Legal and Regulatory Framework for Developing Domestic Debt Markets June 8-11 , 2004 Colombo, Sri Lanka Noritaka Akamatsu Financial Sector Operations and Policy Dept. The World Bank

Characteristics of Govt Debt Market Gov’t bonds are special securities. Largely a market for professional participants. Bonds are securities while being a close substitute to bank loans. Banks are active participants while institutional investors are an important source of demand; Who should regulate whom? Settlement risks are a major concern due to the volume and size of transactions. Only recently started being better organized with electronic trading and information platforms. Etc. Conventional securities regulation is inadequate. Development of bond market raises inter-industrial branch regulatory issues; banks, brokers and institutional investors. SRO may not work due to the poor organization of the market. Systemic risk is an extraordinary concern due to the volume and size of transactions.

Objectives of Securities Regulation - IOSCO - The protection of investors; Ensuring markets fair, efficient and transparent (efficient price discovery); The reduction of systemic risk (maintenance of confidence in the financial system); Q. Do these apply to govt bond market as well as to corporate securities market? Objectives of securities regulation by IOSCO

IOSCO Principles The Regulator Self-regulation Enforcement Regulatory Cooperation Issuers Collective Investment Schemes Intermediaries The Secondary Market

The Uniqueness of Govt Debt Market The special nature of government securities requires special regulations. The issuer is also the regulator – conflict of interest? MOF should retain certain rule making authority. MOF may delegate other regulatory activities. The securities are exempt from regular prospectus requirements. No disclosure?? The ultimate financial authority (including borrowing and taxing) resides with the parliament, the law maker. The will of the parliament cannot be subordinated to a regulatory body. The financial authority is delegated to the MOF by the will of the parliament. MOF has the right and obligation to ensure adequate regulation of the GS market.

Legal Authority & Accountability -- Who does what? MOF Public Finance Debt Management  Legislation Primary market and primary dealers Financial Market Regulator Central Bank Market intermediaries Collective investment Secondary market  Monetary Policy  Settlement systems?

Sources of Investor Rights Budget and public debt law Governmental audit law Securities law Central bank law Bankruptcy law Property ownership law Secured transactions (or collateral) law Contract law Tax law Capital repatriation law Appropriate accountability of the government must be secured.

Other important laws Banking law Insurance law Pension law Investment company law

Legal Components of Public Debt Management Clear borrowing authority to issue public debt; A description of the process by which the legislation enables the government to issue debt; A description of the internal management process and the delegation of legal authority; The legal status of the different types of government securities. The borrowing authority is the starting point. The clear and transparent process of debt issuance and the internal control procedures of the debt manager are a requirement for MOF to be accountable to the parliament which delegates the borrowing authority to it.

Regulatory Tools of Public Debt Management Borrowing Limits Gross or net? Net please ! Internal Management Transparency and Accountability (to the parliament) Disclosure “Access” is a tricky concept.

Tool 1 - Borrowing limits Legislations on a specific ceiling on total debt or net borrowing; Net please ! Requirement of specific approval for issuance by the legislature; Not transaction by transaction please ! limitations on government guarantees. How about implicit guarantees? Limits on gross borrowing create difficulties and inflexibilities for debt managers and not conductive to GS market development.

Tool 2 - Internal Management Defining debt management office’s role, function and organization. Front office, middle office and back office. Giving debt manager sufficient latitude, while ensuring accountability, to execute debt management efficiently. Delegation of the borrowing authority to line officers (particularly those of the front office).

Tool 3 - Transparency & Accountability Requirement of record-keeping and reporting; Issuance and management of debt subjected to audit and internal control procedures. Accountability ultimately to the parliament

Tool 4 - Disclosure Disclosure on government’s financial condition, its future borrowing plans, etc.; Special requirement on disclosure with respect to international issuance.

Tools for Debt Manager Terms of instruments Access to the market Rule making authority should resides with MOF/Minister. MOF should systematically consult with Central Bank and Financial/Securities Regulator before promulgation. Public notice and comment periods Public hearings Industry involvement >Transparency facilitates compliance.

Terms of the Instrument Government should have the authority to issue various bonds: Issued as registered or bearer bonds; But registered bonds … Represented in physical or book-entry form; But book-entry form Have short-, medium-,or long-term maturities; Coupon or discount or indexed. Some callable, “Registered” or bearer bonds.

Primary Market Access Fair, not necessarily equal, access Potentially justifiable cases of differentiated access and exclusivity: Institutions with ability to settle and distribute. Allocation to institutional investors Primary dealer system Consistent with public debt management objectives? “Equal” access can be tricky in terms of consistency with debt management objectives.

Primary Dealer System When is it useful? Typical privileges and obligations: Privileges: Exclusive participation Exclusive counterparties for Central Bank Obligations: Committed purchase Market making Obligations for PDs should be useful for MOF to meet debt management objectives while privileges should compensate the cost of meeting the obligations. When there is doubt about ability of small participants to consistently buy, to make competitive bids, manage liquidity and risks. When market making is considered necessary to generate liquidity; I.e., when open and equal participation is considered inadequate to generate liquidity. Access to the primary market has important implications on the access to the secondary market.

Legal and Regulatory Framework for the Secondary Bond Market

Effective regulation should include: The status of “exempt securities” should not jeopardize the integrity of the secondary market. Effective regulation should include: Regulation of market intermediaries Prudential requirements Regulation of the secondary market and self-regulation Market conduct and surveillance Transparency requirements Secured transactions

Secondary Market Structure and Regulation Over the Counter (OTC) Exchange Electronic Trading System IDB Require intermediaries of post-trade reporting, record keeping, and audit trail requirement Impose requirements for reporting, record-keeping, fair access and risk management

Regulation of Market Intermediaries Particularly when market is poorly organized Set minimum entry standards; Require to comply with standards for internal organization and control; Require initial and ongoing capital; Require proper management of risk; Require high standards of conducts; Provide procedures for dealing with the failure of an intermediary. Q.Need special regulation for inter-dealer broker (IDB)? Market intermediary regulation by IOSCO To be provided directly by the regulator when the market is poorly organized (e.g., telephone OTC market) Current issues: Focuses regulatory activities on risk-based measures and away from simple capital requirements makes external regulation insufficient and require sound internal control. reliance on compliance operations requires transparency

Three-Tier Regulatory Approach Regulatory Authority oversees broker/dealers and SROs to ensure compliance with regulations and directly regulates where necessary. SRO regulates members and, where capable, enforces compliance with regulations and its rules, subject to regulation and supervision by the regulator. Broker/Dealer has regulatory obligation to supervise employees and enforce compliance with regulations, SRO rules and its house rules. Enforcement by SRO is a tricky business

Pros and Cons of SRO compared to government regulator Pros of SRO: possess better expertise and more market information; respond market changes more quickly; are more familiar with the problems and more able to find solutions; have more incentive to promote information sharing among members. Key word is “among members”, I.e., those which are not members are excluded from the benefits as well as the obligations.

Cons of SRO An SRO might transform into a cartel and jeopardize competition, Unable to enforce its rules and impose sanctions for non-compliance due to conflict of interest, Scarcity of institutional and human resources may constrain the quality of oversight; With limited competition in securities markets, SROs not enough to ensure safe and efficient markets.

Oversight on SRO Ensure that SRO rules are fair and based on stability and efficiency principles. Assess SRO entry and sanctioning criteria, and ban discriminatory and unfair practices Ensure SRO information, monitoring and sanctioning systems are compatible with fair competition Ensure that SRO rules and operations are not detrimental to small participants and consumers Membership and Governance structure matters. In case of an exchange, Access matters. Commercial viability matters. Existence of competition matters.

Q. Is SRO Viable in Bond Market? The extent to which the market is organized matters OTC vs Exchange ATS, ECN or electronic trading platforms Inter-dealer broker Extent to which competition exists among organizers of the market matters. SRO vs. Trade Association ISMA vs. BMA Designation by the regulatory authority

Legal and Regulatory Framework for Settlement Legal framework should support: the enforceability of trade contract, the protection of customer assets (against insolvency of custodians and intermediaries), dematerialization of securities and the transfer of securities by book entry, netting arrangements and securities lending, arrangement for achieving DVP, rules addressing the consequences of a participant’s default DVP is a critical precondition for organizing the trading market.

Legal and Regulatory Framework for Settlement - 2 Regulation and oversight Central bank and financial regulator should cooperate with each other and with other relevant authorities. The objectives and responsibilities of the regulators with respect to C&S system should be clearly defined and publicly disclosed. The regulators should gather information on C&S system and assess the operation and design of the system. First dot is important while the second and the third are commonsense. Central Bank is often exposed to credit risk in settlement vis-à-vis market participants participating in the Central Bank payments system, thus has a right to be concerned about the soundness of the settlement system.

Sequencing of the Regulations on Government Securities Market Be cautious of over-regulation Professional investors – what if individuals participate? Clarify regulators and their responsibilities Who regulates/supervise what? --Regulatory gaps or overlaps. Develop a framework to match the different stages of development of the government securities market. As components of the market are built.

Conclusions Key elements of a legal framework are: Clear borrowing authority and its clear delegation Rules for the issuance of government securities Clearing and settlement system rules Rules governing the organization and functioning of the primary and secondary markets Rules setting out the legal status of government securities

Thank You! Noritka Akamatsu