Tokyo Stock Exchange Gear's Up For The Future

On Dec. 8, one of the most astounding transactions took place at the Tokyo Stock Exchange. On that day, instead of placing a sell order of one share for 610,000 yen of J-COM, a trader with Mizuho Securities mistakenly placed a sell order for 610,000 shares of J-COM for 1 yen. Considering that the company’s actual number of outstanding shares was only 14,500 shares, two things should have happened. First, the trading application being used by the Mizuho trader should have caught the error, assuming that the application had some form of pre-trade compliance capability built-in. Second, assuming that the order went through the first line of defense (i.e., Mizuho Securities), the TSE’s trading platform should have caught this erroneous order and either canceled it right away or sent it back to Mizuho for further review. Unfortunately, neither occured. Instead, Mizuho ended up losing 40 billion yen (US$344 million), which ultimately led to the resignation of the president of TSE.

For the TSE, this infamous December debacle was not an isolated technical glitch. In fact, just a month before in November 2005, what was supposed to be a simple upgrade on the trading platform developed by Fujitsu led to the shut down of the entire exchange for most of the morning.

The most recent technical embarrassment occurred on Jan. 18 when the TSE had to stop trading 20 minutes before closing due to trading volume reaching an unmanageable level triggered by the Livedoor scandal. Following this event, the TSE maintained abbreviated trading hours (shortening its afternoon trading session by 30 minutes) until April 24 when after enhancements in its overall capacity, the TSE returned to its normal trading hours.

Brighter past...

Still, contrary to popular belief, the TSE can actually be seen as a pioneer in the exchange market, especially when it comes to electronic trading. The TSE not only trades equities, but also fixed income products as well as derivatives. When measured on market capitalization of listed companies, the TSE is the third largest in the world behind the New York Stock Exchange and the London Stock Exchange.

Source: Tokyo Stock Exchange

The TSE was also one of the earlier exchanges to demutualize, which took place in 2000. The TSE’s plan of going public, however, has been shelved due to current challenges it is facing. And although there are other smaller regional exchanges in Japan, the TSE is the most dominating player in the cash market, representing more than 90% of all stock trading value at the end of 2005. And unlike the NYSE, the TSE’s market has actually been growing over the last five years.

Source: Tokyo Stock Exchange

In terms of IT infrastructure, basic electronic trading features were actually introduced during the 1970s. And although floor-based trading continued side-by-side, by early 1999, the TSE decided to shut down the floor and go fully electronic. The electronic trading platform and the various supporting components were developed by Fujitsu and Hitachi and did not experience any major issues in terms of capacity until recently.

Market reality

The troubles facing TSE could have been predicted, perhaps. But after nearly a decade of recession, the explosive growth in overall trading activity could not have been foreseen that readily, especially in a country where stock market participation has never been the norm for individual investors.

One major mistake that the TSE made in recent years has been underestimating the growth of domestic trading activities by retail investors. Overall, the average daily share volume of TSE has grown from less than 400 million shares a day in 1995 to approximately 2.3 billion shares by end of 2005.

Source: Tokyo Stock Exchange

This tremendous growth in trading activity has been fueled by surprisingly active market participation by the individual investor segment. Ownership of securities by retail investors has increased from 10% in 2002 to 17% by 2005, largely at the expense of deposit and savings financial products.

Source: Tokyo Stock Exchange

Source: Tokyo Stock Exchange

In addition, retail participation in stock transactions has exploded in recent years, as evidenced by the total percentage of retail orders presented—the total value of trades skyrocketed to 45% at the end of 2005 from a mere 16% in 2001. This trend is expected to continue into the foreseeable future.

As a result, the TSE inevitably ran into disturbing capacity issues which could have been addressed had the TSE invested the necessary time and resources over the last decade. Instead, no significant enhancements were made to the existing IT infrastructure and the decades-old trading platform was expected to cope with the sudden burst of trading activity.

When compared to the NYSE, the increase in the daily average number of trades experienced by the TSE appears in line with other major market centers in the U.S. Unlike the NYSE, however, the TSE failed miserably in dealing with the massive growth in overall trading activity. With continued growth in individual investors and the expected increased participation of orders being driven by algorithms, the TSE needed to look for a new alternative to the existing IT reality.

Making improvements

Most of the ongoing improvements with the TSE have focused on organizational structure and short-term capacity enhancements. Soon after the December Mizuho debacle, the Chairman of the TSE assumed the interim-president role until suitable replacement can be found, a search expected to end this month. The TSE also hired a new Chief Information Officer, a post created to deal with the festering IT issues. Further, the TSE developed a new feature within its trading platform to reject any orders that may represent more than a certain percentage of the listed firms’ total outstanding shares to prevent any future Mizuho-like scandals.

On the capacity side, the TSE has continued its efforts in creating additional capacity which really began in September of 2005. Currently, the existing trading platform is able to handle 12 million orders and process approximately 8 million transactions. The short-term goal is to boost capacity to reach 14 million orders and 10 million transactions by the end of 2006.

Source: Tokyo Stock Exchange

Future plans

Of course, despite all of its work on improving capacity, the fact remains that the TSE is still running on outdated technology. In order to rectify this problem, the TSE has come up with a three-year plan to completely revamp its trading infrastructure.

Source: Tokyo Stock Exchange

The plan will involve continuing to improve its current trading platform, while at the same time developing a next generation trading platform which can scale with the future growth of the exchange. Currently, the TSE uses separate platforms to handle equities and derivatives. The idea is to create the next generation platform which can handle multiple asset classes. This will not be a cheap endeavor, however. The expected overall price tag for this plan is an estimated US$527 million over the next three years, with half of that going to designing and developing the next generation trading platform for the TSE.

Source: Tokyo Stock Exchange, Aite Group Estimates

The real question of this plan is whether or not the TSE can afford to spend the next three years developing a new platform to deal with current capacity issues. To date, the TSE has managed to enjoy a virtual monopoly in the Japanese securities industry. However, its reputation has been damaged due to repeated IT breakdowns. Unless the TSE is able to control its IT issues in an efficient manner, opportunities may exist for small exchanges—or even brokers—to launch an alternative electronic trading venue. Perhaps more likely, continued problems within the TSE may invite unwelcome overtures from certain global exchanges that are looking for suitable acquisition targets in the rapidly growing Asian securities market.

Contributor Sang Lee is a managing partner at AITE Group, a Boston-based independent research and advisory firm focused on business, technology and regulatory issues and their impact on the financial services industry.