developing efficient market infrastructure and secondary market of government bonds in developing...
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Developing Efficient Market Developing Efficient Market Infrastructure and Secondary Market of Infrastructure and Secondary Market of
Government BondsGovernment Bondsin Developing Countriesin Developing Countries
Johannesburg, South AfricaJune 19, 2003
Tadashi EndoThe World Bank
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A primary prerequisite for bond market liquidity is a proper set of the demand and supply sides. A well-organized market infrastructure is often secondary.
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Capital Market Profile peculiar to Capital Market Profile peculiar to Developing EconomyDeveloping Economy
Income level is low, and households are predominantly dependent on bank deposits.
Economy is small.
Non-life overweighs life.
Pension funds are small.
Informal economy is sizable.
Market Infrastructure
Informaleconomy
Pension funds
Life
insurance
Individuals
Non-lifeinsurance
Foreign-owned
companies
Government
State-owned enterprises
Local com
panies
Demand Supply Local cos are pr
edominantly dependent on bank loans.
Foreign-owned companies are dominant, and rely less on local financing.
SOEs remain substantial.
Govt crowds out the private sector.
Inefficient market Long-established central bank
vs new-born cap. market regulator
Capital-rich banks vs poorly-capitalized broker/dealers
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Supply- & Demand-side Supply- & Demand-side Principles for Market LiquidityPrinciples for Market Liquidity
Sizable, Regular, Stable (predictable), Transparent and Market-based supply of bonds of High quality, and Uniform characteristics, and,
Supply side
Demandside
Many, Incessant, Competitive, and Diversified demands for the bonds
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Public awareness/consensus about the roles of a government bond market is a key to reduce the direct trading costs of government bonds.
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Why Does Efficiency Matter? (1)Why Does Efficiency Matter? (1)How much does trading affect total returns?How much does trading affect total returns?
Trading in response to an interest rate declineAn interest rate declinesGet the initial investment back and a CAPITAL
GAINReinvest them in a new opportunity for the
remaining maturityHow much do the total returns improve?NOTHING!
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Why Does Efficiency Matter?(2)Why Does Efficiency Matter?(2)How much does trading affect total returns?How much does trading affect total returns?
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
Current coupon bonds
Interest Rate Change
Years to Maturity
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%
Little Impact on Total Returns of 10-yr Bond
Over a yield curve ranging from 3% for 1 year to 8% for 10 years
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Why Does Efficiency Matter?(3)Why Does Efficiency Matter?(3)What is trading for? – Private interestsWhat 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• Rebalancing• Speculation• Arbitrage in an unequilibrium marketin longer-term debt (volatility & trading opportunities)only at low trading costs
Self-interests(Private interests)
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Why Does Efficiency Matter?(4)Why Does Efficiency Matter?(4)What is trading for? – Public InterestsWhat 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
Awareness/Consensus must be formed.
Public interests
WHO SHOULD BEAR THESE COSTS?
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IFC Bond database: Apr 30, 2001 * Indicative quotes
Outstanding
In 2001
US$ mil
Bid/Ask Spreads
Market Impact
Liquidity
PremiumAssumed
cut
Calculated savings
US$ milTightest Median
Czech 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
Why Does Efficiency Matter?(5)Why Does Efficiency Matter?(5)A benefit: how much can you save?A benefit: how much can you save?
3-5 yrs Government Bonds
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Why Does Efficiency Matter?Why Does Efficiency Matter?(6)(6)The basis for efficient primary marketsThe basis for efficient primary markets
Govt Bonds
EfficientPrimaryMarket
LiquidSecondary
Market
Corporate Bonds
EfficientPrimaryMarket
Secondary Market
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.
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Key market infrastructures for market liquidity are a dealers’ market and an expanded repo market.
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Dealers’ Market (OTC) Dealers’ Market (OTC) Continuous readiness to trade
Market making obligations tied to Primary dealership privilege.• Quote-driven (ready to trade)• Inventory & capital• Low cost funding ( Expanded repo market)
Salespeople & interdealer brokers Electronic trading system
• Cost and benefit tradeoff• Transparency and competition• Operational efficiency (linked to STP)
Post-trade reporting
For a market with at least several sizable issues.
Otherwise, may be a call auction market.
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Expanded Repo Market (1)Expanded Repo Market (1)An anchor and catalyst for debt markets
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.
Repo market Short-selling Market making
Must be active.
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Expanded Repo Market (2)Expanded Repo Market (2)An anchor and catalyst for debt markets
-
500
1,000
1,500
2,000
2,500
3,000
1995 1996 1997 1998 1999 2000 2001 2002
Ave
rage
Dai
ly T
urno
ver
(S$
mil)
Repos
Outright purchases & seles
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Electronic Trading System (1)Electronic Trading System (1)Limited roles of an ETS in trading
ETS is not enough to complete a trading action circle.
Effectiveness matters
Efficiency matters
DO
SEEPLAN
Order Execution
Processing/Back Office
Decision FacilitationConsultation
Trading Action Circle Components of Broking
Operational Part
Strategic Part
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Electronic Trading System (2)Electronic Trading System (2)Market and product suitability to an ETS
Screen-broked trading accounts for:• More than 90% of
Yen/US$ forex• More than 40% of US
Treasury bonds• 15-20% of JGBs
Good for mature products/markets
Many emerging markets are here.
Small/modest SpecificComplexImmature
SizableUnspecific
CommoditizedMature
Suitability to E
TS
Growth rates for electronic trading may accelerate.
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Clearing, Settlement & DepositoryClearing, Settlement & Depositoryfor quicker availability of bonds and funds
DVP ( payment system)Rolling settlementBook-entry system “Fail” systemStraight-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 Trading-neutral Accounting & TaxationAccounting & 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 incomesNo preferential treatments against liquidity
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Efficiency & Systemic RisksEfficiency & 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 risksS
ystemic risks
Market efficiency
Efficie
ncy &
risk
trad
eoff
line
Stable
Less stable
Additional measures & costs to contain systemic risks – e.g. Real-Time Gross Settlement (RTGS)
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“Mediocre” investors are an indispensable basis for liquidity. They need brokers for active trading.
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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.
Role of Salespeople or Brokers (1)Role of Salespeople or Brokers (1)Can efficiency alone create liquidity?Can efficiency alone create liquidity?
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Interdealer brokers conduce to trading through:
Price discovery Price improvement
Broker-dealers (market-makers) & their salespeople
Institutional investors: Many “mediocre” investors A few visionary investors
Interdealerbrokers
BrokerDealer
BrokerDealer
BrokerDealer
BrokerDealer
BrokerDealer
BrokerDealer
BrokerDealer
BrokerDealer
Visionary“Mediocre”
Institutional investors
Role of Salespeople or Brokers (2)Role of Salespeople or Brokers (2)Can efficiency alone create liquidity?Can efficiency alone create liquidity?
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“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.
Role of Salespeople or Brokers (3)Role of Salespeople or Brokers (3)Can efficiency alone create liquidity?Can efficiency alone create liquidity?
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Role of Salespeople or Brokers (4)Role of Salespeople or Brokers (4)Can efficiency alone create liquidity?Can efficiency alone create liquidity?
Human intermediaries compete the action circle of trading by facilitating trading decision.
Action Circleof Trading
DO
SEEPLAN
Order Execution
Processing/Back Office
Decision FacilitationConsultation
Components of Broking
Efficiency matters
Effectiveness matters
Salespeople or brokers take care of …..
Liquidity
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"Mediocre" institutional investors are:Price-takers, butNOT price-givers, and,
need:Continuous “price discovery” services, Investment adviceWith human assurance,
for active trading.
Liquidity
Role of Salespeople or Brokers (5)Role of Salespeople or Brokers (5)Can efficiency alone create liquidity?Can efficiency alone create liquidity?
A rich source of
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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.
Which is more valuable for the network owner: an aggregate of personalized information about invent
ors or dealers collected by salespeople or brokers, OR,
investors or dealers’ trading information mechanically gathered through an electronic trading platform ?
Role of Salespeople or Brokers (6)Role of Salespeople or Brokers (6)Can efficiency alone create liquidity?Can efficiency alone create liquidity?
More Valuable!
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Wrap-UpWrap-Up Liquid Market & Secondary Market Infrastructure 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.
.
