DRAFT: June 8, 2003
Developing Efficient Market Infrastructure
and Secondary Market of Government Bonds
in Developing Countries
5th REGIONAL WORKSHOP
on Developing Government Bond Markets
in Sub-Saharan Africa
June 17-19, 2003
Johannesburg, South Africa
Tadashi Endo
tendo@worldbank.org
The World Bank
Abstract
To keep investors’ trading costs enough to maintain an active secondary market of
government bonds, financial support to the market infrastructure should be more
broadly-based across the economy. Public awareness/consensus about the roles of a
government bond market is needed for this policy. An expected repo market performs
economically useful functions in a developing economy, and is significantly effective in
generating the liquidity in the market. Human intermediation by salespeople equipped with
some electronic devises is expected to remain effective in creating and maintaining liquidity
in the secondary markets of government bonds under most emerging market environments.
2
Table of Contents
1
Introduction ................................................................................................................................ 5
2
Capital Market Profile peculiar to Developing Economy .......................................................... 5
3
Demand- & Supply-side Principles for Market Liquidity .......................................................... 6
4
Why Does Efficiency Matter? .................................................................................................... 7
4.1
Impact of trading on an investor’s return........................................................................... 7
4.2
The investor’s trading needs .............................................................................................. 9
4.3
Macroeconomic functions.................................................................................................. 9
4.4
A quantitative example of public benefit ......................................................................... 11
4.5
The basis for efficient primary markets ........................................................................... 11
4.6
An anatomy of trading costs ............................................................................................ 13
4.6.1
Components of trading costs ................................................................................... 13
4.6.2
Positive externalities of securities trading............................................................... 13
4.6.3
“Market failure” in developing country circumstances ........................................... 15
5
Market Infrastructure for Efficiency......................................................................................... 17
5.1
Dealers’ market (OTC) .................................................................................................... 17
5.1.1
Rationales for quote-driven auction ........................................................................ 17
5.1.2
Market making obligations ..................................................................................... 18
5.1.3
Real-time online trading facilities ........................................................................... 18
5.1.4
Post-trade reporting ................................................................................................. 19
5.2
Expanded repo market ..................................................................................................... 19
5.2.1
A prerequisite for market making ........................................................................... 19
5.2.2
A jump-up of trading volume .................................................................................. 20
5.2.3
Limited participation ............................................................................................... 21
5.2.4
Regulation and supervision ..................................................................................... 22
5.2.5
Legal, tax and other issues ...................................................................................... 22
5.3
Electronic trading systems (ETSs) ................................................................................... 23
5.3.1
Limited roles of an ETS in trading .......................................................................... 23
5.3.2
Five major types of ETSs ........................................................................................ 24
5.3.3
Market and product suitability to an ETS ............................................................... 25
5.4
Clearing, settlement & depository ................................................................................... 26
5.5
Trading-neutral Accounting & Taxation ......................................................................... 26
5.5.1
Trading-neutral accounting ..................................................................................... 26
5.5.2
Trading-neutral taxation .......................................................................................... 27
5.5.3
Other preferential treatments................................................................................... 27
5.6
Advanced risk management & arbitrage facilities ........................................................... 27
5.6.1
Symmetric functionalities ....................................................................................... 27
5.6.2
Efficiency and systemic risks .................................................................................. 28
6
Salespeople and Brokers for Liquidity ..................................................................................... 29
6.1
Liquidity vs efficiency ..................................................................................................... 29
6.2
Mediocre players.............................................................................................................. 30
6.3
Network effects ................................................................................................................ 31
7
Conclusion ................................................................................................................................ 32
3
List of Tables
Table 1: Reinvestment of Current Coupon Bonds .............................................................................. 9
Table 2: 3- to 5-year Government Bond Spreads in Selected Developing Countries ....................... 11
Table 3: Externalities of Trading Costs............................................................................................. 14
List of Figures
Figure 1: Capital market in a developing economy ............................................................................ 6
Figure 2: Liquid Secondary Market of Government Bonds & Efficient Primary Markets of
Government and Corporate Bonds ........................................................................................... 12
Figure 3: Costs per Time Unit of Market Development ................................................................... 16
Figure 4: Singapore Government Securities Turnover (Outright & Repo) ....................................... 21
Figure 5: Trading Action Circle ........................................................................................................ 24
Figure 6: Components of Broking ..................................................................................................... 24
Figure 7: “Symmetric Functionalities” of cash and futures markets ................................................. 28
Figure 8: Market Efficiency and Systemic Risk ............................................................................... 29
Figure 9: Mediocre and Visionary Players ........................................................................................ 31
Appendix
Appendix 1 ........................................................................................................................................ 33
4
1
Introduction1
New technologies have been allowing developing countries to leapfrog some hard problems
that are time-consuming to resolve or hopelessly entangled with other parts of the society and
get to an advanced stage of capital markets. This is typified by the electronic trading system,
and the electronic clearing, settlement and depository system. In fact, the introduction of the
both systems has drastically rationalized some key elements of the capital market working in
favor of developing countries.
However, capital markets in many developing countries remain illiquid primarily due to
problems on the supply- and demand-sides of the markets.
Besides the supply- and demand-sides of the market, there are some market infrastructure
elements of government bonds that will significantly contribute to market efficiency or
liquidity if they are designed and/or structured sensitively enough to development country
realities. The failure in addressing such market infrastructure elements often results in the
misallocation of capital market development costs, a repo marker unworkable to facilitate
market making obligations, and the underutilization of human intermediation.
This note will analyze these elements and provide policymakers in developing countries with
guidance on policy actions for making their government bond market more efficient and/or
liquid. Sections 2 and 3 will first outline a capital market profile peculiar to developing
economies, and demand- and supply-side issues of their capital markets. Section 4 will show
how critical low trading costs are for market efficiency by demonstrating that trading per se
is neutral to total returns, and will address externality issues of trading costs. Then, Section 5
will elaborate the benefits of market making obligations in a dealers’ market and an
expanded repo market for market liquidity, followed by brief reviews of electronic trading
systems, clearing, settlement and depository, accounting, taxation, risk management and
arbitrage facilities in light of emerging market environments. Finally, the effectiveness of
human intermediation in the creation of liquidity in the government bond market will be
analyzed.
2
Capital Market Profile peculiar to Developing Economy
Some socio-economic conditions that are typically observed in a developing economy are
different in many aspects from basic prerequisites for capital market development in a
developed economy. The diagram in Figure 1 below schematically depicts a capital market
profile generally peculiar to development economy.
1
This note was originally presented to the Third Regional Workshop on Development of Government Bond
Market in t Middle East & North Africa that was held in Tunis, Tunisia on June 17-18, 2002, and the Fourth
Regional Workshop on Development of Government Bond Market in Sub-Saharan Africa that was held in
Johannesburg, South Africa on November 10-12, 2003, and subsequently revised. The views here are those of
the author and do not necessarily reflect the views of the World Bank.
5
The demand side of securities is where and how funds are accumulated in an economy. The
demand side rectangular in the diagram below symbolically illustrates a distribution pattern
of funds unique to a developing economy. Namely, the per capita income level is low and
households are predominantly dependent on bank deposits for their savings. The aggregate
size of a country’s economy is small. Among various kinds of contractual savings, pension
funds are weak and often captive to government deficit financing. The insurance sector
develops ahead of pension funds. In addition, the non-life insurance industry often
overweighs the life insurance industry in the asset size. The informal economy is quite
sizable.
The supply side of securities is where and how financing is needed for investments in an
economy. The supply side rectangular in the diagram below schematically illustrates a
distribution pattern of financing needs unique to a developing economy. As far as the supply
side of securities in a developing economy is concerned, the government’s policy initiatives
are central to the country’s capital market development through steady implementation of its
privatization programs, and disciplined issuance of government bonds2.
Figure 1: Capital market in a developing economy
Demand
 Non-life
overweighs life.
 Pension funds
are small.
 Informal
economy is
sizable.
Market
Infrastructure
Non-life
insurance
Supply
Local companies
 Economy is
small.
Individuals
Life
insurance
 Income level is
low, and
households are
predominantly
dependent on
bank deposits.
Foreignowned
companies
Pension funds
State-owned
enterprises
 Local cos are
predominantly
dependent on
bank loans.
 Foreign-owned
companies are
dominant, and
rely less on
local financing.
 SOEs remain
substantial.
Informal
economy
 Inefficient market
Government
 Long-established central bank
vs new-born cap. market
regulator
 Govt crowds
out the private
sector.
 Capital-rich banks vs poorlycapitalized broker/dealers
3
Demand- & Supply-side Principles for Market Liquidity
Regardless of a developed or developing economy, certain conditions of the demand and
supply sides of a bond market substantially determine a possible liquidity level of the market.
2
For more detailed analyses and discussion on the peculiarities of emerging markets, please refer to my note
“Capital Market Profile peculiar to Developing Economy”.
6
They are prerequisites for bond market liquidity. A well-organized market infrastructure is
often secondary to them.
The government, as the sole supplier of government bonds, needs to provide investors with a
sizable, regular, and stable (predictable), transparent, and market-based supply of high
quality and uniform bonds through public offerings. Generally, government bonds are
regarded as being of the highest quality in the domestic market. On the demand side,
investors should be many in number, incessant in trading needs, competitive in investment
performance, and diverse in demand patters for the bonds.
It is outside the scope of this note to discuss implications of these demand- and supply-side
characteristics and policy measures to create, reinforce, supplement or enhance each of them.
Assuming that everything necessary on the supply- and demand-sides is reasonably in place,
discussions in this note will focus on how to develop an efficient market infrastructure for
secondary market trading of government bonds in developing countries.
4
Why Does Efficiency Matter?
Trading per se is neutral to total returns, and never pays for trading costs without additional
risk. Therefore, it is critical to keep trading costs low for market liquidity. Due to a public
goods nature of capital markets, a public support is essential to bring down the direct costs of
trading.
4.1
Impact of trading on an investor’s return
Why does the market efficiency matter? “A market has to be efficient” appears a truism.
Nonetheless, it is useful for market designing to know how efficient the market has to be. To
answer these questions, the effect of trading on an investor’s return on bond investment will
be examined.
What if an investor holding a 10-year zero coupon bond sells the bond at a market price in
response to an interest rate decline halfway through the maturity, and immediately reinvests
all proceeds in another identical bond? The proceeds consist of two kinds of capital gains: (i)
accrued interests and (ii) a bond value appreciation due to the interest rate decline. Is the
investor better off as a result of the bond price appreciation caused by the interest rate
decline? In theory, the investor is required to reinvest all the proceeds from the sale of the
original bond just to obtain the full principal amount of the substitute bond even in costless
environments. The selling price of the original bond at a lower interest rate is the same as the
buying price of the substitute bond. Therefore, the investor gains nothing from the trading in
terms of total returns over the original investment horizon, despite of a temporarily realized
capital gain thanks to an interest rate decline (see Figure 2). Most people can understand this
fact intuitively without calculation.
7
Figure 2: Reinvestment of Zero-coupon Bond
100%
Value
5%
98%
Value
appreciation Capital
Gain
Accrued
interest
96%
94%
10%
92%
90%
88%
1.
00
0.
90
0.
80
0.
70
0.
60
0.
50
0.
40
0.
30
0.
20
0.
10
0.
00
86%
Maturity
What if we replace zero coupon bonds with current coupon bonds in the above case? An
investor holding 10-year current coupon bonds sells the bonds at a market price in response
to an interest rate decline halfway through the maturity, and immediately reinvests all
proceeds in other current coupon bonds of the same quality and with the same maturity date
at par. Since a coupon bond is theoretically decomposable into discount cash flows, the
investor gains supposedly nothing from the trading in response to a seemingly favorable
interest rate change in terms of total returns over the original investment horizon.
Impacts of trading were calculated on total returns of a 10-year 8%coupon bond in simple
cases. The bond was assumed to be initially purchased at par under a coupon bond yield
curve ranging from 3% for 1 year to 8% for 10 years, and sold at the end of 4th, 5th or 6th year
as the yield curve made a parallel shift ranging from –1.5% to +1.5% with an increment of
0.5%, and all its proceeds was assumed to be reinvested in a new coupon bond with a
maturity of 6, 5 and 4 years (the total investment time horizon remained unchanged at 10
years). It was further assumed that all coupon payments were reinvested in zero-coupon
bonds maturing concurrently at the end of the 10th year, and that there were no trading costs.
Under these assumptions, the future value of the bond investment at the end of the 10th year
was calculated for each combination of a year of reinvestment and an interest rate change.
Table 1 shows percentage gains or losses of the reinvestment at the future value under 21 (3 x
7) scenarios.
No significant impact was observed in the calculation. In fact, the calculated gains and losses
came merely from a switch of the methodological assumptions for a yield calculation from a
current coupon bond to a zero coupon bond in respect of the coupons.
From the above exercise, it is clear that trading of a bond in response to an interest rate
change is basically neutral to the bond’s total returns over a given investment time horizon in
no-trading costs environments unless the investor takes market risks. Even a capital gain
8
brings about nothing over the life of an initially invested bond. To make matters worse, in the
real world where trading always incurs costs, trading inevitably eats up some yield.
Table 1: Reinvestment of Current Coupon Bonds
Little impact on total returns of 10-yer bond
Yeas to Maturity
4
5
6
-0.03%
-0.06%
-0.13%
-0.02%
-0.04%
-0.10%
-0.01%
-0.02%
-0.07%
0.00%
0.00%
-0.04%
0.02%
0.03%
0.00%
0.03%
0.05%
0.03%
Interest
Rate Change
-1.50%
-1.00%
-0.50%
0.00%
0.50%
1.00%
1.50%
4.2
0.04%
0.08%
0.07%
The investor’s trading needs
Nonetheless, the investor trades for its self-interests. With some yield sacrificed, what needs
is the investor trying to fulfill by trading government bonds? The investor usually trade
government bonds for earning of interest income, hedging of its position, rebalancing of its
investment portfolio, speculation on the direction of an interest rate movement, arbitrage in
unequilibrium market positions. Longer-term bonds are largely preferred for speculative
trading, because they have a larger degree of price volatility and provide more trading
opportunities over their life. All trading costs have to be low enough to easily allow the
investor to serve these operational purposes.
The investor’s trading purposes are not static. As the trading purposes described above, the
investor who heavily trades government bonds is almost always an institutional investor.
Which purposes the investor actually pursues or how much a particular purpose the investor
pursues varies, depending on the investor’s capacity, objectives, investment time horizon,
risk tolerance, strategies, policies, market outlook, available instruments, and other factors.
Furthermore, the boundaries of hedging, rebalancing, speculation and arbitrage are not
necessarily distinct. An individual trading is a mixture of these purposes to varying degrees.
Sometimes, a defined purpose of investment in a certain set of circumstances and
assumptions turns out to be a different one as the circumstances changes. For example, a
hedged fund may inadvertently become a speculative one as the Long Term Capital
Management did.
4.3
Macroeconomic functions
While the pursuit of private interests drives investors to trade government securities, the
public, those who trade and those who do not trade alike, also benefits from active trading of
government bonds thanks to the macroeconomic functions of a government bond market.
9
These macroeconomic functions and their benefits cause the World Bank and IMF to
recommend many developing countries to develop a government bond market as a basis for
efficient and sustainable economic development.
A liquid secondary market of government bonds is expected to perform the following
functions for public interests:

Lowering of financing costs of budget deficits in the medium- and long-term;

Signaling of the conditions of an economy;

Execution of monetary policies; and

Facilitation of market risk management, and diffusion of a concentrated risk;

Rational valuation of financial assets in an economy;

Facilitation of the development of a corporate bond market.
A liquid secondary market of government bonds helps the government lower financing costs
of budget deficits in the medium- and long-term in case the government constantly has a
sustainable level of budget deficit. A narrower bid/ask spread and a reduced liquidity
premium allow new issues of government bonds to carry lower coupons on the average than
the issues would otherwise carry.
A liquid secondary market of government bonds signals the current and prospective
conditions of an economy. The yield of bonds traded in a liquid secondary market reflects the
aggregate demand and supply relationship of the “risk-free” financial assets in the economy,
and serves as the most important indicator for the macroeconomic management of a national
economy.
A liquid secondary market of government bonds facilitates the execution of monetary
policies. The more liquid the government bond market is, the more sensitive the market is to
the monetary authority’s intervention in short-term financial markets, and thus the more
efficiently a monetary policy is transmitted into the economy.
A liquid secondary market of government bonds possibly derives risk hedging transaction
techniques or instruments such as short selling, futures, options or swap transactions. These
techniques or instruments allow a market participant to transfer his/her risk to a more
affordable party in the economy. Hedging will not be effective unless the market is liquid
enough.
A liquid secondary market of government bonds provides the economy with a benchmark
yield or yields of “risk-free” obligations against which assets of various classes are valued.
This enables rational exchanges of different asset classes. The more heavily the bonds are
traded, the more reliable the benchmark yield is.
Corporate bonds are a group of financial asset classes. The liquidity of corporate bonds is
considerably limited, if not nil. The constant availability of a reliable benchmark yield helps
price corporate bonds rationally at any time, facilitating the efficient reallocation of capital to
productive economic activities.
10
Thus, the active trading of government bonds is intended to benefit the whole economy
instead of only investors and the issuer or the government. Not only a government bond
market but also other capital market are more or less the same in the sense that they are meant
to serve public interests as well as private ones.
4.4
A quantitative example of public benefit
Table 2 exhibits a list of selected government bond markets in developing countries whose
secondary market activities the International Finance Corporation (IFC) closely monitored
mainly from 1998 to 2001, and the bid/ask spreads of their 3- to 5-year government bonds on
April 30, 2001. They are ones whose market data were considered as relatively consistent
and reliable among those markets that IFC monitored closely during the same period.
Savings from a liquid government bond market will be significant. The column of the table
shows how much they could have saved interest payments on their outstanding government
bonds if they had made their markets more liquid and cut half the prevailing spreads 3. The
total saving would have been larger than calculated, because these calculations ignored
possible reductions in market impacts and liquidity premiums due to more liquid markets. A
market impact will be much less in a more liquid market. Investors will demand less for a
liquidity premium.
Table 2: 3- to 5-year Government Bond Spreads in Selected Developing Countries
Czech
Hungary
Malaysia*
Poland*
Slovakia
Thailand*
Govt Bond
Outstanding
US$ mil
4,200
10,300
25,900
10,000
4,700
5,900
Bid/Ask Spreads
Tightest
0.03%
0.35%
0.01%
0.04%
0.10%
0.04%
Median
0.09%
0.40%
0.30%
0.30%
0.20%
0.06%
Market
Impact
?%
?%
?%
?%
?%
?%
Liquidity
premium
?%
?%
?%
?%
?%
?%
Assumed
cut
0.05%
0.20%
0.15%
0.15%
0.10%
0.03%
Calculated
savings
US$ mil
1.89 +
20.60 +
38.85 +
15.00 +
4.70 +
1.77 +
Source: IFC Bond database: April 30, 2001
* Indicative quotes. Actual spreads on a firm basis are considered to have been wider.
4.5
The basis for efficient primary markets
A liquid secondary market of government bonds is the basis for the efficient primary markets
of both government and corporate bonds (see Figure 2).
The pricing of a new issue of government bonds in the primary market is based substantially
on the conditions of their secondary market. The more certain the price discovery in the
secondary market, the more precise the pricing can be. A material saving in issuing costs may
be achieved by a combination of a narrower bid/ask spread, a smaller market impact and a
3
If the issuers (the governments) and the investors shared the savings equally, the calculated savings will be a
half of those in the table, which are 25% of the prevailing spreads.
11
less liquidity premium as illustrated in Section 4.4. Hedging instruments derived from the
liquid secondary market will make the primary market further efficient.
Reliable government bond yields benchmark the pricing of new issues of corporate bonds,
which is further adjusted for credit risk, liquidity risk, scarcity value4, and other factors5
unique to an issue. In addition, a liquid government bond market lays a ground for hedging
instruments that issuers, intermediaries and large investors at the time of offering. Otherwise,
the pricing of corporate bond issues would be erratic and uncertain; and, consequently,
engagements in new issues of corporate bonds would involve a fair amount of risk to issuers,
intermediaries and large investors. This uncertainty would leave corporate bond issuance
expensive and may decisively impede the development of a corporate bond market.
When policy measure are taken to enhance market efficiency, the policy weights of the
primary and secondary markets for efficiency are largely equal in a government bond market,
while the policy weight of the primary market is overwhelming in a corporate bond (see
Figure 2). The efficiency of the primary market is critical for the overall efficiency of a
corporate bond market, because the trading of corporate bonds is characteristically limited.
Figure 2: Liquid Secondary Market of Government Bonds &
Efficient Primary Markets of Government and Corporate Bonds
Government Bonds
Corporate Bonds
Liquid
Secondary Market
Secondary
Market
Efficient
Primary
Market
Efficient
Primary
Market
A liquid secondary market of government bonds is the basis for the efficient
primary markets of both government and corporate bonds. The policy
weights of the primary and secondary markets for efficiency are largely
equal in a government bond market, while the policy weight of the primary
market is overwhelming in a corporate bond
Institutional investors often pay a premium for bonds of particular issuers (“names” in the market jargon) that
are scarcely available in the market if other elements of a bond are equal for the purpose of investment portfolio
diversification.
5
The structure of a bond may have specific tax, accounting and/or regulatory implications to the issuer and/or
investors.
4
12
4.6
An anatomy of trading costs
Even though trading costs have to be low enough, many developing countries fail in doing so.
Such a failure is quite attributable to some common causes of a “market failure”, including
market power, externalities, and adverse selection. This view leads to a policy supporting
market infrastructures by the government budget and/or socially more broadly-based
resources than just market players. To this end, public awareness of common interests in the
government bond market should be promoted, and public consensus on a more aggressive
budgetary support should be formed.
4.6.1 Components of trading costs
Trading costs have to be low enough in order to constantly meet the investor’s trading needs
as well as deliver the macroeconomic benefits.
Trading costs consist of (i) brokerage commissions or bead/ask spreads, (ii) market impact6,
(iii) fees payable to the regulator, the clearing house, the depository, etc., (iii) transaction
taxes, and (iv) opportunity costs. Brokerage commissions or bead/ask spreads are the most
visible trading costs. Market impact is often the largest component of trading cost for a large
transaction and for a large investor.
Opportunity costs are usually not included in trading costs. However, opportunity losses
arise from not being able to trade immediately whenever the investor or trader wants to. They
are apparently costs that need to be reduced to make the market more liquid. In fact, most
subjects that are commonly discussed for the enhancement of market efficiency fall into this
category. They are more incurred if the market lacks or is imperfect in (a) a quote-driven
trading mechanism (dealers’ market), (b) a repo market, (c) an electronic trading system, (d)
an electronic clearing, settlement, and depository including a book-entry system, and (e)
position-neutral accounting and taxation (see Section 5).
4.6.2 Positive externalities of securities trading
A failure in making the market efficient is interestingly similar to a “market failure”. It is
quite attributable to some common causes of a market failure, including market power,
externalities, and adverse selection. We can typically see positive externalities in securities
trading and market failures in bearing trading costs. A self-interest seeking behavior of a
market player significantly affects the efficiency of the whole market, going beyond its own
interest. Even within the government, different branches such as the debt management office,
the monetary policy administrator (the central bank), the fiscal authorities (the ministry of
finance), the prudential supervisor, and the market regulator, have different self-interests in
the government bond market, and their interests often conflict each other.
6
Market impact is the effect of the positions bought or sold on the price paid or received for a security. If an
order lot is large relative to the actual liquidity, the order will be executed only at a price low or high enough to
meet the required volume of demand for or supply of the security. The difference between the executed and
initially quoted prices is called the market impact or price impact.
13
Table 3 summarizes conceivable causes and possible remedies of the failure for each of the
five trading cost elements. The possible remedies will be combinations of the mandated
behavior approach and the incentive approach.
Table 3: Externalities of Trading Costs
Trading Cost Elements
Causes of Failure
Brokerage commission Market power
or bid/ask spread
Externalities
Market impact
Adverse selection (trade only
when a market risk is small)
Fees
Externalities
Market power
Externalities (within the Govt)
Imperfect flow of information
Externalities
Taxes
Opportunity costs
Remedies
Primary dealership
Competition
Monitoring & supervision
Primary dealership
Preferential funding
Central bank liquidity
Public goods
Operational transparency
No transaction & w/h taxes
Private sector mechanism with
governmental cooperation or
coordination
Market intermediaries think twice before taking an initiative for making the market efficient
by cutting back on their own brokerage commissions or bead/ask spreads. This is because an
elasticity of a commission or spread cut to a trading volume is uncertain, and because there
will be a time lag between a commission or spread cut and a trading volume pickup, if any.
Primary dealership generally helps cope with this chicken-and-egg situation (see Section
5.1.2). In competitive environments where intermediaries are sensitive to their own
reputation in the marketplace, even post-trade dissemination of trade data such as prices and
volumes at or after the close of the market gives market intermediaries a commercial
incentive to narrow the spreads under competitive environments (see Section 5.1.4).
The market maker’s adverse selection impairs the market’s ability to dissipate market impact.
The market maker may well minimize its market risk exposure by selecting smaller orders to
execute. For the same reason, it may be less willing to trade with the investor when the
market is volatile. Primary dealership with market making obligations is effective in
alleviating this problem.
Market makers are usually granted access to competitive funding enabling them to support
their inventories of marketable bonds in a commercially viable manner. An expanded repo
market serves such a purpose well (see Section 5.2). In some countries, the central bank
provides market-making support through a “secondary market window”. It engages in
trading of government bonds with private sector dealers to induce the liquidity into the
market, hence accommodating the market maker’s position taking.
Fees payable to the regulator, the clearinghouse, the depository, etc. may be so expensive due
to limited economies of scale that investors may be discouraged from trading actively. It is
14
not an uncommon practice in emerging markets to charge the fees to the investor every time
it trades to financially support the market infrastructure. This is probably because most
governments developing a brand-new market infrastructure in their economy are fiscally
constrained, and they are influenced by the trend in developed markets of converting the
market infrastructure into for-profit organizations. The government or its fiscally
independent agencies charge fees to individual trades in a relatively small and low-volume
market to build up and support the market infrastructure.
Since a liquid secondary market of government bonds is intended to serve a country’s public
interests (see Section 4.3), fees charged for trades apparently have externalities. It is more
appropriate to finance the market infrastructure substantially by the government budget
and/or more socially broad-based resources than just market players. The costs are meant to
be spread out across all segments of the economy that benefit directly or indirectly from well
functioning capital markets including government bond market at least until the market has
reached a full-fledged stage. To counter-balance an uncompetitive nature of market
institutions, it is also imperative to require the operators of the market infrastructures to keep
their operations transparent in accordance with stated disclosure rules.
Securities transaction taxes, like other types of trading costs, can obstruct price discovery and
price stabilization, increase volatility, reduce market liquidity, and inhibit the informational
efficiency of financial markets. This is because returns on short-term instruments and
short-term transactions of long-term bonds are highly and negatively sensitive to securities
transaction taxes.
Opportunity costs of trading also arise from imperfect flow of information. Market
information generates trading, and then trading generates a new piece of market and trade
information. Traditionally, private sector institutions are operationally more effective in this
area. Therefore, this task may be outsourced to the private sector under governmental
supervision.
4.6.3 “Market failure” in developing country circumstances
There is a market failure in developing and maintaining a capital market in developing
countries. Today, it is widely recognized that the capital market serves public interests as
much as it does private-interests. Particularly, that is the case with the government bond
market. Capital markets in developing countries have been hastily established for public
interests. The public outside the marketplace also benefits in many ways from information
flows that the market constantly generates. However, the market players can hardly charge
the public outside the market for most of the benefits. The public is not ready to pay the “true
price”. This is a market failure. The market failure of capital market services unavoidably
imposes unproportionately heavy economic burdens on the marketplace. The burdens take
form of high trading costs. The government bond market is far more sensitive to transaction
costs.
The market failure is more serious in developing countries. It is not necessarily unique to
emerging markets. Nonetheless, we do not see the problem in most developed countries. The
15
reason for the market failure in developing countries is presumably that developing countries
are engaged in building up the capital market in a much smaller economy in a much shorter
period under much higher and tighter specifications than many developed countries did in the
past. In addition, the capital market is much more expected to serve public interests than
before. The costs of capital market development per time unit (e.g. a year) in developing
countries today must be higher than that in developed countries yesterday (Figure 3),
resulting in a higher cost of capital market development per trade.
This is a highly possible mechanism other than supply- and demand-side problems, through
which capital markets in many developing countries have been stuck in illiquidity. A
suggested remedy is that market infrastructures in developing markets should be more
financed by the government budget and/or socially broader-based resources than just market
players. For this, public awareness of common interests in the government bond market
(more generally the capital market) should be promoted, and public consensus on a more
aggressive budgetary support to the market infrastructure should be formed.
Figure 3: Costs per Time Unit of Market Development
Who has financed reaching these points?
Market serving
public & private
interests
Discovery of public interests
in capital markets
Market serving
private interests only
Capital markets in
developed countries
Capital markets in
developing countries
Short period (10-20 yrs)
Long period (100-200 yrs)
The slopes of the two triangles diagrammatically represent the costs of market
development per time unit (e.g. a year) in developed and developing countries.
They can be translated in per trade cost of capital market development. The per
unit costs must be higher in a developing country today than in a developed
country yesterday.
16
5
Market Infrastructure for Efficiency
The inefficiency latent in an existing market infrastructure incurs investors and traders
opportunity costs as well as direct costs. The basic ways to reduce these costs are generally
found in (a) market making obligations in a dealers’ market (a quote-driven trading
mechanism), (b) an expanded repo market, (c) an electronic trading system, (d) an electronic
clearing, settlement, and depository including a book-entry system, and (e) position-neutral
accounting and taxation. As the market develops, the policymaker needs to introduce
advanced risk management and arbitrage facilities into its government bond market, while
balancing between market efficiency and increasing systemic risks.
5.1
Dealers’ market (OTC)
Bonds can be more efficient in a quote-driven dealers’ market than on an order-driven
exchange. Nevertheless, bond dealers need to be obligated to make a market in exchange for
a primary dealer privilege to achieve a higher level of market liquidity. The benefits of
real-time online trading facilities should be carefully weighed against costs in developing
country environments. Post-trade reporting requirements are effective in mitigating market
intransparency, which is a conspicuous shortcoming of a dealers’ market.
5.1.1 Rationales for quote-driven auction
Institutional investors, rather than individual investors, drive the development of a
government bond market. Dealers’ market (an OTC market), where the trading system is
quote-driven and the prices of bonds are determined principally by bid/ask quotations that
dealers at their own risk, can deal better with institutional orders7.
Dealers in a dealers’ market are market makers, and they normally keep firmly quoted prices
for bonds almost always available. The market is constantly kept ready to trade at any
moment during trading hours. The trading volume of a cash securities market is considerably
asymmetric: the volume swells and shrinks as the security prices rise and decline. By quoting
bids or offers for specific debt securities against the prevailing market trend, the dealer
provides the specific debt securities with more liquidity and, as a result, makes their price
movements orderly. In addition, its readiness to trade at a given yield also constitutes a basis
for a yield curve.
Transactions in a dealers’ market are by and large more economical in terms of the total
transaction cost, which includes the market impact. The market impact, especially in case of
institutional orders, is often the largest component of the total transaction cost. As long as
dealers’ flexibility in dealing with large and complex orders is of value to investors and
provides much higher liquidity, a dealers’ market remains more cost-efficient to institutional
investors.
7
This discussion assumes that a country has at least several outstanding issues of government bonds. In a
country with one or two outstanding issues, a call market or batch trading system may work better.
17
These dealing activities impose a substantial financial burden on the dealer, and expose it to
significant market risks. Therefore, the dealer must have sufficient capital to not only support
its inventories but also cushion itself against fluctuations in the value of the bonds in its
inventories. In order to mitigate these risks and lower its operating costs, the dealer also
needs to posses highly sophisticated expertise in trading and risk management. It is desirable
that financial tools like short-selling, interest or currency swaps, futures and options are
available for the dealer’s use, though setting up of futures and options markets are unlikely to
be realistic in most developing countries.
5.1.2 Market making obligations
In market making, dealers of government securities and the government have different goals.
Dealers are supposed to maximize their trading profits even at the expense of market
liquidity. They do not mind widening bid/ask spreads to reduce risks and maximize a trading
margin as long as a marginal profit from a wider spread exceeds a marginal loss from a
declined trading volume. The government generally wants to maximize the market liquidity
with a narrowest possible bid/ask spread to minimize its debt funding costs in the medium- to
long-term, and to optimize the benefits of the government bond market as public goods.
This gap can be narrowed, if not closed, when dealers are exogenously compensated for the
risks and costs of market making. Normally, the government obligates a small number of
designated dealers (primary dealers) to continuously quote bid/ask prices with a
predetermined spread or less for a prescribed trading lot on a firm basis in exchange for a
privilege of exclusively bidding for and distributing new issues of government bonds. An
oligopolistic nature of primary dealership allows primary dealers to generate profits on the
primary market to make up for the market making obligations.
To cause this cross-subsidy mechanism to work, a single regulator should regulate both the
primary market and the secondary market of government securities, or the primary and
secondary market regulators should coordinate very closely. Primary dealers’ market making
obligations should be explicitly and specifically defined, their compliance with the
obligation should be regularly monitored, and their actual performance should be reflected in
the degree of privilege they can enjoy.
5.1.3 Real-time online trading facilities
The dealer in an OTC market traditionally executes trades over the telephone, monitoring
video screens displaying market information provided by interdealer brokers and/or
information vendors. This telephone trading has been being replaced gradually by video
screen-based trading. Real-time online trading on a video screen can be generally linked to
order-capturing and order-processing functions, hence considerably enhancing the
productivity of trading. This electronically integrated system is called a straight-through
processing.
However, stakeholders of the market in a developing country where the installation of the
new system is being considered should think twice if the trade volume in the market really
18
justifies costs for the new system. Furthermore, as will be discussed later in Section 6, human
intermediation aided with some electronic trading and information facilities could be more
effective in enhancing liquidity in the secondary market of government bonds in [certain]
circumstances, especially in developing countries.
5.1.4 Post-trade reporting
A dealers’ market, though efficient, is also prone to unfairness or even collusion. Therefore,
the effective regulation of the market is crucial to maintain investors’ confidence in the
government bond market and have them trade frequently. The regulator’s real-time market
monitoring linked to the market-wide trading system is rather effective to deter dealers’
unfair or collusive trading. However, the installation of such a generally expensive system is
subject to a serious cost and benefit analysis. Some emerging markets probably cannot afford
such a system. In that case, the regulator may wish to require dealers to report trade
information after the trade or even after the close of a day’s trading, or collect it from the
clearing system, and disseminate it to the public before the opening of the next day’s trading.
A low-cost trade reporting and dissemination practice is still effective to substantially serve
the purpose.
5.2
Expanded repo market
An expanded repo market underpins the liquidity of the secondary market bonds. An
expanded or open repo market is a repo market in which the participation is open to
commercial banks as well as non-bank institutions. A market making mechanism works well
only when it is backed by an active repo market, which is expanded to a number of capital
market players. The expansion of repo market participation is more needed in developing
countries because the number of commercial banks is generally very small.
5.2.1 A prerequisite for market making
Market making is almost impossible without a repo market in place. Bond dealers
occasionally need to sell short to abide by their firm offers, and to cover their short positions
in a repo market. Otherwise, bond dealers would have to keep an inventory of government
bonds for every foreseeable trading need. This practice would be too costly to bond dealers,
if not impractical. Furthermore, if many bond dealers do this, it will suck up the liquidity of
government bonds from the market and ultimately will defeat the purpose.
Then, a repo market must be active so that bond dealers’ market making may be sustainable.
It is too risky for bond dealers to commit themselves to keeping firm offer prices posted
unless they are able to cover their short position in a repo market whenever necessary. Thus,
a bond dealer’s market making ability is dependent on the liquidity of a repo market, among
other things.
Nevertheless, repo markets in some developing countries are not active. The possible reasons
for the inactivity of a repo market include: first, the participants of a repo market is limited to
19
commercial banks or their equivalents and their number is small; second, they tend to be on
the same side of the market, because they are institutions of the same category and their
funding positions are more or less the same; and third, they defer using a repo market until
the lines of credit for interbank market funding have been exhausted, in case the interbank
loan market is on an uncollateralized basis.
A repo market can be made liquid by expanding its participants beyond commercial banks. A
repo market is set up normally by the central bank of a country to manage the liquidity of the
banking system. The central bank tends to limit the eligibility to participate in the repo
market to commercial banks that it regulates. However, a repo market can be
multi-functional if the eligibility for participation is expanded. It will allow or facilitate the
central bank to conduct open market operations, cash-rich investors to make a flexible,
highly secure, and high yielding money market investment, bond dealers to fund their
inventories or trading positions, or to cover their short positions, commercial banks to
arbitrage between interbank markets and open markets, and so on. The convergence of these
financial needs on a repo market will generate a fair amount of trades of government
securities.
The expansion of repo market participants beyond the banking sector is more needed in
developing countries than developed ones. The number of financial institutions is often too
small in developing countries. A larger number of participants are obviously needed to
generate liquidity in a repo market.
If it is open to non-bank institutions, the repo market will allow non-bank intermediaries such
as broker-dealers to participate more actively in the primary market of government securities.
Broker-dealers may offer repos to their corporate customers as a high-quality short-term
investment product for cash management. State-owned enterprises and private-sector
corporations would be able to invest their temporary surplus funds more flexibly and
favorably. A repo is safer than bank deposits, because their lending to broker-dealers through
repos is secured directly by the credit of the government. This product will eventually
compete with commercial banks' term deposits, and may create pressure to improve their
operational efficiency. The other side of this transaction will be broker-dealers’ financing
tool at a competitive cost for their inventory of government securities.
5.2.2 A jump-up of trading volume
An expanded repo market also increases trade volume of government securities considerably,
and hence enhance price discovery in the market. The US Treasury bond repo market, The
UK’s open gilt repo market and Japan’s Gensaki market are examples of expanded or open
repo markets that support the liquidity of outright markets of government securities.
This is not the case only with large developed markets. The Government of Singapore
liberalized the repo market by (i) lifting size restriction in November 1999, (ii) expanding the
market to offshore banks and non-residents in May 2000, (iii) carrying out its own SGS repo
program in November 2000, and (iv) allowing non-residents to borrow in the repo market
20
without size restriction in December 2000. As a result, not only the trading volume of the
repo market but also that of the outright market jumped up in and after 20008 (Figure 4).
Figure 4: Singapore Government Securities Turnover (Outright & Repo)
Average Daily Turnover (S$ mil)
3,000
2,500
2,000
Outright purchases & seles
1,500
1,000
500
Repos
1995
1996
1997
1998
1999
2000
2001
2002
Source: Monetary Authority of Singapore
Note: Singapore Government Securities include all Treasury Bills and Government Bonds
5.2.3 Limited participation
The benefits of the openness of a repo market have to be balanced against the need to limit
participation in different market infrastructures to those with the necessary expertise, powers
and financial resources. A broad participation is a tradeoff with increased systemic risk.
For example, the openness requires non-bank institutions to have access to the depository
and/or the settlement bank of government securities, which are the central bank in many
countries. However, such non-bank institutions are not necessarily under direct regulation
and supervision of the central bank. They may pose additional systemic risk to the systems
that are crucial to the national economy. This is partly responsible for some central banks
being hesitant to expand the scope of repo market participants.
Therefore, it is prudent to limit the participation in these market infrastructures to only
qualified institutions according to certain criteria9. In some countries, broker-dealers are
Ngiam, Kee-Jin and Lixia Loh, “Developing Debt Markets in Singapore: Rationale, Challenges and
Prospects”, Asia-Pacific Development Journal, Vol 9, No. 1, June 2002. The Government of Singapore
expanded the repo market participants but limited it to financial institutions. This is probably because Singapore,
which has graduated from a developing country status, has a large number of foreign financial institutions on an
on-shore or off-shore basis.
9
Such criteria should be objective and fair to avoid discriminating against classes of market players and
introducing competitive distortions, and should be clearly stated and publicly disclosed so as to improve
certainty and transparency.
8
21
allowed to open clearing and settlement accounts with the central bank on a limited basis10.
Some other countries adopt tiered settlement arrangements for broker-dealers11.
The introduction of a real time gross settlement (RTGS) system 12 can mitigate the conflict
between a broader participation and increased systemic risk, because an RTGS is designed to
eliminate default risk of participants. Therefore, the payment system regulator, which is
usually the central bank, may feel it less concerned to grant well-qualified non-bank
institutions direct access to the depository and the settlement systems.
5.2.4 Regulation and supervision
The expansion or openness of a repo market may give rise to a jurisdictional issue over the
repo market, depending on the legal framework of financial markets in a country. In many
countries, a repo market is intended primarily for liquidity management in the banking
system. As such, the central bank usually regulates and supervises the repo market as an
interbank market. As the market is expanded to non-bank institutions, the regulatory and
supervisory responsibilities over the repo market may get complex if a country has a
specialist regulator for its capital markets. Market players with different regulators rule may
coexist in a repo market.
In such a situation, it is harder for the government to effectively regulate a financial market
by regulating its participants (institutional regulation). Such a commingled market can be
better regulated by regulating functions that market participants perform (functional
regulation). Even before the regulatory philosophy over financial markets is fundamentally
re-oriented, the central bank and the capital market regulator need to coordinate more closely
and to be flexible to each other on jurisdictional issues to run an expanded repo market
smoothly.
5.2.5 Legal, tax and other issues
A legal, tax, credit, or accounting rule may unexpectedly form a bottleneck to the liquidity of
an expanded repo market, and hence the government securities market. Their implications to
repo transactions in a local and/or cross-border context should also be carefully examined. A
standard repo contract should be structured so that no legal, tax, credit, and accounting may
hinder repo transactions.
10
For example, the central bank provides no liquidity to broker/dearlers.
Direct participants in clearing and settlement systems like commercial banks settle across the books of a
settlement institution (usually a central bank), while indirect participants like broker-dealers settle across the
books of direct participants.
12
In a conventional net settlement of interbank funds, a single settlement failure could affect settlement of other
transactions that were netted and are supposed to concurrently settle. In RTGS, every transaction is settled
individually on a continuous, transaction-by-transaction basis throughout the processing day, so that settlement
of each transaction is unrelated to that of other transactions, and transactions are processed one after another
from early in the day; and, therefore, whole payment system is much less prune to systemic risk.
11
22
The economic viability of repo transactions is highly sensitive to even a minute impediment,
since most repo transactions are of short-term. For instance, the imposition of a small
transaction tax can distort a repo market, if it does not damp the entire repo market.
The compatibility or consistency of a repo contract with other financial products or with
foreign currency repos may matter to the liquidity of a repo market. This is because arbitrage
is a driving force for the liquidity of short-term markets, and the incompatibility may
constrain the investor’s ability to arbitrage between a repo market and other short-term
markets. The cross-border compatibility helps generate a foreign demand for investment in a
country’s repo market for the purposes of cross-border arbitrage or short-term forex
management.
A safe choice of repo contract type in the international context is the TBMA/ISMA Global
Master Repurchase Agreement. However, this choice does not warrant domestic
compatibility. A repo transaction can take the legal form of a repurchase agreement, a
securities lending transaction with a cash collateral, a collateralized loan, or a buy/sell and
sell/buy. It can also have different settlement and custodial arrangements 13 that have
different credit implications to a lender of cash.
5.3
Electronic trading systems (ETSs)
ETSs have been rapidly accepted in certain segments of fixed income markets in developed
countries thanks to their efficiency. However, the realities of successful and unsuccessful
ETSs in the US market suggests that it is essential to implement the principles of the market
infrastructure, the supply-side and the demand side for market liquidity in the first place in
developing countries before aggressively eliminating human intermediary functions.
5.3.1 Limited roles of an ETS in trading
An ETS makes a significant difference in efficiency and reliability of securities trading.
However, it stops short of completing the whole trading process. The part of the process that
an ETS cannot fulfill is critical in generating trades.
To understand the roles of electronic trading system in trading, it is useful to see trading
activities as an action circle consisting of “Do” for implementation of a planned action, “See”
for monitoring the result of the implementation, and “Plan” for feeding back of the results
and planning of the next action (see Figure 5). Repeated activities like securities trading
normally require the actor to go round the circle of the three steps to improve the activities or
keep them relevant to changing environments. An ETS undertakes activities mainly from the
moment the strategy for a trade has been established until the trade settles. Subsequently, it
also helps part of monitoring. It covers from a substantial part of “Do” up to a part of “See” in
the action circle. This portion of the action circle may be termed the “operational part of a
trading action circle”. Roughly the half of the circle from “See” to the beginning of “Do”
13
Hold-in-custody or letter repo, delivery-out repo, tri-party repo, four-party repo, and buy/sells and sell/buys.
23
with the entire “Plan” in between, which may be called the “strategic part of a trading action
circle”, is left outside the functionalities of an ETS.
Figure 5: Trading Action Circle
DO
Strategic
Part
PLAN
Figure 6: Components of Broking
Operational
Part
Order Execution
Processing/
Back Office
SEE
Decision Facilitation
Consultation
Efficiency
matters
Effectiveness
matters
Conventional broking of securities transactions can be broken down into three functions:
order transmission and execution, executed order processing, and investment advice (see
Figure 6). An ETS replaces human roles of the first and second functions, but not the third
one. The first two functions are operational in nature. Hence, efficiency and reliability matter.
By contrast, the last one is subjective and the effectiveness on the investor’s mind, rather than
efficiency, counts. The investment advisory function is, in fact, consultation or decision
facilitation for the investor.
The strategic part of securities trading, which corresponds more or less to consultation or
decision facilitation of broking, is eventually the engine of trading activities. It generates
trades. Intermediaries facilitate this process leading to actual trades. Therefore, market
liquidity can be enhanced by properly addressing policy issues surrounding this process in
the first place, rather than by hastily installing an ETS.
5.3.2 Five major types of ETSs
The Bond Market Association, a trade association in the United States, classifies electronic
trading systems into five major types: auction, cross-matching, inter-dealer, multi-dear and
single-dealer systems. Auction systems enable participants to conduct electronic auctions of
securities offerings in the primary or secondary market. Cross-matching systems generally
bring both dealers and institutional investors together in electronic trading networks that
provide real-time or periodic cross-matching sessions. Inter-dealer systems allow dealers to
execute transactions electronically with other dealers through the fully anonymous services
of brokers' brokers. Multi-dealer systems provide customers with consolidated orders from
two or more dealers and provide customers with the ability to execute from among multiple
24
quotes. Single dealer systems allow investors to execute transactions directly with a specific
dealer of choice, with the dealer acting as principal in each transaction14.
Appendix 1 tabulates ETSs in the United States and Europe that the Bond Market
Association surveyed in late 2001, by ETS type and fixed-income product type. Commercial
attempts to electronized fixed-income trading have been made for every type of systems and
products. According to market sources, commercially successful ETSs are found only in
multi-dealer and interdealer systems. The two types are not exclusive to each other in the
marketplace. They serve different needs of the market and are conceivably complimentary
with each other. Electronic trading has not been successful in generating direct trading
among institutional investors.
This indicates that electronic trading has not fundamentally changed established market
infrastructure principles of a liquid market of fixed income securities: quote-driven auction,
well capitalized market makers, and anonymity among investors and dealers. The advent of
ETSs has raised the efficiency of already liquid fixed income markets, through increased
transparency of market prices as well as integration of trading with back-office operations.
The introduction of an ETS packaged with self-regulatory market rules designed for the
enhancement of liquidity has proved to be effective in vitalizing government bond markets in
some European countries.
5.3.3 Market and product suitability to an ETS
ETSs for treasury bonds have been far more successful than those for corporate or other
illiquid bonds. This fact also evidences that the demand- and supply-side principles for
market liquidity – sizable, regular, stable (predictable), transparent and market-based supply
of bonds of high quality, and uniform characteristics, and, many, incessant, competitive, and
diversified demands for the bonds – hold good. Furthermore, the fact that screen-broked
trades are a minority outside dealers’ community suggests that most of screen-broked trades
are those of commoditized products that are of a simple nature.
In other words, the less the strategic part of a trading action circle is required, the more likely
to be suitable for ETSs a product, a trade type, or a market is. The extent of the strategic part
is also a function of sophistication of investors and market intermediaries15.
Conversely, the strategic part is more needed in most of developing countries, for example,
due to large price volatility or less sophistication of market participants. Therefore, human
broking is likely to be essential in generating liquidity in developing country environments.
14
http://www.bondmarkets.com/research/ecommerce/ecommercedraft.shtml
No reliable data of the market share of ETSs is available, because ETSs do not want to disclose their market
shares. Salomon Smith Barnet estimated screen-broked trading at more than 40% of US Treasury bonds in 2000
(Salomon, 2000), and an interdealer broker reckoned in October, 2002 that more than 90% of Yen/US$ forex,
and more than and 15-20% of JGBs were being screen-broked.
15
25
5.4 Clearing, settlement & depository
The objective of clearing, settlement and depository operations is surer and quicker
availability of securities to the buyer and funds to the seller for their next financial
transactions after their trade is executed. Achieving this objective is a key to a liquid
secondary market of government bonds. For this reason, moving to a book-entry system from
a paper certificate system or even starting a brand-new government bond market with a
book-entry system is an established norm. For the same reason, the book-entry system has
been computerized, and has been being electronically integrated with clearing (order
matching, and confirmation), and settlement (delivery of securities, and payment of fund).
Accordingly, a depository, which used to safekeep and record physical certificates for their
holders for security and convenience, is now an institution to process and maintain an
electronic boon-entry system. As a result, a flow of these back-office processes has been
rapidly automated.
Any developing country aiming at a liquid secondary market of government bonds cannot
avoid taking this course. Any market can no longer carry out practices and methodologies in
a reliable and efficient manner to create and maintain market liquidity such as delivery versus
payment (DVP), rolling settlement, securities lending, repos, etc. without a computerized
central depository of government bonds.
The actual structure of a country’s clearing, settlement and depository system depends on
local factors. Structural choices include one- vs two-tier structures, general vs specialized
depository systems, a unit of the central bank vs a self-standing institution, and membership
criteria. The central bank is expected to play an important role in making an optimal mix of
choices in the view of inducing the largest possible volume of trading activities with a
minimum systemic risk under local circumstances.
Information technologies or combination of computer and communication technologies is
now presenting new choices to developing countries. A developing country may elect to
unbundle clearing, settlement and depository operations and outsource their parts from
foreign established depositories to minimize overall costs.
5.5
Trading-neutral Accounting & Taxation
5.5.1 Trading-neutral accounting
An accounting standard for evaluation of marketable securities influences the trading
behavior of the investor. The cost method largely discourages the investor from selling its
marketable bonds whose market value has dropped below the acquisition cost, since the sale
will cause the investor to realize losses on its income statement. If the government forcefully
places bonds at a sub-market rate to myopically save the financing costs of its budget deficit,
the investors, which are mostly regulated financial institutions, will be hardly able to sell
them in the market unless they realize capital losses; however, they do not need to account
for the losses under the cost method if they hold them.
26
Some countries distinguish securities holdings between trading and investment portfolios,
and require the investor to evaluate its trading holding on a lower of cost or market basis.
Some other countries more aggressively require the investor to mark its trading portfolio to
the market at the end of each accounting period16. The International Accounting Standards 32
and 39, which are increasingly adopted in developing countries, have similar requirements.
The mark-to-the market substantially eliminates an incentive not to trade bonds for
accounting purposes. It creates little basis against trading, and, therefore, is neutral to trading.
5.5.2 Trading-neutral taxation
As has been discussed earlier, securities transaction taxes works against trading. The
imposition of withholding tax on interest payments of government bonds complicates the
calculation and adjustment of accrued interest between the seller and the buyer of bonds, and
consequently impedes trading. It may also fragment the market into segments according to
the investor’s tax status, resulting in reduced liquidity of bonds. Different tax treatment
between interest and capital gain or loss often creates some preference towards particular
issues of bonds over others, depending on the investor’s tax position. The interest as part of
capital gain or loss may be treated differently from the outright interest payment. Excessive
differentiation of this kind hinders trading.
5.5.3 Other preferential treatments
Some of these preferential treatments of government bonds might adversely affect their
liquidity. Examples are exemption from statutory reserve and recognition as liquidity assets
for capital adequacy ratio purposes. This exemption will create demand for government
bonds from banks that are subject to statutory reserve requirements or whose assets are
subject to capital adequacy rules. The problem with this is that only banks will benefit from
the preferential treatment and most of the issues will be sucked into banks’ portfolio.
5.6
Advanced risk management & arbitrage facilities
5.6.1 Symmetric functionalities
Advanced capital market facilities of government bonds such as short selling, repos,
securities lending, and derivatives (futures, options, and swaps) enhance market participants’
ability of risk management and arbitrage operations. A highly efficient clearing, settlement
and depository system is a prerequisite for smooth operation of these facilities. Risk
management and arbitrage operations, if permitted, would generate a tremendous amount of
trading, and further enhance the price discovery function of the market.
The advanced capital market facilities of government bonds complete a full set of long and
short position taking tools in cash and futures markets. This may be called “symmetric
16
In the United States, for example, FASB Nos. 107 and 113 require corporations including financial
institutions to disclose their financial asset holdings on a mark-to-the-market basis.
27
functionalities” of cash and futures markets (see Figure 7). With a full-fledged risk
management and a rational price discovery mechanism in place, investors and dealers can bid
for primary issues of government bonds precisely, and corporate bond issuers and
underwriters can issue or underwrite corporate bonds in an efficient manner. In other words,
it enables them to take market positions with a reasonably controlled risk under ever
changing market conditions.
Figure 7: “Symmetric Functionalities” of cash and futures markets
Cash
Long
Cash
Short
Securities
Lending
Short-term Market
Clearing, Settlement & Depository
Futures
Long
Futures
Short
In realty, however, it is extremely difficult for many developing countries to develop such
liquid derivatives markets of fixed income products that intended risk management and
arbitrage operations can be reasonably performed. It is more realistic to concentrate their
efforts on the introduction of short selling, repos, and securities lending. This will enable
them to maintain “symmetric functionalities” of the cash government bond market, and
enhance market liquidity. Symmetricity is a kind of minimum requirement for a system to
serve risk management and arbitrage purposes.
5.6.2 Efficiency and systemic risks
As a result of reducing opportunity costs, the whole market system becomes efficient. A
trading decision gets quicker. Trading volume increases. A settlement cycle shortens. A bond
trade may involve more financial products and counter-parties beyond the bond market.
Trading and settlement may involve parties more distant from each other than before. They
may be not only across nation borders and in different time zones, but be a half world away.
A larger amount of money and/or foreign exchange may be involved. The flip side of the coin
is that systemic risks of the financial market also increase, and the whole economy may
become less stable and more vulnerable to shocks (see Figure 8-A). The government needs to
take more sophisticated measures to monitor, eliminate or contain increasing risks.
Conceptually, it needs to shift or bend the risk/efficiency tradeoff line in our favor (see Figure
8-B). An RTGS system17 will make the shift possible.
17
See Footnote 12
28
Figure 8: Market Efficiency and Systemic Risk
fl
of
de
tr a
k
ris
&
ie
nc
y
fic
Ef
Stable
Systemic risks
Less stable
B
in
e
A
Market efficiency
6
Salespeople and Brokers for Liquidity18
Regardless of a developed or developing economy, average investors and dealers are likely
to find more personal values in manpower-based intermediary services to trade government
bonds. Sophistication of salespeople at broker/dealers and utilization of interdealer brokers
should be viewed as a liquidity enhancement measure. Under emerging market environments,
human intermediation by salespeople and brokers equipped with some electronic devises is
expected to remain effective in creating and maintaining liquidity in the secondary markets
of government bonds.
6.1
Liquidity vs efficiency
We have discussed extensively how to make the market efficient. However, can market
efficiency alone create a liquid market? Liquidity is a different concept from efficiency.
Efficiency and liquidity compliment each other in most cases. Yet, there are some cases
where liquidity can or must be achieved even at the expense of some degree of efficiency. As
far as I have observed it, the market needs some human factors in its working for its smooth
running. Such factors are represented by salespeople and brokers.
Salespeople are usually employees of broker/dealers, and solicit orders from investors for
their in-house traders as counterparty. They are paid out of trading profits that are bid/ask
spreads. Brokers in this context are interdealer brokers. They provide their customers with
18
My argument in this section was developed through my email discussions with Mr. Naoki Yokoyama,
Chairman of SBI Asset Management Co., Ltd. in Tokyo, Japan.
29
ongoing prices and market information, and broke trades on a “name give-up” or matched
principal basis. Normally, interdealer brokers do not broke or trade with end-investors.
6.2
Mediocre players
Mediocre investors are an indispensable basis for liquidity. The market consists of a small
number of visionary players and, a large number of mediocre ones (see Figure 9). A player
may have some visionary elements and some mediocre ones in himself. Players in the
marketplace vary in preference. Moreover, they do not have the same level of quality in
terms of knowledge, comprehension, reasoning, insight, and foresight. Only the minority of
the players is visionary and capable of independently making investment decisions, though
this ability does not always guarantee excellent investment skills.
Mediocre institutional investors, or mediocre fund managers at institutional investors, are
laden with: uncertainty, accountability, decision-making anxiety, post-decision making
anxiety. They are in sharp contrast with so-called “day-traders” who rapidly buy and sell
mostly equities on line for their own accounts, and are not required to be accountable to
anybody else for their trading. Fund managers and traders at most institutional investors are
strictly bound by investment/trading policies and rules under close supervision, and are
required to be accountable to their superiors, beneficiaries and regulators for their trading
being carried out under a great amount of uncertainty. A failure in accountability risks their
job. In this kind of job, they have to live with decision-making anxiety and post-decision
making anxiety.
Therefore, the mediocre fund manager needs a routine mechanism that assures him of some
confidentiality even from his supervisors, stress control, and, damage acceptability in respect
of his trading decisions. At the same time, he is a “price-taker”, but not a “price-giver”, and,
nervously needs continuous “price discovery” services and investment advice with human
assurance from his “accomplice”. Other players in the industry, even traders at
broker/dealers, are in the similar situation. Salespeople and/or brokers are considered to play
a critical role in this psychological process of mediocre players.
Thus, routine interactions between mediocre players and salespeople and/or brokers with the
psychological implications conceivably generate many orders for trades at random under
normal market conditions. This human process of inducing market players to trade
significantly contributes to liquidity of government bonds in emerging markets. Therefore, it
is advisable that policymakers should incorporate sophistication of salespeople at
broker/dealers and utilization of interdealer brokers in their strategy for enhancing secondary
market liquidity of government bonds. Policy measures under such a strategy include
professional education and certification programs for salespeople, and a licensing category
for interdealer brokers.
30
Figure 9: Mediocre and Visionary Players
Institutional
investors
Broker
Dealer
Broker
Dealer
Broker
Dealer
Broker
Dealer
Interdealer
brokers
Broker
Dealer
Broker
Dealer
Mediocre
6.3
Broker
Dealer
Broker
Dealer
Visionary
Network effects
Capital markets are known for their network effects. This is a reason for the importance of a
critical mass for market liquidity. The secondary market or the service rendered in it becomes
more valuable as more investors use it. However, the network will not grow large enough
unless its owner is allowed to internalize (privately benefit from) network effects.
Conversely, a new investor will not join the network for the additional value derived from
being able to interact with other market participants if the owner internalizes all network
effects. A right balance between the private value and the social value of the network to reach
the optimal size of the network is a function of a traded product, characteristics of demand
and supply, a level of maturity and sophistication of the market, and so on.
The quality and quantity of public information are generally far imperfect or inadequate in
emerging markets. In such markets, an aggregate of personalized information about
inventors or dealers collected by salespeople or brokers is likely to have more values for the
network owner to internalize than investors or dealers’ trading information mechanically
gathered through an electronic trading platform. The aggregate of personalized information
about other inventors or dealers will attract new participants to the network. Therefore, the
network owner has a better incentive to expand its network.
Personalized collection of information is arguably more expensive than mechanical
collection. The number of skillful salespeople or brokers is limited or slow to grow.
Consequently, diminishing returns and/or capacity constraints will inevitably bring a
manpower-based network to the point where the addition of new participants does no longer
make sense to the owner or is no longer possible much sooner than an electronic-based
network. The potential size of the former will be smaller than that of the latter. Multiple
networks may be able to exist profitably.
31
This limitation of manpower-base intermediation is unlikely to impede the development of
government bonds in most of developing countries at least in the short- or medium-term.
This is because their economies may be too small due to heir population size and/or their
income level to reach the potential size limit of manpower-based networks. Under such
circumstances that are widely common in many developing economies, human
intermediation rather than purely electronic intermediation is more practical and effective in
driving the owners of intermediary networks to expand their business and generating
liquidity in secondary markets of government bonds at least in the initial stage of market
development as well as perhaps in the foreseeable future.
7
Conclusion
A proper set of the demand and supply sides of a bond market is a primary prerequisite for
bond market liquidity. A well-organized market infrastructure is often secondary to them.
Public awareness/consensus about the roles of a government bond market is a key to reduce
the overall trading costs of government bonds. Trading per se is neutral to total returns, and
never pays for trading costs without additional risk. Therefore, it is critical to keep trading
costs low for market liquidity. Due to a public goods nature of capital markets, a public
support is essential to bring down the direct costs of trading.
Key market infrastructures for market efficiency are market making obligations in a dealers’
market and an expanded repo market, followed by an electronic trading system, an electronic
clearing, settlement, and depository, and position-neutral accounting and taxation. As the
market develops, the policymaker needs to introduce advanced risk management and
arbitrage facilities into its government bond market, while balancing between market
efficiency and increasing systemic risks.
“Mediocre” investors are an indispensable basis for liquidity. They need brokers for active
trading. Interdealer brokers should be considered as a liquidity enhancement measure if a
market size justifies them. Under emerging market environments, human intermediation by
salespeople equipped with some electronic devises is expected to remain effective in creating
and maintaining liquidity in the secondary markets of government bonds.
32
Appendix 1
Fixed-Income Products and Types of Electronic Transaction Systems
Auction
Automated Bond
System
Inter-dealer
Multi-dealer
Single-dealer
BondDesk Group
BondGlobe
ValuBond
XBond
BrokerTec Global,
LLC
eSpeed, Inc.
Garban-Intercapital plc
Tradesoft
Bloomberg
BondTrader
Fixed Income
Securities, Inc.
Spear, Leeds &
Kellogg
TradeWeb LLC
Autobahn Electronic
Trading
Bear Stearns & Co. Inc.
Credit Suisse First
Boston
FiDirectX
G.X.Clarke & Co.
Goldman, Sachs & Co.
GoveRate/Odd-Lot
Machine
J.P. Morgan eXpress
Merrill Lynch Capital
Markets
Mizhuho Securities,
Inc.
Morgan Stanley
Ragen MacKenzie
Incorporated
Tradebonds.com
Grant Street Group
Automated Bond
System
BondDesk Group
BondGlobe
ValuBond
XBond
BrokerTec Global,
LLC
eSpeed, Inc.
Garban-Intercapital plc
Tradesoft
Bloomberg
BondTrader
Fixed Income
Securities, Inc.
Spear, Leeds &
Kellogg
TradeWeb LLC
Autobahn Electronic
Trading
Credit Suisse First
Boston
FiDirectX
G.X.Clarke & Co.
Goldman, Sachs & Co.
GoveRate/Odd-Lot
Machine
J.P. Morgan eXpress
Merrill Lynch Capital
Markets
Ragen MacKenzie
Incorporated
Tradebonds.com
DealComposer
Grant Street Group
Automated Bond
System
Bloomberg Spread
Execution System
BondDesk Group
BondGlobe
BondHub.com
MarketAxess
ValuBond
XBond
BrokerTec Global,
LLC
eSpeed, Inc.
EuroMTS Limited
Garban-Intercapital plc
GFI
TheMuniCenter
Tradesoft
Bloomberg
BondTrader
Bondpage.com
Fixed Income
Securities, Inc.
MarketAxess
Spear, Leeds &
Kellogg
SWX Eurobonds
TradeWeb LLC
Autobahn Electronic
Trading
Credit Suisse First
Boston
FiDirectX
G.X.Clarke & Co.
Goldman, Sachs & Co.
GoveRate/Odd-Lot
Machine
J.P. Morgan eXpress
Merrill Lynch Capital
Markets
Ragen MacKenzie
Incorporated
Tradebonds.com
Lehman Live
RetLots Caboto
Treasury
TAAPSLinkR
TreasuryDirect
Agency
Corporate
Auction
Automated Bond
System
Inter-dealer
Multi-dealer
Single-dealer
Asset-back Mortgage-b
ed
acked
Money Market
Municipal
Bloomberg Spread
Execution System
BondHub.com
CreditTrade
XBond
GFI
SWX Eurobonds
BondDesk Group
BondHub.com
XBond
BrokerTec Global,
LLC
Garban-Intercapital plc
GFI
Fixed Income
Securities, Inc.
TradeWeb LLC
Autobahn Electronic
Trading
FiDirectX
Goldman, Sachs & Co.
Tradebonds.com
Grant Street Group
American Express
Credit Corporation
Prescient Markets, Inc.
BondDesk Group
Garban-Intercapital plc
Bloomberg Money
Markets Platforms
Fixed Income
Securities, Inc.
Global Link
Autobahn Electronic
Trading
Credit Suisse First
Boston
Goldman, Sachs & Co.
Merrill Lynch Capital
Markets
Tradebonds.com
Bloomberg Municipal
System
Grant Street Group
Automated Bond
System
BondDesk Group
BondGlobe
BondHub.com
ValuBond
XBond
eSpeed, Inc.
Garban-Intercapital plc
GFI
Hartfield, TItus &
Donnelly LLC
TheMuniCenter
Bondpage.com
BondWave
Fixed Income
Securities, Inc.
i-Deal LLC
Spear, Leeds &
Kellogg
eBondTrade
GoveRate/Odd-Lot
Machine
Lehman Live
Merrill Lynch Capital
Markets
Morgan Stanley
Tradebonds.com
Grant Street Group
Repo
BrokerTec Global,
LLC
eSpeed, Inc.
Eurex Repo
Garban-Intercapital plc
GFI
BondVision
Direct-Issue Limited
Europeans*
Bloomberg Spread
Execution System
BondGlobe
CreditTrade
debtdomain.com
Direct-Issue Limited
Eurex
Eurex Bonds GmbH
Helaba
MarketAxess
BrokerTec Global,
LLC
CoredealMTS Ltd.
eSpeed, Inc.
Eurex Repo
EuroMOT
EuroMTS Limited
Garban-Intercapital plc
GFI
MOT
MTS Amsterdam
MTS Associated
Markets
MTS France
MTS German Market
MTS Ireland
MTS Portugal
SGMR,SA
MTS S.p.A.
MTS Spain
Tradesoft
34
Lehman Live
Morgan Stanley
Bloomberg
BondTrader
Confederacion
Espanola de Cajas de
Ahorros
LoanX, Inc.
MarketAxess
SWX Eurobonds
TradeWeb LLC
Merrill Lynch Capital
Markets
Autobahn Electronic
Trading
Goldman, Sachs & Co.
Credit Suisse First
Boston
FiDirectX
J.P. Morgan eXpress
RetLots Caboto
Banco Portugues de
Investimento SA
dbconvertibles.com
SEB Merchant
Banking
Auction
Automated Bond
System
Inter-dealer
Multi-dealer
Single-dealer
Derivatives
Blackbird
Chicago Board of
Trade
Loans
Others
DebtX
HanoverTrade.com
lexc.com
CreditTrade
debtdomain.com
lexc.com
DealComposer
BondDesk Group
BondGlobe
Creditex, Inc.
MarketAxess
ValuBond
Garban-Intercapital plc
GFI
Tradesoft
MarketAxess
TradeWeb LLC
Autobahn Electronic
Trading
dbconvertibles.com
FiDirectX
J.P. Morgan eXpress
Merrill Lynch Capital
Markets
RetLots Caboto
Compiled from "Review of Electronic Transaction Systems for Fixed-Income Markets", The Bond Market Association, December 2001
* European securities are not classified into sovereign, corporate, etc.
35
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