- International Monetary Fund
- Published Date:
- August 2003
The public debt management policy in Italy, as conducted in the last decade, has followed the prescriptions of the Maastricht Treaty, which created a monetary union and the single currency, the euro, among those European countries respecting the criteria of economic stability and fiscal discipline.
Since 1992, the Italian Treasury has undergone a process of profound change in the structure of its liabilities. The main goals to be reached at the end of this process were, in brief:
the reversion in the growth path of general government consolidated gross debt, as defined according to the specification of the excessive deficit procedure related to the European Monetary Union (EMU);
the overall reduction of the pressure on capital markets due to excessive supply of bonds;
the reduction of the exposure to interest rate fluctuations; and
the creation of a deep and liquid market for government securities.
The strong commitment to the attainment of these goals has been expressed in the legislation passed from 1992 on and in the organizational and structural reforms in the field of public debt management.
Developing a Sound Governance and Institutional Framework
Debt management objective and scope
The strategic guidelines for 2002 and 2003 define the objective of public debt management as “…to ensure that the financing needs of the State and its repayments obligations are met, minimizing the cost of debt, the level of risk being equal.”
Referring to the legal framework of responsibilities, the Public Debt Direction (PDD) of the Italian Treasury Department is directly responsible for the issuance and management of public debt domestic securities.
The PDD is also responsible for issuance and management of all other securities. This includes borrowing and other activities in the international capital market, such as issuing syndicated loans and commercial paper and activity on the swap market. The PDD also manages the public debt sinking fund and the cash account (conto disponibilità) at the Bank of Italy (BOI) (both dating back to 1993).
The PDD also exercises surveillance over access to financial market funding of public entities, local authorities, and companies controlled by the state that have or do not have a state guarantee
Coordination with monetary and fiscal policies
Coordination between fiscal and monetary policies and debt management activities is a priority for Italian authorities. The division of responsibility and specialization of tasks among the different institutions is clearly stated. The PDD has the responsibility of the issuance and management of public debt. The Italian Treasury Department is responsible for the management of the state treasury and monitoring the financing needs of the central government. The BOI—as a member of the European Central Bank (ECB)—is in charge of monetary policy and surveillance over the Italian financial system.
The set of rules and constraints and the different tasks assigned to each of the acting departments (PDD, treasury department, BOI, and also general government entities) require a deep and constant coordination in activities to prevent the breaking of legal rules and ensure the orderly functioning of state activities (collection of revenues and distribution of payments).
As it is for all members of the EMU, the issue of coordination of debt management with monetary policy in Italy must be seen in the framework of the Maastricht Treaty. The treaty establishes a prohibition against monetary authorities financing the state deficit by buying government securities on the primary market. This provision of the treaty was reflected in national legislation in 1993, which prohibited the BOI from participating in government bond auctions. Regarding the conduct of monetary policy, the PDD has never had any privileged information, because the setting of official interest rates was an exclusive privilege of the BOI until 1998 and of the ECB thereafter.
The legal framework ensures a complete separation of objectives and accountability for monetary policy and debt management. The BOI is fully independent from the government and acts as an independent authority, or an institution performing its activities with no interference and deriving its powers from specific legislation, without any possibility of intervention or influence by the government onging to specified categories. However, according to the BOI statute, the majority of shares must be in the hands of public entities or companies owned by public entities. As of December 31, 2000, there were 86 shareholders (80 with voting rights).
In addition, Italian law, in accordance with Article 101 of the treaty establishing the European Community as modified by the Maastricht Treaty, forbids all overdraft facilities of the state with the BOI or the ECB, in any form and amount. Since 1993, the direct purchase of public debt instruments from the BOI is forbidden by law. The system also includes the cash account of the treasury at the BOI, implying the removal of any overdraft facility for the treasury. According to the law, this account has to show an average positive balance of €15.49 billion.
However, even though Italy has implemented a clear separation of roles between the treasury and the BOI, these two institutions have always maintained a close dialogue on public debt management issues. First, they exchange views in regular meetings in which issuance policy matters such as amount and instrument mix to be offered are discussed. Second, the BOI is usually involved in workgroups that are occasionally established to work on specific innovations or questions that are relevant for debt management, such as the creation of the strip market, the definition of new facilities, and the like. Third, a close exchange of information is maintained on the issuance activity in foreign currency, given its implications on reserves management and the fact that the BOI is the fiscal agent of the republic.
The smooth functioning of the borrowing activity of the PDD requires constant monitoring of the financing needs of the state in coordination with the direction of the treasury department. This constant monitoring is also done by means of estimates and forecasts of the possible future trends in those needs, taking into account the usual annual cyclical and extraordinary patterns of cash expenses and revenues (typically, revenues from direct and indirect taxation, expenses for salaries, and the like). Finally, the financing requirements need to take into account the maturity and reimbursement profile of outstanding debt.
A close exchange of information is also maintained on the balance of the cash account that the treasury holds at the BOI, through which most payments of the republic are channeled. Although this account is established at the BOI, only the treasury is entitled to order any payment or receipt. However, the two institutions keep close contact on the balance on account because of its implications for liquidity in the system and therefore on monetary policy.
The budget law (legge finanziaria), passed annually by parliament, sets the binding limit for the net borrowing of the state and for the market borrowing activity during the financial year. The latter represents, in brief, the total amount of gross issuance of public debt.
The legal framework for public debt management activity is defined first by the state law, which has recently created the new ministry of the economy and finance (MEF). The MEF is assigned—among others—the competencies related to the “… funding of Government’s financing needs and of Public Debt. …”
A secondary regulation defines the concrete organization and division of competencies assigned to the treasury department within the MEF, and in particular to the PDD.
The PDD is responsible for the issuance and management of domestic and external public debt, the management of public debt sinking fund, and surveillance of market financing activities of other local and public entities. This surveillance over public and especially local entities is a sensitive issue for the PDD. The obligations of the state related to the excessive deficit procedure are to be met at the general government level—for example, taking into account the funding activity of the local entities and of all entities included in the general government sector.
The particular legislative framework, together with the hierarchy of legislative sources, entails a sound assurance that Italian government stands behind any transactions the PDD managers enter into. The officials of the PDD are civil servants; the managers of the various offices that form the PDD are subject to accountability principle, implying civil, administrative, accounting, and criminal law responsibility.
The PDD produces four main documents illustrating its activities and strategic plans for the future:
The annual strategic guidelines are drafted internally after extensive discussions among the various offices of the department. The director general of the PDD coordinates the preparation of the document and is responsible for presenting it to the director general of the treasury, who approves the draft. There is no formal presentation to parliament or direct control by the minister of the economy.
The semiannual report to the Supreme Audit Court (Corte dei Conti).
The quarterly bulletin of public debt.
The public debt section within the quarterly public sector cash balance and borrowing requirement report.
The last two documents are also provided under the Special Data Dissemination Standard (SDDS) program of the IMF.
The nature of public debt management activity is recognized as essentially governmental. Options for alternative institutional arrangements have been considered in the past, such as an independent office or agency operating in a civil law environment. Although a precise analysis of costs and benefits and an evaluation of the project have never been conducted in an exhaustive manner, the current deputy minister of economy and finance has been put in charge of exploring the possibility of establishing an independent agency for public debt management. For the moment, this remains an issue for academic discussion and research.
The management of operational risk is conducted by means of sound practices developed during several years of activity and, in particular, starting from 1991, when the present organizational structure of the PDD was outlined. This process was completed in 1997, when all activities related to public debt management were brought under the authority and responsibility of the PDD.
The legislative division of labor in public debt management makes a clear distinction between the treasury department and the BOI, thus avoiding any conflict of interest between the two entities. There is a tradition of cooperation between the two institutions and the smooth functioning of the auction and settlement procedures, and all operations connected to the secondary market activity, is the result of the successful public debt management reforms in Italy. In particular, an auction procedure manager (at the BOI), of secondary market autonomous trading platforms,2 and an independent depository institution (Monte Titoli SpA) ensure that the responsibilities are clearly separated and provide full accountability.
A great effort has been made in in human resources management to ameliorate and renew the human capital endowment of the PDD. The main effort is addressed toward strengthening information technology (IT) and foreign language skills in Italian public administration. The advancements made are considerable and connected with a broader effort of Italian public administration as a whole.
Compared with private institutions, the turnover rate of staff is low. Most of the mobility involves people moving from one department of the MEF to another, from one office of the PDD to another, or retiring. Nevertheless, recently more staff have been moving to international or private institutions (mostly financial institutions). The Italian legislative framework does not provide flexibility in salaries and incentives, except for a few top managers (generally department heads or general directors). The recent legislative reforms, however, try to sketch a more flexible and dynamic framework, especially for managers (the level immediately below general directors), allowing for temporary contracts and some “weak form” of performance-related bonuses. Nonetheless, the PDD, among the other administrations, can offer to its staff training and the development of skills comparable to those offered by the private sector.
A specific code of conduct does not exist, but PDD officials are subject to normal provisions for public officials. The Italian administrative and criminal laws meet all of the criteria of impartiality and help to avoid any conflict of interest.
The public debt management activity is subject to the control of the accounting department of the MEF and of the Italian Supreme Audit Court.
The formal control by the MEF accounting department is continuous and conducted only on a documentary basis for the whole administration and for a limited number of activities specified by law. This means that the auditing procedures examine and certify the ex ante conformity to the law and accounting regularity of the documentary evidence.
The Supreme Audit Court performs formal controls based in specific laws. Some documents and activities (e.g., purchase agreements above a specified amount) require ex ante legal and accounting approval by the Supreme Audit Court. The Supreme Audit Court’s ex post nonformal control of the yearly activity is conducted by sampling the entire Italian administration and, therefore, does not regularly cover the PDD’s activity.
In addition, the PDD submits a biannual public debt management activity report to the Supreme Audit Court, detailing the evolution in the composition of public debt and describing the operations undertaken during the semester. This document is not made public. Its main aim is to deepen the knowledge and comprehension of public debt management activity. The examination of numerical results—routinely made by the Supreme Audit Court—is enlarged to include evaluation and explanation of strategies and actions in connection, for instance, with trends in the international capital markets.
Transparency is a strategic priority for the Italian Treasury and the PDD, and the commitment to it is very strong. The PDD’s web site (www.tesoro.it/publicdebt) is updated daily and fully available in English. The web site is the result of the great importance attached to communication with the vast audience of international and domestic investors.
A document describing the strategic guidelines for public debt management is published yearly on the web site. The strategic guidelines disclose the objectives of the PDD in terms of risk management, portfolio composition, liquidity of the securities on the secondary market, and forecasts of possible gross issuances and of the number of new bonds and treasury bills to be placed on the market. The public disclosure of strategic cost/risk analysis and objectives is at an early stage, but has been provided in the latest strategic guidelines document.
Also available on the web site are
the annual auction calendar,
the quarterly issuing program,
the quarterly bulletin of the PDD,
the offering announcements for treasury bills and bonds,
the results of the latest auctions of all bonds and treasury bills, and
specific sections devoted to
– specialists on Italian government bonds,
– public debt statistics,
– the Italian public debt sinking fund,
– a listing and description of Italian Treasury securities, and
– other information and news (e.g., new legislation on fiscal treatment of bonds and treasury bills).
The administrative and organizational framework for debt management is designed primarily through the Italian law and the regulations of the MEF.
The regulations and the procedures for the primary distribution of public debt securities are made clear to the participants through
the legislative framework,
the annualdiffusion of the rankings of specialists (on the web site), and
the public availability of the criteria for evaluation by specialists (on the web site).
As regards the auction framework for Italian public debt securities, the law provides a set of rules, and the electronic procedure for public auctions ensures a clear carrying out of all operations (sending of bids, opening, ranking, and assignment of quantities). Manual or semielectronic recovery procedures are provided in case of IT failure. Since 1988, the secondary market for public debt has been conducted through an electronic platform (MTS.
The reform process of the secondary market ended in 1998, when a law and two decrees were passed to regulate the framework of the secondary market and the role of the MTS electronic platform in the wholesale market for Italian and foreign government bonds.
Information about the flow and stock of government debt is sent to the market with the availability of final data. The PDD releases a quarterly bulletin of the public debt market, showing
the results of the latest auctions of Italian public debt securities,
the outstanding amount of benchmark securities,
the quarterly issuance program of new securities,
the breakdown by instrument of outstanding government debt,
historical data on average life of government debt,
redemptions of outstanding bonds,
redemptions of the next 12 months, and
the trading volumes and average bid/offer spreads observed in the secondary market (MTS).
In addition, the Italian Treasury Department provides, when needed, information about changes in fiscal treatment of public debt securities. This has happened with the recent innovations in the taxation regime (withholding tax) for nonresidents: The explanatory notes on the reform and an application form have been published on the PDD web site.
As regards the financing needs of the public sector, a partial disclosure of summary data referring to those aggregates is provided monthly by the Italian Treasury Department. No official forecasts are provided to the public because of the fluctuations and uncertainty of these data.
Debt Management Strategy and the Risk Management Framework
Italy has one of the largest debt stocks among advanced economies, both in nominal terms and as a percentage of GDP. The debt-to-GDP ratio, which stood at 97.2 percent in 1990, reached a peak of 124.3 percent in 1994, when it started to decline as a result of a major fiscal consolidation. Such an enormous debt burden undermined the financial stability of the country and conditioned the government’s action in the political economy domain. Throughout the 1980s and the first half of the 1990s, Italy was facing increasingly large expenditure outlays due to the debt service to the point that, in 1993, interest payments on the public debt absorbed 22.6 percent of total expenditure. To service its debt, the republic needed to keep taxes at a high level, and there was very little room for maneuvering to use fiscal policy as a countercyclical tool. Doing so would result in a relaxed fiscal policy that would soon exacerbate the balance of the country’s fiscal accounts. Even the independent conduct of monetary policy, which was fighting inflation through a restrictive stance on official rates, could have a negative impact on public finance through an increase in the cost of debt. However, because Italy was not overly exposed to foreign currency–denominated debt (only 3.5 percent of total debt was denominated in foreign currency in 1993), there were not large implications of the large stock of debt on reserves management. As recently as 1994–95, the spread between Italian and German 10-year bonds was still oscillating between 250 and 600 basis points, and it became clear that such a wide spread was unsustainable over the long term.
In this context, although up to the early 1980s the PDD’s main concern was to raise the necessary cash to fund the government’s operations, the PDD decided to better define its mission and put together a more precise strategy to guide its action. Therefore, even though a set of constraints remained, which made it difficult to shift away from the risky treasury bill market, the treasury department began to put forward some basic concepts to be followed in debt management policy.
A general objective of debt management policy was then considered of minimizing the cost of funding. However, to avoid excessive risks in the presence of specific market conditions, it was decided that this objective should be achieved in a context of careful control of the interest rate risk and refinancing risk. The rationale was that the objective of minimization of the funding cost was not sufficient in itself to prevent the budget from possible shocks. For example, in a situation of declining interest rates, this objective could have led to an excessive issuance of short-dated securities. Although this strategy could indeed save money in the short term, it could also lead the government to assume an unnecessary exposure to the risk that interest rates would rise in the future and determine a sharp increase in the cost of debt.
The work undertaken to better evaluate the main risks faced by the PDD was instrumental in defining the mission of debt management activity. Throughout the 1990s, because of the size and composition of its debt, Italy was largely exposed to two main risks:
Interest rate (market) risk: Because of the very short duration of the public debt, the cost of debt was very sensitive to changes in interest rates.
Refinancing (rollover) risk: The average life of public debt was only 2.6 years in 1990. This implied that every year, the Italian authorities had to roll over massive amounts of securities, overloading the market with frequent and large auctions.
The approach to interest rate (market) risk
The need to contain the interest rate risk required the PDD to engage in an active debt management policy with the aim of modifying the composition and increasing the duration of the stock of debt.
The beginning of the fiscal consolidation and the reduction in the inflation rate created a better environment for investors to buy long-term securities. The increased demand made it possible to issue certificati di credito del tesoro ([CCTs] 7-year floatingrate bills) and buoni del tesoro poliennali ([BTPs] 3-, 5-, 10-, and 30-year bonds) in higher amounts. In 1990, short-term and floating-rate notes accounted for 73 percent of the total debt, declining to 49 percent in 1995 and reaching 30 percent by 2000. At the same time, the duration of the debt portfolio increased from 1.7 years in 1993 to 3.7 years in 2000.
As a result, the exposure to fluctuations in interest rates declined significantly. Given the current composition of the debt, the impact of a 1 percent shift in the yield curve would determine an increase in interest expenditure of about one-third lower with respect to 1996.
The approach to refinancing (rollover) risk
An even bigger challenge for Italy was that of reducing rollover risk. The structure of the public debt was, until recently, such that the short average life caused a constant need to roll over maturing debt. For example, in 1995, the public debt to be reimbursed amounted to 50 percent of the total debt outstanding. There was also a high concentration of maturities on specific dates, and consequently the recourse to the market had to be particularly large to meet those redemptions.
The strategy to address this risk was based on two pillars. First, the objective was to increase the average life of the public debt. During the 1990s, the average life more than doubled from 2.6 years in 1990 to 5.7 years in 2000. Second, the aim was for a smoother distribution of maturities during the year. Although the borrowing requirement maintained a pronounced seasonality, the PDD strived to spread out maturities more evenly across the various months.
The operative framework to address market and rollover risk
The quest to reduce these two risks went on for most of the 1980s and 1990s, when Italy adopted an active debt management policy and explored all possible avenues to educate investors to buy securities other than short-term treasury bills, which were the backbone of the portfolio of any Italian investor. Moreover, there was a need to diversify the range of instruments used to raise funds, so as not to depend excessively on a specific segment of the market. The PDD launched innovations on both the primary and the secondary markets. In the primary market, the action concentrated mainly on two lines, the diversification of instruments and the introduction of new issuance procedures.
In terms of diversification of instruments, there was a policy aimed at increasing the types of securities to be offered so that the treasury could target a wider range of investors, increase the average maturity of the debt, and obtain a smoother redemption profile. Several new types of securities were introduced:
The CCT: In a constant struggle to reduce the recourse to short-term treasury bills, in 1978 Italy introduced the CCTs with the aim of lengthening the average life of its debt. However, because of the then prevailing reluctance to invest in long-dated, fixed-rate Italian securities, the PDD decided to index the coupon payments to the current treasury bill rate. This new instrument (whose maturity initially varied but stabilized at seven years in the early 1990s) was extremely successful, especially with households, and accounted for more than 40 percent of the total debt in 1990. In this way, the PDD was able to substantially reduce refinancing risk, but remained exposed to variations in the interest rate level.
The certificati del tesoro (CTEs) denominated in European currency units (ECU): With the CTE, launched in 1982, Italy was among the first issuers to offer securities denominated in the European unit of account, the basket of currencies that was to generate the euro. In doing so, the PDD was able to attract new investors to longer maturities, preventing the fears of devaluation of the Italian lira from discouraging them.
The buoni del tesoro (BTEs) denominated in ECU: Similar to CTEs, but with shorter maturities, these were introduced in 1987.
The certificati del tesoro con opzione (CTOs): These securities, introduced in 1988, were six-year fixed-rate bonds embedding the option for the holder to request advance reimbursement after three years.
The first 30-year BTP was launched in 1993 with the objective of increasing the duration of the public debt.
The funding program in foreign currency: Starting in 1984, the Italian government launched bonds denominated in foreign currencies to attract those investors that were not willing to invest in a currency characterized by high inflation. Eventually, Italy became one of the main issuers in the Eurobond market and subsequently complemented this activity with the inclusion of sources of financing other than benchmark bonds, such as the euro medium-term notes (EMTNs) program launched in 1999.
For issuance procedures, several changes have been adopted over the years to improve placement techniques, especially for medium- and long-term bonds. Until the 1980s, medium- and long-term bonds were placed through a syndicate of major domestic banks. To avoid excessive market fluctuations, the PDD would indicate the amount and price of securities to be sold. In 1985, in light of the growing number of intermediaries that could access the Italian market, and with a view to standardizing its placement procedures, the PDD started to test the uniform-price auction and began to make this a standard practice in 1988. By 1990, all treasury securities except foreign currency bonds and treasury bills were placed via uniform-price auction, and in 1992, the requirement of a base price was removed.
As for buoni ordinari del tesoro (BOTs), treasury bills of varying maturities, the decision to remove the indication of a base price for the auction (which came in 1988 for 3-month bills and in 1989 for 6-month and 12-month bills) was a very important move, which favored a more precise separation of roles between the treasury and the BOI. The indication of a base price for treasury bills was regarded as extremely important by market participants, who tried to extract from it a signal of the direction of official interest rates. This approach favored a confusion of roles between the treasury and the BOI and would sometimes generate uncertainty in monetary policy expectations.
Another important step in issuance procedures concerned the introduction of reopening auctions for medium- and long-term bonds in 1990. This decision responded to the need to boost the liquidity of the newly established on-screen secondary market (MTS). Transactions on this market could not pick up momentum as expected because of the large number of bonds outstanding, none of which was liquid enough to absorb large transactions. Benchmark bonds would change very frequently, and the market remained fragmented. Therefore, the PDD started to conduct several auctions over time on the same bonds, reducing the number of bonds issued on the same maturity, initially for a period of two to three months, and then for progressively longer periods. Today, a 10-year bond can remain open for more than 6 months and a 30-year bond for more than 1 year. This allows the bonds to reach an optimal outstanding amount, and there is evidence that the introduction of reopening auctions contributed to reducing the cost of debt because investors were more willing to buy liquid securities. This reform was also key to the development of an efficient secondary market.
More recently, the PDD also announced a finalized program to exchange securities nearing maturity with securities in the process of being issued (exchange offers). The objective is to make the profile of maturities more uniform. By means of exchange offers, the PDD will retire old bonds with a short remaining maturity and exchange them for newly issued securities with a longer maturity. The benefit will be twofold:
On refinancing: By retiring old bonds with a short remaining maturity, the PDD can smooth out the redemption profile for the near term (usually the securities to be repurchased have a maturity up to one year). The securities are usually replaced by new medium- and long-term bonds, which help in spreading out maturities over a longer time horizon.
On market liquidity: In general, bonds nearing maturities are no longer liquid, therefore they tend to not being actively traded on the secondary market, resulting in an increased burden for primary dealers if they are obliged to quote them. Through the exchange offer facility, the primary dealers are given a window to swap illiquid bonds with highly liquid ones, such as those used by the PDD to execute the exchange offers.
The exchange offers, which were executed for the first time in early 2002, can be carried out according to two procedures:
through auction, by following the same procedure used for buyback operations made with the proceeds of privatization. (These transactions will preferably be made in the middle of the month, concurrent with three- and five-year BTP auctions.); and
at a later stage, by operating directly on the regulated secondary market through bilateral transactions.
In both cases, these transactions are reserved for specialists in government bonds, because they are the most active operators on the secondary market and those on whom the treasury relies to maintain high liquidity and efficiency in the secondary market.
Given the sophistication that characterizes today’s markets, the development of adequate information systems is key to a smooth functioning of debt management. Over the past 10 years, the PDD has worked to improve its systems by focusing on three areas: pricing systems, forecasting systems, and risk management systems.
Pricing systems are instrumental for the front office, because they enable the PDD to have a better understanding and evaluation of the trades that are entered into. The need to develop such systems first arose for liability management purposes, when the PDD started to directly negotiate derivatives contracts with its counterparts; later, such systems were used for issuance activity and other operations on the domestic debt as well. Rather than develop in-house models, the PDD chose to draw upon the experience of investment banks in this field. Therefore, it benefited from their advice in setting up and customizing the pricing tools needed in debt management operations. These models are used for a wide range of purposes, from simple calculation operations such as discount rates, to pricing of complex structures or determination of the fair value of bonds to be repurchased on the secondary market.
Forecasting systems are being developed for the PDD to have its own views on the evolution of key variables for debt management, such as interest expenditure, stock of debt outstanding at future dates, and so on.
The other area under development is that of risk models, which are gaining importance for reporting and accountability purposes. Here, work is under way to refine the models that allow the PDD to accurately measure its exposure at any given time. Most existing models are based on customizing the value-at-risk (VaR) models, which are the most widely used by investment banks. However, because of the peculiar nature of the fund-raising activity and the accounting methodology for recording debt, the PDD is also working to develop more tailored indicators, such as models calculating the sensitivity of the interest expenditure to variations of interest rates or to changes in the composition of the debt outstanding. The interest expenditure, given its impact on Italian public finances, is a variable that needs to be closely monitored, and it is one for which the PDD can take very little risk. For this reason, many of the simulations that are regularly run at the PDD concern the testing of various compositions of the debt portfolio to see how the interest rate expenditure would react under different market circumstances. The results of such simulations are also the basis for strategic planning of the issuance activity.
Developing the Markets for Government Securities
Italy has invested extensive resources to develop an efficient securities market. Given the heavy financing needs managed by the PDD, the need to create a dependable mechanism for raising funds was one of the top priorities during the 1980s. Work was carried out to develop both the primary and the secondary markets.
Since then, the Italian financial system has undergone constant and rapid development—mostly in the field of IT trading, settlement, and depository systems. Separate institutions were created during the 1990s to operate the secondary market for public debt securities. A wholesale market to trade Italian government securities, MTS SpA, by means of a screen-based system was introduced in 1988. In 1994, MOT, a retail market for securities was created as a branch of Borsa Italia SpA. The latest innovation, started in August 2001, is BondVision (a division of MTS SpA), an Internet-based, multidealer-to-client, wholesale, fixed-income market.
In parallel, since 1991, a number of laws have been passed, ensuring the modernization of the financial markets and institutional investors–related legislation.
Domestic government securities
In the domestic market, the PDD today issues the following instruments:
BOTs (3-, 6-, and 12-month treasury bills);
BTPs (3-, 5-, 10-, 15-, and 30-year bonds);
certificati del tesoro zero-coupon ([CTZs] 24-month zero-coupon bills); and
certificati di credito del tesoro ([CCTs] 7-year floating-rate bills).
To place its debt, the Italian government uses very standardized and reliable mechanisms. Traditionally, domestic debt has been issued via auctions and foreign debt via syndication of banks. Today, these remain the most important mechanisms, even though, as new products are developed, some other channels may gain ground. The methods can be summarized as follows:
Treasury bills: competitive auction without any indication of the base price. Investors can submit up to three bids, each of which is assigned the price requested. There is a cutoff price to avoid speculative bids.
Medium- and long-term bonds: marginal auction, whereby each request is assigned at the marginal price, which is determined by accepting higher bids until the total amount of bids accepted equals the amount offered. There is a cutoff price to avoid speculative bids.
Bonds denominated in foreign currency: syndication.
Commercial paper: direct quote on various networks and over the telephone.
Besides issuing marketable debt, the Italian government also guarantees the debt of the Cassa Depositi e Prestiti (CDP), which is placed through the post offices. The CDP is a public institution in charge of funding local authorities or specific projects for public infrastructure. However, to ensure that the borrowing of the CDP is done on similar terms to the funding managed by the PDD, the minister of the economy and finance, who is responsible for debt management, is given the authority to set the financial conditions under which the CDP can issue debt.
Issuance procedures have been continuously enhanced in transparency and effectiveness. At the end of 1994, to improve transparency and predictability of issuance policy, the PDD started to disclose an advance calendar of the auction dates for the following year, along with a quarterly issuance program that gives more detail about the bonds and the amounts to be issued in the coming quarter. In this way, all market participants are given detailed information, which is key to accurate planning of their activity for the next year or quarter.
Since 1995, the auctions have been carried out via a completely automated procedure at the BOI. As a result of constant improvement, the lag between the collection of the bids and the announcement of the results has been reduced to a few minutes. The number of institutions allowed to participate in the auctions has been increased over time, and today an average of 40 institutions submit bids at each auction, including foreign institutions, who can submit bids even if they are not resident in Italian territory.
Supplementary auctions take place at the end of every regular auction of medium- and long-term bonds. Only specialists are allowed to participate in this part of the auction. Each specialist who has been assigned bonds during the regular auction is entitled to submit voluntary bids for an extra allotment of bonds. The extra allotment equals 25 percent of that offered at the regular auction if it concerns a newly opened line of bond (i.e., the first tranche); otherwise, it is 10 percent. The price for the supplementary auction is the same as the regular auction price (the weighted average for treasury bill auctions or the marginal price for uniform-price auctions). This privilege, which transfers the market risk to the treasury (if only for a few hours), is valued highly by the selected institutions.
Bids for the supplementary auction can be submitted until noon of the business day following that of the regular auction, and they follow the same procedure as the regular auction. Each specialist is entitled to be allotted a share of the supplementary auction equal to the ratio between the total amount assigned to the specialist in the last three auctions and the total amount assigned to all specialists in the same three auctions.
By means of supplementary auctions, the PDD has found a way to increase the amounts issued at each auction without committing in advance to larger amounts, which might have proved difficult to place. Instead, the possibility to increase the amount being issued is left in part to the market conditions. If the market yields are decreasing, specialists will find it convenient to participate in the supplementary auctions and the issued amount will rise. Conversely, nothing will happen if market conditions deteriorate in the hours following the regular auction.
A very important innovation concerned the establishment of the specialists in government bonds. This category of operators, introduced in 1994, was selected from among the primary dealers operating in the Italian-regulated on-screen market (MTS) with a view to enhancing the demand at auctions of Italian government bonds, increasing liquidity of the secondary market, and assisting the treasury with advice on debt management policy issues.
The specialists in government bonds are granted the exclusive right to participate in supplementary auctions and have also been exclusively entitled to participate in the buyback operations launched by the treasury to reduce the public debt outstanding.
In 2000, a strategic guidelines document was introduced, outlining the principles to be followed in debt management policy for the coming year and released at the end of each year. This document is published to disclose as much information as possible on the reasoning behind the decisions that guide the PDD’s action in debt management. In this way, market participants are offered useful tools to help them form their expectations on issuance activity for the year to come.
On the secondary market the key reform was the establishment in 1988 of MTS, the on-screen market for government bonds. The MTS model was based on a very simple concept, that is, to provide easy, low-cost access for market makers to the Italian government bond market and facilitate transactions as much as possible. These conditions helped enormously to build up liquidity and favored the stability of the market, because investors could always count on an efficient tool to divest their positions, and such circumstances attracted new investors to the Italian market. Today, the Italian secondary market is one of the most liquid in the world, with very high trading volumes and tight bid/ask spreads. Moreover, the on-screen market is very reliable in times of severe crises. Because of their discretionary nature, transactions based on over-the-counter systems tend to diminish in volume in times of uncertainty or disruption in the financial markets. However, it is standard practice that market makers undertake specific commitments to show two-way quotes on the on-screen market. This commitment is very valuable to the issuer, who can benefit from the information (however little it may be when liquidity tends to dry up) that on-screen systems continue to provide, even during periods of distress.
Another sector that was key to developing the Italian market was the fiscal treatment of government securities. In the mid-1980s, it was decided to put an end to the long-standing policy of tax exemption on Italian government bonds and enforce a 12.5 percent withholding tax on new bonds. This measure determined a fragmentation of the market, because it introduced the practice of quoting the yield on a net-versus-gross basis, depending on the tax treatment of the holder. Moreover, it hampered the appeal of Italian bonds for foreign investors, because the Italian authorities decided to establish a quite complex procedure to avoid double taxation. Such a procedure would require foreign investors to pay the withholding tax as if they were subject to tax and then apply for a refund. Given the long period that was usually required to process the applications, for some time, there was extensive arbitrage activity on Italian bonds based on this mechanism. Therefore, the PDD started a process that was initially aimed at streamlining the procedure for reimbursement of the withholding tax and eventually (in 2001) implemented a major reform that granted fiscal exemption to virtually all nonresident investors, provided they are not resident in fiscal havens. This reform responds to the assumption that in debt management—and in particular, in fiscal issues associated with debt management—the simpler, the better.
The reform of the taxation for nonresidents was one of the by-products of a closer and more frequent dialogue established by the PDD with investors, and in particular international investors, who may not have been aware of the opportunities offered by the Italian market. For example, because of the technicalities related to the management of the withholding tax, those involved in debt management could gain a good understanding of the problems outstanding because of direct contacts with the interested investors. Based on this experience, the PDD has expanded this type of activity. Today, regular meetings are held with market makers to gain better input on market trends, the treasury conducts road shows to bring new products or market innovations to the attention of investors, and videoconferences are organized as requested to favor exchange of views, preferences, and information between the PDD and investors.
Dealing with exceptional events and financial crises
The system of auction, settlement, and trading for Italian government securities has shown a good resilience to financial crises or disruption at the continental or world level. For instance, in 1992, when the Italian lira was devalued and forced out of the fixed-rate regime of the European Monetary System (EMS), causing continuing pressure on the Italian financial market and the widening of the interest rate spread with major sovereign issuers, the market proved to be efficient and continued to price Italian government securities, despite some problems with the auction procedures.
Another important and decisive test came in 1995, when, after the Mexican crisis of 1994, the framework of primary dealers and specialists and new criteria for quoting securities on MTS proved to be a welcome resilience during major international crises. On that occasion, the benefits were transferred from the secondary to the primary market, where no disruptions were observed in the auction mechanism. The treasury department could continue to place its bonds without any adverse effect.
More recently, on the occasion of the terrorist attacks of September 11, 2001, the treasury department and the PDD continued their activity on the primary market and fulfilled all their plans of auction. In that case, the smooth functioning of the secondary market was ensured by the combination of continental-scale intervention (especially from the ECB) and a well-tested market infrastructure.
Based on these experiences, there are a few lessons that can be drawn. First, developing the market may require the issuer to pay a price initially. For example, when the PDD decided to increase the maturity of the public debt, it did so mainly by issuing floating-rate bills (CCTs) in the beginning. This instrument, because of its peculiarity in the indexation of the coupon, was considered by some analysts to be too costly for the treasury. However, the commitment demonstrated by the PDD to develop the market for CCTs determined a comfortable pickup in liquidity and allowed the treasury to initiate a process of lengthening the maturity of the public debt.
Second, it is advisable that debt managers do not engage in the proposal of too complex or sophisticated securities ahead of time. For example, in 1988, when the treasury department started to issue long-term bonds with an embedded option (CTOs), the market was not yet able to correctly price the value of the option. Because investors were not accustomed to such securities, pricing models were not as widespread as they are today, research on volatility was not developed and available, and investors were treating these bonds as if they were bullet bonds, ignoring the value of the option. This implied that the issuer, while incurring the risk of advance reimbursement associated with the option, could not monetize the premium associated with it.
Third, there may be a trade-off between the requirements for the establishment of an efficient market and short-term gains. To ensure smooth functioning, an efficient market must be organized with simple and standardized practices, so that the issuer’s behavior is predictable and does not come as a disruption to normal activity. Italy has followed these prescriptions by adopting, for example, a yearly calendar of government bond auctions, disseminating formal guidelines that anticipate for each year the innovations in debt management policy, and publishing quarterly calendars that detail the characteristics of any new bonds to be sold. A consequence of such a level of disclosure is that the PDD may face situations in which it is costly to honor a commitment. However, credibility is a highly important attribute of the issuer: in the long run, there is a payoff from the commitments that are undertaken, even if a mere short-term perspective may indicate that some costs are being incurred.
The case study was prepared by Domenico Nardelli and Gianluca Colarusso from the Public Debt Management Department of the Italian Treasury.
MTS, MOT, and BondVision, described in the section “Developing the Government Securities Market.”