y10bn-worth of damages for the TSE's failure to cancel the botched order in 2005.

With the Mizuho affair hopefully, but not certainly settled (Mizuho has appealed against the court settlement, although the TSE accepted it), the TSE should be free to press ahead with a series of innovations that Mr Saito believes will make the market a world leader "almost on a par" with top US and European markets. The most important step in this direction has already been taken. Arrowhead not only rivals systems offered by the London Stock Exchange (LSE) and New York Stock Exchange (NYSE) Euronext group in terms of speed, the exchange also prides itself on reliability - specifically the fact that it boasts two back-up systems. A transaction interrupted by a system failure will resume without a break when a back-up system takes over, instead of having to be re-initiated by the trader, thereby losing precious milliseconds. Co-location, a service which allows brokerages to locate their servers in the same data centre hosting the exchange's trading platform, is another millisecond-saver that gives high-frequency traders such as hedge funds something close to direct market access, an option that is still reserved under Japanese law for licensed brokerages.

Kenichi Kobayashi, manager of the TSE's IT development department, adds another vital point. Capacity upgrades to Arrowhead can now be made within a week, instead of the six months needed in 2006 when the market was struggling with excess orders. This will prove critical if, as head of sales promotion Eitaro Nakagawa claims, the spread of high-frequency trading generates a five-fold increase in TSE trade volume in the next two to three years. Mr Nakagawa claims that this is a reasonable guess, given the "exponential" rise in trade volumes seen in other faster markets.

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Atsushi Saito, the first CEO in the Tokyo Stock Exchange's history

Ease of use

Whatever they may think of these growth forecasts, foreign brokerages are forthcoming in their praise for the new system and were pleasantly surprised - given past problems - at how smoothly things have gone. At Credit Suisse Securities, Japan, Tomohiko Hamada, director of equity programme trading, says the reduction in 'tick' sizes (the minimum increment by which stock prices may move) has made trading cheaper and easier. The speed of Arrowhead itself, he says, has meant that staff can set up a hedging position on any stock when the market closes. Before Arrowhead, time was needed to determine closing prices.

Most crucially, Mr Hamada says that Arrowhead has made it very easy for traders to "compare the best prices in different market venues". This is partly because of the speed with which orders can be cancelled using the new system, an important feature of high-speed markets with multiple trading venues: several of the most popular high-frequency trading techniques that Tokyo is likely to attract after Arrowhead's roll-out involve placing huge numbers of small orders for a given stock, followed by cancellations when prices are compared for the same stock on different markets.

While Arrowhead may have given the TSE a winning system for processing cash equity transactions, the market is still not fully up to speed, or volume, with Western exchanges in some derivative transactions. An important step towards closing this gap occurred in October 2009 when the TSE installed technology for high-speed option trading bought from Liffe, a NYSE-Euronext subsidiary. But Mr Saito says there is still a need to match option throughputs with a similar system for futures. It has not yet been decided whether this will also be insourced from Liffe.

Creating a market that can accommodate ultra-fast trading in equities or derivatives may have been the most urgent TSE priority, but it is not the only thing needed to give the TSE breadth and significance. Mr Saito says that one of his tasks in 2010 will be to galvanise the Tokyo AIM market, which was launched in mid-2009 as a joint venture between the TSE, with 51%, and the London Stock Exchange. Designed for 'professional' investors, Tokyo AIM differs profoundly from the TSE's main board in that it does not require applicants for listing to use the Japanese language or Japanese accounting procedures and accepts track records as short as one quarter's results as a listing qualification instead of the TSE First Section's conservative two years.

Opened in June 2009, Tokyo AIM was designed to provide a launchpad for fast-growing high-tech firms based throughout Asia but, by the end of 2009, its score of listings was zero. This may not be as bad as it sounds, given that the TSE main board attracted only nine new listings, the lowest figure in years and down from annual figures of 100 to 150 in the recent past. But Mr Saito admits that there is a problem to be solved. "Lots of companies want to list on Tokyo AIM", he says, "but underwriters are being very cautious." This is important because the seven underwriters designated as J-Nomads (nominated advisers) by the TSE are responsible for approving listings and monitoring a listed company's performance after it goes public.

Mr Saito believes that J-Nomads may have been intimidated by the fate of colleagues in London, some of whom faced penalties for failing to monitor the faulty performance of companies listed on the London AIM market. He plans to recruit more risk-oriented, possibly non-Japanese, Nomads this year. In the meantime, he has put his faith in Tokyo AIM as an instrument, first, for revitalising the Japanese economy, and second, for attracting into equities part of the Y14,000,000bn held by Japanese savers in riskless instruments such as bank deposits insurance policies and government bonds.

On the first half of this two-pronged strategy, Mr Saito has no doubts at all that the TSE has a vital role to play. "Because of China and India, we have to move from being a mass-production to a knowledge-based economy and it is part of our mission at the TSE to make this happen," he says. On the second part of this two-pronged strategy, he is a bit more cautious. "We are asking conservative Japanese savers to take risks, but we have to admit that the conservatives were absolutely right to play safe in the 1990s and much of the following decade when equity values fell by 70% and real estate by 90%." In spite of this, Mr Saito says that his dream is to attract 20% of Japan's vast pool of bank deposits and other riskless savings into the stock market with Tokyo AIM as a prime attraction.

A stepping stone to buying shares in Tokyo AIM - if there eventually are some to buy - might be to invest in the rapidly growing exchange-traded fund (ETF) sector, which is another TSE priority. Mr Saito says that the TSE had listed 19 ETFs when he became president. There are now 70 funds in the ETF sector and the target is to reach 100 by March 2011. The TSE is not only offering ETFs that follow domestic indices, although most products follow an index and are close to being passive, but marketable investments. It also lists ETFs following foreign equity indices and commodities. Energy and carbon dioxide emissions are fields that could be added to help make up the quota of 100 listings.

Launching new products and markets may not be much help if Japanese business leaders continue to believe that staying on good terms with their main bank is more important than listening to investors. In bygone days, the TSE did not have much to say about this. Now, it is using its listing department to nudge companies to meet international standards of transparency and consideration of shareholder rights. This is important because foreign investors, including a number of vocal US pension funds, are among the largest owners of Japan's stocks, with a share of more than 23%.

Value of TSE share trading ($bn) 1995-2009

Value of TSE share trading ($bn) 1995-2009

International standing

Foreigners also dominate TSE trading, with a 56% share, so it is not surprising that Hiroyuki Matsuzaki, director of the TSE listing department, has fought hard to improve management transparency and achieve international standards of corporate governance. Two recent issues here have been so-called third-party share issues and the presence or absence of independent directors on company boards.

The issue of third-party share issues was settled in August 2009, when the TSE included a clause in its listing rules requiring companies to announce plans for proposing share issues and submit them to votes at annual shareholder meetings. Previously, the issues (not to be confused with public share offerings) had been largely unregulated and were favourite devices for warding off unwanted takeover bids or changing de-facto control of companies.

The subject of independent directors was settled in December 2009 after an eight-year battle between the TSE and the Keidanren (Japan's main federation of big business associations). The revised requirement in the TSE's rules calls for a listed company to appoint at least one 'genuine' independent to its board. 'Outside' directors who may work for subsidiaries or close business partners of the company are explicitly excluded from the definition of independence.

With so many changes under its belt, there has been one reverse in the TSE's forward march. The market was overtaken last year as the world's third largest - and Asia's largest - market in trading terms by the explosive growth of Shanghai. To put it mildly, this is something that does not seem to concern top management in Tokyo. "It is natural for countries with big populations to have large stock markets. But we are still ahead of China in per capita terms and we think a fair market is one where you are free to buy and sell shares and free not to buy and sell them," says CEO Mr Saito.

The upshot seems to be that the TSE does not plan to waste much time on deciding whether to compete with Shanghai or to join it in any conceivable kind of alliance. International tie-ups involving exchange of capital are not high on the TSE's agenda, particularly as the market's only existing capital tie, a 4.99% stake in the Singapore Stock Exchange, has yielded dividends but not much else. The only kind of capital alliance that the TSE might conceivably be interested in is one that promises a genuine advantage in shared economies of scale or exchanges of technology.

Until - and unless - that happens, Mr Saito and his colleagues will have their work cut out with two aims closer to home: accommodating the impending surge of alternative trading and turning Japan into what it has never been: a society with an equity culture. The TSE has made a good start on the first of these agenda items. The second remains elusive.

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