Government Bond Market Development – Managing Interdependencies – June 17, 2003 Johannesburg, South Africa Noritaka Akamatsu Financial Sector Operations & Policy Dept. The World Bank

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.

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).

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

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.

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?

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

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.

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 gov’t 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 gov’t bonds. Govt bond market development should be the third objective. Standardize instruments, regularize and announce issuance calendar, and create benchmarks.

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.

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).

Investors and Intermediaries

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).

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

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.

Institutional Investors and Trading Market If there are developed institutional investors, trading market architecture would need to accommodate their business needs. If there aren ’ t, 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.

Trading and Market Transparency

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?

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?

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???

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?

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

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?

Trading Market and Institutional Investors II ’ s may wish to access the trading platform directly so that they can avoid intermediation cost. If II ’ s trade directly among them, dealers (e.g., banks) may lose significant business. It may be good for the II ’ s. 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.

Settlement Systems

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.

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 gov’t 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

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

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

Money Settlement RTGS 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 T+1 Real time DVP for government securities?

Law, Regulation and Self- Regulation

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

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. => 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?

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..

How should reform plans be prioritized? Depending on each country’s circumstances - size of its economy- Trading volume - sophistication of its financial system- Number of market participants - its investor profile- etc. Depending on each country’s circumstances - size of its economy- Trading volume - sophistication of its financial system- Number of market participants - its investor profile- etc. Short-term measures Medium-term measures DEVELOPED MARKET Credibility Lowering of risks and costs Security Liquidity

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.

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.

Thank you ! Noritaka Akamatsu