Is Tokyo Getting Tough Or Getting Jealous?

The Tokyo stock market has plunged 50% since late 1989--a slaughter that has buffeted Japanese investors and brokers alike. But for the big U.S. firms in Tokyo--Salomon Brothers, Goldman Sachs, and Morgan Stanley--Japanese equities have been a source of rousing profits. By dint of program trading and a roster of other computer-driven strategies that rake in cash even when stocks decline, Wall Street firms have had a banner year in Japan.

In 1991, Salomon, Goldman Sachs, and Morgan Stanley dominated the list of the five most profitable brokers in Japan (table). By raking in $176 million in the fiscal year ended Mar. 31, 1992--triple the prior year--Salomon was second only to Nomura Securities Co. in profits. But the trading-driven profit festivities may be about to cool.

Japanese regulators are taking steps that are making trading more difficult--and costly. The target is index arbitrage, a form of program trading that has troubled regulators on both sides of the Pacific as a possible source of market volatility. In index arbitrage, traders profit from price discrepancies between the price of index futures and underlying "baskets" of stocks. Such discrepancies have largely vanished from the U.S. markets as index arbitrage has proliferated, but spreads are wider in Japan, where index arbitrage is shunned by all but the biggest local firms.

SCAPEGOATS? Tax authorities are pushing for a rule change that would allow them to collect a bigger chunk of the profits from index arbitrage. The proposal rankles U.S. brokers, because it would be collected retroactively. Officials may also redesign the popular Nikkei Stock Average into a capital-weighted index like Standard & Poor's 500-stock index. That would make it tougher to put together a small basket of stocks that mimic the Nikkei's movements, thus making index arbitrage more costly.

U.S. brokers privately complain that they are being used as scapegoats for the Tokyo market decline. The malaise has hurt local firms much more than U.S. firms, because the locals put far less emphasis on trading. Says one U.S. brokerage official: "What's embarrassing is that we're making good money by using well-accepted, legitimate trading techniques, whereas the Japanese firms are losing money."

`SIGNIFICANT BARRIER.' This is not the first time action by regulators has hampered the growth of U.S. financial companies in Japan. When Citibank expressed interest in the branch network of a troubled savings and loan association in 1986, the Finance Ministry intervened and arranged for Sumitomo Bank Ltd. to take the bank over. Japanese officials are also slow in opening up the mutual-fund industry to foreign firms. The ministry is expected to ease restrictions on foreign mutual funds by cutting the minimum capitalization of a fund from $8 million to $2.5 million. But the minimum in the U.S. is still just $100,000, and fund managers are free to determine their own fees, while they remain fixed in Japan. "There's still a very significant barrier to entry," says Fidelity Chief Counsel Robert Pozen. "It's a far cry from an open market."

Japan may soon come under new pressure to loosen restrictions. The Riegle-Garn Fair Trade in Financial Services bill has cleared the Senate and is now being considered by the House (page 31 23 ). If made law, it would authorize U.S. regulators to block expansion plans by financial institutions based in countries that deny American firms opportunities equal to those enjoyed by local firms.

Fortunately for the American firms, Japan's effort to restrict trading has met with little success so far. For example, much of the futures trading related to index arbitrage once conducted in Osaka has simply migrated to Singapore--where officials rejected a Japanese request to join Osaka in raising commissions.

U.S. brokerage officials are putting on a brave front. "Even if Japan Inc. tries to drum us out of business, it can't do it," says one U.S. executive. "Whatever they try to do, there will be a profitable niche for us." But so long as Japan Inc. remains hostile, it cannot help but gnaw away at the Tokyo money machine.

Before it's here, it's on the Bloomberg Terminal.