Download Secondary Market Regulations of Government Bonds

Developing Efficient Market
Infrastructure and Secondary Market of
Government Bonds
in Developing Countries
Johannesburg, South Africa
June 19, 2003
Tadashi Endo
The World Bank
A primary prerequisite for
bond market liquidity is a
proper set of the demand
and supply sides. A wellorganized market
infrastructure is often
secondary.
2
Capital Market Profile peculiar to
Developing Economy
Demand
 Non-life
overweighs life.
 Pension funds
are small.
 Informal
economy is
sizable.
Non-life
insurance
Supply
Local companies
 Economy is
small.
Individuals
Life
insurance
 Income level is
low, and
households are
predominantly
dependent on
bank deposits.
Market
Infrastructure
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
 Long-established central bank
vs new-born cap. market
regulator
 Capital-rich banks vs poorlycapitalized broker/dealers
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Government
 Govt crowds
out the private
sector.
Supply- & Demand-side
Principles for Market Liquidity
Supply
side
Demand
side











Sizable,
Regular,
Stable (predictable),
Transparent and
Market-based supply of bonds of
High quality, and
Uniform characteristics, and,
Many,
Incessant,
Competitive, and
Diversified4 demands for the bonds
Public awareness/consensus
about the roles of a
government bond market is a
key to reduce the direct
trading costs of government
bonds.
5
Why Does Efficiency Matter? (1)
How much does trading affect total returns?
Trading in response to an interest rate decline
An interest rate declines
Get the initial investment back and a CAPITAL
GAIN
Reinvest them in a new opportunity for the
remaining maturity
How much do the total returns improve?
NOTHING!
6
Why Does Efficiency Matter?(2)
How much does trading affect total returns?
Current coupon bonds
Little Impact on Total Returns of 10-yr Bond
Interest
Rate
Change
4
5
6
-1.5%
-0.03%
-0.06%
-0.13%
-1.0%
-0.02%
-0.04%
-0.10%
-0.5%
-0.01%
-0.02%
-0.07%
0.0%
0.00%
0.00%
-0.04%
0.5%
0.02%
0.03%
0.00%
1.0%
0.03%
0.05%
0.03%
1.5%
0.04%
0.08%
0.07%
Years to Maturity
Over a yield curve ranging from 3% for 1 year to 8% for
10 years
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 Coupon payments
complicate cash flows
 Decomposable into
discount CFs
 The YTM is the average
YTM of component CFs.
 Reinvestment makes
little difference in total
returns
Why Does Efficiency Matter?(3)
What is trading for? – Private interests
 Trading per se is neutral to total returns, and never
pays for trading costs without additional risk taking.
 Even a capital gain brings you nothing.
 Trading always eats up some yield.
 Nonetheless, people trade for:
• Hedging
Self-interests
• Rebalancing
• Speculation
(Private interests)
• Arbitrage in an unequilibrium market
in longer-term debt (volatility & trading opportunities)
only at low trading costs
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Why Does Efficiency Matter?(4)
What is trading for? – Public Interests
Macroeconomic benefits
 Lower financing costs of
budget deficits
 Risk management facilities
 Financial asset pricing
 Signaling function for
effective monetary policies
 Development of a corporate
bond market
Trading costs
 Brokerage commissions or
bid/ask spreads
 Market impacts
 Fees
 Transaction taxes
 Opportunity costs
• Dealers’ market (OTC)
• Clearing, settlement & depository
• Accounting
Public interests
Awareness/Consensus must be formed.
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Why Does Efficiency Matter?(5)
A benefit: how much can you save?
3-5 yrs Government Bonds
Outstanding
In 2001
Bid/Ask Spreads
US$ mil
Calculated
savings
US$ mil
Tightest Median
Market
Impact
Liquidity
Premium
Assumed
cut
4,200
0.03% 0.09%
?%
?%
0.05%
1.9
Hungary
10,300
0.35% 0.40%
?%
?%
0.20%
20.6
Malaysia*
25,900
0.01% 0.30%
?%
?%
0.15%
38.9
Poland
10,000
0.04% 0.30%
?%
?%
0.15%
15.0
Slovakia*
4,700
0.10% 0.20%
?%
?%
0.10%
4.7
Thailand*
5,900
0.04% 0.06%
?%
?%
0.03%
1.8
Czech
IFC Bond database: Apr 30, 2001
* Indicative quotes
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Why Does Efficiency Matter?(6)
The basis for efficient primary markets
Govt Bonds
Corporate Bonds
Liquid
Secondary Market
Secondary
Market
Efficient
Primary
Market
Efficient
Primary
Market
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 A liquid secondary
market of govt
bonds is the basis
for the efficient
primary markets of
both govt and
corporate bonds.
 A policy weight of
the secondary
market of govt
bonds is large.
Key market infrastructures
for market liquidity are a
dealers’ market and an
expanded repo market.
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Dealers’ Market (OTC) 
Continuous readiness to trade
 Market making obligations tied to Primary
dealership privilege.
 For a market with
at least several
• Quote-driven (ready to trade)
sizable issues.
• Inventory & capital
• Low cost funding ( Expanded repo market)
 Salespeople & interdealer brokers
Otherwise, may
 Electronic trading system
be a call auction
market.
• Cost and benefit tradeoff
• Transparency and competition
• Operational efficiency (linked to STP)
 Post-trade reporting
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Expanded Repo Market (1)
An anchor and catalyst for debt markets
Repo market
 Must be active.
 Short-selling
 Market making
Expended/Open repo market
 Open to non-bank institutions
 Non-bank intermediaries
 Links the open market to the interbank market
( Arbitrage  Will improve banking)
 Japan, South Africa, Singapore, UK, etc.
14
Expanded Repo Market (2)
An anchor and catalyst for debt markets
Average Daily Turnover (S$ mil)
3,000
2,500
2,000
Outright purchases & seles
1,500
1,000
500
Repos
1995
1996
1997
1998
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1999
2000
2001
2002
Electronic Trading System (1)
Limited roles of an ETS in trading
Trading Action Circle
Strategic
Part
DO
Components of Broking
Operational
Part
Order Execution
Processing/
Back Office
PLAN
Decision Facilitation
Consultation
SEE
Efficiency
matters
Effectiveness
matters
ETS is not enough to complete a trading action circle.
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Electronic Trading System (2)
Market and product suitability to an ETS
Suitability to ETS
 Screen-broked trading
accounts for:
Growth rates for
electronic trading
may accelerate.
Small/modest
Specific
Complex
Immature
• More than 90% of
Yen/US$ forex
• More than 40% of US
Treasury bonds
• 15-20% of JGBs
Sizable
Unspecific
Commoditized
Mature
 Good for mature
products/markets
Many emerging
markets are here.
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Clearing, Settlement & Depository
for quicker availability of bonds and funds
DVP ( payment system)
Rolling settlement
Book-entry system
“Fail” system
Straight-through processing (STP)
Linkage with int’l settlement systems
Manually possible, but ……
No efficient government
bond market without a computerized central depository
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Trading-neutral
Accounting & Taxation
Trading-neutral accounting
• Mark-to-market for trading portfolio
• Current coupons
• No submarket issues (market-based issues)
Trading-neutral taxation
• No transaction taxes
• No withholding tax
• No differentiation between interest and capital
gain incomes
No preferential treatments against liquidity
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Efficiency & Systemic Risks
Less stable
Stable
Systemic risks
As the market becomes
more and more efficient, the
whole system may be
getting less stable and more
vulnerable to shocks –
increasing systemic risks
Additional measures &
costs to contain systemic
risks – e.g. Real-Time
Gross Settlement (RTGS)
Market efficiency
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“Mediocre” investors are an
indispensable basis for
liquidity. They need brokers
for active trading.
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Role of Salespeople or Brokers (1)
Can efficiency alone create liquidity?
A market consists of:
A small number of visionary investors, and,
A large number of “mediocre” investors.
“Mediocre” investors are an indispensable
basis for liquidity.
Salespeople or brokers play a critical role in
the psychological and emotional process of
mediocre investors.
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Role of Salespeople or Brokers (2)
Can efficiency alone create liquidity?
Institutional
investors
Broker
Dealer
Broker
Dealer
Interdealer brokers conduce
to trading through:
Broker
Dealer
Broker
Dealer
Interdealer
brokers
Broker
Dealer
 Price discovery
 Price improvement
Broker
Dealer
“Mediocre”
Broker-dealers (marketmakers) & their salespeople
Broker
Dealer
Broker
Dealer
Institutional investors:
 Many “mediocre” investors
 A few visionary investors
Visionary
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Role of Salespeople or Brokers (3)
Can efficiency alone create liquidity?
“Mediocre” institutional investors are laden
with:
Uncertainty,
Accountability,
Decision making anxiety,
Post-decision making anxiety, and,
need:
Confidentiality,
Stress control, and,
Damage acceptability
for their trading decisions.
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Role of Salespeople or Brokers (4)
Can efficiency alone create liquidity?
Action Circle
of Trading
Salespeople or
brokers take
care of …..
Components
of Broking
DO
Order Execution
Processing/
Back Office
PLAN
Decision Facilitation
Consultation
SEE
Human intermediaries compete the
action circle of trading by facilitating
trading decision.
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Efficiency
matters
Effectiveness
matters
Liquidity
Role of Salespeople or Brokers (5)
Can efficiency alone create liquidity?
"Mediocre" institutional investors are:
Price-takers, but
NOT price-givers, and,
need:
Continuous “price discovery” services,
Investment advice
With human assurance,
for active trading.
A rich source of
Liquidity
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Role of Salespeople or Brokers (6)
Can efficiency alone create liquidity?
In many DCs, human intermediation is more
practical and effective in:
 driving the owners of intermediary networks to expand
their business (Internalization of network effects), and
 generating liquidity in secondary markets of
government bonds.
More
Which is more valuable for the network owner: Valuable!
 an aggregate of personalized information about
inventors or dealers collected by salespeople or
brokers, OR,
 investors or dealers’ trading information mechanically
gathered through an electronic trading platform ?
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Wrap-Up
Liquid Market & Secondary Market Infrastructure
 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 direct
trading costs of government bonds.
 Key market infrastructures for market liquidity are a
dealers’ market and an expanded repo market.
 “Mediocre” investors are an indispensable basis for
liquidity. They need brokers for active trading.
.
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Thank You!
Tadashi Endo
[email protected]
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