Although markets in Japanese equity derivative products started to appear at the end of the 1980s, due to the lack of a complete regulatory framework general knowledge about these products remained very limited in Japan until the start of the Japanese Big Bang in 1998. During most of the 1990s, domestic players remained virtually absent from the market, except for a handful of corporate end-users dealing in complex hybrid products. Japanese banks and securities companies rarely participated in these transactions and, as a result, foreign investment banks used the know-how that they had gained in foreign markets in order to acquire a quasi-monopoly on offshore equity derivative transactions and domestic hybrid structures.
Warrants and Convertible Bond Arbitrage
These were the first equity derivatives instruments traded in the Japanese market. Japanese bonds cum-warrants were in particularly high demand in the last years of the bubble economy. They were seen by issuers as a cheap way of getting access to new equity capital and by investors as highly geared bull instruments in a market which never seemed to experience any downward corrections. Even after the end of the bubble economy, warrants remained popular trading instruments among professionals, who used them for highly profitable volatility arbitrage transactions, as long warrant positions hedged by short delta positions consisting of cash stocks were the source of extremely cheap gamma positions. With the bad equity market conditions preventing new warrant issues, the outstanding stock of existing warrants eventually dwindled to levels were arbitrage desks were not sustainable any more, but some of this activity shifted then to convertible bonds.
Listed Products and Index Arbitrage
Nikkei 225 futures became rapidly popular after their listing on the Osaka Stock Exchange in 1989, as foreign traders quickly found out that the actual basis between cash equities and futures frequently traded far above its theoretical value and soon became active in Nikkei 225 cash and carry transactions. Mispricing of the futures contracts persisted for many years. This was due first to what appeared to be attempts by the Japanese authorities to support the equity market by intervening indirectly in the futures market, and then to the various regulatory constraints that created different levels of transaction costs, tax and capital requirement for different players in the market.
OTC derivatives
These instruments came out of the legal gray zone with the promulgation of the Law on the Reconstruction of the Financial System in June 1998. Japanese banks and securities companies were finally allowed along with end-users to deal in OTC equity derivatives from Dec. 1, 1998. Since then, while foreign investment banks have remained the dominant players in structuring and trading activities, Japanese houses have progressively become active in the distribution of these products to their traditional client base. End users can be categorized as follows:
International investors, in particular hedge funds and U.S. pension funds have been using for several years a number of structures allowing them to modulate their equity exposures without handling physical stocks. A lot of these trades involve equity swaps, designed in such a way that the client in effect borrows part of the balance sheet of a professional counterpart in order to gain exposure to Japanese equities.
Japanese financial institutions have been prevented by local regulations to enter the equity derivatives market until December 1998. They still seem to have had relatively little involvement in the market since its deregulation, but are starting to use these products in order to set up investment trusts with partial guarantees on invested principal. They should become more important players as they shift to mark-to-market accounting and get better accustomed to structuring new investment products.
Japanese corporations involved in equity derivatives have long been made of a small number of companies looking either for speculative investments or for highly structured hybrid products designed to exploit loopholes in accounting or tax regulations. This type of activity has now virtually disappeared, as deregulation has deprived most of these structures of their purpose and as the new Japanese regulatory authorities have started to look more severely at borderline transactions. With the introduction of mark-to-market accounting, corporations are now mainly using equity derivative structures in order to dissolve at a low cost and with a minimal market impact some of their cross shareholdings. Although needs should appear in the future, regulations are still a hurdle to the use of equity derivatives in corporate finance transactions, despite the recent introduction of stock options and share buy-back schemes.
Japanese individual investors have actually been the main end-users of Japanese equity derivatives in recent years, mainly through reverse convertible bonds and index-linked bonds. The deregulation of equity derivatives and the current low or negative returns on traditional investments (deposits, JGBs and stocks) have given foreign investment banks the opportunity to introduce new investment products to Japanese retail investors with local institutions acting mainly as selling agents. The recent focus of Japanese authorities on the exchangeable bond market shows the importance that these instruments have gained in the retail market but also the excesses that can result from the relative lack of experience of investors, aggressive expansion of foreign firms and lack of a fully adequate regulatory framework.
Judging from these recent developments, the Japanese equity derivatives market seems clearly promised to further expansion, although the local deregulation process and financial environment set it apart from its Western equivalents. It is now up to foreign investment banks to define strategies that will fit its characteristics and support their long-term expansion in Japan, and up to local institutions to catch up with their Western rivals in their ability to handle the new products that their clients now require.
This week's Learning Curve was written by Philippe Avril, business manager at Commerz Securities (Japan )in Tokyo.
