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After a Merger at Home, Japan Exchange Wants to Grow in Asia

The new JPX is benefiting from a revival in Japanese corporate confidence; can CEO Atsushi Saito win back business from Hong Kong and Singapore?

Atsushi Saito is a man who clearly remembers how powerful Japan Inc. and the Japanese capital markets once were. As head of Nomura Securities Co.’s operations in New York from 1983 to 1985, he was part of a team that helped build the firm into one of the world’s biggest investment banks; by the late 1980s the outfit’s $10 billion in capital exceeded the combined resources of Merrill Lynch & Co., Salomon Brothers and Shearson Lehman Hutton. By 1988, when Saito was back in Tokyo, Japan’s stock market capitalization topped $3.84 trillion, more than 25 percent larger than the U.S.’s market cap that year.

But it’s been all downhill from there for both Japan’s financial clout and Nomura. Japanese stocks suffered one of history’s great bear markets, losing nearly 80 percent of their value during the 1990s and early 2000s, while a deflating economy forced a protracted retrenchment of the country’s once-mighty banks and brokerages. Saito, who left Nomura in 1998, went on to become chairman of Sumitomo Life Investment Co. and later president and CEO of Industrial Revitalization Corp. of Japan, the state-run firm charged with reviving Japan Inc. In that post from 2003 to 2007, he led the government’s efforts to buy more than ¥100 billion ($1 billion) in bad debt and provide more than ¥10 trillion in new loans in a bid to help banks regain competitiveness.

In the past six years, Saito has taken on the biggest challenge of his career: overhauling the engine of Japan’s capital markets as head of the Tokyo Stock Exchange Group. Though he is not a young man, the 73-year-old says he has put in ten-hour days over the past few years to bolster Japan’s markets. His work is just beginning to bear fruit. Early this year he succeeded in merging the Tokyo and Osaka exchanges, creating the world’s third-largest exchange operator in terms of the market capitalization of its listed companies: $3.7 trillion, behind NYSE Euronext’s $14 trillion and Nasdaq OMX Group’s $4.6 trillion. The new entity is listed on the TSE as Japan Exchange Group (JPX).

Saito has great ambitions for his enlarged empire. “I want to make Japan Exchange Group the most preferred exchange in Asia and one of the most competitive in the world,” he tells Institutional Investor in an interview at the company’s headquarters in Tokyo’s Nihonbashi district, among the offices of major brokerage houses and banks. “With our colleagues in the corporate world, we are working hard to make Japan Inc. strong and competitive again.”

By merging the two exchanges, Saito and his team have eliminated overlaps and plan to cut costs by ¥8.5 billion, a 15 percent reduction over the previous fiscal year. Since July the group has moved all equity trading to the TSE, and beginning in March all derivatives trading will occur in Osaka. Saito is also streamlining the famously bureaucratic listing-application process, making it easier for qualified companies to seek initial public offerings, and reaching out to Asian companies to encourage them to list in Japan. And he is leading an initiative to develop more derivatives products while boosting investments in trading technology.

“Saito-san has done a good job straddling both the political and financial spheres,” says Morgan Stanley’s veteran financial markets analyst Hideyasu Ban. “We can see market efficiencies improving.”

Under Saito in 2010 the TSE introduced its proprietary Arrowhead trading platform, reducing latency from several seconds to about two milliseconds. Even before the merger the Osaka Securities Exchange had been using J-GATE, based on Nasdaq OMX technology, which brought latency down from 100 milliseconds to two milliseconds for derivatives trading. These upgrades seek not only to make the exchanges more competitive but to avoid repeating the technological fiascoes that led to a half dozen shutdowns of the TSE in the past decade. JPX inherited Mizuho Securities Co.’s lawsuit against the TSE for ¥41.5 billion over a mistaken share order in 2005. The suit has yet to be settled.

“There were serious problems with our system in 2005,” admits Yoshinori Suzuki, JPX’s chief information officer, who joined in 2006 from Nippon Telegraph and Telephone Corp. subsidiary NTT Data. “We have been upgrading our systems since then. My mission in joining the Tokyo Stock Exchange was to handle the problem and upgrade the system to global standards.” Suzuki oversaw the development of Arrowhead, which, aside from a three-hour halt in trading in February 2012, has avoided problems.

“The Japan Exchange merger has put Japan’s trading infrastructure on even footing with the advanced markets in Asia, such as Singapore and Hong Kong, and many other parts of the world,” asserts Neil Katkov, the Tokyo-based senior vice president in charge of financial technology in Asia for Boston research and consulting firm Celent. “So this merger made sense.”

Timing couldn’t have been better for Saito’s initiatives. Under Prime Minister Shinzo Abe, who returned to power last December with a mandate to kick-start economic, financial and political reforms, Japanese capital markets have enjoyed a resurgence, with the Nikkei 225 surging nearly 70 percent to stand at 14,620 late last month. Daily volume of index constituents exploded from 81 million shares traded in early December to a high of almost 600 million shares in May before falling back to the 160 million range in September.

Economic optimism in Japan is building, especially since the International Olympic Committee chose Tokyo to be the venue for the 2020 Summer Olympic Games. According to Nomura Securities, the selection will give Japan — and Tokyo in particular — an economic boost of close to ¥3 trillion in the run-up to the games, including ¥1 trillion worth of infrastructure projects. The victory over Olympic competitors Istanbul and Madrid further boosted Japanese investors’ psychological confidence, at least over the short term, analysts say.

“We think that the economic impact of the 2020 Olympic Games is rather small, although it should be bigger than the Tokyo metropolitan government’s estimate of 0.6 percent of GDP on a cumulative basis,” says Nomura Securities’ chief economist, Tomo Kinoshita. “However, this should provide Japan’s consumers and corporations with a feel-good factor, which should generate positive externalities.” Kinoshita sees this as a chance to develop Japan’s “underutilized” tourism industry.

JPX now controls more than 90 percent of all equity- and derivatives-trading volume in Japan and has been a primary beneficiary of so-called Abenomics, which has seen the yen depreciate by more than 20 percent against the dollar in the past 12 months, giving export-oriented Japan Inc. a big boost. Average daily trading value in August on the TSE’s first section, where large-company shares list, reached ¥1.97 trillion, the highest since the financial crisis in 2008. Total derivatives volume of the Nikkei 225 VI Futures index hit 3,502 contracts in August, a high since it was launched in February 2012.

“The upturn of Japan’s capital markets is indicative that Japan is back and that it is able to compete on equal terms with the rest of the world,” says Charles Beazley, chief executive officer of Tokyo-based Nikko Asset Management. “There is a very significant rebasing of Japanese corporations.” Beazley believes the exchange merger is symbolic of a rising, reform-minded new Japan: “The JPX merger is good for the market. As a practitioner, we are happy to see it.”

Business and consumer sentiment has certainly climbed since Abe won a landslide election victory last December, notes Kinoshita. The country’s economy expanded at a brisk annualized 3.8 percent in the April-June quarter, and capital expenditure rose at a 5.1 percent clip, the first gain in six quarters. “Abenomics seems to have changed the long-term deflationary mind of most Japanese companies. So companies have become more optimistic and bullish,” says Kinoshita. “As valuations of those companies have risen, they are more willing to have an aggressive investment plan. Many companies have initiated fundraising processes. We have more and more companies wanting to raise funds through the stock market. The IPO market is recovering.”

Part of Japan’s exchange problem stemmed from a fragmented market, particularly when the economy stopped growing. Though tiny in terms of volume, exchanges in Nagoya, Fukuoka and Sapporo openly competed with Tokyo and Osaka, the dominant players.

Saito’s vision was to merge Tokyo, which controlled 90 percent of the equity market, and Osaka, which boasted 60 percent of the derivatives market, to create a single group that could compete globally. The merger didn’t come easily, however. It took nearly three years of wooing before Osaka seriously considered Saito’s offer.

“Soon after I joined this company in 2007, I felt it was a good idea to marry with them,” Saito recalls. “The Tokyo Stock Exchange is strong in equities, while Osaka Securities Exchange is strong in derivatives. This would be a merger between the No. 1 exchange and the No. 2 exchange. I was trying to send love calls to my partners, but they didn’t work until 2010.”

As stewards of a proud trading heritage, Osaka Securities Exchange executives weren’t enthusiastic about a merger. Their market traces its lineage to the Dojima Rice Exchange, which was established in 1697, nearly two centuries before the TSE’s founding in 1878. In 1730 it introduced the world’s first commodity futures trading. When Saito broached his idea for a possible merger by asking for meetings to discuss cooperation, Osaka exchange president and CEO Michio Yoneda didn’t initially respond. And when the two sides began talking, it took more than a year and dozens of meetings to negotiate a price and a structure. Saito and Yoneda announced the merger on November 22, 2011, with Tokyo, which wasn’t publicly listed, acquiring 67 percent of Osaka for $1.7 billion and Osaka’s publicly listed corporate structure as the holding company. Osaka CEO Yoneda agreed to become chief operating officer of JPX.

Osaka’s expertise in futures and options is essential for equity-heavy TSE. Globally, exchanges are getting an increasing amount of their income from derivatives trading and far less from equities. NYSE Euronext saw operating income from derivatives trading rise 21 percent, to $103 million, in the quarter ended July 31, accounting for some 40 percent of the group’s total. Profits from equity trading and stock listings grew only 1 percent, to $128 million.

JPX’s current strengths remain in equities. According to Credit Suisse, JPX, with 3,481 listed companies in 2012, led the major global exchanges; annual share-trading volume was $3.6 trillion in 2012. By comparison, NYSE Euronext had 2,339 listed companies in 2012 and $13.4 trillion in trading volume, and Nasdaq OMX had 2,577 companies and $9.8 trillion in volume. The Asian exchanges are smaller: Hong Kong had 1,547 listed companies and trading volume of $1.1 trillion; Shanghai, 954 companies and $2.6 trillion; and Singapore, 776 companies and only $256 billion in volume.

Despite its lead in listed companies, JPX trails in foreign listings. It’s also weak in terms of options, futures contracts and exchange-traded funds (ETFs), compared with the big U.S. exchanges, though it is competitive with its Asian rivals.

JPX doesn’t break out derivatives revenue. But according to Takehito Yamanaka, Credit Suisse’s Tokyo-based financial sector analyst, derivatives trading contributed ¥9.8 billion, or 12 percent of gross operating revenue, in fiscal 2012, ended March 31, 2013. “The small contribution from derivatives is one of their weaknesses,” he says.

Derivatives trading at JPX totaled 232 million contracts for 2012, only a quarter of the number generated by NYSE Euronext and Nasdaq OMX, which had 992 million and 996 million contracts, respectively, Yamanaka says.

Notwithstanding its logic, the Tokyo-Osaka merger probably would not have been approved by regulators in the recent past, says Kotaro Yamazawa, JPX’s senior executive officer for corporate strategy and corporate communications, who worked at the Osaka exchange before the merger. “I suppose we could not get approval from the Japan Fair Trade Commission even five years ago,” Yamazawa says. “Five years ago the Asia and Pacific headquarters of most global financial companies were in Tokyo. Now there are few: All moved to Hong Kong or Singapore. That is why the Japan Fair Trade Commission and the Japanese government supported this merger, and the Japanese government is expecting us to be more high profile in the Asian financial competitive arena. The Abe government expects us to be No. 1 exchange in Asia, which fits JPX’s future vision to be the most preferred Asian exchange.”

“By acquiring only 67 percent of Osaka, our message to them is that we don’t have the intention to control them or just buy them up,” Saito adds. “Rather, this merger is for the sake of the future of Japanese capital markets. ‘We will concede a lot to you for the future. Let’s make a friendly merger.’”

The JPX merger followed a host of other exchange deals around the world, not all of them friendly or successful. Globally, exchanges announced $83 billion worth of mergers and acquisitions in the past five years as they rushed to cut costs and diversify in the face of dwindling equity-trading revenues and market-share losses to new rivals.

The Tokyo-Osaka merger strengthens the overall competitiveness of Japan’s capital markets, says Hong Kong–based Endre Markos, who heads Citigroup’s electronic markets and platforms business in the Asia-Pacific. “In the wake of numerous alternative trading venues, exchanges globally have a major challenge to show relevance,” he says. “The entire exchange model is changing and looking for relevance. The merger is allowing for more efficiency. It will alleviate some of the redundancy.”

In Japan players such as Nomura’s Chi-X Japan and SBI Japanext, owned by Goldman Sachs Group, have been gaining market share, rising from zero to as much as 6 percent over six years or so. Japan’s securities regulator, the Financial Services Agency, doesn’t require but encourages them to clear through JPX-owned Japan Securities Clearing Corp. (JSCC).

JSCC has offered clearing and settlement for all Japanese exchanges since it was founded in 2002, and in the past few years it has actually helped these proprietary trading platforms to grow, says JPX’s chief financial officer, Moriyuki Iwanaga, who until June ran TSE’s clearing and settlement business. JSCC shares a small part of the revenue growth of alternative trading venues, he adds.

To fend off proprietary trading platforms and global rivals, JPX is mustering bureaucratic support. It received permission to fully merge JSCC with Japan Government Bond Clearing Corp., which will be brought onto JSCC’s platform and cease to exist. Beginning in October the combined entity will clear and settle most exchange-traded and over-the-counter products in Japan. Corporate bonds currently trade on the TSE as well as alternative venues such as Japan Bond Trading Co., though all clear and settle on JSCC.

“The government is supporting the merger,” says Iwanaga. “We got consent from the government. We want to make the clearing function of our market stronger and more efficient against foreign markets such as Hong Kong, Singapore, the U.S. or Europe.”

“If JPX just maintains its current status as the dominant player in Japan, it doesn’t need to compete. But if it wants to be the No. 1 exchange for Asian companies or No. 4 or 5 globally, there is a lot they still have to do,” says Sadakazu Osaki, head of research at the Center for Strategic Management and Innovation at Nomura Research Institute, one of Japan’s major systems integrators and a Nomura affiliate. “They realize that situation.”

JPX had consolidated group revenue of ¥82.5 billion for fiscal year 2013, ended March 31, up 9.2 percent over the previous year; net profits rose 10 percent, to ¥12.9 billion. Saito has told his managers he wants net income to exceed ¥26 billion in the fiscal year ending March 31, 2015.

To grow JPX’s volume and bottom line, Saito says he will reach out to Asia. He is in the process of devising a campaign targeting the debt-raising needs of Asian companies. “I am keen to expand the fixed-income areas,” he says. “Many Japanese corporations or Asian corporations have bond needs. I would like to explore inviting Asian companies to Tokyo to issue bonds.”

Other possibilities include secondary listings of Asian equities or ETFs and derivatives on foreign stock indexes, he says, adding that JPX is currently in discussions to cross-list secondary shares and ETFs with the National Stock Exchange of India and Borsa Istanbul.

“We would like to list as many ETFs as possible,” Saito says. “We have 162 ETFs, and trade volume exceeds those of our friends in Asia already, but the U.S., Germany and London each have about 1,000 ETFs. So 162 is still a baby. I would like to invite many ETFs to come here.”

With Japanese households owning more than $15 trillion in savings accounts, “there is a lot of money here for investments,” Saito says. “It’s just that Japanese investors hesitate to invest because of concern of low return of equity products. But if equity shows a reasonable return, quite a lot of money will shift from savings or bonds to equity or ETF markets. We are not short of money. The point is how smartly we can show them attractive products.”

Saito’s team is also busy reaching out to Japanese entrepreneurs, especially those in high technology, to persuade them to consider IPOs.

Of JPX’s most recent count of listed companies, 1,761 are in the first section, or main board, and 569 are on a secondary board for midsize companies, known as the second section. In addition, there are 887 on the Jasdaq exchange, which came with the Osaka acquisition and has a number of information technology companies, and 187 on TSE’s Mothers, which caters to small enterprises and start-ups that don’t have to be profitable to list but only need to show potential.

IPOs have been rising recently, a result of optimism and pent-up demand. This year through September 15, the TSE saw 13 companies launch IPOs worth a total of $7.7 billion, beating last year’s number of deals — four — but 21 percent below last year’s $9.8 billion in money raised. The year was good for third place globally in terms of money raised, behind NYSE Euronext and Nasdaq OMX, according to Dealogic. (The JPX group as a whole had 32 IPOs, including 13 on Mothers and six on Jasdaq, up from 26 in the same period last year; volume, however, was down 20 percent at $8 billion.)

Tokyo also ranked No. 3 for IPO deals by money raised in 2012, after a miserable No. 18 showing in 2011, when a strong yen and the Tohoku earthquake and tsunami dealt body blows to the economy. Aside from 2012 and a No. 7 ranking in 2010, Tokyo has consistently been in the teens for IPO deal volume over the past decade, outperformed by Asian rivals, chief among them Chinese exchanges in Hong Kong, Shanghai and Shenzhen.

TSE management wants to attract more listings to Jasdaq and TSE Mothers, says Yasuyuki Konuma, executive officer in charge product and market development and head of listings. JPX is working with various investment banks to bring not only small start-ups but also major privately held groups to market, Konuma says. The biggest IPO so far this year has been the $4 billion fundraising in July of Suntory Beverage & Food, an Osaka-based food, beverage and spirits conglomerate founded in 1899.

“There are many good, private, fast-­growing companies out there,” he says. “There are many in Kyushu prefecture. They are close to Asia, and they are expanding in Asia. There are many companies in information technology, in services and in health care. We see huge growth in demand for companies in these areas. Japan doesn’t have a Silicon Valley. In the past most companies developed in Tokyo, but now many are developing outside of Tokyo, all over Japan. We are reaching out to them to seek IPOs.”

Saito certainly understands that the area of greatest potential for growth is derivatives. He and his team will be focused on promoting Osaka, which so far trades only stock options and equity-linked derivatives and was ranked by the World Federation of Exchanges as the 18th-largest derivatives exchange in the world in 2012.

“There are many things we have to do, especially on the derivatives side, to become the most preferred exchange in Asia,” Saito says. “We achieved 270 million contracts traded in 2012. Our goal is to reach 400 million contracts traded annually by 2015.”

Credit Suisse’s Yamanaka estimates that derivatives income in the fiscal year ending March 2014 will reach ¥15.2 billion, roughly 12.5 percent of expected group revenue of ¥121 billion. According to Yamanaka, that makes JPX, while small compared with the NYSE or Nasdaq, the leading derivatives exchange in Asia.

JPX doesn’t offer commodity derivatives, but it is exploring that possibility. On Saito’s radar screen is some form of cooperation with the Tokyo Commodity Exchange (Tocom). Saito has approached Tocom’s executives and floated various scenarios. Once again Saito’s love overtures aren’t getting an immediate response, and once again he isn’t giving up. “I would like to find a good business in commodities or derivatives,” he says. “Commodities is one area we have to discuss with Tokyo Commodity Exchange. We have to sit at the table with them and find if it is possible we can jointly work together or not.”

There are two hurdles that Saito must overcome to pull off a Tocom merger, says a senior financial analyst who follows JPX and Tocom closely. JPX’s supervisor is the securities regulator under the Ministry of Finance, whereas Tocom is watched over by the Ministry of Agriculture, Forestry and Fisheries. The ministries “don’t talk to each other and protect their own territory,” the analyst says. Even if JPX and Tocom agreed to merge, they must show they can bring Japanese commodity-trading groups back to Japan, he says; these firms currently trade offshore, mostly on the NYSE, Chicago Board of Trade, London Metal Exchange and Australian Securities Exchange.

Another challenge is price. “Tocom may want a high price to be bought out,” Ban says. Still, he believes JPX has the upper hand. “If JPX decides to do commodities on its own, Tocom will be pushed out easily. So far, JPX hasn’t been that tough of a negotiator.”

Saito says he looks to one person when it comes to acquisitions: Charles Li, CEO of Hong Exchanges and Clearing, which in July 2012 acquired the LME for £1.4 billion ($2.2 billion). “My teacher is Charles Li, who bought LME to emphasize more commodity derivatives,” Saito says. “He declared he will be the Asian gateway to China. It sounds nice, his strategy. As a friendly competitor, I respect him.”

Would Saito ever consider following Li and acquiring an offshore rival?

He thinks carefully before answering. “The possibility of JPX buying something like the LME is possible,” he says, but he adds that it’s not likely. “Let’s look at why Hong Kong can make an investment in LME. First of all, they all speak English, and regulators on both sides share basic British commonwealth regulation. Even when Hong Kong became a shareholder, physically the exchange still exists in London, and operators and traders are Europeans, not Chinese. In my understanding — I might be wrong — Mr. Charles Li became the largest dominant shareholder in LME but is not yet the real operator.

“As long as I spend the money,” adds Saito, “I could acquire a foreign exchange, but as you know, management becomes something of a problem. That’s why I won’t buy one.”

Not everyone believes Saito means what he says. Nomura Research Institute’s Osaki says JPX investors have high expectations that Saito and his team will take the group global, in part through overseas acquisitions. He has his doubts, though. “I don’t see a very clear global strategy,” says Osaki. “If they don’t do anything in one or two years, a number of investors would be very disappointed. One important thing is not just saying you’re going global but having a real strategy abroad, a regional strategy. They need to do something impressive. At least they have to propose, or disclose, an idea.”

There is no question that Saito and his team have their work cut out for them. Despite their achievement in creating a viable equities platform in Japan, they still have to prove that JPX can succeed in global markets. • •

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