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After Boursezilla

As Japan readies itself for a single primary exchange, Fidessa’s Hiroshi Matsubara, also Co-Chair FPL Japan Regional Committee, and Steve Grob look at the country’s motivations for change and ambitions for the future.
The TSE/OSE merger has been big news in Asia since it was announced last year. Creating the world’s third largest exchange by market capitalisation, the merger brings derivatives and cash under one roof and puts equities on a single trading platform. Not only will this create a much bigger and more liquid venue, but it will also give the Japanese exchange a gravitas that neither the TSE nor the OSE has enjoyed on its own.
The merger attempts to position Japan as a super resource centre for pan-Asian trading. With a vibrant and growing PTS market, Japan’s market structure is certainly one of the more advanced in Asia, although challenges still remain. One challenge that was removed earlier in the year was the 5% TOB rule.
Under Japan’s Financial Instruments and Exchange Law, investors who purchase a 5% or greater stake in any firm off the primary exchange had to launch a full tender offer bid (TOB). Because trading on PTSs was originally designated as “off exchange” they inadvertently got tripped up by this rule. This discouraged many firms from buying stock on PTSs, due to the complexities involved in knowing when exactly the 5% threshold was reached. Other firms would sell on PTSs but not buy, for the same reasons. With the relaxation of this rule being implemented in October, the barrier to using PTSs for both sides of transactions has been lowered significantly. By next summer PTS trading could account consistently for around 10% of the market in some blue chip stocks. Indeed, PTSs are already trading steadily larger volumes in the market’s biggest names. Considering PTS trading accounted for practically nothing just two years ago, the fact that SBI Japannext, for example, is regularly trading upwards of 10% in stocks like Mizuho and Mazda is a healthy sign of further growth to come.
The next challenge for PTSs is the 10% rule, stating that once a PTS reaches 10% of the national market, it must apply for a formal exchange license. It comes into effect when daily average trading values of all trading stocks on a particular venue measure 10% of all exchange and PTS trading in Japan, over a six-month period. While it’s unlikely that one PTS will breach this threshold within the next year or two, when they do, the FSA will have to re-address this rule. This is because under Japanese exchange regulation, an exchange can only trade instruments that are listed on it (unlike other jurisdictions, where multiple venues can support secondary trading on the same stocks). So, if a PTS were to become an exchange, it would suddenly have nothing to trade.
At present, smaller tick size is an important differentiation for the PTSs as it allows them to offer prices inside the spread of the main market. However, if the new Japan Exchange Group adopts decimals for tick sizes, there will be work to do in order for them to demonstrate the additional value they offer. Venues should be thinking seriously about this now. Speed has been a battleground in other regions, and SBI Japannext enhanced its platform in September, making its processing speed ten times faster than the TSE’s arrowhead.

International experience shows that tick sizing is important for market participants. In the US, however, tick sizes are set centrally for all venues, and yet fragmentation of liquidity is at its greatest there. In Europe we witnessed a somewhat disorderly process as venues reduced tick sizes arbitrarily to try to gain a competitive edge. This was eventually replaced with a common process as market participants struggled to keep up with the pace of change.
In Japan, many brokers don’t have decimalised systems so can’t take advantage of smaller tick sizes in any case. Whether or not the exchange moves to decimalisation soon, there’s some evidence to suggest a tipping point is being reached where firms need to play catch-up with their systems if they are to be able to offer, or execute, the best quality trading.

Regardless of the future of tick sizes and the 10% rule, brokers and buy-sides in Japan are having to get serious about smart routing right now. Fidessa’s experience of watching this experiment take place globally is that there are two thresholds where alternative venues receive an extra boost in liquidity. The first is at around 5%, at which point brokers start using smart order routing. The second, at around 10%, is when buy-sides start asking their brokers if they are connected to a particular venue, and wanting proof that their orders are getting filled in the most advantageous ways. It makes sense of course – if your firm is seriously trading East Japan Railway or Nishin Steel, and 10% of the stock is trading away from the main exchange, you need to be looking at both (or all) venues.
For the Japanese sell-side these add to existing pressures of changing regulation and flattening volumes. Firms will need either to become specialists or to scale up to meet the new requirements of a more complex market and more demanding clients. This global theme has already played out in the US and in Europe, and has seen the sellside rely increasingly on technology to sharpen their competitive edge and generate efficiencies so as to scale revenue faster than cost.
Another effect of increasing buy-side focus on execution quality may be the introduction to Japan, in a regulatory sense, of commissionsharing agreements (CSAs). As firms focus more and more on where and how their trades are executed, a natural consequence will be an increasing reluctance to spend money on sub-optimal trading in order to pay the research bill. While the CSA discussion has been going on for some time now, it’s likely that real change will happen in the next couple of years or so.
For the sell-side this again means that it will be required to prove the effectiveness of its technology in order to be chosen as the executing broker in a CSA environment. Those who prepare now will be best positioned for change when it comes.
A very contentious change that’s come to international markets in recent years is high-frequency trading (HFT). The new depth of the Japanese market, with the addition of OSE liquidity and the TSE’s speed on arrowhead, will further improve the prospects for electronic trading of all varieties. Japan has been more sanguine on HFT than the sometimes hysterical reaction elsewhere, and while there is watchful concern from buy-side and retail firms, it’s unlikely that HFT will be vilified in the way it has been elsewhere.
In the changing Japanese market it’s certain that, as everywhere else in the world, there will be winners and losers. Regardless of the regulatory framework that eventually settles into place, technology will be the critical key to success for those offering and taking part in trading.

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