DEVELOPING A LIQUID GOVERNMENT BOND MARKET

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1 2010 DEVELOPING A LIQUID GOVERNMENT BOND MARKET Sound Practices to Facilitate the Development of a liquid Domestic Bond Markets A mature and liquid debt market can improve resource allocation by effectively channeling both local and foreign savings into domestic investments and can diversify the investment channels for both retail and institutional investors. Greater diversification of financing and investment channels is beneficial to the stability of financial markets. In the MEFMI region, tremendous efforts have been made to develop liquid debt markets. In order to achieve a high level of liquidity and maturity in the debt markets in the region, there is need for member countries to put in place sound practices in the following areas Government Policies, Regulatory Framework, Market Infrastructure, Liquidity and Risk Management. Lazarus Kamanga Bank of Zambia 5/20/2010

2 1.0 Introduction A stable macroeconomic environment particularly a credible monetary policy along with supporting fiscal management and financial system stability have found to be the prerequisites for the development of the bond market. Similarly, the bond market development contributes to enhance the efficiency of monetary management and financial system stability 1. A developed bond market also plays an important role in improving the efficiency of overall economic management through expanding the range of opportunities of available to financing large scale projects, contributing to better allocation of capital, providing a non-inflationary source of finance for government and facilitating public debt management, and contributing to promote sustainable economic growth. Therefore, it is important that concerted efforts are taken to develop a deep and liquid bond market. A mature and liquid debt market can improve resource allocation by effectively channelling both local and foreign savings into domestic investments and can diversify the investment channels for both retail and institutional investors. Greater diversification of financing and investment channels is beneficial to the stability of financial markets. In the Macroeconomic and Financial Management Institute of Eastern and Southern Africa (MEFMI) region, tremendous efforts have been made to develop the debt markets. In as much as progress has been made more is needed to take the debt market to maturity and higher liquidity. Jamshed (2006) Active bond markets facilitate corporations and financial institutions in balancing the currency and maturity structure of the assets and liabilities, thus promoting financial stability. Financial markets also facilitate capital restructuring to ease financial distress. The financing flexibility provided by deep, broad and active bond markets reduces vulnerabilities not only for the corporate sector but also for the economy through its internal and external linkages. On the demand side the institutional investors can tap into the local corporate bond markets for investing in fixed-income securities which provide longer maturities and improved yields over public agency and treasury securities. The bond markets provide opportunities for contractual financial institution, pension 1 Ananda Silva, Bond Market Development: Monetary and Financial System Stability, P age

3 funds and life insurance companies in particular, for investments with longer maturities that match maturities of their liabilities, and thus help to strengthen balance sheets. A deep and liquid corporate bond market may also help to absorb growing demand for long-term securities from institutional investors which otherwise may be directed towards real estate or stock markets and result in asset inflation with consequent potential instability. Governments have continued to improve their financial management by financing the budget deficit through the issuance of securities at market based interests through treasury bills and bonds. This is as opposed to central bank providing the funds in a situation of revenues shortfalls. It is expected that the development of the bond market will help the developing economies in the MEFMI region wither some of the problems other emerging economies have faced, such as the financial crisis of Asia in The primary markets for the Government bonds are operating effectively since the introduction of auctions. Most bond markets continue to be fragmented, with several small bonds issued across the maturity horizon. The fragmentation of the Government bond markets makes secondary market trading limited as the amounts outstanding are small causing the illiquidity of such bonds. In some markets such as the Zambian bond market, there is need for further reforms to bring about the much needed liquidity in the secondary markets. These reforms may also be replicated in other countries within the region. Primary markets Efficient primary markets for government securities should be characterised by the following best practices: issuing strategy based on regular auctions; the issuance of benchmarks; abolition of privileged access by governments; a transparent debt management framework; a primary dealer framework with the capacity to develop markets. Secondary Markets Efficient secondary government securities markets should be characterised by the following features: liquid markets with a large stock of outstanding benchmark issues and repo market financing; 3 P age

4 safe and sound clearing and settlement systems; transparent and equitable regulatory and supervisory framework; a market-making structure based on primary dealers; liquid futures markets; good access by foreign investors to domestic debt markets. The areas that require further reforms are Government debt management policies, regulatory framework, policies on the development market infrastructure, policies to further promote liquidity of the bond markets and the general risk management by issuers, the Government and the investors. This paper is organised as follows; section two will look at the various policies the governments needs to put in place to develop the bond markets, section three will look at the regulatory framework that will help the development of the bond market, section four will look at the market infrastructure to ensure the bond market thrives, section five will look at policies that would promote market liquidity, section six will look at the risk management issues for both issuers and investors and the final section will be the conclusion. 2.0 Challenges to developing bond markets in the MEFMI region The African Financial Markets Initiative study found that bond markets in most African countries are characterized by fragmented markets, illiquidity and general dissatisfaction with the primary dealer system. There is a fragmentation of the market as evident by an excessive number of bonds issued with no benchmark bonds and insufficient liquidity in each of the issues. In addition, there is a general dissatisfaction with the Primary Dealer (PD) system among the regulators who argue that the PDs do not effectively discharge their market-marking functions while the dealers are concerned about the insufficient incentives. Also, there is a lack of issuance programs which impedes potential investors (and PDs) from anticipating the future supply of securities 2. Bond markets in the MEFMI region are still small and in their infancy. Although a number of policy initiatives have been put in place by the various governments through their respective central banks, there is still a long way 2 Mapping of Current Ongoing Initiatives related to Bond Market Development in African, The African Financial Markets Initiative (AFMI), African Development Bank 4 P age

5 to have liquid bond markets in the region. Most of the challenges can be attributed to (i) government policy, (ii) supply and demand, (iii) market infrastructure, (iv) regulatory framework, (v) lack of benchmarks issues and (vi) issues to do with risk management by both issuer and investors. In order to respond to all these challenges, the governments in collaboration with the central banks will need to continue to reform the financial sector in general and develop the bond market. 3.0 Government Policies The Government is a key actor and can play various roles as an issuer, regulator, facilitator, promoter and catalyst in the early stage of bond market development. In fact, the government bond market is very often expected to be the foundation for the broader domestic bond market. In order for the Government bond market to flourish in the developing economies, the Government should continue to undertake reforms that support the development of the markets. To manage the potential tension between policy objectives which could in turn disrupt the stability of financial markets, it is important that the government defines and prioritises policy objectives regarding debt management and bond market development and identifies the constraints in achieving the set objectives. The following are some of the areas that the Government should ensure are in place in order to encourage the development of the bond market; 3.1 Sound Legal framework The fundamental parts of the legal framework supporting an efficient domestic government securities market usually include an explicit empowerment of the government to borrow, budgetary rules for the issuance of government securities, rules for the organization of the primary market, role of central bank as agent for the government, the debtmanagement framework, rules governing issuance of government securities, and rules pertaining to the secondary market. 3 Reforms in the legal frameworks are needed to ensure that the law is clear on the borrowing powers of the government through the issuance of debt instruments. In order to develop the bond market, the government should ensure that there is sound legal framework that will govern its role and practices as regards its issuance programme of bonds in the market. The 3 Legal and regulatory framework for developing government bond markets suggested issues for discussion, Hans Blommestein, P age

6 legal framework should clearly stipulate that the government is allowed to borrow funds from the market. In addition, the legal framework should clearly stipulate the different roles of the various institutions involved in the borrowing programme. 3.2 Sovereign debt and bond market development policies Balancing sovereign debt and bond market development policies can be a challenge to debt managers. In most cases debt managers may need to borrow at the lowest possible cost. This low cost may be at lower interest rates than market clearing interest rates. This might discourage would be investors if the real interest rates on these bonds are very negative. The government should ensure that there is balance between the sovereign debt policy and its quest to develop the domestic bond market. The government should define its debt management objectives clearly and prioritise these objectives. The objectives for sovereign debt management should be clearly defined and publicly disclosed, and the measures of cost and risk that are adopted should be explained. In Some jurisdictions, debt managers do also publicly disclose their portfolio benchmarks for cost and risk. Such disclosures enhance the credibility of the debt management program and helps achieve debt management goals. Complementary objectives, such as domestic financial market development, should also be publicly disclosed. Their relationship with the primary objective should be clearly explained. 3.3 Comprehensive bond market development strategy The government in consultation with the monetary authority, that is the central bank, should develop a comprehensive bond market development strategy. The comprehensive programme should always address the conflicting roles the government plays in the market, that is, of the issuer, regulator and the macroeconomic policies. The government should commit itself to developing the market not necessarily for its own cause but to enable the private sector have access to capital. This mean government s commitment should be shown through their continued presence in the market. The government should ensure that the market has enough amounts of bonds to facilitate market development in the long term. The government may at times be under pressure to reduce budget deficit, this would mean a reduction in the amount of funds to borrow through the 6 P age

7 issuance of bonds. It will be expected that even in times of budget surplus, the government should continue to supply enough securities to ensure the smooth operation of the bond market. This will ensure that the market continues to price such securities in an efficient manner for the benefit of all players in the market. 3.4 Tax policy Taxation policies in a number of our countries have different effects on the development of the debt securities market. Taxation in the financial markets should be fair in order to avoid distortion differential tax rates can have on the investors. The government should ensure that the tax policy is as fair as possible. The tax should apply on both financial instruments and participants. The government should avoid applying different tax rates on the various financial instruments as well as on the participants. Tax legislation should as fair as possible on instruments and participants. In certain markets, foreign investors may pay a lower rate than domestic investors. This will tend to discourage local investors as the tax policy is distortional and affects the development of the bond market. Any bonds or types of transactions which are disadvantaged in terms of tax are often hardly used by some investors. Distortions mean favouring some instruments, services or industry segments over others. This also means existence of loopholes in the tax system, making tax collection inefficient and ineffective. In a number of the countries, there is withholding tax on income on bonds and treasury bills. There are some different tax rates charged to domestic investors and foreign investors. In some jurisdictions, only the coupon interest is taxed while in other both the coupon interest and capital gains are taxed. This tends to disadvantage some investors in the same markets. In such a case the government should revisit such laws to ensure that all investors are taxed at the same rates to avoid the distortions. 3.5 Consistency between debt, fiscal and monetary policies Debt management, fiscal and monetary policies can pose some conflicts as they are implemented. Debt managers would like to issue the debt securities at the list cost possible at time below market clearing prices. At the same time the fiscal policy would be for the reduction in domestic borrowing in favour of foreign borrowings. Monetary authority would like to 7 P age

8 control the growth of money supply by increasing the key policy rates which impacts other rates in the market. All the three policies are for achieving specific policy objectives. In case where the three policy areas are in conflict with each other, it is important that three arms of government harmonise their policy objectives to ensure each player contributes to the bond market developments. Government decisions about their own borrowing have a major impact on the development of the local debt markets. The local debt markets will not develop if the government rely on short term debt or, when they borrow long term, foreign currency denominated borrowing. Normally, government investments are long term hence, it is imprudent for the government to finance such investments with short term borrowings. Government should commit itself to developing local debt markets through the issuance of long term debt instruments. Policymakers should understand the ways in which the different policy instruments operate their potential to reinforce one another, and how policy tensions can arise. Prudent debt management, fiscal and monetary policies can reinforce one another in helping to lower the risk premia in the structure of long-term interest rates. 4 The main objective of public debt management is to ensure that the government's financing needs and its payment obligations are met at the lowest possible cost over the medium to long run, consistent with a prudent degree of risk. Government being large issuer of debt instruments will normally crowd out the private sector through its impact on the available capital and interest rates. On interest rate, the may rise fast and the central bank will normally welcome the development, but the sharp increase in interest rates may be unwelcome from a fiscal perspective. Since monetary operations are often conducted using government debt instruments and markets, the choice of monetary instruments and operating procedures can have an impact on the functioning of government debt markets, and potentially on the financial condition of dealers in these markets. By the same token, the efficient conduct of monetary policy requires a solid understanding of the government's short- and longer-term financial flows. The monetary authority should maintain its independence in 4 Guidelines for Public debt management, IMF and World Bank P age

9 implementing monetary policy. The government should accept to be a price taker, which is accepting the interest rates set by the market at the same time continuing to fund its requirements in the financial markets. In addition, Debt management, fiscal, and monetary authorities should share information on the government's current and future liquidity needs. It is through this sharing of information that the conflicts between the three organs on debt management can easily be resolved. 3.6 Phasing of the bond market development Governments should normally have a phased approach to the development of the domestic bond market through, for instance, consensus building, primary market development, secondary market development for government securities, and corporate bond market development. In most of the countries in the region, consensus building and primary market development have been implemented effectively. The main challenge remaining is the development of the secondary and corporate bond markets. In order to take the market development agenda further is the programme to develop the secondary market. The main aim is to improve market liquidity. The government and other key stakeholders should put in place a work programme to cover the three main areas. Firstly, the market infrastructure should be enhanced, that will include the legal and regulatory framework, the clearing and settlement systems, the market for repurchase agreements, and bond lending arrangements as appropriate. The legal and regulatory framework should provide for the protection of both issuers and investors. Secondly, a comprehensive study should be conducted to identify and then commence the process of mitigating the adverse effects of legal, regulatory, accounting and tax impediments to investment in and trading of bonds. In a number of countries, there are in place a number of these impediments to investing and trading in bonds. Addressing these impediments is key to the development of the bond market. Thirdly, the bond market information dissemination mechanism should be enhanced to facilitate trading and protect investors' interests, and the role of intermediaries such as market makers and inter-dealer brokers should be enhanced with the objective of improving the depth and liquidity of the market. The development or establishment of a bond or interest futures 9 P age

10 market should also considered once the cash market has attained an adequate level of development. The final phase is the development of the corporate bond market. The size and growth of corporate bond markets ultimately hinge upon the financing patterns of companies. Corporations in most developing economies tend to rely heavily on a combination of internal earnings and bank debt to finance their fixed investments. A corporate bond market is generally expected to play the following roles: 5 diffusing stresses on the banking sector by diversifying credit risks across the economy; supplying long-term funds for long-term investment needs; supplying long-term investment products for long-term investors; lowering funding costs by avoiding a liquidity premium; providing products with flexibility to meet the specific needs of investors and borrowers; and allocating capital more efficiently. 4.0 Regulatory Framework The legal and regulatory framework for the development of the bond markets should ensure that there are clear objectives, themes, structure and laws. The regulations should be enforced to ensure fair play by all participants in the bond market. The structure should be clear; the central bank should be responsible for the regulation of the Government bond market while the Securities Commission should be responsible for the regulation of the corporate bond market. In addition, the regulation and supervision of bond markets, intermediaries, institutional investors and other market participants must include systems and procedures to protect investors, to promote sound business practices, and to address systemic risk issues. There are strong theoretical arguments and empirical evidence that link financial sector development to economic growth, though some researchers argue that the development of financial systems simply reflects economic development. The financial system contributes to economic development by reducing costs associated with acquiring information, enforcing contracts, and conducting transactions. Besides, financial systems mitigate problems of 5 THE DEVELOPMENT OF CORPORATE DEBT MARKETS, Tadashi Endo, International Finance Corporation, The World Bank Group 10 P age

11 free rider, moral hazard, and adverse selection by producing information on investment returns, thus facilitate a more efficient allocation of resources. By providing diversification and risk-sharing opportunities the financial systems also help in mobilizing saving and efficient intermediation of financial resources. Hence, the need for proper regulation of all the players in the financial market that will ensure fairness and efficiency. An effective regulatory and supervision framework for a bond market, intermediaries, institutional investors and other market participants should provide for adequate investor protection and sound business practices or codes of conduct that reduce systemic risks to the minimum. This requires clearly defined market rules, a high degree of transparency as well as high prudential standards and governance principles that recognise the importance of fiduciary obligations. There should be a combination of internal and external checks and surveillance to monitor compliance with the regulatory framework. The Government should ensure clarity in the roles, responsibilities, and objectives of the regulatory authorities. It is essential for maintaining transparency and public confidence in the regulatory framework. Sometimes, effective regulation is complicated by the vast array of financial instruments, diversity of bank and non-bank participants in the bond market and the existence of financial conglomerates engaging in a wide range of investment activities. Clear legal definitions and enhanced co-operation and coordination between different regulatory authorities, including self regulatory organisations, is therefore essential to avoid regulatory gaps and duplications. In general, regulatory authorities should strive to avoid impeding market innovation through their regulatory measures. 4.1 Disclosure of Information The Government should ensure that there is an environment that allows quick and accurate disclosure of material information to the public. This should involve a combination of tools such as on-site inspections, off-site surveillance, internal and external audit along with a strong code of conduct and high fiduciary standards are needed to ensure the adequacy of safeguards for the protection of investors. High and internationally accepted accounting standards should be adopted in the market. This will ensure that investors make informed decisions as they decide to invest in the securities market as well as them being protected. 11 P age

12 The government should ensure that there is differentiation between public offerings and private placement of securities. In a situation where the borrower would like to use the private placement to raise capital, the disclosure requirement could be less stringent than for public offerings. As it is assumed that in a private placement, this will be done with sophisticated investors. It should be made clear that private placements should be done with investors that understand the investment environment and should not be made to unsophisticated individual investors. 4.2 Good Corporate Governance The regulatory regime should promote good corporate governance in the institutions involved in the bond market. This is particularly important in the regulation of institutional and contractual savings investors. Institutional investors such as pension funds and insurance companies play an important role in the development of the capital markets but they may not develop if they are not well regulated and have confidence in the soundness of the financial sector. In order to make these institutional investors play their role in the financial system, they may best be regulated by the application of high prudential standards and governance principles that recognise the importance of fiduciary obligations. 4.3 Roles of the different regulatory authorities In the financial system, there are a number of players, such as banks and nonbank institutions. It is important in defining roles, responsibilities, and objectives of the different relevant regulatory authorities for a wellorganised market. In order to minimise overlap and conflict relating to financial conglomerates that engage in banking, securities, and other financial services as well as serving in the capacity of dealer or broker in debt instruments, it is a requirement in defining respective roles and responsibilities of the different regulatory institutions. In order to avoid the overlaps, the laws governing the securities industry should clearly differentiate the roles of the different regulatory authorities. Central banks are well placed to regulate, the money and government securities markets, the Securities and Exchange Commission regulating other capital markets instruments, the Pension and Insurance regulator in regulating the activities of the pension funds and insurance companies. Central banks should therefore enter into memorandum of understanding with other regulatory institutions to ensure that there is sharing of 12 P age

13 information on the activities of the different units of the financial conglomerates to ensure financial stability and integrity. 4.4 Promotion of Transparency Every regulatory system should promote transparency in the operation of the financial system in general and the bond market in particular. Transparency should be promoted on both primary and secondary markets of the bond market. Regulation should promote transparency in trading and price reporting and to deter manipulation and unfair trading practices. In the primary market, transparency should start with the requirement of issuance of a prospectus that will stipulate all the conditions of the issue. This information should at the most minimum be made public to all prospective investors at the same time or through a media that is easily accessed by all. This will enable those that would like to trade on-the-run bonds to do so. When the results of the auction are out, again the regulations should ensure that all the necessary information is made available to all those that participated at the same time. Secondly, the primary market auction design is an important consideration in mitigating non-competitive behaviour at primary bond market. The key aspects of auctions design in achieving this objective include: (a) the scope of private sector participation, (b) the role of competitive versus noncompetitive bids (c) central bank participation (d) the price determination and allocation mechanism for competitive bids; and (e) the transparency of the auction. 6 In the secondary market, transparency is promoted through price reporting and trading activity as it aids in the valuation of securities. It contributes to pricing efficiency and thereby aids in establishing a market-based yield curve. It is important that all participants in the secondary market provide the necessary information to the regulator in order to promote market efficiency as the information is made available to all participants on the closing prices and traded volumes. In a case where debt instruments are listed on the stock exchange or any trading arrangements, the government should ensure that listing and 6 Teo Swee Lian, Debt Market Development in Singapore, BIS paper Number P age

14 delisting rules are in place. These standards or rules should be adhered to ensure no investor is disadvantaged with any delisting action. In promoting transparency as regards the participants in the bond market, it is important that all intermediaries should be registered, regulated and supervised by an appropriate regulatory authority and uniform standards applied to all market intermediaries. It is important to prevent regulatory arbitrage between markets. This requires adequate procedures for monitoring compliance and enforcement of applicable rules and regulations. 4.5 Treatment of different financial instruments Laws in every jurisdiction should clearly distinguish the different financial instruments in a particular market. It is therefore important the laws and regulations have clear definitions of the different financial instruments. The different instruments have different implications on the balance sheets of the different participants. Laws and regulations should make a clear distinction between bank deposit, deposit substitute, money market instrument, and longer term fixed-income securities issued in the form of notes or bonds. This is important in the context of allocating regulatory responsibilities, the tax treatment of the different financial instruments. The legal definition of debt securities should normally cover notes and bonds with maturities of over one year. From the participants point of view, commercial banks tend to play a larger role in the money market and government securities markets while investment banks, merchant banks, and securities firms more often serve as intermediaries in the capital market for private debt and equity securities. 5.0 Market Infrastructure Robust market infrastructure is indispensable for the smooth functioning of a debt market. Market infrastructure should cover such issues as the players, instruments, trading systems and settlement systems. These systems should enable the smooth functioning of the bond market. These systems should be governed by clear and unambiguous rules and procedures that are soundly enforced and made freely available to interested parties. Such information would enable market participants to understand clearly their roles, responsibilities and liabilities. It also allows market participants to form clear 14 P age

15 expectations about the operation of the systems in times of stress and the financial risks involved. The market infrastructure is also still being improved but there are substantial improvements to be made. Most countries adopted the auction systems for selling bonds to the public in the primary market. What is not clear are the rules and guidelines in the secondary market trading, clearing and settlement of the bonds. Most issues are not rated by renowned rating agencies as the sovereign themselves are not rated. 5.1 Clear rules and procedure governing market infrastructure The rules governing the market for bonds have to be as clear as possible to all the players. All the players must understand their roles and responsibilities as they trade in the bond market. The rules should provide the participants with the confidence that once they enter into a transaction, they will execute it at a fair price and in an efficient manner. It is important to have clear primary and secondary rules in the bond market for all participants to adhere to. Further, the rules should enable participants to clearly understand all the financial and other risks as they transact with others in the bond market. The rules should as much as possible be made public to all participants and potential participants. 5.2 Legal enforceability Rules by themselves are not enough without being enforced in courts of laws. A system which is not legally robust could endanger its participants by giving them a false sense of security, for example, by leading them to underestimate their exposures. A well-founded legal basis is achievable only if the relevant legal environment permits such enforceability and predictability of the rules. The authorities must ensure that the rules being put in place to govern the bond market are enforceable. There are some specific aspects of payments systems which need special attention in determining whether the legal basis is well founded. These include the legal enforceability of any provisions relating to: a. the irrevocability of payments; b. finality of settlement; c. taking of securities as collateral for providing credit; d. the netting of obligations between participants; and 15 P age

16 e. the allocation of liabilities among participants, e.g. as part of a losssharing arrangement. It is important that a payment system law is put in place so that these aspects above are clearly articulated in the law. The legal enforceability of the system's rules and procedures in all relevant jurisdictions should be established. 5.3 Effective regulation In addition to the rules of the game in the bond market, the regulatory system should be robust. The regulatory system will ensure an oversight on the system participants and the system itself. This oversight function may vary from economy to economy in both scope and procedure. Some economies have a statute-based system of oversight with specific tasks, responsibilities and powers assigned to the central bank and/or to other agencies while others are dependant on custom and tradition of doing things. The regulatory environment should meet the current needs of the market effectively and is capable of accommodating foreseeable changes in these needs. 6.0 Liquidity Although the aggregate volumes of bonds issued by governments in the MEFMI region has grown significantly, liquidity of these bond markets remain the main challenge. Turner (2003) stipulates that Illiquidity in government bonds market is in part a function of the size of the market and other factors. Taxation is one such policy that may discourage liquidity in nascent bond markets in most developing economies. Bond market liquidity facilitates efficient market pricing as well as economically efficient borrowing and investment decisions. Certain key elements would assist in enhancing the liquidity of domestic bond markets. A government can promote the development and maintenance of an efficient secondary market for its securities by removing both taxation and regulatory impediments that hinder investors' willingness to trade securities. These include removing possible regulations that provide captive funding from financial intermediaries to the government at low interest rates, and modifying tax policies that distort investment in and trading of financial and non-financial assets. In addition, government approaches to regulating financial markets and market participants often include a wide range of disclosure and supervision requirements to reduce the risk of fraud, and limit 16 P age

17 the risk that market participants may adopt imprudent asset and liability management practices that could increase the risk of insolvency and systemic failure in the financial system. 7 Illiquidity in government bond markets is in part a function of size of the market. Liquidity in the secondary market can be affected by size, heterogeneity of instruments, fragmentation and lock-in effects. In most countries liquid secondary markets are based on the following cornerstones: (i) concentrating issuance in critical tenors; (ii) well-functioning repo markets and ability to short issues; (iii) plain vanilla derivatives markets; (iv) facilitating investor demand and price discovery; and (v) supporting a network of primary dealers8. In most developing markets, the secondary markets are very illiquid. The sizes of issues are small to generate enough liquidity. The issues are so fragmented in small outstanding amounts and there is the absence of the repurchase agreement (repo) markets. In order to promote secondary market liquidity, the authorities should put in place measures that will deal with the identified shortcomings. The authority should implement the policy of auction reopening to deal with the problem of fragmentation. This policy will concentrate issuance in the critical tenors as may be agreed upon with the market stakeholders. Auction reopening enhance liquidity of the bonds by increasing the size of each issue. Further, the authority should consider the standardisation of the pricing of government bonds. 6.1 Market based interest rates The Government should ensure that they issue the debt instruments on market based principles. The government should be committed to issue its debt instruments at market determined interest rates. This will help create a risk-free yield curve. The creation of such a curve will enable all corporate institutions to issue their own instruments that are typically priced at a premium to the risk-free yield curve. Once the risk-free yield curve has been established, institutional investors may then price corporate debt at a premium to the curve. And as the 7 Guidelines on Debt Management, IMF and World Bank 8 Secondary Market Liquidity in Domestic Debt Markets, Tenth Annual OECD World Bank IMF Global Bond Market Forum 17 P age

18 corporate market grows, a corporate credit curve that is able to provide additional pricing information to both issuers and investors will develop. The sovereigns will need to support the creation of a yield curve by issuing securities of appropriate maturity. This will be vital to the success of the bond market, and should occur regardless of whether or not sovereigns need to issue for funding purposes. 6.2 Repurchase agreements market In a number of the MEFMI countries have introduced Repurchase agreement markets (Repos) to implement monetary policy. This was indirectly expected to help the development of liquidity in the debt markets. The authority should also promote the use of the repurchase agreements (repo) market to enhance market liquidity in the bond market. "Repo" is short for "sale and repurchase agreement", where one party agrees to sell bonds or other financial instruments to another party, with an agreement to repurchase equivalent securities in the future, under a formal legal agreement. It is widely used in financial markets as an alternative to collateralised lending as it can fulfil the same economic function while offering greater flexibility and better security. Repo is increasingly being used by central banks in their own monetary operations, and can also be important in the development of liquid financial markets in emerging economies. 9 The use of repos does enhance liquidity in the government securities market. The authorities should ensure that they put in place legal documents that should govern these transactions. It is important that countries adopt the Global Master Repurchase Agreement (GMRA) as the legal document for the conduct of all repo transactions. The central banks should also use the repo in their implementation of monetary policy through the open market operations. The central bank s involvement in the initial stages would provide the necessary confidence to other participants in the use of such transactions. 6.3 Benchmark bonds In most countries within the MEFMI region, bond markets are highly fragmented. There are numerous government bonds outstanding into large 9 Simon Gray, Repo of Government Securities, Handbooks in Central Banking Number 16, Bank of England P age

19 distinct issues that hinder the promotion of liquidity. This is as a result of the debt managers going to the markets on different times of the year with different bonds with different maturity dates in small amounts. A key feature of liquid bond markets is a benchmark yield curve that is comprised of the yields on several standardised bond issues. Standardised bond issues that are simply structured are more easily understood by market participants and can be more readily priced. Each benchmark maturity should have a volume of bonds on issue that is sufficiently large relative to the market's total size and the market's average transaction size. The government can build these benchmark bonds by reopening maturities after initial issuance and therefore have less market fragmentation. Regular issuance into benchmark bond maturities along the entire yield curve also assists the price discovery process, which facilitates the pricing of bond market transactions and creation of liquidity. 6.4 Primary dealer system A primary dealer system normally gives a small number of well specialised dealers an exclusive or preferential right to participate in primary market issuance. In order to promote liquidity, countries should consider the introduction of a primary dealer system. Even though it has been argued that primary dealer system may not work very well in developing countries. Liquidity is facilitated if there are active market-makers who will undertake to make, on demand and in any trading conditions, continuous and effective two-way prices. This market-making is the core purpose of a system of primary dealers 10. The authorities should ensure they put in place fair selection criteria that should include; (a) Sound financial capacity All institutions that would like to act as primary dealers should have enough capital to enable the institution carry out its responsibilities as a primary dealer. The institutions should put aside capital that it will employ dedicated to the government securities market and stated to be not available to support any other business. 10 Robin McConnachie, Primary dealers in Government securities Markets, Handbooks in Central Banking Number 6, Bank of England P age

20 (b) Adequate management capacity Authorities must insist on these institutions vying to be primary dealers to have a strong management team, competent trading personnel and an efficient back-office operation. This requirement will ensure that there is professionalism in the trading of government securities. (c) Market activity The institution applying to be a primary dealer should show evidence of its activities in the market. Past participation in auctions and volumes of trades it has been able to conduct in both the primary and secondary markets. (d) Relations with authorities The central bank or any supervisory authority should put in place a mechanism through which all the primary dealers should provide adequate information on their activities to the authorities. This information is vital in order for the authority to gauge the actual size of the market, prices and volumes being traded in the secondary market. In addition to the selection criteria, the authorities should clearly stipulate the obligations and privileges of the primary dealers. The main ones are as follows: (a) Supporting the auctions Primary dealers should be required by the authorities to submit bids at auctions in order to ensure the placement of government securities. It is important to set a minimum threshold to ensure participation by primary dealers in the government securities market. (b) Market-making The primary dealers should be obliged to guarantee liquidity in the government securities market. (c) Retail market Primary dealers should show evidence of their commitment in the development of the retail market, particularly for individual investors. Privileges In return to the obligations, the authorities should also grant specific privileges to the primary dealers such as exclusive right to auctions, having access to central bank liquidity in times of need. 20 P age

21 6.5 Short selling and securities lending operations The authority should also consider the introduction of short selling of securities to promote liquidity in the bond market. Short selling allows for sophisticated trading strategies that might include arbitrage and hedging. This process contributes to the efficient price discovery in the bond market. Authorities should only allow short selling if the market players have put in place risk management frameworks. Securities lending facilities have had a positive liquidity impact on government bond market. In order to support the short selling, the central bank will need to have some stock of the bonds for the participant s to borrow in order to settle. In this case, the central banks will play an important role of lender of securities to ensure that participants are able to settle their trades. 7.0 Risk Management. Effective risk management by both the issuers and investors is important in fostering the development of domestic bond markets. This is particularly so for the government as the key issuer in the bond market. Risk management by all issuers of bonds that is government and private sector is very important as the clear understanding of all the risk will reduce the vulnerability to shocks in the market. The first step in putting in place a risk management framework by an issuer is to conduct risk audit. This is the process of identifying all the risks an issuer faces as they issue the securities in the market. This will then allow the issuer to put in place a risk management framework. The framework should provide all details on the risks identified how the issuer will measure such risk and manage it. Government as an issuer should undertake the risk audit by analysing all risks on all its instruments. The following are some of the areas that government should look at to identify the various risks; risks related to foreign borrowing, Exchange rate risks, interest rate risk, country-specific shifts in market sentiment (liquidity risk); global business cycle shocks; risk emanating from the foreign holders of the local debt financial market dislocations; and 21 P age

22 the governments should analyse the risks originating from guarantees for regional or local governments or public sector companies. In addition to the process of identifying factors that can increase government s exposure in its debt issuance programme the following risks should also be clearly identified and analysed; Market risk; the risk that is associated to changes in market prices such as interest rate, exchange rate and commodity prices on the cost of government debt service. Rollover risk; the risk that the debt may be rolled over at higher interest rates Liquidity risk; the penalty investors face when they try to exit the government securities market. The issuer also faces this risk when the volume of liquid assets can diminish quickly in the face of unanticipated cash flow obligations or the difficulty the borrower will face to raise funds in a short period of time. Credit risk; non-performance by the borrower or counterparty on a financial contracts. Settlement risk; the possibility that the buyers of government securities fail to pay the seller. Operational risk; this refers to the loss the government or an issuer could face related to errors at the time of executing these transactions. To assess all these risks, the debt managers should from time to time conduct stress tests on the entire debt portfolio. The stress testing will enable debt managers to understand the levels of risk the government will face under different economic and financial situations. The government can use the asset and liability management (ALM) approach as one conceptual framework which can be deployed for dynamic as well as static risk management. This framework entails that the government should try to match its assets and liability as it issues debt instruments. ALM is an active management of the government's balance sheet to maintain a mix of assets and liabilities consistent with its goals for long-term growth and risk management. The government should ensure the calculation of the assetsliability gap. The asset-liability gap model should take into account projected future balances or the difference between interest sensitive assets and interest sensitive liabilities at specific future time periods. 22 P age

23 The other method that the government as an issuer can try to mitigate risk is through the maintenance of an appropriate debt profile. A good debt profile will help mitigate risks in times of market shocks. The government should ensure the mixture of short and long term instrument is appropriate. The government should avoid over reliance on short term instruments to fund long term investments. Investors as well should have a clear understanding of all the risks inherent in the fixed income instruments. For institutional investors such as pension funds and insurance companies, the board of directors should give the managers risk tolerance levels and risk budgets. The major risks related to fixed-income investments are: a) credit risk (counterparty risk, borrower risk and sovereign risk); b) market risk (interest rate risk, price risk, currency risk and correlation risk); c) liquidity risk, operational risk, fiduciary risk, legal risk, concentration risk. For an investor to effectively monitor, measure, and control the above risks, a core set of sound risk management practices is a necessity and such practices should be promoted at least among the major bond investors, public or private. 8. Conclusion A mature and liquid debt market can improve resource allocation by effectively channelling both local and foreign savings into domestic investments and can diversify the investment channels for both retail and institutional investors. Greater diversification of financing and investment channels is beneficial to the stability of financial markets. In order to develop the bond market, the government macroeconomic policy should support market mechanism of funding budget deficit. The government in collaboration with the central bank should engage all stakeholders to ensure that all players are acting to develop the bond market. In addition the legal framework should clearly give powers to the government to borrow. 23 P age