Development ofdomestic bond markets

Jeppe Ladekarl

Financial Sector Department

The World Bank

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Introduction

• Key components of equity markets include: demand (investors and intermediaries) Supply (opportunistic and non-opportunistic) infrastructure (settlement, trading, registration) regulation

• Key characteristics fair, efficient and transparent

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Overview of the key components

IssuersUser of capital

InvestorsSuppliers of capital

Market infrastructure- trading systems- information systems- brokers- clearing and settlement- registration

Regulation and supervision.- The Central Bank,- The Government- Self Regulatory Organizations

Intermediaries- provides liquidity- access to investors

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Source: Asian Emerging Bond Markets, Ismail DALLA, Financial Times, 1997

* Data for USA, Germany and Japan is for 1993.

Bonds outstanding as a percentage of GDP, 1996-97

0%20%40%60%80%

100%120%

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Common questions

• This presentation will try to address some of the most common questions you will be faced with talking to the Minister of Finance about debt market development and debt management: What are the basic pre-requisites for bond market

development? How can we progress from inflationary to non-inflationary

financing of the deficit? How can we lower our borrowing costs? How can we extend the yield curve?

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Common questions

How should we organize our debt management? How can we de-link monetary policy and debt

management? Should we implement a primary dealer system? Is electronic trading better than OTC? How can we move to continuous trading? How do we become the regional market for fixed income

securities?

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Basic Prerequisites

• Continued macroeconomic and financial sector stability Prudent and sustainable fiscal policies Stable monetary environment that contains inflation Credible exchange regime and capital account policies

• Institutional infrastructure Effective legal, tax and regulatory infrastructure Efficient and secure settlement arrangements Liberalized financial system with competing intermediaries

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The transition from inflationary to non-inflationary finance - I

• Stop the printing press & release captive investors

• Key challenge: Accept (higher) market rates as the funding rate (The

“cheap” funds obtained from captive investors are costly to the economy in terms of high inflation and low growth)

Deal with increased volatility in debt servicing costs

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The transition from inflationary to non-inflationary finance - II

• Liquid debt markets will not develop with captive investors

• Macro-economic stability is a prerequisite for bond market development Controlling inflation and the fiscal balance Reducing the volatility of exchange and interest rates Increasing the stock of international reserves to

cushion the economy

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Domestic debt markets - I

• Getting a liquid domestic debt market usually requires at least one non-opportunistic issuer Central government running a deficit (government) Central government running a surplus

(government, central bank, mortgage credit institution, sub-sovereign finance, other?)

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Domestic debt markets - II

• The basis of the market is a regularly issuance of standardized high quality bonds Supplies a yield curve Provides volume and standardization

• Other issuers “piggy back ride” on the benchmark issues

• Should the government always “supply” a yield curve i.e. is there an “optimal” level of gross debt?

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Minor corporate issues

Gov’t bonds

Major corporate issues

Major corporate issues

“Generic” structure of bond markets

Adopted from Tadashi Endo, 2001

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Composition of domestic debt markets in selected countries - I

% of total

0

20

40

60

80

100

USA

Japa

n

Ger

man

y

Italy

Fran

ce

U K

Spai

n

Braz

il

Sout

h Ko

rea

Chin

a

Arge

ntin

a

Mex

ico

Public Sector Financial Institutions CorporateSource: BIS.

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Composition of domestic debt markets in selected countries - II

All Issuers Public Sector Financial CorporateUS$ bn

United States 14,938.0 55 28 17Japan 5,938.0 74 14 12Germany 1,921.7 42 57 1Italy 1,485.6 77 23 0Spain 347.8 84 9 7Brazil 271.3 81 18 1South Korea 251.9 25 33 42China 196.5 65 33 2Argentina 76.6 31 69 0Mexico 47.7 82 6 12Turkey 44.1 100 0 0Hong Kong 29.8 19 73 8Poland 26.9 100 0 0Czezh Rep 19.5 75 12 13

Percentage share

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Government debt management - I

• Government debt management is a key element in the development of domestic debt markets Develops a (“risk free”) yield curve Provides standardization and volume Sets up the basic infrastructure in the market

• Developing sound debt recording and an ability to make funding forecasts is the first step in debt management

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Government debt management - II

• Common questions: What should our objective function be? How can we lower our borrowing costs? What instruments should we issue? How can we extend the yield curve? How should we organize our debt management? How can we de-link monetary policy and debt

management?

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Government debt management - II

• Common questions: What should our objective function be? How can we lower our borrowing costs? What instruments should we issue? How can we extend the yield curve? How should we organize our debt management? How can we de-link monetary policy and debt

management?Get inspira

tion fr

om the T

he

World

Bank / IMF G

uidelines

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Government debt management - III

• An important part of debt management is risk management Risk must be controlled to avoid macroeconomic

vulnerability Transparent risk management lends credibility to the

issuer and thereby lowers the funding costs By providing examples of best practice to the market

risk management can increase the stability of the financial system in general

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Government debt management - IV

• Sale of government securities at market-determined interest rates is critical for market development Process may be gradual but direction of change must be irreversible Timely information on public debt structure and treasury operations

should be provided to market participant

• Development of government benchmark securities is an essential element of a well-functioning bond market Concentration of new issues in limited standard maturities enables

their use as benchmarks Spreading few benchmark issues across a range of maturities leads

to a “benchmark yield curve”

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The organization of primary markets - I

• Common questions: What is the most efficient way to sell bonds? Should we use multiple and single price auctions? Should we implement a primary dealer system? How can we increase competition in the primary

market? Should we have a special sales channel for retail /

small order clients ?

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The organization of primary markets - II

• Distribution Options: Auctions Direct sales using “new” technology Private placements/syndication “Tap”-sales Announcing a price and soliciting public subscription over a

fixed period Announcing a price and offering sales on tap over an

unlimited period altering the price with varying frequency

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Organization ofprimary markets - III

• The use of Primary dealers (PD) Primary dealer system may facilitate change to an

environment of market-based funding PDs may pose the risk of collusion in countries with small

financial sectors PD system should not impair distribution of government

bonds directly to wholesale or retail investors

• There are no international standards for PDs

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PDs in selected countriesCountry # Rights/Privileges Obligations

Canada 12 Exclusive counterpary rights for central bank’s omo’s and borrowing privileges with the central bank

To bid in auctions. To make firm two-way quotesTo report to the central bank

Greece 15 Exclusive access to primary aucitons To bid in auctions. To make two-way quotes

Hungary 13 Exclusive access to primary auctionsConsultations with the debt management agency

To bid in auctions. To make firm two-way quotes. To report to the debt agency.

Korea 26 Exclusive access to primary auctions and non-competitive bidding

To bid in auctions. To make firm two-way quotes. To trade a minimum of 2 percent of total secondary market volume

New Zealand none

Sweden 7 Exclusive access to primary auctions and counterparty to central bank’s omo’s

To bid in auctions. To report to the central bank. To contribute with good liquidity in the market

Thailand 9 Exclusive counterparty to central bank omo’s To make two-way quotes

UK 17 Exclusive access to primary auctions and participation in consultation meetings, secondary market dealing with the central bank

To make firm two-way quotes. To report to the central bank. To report trades to the LSE

USA 25 Exclusive counterpart to central bank’s omo’s. Ability to borrow securities intraday form central bank’s portfolio.

To bid in the aution (non-contractual obligation)To report to the central bankTo participate in the Federal Reserve’s omo’sTo provide the Fed with market information and analysis

Source: IMF 2002, MAE Operation Paper (OP/02/02)

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The organization of secondary markets - I

• Options: Over The Counter (OTC) Exchange traded Alternative Trading Systems (ATS)

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The organization of secondary markets - II

• Common questions: Is electronic trading better than OTC? Should the stock exchange play a role in debt

markets? How can we move to continuous trading? Who should participate in the wholesale market? How do we become the regional market for fixed

income securities?

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Word of warning in secondary market development

A quiz : what percentage of the 400,000 corporate issues outstanding in the US market in 1996 traded at least once during that year ?

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Word of warning in secondary market development

A quiz : what percentage of the 400,000 corporate issues outstanding in the US market in 1996 traded at least once during that year ?

Answer: 4 percent, so get your priorities straight !!

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The organization of secondary markets - III

• Promoting a vibrant secondary market is difficult aspect of market development Active participation required of many different groups:

investors, intermediaries, and providers of infrastructure Change in taxation or regulation can produce significant effects

• First step: building a safe spot trading system In early market development, building the infra-structure to

support spot trading practices is key More advanced transactions (e.g, swaps, futures and options)

should be pursued subsequently

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The organization of secondary markets - IV

• Market Architecture OTC trading has been the convention in bond markets Inter-dealer broker (IDB) can be crucial for wholesale OTC

trading of government bonds Some governments require small orders to be centralized

into an exchange to ensure best execution for retail investors

• Regulatory framework for market transparency Centralized reporting and dissemination system (e.g., the

U.S. GovPx) greatly increase market transparency

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Developing demand for fixed income products - I

• Key groups of investors: Banks International investors Institutional investors Retail investors Public (social security) funds

• A diversified investor base promotes liquidity and stabilizes market demand Heterogeneous investor base (different time horizons, risk

preferences and trading motives) ensures active trading

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Developing demand for fixed income products - II

• There are three important elements in stimulating voluntary demand for domestic debt instruments: The macro-economic environment Building a potential investor base Having the right regulation

• Major obstacles: no demand from institutional investors excessive reliance on banking system as end-investors

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Developing demand for fixed income products - III

• Common questions: How can we develop long term savings? Should we encourage foreign investor to access the

market? Should we develop special products for retail

investors? What role should the banking sector play in the

promotion of debt instruments?

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Developing demand for fixed income products - III

• Measures for developing a broader-based market include: PDs obliged to place securities with end-investors Moving securities out of bank portfolios Direct access to retail and/or foreign investors Structural reform of pension and retirement funds Reform or creation of mutual funds

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Demand: Institutional Investors - I

• Contractual savings institutions (pension funds and insurance companies) provide demand for long term “fixed-interest, low credit-risk” bonds

• Collective Investment Funds (e.g., mutual funds) help develop short-term securities market As an investment alternative to bank deposits, CIFs enhance

competition in financial sector CIFs are also a cost-effective way for governments to reach

retail investors

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Pension Institutions Assets % of GDP (Selected Countries- 1997)

0 20 40 60 80 100 120 140

Netherlands

Switzerland

UK

US

Malaysia

Chile

South Africa

Egypt

J apan

J ordan

Sri Lanka

Morocco

Portugal

Tunusia

Brazil

Italy

Germany

Argentina

Spain

Czech Republic

Hungary

Source: Grais, Vittas, 2000

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Institutional Investors Assets % of GDP (Selected Countries- 1997)

0 50 100 150 200 250

Hungary

Argentina

Czech Republic

Tunusia

Sri Lanka

J ordan

Brazil

Morocco

Portugal

Egypt

Italy

Spain

Germany

Chile

J apan

Malaysia

South Africa

US

UK

Switzerland

Netherlands

Source: Grais, Vittas, 2000

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lon

g t

erm

de

bt o

ver

/ to

tal d

ebt

Financial Assets of Contractual Savings / over GDP . 1.482

.958

AUS AUT

BEL

CAN

DNK

FIN

FRA

GRC

HUNG

ISL

ITA

JPN

KOR

NLD

NZL

NOR PRT

SGP SAF

SPN

SWE

SWIT

UK

US

Long-term Government Securities and Contractual Savings Development

Source: Elias, Impavido and Musalem (2001) Note: Data are for 1996.

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Demand: Institutional Investors - II

Minimum return requirements for pension funds discourage long-term investment

Institutional investors may behave as quasi banks --guarantee yields, raise liabilities through deposits, and invest in loans

Limited capacity for proper portfolio management Rules addressing conflict of interest: Chinese walls within

management companies, no front-running by related brokerage entity

Mark-to-market accounting and risk management capacity Adequate disclosure to investors, minimum standards for

prospectus

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Demand: Foreign Investors

• Double-edged sword Contribute to sound development of national market through

positive pressure to improve quality and services of intermediaries, along with emphasis on robust market infrastructure

May make national markets more volatile and vulnerable as they are more sensitive to risk and manage their portfolios actively

• Types of investors and differing emphasis on liquidity Hedge funds place a high premium on liquidity Crossover investors such as pension funds and insurance

companies may have longer holding periods

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Demand: Retail Investors

• They can cushion impact of institutional and foreign sales amidst volatility Special non-tradable instruments are traditionally popular Preferred course is concentrating on efficient mechanism

development for delivering standard securities to retail clients

• IT makes for easier penetration to retail investor U.S. Treasury’s TreasuryDirect has over 800,000 subscribers IT utilization to access broader set of new investors (e-bond

issuance) impacts primary market design and reduces bank dominance in market’s retail end

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Market intermediaries - I

• Market intermediaries are needed to: place bonds with investors provide information to potential investors about key issues

relevant to investment in bonds provide liquidity to secondary markets

• Types of intermediaries include: Securities’ houses Brokers Banks

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Market intermediaries - II

• Market intermediaries should be competitive efficient risk willing (have a strong capital base)

• Common problems: lack of competition illiquid secondary markets conflicts of interest

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Market intermediaries - III

• Common problems (continued): insufficient capital lack of instruments to disburse risk (futures, repo

markets, securities lending) no mark to market valuation of securities little incentive for market insiders to improve conditions

voluntarily lack of human capital (skill and experience in

bondmarket trading and market making)

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Market intermediaries - IV

• Proper entry policy ensures competition and innovation Fit-and-proper tests and certification of those

permitted to enter the brokerage business Foreign entities be permitted to offer brokerage and

other services and to participate in national government securities markets

Use of PD’s as market makers

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Regulation - I

• Objectives of regulation: Ensure fair, efficient and transparent markets Minimize systemic risk Ensure investor protection

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Regulation - II

• Common tools: Ban improper trading practices (e.g. market manipulation

and insider dealing) Use disclosure requirements for issuers Use minimum capital requirements and internal control Establish reliable systems for securities settlement Have disclosure rules for intermediaries and investment

advisors, use “fit and proper” rules and supervision Use Chinese-walls to avoid conflict of interest and market

segmentation

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Regulation- III

• De-regulation release captive investors (avoid market

segmentation) attract demand from international investors allow self-regulation where appropriate

• With regulation the devil is in the detail

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Sequencing: Immediate initiatives - I

• Sequencing depends on country-specific circumstances Important factors: size of economy, sophistication of financial

sector, types of investor

• Priority during nascent stages should be given to strengthen and develop the short-end of market Developing an active money market with market-determined price

setting with the central bank

• Improvement in primary market policies Establishment of auction procedures and schedules, transparency in

government securities operations Standardization of issues (consolidation)

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Sequencing: Immediate initiatives - II

• Unequivocal move away from use of below-market rates through sales to captive investors Legal framework that gives responsible agencies the mandate and

institutional capacity to start the process through a clear borrowing authority

• Fundamental initiatives regarding market infrastructure Focus on simple, secure solutions capable of handling the limited

number of daily transactions expected

• Common pitfalls in market development Inconsistency in government commitment to reform process Attention focused on technical issues

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Sequencing: Medium-term Initiatives - I

• Move from short to long-term instruments requires multiple initiatives Initiate development process of investor base with long-time horizon

(pension and insurance reforms) Develop a Repo market to bridge the gap Encourage efficient market intermediaries, upgrade settlement systems,

and strengthen market regulation

• Unrealistic expectations on long-term bond pricing is a common problem Until credibility is improved, government will have to accept a

premium on its borrowing; higher costs are, however, offset by reduced risk

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Sequencing: Medium-term Initiatives - II

• Build a strong debt management capacity Define optimal trade-off between cost and risk Upgrade human resources and IT

• Examine the use of primary dealers Balance advantages of gaining small group of committed players against

disadvantages of reduced competition

• Further standardization of bonds Make issues fungible further increase the maturity of bonds Create benchmark bonds across the yield curve

• Develop auxiliary markets (swap, Repo and futures)

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Sequencing: Conclusion

• Proper sequencing requires prioritizing between different initiatives and considering their time horizon Take concurrent initiatives with short and long-term effects

(taking into account that some have long gestation periods e.g. pension and insurance reforms)

• Needs assessment early in process is essential Scarce resources available in both public and private sectors

limit sequenced market development Needs assessment helps devise an optimal allocation of the

scarce resources among different options

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Lessons from OECD countries

• “Triggers” in developing a domestic government debt market ITL: 1) a fall in inflation expectations and reduction in

exchange rate volatility (EMU), 2) international investor appetite for longer dated securities.

FR: A strong committed policy maker ready to push change against the short term interest of the financial community.

ES: A political push.

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Lessons from OECD countries

• Liquidity can be achieved in the secondary market if you have: large fungible standardized issues efficient repo-markets committed dealers (market makers)

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Closing remarks - I

• The government is in an unique position to ensure an integrated approach to bond market development addressing the functionality of the entire market from reforms on the demand side over infrastructure to a stable source of supply

• The government also has an important role to play as regulator and supervisor

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Closing remarks - II

• The government can be instrumental in promoting the use of bond markets for investment and issuing thereby mobilizing savings in an efficient way, but to be successful the project requires strong political support

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Thank you !

Questions/comments/suggestions to:

Jeppe Ladekarl

jladekarl@worldbank.org

(202) 473-4718