This guidance note was prepared by International Monetary Fund (IMF) and World Bank Group staff under a project undertaken with the support of grants from the Financial Sector Reform and Strengthening Initiative, (FIRST).The aim of the project was to deliver a report that provides emerging market and developing economies with guidance and a roadmap in developing their local currency bond markets (LCBMs). This note will also inform technical assistance missions in advising authorities on the formulation of policies to deepen LCBMs.
The need to develop domestic securities markets has, following the recent international financial crises, increasingly attracted the attention of national and international policymakers.1 This has resulted in the issuance of a number of policy recommendations by various organizations, such as the Asia-Pacific Economic Cooperation (APEC) collaborative Initiative on Development of Domestic Bond Markets. The issue of government debt management is intrinsically linked to government securities market development. Work is currently under way on this issue at the International Monetary Fund (IMF) and the World Bank, where guidelines have been developed to guide government actions as an issuer, thereby steering development of the government securities market.2 This handbook on government securities market development seeks to fill an existing gap between specific technical studies about securities market microstructure and publications that offer general policy recommendations about securities market development. The handbook integrates these two perspectives by outlining important issues confronting senior strategic policymakers or those implementing policies to support development of a government securities market.
In the last 10 years there have been a growing number of countries establishing primary dealer (PD) systems. This paper discusses the role of primary dealers, as well as operational and technical issues related to the establishment of a PD system, in the overall management of public debt for countries that may be considering establishing such a system. One of the goals of the paper is to provide guidance on how to design a primary dealer system in an appropriate way to meet market development needs.
Tax policy has significant impact on financial decisions of investors and firms. Certain tax policies, such as transaction tax, can stifle the development of capital markets. New financial products, such as mutual funds and asset-backed securities, will have difficulty in competing against traditional substitutes without proper tax treatment. Thus, a well-developed financial system requires a well-designed tax policy.
Decentralization of some governmental functions is taking place in many developing and transition countries. Decentralized entities are becoming responsible for undertaking various infrastructure investments required to meet basic needs at the local level, including utilities, water and sanitation, transportation, health and education, and environmental protection. Owing to fiscal constraints at the center, decentralized entities can rely only partly on capital grants from the center to fund these investments. To meet their funding needs, decentralized entities, therefore, need to broaden their own resource base, access subnational bond markets, and increase the efficiency of resource use. In emerging-market countries, these funding needs must be weighed against the prospect that multiple issuers of securities with varying claims to sovereign creditworthiness will fragment a nascent market and thereby reduce its liquidity and efficiency. On the other hand, properly managed subnational bond market can complement the national bond market.
The issuance of debt securities by private sector entities has considerable public policy benefits. Such securities help the private sector contribute to economic development through more efficient reallocation of capital. In particular, they improve access to capital for housing and infrastructure at a time when privatization and deregulation in many developing countries are shifting the financing of these projects from public to private hands. Private sector securities also help diffuse stresses on the banking system by matching long-term investments with long-term capital. There is thus a strong public interest in a viable bond market for private sector issuers. Authorities can support private sector bond market development by maintaining a well-functioning market for government securities and by helping to establish disclosure procedures and a credit-rating system for private sector securities, bankruptcy laws, avoiding public sector crowding out, and limiting statutory restrictions on the issuance of private sector debt securities.
In simple terms, a primary dealer system is an agreement between two major stakeholders in the domestic government debt market—the debt manager and a group of dealers—to pursue a common strategy in support of the functioning and development of primary and secondary markets for government securities. Primary dealers are financial intermediaries selected to perform a specialized role in the market for government securities. Generally, in exchange for specific privileges, primary dealers agree to perform specific obligations or functions in the operation of markets for government securities.
The money market is the cornerstone of a competitive and efficient system of market-based intermediation, and should normally be in good working order before a government bond market is developed. The money market stimulates an active secondary bond market by reducing the liquidity risk attached to bonds and other term financial instruments and assisting financial intermediaries in managing liquidity risk. The money market serves as the medium for government cash management and provides the first link in implementing monetary policy using indirect instruments.
To be a successful issuer of government securities, the government must earn the confidence of financial market participants. In addition to pursuing sound and sustainable fiscal and monetary policies and establishing an appropriate legal and regulatory infrastructure, the government needs a credible government bond issuing strategy, based on a strong commitment to market financing and a well-structured management framework. The strategy must provide a clear mapping of the portfolio structure and the instruments to obtain that structure. It must also devise procedures for marketing government securities issues and managing the government’s cash position in ways that establish efficient distribution channels and encourage the development of secondary markets.
The main purposes of a primary dealer system include strengthening the primary market by (1) helping to build a stable, dependable source of demand for securities; (2) providing liquidity in the secondary market; (3) devoting capital resources to underwriting (as a proprietary buyer) to absorb an occasional shortfall of liquidity; (4) building distribution channels (to act as intermediaries); and (5) providing market information, including prices, volumes, and spreads between bids and offers. These objectives, in turn, serve the overall goals of (1) lowering the cost and associated risk of servicing the public debt; (2) developing financial markets; (3) enabling the central bank to use indirect instruments of monetary policy; and (4) encouraging saving by providing a relatively risk-free investment with attractive returns.