The Butterfly Effect: Japanese Exchange Proposals May Have Major Global Impact

June 17, 2019

The Tokyo Stock Exchange (TSE) is the fourth largest in the world.1 As of April, the TSE had a market capitalization of $5.76 trillion. Any material change to the TSE’s composition can have impacts on the listed companies themselves or on any investors who are tracking or running portfolios linked to the TSE benchmarks. This is particularly true of the passively managed portfolios, exchange traded funds (ETFs), and derivative contracts that are linked directly to the performance of the benchmark. Even the initial publication of the consultation on the proposal caused the indices to drop in value, with the Tokyo Stock Price Index (TOPIX) declining 1.7%.2

Given its size and centrality to global markets, the current market discussions are regarding plans for the TSE to implement stronger standards on listing firms for inclusion to its “First Section,” the top tier sub-set of the TSE, to be comprised of only Japan’s leading companies. By only including established companies with high market capitalization (Japan's leading companies), and removing smaller, early-stage companies (many of which have significant growth potential), the TSE could sap much-needed diversification from the market. Even worse, once dropped, many of the smaller companies face defunding issues and may never make it to the top-tier again. This comes at a time when Japan, after years of stagnation, needs high-growth companies in order to compete on a global scale. While index compositions change across global stock exchanges on a relatively regular basis, the planned TSE restructuring stands out as it will likely have a significant and long-lasting impact on Japanese equity investors from within and outside of Japan.

The TSE is one of kind

Before we can understand what is to change, it is important to understand how the TSE is structured. It is split into four distinct sections based on the characteristics of the listing company:

First Section                

The First Section is viewed as one of the top ranked global markets in terms of its size and liquidity. It is also interesting to note that foreign investors account for a substantial portion of the equity trading that occurs on the First Section.

Second Section

The Second Section is comprised primarily of companies that are too large and mature for Mothers but are not of a market capitalization, growth, or maturity scale to merit inclusion in the First Section.


Mothers is primarily comprised of companies with strong growth potential, who also have ambitions to ultimately be reassigned to the First Section soon. Since the primary objective of Mothers is to offer opportunities for newer companies with high growth potential, it has no restrictions on the size or business category of applicants.


JASDAQ member companies are supposed to be reliable, innovative, and can be regional or international. JASDAQ is also split into two sub-sets, standard and growth, to reflect a company’s current size, growth potential, and maturity. 

Tokyo Pro Market

Tokyo Pro Market limits participation exclusively to professional investors. This allows it to apply less restrictive standards in terms of disclosure language, disclosure documents, accounting standards, and so on, compared to traditional markets.

Structural issues

The primary reason for the proposed TSE restructure is the suggestion that its prestigious First Section contains too many companies overall and some current constituents are too small or unknown to merit their place among these “premium” companies.

Several market commentators, including the TSE itself, have suggested that as currently constituted, it is difficult to distinguish respective companies in the First Section from one another based on the defining characteristics.

A public consultation on the matter has already been held in Japan on proposals and an advisory panel drawn from various sectors of the financial markets have proposed adding more prescriptive conditions. Those include: mandatory corporate governance requirements and use of return on equity metrics (rather than current use of profitability) criteria to all companies wishing to reside on the First Section.

When compared to similarly sized exchanges, such as London’s Premium Listing or NASDAQ in the US, the differential in market capitalization between the biggest and smallest firms on the First Section is vast, a dynamic that normally does not occur across other market capitalization weighted exchanges. For example, Toyota Motor Corporation has a market capitalization of 22 trillion yen (about USD $200 billion) while other companies in the First Section are valued at 2 billion yen ($18 million).[3]

It is also important to note the specific significance of a company’s inclusion in the First Section. The price for all member companies of the First Section are automatically included in the Tokyo Stock Price Index (TOPIX).

Along with the Nikkei 225, the TOPIX is the most influential of all Japanese equity benchmarks. There are trillions of dollars invested into these companies which are used as a proxy of the total Japanese market. It is for this reason that many global institutional investors allocate either primarily or exclusively to First Section companies. 

Mixed industry feedback

Like any major market move, the proposed revisions have been met with mixed reactions from the various stakeholders in the market. The public consultation made it clear that there is a mixture of supporters and detractors to the proposals.

Naturally, the most vocal detractors to the proposals are those companies likely to lose their place in the First Section because of the revised methodologies. The consequence to excluded firms is not just the reputational loss, it could also result in significant divestment from institutional investors who closely track benchmarks. 

Advocates of the change, include the TSE itself, suggest that the proposed revised methodologies make more intuitive sense and with increased focus on the transparency of benchmark composition, this is a necessary evolution to harmonize with global standards and to ensure investor confidence in the Japanese equity markets.  

One point of frustration regarding the proposals is that even though there seems to be consensus about moving forward with the changes to the exchange compositions, there is no firm timeline for the changes, making planning difficult. Even one of the main decision makers in this regard, JPX chief executive Akira Kiyota said that there is no fixed schedule as to how long the process will take: “I can’t say for sure that it will be completed in three years.” For now, companies directly affected or global asset managers who might be readying themselves for a large asset re-allocation of their Japanese related portfolio compositions, must wait patiently but also be ready to act when the changes occur.


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