Backing the tortoise – Is Japan’s slowly, slowly approach the best route to the best best execution?

That said, Japan has its advantages. Widespread fragmentation, seen in other international markets, has not happened, and this has allowed the procedures of clearing and settling to remain relatively straightforward. So, while it is clear that Japan needs to keep abreast of global changes, its careful hold-back approach is not always a bad thing.

Accessing domestic capital
One of the tallest hurdles for any foreign investor in Japan has been how to approach the vast and generally conservative wall of domestic money. Domestic money is principally held via Toshin Funds (mutual funds) or Tokkin Funds (investment trusts), and the onshore nature of these products makes it both complicated and expensive for genuine advances to be made. For example, it is only within the last few years that these Toshin and Tokkin onshore funds have started to accept an average price for a trade rather than seeing a print for every line of execution [i.e. the fund couldn’t buy 10,000 SONY 6758 @ an average 25.11, it would have to buy and book trades in the actual lot sizes purchased, say 1,000 shares, 10 times over].
Japan does now allow Direct Market Access (DMA), so some advances have been made, and exchange latencies and capacities have improved, but for as long as FIX becomes increasingly relevant, significant challenges remain if some of the possible advances are to be fully and successfully explored.

Entering the unbundled world
A key driver behind recent international changes has been the need for fund managers to be more open to their stakeholders about the services for which they are paying, and how much they are paying. Japan has yet to embrace the concept of unbundling, but its regulators have investigated the issues to the point of exhaustion, and are now prepared to consider how best this process might be implemented in Japan. The indications are that some direction on this matter will be issued from the FSA (Financial Services Agency) towards the end of this year, and the market waits expectantly.
Commission Share Agreements, (CSAs, or CCA, Client Commission Agreements in the US) are now an established part of the international trading landscape, and the universal uptick of interest in alternative research is immense – but neither has yet reached Japanese shores. These are two areas that could seriously benefit Japanese brokers. Alternative research can, by its very nature, afford to be more thought provoking and useful than its bulge bracket competitor. To that end, if a research provider is able to be rewarded for that product via a CSA (executed using cutting edge technology, with the commission credits being held in segregated accounts), research providers would probably find themselves better rewarded than they are currently: CSA’s would uphold the value of research and not tarnish the quality of research at the expense of poor quality execution.
Would CSA’s mean that trade flows are concentrated into a smaller number of venues? Potentially, but the deciding factor would be best execution. In the same way that independent / alternative research has to stand on its own two feet, so execution venues should need to justify their existence.
On the face of it, any move to an unbundled world might not appear to be good news for Japan’s onshore brokers: if a fund manager is not compelled to pay directly for services via execution and can use alternative, preferred execution venues to pay for research services via a commission share, many of Japan’s very able and worthwhile brokers may suffer. If the principles of best execution are not being met by a given broker, it stands to reason that there should be other ways of paying for research. Indeed, implicit within the CSA model is a requirement for fund managers and/or traders to examine and understand their rationale for trading through a particular venue, as payments are no longer locked to any one broker.
Japan is lucky to have a variety of influential regional and smaller brokers that provide valuable insights into the depths of domestic Japan and add significant value to fund managers, but as the trading landscape moves towards global imperatives, it may happen that being a large local entity is not in itself sufficient to ensure continued trade flows. On the other hand, a good local service or agency only local execution broker will generally be required in all local markets in which a fund manager needs to trade. The defining issue is pure, unbundled quality.

However, some brokers have yet to embrace FIX technology which makes it difficult to trade with them, both from a best execution and counterparty risk perspective. Given all these factors, it is doubly important for regulators to think long and hard about how advances in the execution landscape could impact the local brokerage community.