The role of debt policy in the development of a derivatives market Fifth annual OECD-World Bank Bond Market Forum June 2-3, 2003 Thomas Olofsson, Head of Funding, Swedish National Debt Office

Goals for debt policy Minimize costs under due consideration of risks Policy implications: Liquidity, predictability, openness and transparancy Liquidity and attractivness of a market is enhanced by a well-functioning derivatives market

Why derivatives? Derivatives part of a complete market Enables achievement of desired portfolio and risks Step to efficient capital market Gains for both investors and Debt Offices External effects for the whole economy

Management of exposure Debt Office could use derivatives to separate borrowing from exposure Investors could hedge investments in bonds Market makers could use derivatives to manage risks Foreign investors could invest without taking exchange rate risks

Pre-requisites Underlying instruments needed Deep and liquid market with transparent and well functioning price mechanism Usually the Government supply debt instrument providing a reference curve (benchmark) Repo market important

Organization Market could be set up by private player or group of e.g. banks or an existing Exchange Whole transaction chain (pluming) important Clearing and settlement function Central Clearing Counterpart (CCP) Credit and other risks ISDA/CSA agreements

Swedish experiences 1980’s two players in options (OM and SOFE) Market killed by transaction tax OM merged with Stockholm Stock Exchange OM set up an interest rate ’futures’ market with settlement, but trading OTC with banks as market makers Swaps (and some options) provided OTC by foreign and domestic banks Currency derivatives traded by foreign and domestic banks

Swedish experiences Attempt to set up a proper futures exchange with OM as market provider failed Idea was to create a very liquid market for interest rate risks, giving great opportunities to manage risks and price discovery 2 and 10 years were traded aiming to create benchmark pricing Not only Primary dealers could participate, electronic trading, real real time price discovery Investors appreciated the price discovery, but to few actively traded As turnover was to small it was abandoned

Swedish experiences Today we are back to OTC-traded ’futures’ cleared by OM Stock exchange Useful as a complement to spot market Turnover small compared to spot market Many investors use the Bund market for risk management and short-term positions as the bond yield a spread fairly stable short-term Derivatievs in term of swaps is deep and used by e.g. Debt Office for duration adjustment and managing foreign currency exposure A smaller option OTC market also exists

Role of Debt Office Debt Office/Central bank/MoF As a large player it is possible to influence market participants and market development Different alternatives possible: As owner or partner in setting up institutions As speaking partner, mediator or example PD-agreements and fees could be used demanding certain behavior Selection of counter-parties is another opportunity Relying on spontaneous market development could be futile Larger banks often ends up in grid-look and make improvement difficult

Role of Debt Office Debt Office own participation could affect market development As a market participant you contribute to the liquidity and development However, avoid to be too dominant Swedish Debt Office use of CSA-agreements has facilitated the use such agreements – development of market practice

Comments Derivatives contribute to liquidity and attractiveness of the fixed income market An exchange traded future market requires strong turnover, liquidity and participation to be benchmark for risk management and pricing Debt Offices/CB/MoF can contribute to market development of market structures as an important costumer, issuer of benchmark bonds, state representative, partner or mediator Derivatives are important in debt management A very successful derivative market not decisive for the bond market