Exploring the Global Financial Information Superhighway

Vol. 4: Dawn Period of Offshoring and Outsourcing in the Investment Banking Industry (part two)

Consulting Fellow, RIETI

When investment banks enter new financial markets, they need to develop business processes and information systems that comply with local laws and regulations. The Western investment banks that entered the Japanese financial markets in the late-1980s were able to generate profits by applying the trading techniques they had developed in European and U.S. markets to the Japanese bond market, but they found the Japanese stock market an altogether more difficult proposition. This report considers the roots of the high operating costs in Japanese financial markets that troubled Western investment banks during the dawn period of offshoring and outsourcing from 1990-1994.

A history of the Japanese securities industry: Development, restoration, growth, globalization, and digitalization

Today, there is a legal structure that companies must comply with when they conduct securities business in the Japanese financial markets. This section looks at the history of the securities industry in Japan from the view of the historical processes which the legal structure in Japan has been developed.

Japan began developing its financial markets in the Meiji Restoration, as part of its efforts to modernize. Stock exchanges were established in Tokyo (Note 1) and Osaka (Note 2) in 1878, and in Nagoya (Note 3) in 1886. In the period until the start of World War II, another eight stock exchanges were established, in Yokohama, Niigata, Nagaoka, Kyoto, Kobe, Hiroshima, Hakata, and Nagasaki, so that securities were being traded on 11 exchanges in total. Moreover, in 1940 and 1941, securities dealers associations were established on the basis of one association for each prefecture, developing the foundations of a nationwide organization. This eventually resulted in the formation of what is now called the Japan Securities Dealers Association (JSDA). (Note 4)

Following the end of World War II in 1945, Japanese securities markets were rebuilt, using the U.S. securities markets as their model. This rebuilding began with the introduction of the Securities and Exchange Law in 1948. Earlier, in March 1943, the stock exchanges had been integrated into one bourse, the Japan Securities Exchange, as a wartime measure. In 1949, exchanges licensed by the prime minister were reopened in three locations: Tokyo (Note 1), Osaka (Note 2), and Nagoya (Note 3). Since then, another six exchanges have been established, in Sapporo, Niigata, Kyoto, Kobe, Hiroshima, and Fukuoka, making nine securities exchanges in total. In 1951, securities finance companies began operating in Tokyo (Note 6), Osaka (Note 7), and Nagoya (Note 8) to ensure the smooth development of the securities market. These initiatives enabled the creation of a margin trading system for the Japanese stock market.

In 1965, the Japanese securities industry battled a slump, which ultimately led to a number of scandals within the industry. In response, the Securities and Exchange Law was comprehensively revised, adding provisions for a licensing system for securities companies and a system of registration for securities sales representatives, for instance. Following several years of turbulence, in 1971, rules for foreign securities companies were established. In addition, in line with the establishment of the JSDA in 1973, regulations associated with the unification of securities transaction accounting rules and legal documents, such as a customer account ledger, were established. As a result of these initiatives, back-office processing became consistent throughout the Japanese securities industry. (Note 4)

In 1981, restrictions on the securities operations associated with public bonds were lifted. In 1986, Nikkei 225 futures contracts began to be traded on the Singapore International Monetary Exchange (SIMEX). In 1988, TOPIX futures and Nikkei 225 index futures were listed on the Tokyo Stock Exchange (TSE) and the Osaka Securities Exchange (OSE), respectively. In 1989, TOPIX options of the TSE and Nikkei 225 index options of the OSE were listed (Note 1 and 2), and in 1992, banks and securities companies were permitted to enter each other's markets through subsidiaries. In the same year, following an amendment to the Securities and Exchange Law, the JSDA was changed from an incorporated association under the Civil Code to an authorized corporation under the Securities and Exchange Law. (Note 4) Following these reforms, the government of Prime Minister Ryutaro Hashimoto launched the Japanese version of the "big bang" reforms in 1996.

These reforms were designed with reference to the large-scale financial system reforms initiated by the Thatcher government in the United Kingdom, and sought to raise the Japanese financial market to international standards, on a par with the New York and London markets. These big bang reforms continued until 2001 under the theme of "free, fair, and global," and brought with them a number of changes. For instance, stock brokerage commissions were deregulated, the licensing system for securities companies was changed to a registration system, the obligation to trade through stock exchanges was dropped, stock options on individual issues were introduced, rules for stock borrow/loan transactions were established, the Foreign Exchange Law was amended, asset-backed securities (ABS) were liquidated, the establishment of financial holding companies was liberalized following the revision of the Anti-Monopoly Law, and the establishment of Internet securities companies was lifted in line with the revision of the Securities and Exchange Law.

Meanwhile, the Japanese financial market managed projects that required global coordination, such as dealing with the European Monetary Union (EMU) in 1999 and the Y2K computer problem at the turn of the century. In 2001, the Real Time Gross Settlement (RTGS), a settlement system for transactions involving government bonds, was adopted by the Bank of Japan (BOJ). In 2002, securities depository receipts were eliminated, and reports on the outstanding balance of transactions were introduced. In 2004, Delivery Versus Payment (DVP) settlement was adopted by the Japan Securities Depository Center (JASDEC). Following that, the Securities and Exchange Law was renamed the Financial Instruments and Exchange Law, and went into effect following a comprehensive review of regulations associated with financial products in 2006 and 2007. At present, the Japanese financial market is preparing for paperless share certificate operations, expected to start in 2009.

Financial Instruments and Exchange Law and other regulations

Securities companies today must comply with a number of other laws when operating in Japan. These laws include the Commercial Code, which covers matters associated with commercial transactions, the Financial Instruments and Exchange Law (the former Securities and Exchange Law), which stipulates direct financing, the Banking Law, which covers indirect financing, the Foreign Exchange Law (official name: the Foreign Exchange and Foreign Trade Control Law), which deals with foreign exchange, and trade, and other laws associated with commerce, finance, exchange, trade, securities, and stock companies, such as the Financial Futures Trading Law, Commodities Exchange Law, Act on Foreign Securities Brokers, Civil Code, Civil Procedure Law, Criminal Law, Criminal Procedure, Administrative Procedure Act, Act on Preferred Equity Investment, Bankruptcy Law, Civil Rehabilitation Law, and Corporate Rehabilitation Law.

Among these laws, the Financial Instruments and Exchange Law has a central role. Article 1 of Chapter I: General Provisions of the Financial Instruments and Exchange Law, which is related to and maintains consistency with the above laws, describes the purpose of the Law as ensuring the fair issuing, trading, and other transactions of securities, and facilitating circulation of securities to achieve appropriate management of the national economy and the protection of investors. (Note 9)

In its subsequent chapters, the Financial Instruments and Exchange Law defines securities, such as stocks, bonds, and investment trusts. It also defines the solicitation and underwriting of securities in the primary market, as well as the trading, intermediary, broking, and introducing of securities in the secondary market. The Law also defines the securities business and securities brokerage business, as well as securities companies, securities brokerage companies, and securities dealers associations, in addition to securities markets and securities exchanges. It also defines various transactions, including securities futures transactions, securities index futures transactions, securities options transactions, foreign securities futures transactions, securities forward transactions, securities over-the-counter (OTC) index forward transactions, securities OTC options transactions, and securities OTC index swap transactions. It then sets out rules for disclosure, including the disclosure of corporate profiles, the disclosure of tender offers, and the disclosure of large holdings of shares and other instruments. Moreover, it provides rules for securities companies, securities brokerage companies, the securities dealers association, investor-protection funds, securities exchanges, foreign securities exchanges, and securities transactions clearing organizations.

Regulations supplementary to the Financial Instruments and Exchange Law also apply to the Japanese financial market. For example, the Fair Business Practice Regulations of the JSDA require the segregated management of customer assets, trading of listed stocks in markets other than the financial product markets of securities exchanges, stock borrow/loan transactions and other instruments, bond OTC options transactions, Gensaki transactions (bond transactions with repurchase agreements), Chakuchi trade (bond transactions with delayed settlement), short selling and debt-credit transactions, foreign securities transactions, and foreign securities futures transactions. The Uniform Business Practice Regulations cover the processing of failures in the settlement of bonds, and the handling of rights if processing share transfers is overlooked. In the form of the Resolutions of the Board of Governors, there also are operational rules for securities companies in customer management and unified accounting. (Note 5) There are other rules, including the Brokerage Agreement Standards that apply to securities companies that are members of securities exchanges, the Act on Custody and Transfer of Share Certificates, Etc. that applies to participants in the JASDEC, and the Lending Rules for Debit-Credit Transactions, which cover securities finance companies.

Legal documents and regulatory reports associated with securities transactions

The Financial Instruments and Exchange Law sets out standards in detail for each transaction method and financial product for preparing several types of books, known as legal documents, that securities companies need to prepare. This section summarizes the operations of investment banks from the perspectives of what kind of legal documents are prepared by which department and when.

On the trade date of the securities transactions, three legal documents need to be prepared. Order tickets are required when orders are received from customers. Even if the order is not filled, the order ticket must be prepared and maintained. These tickets are prepared by the front office. Next, trade confirmation must be issued to customers when financial transactions take place. Finally, all the details of securities transactions that a firm executes on its own, customer, or partner accounts are recorded in a transaction daily blotter. Trade confirmation and transaction daily blotter are prepared by the back office.

Next, settlement instruction and certificate of deposit used to be issued to customers on the settlement date of securities transactions. When the Securities and Exchange Law was revised in 2001, transaction and position reports, presenting all transactions and positions of bonds, investment trusts, and other instruments, were adopted in place of the settlement instruction and certificate of deposit. Since then, transaction and position reports have been prepared, in principle, at least every quarter by the back office, and sent to customers regularly.

Legal documents that are required to be prepared at the end of the month include the following: Account Ledger by Securities Types, related to accounting booking based on the securities type; Account Ledger of Principal Accounts, which describes transactions that securities companies conduct on their principal accounts; Customer Account Ledger, which describes transactions with customers; Safekeeping Securities List, which describe details of safekeeping securities deposited by customers; Details of Outstanding Balance of Month-End Agency Gensaki Transactions and Details of Outstanding Balance of Month-End Principal Gensaki Transactions, which are both related to transactions with repurchase agreements (Gensaki); as well as the Chakuchi Transaction Ledger, Details of Outstanding Balance of Selling Chakuchi Transaction by Delivery Month and Security Name and Details of Outstanding Balance of Buying Chakuchi Transaction by Delivery Month and Security Name, all of which are related to transactions with delayed settlement (Chakuchi). Supplements to the Account Ledger of Principal Accounts and Customer Account Ledger must be prepared for margin transactions, futures transactions, and options transactions. These books are also prepared by the back office.

The Delivery Securities Numbering Book (deposit and withdrawal instructions can be used instead) records the number of securities deposited and withdrawn. Regarding stock borrow/loan transactions bond borrow/loan transactions, and bond OTC options transactions, an individual transaction base trade confirmation is exchanged with the counterparties of the transaction. In addition, participants in the JASDEC prepare a customer account book. Along with the above legal documents, compliance demands that securities companies prepare and submit statistical reports on securities transactions to the Ministry of Finance (via the BOJ), securities exchanges, and the JSDA. These regulatory reports are separately issued daily, weekly, monthly, quarterly, and annually. Each report contains a range of information; some reports are used to calculate the international balance of payments, and some are used to understand the details of securities transactions. All are prepared by the back office.

Self-developed or bureau-type systems

To this point, I have analyzed the existing laws and regulations related to finance, and the legal documents and regulatory reports that they require. We now return to the main subject of this report, the dawn of offshoring and outsourcing during the period from 1990-1994. During this dawn period, because digital technologies were not as advanced as they are today, all legal documents and regulatory reporting documents needed to be prepared in paper form. In addition, because the deregulation under the Japanese-style big bang reforms was still in the future, securities companies had to prepare settlement instructions, certificates of deposit, and deposit and withdrawal instructions for the receipt and delivery of securities based on the settlement date of securities transactions.

At the same time, it was necessary to adopt additional external online systems, such as the system of JASDEC, which began operating in October 1991, and the online terminals of Japan Securities Finance, which handles stock margin transactions and stock borrow/loan transactions. For bond operations, the BOJ financial network system through which government bonds are settled at the central bank had to be adopted. These systems were developed and operated using different technologies. Some systems, for example, required the use of optical character recognition. Users of these systems are then required to record symbols and numbers in specially designated vouchers using a pencil or ballpoint pen, and deliver them to administrative processing centers.

To respond to the legal requirements for this administrative processing, when developing information systems, Western investment banks that entered the Japanese market selected strategies for developing systems by adopting one of several choices including a method of developing their own systems internally and a method in which the bureau-type systems provided by Japanese consultants were used. Most European investment banks adopted the bureau-type systems, which were equipped with all the functions needed to respond to legal requirements, such as the execution of stocks, bonds, and futures transactions, settlement of finance securities, accounting processing, overnight processing, and the preparation of legal documents and regulatory reports. Developing systems internally entailed an enormous investment, few systems had been developed successfully, and most investment banks did not know exactly how to go about it.

However, upgrades to the bureau-type systems often could not keep pace with new products and markets, so when front offices began trading new products that were not compatible with the bureau-type systems, or when a firm entered into a new market, additional modules needed to be developed internally. This in-house system development was done on one of two main platforms: the Unix platform developed jointly by AT&T and Sun Microsystems in the 1990s and widely used in the computer market, and the MS-DOS/Windows platforms marketed by Microsoft, which held a dominant share of the market for personal computers being manufactured by IBM, Toshiba, NEC, and other companies.

Amid these circumstances, for several years after entering the Japanese financial market, in addition to the impact of the then strengthening yen, Western investment banks were forced to deal with a heavy cost burden in developing and managing the information systems needed to respond to Japanese legal requirements. Consequently, some investment banks began looking closely at cost performance per employee in Tokyo and other financial markets, such as Hong Kong and Singapore.

Financial management architecture as national intellectual property

As noted, the layers of legal requirements and the administrative processing to meet those requirements meant that operating costs in Japan were high. When this problem is raised, it can often become convenient to call for a lowering of legal standards by relaxing regulations. In fact, some U.S. or British managers who manage the Tokyo branches of western investment banks appreciate the logical consistency with which the system of legal documents and regulatory reports governed by the Financial Instruments and Exchange Law has been developed.

As described above, the system of legal documents and regulatory reports that are governed by the Financial Instruments and Exchange Law in Japan is part of a mechanism that has been developed over the history of the securities market, starting more than 130 years ago in the Meiji Restoration. It is also a highly systematic and well-balanced architecture for confirming the details of financial transactions, maintenance of the history of financial transactions, and segregation of customer assets. I believe that countries that are seeking to develop financial markets in the future will be able to obtain useful knowledge and know-how from the Japanese administrative processing architecture for securities transactions.

For this reason, "Report Series: Exploring the Global Financial Information Superhighway," after offering further analysis from different viewpoints, will turn to look at issues such as ways to use this national intellectual property. I will do this by connecting the focus of the discussion with the Japanese financial market strategy presented in my column, "Japanese Financial Market's Strategy in the Globalization Era."

The next installment in this series will focus on new strategies for information systems developed by Western investment banks in the face of high costs described above during the dawn of offshoring and outsourcing.

December 18, 2007
  1. "History of the Exchange," Tokyo Stock Exchange, 2007
  2. "History of the Exchange," Osaka Securities Exchange, 2007 (in Japanese)
  3. "Corporate History," Nagoya Stock Exchange, 2007 (in Japanese)
  4. "Profile of the Association," Japan Securities Dealers Association, 2007
  5. "Fair Business Practice Regulations," Japan Securities Dealers Association, 2007
  6. "Corporate Profile," Japan Securities Finance, 2007
  7. "Corporate History," Osaka Securities Finance, 2007 (in Japanese)
  8. "History," by Chubu Securities Finance, 2007 (in Japanese)
  9. Electronic Government, "Securities and Exchange Law," and System for the Provision of Laws and Regulations, 2007 (in Japanese)

December 18, 2007

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