World over, a market is a place where goods and services are traded. When it comes to financial markets the good being talked about is Money or currency. The financial markets develop mainly on account of surplus money available to individuals as well as businesses. For better use of this surplus money individuals and institutions would invest this money for purposes of earning more money. This is the fundamental reason for the development of financial markets.
When we say market place, it may be referring to physical location of a financial market such as banks, financial institutions and Stock exchanges. But more importantly market could be the virtual space of internet, which is the biggest cause of growth for the financial markets in the recent times.
There are those who have a need for money and those who have surplus money. A simple exchange between the two does not make it a financial market. If money is just exchanged between the two parties it becomes a charity. However if the money is exchanged for a consideration either in terms of interest or dividend then it becomes a financial market transaction.
Financial markets play a very vital role in the development of economy. For any economy to develop there needs to be creation of infrastructure congenial for establishment of businesses and markets. Towards this the concerned government would be investing significantly on building the requisite infrastructure. For this the governments would be depending or two sources: a. Tax money and b. Funds from the public. Similarly private sector companies would be needing funds for establishing and expanding their business. They resort to the financial markets for funds. Their sources are banks, financial institutions or general public through public issue of shares. In both the above cases there is one party who is in need of funds, the other party who is willing to fund - this forms the financial market. The structure of financial markets in economy could be by way of banks and share markets apart from private equity placements. The financial markets also exist due to trading in currencies.
Investors typically buy securities through brokers. Since the broker keeps track of the various requirements of the investor and makes it hassle free transaction, investors go through brokers.
Looking at Japanese market over the last few decades, we find that the market has gone through the peaks and troughs and has had its share of successes and disasters.
While some of the leading economies in the world as US, Germany, France, and UK, largely traded in their own currency for all their exports for many decades, Japan was the only country which used to trade and export their goods and services only in USD. After the Second World War the dollar replaced the UK pound as the dominant currency in the world trade. Over the years despite US economy getting weaker the currency has got stronger for international trading as common currency. Over the years it has become more a habit to trade in USD than a real need.
Japanese market grew phenomenally till the 1990. Post that there was a stagnation and downward trend in the market economy. The biggest fall of the Nikkie index happened in the 1992 when it crashed by 70% down to ~14000 levels. Similar to the subprime, the land rates and real estate crashed to one fifth the price. The international competitiveness of Japanese economy worsened dramatically. Many irregularities in financial discipline surfaced during this period and the economy went on a downward spiral. The resultant stock market crisis led to many companies opting to list themselves in other countries than in Tokyo stock exchange. As a recovery measure Japanese government took initiatives to make it a free, fair and global' market by accommodating many concessions for investors to find Japanese market attractive. This was called the Japanese 'Big bang'. Over time the financial innovations widened leading to new types of derivatives, securitized loans, and creation of synthetic assets through trading.
The financial instruments moved from one set to the other:
Institution Issuing
Financial Instrument
Traditional
Modern and recent
Governments
Bonds, notes, bills
securitized loans, swaps
Banks
deposits, acceptances
Derivatives
Firms
equity, bonds, convertibles,
floating-rate debt, synthetics
preferred stock, commercial paper,
Warrants
Exchanges
commodity futures
financial futures, options
As we all know financial markets are hinging on continuous arbitrage opportunities. An opportunity in one market attracts investments from another market if the returns are different from one market to another. In Japanese financial markets many years of financial infrastructure investments had led to a strong well functioning financial system comparable to UK and the US. Some of the reforms in terms of accounting standards, audit processes and transparency in financial reporting were far superior to other Asian countries as of mid 2000s.
During these times the money markets in Japan were mainly of two types, Interbank markets and Open market.
The interbank segment dealt with call market and bill discounting markets where as the open market instruments were repurchase agreements, commercial papers, Certificates of deposits, financing bills and treasury bills. Additionally the dollar call market and offshore markets became part of the Japanese money markets.
However, over the years the Bank of Japan tried to bring down the interest rates in order to attract investments. Many schemes as 'Zero interest rate policy', 'Quantitative easing policy' etc were introduced to mobilize deposits and investments in the early 2000s. While initially the schemes allowed a lot of money flow, since it was overdone the interest rates plummeted to all time low resulting the investors losing interest. It made more sense to invest in other countries than in Japan as the returns were more attractive elsewhere.
While that was the story on the currency market side, till the year 2003, on the EQUITY market side of the financial markets, the Japanese equity market has also seen varied trends from low to high and low tides. After the bubble burst in 1980s till 1990s the stock markets went very weak with low trading and low activity on mergers and acquisitions. One of the key weaknesses in the Japanese financial system is the systemic separation of financial institutions and stock markets. Instead of complimenting each other they were competing with each other unlike other countries. The first step to stop this came in 1993 by introduction of a reform in the policy which allowed banks to set up wholly owned subsidiaries for securities trading. Since this did not find much traction in 1998 the big bang and financial reforms bill was introduced. This enabled the Banks to directly engage in securities and derivatives over the counter. Many more reforms were introduced such as abolition of restrictions in non exchange market trading for listed stocks and new accounting standards for securities and derivatives. As a result the market became more competitive. However despite all these the measures the market trading of equities did not dramatically improve. About 35-40 percent of the bank loans were invested in non business activities. This is not a high share compared to other economies as of 1999.
The financial markets all over the world shine better on transparency in governance and standards. In Japan unfortunately the feedback of the international trading community is of skepticism and doubt. The root cause of this is various government interventions and non transparent policies. For ex: the bond markets in Japan. From 1999 to 2003 the bond market borrowing by the government rose to as high as JPY 500 trillion. This high volume of government borrowing, led to choking of the private business. After continuous downgrading of Japanese public debts by various international rating agencies, the Japanese bonds had the lowest rating among major developed economies by 2003.
Interestingly there are many strong points favoring Japan. It was the second largest economy worldwide(now 3rd largest), the largest creditor nation and third largest exporter. All this ideally should have kept the financial markets strong for Japan.
But unfortunately the market imperfections of Japan have caused a lot of skepticism in the investors mind. In Japan the ratio of trading volumes to the outstanding shares is low compared to other economies. Most of the traded securities are long term bonds of 10 years. The short term securities are just about 10% of the volumes. Of the bond market the government bond takes the highest share and the privates are very low in percentage terms. With such a huge public debt, the market sentiments about government default on bonds, is looming large in the minds of the international investors.
Worldwide derivatives trading are the highest but in Japan it is not. Negative interest rates, Premium on government bonds, very low traction on domestic corporate debt market, long term confidence on Japanese yen instruments, are some of the financial system deficiencies making the Japanese financial market unattractive to international investors.
Discussion of players, their profiles and objectives in the Market
Major foreign exchange players are defined as those who have greater than USD 50 billion equivalent of foreign exchange contracts on the last business day of any calendar quarter. As of 1997 there were 36 such entities who qualified for such title. Of these 36 30 were banks and balance were other financial institutions.
The large players are generally Banks and Financial institutions, Forex dealers, Global custodian banks, Retail Aggregators.
The currency derivatives markets are the largest traded and constitute about USD 2 Trillion daily average, and is about 35 times larger than the exports and imports of the largest of economies combined. And about ten times larger than the equity turnover. A major reason for this explosion is the enabling of electronic trading for Forex. In one decade the forex market has grown by 21/2 times.
When we compare the Japanese share of the global foreign exchange trading volumes, it constitutes to about 10% to 6.5% over the last decade. In fact its share of the global volumes is declined over the period 1998 to 2011.The 3 large currencies which are traded are USD, Euro and JP Yen.
Most commonly traded forex instruments are Spot which is the highest percentage of over half of the total volume, followed by forex swap, forwards, currency swaps, options and others. While in the initial years the spot was a small percentage, over the years spot has contributed to the maximum growth in the trading volumes.
The large players in forex derivatives markets are generally the financial institutions such as banks. Compared to corporate customers, financial institutions trade substantially large volumes. While Private financial institutions dominate the trading on a daily basis, Central banks make a significant impact on currency movements. Hence they are considered to be the informed traders. The corporate customers mainly trade in forex to hedge their risks. They do not generally play for speculative purposes. Most common type of forex activity carried out by Corporate entities is 50:50, where in they hedge 50% of their outstanding payments and leave the balance for bridging the speculative trends. If the markets go higher than the hedged value, it gets offset by the non hedged amounts and vice versa if it the markets go down.
The large players are techno savvy and adopt technology as well as logic for their trading. For ex: algorithmic and high frequency trading is quite commonly used by them. In algorithmic trading a preprogrammed algorithm keeps monitoring the trades and executes based on the patterns generated during the given trading period. High Frequency trading generally utilizes the technology advantage of completing a transaction in milliseconds speeds. This is essentially used to leverage arbitrage especially in occasions of triangular arbitrages where currency quotes are at different rates in different counters, the system completes the trade in milliseconds to encash on the time delay of adjustments by different markets to corresponding rates in other markets.
In Japan mainly there are five exchanges to deal in and manage listed derivative products -
Tokyo Stock Exchange (TSE), is going to be merged in OSE and having alliance with London stock exchange to jointly trade financial products and technology.
Osaka Securities Exchange, founded in 1878 and is a key driver for growth and innovation for Japanese financial markets. With the merger of TSE it will become major player to handle futures, commodities and stocks.
Tokyo Commodity Exchange (TOCOM), is a non-profit organization. It is mainly regulator of futures contracts and option products trading of commodities. In 1984 following were merged and TOCOM was born -
Tokyo Textile Exchange
Tokyo Rubber Exchange and
Tokyo Gold Exchange,
Tokyo Grain Exchange is again Non-profit and it regulates futures and options products for grain e.g. Coffee, Soybeans, corn, coffee etc. It had introduced electronic trading first time in Japan.
Tokyo Financial Exchange(TFX), was introduced in 1989 for futures exchanges. It was following Financial Futures Trading Law of Japan and handles securities and derivatives. It supplies derivatives to investors and helps in development of new products in Japanese market.
To regulate derivative markets Japan has regulatory frame work. It has two organizations - FSA and SESC (Securities and Exchange Surveillance Commission) as described below.
Financial Services Agency (FSA) ensures stability in financial system of Japan. It is a Govt. Org. Its responsibilities includes overseeing -
Securities
SESC
Banking
Certified Public Accountants
Insurance
Auditing Oversight Board
To regulate the market FSA introduced
Financial Instruments and
Exchange Act
The Securities and Exchange Surveillance Commission (SESC) is a Japanese commission and it reports to FSA. It checks fairness of transactions in futures and securities.
The SESC performs mainly 5 tasks and each task has a department
Investigation, Criminal Charge filing and Enforcement
Surveillance of Markets
Investigation of Administrative Civil Monetary Penalties
Inspection of Disclosure Document
Inspection of Compliance
It is only reporting authority and cannot punish people.
Recent Trends in the Financial Market of Japan
Current trend suggests that derivatives markets in Japan started growing because of following.
Increased use of high-frequency trading
Exchange mergers
Central clearing
Growing volumes of foreign exchange transactions.
As per Consulting firm Celent, while Japan's derivatives market is growing but that growth is limited to few instruments, not all are showing equivalent strength in growth.
Last year, listed derivatives in the Japan recorded 404.3 million transactions, OTC derivatives in 2011 recorded 5.1 million transactions i.e. 1/4th of world's OTC derivative trading volume.
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Exchanges listed below for derivative products are already described in previous section
the Tokyo Stock Exchange (TSE),
Osaka Securities Exchange,
Tokyo Commodity Exchange (TOCOM),
Tokyo Grain Exchange and
Tokyo Financial Exchange.
Although all of them manage multiple derivative products yet they have a specific orientation. Now merger of the Tokyo and Osaka stock exchanges is scheduled in Jan 2013 and Osaka will manage derivatives market.
To tackle risks on OTC trading a mandatory central counterparty (CCP) will be available between buyer and seller and all OTC derivative contracts will be cleared centrally by the end of 2012. This will bring transparency and help derivative markets to grow.
Many foreign investors are investing in derivatives in Japan using high frequency trading (HFT). Japan's exchanges are equipped with latest technology that is required by HFT. HFT allows short-term trading, high liquidity and price discovery. HFTs can be held only for seconds and by EOD no open positions remain in market.
Some trends from Bank of Japan website -
End-June 2012 Vs End Dec 2011
Derivatives Market Statistics in Japan
Shares by instrument type
Derivatives outstanding
Notional amounts outstanding
For OTC contracts - 49.4 trillion U.S. dollars decreasing by 5.2 percent
For Exchange-traded contracts - ~4.1 trillion U.S. dollars increasing by 28.4%,
Shares by instrument type as of end-June 2012
IR swaps were 72.2% in OTC contracts
IR futures were 61.2% in Exchange-traded contracts
Amounts outstanding in market value
From Dec 2011 to June 2012,
For OTC derivatives contracts,
Gross positive market value - decreased by 2.3% to 791.7 billion U.S. dollars
Negative market values of decreased by 2.6% to 762.0 billion U.S. dollars.
Breakdown by currency
Interest Rate contracts in OTC derivatives, first was US then was Japan and both together have a market share of 73.6%, it was 74.1% percent in December 2011.
Breakdown by counterparty
Outstanding in OTC IR 67.3% and 68.8% in FX contracts
Breakdown by remaining maturity
IR derivatives were at 42.6% of all OTC,
Contracts with remaining maturities of one year or less were 65.6% of all FX derivatives
Credit default swaps
Credit default swaps (CDSs) were ~1.1 trillion U.S. dollars.
