Development of domestic bond markets

1
Development ofdomestic bond markets

• Jeppe Ladekarl
• Financial Sector Department
• The World Bank

2
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

3
Overview of the key components
Issuers User of capital
Investors Suppliers of capital
Intermediaries - provides liquidity - access to
investors
Market infrastructure - trading systems -
information systems - brokers - clearing and
settlement - registration
Regulation and supervision. - The Central Bank,-
The Government- Self Regulatory Organizations
4
Source Asian Emerging Bond Markets, Ismail
DALLA, Financial Times, 1997 Data for USA,
Germany and Japan is for 1993.
5
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?

6
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?

7
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

8
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

9
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

10
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?)

11
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?

12
Generic structure of bond markets
Adopted from Tadashi Endo, 2001
13
Composition of domestic debt markets in selected
countries - I
100
80
60
of total
40
20
0
Italy
China
Brazil
Japan
France
Mexico
USA
Germany
Spain
Argentina
U K
South Korea
Public Sector
Financial Institutions
Corporate
Source BIS.
14
Composition of domestic debt markets in selected
countries - II
15
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

16
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?

17
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 inspiration from the The World Bank / IMF
Guidelines
18
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

19
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

20
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 ?

21
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

22
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

23
PDs in selected countries
Source IMF 2002, MAE Operation Paper (OP/02/02)
 
24
The organization of secondary markets - I

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

25
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?

26
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 ?

27
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 !!

28
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

29
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

30
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

31
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

32
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?

33
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

34
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

35
Source Grais, Vittas, 2000
36
Source Grais, Vittas, 2000
37
Long-term Government Securities and Contractual
Savings Development
Source Elias, Impavido and Musalem
(2001) Note Data are for 1996.
38
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

39
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

40
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. Treasurys 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
  markets retail end

41
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

42
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

43
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)

44
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 PDs as market makers

45
Regulation - I

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

46
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

47
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

48
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)

49
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

50
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

51
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)

52
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

53
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.

54
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)

55
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

56
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

57
Thank you !

• Questions/comments/suggestions to
• Jeppe Ladekarl
• jladekarl_at_worldbank.org
• [phone]