Government Bond Market Development

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Government Bond Market Development Managing
Interdependencies

• June 17, 2003
• Johannesburg, South Africa
• Noritaka Akamatsu
• Financial Sector Operations Policy Dept.
• The World Bank

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Why develop Government Bond Market?

• Capital markets in general
• complement bank financing and contribute to the
  development of multi-layered financial systems.
• mobilize domestic long-term savings to finance
  investment for growth without excessively relying
  on external borrowing.
• thus, reduces risks or enable management of those
  and makes the growth sustainable.
• Government bond market in particular
• is a backbone of fixed-income markets
• provides a number of positive externalities for
  overall debt market development.

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Some externalities

• Macro level
• non-inflationary funding of budget deficit,
• smooth transmission of monetary policies
• Micro level
• support development of the rest of the debt
  market by offering pricing benchmarks
• stimulate development of financial
  infrastructure, products, and services
• Enable management of exposure of portfolios to
  interest rates and exchange rates (derivatives).

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The Necessary Environment

• Macroeconomic stability, low inflation
• Fiscally sustainable growth
• Credible commitment of the government
• Adequate financial sector development
• Liberalization of the financial system,
  particularly that of interest rate
• Competition among intermediaries
• Solvent financial system

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Recent efforts to foster Government Bond Market

• The objectives are to
• provide a strategic and comprehensive vision.
• emphasize medium- and long-term markets, and
• highlight linkages with other markets.

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Govt Bond Market as a place of interaction

• Govt bond market, like any other financial
  market, is NOT a single institution but a place
  of interaction among participants, supported by a
  complex set of institutions.
• Everything depends on everything else, and no
  single party can dictate the development process.
• Requires a political commitment.
• An opportunistic strategy is needed to manage a
  complex set of chicken-and-egg problems.
• Q. Where to start? How to sequence?

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Six Building Blocks

• The Issuer (i.e., the government)
• Investors
• Market intermediaries
• Trading and settlement infrastructure
• Legal and regulatory infrastructure
• Instruments

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Government as the Issuer- Supply of GSs -

• There must be bonds in order for a bond market to
  exist and develop. The government must
• have a fiscal policy stance which enables
  sustainable issuance of government bonds,
• be adequately empowered to borrow from the
  domestic market (i.e., borrowing authority),
• be capable of managing the borrowing well
  (together with the central bank), and
• be able to manage the cash and debt efficiently.
• Fiscal policy should be separated from the
  monetary policy.
• Clear mandates and governance of debt manager.

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Public Debt Management and Primary Market

• Two key objectives of government debt management
• Raise a needed amount of funds when needed, and
• Do so price-competitively accounting for risks.
• The govt should be a price taker (because
  otherwise, the secondary market will not
  develop).
• Reserve requirement for banks should not be a
  tool to generate demand for govt bonds.
• Govt bond market development should be the third
  objective.
• Standardize instruments, regularize and announce
  issuance calendar, and create benchmarks.

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Govt Cash Management and Money Market

• Deep and liquid money market and upward sloping
  yield curve enable trading along the yield curve
  and encourage demand for long-term govt bonds.
• Open market operations by the Central Bank and
  borrowing operations by the government need to be
  coordinated.
• i.e., requires sound cash and debt management by
  the government.
• Sound management of excess reserves of banks by
  the Central Bank is required.

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Public Debt Management and Primary Dealer System

• Obligations for PDs should be designed to be
  useful for the debt manager to meet debt
  management objectives. Typical obligations for
  PDs include
• Always participate in primary auctions
• Market making, i.e., maintaining price quotes for
  buy and/or sell and a high trading volume through
  the prices it quotes.
• At the same time, benefits for PDs from
  privileges should outweigh costs from the
  obligations. Typical privileges include
• Exclusive right to participate in the primary
  auction
• Exclusive counterparties for Central Bank
  operations
• Needs a reliable mechanism to monitor PDs market
  making performance (e.g., trading platform).

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Investors and Intermediaries

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Institutional Investors- Source of Demand -

• A critical source of demand for long-term govt
  securities.
• Life insurance, pension funds, mutual funds
• Mandatory insurance (e.g., auto insurance,
  mortgage indemnity insurance), second pillar
  pensions
• Investment regulations for pension funds and
  insurance companies regarding their portfolio
  allocation should be made conductive to
  investment in bonds (usually not a problem with
  govt bonds but often with corporate bonds).

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To generate liquidity

• There need to be investors with different
  investment / trading needs (e.g., banks,
  institutional investors, non-financial companies.
  Individuals?).
• Prudential regulation and risk management
  requirements (including adoption of
  mark-to-market accounting) should be conductive
  to generation of liquidity in the market

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Prudential Regulation Risk Management

• Institutional investors are typically required
  to
• invest in liquid and creditworthy instruments
• diversify the portfolio, and
• mark-to-market the portfolio to manage risk and
  provide fair market value for the beneficiaries.
• Mark-to-market requires
• adoption of proper accounting standards, and
• reliable market price information.
• Both depends significantly on the existence of
  liquid secondary market for benchmarks.

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Institutional Investors and Trading Market

• If there are developed institutional investors,
• trading market architecture would need to
  accommodate their business needs.
• If there arent,
• banks as dealers would likely be the primary
  investors as well as intermediaries.
• Inter-dealer broker (IDB) or inter-dealer system
  instead of multi-dealer system is likely to be a
  trading market architecture.

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Trading and Market Transparency

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Bond Market Transparency Information Systems

• Reliability and transparency of market price is
  crucial.
• benchmark for pricing in the primary market to
  ensure smooth absorption.
• enables investors to obtain fair value, thus
  encouraging wider and more active participation
  in the market
• effectuates Mark-to-Market valuation of portfolio
  and collateral for risk management, mutual funds,
  etc..
• Q. How can a critical mass of transactions be
  captured to give reliable market price
  information back to the market?
• Information system, trading system or settlement
  system?
• Mandatory reporting of every transaction?

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Transparency required

• Not all transparencies are good.
• Post-trade price and volume information for all.
• As equal access as possible to pre-trade price
  information at least for all direct market
  participants.
• How about identity of market participants?
  Pre-trade or post-trade?

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How to Achieve the Transparency

• Organize the trading market to the extent
  possible.
• Standardize pricing formula and other transaction
  conventions.
• Electronic trading systems, IDBs
• Q. Can electronic market attract critical mass
  of trading in benchmarks? Fragmentation if
  multiple platforms?
• OTC market - how do we know what the market price
  is?
• Competing private information vendors (e.g.,
  Reuters, Telerate, Bloomberg, Quick, etc.). But
  fragmentation?
• Reporting requirement to a central point. To
  whom? Not a private info vendor. Bond dealers
  association?
• Settlement system can gather trade information?
• if standardize settlement cycles and shorten it
  to be Real Time (G-G) DVP. If not???

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Transparency and Self-Regulation in Bond Market

• Bond dealers association can standardize pricing
  formula and other trading business conventions
  (e.g., master repo agreement) to enhance
  transparency and liquidity.
• Can self-regulation work in bond market?
• Bond dealers association a trade association or
  an SRO?
• Reporting requirement to a bond dealers
  association. Cooperation with private
  information venders?
• Does it have a technical capability?

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Electronic Bond Trading

• Equity market has been organized in exchanges
  while bond market has operated OTC. Why?
• More recently, the architectures of the two
  markets are converging with respect to government
  securities.
• Demutualization of stock exchanges and emergence
  of ATSs and ECNs are making the equity market
  architecture open and competitive.
• The possibility of DVP with end-to-end STP with
  dematerialized securities is making trading of
  government bonds through a common trading
  platform more possible.
• Electronic trading systems
• Inter-dealer system/IDB vs. multi-dealer system

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Trading Market

• Organized trading may be possible and useful only
  for benchmarks. Why?
• Big players want anonymity to avoid impact
  cost.
• Bond Exchange?? NYSE, NASDAQ used??
• Electronic trading systems?
• Inter-Dealer Broker (IDB).
• There should first be a DVP settlement
  arrangement. Why?

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Trading Market and Institutional Investors

• IIs may wish to access the trading platform
  directly so that they can avoid intermediation
  cost.
• If IIs trade directly among them, dealers (e.g.,
  banks) may lose significant business.
• It may be good for the IIs. But it is not
  entirely clear whether it will be good for market
  development, because
• banks as dealers may be discouraged to make
  market, and
• viability of a primary dealer system may be
  reduced.

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Settlement Systems

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Efficiency in Settlement

• Underpins cost-efficiency of transactions and
  thus competitiveness of the market.
• Efficiency-Safety tradeoff
• RTGS vs. netting
• Capital/liquidity efficiency (i.e., efficient use
  of capital/ liquidity required to run a
  settlement system)
• Use of collateral instead of capital/liquidity
• But the collateral has opportunity cost and must
  be reasonably liquid
• Cross margining / collateralization (e.g.,
  derivatives and spot markets)
• DVP first and maybe central counter-party (CCP)
  later.

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Links between Trading and Settlement Systems

• An anonymous trading system needs to be supported
  by DVP settlement because
• each market participant must minimize
  counter-party risk when there is no CCP and
• the CCP needs to manage counter-party risk
  vis-à-vis its participants when there is a CCP.
• In an emerging market, a CSD was often created as
  part of a monopoly stock exchange while that for
  govt securities is often operated exclusively by
  the central bank. Is there room for
  consolidation?
• Straight through processing (STP)
• Single entry point
• Mark-to-market valuation of collateral

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London
iX (failed)
European Clearing House
Clearstream Crest Monte Titoli SCLV
Frankfurt
Milan
Madrid
Nasdaq Europe
Euroclear Sicovam Necigef CIK
Brussels
Euronext
Amsterdam
Paris
Tradepoint
Virt-X
SIS
Zurich
Oslo
Norex
VPC
Stockholm
Copenhagan
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Institutional Framework

• Institutions can be linked or integrated
• Clearing House / Central counterparty (CCP)
• Central Securities Depository (CSD)
• Custodians
• Registrars
• The processing should be as straight through
  (STP) as possible regardless of the combination.
• Governance of the body matters in deciding on
  integration.
• CPSS-IOSCO Recommendations for Securities
  Settlement Systems

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Money SettlementRTGS vs. Netting

• RTGS or netting (by novation with a CCP) - which
  is better?
• Efficiency-Safety tradeoff RTGS eliminates
  systemic risk while requiring liquidity which is
  often to be provided by the central bank.
  Netting reduces the liquidity requirement while
  accumulating systemic risk.
• CCP substantially reduces, if not eliminates, a
  need to assess creditworthiness of the
  counterparty.
• Collateral requirements as functions of trading
  volume
• Shortening of the settlement cycle to reduce
  systemic risk and market risk.
• Settlement cycle is moving toward T1
• Real time DVP for government securities?

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Law, Regulation and Self-Regulation

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Legal and Regulatory Framework

• Debt management law
• The borrowing authority and its delegation
• Net borrowing limits
• (disclosure)
• Primary market regulation
• Participants of the primary market
• Secondary market regulation
• Participants of the secondary market
• Trading platforms, inter-dealer brokers
• Clearance settlement system (incl. repos,
  collateral)
• Self-regulation

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Self-Regulation in Bond Market

• Would Self-Regulation viable in bond market?
• The monopoly organized market.
• Good for transparency. But efficient
  architecture?? Government securities vs
  corporate bonds
• Competitive organized markets
• Compete among them and with OTC. I.e.,
  participants can go anywhere if it does not like
  stringent rules by a market operator. gt Hard
  to enforce rules.
• OTC market
• Bond dealers association trade association or
  SRO? What is the difference?
• Self-regulation by regulation of the Regulatory
  Authority?

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Other Important Tasks

• Rationalization of taxation of trading of and
  investment in debt and equity securities and
  derivatives (neutral and symmetric capital income
  taxation).
• Standardization of repo transactions (e.g.,
  adoption of BMA-ISMA model of master agreement).
• Establishment of derivatives market to provide
  hedging instruments for dealers and investors.
• Legal and regulatory foundations and technical
  capability for CSD lending and borrowing (with
  STP-based mark-to-market valuation of
  collateral).
• Government debt management for government
  securities.
• Credit rating for sub-sovereign and corporate
  bonds including SOE bonds.
• Etc., etc..

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How should reform plans be prioritized?
Depending on each countrys circumstances -
size of its economy - Trading volume -
sophistication of its financial system - Number
of market participants - its investor
profile - etc.
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Comprehensive Approach

• Bond Market Committee
• to be led by MOF and Central Bank at high level.
• to be participated by
• securities regulator,
• bond market association of trading market
  operator
• settlement system operator,
• dealers,
• institutional investors and asset managers
• To manage this complex set of chicken-and-egg
  problems.
• Political commitment and high level leadership by
  MOF and Central Bank crucial.

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Task Forces

• Primary market issuance
• Secondary market trading mechanism and
  architecture
• Delivery versus payments (DVP) and settlement
  systems
• Tax, accounting and regulatory impediments
• Market information systems
• Standardization of trading practice and
  conventions including repo master agreement
  market
• Repo clearing and bond lending
• Dderivatives market and
• Treasury and debt management.

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Thank you !

• Noritaka Akamatsu