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1 Contents List of Figures List of Tables Preface and Acknowledgments Introduction vii viii x xiii 1 Introduction to the Trading System at the Tokyo Stock Exchange 1 2 Reform and Deregulation of Financial Markets in Japan: Evolution of Law and Accounting Standards 13 3 Market Microstructure and Information Asymmetry Variables: The Behavior of TSE Stocks 26 4 Risk and Return on the Tokyo Stock Exchange 42 5 Impact of TSE Quarterly Disclosure on Information Asymmetry 61 6 Price Discovery Process Before and After the Introduction of the arrowhead Trading System at the Tokyo Stock Exchange 88 Epilogue 108 Index 109 vi DOI: /

2 1 Introduction to the Trading System at the Tokyo Stock Exchange Abstract: In Chapter 1 we provide an overview of trading at the First and Second Sections of the Tokyo Stock Exchange. We discuss how investors can send bid ask orders to the TSE and outline how these orders are executed. We also explained the arrowhead trading system, implemented January 2010; by reading our example of the market clearing process, readers should become familiar with TSE trading systems. Then we summarize relevant financial characteristics of the firms listed on both sections of the TSE. Kubota, Keiichi and Hitoshi Takehara. Reform and Price Discovery at the Tokyo Stock Exchange: From 1990 to New York: Palgrave Macmillan, doi: /

3 2 Reform and Price Discovery at the Tokyo Stock Exchange In this chapter we describe an overview of trading at the First and Second Sections of the Tokyo Stock Exchange (TSE hereafter). We also explain how transaction information is transmitted to security firms, institutional investors, and individual investors. This information is for readers who never look at TSE stock data even though they may have knowledge of financial economics, and for readers who have not traded TSE stocks even if they have other stock trading experience. We explain institutional details and regulatory changes affecting Japanese stock trading in Chapter 2. These are TSE listing requirements, trading details, and disclosure rules; the new Companies Act; the Financial Instruments and Exchange Act (FIFA); and new and revised accounting standards. Our explanation is based on the official TSE guidebook (TSE, 2012) and its official webpage (TSE, 2014). We try to accurately convey the minimum information necessary for our readers to understand the mechanism of stock trading. The TSE webpage information (viewed from October 2014 to January 2015) was the most recent at the time of writing. 1 Listing on the Tokyo Stock Exchange There are currently six stock markets at the Tokyo Stock Exchange, all part of the Japan Exchange Group. The daily public markets are: First Section, Second Section, Tokyo Mothers, JASDAQ, and TOKYO PRO MARKET. ToSTNeT is an off-time trading hour public market, classified as a PTS (proprietary trading system) (TSE, 2014). There are also three smaller public stock markets, in Fukuoka, Nagoya, and Sapporo. The stocks listed on these exchanges are, however, smaller firms, and they are not dual-listed on the TSE, 1 unlike in the US where 13 public stock markets compete for buy and sell orders of the same stocks (Lewis, 2014). Overall, 3500 stocks are listed and traded every day in Japan, but most of the large firms are listed in the First Section (1840 firms) and the Second Section (541 firms), according to the October 21, 2014, TSE webpage. In 2007, the TSE was ranked fourth in both total volume and total value, after the NYSE Group, NASDAQ, and the London SE (Berk and DeMarzo, 2011). The Japan Exchange Group was formed in January 2013 by the merger of the TSE and the Osaka Stock Exchange (OSE). The OSE within the Japan

4 Introduction to the Trading System at the Tokyo Stock Exchange 3 Exchange Group now specializes in derivative instruments, while the TSE handles all trading including the stocks listed previously on the OSE. The requirements for listing on the First Section are (1) stockholders numbering more than 2200; (2) floating stocks (as defined by the TSE) 2 over 20,000 units and more than 35% of the stock issued; (3) market equity value (as predicted) over 25 billion, and so forth. We omit delisting conditions, but they are detailed on the English version of the TSE webpage. 2 Trading mechanisms at the Tokyo Stock Exchange Trading sessions are mornings (9:00 11:30) and afternoons (12:30 15:00), Monday through Friday. There are opening and closing auctions for both sessions called Itayose, to decide opening and closing prices, and Zaraba, for continuous auction trading during normal hours. For Zaraba trading, there are two types of orders: limit orders and market orders. There are also specific orders such as: (1) orders to be executed only during the opening auction; (2) orders to be executed only during the closing auction; (3) limit orders that become market orders at the closing session if not already executed (Stop Orders); and (4) Immediate or Cancel (IOC) orders (TSE, 2012). The settlement date is the third business day after the trade date. In Itayose, all sell/buy orders must be executed in the morning opening session or the afternoon closing session. In the morning opening session, orders are handled as if they were received at the same time and are executed in descending order by the number of orders placed by brokerage houses. In the afternoon closing session, allocation by the limit price takes place when there is an order imbalance. For Itayose, three conditions must be satisfied: (1) all sell/buy market orders must be executed; (2) all limit orders to sell (buy) at prices lower (higher) than the execution price must be executed; and (3) at the execution price, the entire amount of both all buy or all sell orders must be executed (TSE, 2012). In the afternoon closing session, Itayose is used again, and the closing price is determined. However, when a possible clearing price may exceed (go below) the daily price limit (which we shall explain shortly), due to a large order from either the bid or the ask side, a special method to conduct a closing auction at the limit price is implemented. 3

5 4 Reform and Price Discovery at the Tokyo Stock Exchange In Zaraba, however, which takes place during continuous trading hours in the morning and the afternoon sessions, the priority of order execution is first by price, and then if the bid-and-ask limit order prices are equal by time. In TSE trading, unlike on the NYSE, a daily price limit is imposed; for example, for a price between 500 and less than 700 the limit is 100; for a price between 2000 and less than 3000 the limit is 500; and so forth. Outside these limits, no trading is allowed to take place. The price limit is determined by the base price, which is usually the previous closing price. Base price exceptions are for large unbalanced orders from the previous day, when a special quote (explained below) is formally flagged, or on an ex-dividend day for dividend adjustments. In addition, the executed price during the continuous auction has to stay within certain smaller parameters based on the previous executed price of the current day, even within the daily price limit. These parameters form the special quotation renewal interval, and if execution cannot take place within this interval, the TSE will announce a special quote (Tokubetsu Kehai) price as a boundary of the next price-change interval. For example, if the last executed stock price (or the special quote price) was between 500 and 699, the interval is 8 on either the upper side or the lower side, and if it is between 2000 and 2999, it is 50, and so forth. This special quote price is renewed every three minutes, if still not executed to meet the order imbalance of buy and sell orders. TSE s arrowhead system can process a single large order, either buying up or selling down, which stays within the bounds of the special quote renewal price, by using a sequential trade quote. When this order is received, the sequential quote is provided every one minute, which is within the bounds of twice the initial special quote range and in this case the Itayose trading method will be implemented. 4 When specifying the bid or ask price for a trade, the price has to be on an integer base of Japanese yen. The pre-determined typical tick sizes for TSE stocks are as follows: 1 yen for stocks less than 3000 yen; 5 yen for stocks above 3000 and less than 5000 yen; 10 yen for stocks above 5000 and less than 30,000 yen; and so forth. After the launch of the arrowhead, the finer pre-determined tick price was provided. For some stocks whose pre-determined minimum bid ask spread was reduced, the effective spread of these stocks might have been reduced; this is an empirical question. If so, the resulting decrease in the bid ask spread for some price ranges is expected to reduce the trading cost as

6 Introduction to the Trading System at the Tokyo Stock Exchange 5 measured by the spread. Note that changes apply to some stock price ranges, but not to others, so the researchers have to be careful to distinguish these stocks when analyzing the impact of the arrowhead on spreads. 5 In market microstructure theory, bid ask spread is considered a liquidity measure. We report some results in Chapters 3 and 5 on the trend of bid ask spreads in the early years of the 21st century. 3 Stock trading execution and trading information transmission In this section, we first provide a concrete example of how the traded price is determined and how orders are executed during the Zaraba continuous auction sessions. In Figure 1.1, assume the minimum ask (sell) price is currently 500 and there are 6000 shares of limit orders, the maximum bid (buy) price is 499, and there are 5000 shares of limit orders. We also assume that there are market buy orders of 8000 shares. Then, as the figure shows, this market buy order is first matched with the highest priority sell order. In this case, the sell order with the lowest price 6000 shares at 500 is matched first. Next, 2000 shares are executed at 501 from this Ask price Order book Quote Depth Price Tick Bid price Ask price Price Bid price figure 1.1 Zaraba example (continuous auction)

7 6 Reform and Price Discovery at the Tokyo Stock Exchange market buy order, and leaving the rest of the 5000 shares offered at 501 unexecuted. The difference in the shades of the graph at the bid-and-ask shows how orders were executed and remain unexecuted. The best four bid-and-ask orders in the graph are an illustrative example at the TSE but what kind of order information is available to investors? The TSE provides two kinds of market information to investors; in Zaraba, (1) all quotes, without any processing, and (2) the processed information of order quantities at the best bid and offer, the second-highest to eighth-highest (-lowest) prices, and the aggregated bid (offer) quantity of the ninth-highest -lowest) prices or lower (higher). In Itayose trading, the information will be only up to the seventh (no aggregate) (TSE, 2012). Commercial stock information vendors usually purchase Type 1 information, unprocessed, and provide it on a fee basis to customers such as investors, banks, and other information users. Depending on the fees, they may provide five best bid-and-ask prices and quantities, or ten, or all. As we explain in the next section, after arrowhead was launched, order processing and transaction dissemination speed grew dramatically faster, by milliseconds. We also expect the impacts of high-frequency traders (HFT) to be large. However, as there is only one stock market in Japan for each stock, the trading situation for sent and executed orders initiated by HFTs is fundamentally different from those in US stock markets (Conrad et al., 2014, Lewis, 2014) arrowhead trading system Arrowhead was launched on January 4, Called a next generation trading system by the TSE, it combines low latency, high reliability, and scalability. The low latency means a guaranteed 1-millisecond order response time on average, and order acceptance notices are sent much faster than that. Stock prices and quote information are disseminated in less than 2.5 milliseconds (TSE, 2014). Because there were a few cases in the past when the old trading system overflowed, this new system possesses three nodes (with two redundancies) which dramatically improved system reliability. The maximum capacity to handle orders is twice as large as the average order and execution frequencies, and thus system scalability is guaranteed (TSE, 2014).

8 Introduction to the Trading System at the Tokyo Stock Exchange 7 Furthermore, using arrowhead, order matching is immediate, while in the previous system the frequency was every few seconds (ibid.). As for scalability, the allowance for trading intensity surpasses what might be expected from current order frequency. At the same time, various trading rules at the TSE were changed; one example is the finer price tick size and the sequential trade quote order, both explained in Section 2. For the information dissemination mechanism, the TSE is able to provide all data in the order book since the adoption of the arrowhead through their FLEX Full (Type 1 information mentioned in Section 3). With respect to the impact of HFTs, we emphasize the role of the TSE s Co-Location Service. This is not a matter of proximity to stock exchange computers or the building where the stock exchanges are located, as is the case in the US (Lewis, 2014). The TSE Co-Location Service and brokerage house computers are actually situated inside the TSE s primary site (TSE, 2014). For brokerage houses whose computers are inside this system, the speed and time simultaneity of sending and executing orders is guaranteed. In the case of US stocks, some millisecond differences in computers at various stock exchanges and the location of computers in investment banks seem to be crucial points for conducting front-running profits for HFTs (Lewis, 2014). Such an opportunity does not, however, exist among Japanese brokerage houses, which use the same type of Co-Location Service except for the difference in efficiency of their own computer systems 5 Characteristics of firms listed on the Tokyo Stock Exchange In this section we present financial characteristics of firms listed on the First and Second Sections of the TSE. Table 1.1 summarizes basic firm statistics and Figure 1.2 depicts a histogram of size distributions of the market value of equity of all listed firms. From Figure 1.2 it can be seen that the distribution is skewed to the right, which means that on the right-hand side there is a smaller number of firms which are very big, whereas on the left-hand side, a larger number of smaller firms most likely Second Section firms rather than First Section firms.

9 8 Reform and Price Discovery at the Tokyo Stock Exchange 140 Distribution of firm size Frequency Log of market value (million yen) of equity figure 1.2 Histogram of size distributions of the market value of equities Note: At the end of March Every day, two market indices are reported in the newspapers and on TV as representative stock indices for Japan. One is the Nikkei 225 (Nikkei Stock Average), which is computed by Nihon Keizai Shinbun (Nikkei Inc.), and an average value of 225 stocks is reported. This index is computed with the same weighting method as the Dow Jones Industrial Average, that is, by the price of each stock. Another is TOPIX, the Tokyo Stock Price Index, computed and reported by the TSE. This index is computed from listed firms on the First Section of the TSE and is valueweighted by the market equity of each firm. Thus, from Figure 1.2 we can expect a higher influence from large stocks on TOPIX than on the Nikkei 225. The characteristics of firms listed on the First and Second Sections of the TSE are summarized in Table 1.1, whose data we will use in the following chapters. As shown in the first column of Panel A, we find that the number of listed firms from 1990 to 2012 on the First Section increased from 1199 to 1682, and on the Second Section decreased from 463 to 428, as shown in the second column.

10 Introduction to the Trading System at the Tokyo Stock Exchange 9 table 1.1 Basic Firm Statistics of Tokyo Stock Exchange Stocks Year #Firms in First Section #Firms in Second Section Market value of equity Valueweighted MVE 25% ile Median 75% ile 95% ile Panel A: Number of firms and descriptive statistics for market value of equity Note: The unit for market value of equity is reported in trillions. Other figures in the upper right columns are measured in millions. Panel B: return on equity, return on assets, and debt ratio Return on equity Return on assets Debt ratio (equity in book) Debt ratio (equity in market value) Year Mean Median Mean Median Mean Median Mean Median (Continued)

11 10 Reform and Price Discovery at the Tokyo Stock Exchange table 1.1 Continued Note: Unit for both returns and rations are in percentages. Debt ratios are computed with respect to total assets as denominators where both the book value and the market equity are used for equity account, and the debt is measured by book value. The next column shows the time trend of total market value of equity listed on both TSE sections as measured in trillions at the end of March each year. The peak year was 2006 at 565 trillion. Note that the Nikkei 225 recorded the highest in December Following that month and during the Lost Two Decades, we find a stagnant tendency with some ups and downs in the total value of market equity. The next column reports the value-weighted average of market equity of listed firms. As explained above, value-weighted averages are driven by large stocks measured by the size of market equity, which represents the price movement of large firms in general. Unlike total market equity, we find the peak year was 2000 at million. That was the year when Japan showed a slight recovery, just before the IT bubble burst in In FY 2001 most of the large electronic firms in Japan suffered a huge loss, and so we find the average value decreased by half from Looking at the column of median values, the highest year was 2000 at million, and the lowest was 2003 at 18.4 million. Percentile figures show a similar trend, that is, for the number of 95 percentile firms, the largest 5% of all firms, the time trend shows a related pattern of value-weighted market equity. From these figures, we can conclude that the TSE stock market had a rather tough time. But from the viewpoint of conducting quantitative

12 Introduction to the Trading System at the Tokyo Stock Exchange 11 analyses from financial economics and the market microstructure field, our interest is on the changes in risk and return structure, liquidity, and information asymmetry, which cannot be revealed by this simple time trend. Detailed analyses about this will be conducted in Chapters 4 and 6. Panel B reports the profitability of firms as measured by the return on equity (ROE), return on total assets (ROA), and the financial risk as measured by leverage in market value and book. We focus on the median values, because we expect the distribution will be skewed to the right with these financial characteristic variables. We find ROE was the highest in 1990 at 7.12% and the lowest in 1999 at 1.99%. ROA was computed with the numerator Net Operating Income instead of Net Income, and the highest and lowest years were the same as the case for ROE. For the debt ratio, when it is measured in book value, the highest was 1990 at 70.36% (again in median value) and the lowest in 2009 at 50.71%. When measured in book value, we find that the leverage ratios of listed firms do not change drastically, but show a slowly decreasing trend overall. On measuring leverage in the market value of equity, the highest was in 2003 at 65.94% and the lowest in 1990 at 31.78%, reflecting an overall time trend in the stock market price level. In this section we have presented the basic picture of the trend of aggregate market prices, and the characteristics of firms in size, profitability, and leverage risk. The reader should now have a clear understanding of why the 20 years bracketing the turn of the 20th and 21st centuries are called the Lost Two Decades in Japan. In spite of the TSE experiencing such hard times, it has made great efforts to bring in some important reforms. Later in this book we investigate the impact of these reforms upon the risk and return structure and the price discovery of stocks. In this chapter we have discussed how investors can send bid-and-ask orders to the TSE and how these orders are executed; with this simple example of the market clearing process, readers should now be reasonably familiar with TSE trading systems. We have summarized relevant financial characteristics of the firms listed on both sections of the TSE; using this sample and excluding financial firms, we will conduct risk return and market microstructure analyses of firms in Chapter 4. Meanwhile, in Chapter 2 we will explain the institutional details of regulations, law, and accounting standards from 1990 to 2012, which may have influenced the pricing mechanisms of TSE stocks.

13 12 Reform and Price Discovery at the Tokyo Stock Exchange Notes Until the Tokyo and Osaka Stock Exchanges merged, several stocks had been listed on both markets, especially companies whose headquarters were situated in the Osaka area. It is computed by the TSE as 1 minus the fixed stock ratio. (Fixed stocks include top shares held by the ten largest shareholders, stocks held by board members, group cross-held shares, and other stocks considered to be held long term.) For details, refer to section Q25 in the TSE (2012). For details, refer to section Q23 in TSE (2012). For example, Conrad et al. (2014) selected a sample of stocks whose tick size had changed, and analyzed the impact of the launch of arrowhead on spreads. Note that after 2014, the tick size of some selected stocks dropped to less than 1. References Berk, J. and DeMarzo, P. (2011), Corporate Finance (second edition). New York: Pearson Education Inc. Conrad, J., Wahal, S., and Xiang, J. (2014), High frequency quoting, trading, and efficiency of prices, JPX Working Paper, Japan Exchange Group. research-study/wp.html Japan Securities Research Institute (2014), Securities Market in Japan Tokyo: Japan Securities Research Institute. Lewis, M. (2014), Flash Boys: A Wall Street Revolt, New York: W. W. Norton & Company. Nihon Shoukengyou Kyokai and Tahakashik, F. eds. (2012), Shin Shouken Shijou 2012 (in Japanese, Securities Market 2012), Tokyo: Chuo Keizai-sha. Tokyo Stock Exchange (2012), Guide to TSE Trading Methodology: arrowhead, Tokyo: Tokyo Stock Exchange. Tokyo Stock Exchange (2014), Official Webpage, (in Japanese) (taken from October 21, 2014 through January 18, 2015).

14 Index 10-K, F, 21 Accounting Standards Board of Japan (ASBJ), 14, 19 Accounting Standard for Financial Instruments and its Implementation, 22 Earnings per Share, 20 Treatment of Treasury Stock and Regulatory Reserves, 20 AIM, 32, 73 algorithmic trading, 34, 97 American Depositary Receipt (ADR), 21 Amihud illiquidity measure, 73 Bayes rule, 30 bid ask spread, 4, 28, 69, 82 brokerage commissions, 15 Business Accounting Council, 18 buy orders B, 29 CAPM, 55 Carhart four-factor model, 45 circuit breaker, 90, 104 closing auction, 3 Co-Location Service, 7 TSE s primary site, 7 Companies Act, 16 consolidated financial statement disclosure, 22 continuous auction, 3 Zaraba, 3 convergence, 14 corporate governance, 22 difference-in-differencein-differences (DDD) estimations, 81 EDINET, 17 effective bid ask spread, 28 efficient markets hypothesis, 20 insider information, 20 electronically driven order market, 29 Euler conditions, 56 ex post probability, 38 excess market returns, 46 fair value, 22 Fama and French three-factor model, 45 Fama and MacBeth regressions, 93 financial analysts, 104 Financial Instruments and Exchange Act (FIEA), 14 Financial Services Agency, 16 Five-factor model, 59 free, fair, and global, 15 DOI: /

15 110 Index full-scaled quarterly financial statements, 62 GMM test, 59 Hansen and Jagannathan s distance measure, 56 HFT, 6, 7, 49, 90, 97 HML beta, 58 HML factor, 45 illiquidity, 82 impairment rule, 20 information asymmetry, 27, 59, 66, 69, 73, 81, 82, 102 interim quarterly statements, 21 internal control, 22 International Accounting Standards, 20 Itayose, 3, 6 Japan Exchange Group, 2 Jensen s alpha, 58 large-cap stocks, 34, 92, 102, 103 likelihood function, 30, 38 limit order, 3, 32, 73, 92 Lost Two Decades, 49, 57 low latency, 6 marginal cost for trades, 29, 34, 96 market for information, 27 market liquidity, 27, 48, 69 minimum pension liabilities, 20 nested models, 56 Nikkei 225 (Nikkei Stock Average), 8 noise traders, 92 OECD Principles of Corporate Governance, 14 one-share one-vote rule, 16 one-year momentum factor (UMD12), 52 opening auction, 3 other comprehensive income (OCI), 20 Paris Bourse, 91 Pastor and Stambaugh s liquidity innovation factor, 46, 59 pension liabilities, 19 PIN, 29, 69, 79, 96 Adjusted PIN, 29, 66, 96 PSOS, 29, 66, 99, 103 Poisson process, 29 price limit, 4 Prime Minister Hashimoto, 15 private information, 27, 30, 32, 80, 92, 104 prompt summary reports, 62 QDDummy, 64 quarterly reports, 21, 69, 74 Regulation Fair Disclosure (RFD), 90 return on equity (ROE), 11 return on total assets (ROA), 11 risk and return, 99, 103 Sarbanes Oxley Act, 22 self-regulatory organizations (SRO), 18 self-selection problems, 81 sell orders S, 29 sequential trade quote, 4 signaling equilibrium, 82 size and the book-to-market ranked 25 portfolios, 55 size distributions of the market value of equity, 7 slicing small orders, 92 small-cap stocks, 35, 88, 91, 92, 103 SMB beta, 59 SMB factor, 45 special quotation renewal interval, 4 special quote (Tokubetsu Kehai), 4 symmetric order-flow shocks, 32 TDnet, 64 tick data, 30 DOI: /

16 Index 111 tick size, 4, 7 Tokyo Stock Exchange, 2 arrowhead, 2, 6, 43, 44, 93 First Section, 2 Second Section, 2 TOPIX, 8 UMD beta, 57 upward-minus-downward (UMD) factor, 47 voting vs. cash flow rights, 16 Wilcoxon tests, 74 zero-trading day measure, 39 DOI: /