Japan Puts Foreign Arbs On Its Endangered List

Since Japanese stocks went into their historic nosedive in 1990, Mitsuo Sato, deputy president of the Tokyo Stock Exchange, has nowhere to hide--even at home. Angry investors, he says, keep his phone ringing off the hook. They have a beef, and not with the big domestic brokerage firms that dominate Japanese equities. It's those blasted foreign index arbitrageurs.

Do Japanese investors have reason to be upset? Not necessarily. Index arbs take advantage of momentary price discrepancies between stock-index futures and the underlying stocks--which, in Japan, are the components of the Nikkei 225-stock average. Theoretically, at least, arbitrage should not move markets over the long term. But fair or not, all this griping is beginning to take its toll. And it could spell the end of a lucrative source of profits for an illustrious roster of foreign firms: Morgan Stanley, Salomon Brothers, and Swiss Bank among them. The Finance Ministry and Tokyo Stock Exchange now want to shut down the arbs' current game.

SCAPEGOATS? Officials are pressing the Osaka Securities Exchange to scrap its Nikkei futures contract as early as 1995. In its place, the exchange would list a new contract tracking a more broadly based index, one supposedly less prone to price swings from program trading. The idea is to restore investor confidence. But to some Westerners, the anti-arb campaign is using overseas firms as whipping boys for the Tokyo doldrums. "It's convenient to have a scapegoat--particularly one who's foreign," says Gary Gastineau, a vice-president at Swiss Bank Corp.

The Nikkei average is at the center of the controversy. Unlike the market-cap-weighted Standard & Poor's 500-stock index, the Nikkei is a price-weighted average. And it includes thinly traded issues that subject it to price swings when programs hit the market. The new index proposed by Tokyo officials would resemble the S&P. But critics say it may have the same flaws as the Nikkei. Big banks would loom large in the new index. Most of their shares are closely held and rarely traded, making them as volatile as small companies. Sato concedes that "inclusion of banks' shares will give rise to the same questions we face now."

TOUGH SELL. The anti-arb campaign may not succeed. Osaka plans to keep Nikkei futures until the new contract overtakes it in volume. And profits from program trading appeal to Japanese as well as foreign firms. Morgan Stanley's Tokyo branch, a major arb, earned some $101 million in the six months ended last September, more than six times what Daiwa Securities Co. earned in the same period. Japanese brokerages use programs to enhance the profitability of some of their hottest financial products. One Japanese firm is said to be selling warrants to investors in Europe that pay off if the Tokyo market rises past a certain level. To hedge their market exposure, the firm must engage in extensive trading in Japanese index futures. Index arbitrage makes such trades more lucrative.

Sato wants all exchange members--domestic and foreign--to quit selling those warrants. But that's a tough sell for a simple reason--they make money. If program trading can become a major part of the Japanese money machine, it will be around for a long time.

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