Japan is one of the world's top three capital markets, powered by the world's third -largest economy. And that giant economy is roaring along, logging a third straight quarter of growth in September and set to achieve Prime Minister Shinzo Abe's prediction that Japanese growth this year will create the equivalent of an economy bigger than Israel's. The mountain of cash held by Japanese companies hit a new record of $2.4 trillion earlier this year, a figure Bloomberg News notes is bigger than the Italian economy and bigger than the liquid assets held by US companies.
Eiichiro Yanagawa, Celent
So why has Japan been punching below its weight in volumes and development of algorithmic trading? Market participants blame the absence of the aggressive regulation that has triggered profound changes in North American and European markets by forcing through structural reforms that have driven the revolution in trading technology.
"The adoption of algorithmic trading has been slow in Japan compared with the rest of the world and even compared with other Asian countries," said Keith Ducker, CIO of Asian electronic trading platform TORA. It's growing, he said, but at a relatively slow pace, with Japan relatively lacking in more sophisticated algorithmic trading. "More than 75% is VWAP," he said. But some large firms are building their own algorithms, he says, and Japan is also seeing some sophisticated pair trading, mainly option/equity pairs.
Other observers blame trading venues rather than the buy-side for the slow uptake. Japan has lagged, according to ABN AMRO Tokyo Clearing CEO Sean Lawrence, because exchanges have been slow to upgrade their technology on matching engines, and local brokers and banks have been reluctant to invest in new technology. "Automated trading remained the preserve of foreign banks and proprietary trading firms well beyond the expected timeframe for this mode of trading to evolve in Japan," he said.
David Wilkinson, Equinix
"If you look across Asia, it's a bit of an anomaly"
"If you look across Asia, it's a bit of an anomaly," said David Wilkinson, senior director of financial services business development at Equinix Asia-Pacific. "Japan has a largely deregulated environment with multiple trading venues, which should make it attractive for algorithmic trading - and for trading in general. But uptake [of algorithmic trading] is mixed, and certainly compared to North America and Europe, it's not as prevalent."
A Bank of Japan paper in June 2013 noted that orders from co-locations on the Tokyo Stock Exchange notched just above 50% by September 2012, showing strong growth since the exchange's arrowhead trading system launched in early 2010. Now levels roughly match European figures, but trail US exchanges at 60-70%.
The Tokyo exchange, which dominates cash equities trading in Japan, in January completed a merger with the Osaka Securities Exchange, much stronger in derivatives, to create the world's third-largest exchange by market capitalisation. ABN AMRO notes that 63% of orders on the new combined group, the Japan Exchange Group (JPX), originate from co-locations. That's compared with 10% three years ago.
Mitch Fulscher, chairman of the Futures Industry Association of Japan, says change is underway after a couple of decades when exchanges failed to push ahead with new technology and products, and both exchanges and the domestic broking industry were slow to recognise the power and value of developments elsewhere to transform trading. Fulscher, who has worked in the industry for 25 years in Tokyo, says he is now confident about the prospect that Japanese capital markets can halt their competitive slide.
"Yes, I am optimistic - I wouldn't even say cautiously. I think there is power behind the movement to break down these walls and to position Japan in a growth pattern," he said. Politicians are forcing change and forcing regulators to change the management of Japanese exchanges. "The recent merger of the Osaka Securities Exchange with the Tokyo Stock Exchange is a perfect example of this government pressure. It's underway."
Fulscher says now that Japan has grasped the importance of algorithmic trading, it is showing little apprehension. "Now they understand it, they're not showing any fear of it - there isn't that 'they must be doing something bad if they're making money' attitude you sometimes see in other places."
Keith Ducker, TORA
"The adoption of algorithmic trading has been slow in Japan compared with the rest of the world and even compared with other Asian countries."
The JPX merger, which will integrate listing, trading, clearing, settlement and information services, will drive further growth in algorithmic trading, says ABN AMRO Tokyo Clearing CEO Sean Lawrence. "Simply, it creates half the cost for the same opportunity, which is a significant advantage for everyone, not just automated trading. And in addition to the obvious benefits, it should also create organic growth." Traders interested in diversifying from equities to derivatives or vice versa could now move into a different product area without adding on additional co-location cost, he said.
A new ability to net margins for listed derivatives on both Tokyo and Osaka markets, will free up capital for additional trading, predicts post-trade services firm Omgeo.
If the merger doesn't force change, the proprietary trading system (PTS) sector might. One of the conditions for the merger by Japanese competition regulators was that PTS operators were able to continue to exist without the JSE asserting an unfair advantage. Celent analyst Eiichiro Yanagawa said in a report published in May that the merger is spurring current PTS operators Chi-X Japan and SBI Japannext to expand their offerings. He said their share of trading volume languished at below 1% until 2010; now it is edging above 5% after regulators dropped a rule forcing investors who owned more than 5% of a company to launch a takeover bid. The rule had not applied on exchanges but did apply to investors trading on PTSs.
SBI Japannext, the country's largest PTS by value traded, this year launched a platform that allowed orders to be crossed before the primary exchange market opened and settled at the volume-weighted average price after it closed. It also has set new daily trading records this year.
But growth for PTS volumes is still slow, according to Chi-X Global head of marketing Beth Haines. "I think a lot of people thought we'd see this huge jump in PTS volumes [after the takeover bid rule change] and we haven't yet." One reason, she says, is that another regulatory improvement - the easing of margin rules on stock trading - does not yet apply to PTS operators. The new rules, which eliminated a three-day waiting period on rolling collateral over into new trades, went into effect in January. The new provisions have been cited by many market-watchers as one of the strongest spurs to a surge of activity by retail investors in Japan. Exchange data shows margin transactions accounted for more than 65% of retail transactions by June, compared with fewer than 57% at the end of last year. Domestic retail transaction volume across all venues jumped 128.5% from October 2012 to end-March.
ABN AMRO's Lawrence points out there is nothing in the existing "outdated" regulations to hinder automated trading, and many brokers have grown their automated trading substantially while staying compliant with the rules. But others say forcing all brokers across the market to connect and trade on multiple markets is a change that is overdue."About 30% of flow in Japan is retail," said Haines. "We've seen a really big uptick - at the end of last year it was only about 18%." But perhaps the biggest drag on the development of algorithmic trading, which in other markets has received a leg-up from smart order routing, is the lack of tough regulations on best execution. Unlike the tightly prescriptive rules applying to US and European transactions, by comparison the rules in Japan are "extremely lax", says Celent's Yanagawa, leaving the definition of best execution at the discretion of brokers.
"Regulation on best execution would be the single most important and useful thing the FSA [Japan's Financial Services Agency] could do," said Tora's Ducker. "It would force managers to break these long-established bonds among financial market participants that are disadvantaging investors. And the second thing it would do is bring some of that improvement to the retail market."
Celent's Yanagawa says in his report that pressure to improve execution is growing. He cites an unnamed head of trading at a large Japanese asset management firm who told him that increasingly institutional investors and their customers will be demanding timely disclosure of trade execution quality - "including wanting to know why trades were executed at certain prices and in certain markets".
At the same time, observers say that the growing clout of PTSs should lead to a bigger focus on smart order routing as the buy-side begins to see the advantage of tapping into more liquidity pools or refining the choices they want to make for participating in different venues.
Outside cash equities and derivatives, algorithmic trading is still small. Despite the colossal size of Japan's JGB market - Japan is carrying a load of more than 1000 trillion yen of government debt, or almost $10 trillion - algorithmic trading accounts for a very small proportion of volumes. Japan's total electronic trading volumes for fixed income are estimated in the low teens.
Market participants say algorithmic trading volumes are even lower in commodities markets. There too, says Fulscher, where trading is split across exchanges including the Tokyo Commodity Exchange, there is reason for change. And probably for consolidation. "They need to liberalise and internationalise; they need more capital; they need to create a sounder clearing organisation. They need to do something, to link up with another exchange, domestic or local. But what that something is, is not yet clear."
ABN Amro's Lawrence says the creation of JPX is a good first step at reducing costs for market participants. But the fact that few new brokers enter a Japan market which is 'overly delineated and overly complex' shows more streamlining is needed. He rattles off a list of acronyms for the three self-regulatory organisations, four clearing houses and two regulators with which any securities broker needs to register, and says the list is about as long for anyone venturing into commodities. "The US and Europe have equally diverse landscapes; the difference is that Japan does not have the volume in each market silo to justify the clearing/regulatory costs that each market segment demands," he said.
Has the tide actually turned?
Trading started picking up a year ago but has cooled sharply in recent months.
Data source:World Federation of Exchanges.
But in foreign exchange trading, another area where Japan ranks number three in the world, Equinix's Wilkinson sees a "vibrantly growing" trading community, helped by big retail flow, as the market continues its shift from voice to electronic execution. Equinix opened a fourth data centre in Japan in August. "It's been a very rapid take-up, focused around FX," he said.
An Aite Group report in May said about 5% of Japanese adults have a retail FX account, compared with around 1% in the US. It estimates Japan's retail FX market traded around $160 billion daily in the first four months of 2013, against $80 billion in 2012, and forecasts that Japan will drive most of an expected 36% increase in global retail FX trading volume this year as easier Japanese monetary policy weakens the yen. It expects Japan to account for around a third of global retail FX volume this year.
But some say the relatively big retail presence in Japanese markets has created something of a gap in capability between international brokers and those who are domestically focused, especially in technological development. "That is true, and a real problem limiting the speed of evolution of the financial markets in Japan," says ABN AMRO's Lawrence.
And compounding the problem, he says, is a skills shortage among local brokers and investors on networks, hardware and trading system support, because they have mostly outsourced technology to service providers. That means brokers are less able to swiftly capitalise on evolving market trends.
"That said, we are encouraged by the recent rise of the domestic online brokers, plus a few forward-thinking domestic institutional brokers who have understood the need to invest internally in building technology and growing their staff expertise to remain competitive," he says.
Tora's Ducker says the gap is costing investors money. "Lack of investment [in technology] at second-tier brokers means domestic managers are paying two or three times what they need to be paying for the same service," he says. Both the buy- and sell-side in Japan are beginning to come to grips with the high costs of keeping technology up-to-date, but they are faced with tough decisions about how to pay for it.
Japan still has plenty to do to keep up the momentum for rejuvenation in financial market structures that is being partly powered by Abenomics, which includes a raft of structural reforms to improve competitiveness. Many believe change was already underway in the financial markets. Abenomics has given extra impetus but opinion is divided on its likely pace. "There is an undercurrent of people in Japan who'd like to see things changing but a lot of the chairmen of the broking firms are in their 80s," said one market-watcher who did not want to be identified. "It'll be another 20 or 25 years of slow change."
But Futures Industry Association chairman Fulscher believes now the mood is catching hold, steady progress will turn into an avalanche: "It's never as fast as you want, but it's moving, and it will happen."