Japan: IOSCO Objectives and Principles of Securities Regulation
Detailed Assessment of Implementation

This report analyzes the functioning of the legal and regulatory framework for the securities market in Japan. The Financial Services Agency (FSA) enjoyed specific powers with respect to the various security laws and regulations laid down by the International Organization of Securities Commission (IOSCO). The FSA has been authorized to bring about certain changes, to implement new principles, and to develop new frameworks to ensure and strengthen the smooth functioning of supervision and investigation. It is also necessary to identify and assess risks to determine FSA intervention.

Abstract

This report analyzes the functioning of the legal and regulatory framework for the securities market in Japan. The Financial Services Agency (FSA) enjoyed specific powers with respect to the various security laws and regulations laid down by the International Organization of Securities Commission (IOSCO). The FSA has been authorized to bring about certain changes, to implement new principles, and to develop new frameworks to ensure and strengthen the smooth functioning of supervision and investigation. It is also necessary to identify and assess risks to determine FSA intervention.

I. Summary

1. The legal and regulatory framework for the securities market in Japan exhibits a high level of implementation of the International Organization of Securities Commissions (IOSCO) Principles. In particular, there is a robust legal framework that provides extensive powers to the Financial Services Agency (FSA) to supervise regulated entities, to investigate breaches of securities laws and regulations, as well as to cooperate both domestically and internationally. In addition, the FSA has made changes in its organizational structure to upgrade its capacity to identify, monitor, and mitigate systemic risk.

2. However, ongoing supervision of securities firms should be strengthened. First, the FSA should develop a more robust framework to identify and assess the scale and scope of risk posed by individual firms that could also serve as a tool to determine the intensity of regulatory intervention (including on-site inspections). Vis-á-vis investor protection, the Securities Exchange and Surveillance Commission (SESC) should intensify the coverage of its inspection program for smaller firms, as conduct issues cannot be easily captured through off-site reporting. This could be accomplished through a combination of additional institution-based inspections, thematic reviews, and/or random inspections.

3. In addition, the FSA should consider reviewing its enforcement program to ensure proper balance between different type of regulatory measures at its disposal, from orders for improvement to suspensions and cancellations of registration. Also, the authorities should consider reviewing the current framework for administrative money penalties to (i) ensure that the amount of the penalties is sufficient to ensure a deterrent effect; as well as (ii) to expand the type of misconducts to which administrative money penalties could be applied.

4. From an organizational perspective, FSA governance arrangements and resources should continue to be strengthened. Mechanisms should be explored to ensure that the FSA can hire and retain expert staff across the different departments of the organization, including for example by reviewing the salary scale. In this context, the FSA should review whether current resources are sufficient to ensure the robustness of its supervisory program. The authorities should also explore ways to enhance FSA legal independence.

5. Finally, efforts to implement the new principles should continue, in particular in connection with the identification of emerging and systemic risk. The creation of the Office of Securities Business Monitoring (OSBM) is a step in the right direction. However, it is important that some type of arrangement be in place to more comprehensively and systematically identify and assess risks and determine the need for regulatory intervention.

II. Introduction

6. An assessment of the level of implementation of the IOSCO Principles in the Japanese securities market was conducted from November 28–December 16, 2011, as part of the Financial Sector Assessment Program (FSAP) by Ms. Ana Carvajal, Monetary and Capital Markets Department (MCM) and Mr. Martin Kinsky (external expert). An initial IOSCO assessment was conducted in 2003. Since then, significant changes have taken place in the Japanese market, in terms of market development and upgrading of the regulatory framework. In addition, IOSCO approved a new set of principles in 2010, and a revised methodology in 2011.

III. Information and Methodology Used for the Assessment

7. The assessment was conducted based on the IOSCO Principles and Objectives of Securities Regulation approved in 2010, and the methodology adopted in 2011. As has been the standard practice, Principle 38 was not assessed due to the existence of a separate standard for securities settlement systems. A technical note on the oversight framework for systemically important financial market infrastructures was delivered during this mission. The assessment did not cover commodities derivatives exchanges or other derivatives exchanges where the underlying asset is not a security.

8. The IOSCO methodology requires that assessors not only look at the legal and regulatory framework in place, but at how it has been implemented in practice. The recent global financial crisis has reinforced the need for assessors to take a critical look at and to make a judgment about supervisory practices, to determine whether they are effective enough. Among others, such a judgment involves a review of the inspection programs for different types of intermediaries, the cycle, scope and quality of inspections as well as how the agency follows-up on findings, including the use of enforcement actions.

9. The assessors relied on: (i) a self-assessment developed by the FSA; (ii) the review of relevant laws and reports available in English; (iii) meetings with staff from the FSA, the SESC, the Certified Public Accounting and Auditing Oversight Board (CPAAOB), and the Bank of Japan (BOJ); as well as (iv) meetings with market participants, including issuers, securities firms, fund managers, exchanges, external auditors, credit rating agencies, the Japanese Securities Dealers Association (JSDA), the Investment Trust Association of Japan (ITAJ), the Japanese Institute of Certified Public Accountants (JICPA), and law firms. The limited availability of information in English was a challenge; however, to some extent, gaps were filled through the discussions with the authorities and market participants, although review of supervisory files could not be conducted in an optimal manner.

10. The assessors want to thank the FSA and the BOJ for their full cooperation as well as their willingness to engage in very candid conversations regarding the regulatory and supervisory framework in Japan. The assessors also want to extend their appreciation to all other public authorities and market participants with whom they met.

IV. Institutional Structure

11. The regulation and supervision of the Japanese securities markets are responsibilities of the FSA, SESC, and the CPAAOB. The nature of these entities differs: the FSA is an agency within the Cabinet, while the SESC and the CPAAOB are boards within the FSA, but to which the Financial Instruments Exchange Act (FIEA) afforded a high degree of independence vis-à-vis the FSA.

12. These agencies exercise delegated authority, as the responsibility for regulation and supervision of securities markets is assigned to the Prime Minister (PM) by the FIEA. Such act delegates all authority and functions in connection with the regulation and supervision of securities markets to the FSA except functions excluded by a Cabinet Ordinance. Current exceptions are limited, mostly circumscribed to the licensing of exchanges and the authorization of associations. The FIEA prescribes a second level of delegation, in this case of the authority of the FSA in the SESC, to which it entrusts the authority to request reports from regulated entities and conduct on-site inspections and investigations. Finally, the CPA Act delegates to the CPAAOB the oversight of auditors. From an operational perspective responsibilities are distributed as follows—the FSA is responsible for policy, off-site monitoring, and imposition of enforcement actions. The SESC carries out onsite inspections and investigations. Based on the results, the SESC may make a recommendation on enforcement actions to the FSA. The CPAAOB oversees the quality control program developed by JICPA, carries out inspections on auditors, and as a result of such inspections, the CPAAOB may make a recommendation for enforcement actions to the FSA.

13. A third level of delegation is to the local finance bureaus. The FIEA authorizes the FSA and the SESC to delegate their monitoring and inspection functions to the local finance bureaus. In practice, the FSA and the SESC entrust to the local finance bureaus the review of prospectus and periodic information of issuers; the review of tender offer documents; the registration of financial instruments business operators (FIBOs); and the off-site monitoring and on-site inspections of FIBOs whose capital is less than ¥12 billion.

14. Several types of self regulatory organizations (SROs) coexist and perform important self regulatory functions. Pursuant to the FIEA, three different types of entities can perform self regulatory functions: the exchanges, associations and SROs, which are entities that can only be constituted by exchanges. In practice in addition to the exchanges, there are several more entities performing important SRO functions—the Tokyo Stock Exchange (TSE) SRO, the JSDA, and the ITAJ. There are two more associations—the Japan Securities Investment Advisers Association (JSIAA) and the Type II Financial Instruments Firms Association (Type II FIA). The JSIAA has some rulemaking functions in connection with investment advisers, and has subject them to off-site reporting; however it does not conduct on-site inspections on them nor exercise enforcement functions—although it can withdraw membership. Finally the Type II FIA has self regulatory functions in connection with Type II FIBOs; but is of very recent creation. Therefore this assessment has not covered these two associations.

V. Basic Legal Framework for Market Participants

15. The main laws applicable to securities markets are the Financial Instruments Exchange Act (FIEA) and the Investment Trust and Investment Corporations Act (ITIC).

16. Issuers of securities that are offered to the public are required to notify the FSA and file a registration statement. They are also required to submit an annual report, and either a quarterly report (for listed issuers) or a semiannual report (for non-listed issuers). Issuers are also required to notify a list of corporate events to the FSA. In addition, the TSE has established a principle of timely disclosure of corporate actions which requires disclosure to the exchange of any event that could have a material effect on investors’ decisions.

17. Collective Investment Schemes (CIS) that are offered to the public are also required to file their offering documents with the FSA. CIS can be constituted as trusts or corporations, in both cases the law requires that they be managed by a financial instruments business operator (FIBO) registered as an investment management business operator (IMBO).

18. The provision of securities activities in Japan requires registration as a FIBO. There are four main types of FIBOs: Type I, which is essentially a broker dealer which can trade in a wide array of securities including stocks, bonds, shares of CIS, derivatives, etc.; Type II, which is a broker-dealer that can only trade in a very limited category of securities (those not included in the list of authorized securities for Type I and which are commonly referred to as “illiquid” securities); IMBO which is an asset manager; and an investment advisory firm, which can provide investment advisory services. Registered financial institutions (such as banks, cooperatives, and insurance companies) can also provide a limit number of securities markets services to retail investors, mainly related to the distribution of government debt and CIS. The FSA has established a system of consolidated supervision for securities firms with assets equal or above ¥1 trillion.

19. Two different types of regulated markets coexist: exchanges and proprietary trading facilities (PTS). Exchanges require a license which is granted by the MoFS on behalf of the PM (PM) while Proprietary Trading System (PTS) must be registered as a Type I FIBO. A trading volume limit of 10 percent is set up on PTS

(Article 1 of the Cabinet Order for Enforcement of the FIEA).

VI. Market Structure

Equity markets

20. A total of 2,900 companies are listed on any of the six exchanges that operate in Japan. Out of such number, 2,280 were listed on the Tokyo Stock Exchange (TSE). The TSE is the main equity exchange in Japan, with a market capitalization of roughly US$3,634,790 million as of March 31, 2011. Publicly listed companies are dominated by industrial (including telecommunication and services) and consumer goods companies. Large caps account for 85 percent of market capitalization, though they amount to only one third of the number of listed companies. There are currently 12 foreign companies listed in Japan. The number of new listed companies had decreased overtime but increased in 2011. In 2010, 26 new companies were listed in the TSE, while 68 delisted.

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(Source) TSE, end-2010.

21. The TSE and the London Stock Exchange recently established a joint venture called Tokyo AIM, a new Tokyo equity based market for growing companies that is only open to professional investors. The market is still at an early stage. Tokyo AIM is also considering a debt securities market for professional investors only.

  • i) Note—The TSE plans to integrate TOKYO AIM into the Tokyo Stock Exchange effective July 1, 2012, and re-brand the TOKYO AIM market as ‘TOKYO PRO Market.’

Bond markets

22. In recent years, Japanese companies have issued increasing amounts of corporate bonds, even though the size of this market remains small compared to other advanced economies. For 2010, the total amount of bond issuance was ¥198,439 billion, out of which only 4.8 percent were corporate bonds, municipal bonds amount to 3.9 percent, while Japanese government bonds (JGBs) make up for 83.6 percent.

23. Trading of debt is mostly conducted in the over the counter (OTC) markets. Outside of OTC, the TSE is the main securities exchange in Japan, though the number of companies with listed debt is small compared to equities. No straight bonds are listed on the TSE, except for certain government debt bonds. Some convertible bonds are currently listed (as of November 30, 2010, the number of issuers was 37, the number of listed securities was 39 and the total amount was ¥1,239 billion).

Collective investment schemes

24. As of end 2010 the total amount of assets under management (AUM) held by investment trusts amounted to ¥98 trillion. Of this amount, ¥63 trillion was invested in publicly offered investment trusts, roughly ¥4 trillion in real estate investment trusts and ¥31 trillion in privately placed investment trusts. Of the assets invested in publicly offered investment trusts, ¥52 trillion were invested in stock investment trusts, ¥9 trillion in bond investment trusts and ¥2 trillion in MMF. The major securities firms, as well as most of the major banks, are the largest CIS managers.

Securities intermediaries

25. There are currently 322 Type I FIBOs operating in Japan, out of which 22 are foreign firms (not incorporated). The majority of them are small firms with simple business models, and still retail oriented. However, there are a few large firms with complex business models (e.g., including proprietary trading and derivatives portfolios). There are currently 16 securities companies subject to consolidated supervision. A subgroup of them is subject to more intense monitoring and supervision, based on an assessment of their business models and potential systemic implications. In their case supervision (off and onsite) is assigned to a dedicated unit, the OSBM. Currently 19 firms have presence overseas. The main overseas cities where they operate are New York, London, Singapore, and Hong Kong.

26. There are other intermediaries providing services in the market. In addition to Type I FIBOs, there are 1,293 Type II, 1,122 Investment Advisory and Agency Business and 322 IMBOs, as of November 2011.

Trading platforms

27. There are six exchanges operating in Japan—the TSE, the Osaka Stock Exchange (OSE), the Nagoya Stock Exchange, the Fukuoka Stock Exchange, the Sapporo Stock Exchange and the Tokyo AIM. However, only the TSE and the OSE have significant trading volumes. On the cash side, the TSE accounts for roughly 90 percent of trading volumes, while the OSE is the main market in connection with derivatives. A merger between these two exchanges has recently been agreed, with completion expected by 2013. In addition, there are five PTS that trade equity, government debt, and corporate debt; but their trading volumes are not significant.

VII. Preconditions for effective securities regulation

28. Market participants highlighted the need to further strengthen corporate governance, through the inclusion of additional independent directors and the constitution of strong, independent bodies (such as a system of committees) to support the oversight function of the board. All other preconditions appear to be largely in place. In particular, foreign issuers can tap the markets under similar conditions to domestic issuers. Foreign corporations can register as financial instruments business operators, with the same requirements than domestic corporations and there are no barriers for foreign investors to invest in the domestic market. The company law is modern and it is easy to constitute a corporation in Japan—incorporation typically takes less than a week. The insolvency framework includes rehabilitation procedures. Out of court proceedings can be worked out, and guidelines exist in this regard. The judiciary system is perceived as impartial. The prosecution office has created specialized offices in Tokyo, Japan, and Osaka, Japan, to deal with financial crime, but participants commented that courts might lack expertise. Accounting and auditing standards do not have major differences from international standards.

VIII. Main Findings

29. Principles for the regulator: Responsibilities for the supervision of securities markets lies in the FSA, the SESC, and the CPAAOB. Certain features of the legal framework raise concerns in regard to their independence; however, in practice there is no evidence of day-to-day interference from the government. In the areas of their competencies, such agencies have been provided with broad powers vis-à-vis regulated entities, although the FSA cannot impose money penalties except in connection with a limited number of misconducts. The FSA has taken important steps to strengthen its capacity to identify and monitor emerging and systemic risk.

30. Principles for SROs: There are a number of SROs currently active and most have a long history of operation. They are subject to “authorization” and must meet criteria that address issues such as capacity, management of conflict of interest, fair treatment of members, and confidentiality. The FSA has enforcement powers over them. The FSA has developed a system of oversight tailored to each SRO that appears to be working well.

31. Principles for enforcement: Supervision of securities firms requires further strengthening. First, the FSA has not yet developed a framework to identify and determine the scale and scope of risks of individual firms and determine the intensity of regulatory intervention (including on-site inspections). In addition, the coverage of the on-site inspection program is limited, especially for smaller Type I and IMBOs as well as for Type II and investment advisors—most of which are inspected only by cause. In connection with enforcement, the assessors observed that the FSA is making more use of stronger measures, such as suspensions, in addition to orders for improvement on which it has traditionally relied. In such context, it is important that the FSA periodically reviews its strategy towards enforcement. Criminal convictions have been secured, but commuted sentences can limit the effect of deterrence.

32. Principles for issuers: Issuers of public offering are subject to disclosure obligations at the moment of registration and on a periodic and on-going basis that are in line with the IOSCO Principles. The FSA and the SESC have a system to review offering documents as well as periodic reports, which helps to ensure compliance by issuers with their disclosure obligations. Basic rights of shareholders are imbedded in company law. Certain additional protections are provided by the FIEA, in particular the requirement for a mandatory tender offer under certain conditions. There are notification obligations for substantial holdings. Holdings of insiders must be included in the disclosure documents but a system of timely notification of transactions carried out by them is not in place. Financial statements must be prepared according to local GAAPs, which are broadly consistent with IFRS.

33. Principles for auditors, credit rating agencies and other information service providers: A system of quality control for auditors is in place, which involves reviews by JICPA (the professional body) under the oversight of the CPAAOB. Such system is also complemented with direct examinations by the CPAAOB. Auditors are required to be independent of the entities they audit. Issuers’ mechanisms to monitor auditors’ independence require strengthening. Credit rating agencies are registered by the FSA, and are subject to ongoing supervision through reporting and on-site inspections. There is a framework in place for sell-side analysts to address conflicts of interest, which is based on disclosure.

34. Principles for collective investment schemes: Managers and distributors of CIS are required to register with the FSA. Registration requirements for managers (who must register as IMBOs) include capital requirements, fit and proper requirements and organizational requirements or deposits for operation. The SESC does not have a policy to inspect newly registered CIS managers within a short timeframe after registration. The current risk-based approach ensures regular on-site inspections for CIS managers, although the SESC should further strengthen the inspection program for CIS managers especially if the managed CIS is offered to the public and is subject to similar disclosure obligations to an issuer. Assets must be entrusted to a separate custodian. There is no obligation that the custodian be independent; however, custodians (trust banks) are subject to regulation and supervision by the FSA. Assets must be valued at fair value. ITAJ has developed guidance on valuation of assets, including illiquid assets. Conditions of suspensions of redemptions must be disclosed in the offering documents. Suspensions of redemptions are notified to the FSA.

35. Principles for securities intermediaries: Financial instruments business may only be carried on in Japan by entities registered by the FSA and that comply with registration requirements, which include minimum capital, fit and proper and organizational requirements. The SESC does not have a policy to inspect newly registered FIBOs within a short timeframe after registration. Ongoing capital requirements apply only to Type I FIBOs, which must comply and report a capital ratio similar to Basel II. Reporting requirements are extensive for Type I FIBOs. Smaller intermediaries are not necessarily subject to external audit. The current risk-based approach ensures regular inspection of larger Type I FIBOs and IMBOs by the FSA, which is complemented by JSDA/TSE inspections and ITAJ inspections. Longer cycles apply to smaller Type I and IMBOs, Type II and investment advisors are inspected mainly by cause. The FSA has not developed a plan to deal with the failure of a securities firm, but experiences of how past failures were handled have been documented.

36. Principles for secondary markets: Exchanges and PTS are the only secondary markets that can trade securities and each must comply with criteria set down by FSA. The SROs are responsible for ensuring orderly trading, while the SESC is responsible for market surveillance for purposes of detecting unfair trading practices—in such function, it is supported by the exchanges. There has been active enforcement of the requirements prohibiting unfair trading practices. CCPs manage exposures on a daily basis and have powers to request members to post additional margin. Default procedures are known to members. Price limits apply in both the cash and derivatives and circuit breakers apply to derivatives trading if there is excessive volatility. Naked short selling is prohibited.

Table 1.

Japan FSAP—Summary Implementation of the IOSCO Principles

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Table 2.

Japan FSAP—Recommended Action Plan to Improve Implementation of the IOSCO Principles

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Authorities’ response

37. The Japanese authorities welcome the opportunity to be assessed as the first jurisdiction under the new IOSCO Principles and Objectives published in 2010, and the methodologies published in September 2011. The authorities also wish to express their sincere appreciation to the IMF and its experienced assessors for the dedication, time, and resources committed to this assessment. It provided the authorities with an opportunity to comprehensively review their regulatory and supervisory framework through their self-assessments and dialogue with the IMF.

38. The authorities welcome the overall assessment by the IMF that they have achieved a high level of compliance with the IOSCO Principles. The recommendations made by the IMF are generally well received. While some initiatives toward reform have already been taken since the time of the assessment, the authorities will thoroughly take into account these recommendations in their continuous efforts to strengthen their capacities for better regulation and supervision.

39. However, the authorities find that the Methodologies need to be improved further to enable more risk-based assessments with more emphasis on the outcome, not on the form of policy action. Presently, the methodologies provide only a single set of policy actions to be in compliance with each principle, irrespective of a country’s risk profile or differences in the effectiveness of the policies depending on the country’s circumstances. For example, full compliance with Principle 30 would not be achieved until all market intermediaries holding client assets are subject to external audit, regardless of their risk profile. The authorities maintain that, although external audit would be useful, other measures could also achieve the same objectives. The authorities believe that an excessive emphasis on the form of regulation and supervision could lead to a box-ticking approach which does not lead to the desired outcomes of enhancing market integrity and efficient markets, as well as to ensure financial stability. The authorities will continue to work with the IOSCO and the IMF for further improvement of the methodologies.

IX. Detailed Assessment of IOSCO Principles

40. The purpose of the assessment is primarily to ascertain whether the legal and regulatory securities market requirements of the country and the operations of the securities regulatory authorities in implementing and enforcing these requirements in practice meet the standards set out in the IOSCO Principles. The assessment is to be a means of identifying potential gaps, inconsistencies, weaknesses and areas where further powers and/or better implementation of the existing framework may be necessary and used as a basis for establishing priorities for improvements to the current regulatory scheme.

41. The assessment of the country’s observance of each individual Principle is made by assigning to it one of the following assessment categories: fully implemented, broadly implemented, partly implemented, not implemented, and not applicable. The IOSCO assessment methodology provides a set of assessment criteria to be met in respect of each Principle to achieve the designated benchmarks. The methodology recognizes that the means of implementation may vary depending on the domestic context, structure, and stage of development of the country’s capital market and acknowledges that regulatory authorities may implement the Principles in many different ways.

  • A principle is considered fully implemented when all assessment criteria specified for that Principle are generally met without any significant deficiencies.

  • A principle is considered broadly implemented when the exceptions to meeting the assessment criteria specified for that Principle are limited to those specified under the broadly implemented benchmark for that Principle and do not substantially affect the overall adequacy of the regulation that the Principle is intended to address.

  • A principle is considered partly implemented when the assessment criteria specified under the partly implemented benchmark for that principle are generally met without any significant deficiencies.

  • A principle is considered not implemented when major shortcomings (as specified in the not implemented benchmark for that Principle) are found in adhering to the assessment criteria specified for that Principle.

  • A principle is considered not applicable when it does not apply because of the nature of the country’s securities market and relevant structural, legal and institutional considerations.

Table 3.

Detailed Assessment of Implementation of the IOSCO Principles

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