Chapter 9 Legal and Regulatory Framework
- International Monetary Fund
- Published Date:
- September 2001
An appropriate legal framework is a key underpinning of an effective government securities market. The legal framework should set out clear government borrowing authority and establish the process for issuance of government securities. The legal framework should also provide investors with certainty as to process, rights, and responsibilities. It should include appropriate regulation of market participants, market conduct, and rules for clearing and settlement.
Government debt securities must be supported by a clear legal framework that grants government the authority to issue debt, binds it to meet its repayment obligations, and governs the rights and responsibilities of those who purchase and trade in government debt securities.
Because a government issuer is a public body, the process through which it issues debt should be set out in law. This law, or laws, should include (i) clear authority to issue debt and, if the issuance of debt is to be made by a government agency, ability to delegate that authority to the appropriate agency; (ii) a description of the process by which the legislature enables the government to issue debt, including any limitations on borrowing; (iii) a description of the internal management process and legal authority with respect to issuance of government securities and management of the debt portfolio; and (iv) the legal status of the different types of government securities.
The secondary market in government securities should be supported by effective regulation through a securities regulatory authority, and rules related to market intermediaries, market conduct, transparency requirements, and clearing and settlement.
9.2 Government Borrowing Authority
Governments should have an explicit and well-defined authority to borrow, with such authority to be granted in the constitution or in legislation. Box 9.1 provides examples of borrowing authority for several countries. The law in some countries grants the capacity to borrow directly to the legislature, while in others the government is granted the authority subject to approval from the legislature. The law may impose prior legislative authorization on the issuance of government securities as a check against abuse of the borrowing authority.
By setting out clear authority to borrow, the law establishes explicit parameters for the government in borrowing and serves to connect the debt obligation to the government or state, thereby providing investors with the assurance of repayment when the government changes hands.
For a number of historical, political, and sometimes technical reasons, the law of some developing countries either does not expressly allow or prohibits the government from borrowing in the domestic market. This limitation has serious implications for the development of government securities markets and the creation of a viable domestic capital market. Policymakers should carefully review whether the original reasons for imposing this limitation on government authority remain relevant.
As part of its authority, the government should also have the legal ability to delegate borrowing authority and debt management policy to the public agency or department that carries out the debt management work. The law should set out debt management objectives and guidelines for the debt manager, balancing the flexibility to efficiently structure the government’s debt portfolio with accountability.
Lack of clarity in the borrowing authority (as between the legislature and government, for example) can increase the cost of debt financing because there is uncertainty as to the government’s control over repayment. Credit-rating agencies, for example, focus on the clarity or ambiguity in legislative control of government borrowing activity as a way to measure the prospects of the government servicing its debt or government bailouts.
Box 9.1:Examples of Borrowing Authority
The Congress delegates general responsibility for Treasury debt management to the Secretary of the Treasury. A ceiling on the outstanding stock of debt is set by the Congress (although the ceiling has been made flexible in historical practice). United States Code Annotated (USCA), Chapter 31, Section 3102-3104. (a) With approval of the President, the Secretary of the Treasury may borrow on the credit of the United States Government amounts necessary for expenditures authorized by law and may issue bonds of the Government of the amounts borrowed and may buy, redeem, and make refunds under section 3111 of this title.
Constitution Chapter 9, Section 10: The Government may not, without authorization by the Riksdag (i.e., the Swedish people’s assembly), borrow funds or otherwise assume financial obligations on behalf of the State. Act on State Borrowing and Debt Management, Section 1: Following specific authorization by the Riksdag for each individual fiscal year, the Government or, following resolution by the Government, the Swedish National Debt Office, may borrow funds on behalf of the State in order to: (1) finance current deficits in the National Budget together with other expenditures incurred pursuant to Acts of the Riksdag; (2) provide such loans and fulfill such guarantees as resolved by the Riksdag; (3) amortize, redeem and repurchase state debt; and (4) fulfill the central bank’s requirements of currency reserves.
National Loans Act 1968, Section 12, “Power of Treasury to Borrow”: Any money which the Treasury considers expedient to raise for the purpose of promoting sound monetary conditions in the United Kingdom and any money required —(a) for providing the sums required to meet any excess of payment out of the National Loans Fund over receipts into the National Loans Fund, and (b) for providing any necessary working balance in the National Loans Fund, may be raised in such manner and on such terms and conditions as the Treasury thinks fit, and money so raised shall be paid into the National Loans Fund.
Constitution, Article 85. Expensing the government budget or the government’s incurring a liability shall require approval of the Diet.
Hong Kong, China
Exchange Fund Ordinance, Section 3 (3): Without restricting the generality of the powers of the Financial Secretary…, the Financial Secretary may borrow for the account of the Fund either in Hong Kong, China or elsewhere, on the security of the general revenue. (4) The aggregate amount of borrowing under subsection (3) outstanding at any one time shall, subject to subsection (5), not exceed fifty thousand million dollars, or if held in foreign exchange, the equivalent at the current rate of exchange. (5) The Legislative Council may from time to time, by resolution proposed, with approval of the Governor in Council, by a designated public officer required and directed by the Governor to attend a sitting of the Legislative Council for that purpose, determine some other amount to be the amount which the aggregate amount of such borrowings outstanding at any one time shall not exceed.
9.3 Details of Legal Borrowing Authority
The legislation governing government borrowing may establish details of borrowing authority, including issuance limits, internal procedures, transparency, and accountability. These details might also be contained in guidelines, policies, or regulations that accompany the legislation.
9.3.1 Borrowing Limits
Limitations on the government’s authority to issue debt securities can be established in legislation with a specific ceiling on total debt or minimal net increment limit or by requiring specific approval of the issuance by the legislature (either through the annual budget law or through a specific law approving a particular issue). If such limits are contained in the legislation, it is important to establish a system of legislative authorization consistent with modern practices for the issuance of government securities. A system that calls for a case-by-case authorization may be inefficient because the legislative process is usually time consuming and has an uncertain outcome.
The system should balance accountability to the legislature with flexibility. For example, the authorizing legislation in some countries sets out general legislative authorizations to issue government securities for every fiscal year (corresponding to the budget cycle) and requires the government to report annually to the legislature. This system provides a check on government authority (legislative approval and annual reporting), but it gives the government the necessary flexibility to manage debt (by granting the terms of authority for a year). Other systems grant the government authority to issue securities up to a certain amount within the fiscal year.
The legislation may also impose limitations on government guarantees or allow the legislature to set such limits. The legislation should also allow for requests to be made to the legislature for additional borrowing outside of prescribed limits.
9.3.2 Internal Management
The authorizing legislation should be set out in the authority to delegate debt issuance responsibility and may also define the administrative process for debt management.
Whether in the form of a government agency, the central bank, or within the finance ministry, a debt management office’s role, function, and organization need to be defined in appropriate law and regulations along with record-keeping and reporting requirements. To eliminate any doubt by potential creditors, the law should clearly indicate that financial obligations incurred by a delegated agency fully and wholly bind the state.
The administrative organization for the management of public debt must have a sufficient degree of functional autonomy to fulfill its mandate without undue political interference. The debt manager must be given sufficient latitude to allow him or her to execute debt management effectively. Such autonomy, however, carries with it the requirement that the debt management office be accountable and transparent in its operational activities, procedures, and results.
9.3.3 Transparency and Accountability
The legislation should include record-keeping and reporting requirements for the debt management office in addition to the means by which transactions are recorded, to whom they are reported (for example, the legislature or cabinet), and the frequency with which they are reported. The government debt issuance practice should be transparent and accountable in order to assure investors that the contract (repayment of the debt and payment of interest) is a secure investment. When governments report to the legislature on public-debt management, such records provide a basis for the legislature to exercise its control. Of course, a balance between accountability and transparency, which are desirable, and excessive bureaucracy, should be struck. In addition, the issuance and management of public debt must be subject to audit and internal control procedures.
Government securities are generally exempt from disclosure obligations (such as prospectus requirements) applicable to private sector issuers. This practice has developed because of the unique position of government as a public issuer. A public parliamentary approval and budget process provides information to investors, and, as a matter of choice, the government may disclose its financial condition, its future plans for borrowing, and other information of interest to the investor in a manner similar to conventional private issuer disclosure. Indeed, many debt managers now publish comprehensive annual reports outlining debt operations and debt strategies.
Should the government decide to issue debt in international markets, substantial additional disclosure may be required, since the foreign market will treat the government as it would any private issuer. Even in those cases, because of the special status of most government debt obligations, the market concedes some special treatment for these bonds, which are called sovereign and subsovereign bonds. The same is true of obligations to establish bondholder committees; while normally exempt from such requirements, the government may have such an obligation in a foreign market.
The law should contain a clear basis for the distribution of government securities in the primary market and, as a general rule, there should be fair and equal access. Detailed terms of access may be set out in guidelines or policy. Exemptions to the general rule of equal access may also be set out in such guidelines or policies; for example, in (i) allocations restricted to institutional investors, (ii) allocations for market makers, (iii) allocations for financial sector entities that assume special commitments with the government as part of financial restructuring operations, and (iv) limited allocations to facilitate the dispersion of government securities in the market.
9.4 Terms of the Instruments
The government should have the authority to issue bonds in a wide variety of forms and should not be proscribed by legislation. Government bonds can be (i) issued as nominative or bearer bonds; (ii) represented in physical or book-entry form; (iii) have short-, medium-, or long-term maturities; and (iv) have an explicit interest rate or an implicit (discount bonds) or explicit interest rate, or be zero-coupon bonds or even indexed bonds (indexed to inflation or the floating rate, for example). Diversification of the terms of instruments can be a tool for effective management of debt service and profile, especially when the secondary market is not well developed (see Chapters 3 and 4).
Because of their characteristics as public-issued financial instruments, government securities may have some terms and conditions that differ from those applicable to private sector securities. This is true in the case of securing government securities. As a rule, governments do not pledge or create any mortgage or secured interest over public assets or resources to secure their issues of bonds and bills. Government assets and revenues are protected, sometimes even at a constitutional level, by rules prohibiting seizures, attachments, embargoes, and the like. At the same time, in some circumstances, governments can assign government-owned resources or the proceeds of their sale (for example, gold or petroleum) to service or back special-issued securities.
9.5. Legal and Regulatory Framework for the Secondary Bond Market
9.5.1 Regulation of the Secondary Bond Market
In most countries, government securities trade in the secondary market along with all other securities and are, therefore, subject to secondary market regulation. Effective secondary market regulation is necessary to support a viable secondary market. Since government securities are often defined as “exempt securities,” that is, exempt from regular prospectus requirements, it is important to ensure that this status does not undermine the integrity of the secondary market.
Regulatory functions may reside with different authorities, and practices may vary across countries. A typical structure may involve the central bank or Ministry of Finance regulating the primary market and primary market dealers, while the securities regulatory authority regulates market intermediaries in the secondary market. It is important that all aspects of regulation are covered and that the various authorities coordinate their regulation of the bond market. Harmonization and coordination of regulation will avoid gaps that may result in increased risk. A lack of harmonization can result in different treatment of market participants undertaking the same activities, which may give rise to regulatory arbitrage and a distortion of market activity.
Effective regulation of the secondary market should include (i) regulation of market intermediaries, (ii) market conduct regulation (including trading rules) and market surveillance, and (iii) transparency requirements, which will vary according to the choice of market structure.
9.5.2 Authority to Establish a Regulator
Government should have the legal authority to establish a securities regulator. In turn, the securities regulatory authority should have the legal authority to make and enforce rules and regulations related to market and business conduct, market intermediaries, and trading systems. The IOSCO Objectives and Principles of Regulations state that the securities regulator should be operationally independent from government, preferably with autonomy over its budget and “accountable for its functions and the exercise of its power.” The regulatory authority’s powers should be clearly set out in legislation along with provisions for its accountability, such as transparency of rule making, transparency of enforcement proceedings and reporting requirements. The securities regulatory authority should have all necessary authority and resources to carry out its mandate and enforce compliance with its rules.
9.6 Market Structure and Regulation
Regulatory issues related to trading and trading systems and transparency requirements will depend on the type of market structure.
The market can be organized in a number of ways: (i) as an exchange with an order book and post-trade reporting, (ii) as a dealer-driven market with some transparency provided by market intermediary reporting, (iii) as an OTC market with some electronic reporting or information sharing with or without the use of interdealer brokers, or (iv) through a combination of these trading systems. The market may also be open to ATSs, which may set up their own electronic systems independent of or in conjunction with the principal bond market. Market structure choices are discussed in detail in Chapter 7.
The regulatory authority should have the ability to monitor trading and enforce trading rules regardless of the market structure. Most bond markets are OTC or dealer markets, and in this case the regulator may impose post-trade reporting, record-keeping, and audit trail requirements on market intermediaries. If the bond market is an exchange, the securities regulatory authority should have the ability to license exchanges and impose requirements for reporting, record-keeping, fair access, and risk management on exchanges. Similarly, if ATSs feature trading in bonds, the regulatory authority should have jurisdiction over ATSs. The regulator should have the ability to request information from the exchange or ATS, perform an examination of the ATS or exchange, and review and approve any regulations made by an exchange.171 Exchanges and ATSs should be required to maintain an audit trail, conduct effective market surveillance, and have adequate capacity to assist the regulatory authority to detect market manipulation, misleading conduct, and other fraudulent or deceptive conduct that may distort price discovery and unfairly disadvantage investors.
9.7 Market Conduct
Fundamental rules pertaining to market conduct should be included in securities regulation. These rules should address fraud and misrepresentation, duty to clients, market manipulation, and self-dealing. The securities regulatory authority may rely on the exchange to carry out market conduct regulation and market surveillance, but should maintain appropriate oversight of the exchange’s regulatory functions (including reviewing and approving rules). The securities regulator should consider setting out minimum market conduct standards in its own rules in order to ensure consistency across trading systems.
In an OTC market, the securities regulatory authority should develop market conduct rules and should have access to necessary trading records (to be kept at the market intermediary or at a reporting location, if applicable) in order to investigate compliance with the rules. A front-running rule, for example, would prohibit the market intermediary from using information obtained from a client placing a trade on its own behalf ahead of the client, profiting from the client’s trading information. Investigation of the violation of this rule would require access to trade tickets (recording the details and time of the client and market intermediary trades); the identity of employees taking and placing the trades, respectively; and the record of trade executions (trade tape) showing times of trade execution.
9.8 Regulation of Market Intermediaries
The effective regulation of market intermediaries is important to investor protection and to systemic risk, but it is particularly important to the functioning of the secondary market if the market structure relies on market intermediaries (as market makers and in the OTC market).
Market intermediaries should be subject to entry or licensing standards, including proficiency and capital requirements. Market intermediaries should be subject to ongoing capital adequacy requirements and to internal control requirements to ensure sound risk management. In particular, margin and credit rules and rules regarding segregation of customer assets are important. Market intermediaries should be subject to business conduct rules and required to have standards for professional conduct. The regulator should have full authority to conduct examinations of market intermediaries, impose conditions on them, and enforce compliance with regulations.
9.9 Role of SROs
Industry associations and formally recognized SROs and exchanges can assist effective market intermediary regulation and market regulation.
An industry body of market intermediaries active in the bond market may assist the securities regulatory authority to develop a proper regulatory framework and standards. An industry association might establish appropriate dealing or transaction conventions and standards of business conduct and provide expert commentary and advice during policy formulation and rule making. An industry association can also develop transaction standards, such as a Master Repurchase Agreement (MRA) or pricing or yield calculation formulas. These standards may be consistent with similar international standards (for instance, those established by the Bond Market Association in the United States and the International Securities Market Association in London). Consistent transaction standards will facilitate participation of international dealers and investors in the domestic market. An industry association may also consider offering trade execution services when the market is still thin and trading volume does not warrant entry of IDBs. As the market grows and the formation of IDBs becomes warranted, however, the industry association’s trade execution services may conflict with those of the IDBs, which may be members of the association.
While an industry association can contribute to standard setting and policymaking, a formally recognized SRO can assume regulatory responsibility for its members. The securities regulatory authority should have the ability to recognize and delegate authority to SROs. The regulatory authority should have an effective oversight role over the SRO, including the right to conduct examinations, impose conditions, and review and approve rules. In order to be effective in its role, the SRO should have the authority to enforce compliance with its established rules.
9.10 Legal and Regulatory Framework for Payment and Settlement of Government Securities (see Chapter 8, Developing a Government Securities Settlement Structure)
While a principle of safe and efficient payment and settlement applies to the settlement of any securities, trading of government securities requires exceptionally safe and efficient settlement arrangements because of the large value of the transactions and the need to enable active trading. Poor management of settlement risks in government bond trading can generate major systemic risks to the financial system. The legal and regulatory framework must provide clear rights and obligations of parties in government securities transactions in settling executed trades. There should be clear legal treatment of, and effective regulatory enforcement against, failure to pay upon receipt of securities or vice versa in both primary and secondary markets. Given the trend to dematerialize securities in order to effect transfer by electronic book entry, proper legal foundation for recognition of electronic government securities as evidence of obligation and transfer of its legal ownership without (paper) documentation should be provided.
Private sector entities in many countries play a central role in conducting the day-to-day payment and settlement arrangements for both the government and private sector bond markets.172 A government supervisory or oversight role for these activities is nevertheless common in nearly all countries. The agency responsible for the supervision and oversight for the payment and settlement arrangements of government securities varies among countries. In many countries, these responsibilities are handled by the central bank.173 In others, the central bank and the government agency responsible for the regulation of the securities market share the responsibilities. The regulatory agency with oversight responsibility should have clear authority over the clearing and settlement system, including the ability to conduct examinations, impose conditions, and review and approve rules.
The rules and operating procedures governing the payment and settlement arrangements for government securities should be available to market participants. Payment and settlement organizations should be required to have a framework that allows the oversight or regulatory agency to ensure accountability of the systems and to monitor developments in the payment and settlement systems. Finally, the payment and settlement organizations should be required to report periodically to the oversight or regulatory agency and, if necessary, submit periodic audits and examinations.
Sound government securities market development requires the underpinning of a coherent legal and regulatory framework. The principal elements of a legal framework are:
Clear borrowing authority
Rules for the issuance of government securities
Clearing and settlement system rules
Rules governing the organization and functioning of the primary and secondary markets
Rules setting out the legal status of government securities
The focus of regulations for the regulatory and supervisory framework for government securities markets should be to ensure equitable, smoothly functioning, and transparent markets, as well as protect investors and consumers of financial services, particularly in the payment and settlement area. Which government agency or agencies are assigned the regulatory and supervisory responsibilities and accompanying powers must be clearly defined and publicized.
In their role as regulators and supervisors, the authorities should prevent improper market conduct such as market manipulation and insider trading. A requirement that information potentially affecting prices is released expeditiously and to all market participants at the same time will result in fair and transparent markets. Requiring intermediaries to comply with minimum capital requirements and internal control procedures will contribute to reducing systemic risk. Also important for minimizing systemic risk are reliable systems for settlement of cash and securities transactions. Lack of standards in these areas have led to substantial problems and often set back the development of government securities markets.
BIS, Basel Committee on Banking Supervision. 1997. Core Principles for Effective Banking Supervision. Bank for International Settlements,Basel, Switzerland. Available at www.bis.org.
IMF (International Monetary Fund) and World Bank. 2000. Draft Guidelines for Public Debt Management. Washington, D.C. Available at www.imf.org/external/np/mae/pdebt/2000/eng/index.htm.
IOSCO (International Organization of Securities Commissions). 1990. International Conduct of Business Principles. Resolution 16 and Report of Technical Committee, International Organization of Securities Commissions, Montreal, Canada.
IOSCO (International Organization of Securities Commissions). 1994. Operational and Financial Risk Management Control Mechanisms for Over-the-counter Derivatives Activities of Regulated Securities Firms. Report of Technical Committee (35), International Organization of Securities Commissions, Montreal, Canada.
IOSCO (International Organization of Securities Commissions). 1996. Report on Cooperation between Market Authorities and Default Procedures. Report of Technical Committee (49), International Organization of Securities Commissions,Montreal, Canada.
IOSCO (International Organization of Securities Commissions). 1997. Towards a Legal Framework for Clearing and Settlement in Emerging Markets. Report of Emerging Market Committee (73), International Organization of Securities Commissions, Montreal, Canada.
IOSCO (International Organization of Securities Commissions). 1998a. Objectives and Principles of Securities Regulation. International Organization of Securities Commissions, Montreal, Canada. Available at www.iosco.org.
IOSCO (International Organization of Securities Commissions). 1998b. Methodologies for Determining Minimum Capital Standards for Internationally Active Securities Firms Which Permit the Use of Models Under Prescribed Conditions Report. Report of Technical Committee (77), International Organization of Securities Commissions, Montreal, Canada.
Authorities in many countries are currently contemplating the regulatory treatment of ATSs. ATSs have fallen under either exchange or market intermediary regulation in most jurisdictions. Some systems have been intentionally left outside the regulatory framework. In the United States, the SEC has issued “Regulation ATS” as a comprehensive framework for ATS regulation. In Canada, ATSs have only been allowed to operate on a restricted basis, either as members of an exchange or in trading foreign unlisted securities. A proposed new regulation has been published, but implementation is still pending. In Europe, deliberations on EU-wide regulation of ATSs are just starting (see FESCO).
In many countries, the government securities market is supported by a dedicated settlement infrastructure operated by the central bank. However, there are a gradually increasing number of cases in which the government securities custody and delivery function has been transferred out of the central banks and consolidated with central securities depositories serving all types of securities.
Some central bank laws include a clause(s) that authorizes the central bank to be the sole registrar of government securities.