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 Investors Suppliers of capital Issuers User of capital Intermediaries - provides liquidity - access to investors Regulation and supervision. - The Central Bank,- The Government- Self Regulatory Organizations Market infrastructure - trading systems - information systems - brokers - clearing and settlement - registration

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.  Gov’t bonds Major corporate issues  Major corporate issues  Minor corporate issues “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 Argentina Spain 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. 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

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 PD’s 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