POINT OF VIEW/ Sadakazu Osaki: Challenges facing ‘Japan Exchange’ initiative

September 20, 2012

NOMURA RESEARCH INSTITUTE

One after another, initiatives to integrate stock exchanges that have attracted market attention stumbled when faced with the twin hurdles of national interest and antitrust laws, and were forced back to the drawing board.

In Japan, the Tokyo Stock Exchange Group and Osaka Securities Exchange have entered a merger agreement. The two exchanges have been rivals for more than 130 years since they were established in 1878, with a short interlude during the war years when the government integrated the country’s stock exchanges into the Japan Stock Exchange.

The merger will proceed as follows. At the first step, the TSE has launched a public tender offer for OSE shares listed on the OSE JASDAQ market.

Because the number of shares purchased is up to two-thirds of the outstanding OSE shares, the OSE will keep its listing even after this takeover bid.

At the second step, the two companies will be merged in January 2013, with the OSE being the surviving entity. After the merger, the TSE and OSE will come under one combined holding company.

During the subsequent one to two years, the subsidiaries will be reorganized and a company group will be formed that will consist of four organizations under the holding company. They are the cash equity market, derivatives market, self-regulatory organization and clearing organization (Japan Securities Clearing Corp.).

EXPECTED MERGER EFFECTS

The merger between the TSE and OSE is expected to enhance the global competitiveness of Japan’s exchanges.

Combining the TSE, which has an overwhelmingly large share in the cash equity market, with the OSE, which is strong in trading derivatives such as Nikkei 225 futures, will create a well-balanced exchange group as supported by strengths in both cash equities and derivatives.

With the corporate scale being expanded, the management stability will be improved. The integration of trading systems, the use of a single settlement platform for derivatives trades and standardized self-regulatory functions will all lead to gains in efficiency.

While the TSE was sometimes criticized for its “bureaucracy” in the past, the organizational integration with the OSE that accumulated management expertise as a listed company will change its corporate culture in a positive direction.

The fact that the TSE, which is now unlisted, will consequently become a listed company after the merger and will be subject to market evaluation will have a beneficial effect on the TSE in terms of its management discipline.

Nevertheless, market users such as listed companies and investors are unlikely to see any major benefits in the short term after the merger.

This is because there is little possibility that improved efficiency after the merger will quickly lead to a reduction in the burden faced by listed companies and investors partly because the transaction fees (commissions) charged by Japanese exchanges are already at considerably low levels, as compared to international standards.

However, without any doubt, in the medium to long term, it is highly likely that an exchange that has built a stable management foundation and improved its efficiency will be able to offer a more convenient, highly liquid and efficient market to market users than those that have not done so.

In the long run, the consolidation of the TSE and OSE will be seen as the right decision in the eyes of market users.

CHALLENGES TO INTEGRATION

The merger between the TSE and OSE, which should be evaluated positively, is nevertheless subject to worries about conflicting with antitrust laws, which derailed merger deals in other countries.

If we focus on market share within Japan alone, the Japan Exchange Group, born out of the merger of the two exchanges, will have around a 90- to 100-percent share in all of the following markets: cash equities, exchange-traded funds, initial public offerings (IPOs), securities derivatives and settlements involving equities and derivatives.

At this point, upon receiving an application for authorization from the two exchanges, the Japan Fair Trade Commission has been proceeding with the secondary review that involves a detailed investigation.

Given that the proposed merger between NASDAQ OMX and NYSE Euronext as well as that between NYSE Euronext and Deutsche Boerse were found to be in breach of antitrust legislation, people could be forgiven for thinking that the merger between the TSE and OSE would also fall afoul of the same law. However, it is not fair to make such a prediction without actually taking a much closer look at the situation in which Japanese exchanges find themselves.

For example, Japanese cash equities are also traded via proprietary trading systems (PTSs), or off-exchange trading venues. While currently, the PTS share is just slightly more than 5 percent, it has nevertheless been rising notably in recent years.

For IPOs, local exchanges have been opening new markets one after another to such an extent that there is criticism that they are “mushrooming.”

In the case of securities derivatives, Nikkei 225 derivatives, which are one of the core products of the OSE, are also traded on the Singapore Exchange and Chicago Mercantile Exchange. In particular, because its trading hours overlap those of the OSE, the Singaporean market presents greater direct competition.

The situation in Japan is very different from the U.S. IPO market where the U.S. Department of Justice pointed out that the acquisition would substantially eliminate competition. It is also different from the European financial derivatives market where the European Commission ruled that the proposed merger would result in a quasi-monopoly and new competitors would be unlikely to enter the market successfully enough to pose a credible competitive threat to the merged company.

If we take a slightly wider perspective, we see that the Japanese market has been locked in fierce competition with Hong Kong, Singapore and Shanghai to secure the position as Asia’s financial center.

Because Japan is a developed country in relative terms within the region, there is even more concern over a decline in the presence of the Japanese market with the rise of the markets of emerging economies in Asia.

Far from being able to rest on its monopolistic position, the newly born Japan Exchange Group will only be a challenger that must rise up to face intensifying international competition to survive.

Of course, besides the pressure of international competition, without a healthy level of competition in the domestic market, it would not be possible to eliminate concerns over the combined exchange being prone to lax management discipline.

To retain such a level of competition in the domestic market, it will become necessary to review the regulations that are claimed to be impeding the increased use of PTSs by institutional investors and to revitalize the new markets operated by local exchanges, which have seen almost no IPOs in recent years.

“National interest,” which prevented merger deals from going ahead in other countries, conversely constitutes a favorable wind helping along the merger between the TSE and OSE.

This is because raising the significance of the Japanese market as a whole through the merger of the two exchanges is required from the perspective of protecting the national interest of Japan.

This consolidation must accompany efforts to maintain a competitive institutional environment in which multiple players can compete.

* * *

Sadakazu Osaki is head of research at Nomura Research Institute’s Center for Strategic Management & Innovation. His specialties include securities market theory and capital market law.

This article is originally one chapter of a more comprehensive report published in NRI Papers, an English-language publication of the institute, and was edited by The Asahi Shimbun.

The original report, “Two Barriers Hindering the Integration of Stock Exchanges and the ‘Japan Exchange’ Initiative,” is available at (http://www.nri.co.jp/english/opinion/papers/2012/np2012177.html).

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Sadakazu Osaki (Provided by Nomura Research Institute)

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