1. Development of domestic bond markets Jeppe Ladekarl Financial Sector Department The World Bank

2. FSD 2002 Introduction Key components of equity markets include: Ù demand (investors and intermediaries) Ù Supply (opportunistic and non-opportunistic) Ù infrastructure (settlement, trading, registration) Ù regulation Key characteristics Ù fair, efficient and transparent

3. FSD 2002 Overview of the key components Issuers User of capital Investors Suppliers 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

4. FSD 2002 Source: Asian Emerging Bond Markets, Ismail DALLA, Financial Times, 1997 * Data for USA, Germany and Japan is for 1993.

5. FSD 2002 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: Ù What are the basic pre-requisites for bond market development? Ù How can we progress from inflationary to non-inflationary financing of the deficit? Ù How can we lower our borrowing costs? Ù How can we extend the yield curve?

6. FSD 2002 Common questions Ù How should we organize our debt management? Ù How can we de-link monetary policy and debt management? Ù Should we implement a primary dealer system? Ù Is electronic trading better than OTC? Ù How can we move to continuous trading? Ù How do we become the regional market for fixed income securities?

7. FSD 2002 Basic Prerequisites Continued macroeconomic and financial sector stability Ù Prudent and sustainable fiscal policies Ù Stable monetary environment that contains inflation Ù Credible exchange regime and capital account policies Institutional infrastructure Ù Effective legal, tax and regulatory infrastructure Ù Efficient and secure settlement arrangements Ù Liberalized financial system with competing intermediaries

8. FSD 2002 The transition from inflationary to non-inflationary finance - I Stop the printing press & release captive investors Key challenge: Ù 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) Ù Deal with increased volatility in debt servicing costs

9. FSD 2002 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 Ù Controlling inflation and the fiscal balance Ù Reducing the volatility of exchange and interest rates Ù Increasing the stock of international reserves to cushion the economy

10. FSD 2002 Domestic debt markets - I Getting a liquid domestic debt market usually requires at least one non-opportunistic issuer Ù Central government running a deficit (government) Ù Central government running a surplus (government, central bank, mortgage credit institution, sub-sovereign finance, other?)

11. FSD 2002 Domestic debt markets - II The basis of the market is a regularly issuance of standardized high quality bonds Ù Supplies a yield curve Ù 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. FSD 2002 Minor corporate issues   Gov’t bonds  Major corporate issues “Generic” structure of bond markets Adopted from Tadashi Endo, 2001

13. FSD 2002 Composition of domestic debt markets in selected countries - I % of total 0 20 40 60 80 100 USA Japan Germany Italy France U K Spain Brazil South Korea China Argentina Mexico Public SectorFinancial InstitutionsCorporate Source: BIS.

14. FSD 2002 Composition of domestic debt markets in selected countries - II

15. FSD 2002 Government debt management - I Government debt management is a key element in the development of domestic debt markets Ù Develops a (“risk free”) yield curve Ù Provides standardization and volume Ù 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. FSD 2002 Government debt management - II Common questions: Ù What should our objective function be? Ù How can we lower our borrowing costs? Ù What instruments should we issue? Ù How can we extend the yield curve? Ù How should we organize our debt management? Ù How can we de-link monetary policy and debt management?

17. FSD 2002 Government debt management - II Common questions: Ù What should our objective function be? Ù How can we lower our borrowing costs? Ù What instruments should we issue? Ù How can we extend the yield curve? Ù How should we organize our debt management? Ù How can we de-link monetary policy and debt management? Get inspiration from the The World Bank / IMF Guidelines

18. FSD 2002 Government debt management - III An important part of debt management is risk management Ù Risk must be controlled to avoid macroeconomic vulnerability Ù Transparent risk management lends credibility to the issuer and thereby lowers the funding costs Ù By providing examples of best practice to the market risk management can increase the stability of the financial system in general

19. FSD 2002 Government debt management - IV Sale of government securities at market-determined interest rates is critical for market development Ù Process may be gradual but direction of change must be irreversible Ù 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 Ù Concentration of new issues in limited standard maturities enables their use as benchmarks Ù Spreading few benchmark issues across a range of maturities leads to a “benchmark yield curve”

20. FSD 2002 The organization of primary markets - I Common questions: Ù What is the most efficient way to sell bonds? Ù Should we use multiple and single price auctions? Ù Should we implement a primary dealer system? Ù How can we increase competition in the primary market? Ù Should we have a special sales channel for retail / small order clients ?

21. FSD 2002 The organization of primary markets - II Distribution Options: Ù Auctions Ù Direct sales using “new” technology Ù Private placements/syndication Ù “Tap”-sales Ù Announcing a price and soliciting public subscription over a fixed period Ù Announcing a price and offering sales on tap over an unlimited period altering the price with varying frequency

22. FSD 2002 Organization of primary markets - III The use of Primary dealers (PD) Ù Primary dealer system may facilitate change to an environment of market-based funding Ù PDs may pose the risk of collusion in countries with small financial sectors Ù PD system should not impair distribution of government bonds directly to wholesale or retail investors There are no international standards for PDs

23. FSD 2002 PDs in selected countries Country#Rights/PrivilegesObligations Canada12Exclusive counterpary rights for central bank’s omo’s and borrowing privileges with the central bank To bid in auctions. To make firm two-way quotes To report to the central bank Greece15Exclusive access to primary aucitonsTo bid in auctions. To make two-way quotes Hungary13Exclusive access to primary auctions Consultations with the debt management agency To bid in auctions. To make firm two-way quotes. To report to the debt agency. Korea26Exclusive 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 Zealandnone Sweden7Exclusive 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 Thailand9Exclusive counterparty to central bank omo’sTo make two-way quotes UK17Exclusive 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 USA25Exclusive 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 bank To participate in the Federal Reserve’s omo’s To provide the Fed with market information and analysis Source: IMF 2002, MAE Operation Paper (OP/02/02)

24. FSD 2002 The organization of secondary markets - I Options: Ù Over The Counter (OTC) Ù Exchange traded Ù Alternative Trading Systems (ATS)

25. FSD 2002 The organization of secondary markets - II Common questions: Ù Is electronic trading better than OTC? Ù Should the stock exchange play a role in debt markets? Ù How can we move to continuous trading? Ù Who should participate in the wholesale market? Ù How do we become the regional market for fixed income securities?

26. FSD 2002 Word of warning in secondary market development Ù 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. FSD 2002 Word of warning in secondary market development Ù A quiz : what percentage of the 400,000 corporate issues outstanding in the US market in 1996 traded at least once during that year ? Ù Answer: 4 percent, so get your priorities straight !!

28. FSD 2002 The organization of secondary markets - III Promoting a vibrant secondary market is difficult aspect of market development Ù Active participation required of many different groups: investors, intermediaries, and providers of infrastructure Ù Change in taxation or regulation can produce significant effects First step: building a safe spot trading system Ù In early market development, building the infra-structure to support spot trading practices is key Ù More advanced transactions (e.g, swaps, futures and options) should be pursued subsequently

29. FSD 2002 The organization of secondary markets - IV Market Architecture Ù OTC trading has been the convention in bond markets Ù Inter-dealer broker (IDB) can be crucial for wholesale OTC trading of government bonds Ù Some governments require small orders to be centralized into an exchange to ensure best execution for retail investors Regulatory framework for market transparency Ù Centralized reporting and dissemination system (e.g., the U.S. GovPx) greatly increase market transparency

30. FSD 2002 Developing demand for fixed income products - I Key groups of investors: Ù Banks Ù International investors Ù Institutional investors Ù Retail investors Ù Public (social security) funds A diversified investor base promotes liquidity and stabilizes market demand Ù Heterogeneous investor base (different time horizons, risk preferences and trading motives) ensures active trading

31. FSD 2002 Developing demand for fixed income products - II There are three important elements in stimulating voluntary demand for domestic debt instruments: Ù The macro-economic environment Ù Building a potential investor base Ù Having the right regulation Major obstacles: Ù no demand from institutional investors Ù excessive reliance on banking system as end-investors

32. FSD 2002 Developing demand for fixed income products - III Common questions: Ù How can we develop long term savings? Ù Should we encourage foreign investor to access the market? Ù Should we develop special products for retail investors? Ù What role should the banking sector play in the promotion of debt instruments?

33. FSD 2002 Developing demand for fixed income products - III Measures for developing a broader-based market include: Ù PDs obliged to place securities with end-investors Ù Moving securities out of bank portfolios Ù Direct access to retail and/or foreign investors Ù Structural reform of pension and retirement funds Ù Reform or creation of mutual funds

34. FSD 2002 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 Ù As an investment alternative to bank deposits, CIFs enhance competition in financial sector Ù CIFs are also a cost-effective way for governments to reach retail investors

35. FSD 2002 Source: Grais, Vittas, 2000

36. FSD 2002 Source: Grais, Vittas, 2000

37. FSD 2002 Long-term Government Securities and Contractual Savings Development Source: Elias, Impavido and Musalem (2001) Note: Data are for 1996.

38. FSD 2002 Demand: Institutional Investors - II Ù Minimum return requirements for pension funds discourage long-term investment Ù Institutional investors may behave as quasi banks -- guarantee yields, raise liabilities through deposits, and invest in loans Ù Limited capacity for proper portfolio management Ù Rules addressing conflict of interest: Chinese walls within management companies, no front-running by related brokerage entity Ù Mark-to-market accounting and risk management capacity Ù Adequate disclosure to investors, minimum standards for prospectus

39. FSD 2002 Demand: Foreign Investors Double-edged sword Ù Contribute to sound development of national market through positive pressure to improve quality and services of intermediaries, along with emphasis on robust market infrastructure Ù 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 Ù Hedge funds place a high premium on liquidity Ù Crossover investors such as pension funds and insurance companies may have longer holding periods

40. FSD 2002 Demand: Retail Investors They can cushion impact of institutional and foreign sales amidst volatility Ù Special non-tradable instruments are traditionally popular Ù Preferred course is concentrating on efficient mechanism development for delivering standard securities to retail clients IT makes for easier penetration to retail investor Ù U.S. Treasury’s TreasuryDirect has over 800,000 subscribers Ù 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. FSD 2002 Market intermediaries - I Market intermediaries are needed to: Ù place bonds with investors Ù provide information to potential investors about key issues relevant to investment in bonds Ù provide liquidity to secondary markets Types of intermediaries include: Ù Securities’ houses Ù Brokers Ù Banks

42. FSD 2002 Market intermediaries - II Market intermediaries should be Ù competitive Ù efficient Ù risk willing (have a strong capital base) Common problems: Ù lack of competition Ù illiquid secondary markets Ù conflicts of interest

43. FSD 2002 Market intermediaries - III Common problems (continued): Ù insufficient capital Ù lack of instruments to disburse risk (futures, repo markets, securities lending) Ù no mark to market valuation of securities Ù little incentive for market insiders to improve conditions voluntarily Ù lack of human capital (skill and experience in bondmarket trading and market making)

44. FSD 2002 Market intermediaries - IV Proper entry policy ensures competition and innovation Ù Fit-and-proper tests and certification of those permitted to enter the brokerage business Ù Foreign entities be permitted to offer brokerage and other services and to participate in national government securities markets Ù Use of PD’s as market makers

45. FSD 2002 Regulation - I Objectives of regulation: Ù Ensure fair, efficient and transparent markets Ù Minimize systemic risk Ù Ensure investor protection

46. FSD 2002 Regulation - II Common tools: Ù Ban improper trading practices (e.g. market manipulation and insider dealing) Ù Use disclosure requirements for issuers Ù Use minimum capital requirements and internal control Ù Establish reliable systems for securities settlement Ù Have disclosure rules for intermediaries and investment advisors, use “fit and proper” rules and supervision Ù Use Chinese-walls to avoid conflict of interest and market segmentation

47. FSD 2002 Regulation- III De-regulation Ù release captive investors (avoid market segmentation) Ù attract demand from international investors Ù allow self-regulation where appropriate With regulation the devil is in the detail

48. FSD 2002 Sequencing: Immediate initiatives - I Sequencing depends on country-specific circumstances Ù 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 Ù Developing an active money market with market- determined price setting with the central bank Improvement in primary market policies Ù Establishment of auction procedures and schedules, transparency in government securities operations Ù Standardization of issues (consolidation)

49. FSD 2002 Sequencing: Immediate initiatives - II Unequivocal move away from use of below-market rates through sales to captive investors Ù 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 Ù Focus on simple, secure solutions capable of handling the limited number of daily transactions expected Common pitfalls in market development Ù Inconsistency in government commitment to reform process Ù Attention focused on technical issues

50. FSD 2002 Sequencing: Medium-term Initiatives - I Move from short to long-term instruments requires multiple initiatives Ù Initiate development process of investor base with long-time horizon (pension and insurance reforms) Ù Develop a Repo market to bridge the gap Ù Encourage efficient market intermediaries, upgrade settlement systems, and strengthen market regulation Unrealistic expectations on long-term bond pricing is a common problem Ù Until credibility is improved, government will have to accept a premium on its borrowing; higher costs are, however, offset by reduced risk

51. FSD 2002 Sequencing: Medium-term Initiatives - II Build a strong debt management capacity Ù Define optimal trade-off between cost and risk Ù Upgrade human resources and IT Examine the use of primary dealers Ù Balance advantages of gaining small group of committed players against disadvantages of reduced competition Further standardization of bonds Ù Make issues fungible Ù further increase the maturity of bonds Ù Create benchmark bonds across the yield curve Develop auxiliary markets (swap, Repo and futures)

52. FSD 2002 Sequencing: Conclusion Proper sequencing requires prioritizing between different initiatives and considering their time horizon Ù 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 Ù Scarce resources available in both public and private sectors limit sequenced market development Ù Needs assessment helps devise an optimal allocation of the scarce resources among different options

53. FSD 2002 Lessons from OECD countries “Triggers” in developing a domestic government debt market Ù ITL: 1) a fall in inflation expectations and reduction in exchange rate volatility (EMU), 2) international investor appetite for longer dated securities. Ù FR: A strong committed policy maker ready to push change against the short term interest of the financial community. Ù ES: A political push.

54. FSD 2002 Lessons from OECD countries Liquidity can be achieved in the secondary market if you have: Ù large fungible standardized issues Ù efficient repo-markets Ù committed dealers (market makers)

55. FSD 2002 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. FSD 2002 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. FSD 2002 Thank you ! Questions/comments/suggestions to: Jeppe Ladekarl jladekarl@worldbank.org (202) 473-4718