II. BASIC DIRECTION OF REFORM

The task of this Council is to propose how such a restructuring of the Japanese market may be accomplished.

1. From gradual deregulation to structural market reform

Fundamental reforms in many markets around the world have left the Japanese market lagging seriously behind the most advanced markets. In order to recoup this delay, an urgent task is to introduce those products and services that are commonplace in overseas markets but have not yet been introduced in the Japanese market. However, the Japanese market cannot become an international market rivaling New York and London, if Japan only introduced products after they had been developed in overseas markets. Not only will it be necessary to close the gap with more advanced markets, but it should be the aim of this reform to build a mechanism into the market by which the market develops spontaneously.

In Japan, there has been a tendency to introduce new instruments and services on a one-by-one basis: typically, an instrument or a service that had been developed in overseas markets will be identified; its domestic market potential and investor protection measures studied; and after a consensus on desirability had been reached, the new instrument or service will be introduced under a common industry standard. Such a strategy was efficient in the sense that it eliminated trial-and-error process by introducing only those instruments and services with a proven track record. However it not only limited the scope of options available to investors and issuers, but may also have encouraged an imitative attitude among financial intermediaries and discouraged creativity. Similarly, an approach that placed emphasis on distancing investors from risk rather than making risk known to investors, may paradoxically have created the misperception that those areas where restrictions had been lifted were safe areas with an official seal of approval, thereby weakening the idea that each market participant is responsible for his own judgment and must behave in the market with self-discipline.

If the Japanese market is to develop in step with the global market in an age of rapid financial innovation, an approach whereby regulators vet and approve each new instrument or service is not a viable strategy. Rather, regulations that act to restrict new initiatives should be reduced to the extent possible, and creativity be allowed to flourish. To this end, preventive regulations limiting activity and products should be repealed to the extent possible, and policies should shift to one that builds up an environment in which market discipline operates effectively. Investors and firms should be given the freedom to choose from as wide a range of financial instruments and services as possible, basing their decisions on accurate disclosure of information. Through this process, those instruments and services that best meet the needs of the users will be born and will grow. Building a framework that encourages such development of the market based on market forces is the key to enhancing the quality and competitiveness of the Japanese securities market, and, ultimately, in regenerating dynamism on the Japanese economy, as well as ensuring a more efficient allocations of resources worldwide.

The Council proposes to move from a regime that is based on a single, unified system to one that encourages diverse competition. It also asserts a shift in supervision policy from one that attempts to regulate business activity to one that is centered on disciplinary powers of the market. Similar ideas have underscored past market reforms in the United States and in the United Kingdom, and is most probably a natural response to the increased sophistication of financial and communications technology, and globalization of financial markets. It should be noted that the reforms in these two countries have helped create employment and income growth in the securities industry, and have enhanced the global position of the New York and London markets.

The Japanese market has, underlying it, Y1200 trillion of household financial assets, a huge real economy, and financial intermediaries with high potential for innovation. The Japanese market, then, has the ingredients to become a truly international market. By creating an infrastructure that encourages innovation based on market principles, and thereby transforming the market into one where intermediaries with advanced financial technology and flexibility to meet diverse needs can flourish, the Japanese market could become an internationally recognized market that can be compared to New York and London.

2. The Importance of Market Framework

(1)Building a fair and trusted market

A reorientation of regulatory philosophy towards one that emphasizes freedom of activity will increase the importance of creating a market that is fair and can be trusted. A free market should not degenerate into a wild west where self-interest simply collide with one another. Fair competition must prevail in order for the market mechanism to function effectively. To this end, the market must be such that ordinary investors, who are the holders of the Y1200 trillion of financial assets and who are in a disadvantaged position in terms of access to information and negotiating ability, can participate in the market without the apprehension that he may be treated unfairly. If this were not the case, then it would be impossible to require investors to evaluate risk and form their own investment decision. Moreover, in an internationally open market, clear and transparent rules and their swift and effective enforcement are necessary for transactions between professional market participants.

A sense of trust that fair transaction rules are universally

observed is the most basic requirement for a market. Such a goal cannot be achieved through the traditional approach of ensuring the soundness of the market by regulating the business activity of intermediaries, given that the proposed reform intends to create a framework in which market mechanism is to drive market development. A transition from preventive regulation to rule-based surveillance, and in particular strengthening of disclosure, fair transaction rules, and surveillance and enforcement mechanism are essential. Although such a penalty based system provides an underpinning for the market, it will not be enough to rely on criminal penalties alone. A system of dispute settlement whereby compensation for financial injuries from unlawful and unjust actions are quickly and reliably recovered is also important. In addition to penal and administrative penalties, the existence of such a civil procedure will also be an effective deterrent to unfair market activity.

Nonetheless, market cannot exist solely on the basis of a system of rules that can be ultimately be resolved through a judicial or administrative process. Observing established rules is a minimum requirement. As the scope of freedom widens, market participants will be required to regulate themselves in a disciplined manner. In the case of disclosure, for example, it is not enough simply to disclose information required by law: issuers should actively disclose information that may be of value in forming investment decisions, and do so in an easily understood fashion. This is important not only for the market, but it is ultimately in the interest of the issuer himself, as those that do not disclose sufficient information will eventually be shunned by investors.

Irresponsible actions will destroy the market, and in the long run, is not in the interest of the participants that behave in such a manner. Freedom requires a higher ethical standard. It is an important challenge for the Japanese market to firmly establish a high standard of ethics in the market. Those involved in the securities market should make every effort to strengthen the Japanese people's trust in the market.

(2) Developing Market Infrastructure

The other important role for the public sector, along with the establishment of rules, is to improve market infrastructure such as the settlement system.

Recent advances in technology mean that private supply of services is feasible even in areas where it was taken for granted that the service had to be provided by the public sector. It is appropriate for the private sector to take the lead in areas where it is feasible to do so.

It is also important for the public sector to complement private initiatives, if leaving it entirely to the private sector could result in an undersupply or inefficient supply of services. Care must be taken, of course, so that official involvement does not kill off the emergence of alternative sources of supply by constraining the development of market infrastructure into a single mold.

Civil and Commercial Codes, as well as the Tax Code and the Accounting Standards are all important elements of market infrastructure and comprise what may be considered a system of basic software. As deregulation proceeds and improvements in the market's physical infrastructure such as the settlement system take place, the market will gradually converge towards a common global standard. In that process, the market-friendliness of such basic software is emerging as a factor that determines how user-friendly a market is. With globalization of financial markets, users can increasingly even select between different systems of basic rules, by choosing the market in which a transaction takes places. As a result, for financial transactions, there is now emerging a set of de-facto standard for Civil, Commercial and Tax Codes as well as Accounting Rules. A market whose rules differ significantly from such a standard risks being

bypassed by users, particularly professional ones.


[Next Page]

[Table of Contents]