Annex I Government Securities Markets
- International Monetary Fund
- Published Date:
- January 1994
Government securities are the backbone of world securities markets. Their turnover far surpasses that in any other financial market, except the global foreign exchange market. In recent years, government securities markets have undergone great changes. As many industrial countries ran sustained budget deficits in the 1980s and early 1990s, the size of government securities markets mushroomed. International competition for investors has forced governments to institute a wide range of reforms aimed at deepening liquidity in their markets and broadening their investor base. These reforms have attracted foreign institutional holders of government securities. With investors continually rebalancing their portfolios between securities of different countries, these markets have grown increasingly integrated across countries.
This annex provides an overview of major elements of government securities markets in industrial countries and of issues related to those markets. Although it focuses on the marketable obligations of central governments, obligations of other levels of government and nonmarketable claims of the central government are also discussed.
Recent Trends and Developments
The Increase in Debt Issues and Debt Outstanding
The 1980s and early 1990s have witnessed a significant rise in both the amounts of debt outstanding and in issue volumes. These increased stocks and flows have challenged the governments of industrial countries to manage their debt in a way that keeps the cost of debt service as low as possible. High real interest rates during much of this period heightened this challenge for many countries.
Table 4 shows the amount of debt outstanding in the larger industrial countries between 1980 and 1992, both in dollar terms and scaled by GDP in those countries. (Because of data limitations, the table includes debt held by the domestic central bank, and it also includes nonsecurities debt.) In most of the countries shown, debt expanded considerably as a percentage of GDP over the 1980s and early 1990s. Among the major industrial countries, U.S. debt jumped from 27 percent in 1980 to 52 percent in 1992, Italian debt from 55 percent in 1980 to 109 percent in 1992, and Canadian debt from 25 percent in 1980 to 54 percent in 1992. Debt also expanded in France, Germany, and Japan, although less dramatically (Chart 2). Rapid expansions of debt also took place in Belgium, the Netherlands, Spain, and Sweden.1
|(In billions of U.S. dollars)|
|(In percent of GDP)|
|Belgium||55.5||66.4||74.3||83.2||89.3||97.3||105.5||109.3||110.4||112.6||112.6||115.6||117.9|Chart 2.Government Debt Outstanding in Major Industrial Countries
Sources: International Monetary Fund, International Financial Statistics; Bank of Japan, Economic Statistics Annual (1991) and Economic Statistics Monthly, various issues; Bank of Italy, Economic Bulletin, No. 17 (October 1993); Bank of England, Quarterly Bulletin (November 1993); and United Kingdom, Central Statistical Office, Annual Abstract of Statistics 1994.
Table 5 turns from stocks to flows of debt, by reporting the volume of gross issues of securities with a maturity of more than one year. Most of the countries in the table show a strong upward trend in the dollar-equivalent volume of securities issued, but they also show considerable fluctuations from year to year. Such fluctuations can be due to variations in net financing requirements, in the volume of older securities maturing, and in variations in the proportion of medium-term and long-term securities relative to other debt instruments. Exchange rate fluctuations can also affect these data. A comparison of different countries shows that the greatest gross volume of new issues is in the United States and Japan, followed by Germany and Italy.
|(In billions of U. S. dollars)|
|(In percent of GDP)|
The lower half of Table 5 scales the gross issue data by GDP, and data for the major industrial countries are depicted in Chart 3. These figures give an indication of the demands that government debt issues place on the domestic financial infrastructure. Issues in most countries do not exceed 10 percent of GDP in a given year (Belgium and Italy generally are exceptions as were Japan and Spain in 1993).
Chart 3.Gross Issues of Medium- and Long-Term Government Securities in Major Industrial Countries
Sources: Organization for Economic Cooperation and Development, Financial Statistics Monthly, various issues; and International Monetary Fund, International Financial Statistics and World Economic Outlook.
Table 6 provides some data on issues of short-term securities (under one year in maturity). Chart 4 shows these data scaled by GDP for the major industrial countries. Short-term securities include treasury bills and similar products. The gross issue volume of these securities can be large because the debt stock is often rolled over several times a year.
|(In billions of U. S. dollars)|
|(In percent of GDP)|
|Switzerland9||1.3||1.2||1.7||1.8||4.8||10.2|Chart 4.Gross Issues of Short-Term Government Securities in Major Industrial Countries
Sources: Organization for Economic Cooperation and Development, Financial Statistics Monthly, various issues; and International Monetary Fund, International Financial Statistics and World Economic Outlook.
In some countries, including Japan, such bills are issued mainly for short-term cash management. While only limited data are available for short-term issues, Table 6 shows that the United States and Japan are the largest issuers of short-term debt, as they are for longer-term debt. The volume of short-term debt issued by these countries is several times the volume of longer-term debt issued. This is also true in Italy and Canada. All of this makes it important for governments to have efficient mechanisms for issuing such debt into their money markets.
This expansion in both volumes issued and the outstanding stocks has fostered change in government securities markets through two channels. First, the rise in volumes increases the stakes associated with reform of these markets. For example, benefits from changing the method of issuing government securities are magnified as issue volumes expand. Second, the expansion in government debt outstanding tends to bring about changes in the nature of holders of the debt (see below).
The Identity of Holders of Debt
The composition of government debt holdings has changed considerably in recent years. In general, the shares of banks and individuals have fallen, while the share of foreigners has increased. To the extent that behavior differs across holders, these developments may have influenced the dynamics of government debt markets. They may also have affected other markets, notably the foreign exchange market.
Data on holders of government debt are unfortunately quite limited; more is known about holdings by financial institutions (especially banks) than about other holders. Table 7 reports data for 1980, 1986, and 1992 for those countries where this information is published; Table A1 provides more detailed data for the United States.
|Domestic money market funds||0.57||1.79||2.81|
|Domestic insurance companies||3.89||6.34||6.95|
|Other domestic holders||37.31||52.95||50.34|
|Foreign and international||21.04||16.44||19.36|
|Other domestic holders6||21.20||20.32||19.41|
|Other domestic holders||…||79.59||49.22|
|Domestic investment funds||6.81||2.72|
|Domestic insurance companies||1.30||1.88||4.21|
|Other domestic financial institutions10||3.96||4.02||2.31|
|Private sector and foreign||53.42||59.16||73.73|
|Domestic insurance companies||30.36||30.15||36.62|
|Domestic pension funds||16.82||23.43||21.67|
|Domestic investment and unit trusts||0.53||0.76||0.64|
|Other domestic financial institutions12||12.29||8.93||2.34|
|Domestic individuals and private trusts||16.34||12.01||8.94|
|Other domestic holders13||9.88||8.20||8.51|
|Domestic investment and closed-end funds||0.47||1.49||5.46|
|Domestic insurance companies15||9.76||8.80||7.89|
|Domestic trusteed pension funds||7.71||9.75||10.63|
|Other domestic financial institutions16||5.75||5.51||5.78|
|Other domestic holders17||46.07||48.06||34.25|
|Domestic insurance companies||12.96||12.71||10.38|
|Other domestic financial institutions20||2.93||9.39||2.82|
|Other domestic holders21||1.33||14.56||19.24|
One trend that emerges from Table 7 is that the share of government debt held by domestic banks has declined since 1980. In the United States, the share of bank holdings fell from 18 percent in 1980 to 10 percent in 1992 (although bank holdings have risen in the United States since 1990; see Table A1).2 In Germany, the share of bank holdings fell from 70 percent in 1980 to 54 percent in 1992. Marked declines are also evident in Italy and Sweden, and in France since 1986. In the United Kingdom and Canada, the shares of bank holdings have fluctuated, rising and then falling in the United Kingdom, while doing the opposite in Canada.
Insurance companies hold a small but rising proportion of government debt in the United States and in Italy. They are major holders of government debt in the United Kingdom, and this share rose considerably after 1986, so that by 1992 insurance companies held over one third of U.K. debt. Insurance companies held a moderate and declining share of government debt in Canada and Sweden.
The data for other domestic financial institutions are sparse. Pension funds appear to have increased their shares in the United Kingdom and Canada between 1980 and 1992.
A second notable trend is that the share of government debt held directly by domestic households has fallen between 1980 and 1992. In the United States, their share fell sharply in the first half of the 1980s (from 19 percent in 1980 to 10 percent in 1986) and has stayed roughly constant since then. Holdings of individuals and private trusts in the United Kingdom fell from 16 percent in 1980 to 9 percent in 1992. Household holdings rose in Sweden in the first half of the 1980s, but have fallen considerably since 1986.
The third trend is the sharp increase in holdings of government debt by foreigners. Foreign holdings of German public debt rose from 9 percent in 1980 to 26 percent in 1992. Foreign holdings of government debt also rose sharply in France (since 1986), the United Kingdom, Canada, and Sweden.3 In the United States, however, the share of debt held abroad has fluctuated, falling from 1980 to 1985, before rising again in the second half of the 1980s to a peak of 21 percent in 1989.
What are the implications of a relative decline in holdings by individuals and by banks and a relative increase by nonresidents? The decline in individual holdings of debt implies that institutional holdings of government debt are increasing (assuming foreign holdings are primarily institutional). Institutional holders are likely to turn over their debt positions more rapidly than households, although the effect of this on the dynamics of government securities markets is unclear. Such increased turnover could stabilize markets, since institutions probably react to small return differentials more than households do. Conversely, institutions may shift funds more rapidly from one market to the other, causing greater volatility. Institutions holding government debt are also subject to widely varying levels of supervision and regulation. Large swings in the price of government debt may lead to difficulties or even insolvency at some firms.
What about the “internationalization” of government debt holding? By opening a larger market for the debt, internationalization can potentially lower the cost of debt for a country. It has also led to pressure on governments to reform their markets to make them more attractive to international investors.
Internationalization has taken other forms for some issuers, including issuing debt on the Euromarket and in some foreign domestic markets. Such an approach has tended to be popular with smaller countries and with countries that carry relatively high debt levels. This trend has underpinned the issuance of sovereign global bonds, which can be sold simultaneously in several different markets.
Maturity and Currency Composition
Governments of the larger countries issue almost all their debt in domestic currency. Germany, Japan, and the United States do not issue any foreign currency debt. France has a program of issuing European currency unit (ECU) debt, but the bulk of its debt is in French francs. The United Kingdom issues the bulk of its debt in pounds sterling, but issues some ECU debt too. During the European exchange rate mechanism (ERM) crisis, it issued some debt denominated in deutsche mark on the Euromarket, in order to augment its foreign exchange reserves. Canada issues most of its debt in Canadian dollars, but issues debt in U.S. dollars to finance its foreign exchange reserves, and has issued previously in yen and deutsche mark.
Italy is alone among the seven major industrial countries in having an extensive foreign currency borrowing program. It issues Euromarket debt in a variety of currencies, and has recently issued global bonds in U.S. dollars and yen. Italy also issues domestic debt in ECU, on top of a well-developed domestic borrowing program in lira.
While data on maturity structure are limited, Table 8 gives a summary for six countries.4 In the United States, maturities lengthened between 1980 and 1992, with most of this lengthening occurring before 1986. The proportion of debt of less than five-year maturity decreased from 81 percent in 1980 to 71 percent in 1992, while the proportion of debt of greater than ten-year maturity increased from 11 percent to 16 percent. For Germany, data are only available for total government debt, a broader category than central government debt. Like the United States, Germany has engineered a considerable lengthening in maturities. The proportion of debt of less than three-year maturity decreased from 44 percent in 1980 to 26 percent in 1992, while the proportion of debt longer than five years rose from 34 percent to 45 percent. In contrast to the United States, however, Germany has very little debt with maturities greater than ten years.
|United States2||0–1 year||0–5 years||0–10 years||0–20 years||All|
|Japan3||0–5 years||0–10 years||0–15 years||0–20 years||0–25 years||All|
|Germany4||0–1 year||0–3 years||0–5 years||0–10 years||0–15 years||0–20 years||All|
|France5||0–1 year||0–5 years||0–10 years||0–15 years||All|
|United Kingdom6||0–5 years||0–15 years||All|
|Canada7||0–3 years||0–5 years||10 years||All|
The maturity structure of Japanese debt shortened between 1980 and 1986. Since 1986, however, Japan has initiated a slight lengthening of maturities, especially in the very long end (more than 15 years) of the market.
The United Kingdom shows a different pattern. The proportion of debt below five years in maturity has remained roughly constant, but the proportion in the 5–15 year range has risen at the expense of longer-term debt. In March 1993, 72 percent of U.K. debt had maturities below 15 years, compared with 58 percent in March 1981. Like the United Kingdom, Canada also has experienced a shortening of maturities. The proportion of debt less than three years in maturity rose from 53 percent in 1980 to 64 percent in 1992. The proportion of debt with maturities above ten years fell from 27 percent to 14 percent over the same period.
While comparable data are not available for Italy, its effective maturity structure is short relative to other major industrial countries. About 27 percent of Italian debt is in Treasury bills of maturity one year or less, with another 35 percent indexed every six months.
Governments also issue a variety of debt that is not fixed in terms of future cash flows. One type is debt indexed to inflation. Among the seven major industrial countries, the United Kingdom is an active issuer of such debt, and Canada began a program in 1991. Some governments, including Italy and Canada, also issue floating rate debt, which has the interest rate indexed to a short-term interest rate.
Interest rate swaps can also be used to adjust the maturity composition of debt. Canada has an active program of swapping its debt. The Government enters swaps in which it agrees to make floating rate payments to its counterparty, in exchange for receiving fixed rate payments that match the Government’s liabilities on some of its bonds.
Another tool related to maturity management is strips. These are programs that separate a coupon bond into separate zero-coupon securities for each coupon interest payment and for the final maturity payment. Strips are arranged at the initiative of the market, rather than as a decision of the government. However, government policies can facilitate strips. While strips do not change the maturity composition of the government’s debt, they do allow holders to choose more precisely the cash-flow profile of their debt portfolio, and thereby increase demand for the government’s debt.
Primary Dealer Systems
In many countries, the authorities have designated a group of financial firms as the principal intermediaries in the government securities market. These firms receive a set of privileges in this market, in exchange for a set of obligations. The nature of these privileges varies greatly from country to country; the most common obligation is to make a secondary market in government debt. These firms sometimes operate under a special supervisory regime.5
The United States has long had a system of primary dealers in its government securities market. The Federal Reserve Bank of New York designates these firms, which currently number 39. In the wake of the Salomon scandal in 1991, U.S. authorities reduced the extent of both the privileges and the obligations of primary dealers6—in part to increase the competitiveness of government securities markets.7
Primary dealers in the United States are required to be active in both the primary and secondary markets for government securities. They must make reasonable bids in every Treasury auction. The Federal Reserve Bank of New York used to require each primary dealer to account for at least 1 percent of the total transactions of all primary dealers with customers, but it abandoned this rule in January 1992. The rule reportedly had forced some smaller primary dealers to offer steep commission discounts to their customers. Primary dealers, however, still must maintain a presence in the secondary market, because the Bank requires them to “make reasonably good markets in their trading relationships with its trading desk and provide the trading desk with market information and analysis that may be useful to the Federal Reserve in the formulation and implementation of monetary policy.”8
In October 1991, the U.S. Department of Treasury eliminated two privileges that primary dealers had enjoyed. One was the exclusive right to place bids for customers in Treasury auctions. The other was exclusive access to Treasury announcements of its borrowing plans, which the Treasury now disseminates to the entire market.
Primary dealers enjoy two remaining privileges. They have exclusive access to some of the inter-dealer broker screens, although this exclusivity also is eroding.9 They also serve as the Federal Reserve Bank of New York’s counterparties in its open market operations. Primary dealers thus are the main conduit through which the Federal Reserve conducts its monetary policy. It is sometimes argued that such a position gives primary dealers knowledge of monetary policy that other market participants do not have.
Japan does not have a primary dealer system along the U.S. lines. However, it does bestow a special role in the government securities market to a large group of firms. These firms make up the issuing syndicate for Japanese Government bonds (JGBs). Over 900 firms are members of the syndicate, including banks, securities firms, and insurance companies. Additionally, a much smaller group of about 35 firms negotiates the terms of syndicated government bond issues with the Ministry of Finance. In contrast to the U.S. system, the syndicate has a special role only in the primary market, but not in the secondary market or in central bank monetary operations.
The primary obligation of syndicate members is to accept their allocation of bonds. Forty percent of the biggest Japanese issue, the ten-year bond, is syndicated, although most other bonds—and the rest of the ten-year bonds—are auctioned. The syndicated bonds are sold at the weighted-average price from the auction.10 In exchange for accepting their share of syndicated bonds, syndicate members enjoy two benefits. First, they have exclusive access to auctions for government bonds. Second, they receive a commission from both the syndicated and auctioned portions of the ten-year bond.
Germany sells its bonds through a consortium of 109 members. Most long-term bonds in Germany are sold through a combination of a syndicated distribution through the consortium with an auction and subsequent tap sales by the Bundesbank.11 In contrast to primary dealer systems in other countries, membership in the bond consortium appears to carry no significant costs. The primary role of consortium members is to accept their share of syndicated bonds at the price determined by authorities, but there is no automatic mechanism to ensure that this price is close to the auction price. Since a selling commission is paid on these bonds (but not on those allocated through the auction or tap), these shares are probably more a privilege than an obligation. Shares are decided by the Bundesbank. In addition to their syndication shares, consortium members enjoy other privileges: they have exclusive access to government bond auctions; they hold a regular meeting, at which they exchange market information; and they have special access to Bundesbank repurchase agreement (repo) operations in order to finance their government security purchases.
The French Treasury adopted in 1987 a system of primary dealers known as Spécialistes en Valeurs du Trésor (SVTs). These firms were assigned duties in both the primary and secondary markets; SVTs, however, have no special role in central bank monetary operations. The Bank of France carries out monetary operations through a different, separately designated group of firms, although some firms are members of both groups.
The 18 current SVTs have specific, quantitative obligations in the government security auctions and in the secondary market. During the course of a year, each SVT must purchase 2 percent of the total amounts auctioned of each of the three principal types of securities: BTFs (short-term), BTANs (medium-term), and OATs (long-term).12 SVTs must be considerably stronger than this threshold in at least one of these types of securities, because the average of their annual shares in the three types of securities must exceed 3 percent. In the secondary market, each SVT must account for at least 3 percent of the transaction volume in each type of security. SVTs must also provide quotes upon request for any government security and post continuous screen quotes for the most active issues. In addition to these auction and market-making requirements, the Treasury requires SVTs to work to place securities with final investors, both in France and abroad.
In exchange for these obligations, SVTs enjoy two specific privileges. One, which is unique to the French system, is a provision for submitting noncompetitive bids. SVTs are permitted to purchase additional amounts of an auctioned security at the weighted-average auction price for up to one day after the auction. The amount an SVT may buy at this price is proportional to its average purchases in the last three auctions for the same type of security, subject to a ceiling for all SVTs of 15 percent of the issue. The second privilege is that SVTs have sole access to an interdealer broker. SVTs are also expected to advise the Treasury on market conditions and issuance policy. Such a relationship with the Treasury is likely to benefit the SVTs as well as the Treasury.
In the United Kingdom, the primary-dealer equivalent is the gilt-edged market makers (GEMMs). The GEMM system has operated since the Big Bang in 1986. In exchange for a variety of special privileges, GEMMs are required to make markets for gilts—essentially all marketable medium- and long-term U.K. Government securities. GEMMs do not have any special role in the market for short-term U.K. Treasury bills, and their role in Bank of England monetary operations is limited.
The principal obligation of GEMMs is to make continuous markets in gilts. Each GEMM must make a market in the full range of gilts, including index-linked gilts, which tend to have lower transaction volume than conventional gilts. They are also expected to participate regularly in gilt auctions, though this requirement receives less emphasis than the market-making requirement. The Bank of England does not measure the GEMMs’ secondary and primary market conduct against any explicit numerical standards.
GEMMs receive a package of privileges in exchange for their market-making activities. They have the exclusive right to deal in gilts with the Bank of England, and they may borrow from the Bank. They also have the exclusive right to borrow gilts, which they do through special stock exchange money brokers. These gilts are lent by other GEMMs, as well as by investors. Finally, GEMMs have exclusive use of special interdealer brokers. GEMMs do not have any special privileges relating to gilt auctions, except that only they may submit bids by telephone, which may give them some advantage in reacting to late-breaking market developments.
Primary dealer systems such as those described in this section clearly involve constraints on the workings of markets. These systems restrict entry of firms into parts of the government securities market and tie the participation of firms in some parts of the market to participation in other aspects of the market. Their justification is that the obligations of primary dealers satisfy public goals that would otherwise not be met. The most prominent of these goals is to maintain the liquidity of secondary markets, which arguably is increased by requirements that primary dealers make continuous markets. Such an arrangement resembles that in other financial markets, such as stock markets, where agents are charged with making markets in return for some privileges.13 Another justification for primary dealer systems is that such systems serve as devices for authorities to regulate and supervise the firms that are the major players in the domestic government securities market and which play an important role in other domestic financial markets as well.
The methods used by many countries for issuing government securities have changed in recent years; in brief, more securities are being auctioned and fewer are being issued through syndicates. Different auction techniques have also been under consideration, especially in the United States.
Most debt securities are issued by one of four methods: auctions, direct syndications, tap issues, and underwritten syndications. The last of these methods is used for Euromarket and global issues, while the other three are used for domestic issues. Tap issues by the central bank are often used to sell parts of issues that are also sold through auctions or syndications.14Table 9 lists the methods used by governments of the major industrial countries to sell their domestically issued government securities. Of these countries, only Italy is a regular issuer on international markets. Smaller industrial countries use techniques similar to those used by the major industrial countries. Several of these smaller countries are active borrowers on Euromarkets and other international markets and use underwritten syndications for these issues.
|Methods of issuance|
|Canada||Syndicate (indexed bonds)|
|Discriminatory auction (all other securities)|
|France||Discriminatory auction (all securities, except occasional syndicates)|
|Germany||Combination of syndicate, discriminatory auction, and tap sales by central bank (Bundesanleihen)|
|Discriminatory auction (various securities)|
|Tap sales by central bank (various securities)|
|Italy||Discriminatory auction (Treasury bills)|
|Uniform-price auction (longer maturities)|
|Japan||Combination of discriminatory auction and syndicate (ten-year Japanese Government bond)|
|Syndicate (five-year Japanese Government bond)|
|Discriminatory auction (various securities)|
|Uniform-price auction (financing bills)|
|United Kingdom||Discriminatory auction (Treasury bills and some gilts)|
|Uniform-price auction with minimum price (some gilts, infrequently)|
|Tap sales by central bank (some gilts)|
|United States||Discriminatory auction (all maturities)|
|Uniform-price auction (two- and five-year notes, on an experimental basis)|
Auctions are used for the bulk of government debt issued worldwide. There is a variety of types of auctions. Auctions for government securities usually are sealed bid, where the government receives all bids in a single batch before the auction. With improvements in communication and information processing, however, it may also be possible to conduct interactive auctions, in which the government gradually raises prices, soliciting bids at ascending prices, until supply equals demand. U.S. policymakers have considered implementing such a system. Among sealed-bid systems, the big choice is between uniform-price and discriminatory (multiple-price) systems.15 In a uniform-price system, all units of the security are sold for the same price, generally the price of the lowest successful bidder. In a discriminatory system, each bidder pays the price bid.
For their auctioned debt, Canada, France, and Germany exclusively use discriminatory auctions, while the other major industrial countries use a mix of auction techniques. In the United States, the authorities have begun to use uniform-price auctions for sales of some Treasury notes on an experimental basis, after some incidents of manipulation in discriminatory auctions. Initially, this was a one-year experiment from September 1992 through August 1993, but the experiment has been extended for an additional year. Discriminatory auctions are also the more common auction technique in countries other than the major industrial countries.
Auctions often embody incentives to encourage bidding. In Germany, shares in the syndicate for issuing bonds are adjusted periodically, with the amounts syndicate members have purchased in auctions influencing their syndicate shares. Some incentives result in options conferred on some bidders. The noncompetitive bids available to SVTs in France are an example of such an option.
Germany and Japan have made the most prominent use of syndicates for domestic bond issues (see section on Primary Dealer Systems above). Other countries, including Canada and France, have virtually ceased using syndicates in recent years.16
Some researchers have criticized the use of discriminatory auctions and have recommended the use of uniform-price auctions instead. Although the former appears to increase revenue through price discrimination, critics argue that these auctions exacerbate the winners’ curse phenomenon, in which successful bidders suffer from having overestimated the value of the securities, and therefore, that bidders reduce their bids accordingly. It is unclear whether this reduction outweighs the increased proceeds from price discrimination, and therefore it is unclear which technique yields higher proceeds for the government. However, another consideration is that uniform-price auctions do appear to reduce risk faced by bidders. There has also been considerable debate in the United States as to which technique is less prone to manipulation, such as market cornering and collusion among bidders.17
A broader question concerns the advantages of auctions compared with other techniques. This issue has not received as much attention as the debate on auction techniques. At first blush, auctions appear to be a more efficient mechanism to elicit market demand than other techniques. However, the risk inherent in the winners’ curse problem may reduce this efficiency, although the asymmetric information between buyers that drives winners’ curse in auctions must still operate in other systems and may cause other inefficiencies.
Organization of When-Issued Markets
A when-issued market is a market in securities not yet issued. Settlement normally occurs on the same date that deliveries are made in the primary market. In the United States, for example, when-issued trading begins when an auction is announced, up to ten days before the auction.18 The primary economic role of the market is price discovery. The when-issued market provides information on market demand to participants in an auction for a security. The market also plays a risk-shifting role; investors with a demand for the particular security can lock in the yield on this security in advance of the auction, and the risk of interest rate movements is shifted to their counterparties in the when-issued market. These counterparties, who have a short position in the when-issued market, are often bidders in the auction.
A when-issued market exists in all the major industrial countries other than Germany and Japan. Trading starts in these markets when the particulars of an auction are announced, including the amount to be issued and the maturity. This period ranges from as much as ten days before the auction (in the United States) to as little as two days (in France). Settlement of when-issued trades occurs when the auctioned securities are distributed. This post-auction settlement period ranges from one day (in the United Kingdom) up to over three weeks (in France).
Activity on these markets varies considerably from country to country. While volume statistics are not available, the U.S. market appears to be the most active. The when-issued security in the United States becomes the “on-the-run” (i.e., the benchmark) issue. This security is the most recently issued of its maturity range and is the most heavily traded and liquid issue. The when-issued market is also reported to be heavily used for gilts in the United Kingdom and for government securities in Canada. The Italian when-issued market, on the other hand, does not experience heavy trading.
The when-issued market came under scrutiny in the United States because of several incidents of manipulation in 1991. The market was manipulated when one dealer amassed a dominant position in the auctioned security and forced those dealers with short positions in the when-issued market to pay abnormally high prices to cover these positions. This is one example of what is known as a “short-squeeze.” In the U.S. case, rules on the amount one dealer may purchase at an auction were circumvented in order to accomplish this squeeze. The possibility of such squeezes raises risks to participants in the when-issued market and therefore reduces the liquidity and efficiency of the market, in turn reducing the information available to bidders in the primary market. This reduced information may increase the likelihood of winners’ curse and increase debt costs of the government.
There are two important unresolved questions regarding when-issued markets. The first is what are the benefits to the price discovery process of the when-issued market. Preauction trading in the when-issued market permits at least the partial aggregation of private information on the value of the issue. This reduces the asymmetry of information at the auction and therefore reduces the likelihood of winners’ curse. In turn, that is likely to make bidders bid more aggressively and increase proceeds to the government. However, the when-issued market may simply shift risk from auction participants to when-issued participants. The when-issued market may serve to reallocate risk among market participants rather than reduce it, although it will reduce the amount to which the government must compensate auction participants with lower issue prices.
The second question surrounding the when-issued market is how susceptible is it to manipulation, as discussed above. Because of the long settlement periods relative to the cash market, when-issued positions can be taken at lower cost, and it is therefore less expensive to build up market power in such a market. One possible solution to such a risk of manipulation might be to build alternative delivery options into the contract, so that if a particular security were scarce, those with short positions in when-issued securities could deliver either cash or some alternative security.19 Improved reporting of price and trade information also might reduce manipulation, as might improved supervision of the market.
Liquidity in the Secondary Market
The function of a secondary market is to provide liquidity. It is particularly important that markets are able to provide liquidity in times of stress, when buy or sell orders increase. A variety of features in secondary markets contribute to liquidity.
One rough gauge of the liquidity of secondary markets is the volume of transactions in the market. The higher this volume, the more market-makers are compensated for the fixed costs of serving their role. This in turn is likely to increase the financial resources these market-makers have at their disposal, while also drawing additional firms into the market.
Table 10 reports transaction volume in cash government securities markets for five major industrial countries.20 Generally, transaction volume in these markets is very large and has grown tremendously since 1980. The volume of transactions involving primary dealers in the United States grew from an average of $14 billion a day in 1980 to $120 billion in 1993. Volume in the Japanese market has grown even more sharply, from $1.4 billion a day in 1980 to $58 billion in 1993. Volume in the U.K. market is considerably smaller, but has also risen substantially since 1980, especially after the Big Bang in 1986. Using 1992 figures, 3 percent of U.S. debt was traded on an average trading day, compared with 2 percent for both Japan and the United Kingdom.
|Over-the-counter market in Tokyo||1.38||1.63||1.77||2.30||4.84||17.21||29.13||73.90||62.06||49.48||44.11||38.47||44.24||57.62|
|Transactions in stock exchanges3||0.03||0.07||0.08||0.23||0.45||0.80||1.50||1.39||1.15||0.97||0.92||0.53||0.20||0.19|
|Short- and medium-term securities||…||…||…||…||…||…||0.24||1.18||2.12||2.45||2.88||3.65||7.56||13.73|
|Treasury bonds (OATs)||…||…||…||…||…||…||…||…||…||…||…||…||8.16||14.42|
Transaction volume in most markets tends to be concentrated in benchmark securities. In most countries, a benchmark is the most recently issued security of a particular maturity. Usually the list of benchmarks in different countries includes a ten-year bond, which forms the basis for international comparisons of yields. Nonbenchmark securities are traded less frequently than benchmarks and are more likely to be held in the portfolios of longer-term investors. Because benchmarks are traded frequently in liquid markets, market yield information is more reliable and up to date than for other securities. For this reason, markets use benchmarks to price other fixed-income securities. For example, a ten-year corporate bond in U.S. dollars might be priced at, say, a 100 basis point spread to the ten-year Treasury bond with the same maturity, or a French franc bond at a spread above the French Government bond (known as the OAT). Typically, benchmarks also carry a somewhat lower yield than similar nonbenchmark securities; this difference in yield can be thought of as the market price of the greater liquidity of benchmark issues.
In Japan, trading is heavily concentrated in the benchmark Japanese Government bond (JGB). While this benchmark is a JGB with an original maturity of ten years, the benchmark is often not the most recently issued JGB. Instead, the benchmark bond is chosen by securities dealers. Requirements for benchmark status are that the bond have a sufficient volume outstanding, between eight and ten years remaining to maturity, and a price near par (which means that the coupon rate is close to the yield to maturity). Trading in JGBs is heavily concentrated in the benchmark, with about 80 percent of total trading concentrated in this security. Bid-ask spreads are also considerably narrower for benchmarks than for nonbenchmarks, which is a sign of the greater liquidity of the benchmarks.21
Many governments have adopted a practice known as “fungibility” which involves reopening an existing security, instead of issuing a new security. By increasing the amount outstanding of particular issues, markets have available a larger inventory of the security to trade, which increases liquidity. This practice is particularly common in France, which since the mid-1980s has followed a policy of adding frequently to existing securities, while issuing new securities less often. For example, France issues a new ten-year bond only once a year, but auctions additional tranches of this bond every month. Belgium makes heavy use of this technique for its “linear bonds,” and Canada, Germany, Japan, the Netherlands, and the United Kingdom also reopen issues.22
The bulk of volume in government securities is traded over the counter (OTC), rather than on exchanges. This is true in all the major industrial countries except the United Kingdom. This exception is perhaps due to the different nature of the U.K. stock exchange, which relies on dealers’ posting quotes, rather than the order-matching processes more common in exchanges. In most countries, government securities are listed on exchanges, partly because some institutional investors are required to buy on exchanges, even though the bulk of volume occurs off the exchanges. Significant German trading takes place both on the domestic stock exchanges and OTC.
In many markets, interdealer brokers play an important role. They specialize in gathering price quotes from government securities dealers and posting them on an anonymous basis on screens to which all the dealers have access. When dealers trade, interdealer brokers do one of two things. Some interpose themselves between each side of a trade, so each counterparty actually trades with the interdealer broker. In this case, the identity of the counterparties is never revealed. Other interdealer brokers reveal the names of each counterparty to the other, and then the two counterparties complete the trade themselves. In most markets where inter-dealer brokers operate, the bulk of interdealer trades go through them. Interdealer brokers are also active in the offshore market based in London.
Offshore markets can be an important source of liquidity for government securities markets. This market is particularly active in London, where a considerable share of the volume of trading in French and German Government securities takes place.
Futures markets also contribute to the liquidity of government securities markets. Exchange-based futures contracts on government bonds from all the major industrial countries are actively traded. There also are contracts on short-term government securities from several countries. Additionally, options on many of these futures or on the underlying bonds are traded through the same exchanges. Table A2 lists contracts that are traded. In terms of contracts traded, the U.S. Treasury bond futures on the Chicago Board of Trade are the most active of all financial futures listed. Futures on U.S. Treasury bonds also are traded in Tokyo and London, although in much lower volume, making this market a 24-hour market.
Futures and options markets provide a method for market participants to adjust their exposure to government securities markets. Such markets contribute to liquidity in the underlying cash markets in two ways. First, they permit market-makers to hedge cash positions and to adjust those hedges relatively quickly. Some of this liquidity may be illusory, however, since futures markets involve two opposite positions, and the short position may be hedged or arbitraged in the cash market. However, this leads to the second way futures markets contribute to liquidity: futures markets generate trading volume in the cash market, through this arbitraging and hedging. This additional trading volume helps attract additional market-makers in the cash market. Futures markets also enhance market transparency, as contracts are traded on exchanges with published, real-time volume and trade information.
Countries vary in their systems for clearing and settling government securities transactions. Of the major industrial countries, only the United Kingdom and the United States settle transactions in long-term government securities (bonds) as quickly as the next day; other countries exhibit longer delays, although some clear short-term securities more quickly. In the United States, some Treasury bill transactions settle on the same day as the trade. Most government securities in major countries are held in a computerized book-entry system, so that there is no cumbersome physical delivery. In the United States, most government securities transactions are routed through the Government Securities Clearing Corporation (GSCC). The GSCC nets trades, and net payments and securities transfers are made through the wholesale bank payments system, Fedwire, which is connected to the book-entry system run by the Federal Reserve. This netting reduces the volume of payments made over Fedwire.
The time between trade execution and settlement exposes participants to the risk of nondelivery of securities or cash. Having a book-entry system for securities can make settlement considerably more efficient and reduces risk by facilitating delivery-versus-payment settlement. A trade netting system can also contribute to efficiency, by reducing the number of payments brokers and dealers need to make. Links between domestic clearing systems and international clearing systems, especially Cedel and Euroclear, facilitate international transactions in a country’s debt.
Markets vary according to the degree to which information on the market is disseminated. Government securities typically have a lower degree of transparency than stock markets, where real-time price and trade information is available to the public. Since most government securities transactions occur OTC, there is no exchange through which to disseminate information. In many government securities markets, market-makers post quotes and transact through interdealer broker screens. Typically, only market-makers have access to these screens. Thus, agents outside the circle of market makers have less information about the market than insiders do.
Organization of Repurchase Agreement and Securities Lending Markets
Repurchase agreements (repos) facilitate leveraged long and short positions in securities. A portfolio of long positions in securities can be financed in part by executing repos on some of the securities in the portfolio. The trader that held the original portfolio and executed the repos remains exposed to price movements on the securities used in the repos. Conversely, a trader executing a reverse repo can immediately sell the security acquired through the reverse repo, thereby creating a short position which it must cover in the future to complete the repo.23 The ability to engage in these transactions can facilitate inventory management by securities dealers, and thus reduce the cost of market-making and increase liquidity in cash markets. Securities lending is a somewhat more generalized term than repo. Repos are essentially a way to lend a security with the cash lent serving as collateral, but securities may also be lent either with other securities as collateral or without any collateral.
Repo and securities lending facilities are often cited as a key element in a liquid bond market. They allow dealers to take long and short positions in a flexible manner, buying and selling according to customer demand on a relatively small base of capital. Both repo and securities lending facilities allow dealers to acquire specific securities demanded by customers, without having to find another customer willing to sell the bonds. These transactions are often facilitated by brokers who specialize in these markets. Repos also contribute to liquidity by allowing nondealer investors to take positions in securities without putting up much capital. The market can therefore react to any price movements in securities markets, keeping prices close to their equilibrium.
In the United States, the repo market for government securities is very large. As of October 20, 1993, primary dealers had open repo contracts in government securities outstanding of $852 billion. This figure includes repos both in Treasury securities and agency securities, including mortgage-backed securities. This was equivalent to 29 percent of U.S. marketable debt outstanding at the end of the third quarter of 1993. Overnight and continuing repos ($466 billion) were more common than longer-term repos ($386 billion).24 The primary dealers also had $670 billion in reverse repos out-standing. Securities lending by primary dealers was smaller, with a total of $184 billion borrowed and $5 billion lent.25
In the mid-1980s, several government securities dealers in the United States failed. These failures resulted in the failure of several savings and loans, and precipitated the collapse of the Ohio state deposit insurance company. A factor in the failure of these dealers was that the dealers had executed repos with customers, but had failed to place the securities involved in their customers’ accounts. Instead the dealers used the same securities to execute multiple repos. These secondary dealers had been unregulated and unsupervised, since their sole business was government securities. In response to these events, the Government Securities Act of 1986 became law, placing government securities dealers under the regulation of the U.S. Treasury and the supervision of the Securities and Exchange Commission (SEC).
Repo markets in other large countries are substantially smaller than the U.S. market. In many countries, repo and securities lending markets are inhibited by regulatory restrictions or taxes. In Japan, repo transactions are known as gensaki. The market for gensaki on short-term government securities is active and accounts for a reported 28 percent of transaction volume in government securities. The main borrowers of funds in this market are securities firms. Gensaki in longer-term securities are less common, however. The reason for this is that these repos are considered bond transactions and therefore are subject to Japan’s tax on securities transactions. This transactions tax also tends to lengthen the maturity of gensaki relative to U.S. repos.26 In contrast to most U.S. repo transactions, gensaki do not permit the borrower of funds to substitute one security for another as collateral. Total repo contracts outstanding in Japan (including those on nongovernment securities) totaled ¥10.6 trillion ($101 billion) at the end of September 1993, which was 9.8 percent of total Japanese Government debt outstanding.27 While these numbers are substantial, they show less use of repo transactions than in the U.S. market. Bond lending was authorized in Japan in 1989. This type of transaction is not subject to the transaction tax, so it has become an active market and a source of market liquidity in the bond market. Bond lending can be as short as overnight, in contrast to Gensakis, for which the transaction tax makes such a short-term transaction prohibitively expensive.
In Germany, banks borrowing funds through repo transactions face a reserve requirement on these borrowed funds. As a result, a domestic repo market essentially does not exist. In contrast, a repo market in German Government securities flourishes in London, with most of the volume concentrated on the long-term bonds (Bunds). German firms reportedly are active in this market, which is linked to trading in futures contracts on German Government securities.
French Government securities repos are executed both in the domestic market and offshore. There are no tax impediments, although legal uncertainties have hampered the development of the domestic market; the French Government passed a new law intended to eliminate these uncertainties at the end of 1993. As of December 1993, there were about F 200 billion in domestic repos outstanding, and about twice that amount in international repos. Italy also has an active domestic market in repos, especially in longer-term government securities. At the end of 1993, there were Lit 92 trillion in repos outstanding, excluding interbank repos.
In the United Kingdom, a market for repos in gilts between private parties does not exist, and there is only a limited market in gilt borrowing. Only gilt-edged market-makers may borrow gilts, and they must do so through the stock exchange money brokers. The Bank of England began in January 1994 to use gilts repos as a regular open market device. In Canada, there is an active repo market in government bonds. This market has grown rapidly since 1992, after the elimination of a tax on cross-border repos. U.S. investors reportedly are active in the market and have driven much of the growth of the market.
A variety of issues arise in these markets. One is that the legal validity of repurchase contracts has been in question in some jurisdictions. This makes the status of repos uncertain under bankruptcy; while repos have the features of a collateralized loan, bankruptcy procedures may not recognize this. The tax treatment of repos can also be an issue. Such problems stem from the fact that repos combine short-term collateralized lending with a loan of a security, but not formally as a loan, but rather as a sale with a future contract to reverse the sale. Issues related to the transfer of the title to the security can also come up, especially when a dealer conducting a repo holds the security in custody for its counterparty.
Another technical issue concerns the settlement of repo and securities lending transactions. In principle, these transactions can use the same clearing and settlement facilities as regular cash transactions in securities. However, the complexity of these transactions complicates matters.
Finally, these transactions raise potential systemic concerns. Repos in particular are used by some parties, including hedge funds, to take large, leveraged positions in government securities. Dealers essentially lend to these funds using the repo as a collateralized loan. Repos typically are relatively short term (under a week), with the initial market value of the underlying security exceeding the amount of cash loan by small margin. This margin protects the dealer from fluctuations in the value of underlying security. If, however, the volatility of market prices unexpectedly increases, dealers could be left with insufficiently collateralized positions against borrowers.
International Debt Markets
The Distinctions Between Domestic Debt and Eurodebt
Governments tend to issue the bulk of their debt on their own domestic market, but many also issue on Euromarkets. In addition, some governments issue on the domestic markets of foreign countries, although less frequently. Countries normally use international markets for their foreign currency issues, while issuing domestic currency debt at home. In most major currencies, regulatory barriers generally separate the Euromarket from the domestic market. The result is that domestic residents of a country tend to hold more of domestic debt issued in that country, while nonresidents hold more of the Eurodebt. Eurodebt is typically issued in bearer, nonregistered form, which makes it difficult for the authorities to monitor and tax the holders of the debt.
While many countries auction their domestic government debt, Eurodebt normally is issued through an underwriting syndicate. Countries issuing in the domestic market of another country (most often in the United States) also use a syndicate. The nature of the syndicate varies across markets. Euro-syndicates include sellers able to place the debt internationally, while syndicates for domestic issues place more domestically. This distinction typically dictates the nationalities of members of the syndicates.
Although a Eurobond usually is listed on some exchange, most transactions occur OTC. The settlement of Eurobonds typically takes place through two international clearing agencies, Euroclear and Cedel. Domestic bonds most often clear through their domestic clearers, although international trades of these bonds sometimes use international clearers.
In the United States, SEC rules serve to differentiate bonds issued on the domestic market from Eurobonds. Bonds issued in the United States must be registered with the SEC.28 Eurobonds are exempt from SEC restrictions, but consequently they may not be sold to U.S. investors on the primary market. The SEC imposes a seasoning period of 40 days from the date of issue of a Eurobond, during which time the bonds may not be sold in the United States. Although U.S. investors may purchase Eurobonds after the seasoning period is over, the bulk of Eurobonds tend to be held outside the United States.
There are no significant regulatory barriers between deutsche mark bonds issued by foreigners on the domestic German market and Euro-deutsche mark bonds. Bonds that are sold internationally are designated Eurobonds, while others are considered domestic issues. The Bundesbank requires all deutsche mark bonds to clear through the domestic German clearing system, although international trades in Euro-deutsche mark bonds may also clear through international clearers. Euro-deutsche mark bonds arose in the 1960s as a result of a withholding tax imposed on domestic deutsche mark bonds held by foreigners, but this withholding tax has since been abolished.29
As noted above, there is some separation between the Eurobond market and domestic bond markets. An issuer normally must choose on which market to issue. Demand for the bond is then constrained by the barriers between the markets. In the last few years, an instrument known as the global bond has been developed to overcome this segmentation.
The World Bank issued the first such bonds in 1989 and still remains the leading issuer of global bonds. It has issued in U.S. dollars, Japanese yen, and deutsche mark. Its first global bond issue in 1989 was in dollars, and it continues to issue regularly in dollars. It has made four issues in yen and has ¥ 900 billion in yen global bonds outstanding. Most recently, the Bank pioneered the deutsche mark global bond with a DM 3 billion issue in October 1993.
A number of sovereigns have also issued global bonds. Among the Group of Ten countries, Italy and Sweden have used this technique. Sweden issued a $2 billion U.S. dollar global bond in February 1993. More recently, Italy issued $5.5 billion in U.S. dollar global bonds in September 1993 and a ¥ 300 billion yen global bond in January 1994.
Global bonds combine SEC registration and U.S. clearing arrangements with separate clearing on the Euromarket. In some cases, there is also registration and clearing in other domestic markets, particularly in Germany and Japan for deutsche mark and yen issues. These bonds require arrangements for bridges between different clearing systems, so that the quantities of bonds in different markets can shift according to demand. If these bridges work smoothly, bonds can flow across jurisdictions easily. This enhances liquidity in the market, by allowing buyers from different jurisdictions to react to price fluctuations.
By allowing issuers to solicit demand for a variety of markets and to offer greater liquidity to investors, global bonds have the potential to reduce borrowing costs. While there does not appear to be systematic evidence on this, the World Bank has reported that the use of global bonds has reduced its interest cost of borrowing in U.S. dollars by about 18 basis points relative to the interest rates paid by agencies sponsored by the U.S. Government.30 This cost saving does not, however, take into account the fixed costs of borrowing through the global format, such as registration and clearing arrangements. These costs are presumably higher than for comparable Euro-issues, which do not require registration. For a global bond, SEC registration fees are proportional to the amount of the issue placed in the United States.
Administration and Supervision
In most industrial countries, the finance ministry carries out debt management. In doing so, the ministry normally consults with the central bank. In some countries, debt authority is somewhat decentralized in that other agencies can issue debt backed by the central government. In all large industrial countries, the objectives of debt management are cast only in general terms. For example, both U.S. and Japanese authorities maintain that they attempt to minimize debt costs, but they need follow no formal guidelines on the maturity structure of their issues.
In contrast, Ireland and New Zealand have recently reorganized their debt management operations. They have sought to increase the independence of these operations, while also giving debt management more clearly defined goals. Since 1988, debt management in New Zealand has been placed in a division of the Treasury that has a degree of autonomy from the rest of the government. The Debt Management Office (DMO) is responsible for increasing the Crown’s net worth and minimizing the risk to this net worth. New Zealand has developed a set of financial statements for the government, including a balance sheet. The goals of the DMO resemble those of a treasurer’s office for a corporation. It essentially attempts to reduce financial risk while maximizing return. To this end, the DMO adopted the practice of marking its liabilities to market on daily basis.
The DMO is now considering implementing a system of minimizing the risk to the Crown’s balance sheet. Under such a system, the DMO would set the duration and currency profile of its liabilities to match that of its assets. Since most of its assets consist of payments in New Zealand dollars, this strategy would entail reducing its foreign currency liabilities well below the current 45 percent of total liabilities. It would also entail a lengthening of the duration of liabilities. A rigorous matching of asset and liability risk would also call for indexing liabilities to inflation, but the DMO has said that it is unlikely to issue indexed debt.
Like New Zealand, Ireland has organized its debt management in order to provide clear performance objectives and a degree of autonomy from other government objectives. The National Treasury Management Agency (NTMA) began operations in Ireland in December 1990. It took over both the debt management operations from the Irish Department of Finance and the gilt (domestic government bond) market operations of the central bank.
The debt management objective of the NTMA is cast with reference to a benchmark portfolio. The main objective is to fund the Government’s debt at a lower cost than that of the benchmark portfolio. The benchmark consists of debt of a collection of specified maturities, with new debt issued at preset dates. The NTMA attempts to beat the benchmark both by funding at different dates than the benchmark, in order to take advantage of favorable market opportunities, and by issuing at different maturities than the maturities of the benchmark. The NTMA chooses its maturities subject to a limit on the amount of debt it is permitted to issue with maturities less than five years, and subject to guidelines on the proportions of foreign currency and floating rate debt.
Both Ireland and New Zealand have structured debt management to provide the debt manager with a degree of autonomy from the rest of the government and with explicit performance objectives. Such defined performance objectives facilitate the recruitment of personnel with the know-how to attain these objectives.
The Irish NTMA has a clear objective, which is to beat the benchmark. New Zealand’s DMO has a less clearly defined, but more comprehensive, objective, which is to optimize in a risk-return framework the Crown’s net worth. The advantage of a narrow Irish-type objective is that the task of the debt manager is clear and its performance easy to evaluate. Such a narrow objective, however, may fail to take into account other objectives, such as risk (although risk is limited by constraints on the maturity structure of the debt). A broader objective such as in New Zealand runs less risk of omitting such important considerations, but it may also be less clear operationally, and it may be more difficult to evaluate the performance of the debt manager.
Both countries offer an example of providing a government agency with a defined objective against which the performance of the agency can, at least in theory, be evaluated. Among government functions, debt management appears particularly well suited for such an approach, since its goals can be expressed in financial terms for which market prices can be used to determine results. Nonetheless, as discussed above, there is a trade-off between concreteness and comprehensiveness in the objectives. Countries not following this alternative may prefer their more comprehensive, although less concrete, approach.
The goals of debt management are easy to define in general terms, but are more difficult when specifics are examined. Typically a government seeks to minimize the costs of financing itself, perhaps with some allowance made for risk. Such a goal is. however, very difficult to implement in a coherent manner. Ex ante, only imprecise estimates can be made of the ultimate costs of different maturity and currency profiles of debt. Even if one could wait until the debt has matured, when the cost of the profile of debt chosen by the government can be determined and compared to the realized cost on other hypothetical profiles, no account can be taken of the risk of different portfolios. Debt management can also address other goals, such as providing instruments attractive to domestic savers, improving the depth and efficiency of domestic capital markets, and subsidizing and taxing various domestic and foreign entities.
The case for an independent debt management office is not clear-cut. In contrast to the interaction of monetary policy with other short-term policy objectives, such objectives do not conflict so obviously with debt management. Debt managers do not face a time consistency problem similar to that faced by monetary policymakers. However, a case for the independence of debt management is sometimes made on two grounds. First, if the debt management office is independent, its goals can be clearly defined and it can be organized to achieve those goals. Second, the human resources needed to operate a professional debt management operation are also in high demand in the private financial sector. If the debt management office is independent, it can offer salaries and career paths that can attract skilled personnel who might be unwilling to work under the conditions of ordinary government employment.
Finally, there is the interaction of debt management with other government policies. Of particular interest is the interaction of debt management with monetary policy. In theory, central banks may be tempted to manipulate financial markets to reduce the interest rates at which government debt is issued. However, the market will presumably learn about such behavior over time and demand compensation in the form of higher interest rates. Thus, the interests of policy are better served if the central bank does not engage in such manipulation. Central banks may also be tempted to inflate away some of the value of nominal debt, to which the market is also likely to react by demanding a higher interest rate. If the central bank does act in this way, the maturity and currency structure can start conveying information to the market about the central bank’s future monetary policy. Although these two considerations might suggest that monetary policy and debt management should be separate, arguments can be advanced for why coordination between the two functions is necessary. Day-to-day debt management operations affect the demand for liquidity in the economy, to which the central bank must react in order to manage liquidity in the economy. Moreover, many central banks use government securities to conduct their open market operations, and liquid government securities markets are essential for this.
Currency and Maturity Decisions
One of the basic decisions a debt administrator faces is the currency and maturity structure of its debt. The administrator has related options as well, such as issuing floating rate debt or debt indexed to inflation, and some countries also use derivative transactions to adjust their debt exposures. Countries have made very different choices both in the maturity and the currency of the debt, as well as in related matters. Market conditions in different countries, including clientele effects, are among the factors that influence such policies.
Observing that the yield curve has tended to be positively sloped over the postwar period, authorities in the United States in 1993 embarked on a policy of shortening the maturity structure of the debt. To implement this, they have reduced the volume issued of 30-year bonds, which have been the longest maturity securities issued by the U.S. Government. They have also stopped issuing seven-year notes and will compensate by issuing more Treasury bills (one-year maturity or less) and Treasury notes of three-year maturity and less.
Germany and Japan both issue most of their debt in medium-term maturity. The bulk of Japanese Government securities are the ten-year bonds, although Japan also issues a range of other maturities. Most German issues are five-year and ten-year securities. German officials have until recently followed a policy of not issuing liquid short-term issues. This policy has changed incrementally in recent years with the issue of commercial paper by the government-guaranteed Treuhandanstalt and the issue of bills by the Bundesbank.31 German authorities also have embarked on a policy of issuing longer-term debt; they issued a 30-year bond in December 1993, for the first time since 1986, and reportedly plan to issue such bonds regularly. German policy has therefore focused on expanding the range of maturities issued, but the impact of this expansion on average maturity seems uncertain.
France and the United Kingdom follow a policy of not using short-term issues (one-year maturity or less) to finance their budget deficits. In these countries, short-term securities are largely issued in order to provide a liquid instrument in the domestic money market; this is especially true in the United Kingdom, where operations in Treasury bills are the main monetary policy tool of the Bank of England. In 1993, however, the U.K. authorities suspended a full-funding rule that required the deficit to be financed by medium-term and long-term liabilities held outside the banking sector. French debt policy is to finance the deficit with BTANs and OATs, which carry maturities of two years and up.
Adjustment of a government’s maturity and currency profile of debt can reduce the cost of its debt services. Whether this has an economic impact is related to whether government deficits matter, which in turn depends on whether markets are complete.32 Long-term debt often carries a return premium that appears to be in excess of expected future short-term rates. If this term premium is in fact a risk premium, a government could reduce its expected debt costs by issuing short-term debt instead of long-term debt. In a world where debt policy did not matter, future taxes would become riskier to compensate for such a policy, and in an ideal world there might be no economic impact. However, if reducing debt costs is an independent objective, such a term shortening could still be desirable.
An active theoretical literature covers the maturity and currency structure of government debt from a different angle. In terms of maturity structure, there are two contradictory lessons of this literature. The first is that a government with short-term debt will have less of an incentive to choose an inflationary policy than will a government with long-term debt. The reason for this is that a permanent increase in the inflation rate will reduce the value of long-term debt by more than it will reduce the value of short-term debt. It follows from this that a government may in theory be able to enhance the credibility of its monetary policy by reducing the average maturity of its debt. For this to work, however, the value of the debt must be an objective of monetary policy.
On the other hand, short-term debt exposes the government to greater risk of a crisis of confidence.33 A government that is exposed to a speculative attack on its currency can defend its currency by raising domestic interest rates. If the government has to roll over its domestic currency debt during this period, however, it will have to pay the higher domestic interest rates, which will make it less willing to raise interest rates to defend the currency, thus making a successful speculative attack more likely. The solution is for the government to minimize the amount of domestic currency debt coming due at any single time, by lengthening maturities and smoothing the maturity dates over time. This smoothing of maturity dates goes against the desirability of bunching of maturity dates in order to build the size of individual issues and enhance secondary market liquidity.
This literature has a less ambiguous message about debt in foreign currency or indexed to inflation. Such debt is beneficial, because the government cannot affect its real value by changing the rate of inflation. Despite this argument, however, most countries continue to issue most of their debt in their own currency and to avoid indexation. The literature suggests that perhaps this is because nominal debt has an insurance role; if a country encounters a bad shock, it can use inflation as a means of taxing debt holders, some of whom are foreign, thereby spreading the effects of the shock. Knowing this, however, holders of nominal debt may demand a higher expected return.
Supervision of the Secondary Market
Authorities supervise the secondary market in government securities for several different reasons. One goal of supervision is to prevent systemic risk that might arise from the failure of firms operating in the market. A second goal is the protection of investors in the market from deceptive or unfair practices. Authorities may also wish to ensure that the market is liquid.
In the United States, supervision of most major firms involved in the secondary market for government securities is accomplished as part of the overall supervision of these entities. One of the federal banking supervisors (usually the Comptroller of the Currency or the Federal Reserve) supervises the banks involved in the market, which include a number of primary dealers. The main focus of this supervision is to ensure these banks’ financial soundness. Securities firms involved in the market fall under the purview of the SEC. This supervision focuses on both financial soundness and customer protection, although it does not extend to subsidiaries of the registered broker-dealers, which in some cases are unsupervised.
Entities that served as only brokers or dealers for government securities used to be exempted from regulation and supervision. After a series of failures of secondary government securities dealers in the early and mid-1980s, this regulatory gap was plugged by the Government Securities Act of 1986, which took effect in 1987. This act gave authority to regulate these brokers and dealers to the Treasury Department. The act also required them to join a self-regulatory organization, in practice, the National Association of Securities Dealers, which would conduct supervision.
The U.S. system of supervision therefore covers all entities engaged in brokering or dealing U.S. Government securities in the United States. However, firms involved in the market but not brokering or dealing may be exempt from supervision. Firms operating in the U.S. Government securities market outside the United States are also not covered by this supervisory regime. Although Treasury securities are listed on the New York Stock Exchange (NYSE), secondary market trading in U.S. Government securities is almost exclusively an OTC dealer market. This market is subject to little direct regulation or supervision. There are no daily price limits or circuit breakers in place.
Publication of quote, price, and trade information is incomplete. The bulk of secondary market trading occurs between primary dealers through the seven interdealer brokers. Primary dealers have access to broker screens, which contain the quotes and transactions data that give the best picture of the market. Only one of these brokers makes its screen public. A limited amount of information from some of the other brokers began to be made public in 1991 through the GOVPX service. The information available through GOVPX consists of real-time price and quote information for all Treasury securities, although there is no information on strips of Treasury securities (separate trading of interest and principal as zero-coupon issues) and the quote information does not contain quote sizes. Dissemination of market data has also been increased by the expansion of the customer bases of some of the interdealer brokers, which have expanded their customer bases to all netting members of the Government Securities Clearing Corporation, a status for which approximately 75 firms are eligible.
In the last two years, the Federal Reserve Bank of New York has developed a system of market surveillance. It examines price data in an attempt to detect anomalies that may be associated with market manipulation. U.S. authorities recently received authorization to request reports of large positions in securities where a pricing anomaly exists.
In Japan, banks and securities firms acting as market-makers for government bonds must receive permission to do so from the Ministry of Finance. The Ministry examines a firm’s capital level and management before granting this license. The Ministry also authorizes brokers in the market. Trading in government securities can take place either OTC or on the Tokyo Stock Exchange, where all government bonds are listed, although most trading occurs OTC. The transaction tax applies to all domestic bonds, including government securities (except short-term bills), and tends to reduce trading volume. Trades involving two foreign counterparties are exempt from the transaction tax.
Most dealers and brokers in securities markets in Germany are banks. In contrast to the United States and Japan, there is no legal distinction in Germany between securities firms and commercial banks. Banks are licensed and supervised by the Federal Banking Supervisory Office. Some brokers, however, fall outside this supervisory system and normally are licensed and supervised by one of the eight regional stock exchanges. The implementation of a new regime with a federal securities supervisor is under way, with the new supervisor likely to commence operations in 1994. Trading in German Government securities takes place both on the stock exchanges and OTC, in addition to substantial offshore trading. Most domestic trading is in the OTC market, although there is a daily fixing on the stock exchange at which the price of government bonds is set. Most exchange trading occurs at this price, and the Bundesbank sometimes intervenes at this fixing to counteract price pressure. Market activity both on the exchange and OTC is subject to little supervision; the stock exchanges have nominal authority, but their power is limited.34 Some German trading restrictions have loosened recently. The Government eliminated taxes on securities transactions in 1991 and 1992. It also abolished in 1990 a special commission that inhibited the resale of bonds in the first year following issue.
In France, the secondary market in government securities is open to a broad spectrum of participants. The main group of participants consists of the eighteen SVTs. The French Treasury requires these entities to participate in both the primary and secondary markets for these securities, in exchange for certain privileges (see section on Primary Dealer Systems above). Members of the Paris Bourse and other financial intermediaries may also participate in the market; market participants are supervised by the Société des Bourses Françaises. Trading is permitted both on the Bourse and OTC, with most trading OTC. In addition, a substantial portion of the secondary market, especially in OATs, takes place offshore. In general, France has no capital restrictions that apply separately to government securities. SVTs, however, must satisfy a minimum capital requirement of F 300 million. SVTs are supervised by the Commission Bancaire; they must also submit weekly activity reports to the Treasury. Other participants in the market do not appear to face separate supervision or reporting requirements for their government securities operations.
The market for government securities in the United Kingdom centers on the GEMMs (see section on Primary Dealer Systems above). These are firms approved by the Bank of England, which also supervises the firms’ market-making activities in gilts. Through the same system, the Bank authorizes and supervises two special types of institutions, the interdealer brokers and the stock exchange money brokers, which do business with the GEMMs. Other participants in the gilts market fall under general U.K. investment business regulation, and must generally be authorized by the Securities and Investment Board (SIB) and join a self-regulatory organization. This authorization does not apply to firms operating offshore, although it does apply to foreign firms operating in the United Kingdom. It also does not apply to investors in gilts and other securities.
Firms operating in the market for Treasury bills fall under the money markets’ supervision system. Firms conducting wholesale transactions in the sterling money market or in the foreign exchange or bullion market must be “listed” by the Bank of England under its wholesale markets supervision regime. This listing entails a series of checks on the firms’ management, reputation, and financial position. Firms conducting nonwholesale money market transactions fall under the general securities regulation and supervision of the SIB and its self-regulatory organizations.
GEMMs are under stringent capital adequacy rules. Other participants in government securities markets face capital requirements set by the Bank of England for banks and money market firms or by the SIB or a self-regulatory organization for securities firms. Banks with significant securities business may also face the SIB’s securities capital rules. These rules, as well as those of the Bank’s money markets regulation, focus on market risk as opposed to credit risk.
U.K. authorities conduct intensive monitoring of market participants. GEMMs submit daily electronic reports of their position in each gilt issue to the Bank of England. For money market firms, the Bank requires fortnightly reports on risk exposures and capital positions, except for pure brokers, which must submit reports only monthly. The Bank can also carry out spot checks of these firms at other times to ensure continuous compliance with its capital requirements.
U.K. securities firms also are subject to detailed investor protection rules. Most securities firms, including GEMMs, are subject to the rules of the Securities and Futures Authority (SFA), one of the self-regulatory organizations under the SIB. Wholesale money market firms are subject to a lighter regulatory system under the Bank of England. For GEMMs, the Bank also solicits feedback from investors to verify that the GEMMs are providing adequate investor services.
There are no formal circuit breakers for the gilts market. However, procedures are in place for the Bank of England to intervene in the market. The Bank has the authority to enter the market to react to price anomalies for particular issues. The Bank’s tap mechanism is also designed to react to market conditions. The guiding principle is for the Bank not to sell additional amounts of an issue into a falling market.
In Italy, the domestic secondary market in government securities is divided in three parts, two of them closely supervised. The bulk of trading volume occurs on the screen-based Mercato Telematico Secondario (MTS). A variety of financial firms can join the market; over 330 have signed up to be dealers on the MTS. A small proportion of Government securities transactions, mostly retail, pass through the Milan Stock Exchange. All Government securities except Treasury bills are listed on the exchange. There is also an informal OTC market that is more loosely regulated. In addition, some trading of domestic issues of Italian Government securities occurs in foreign countries. Until recently, there was a stamp tax on government securities transactions. The Government abolished this tax at the end of 1993, in part to entice trading back from offshore centers.
Primary dealers on the MTS are required to post continuous two-way quotes in a subset of Government securities issues. These quotes must be for a minimum size of Lit 5 billion, which is also the minimum trade size on the MTS. Other dealers on the MTS face no market-making requirements. There also are no market-making requirements on the OTC market.
Primary dealer status is open to both banks and nonbanks incorporated in Canada. These entities are known as “primary distributors,” with a more active subset known as “jobbers.”35 Jobbers are required to make markets in government securities. Both primary distributors and jobbers must submit weekly statistical reports on their trading activities to the Bank of Canada. The domestic market in Canadian Government securities is exclusively an OTC market, but trading also occurs internationally. Since August 1993, information from interdealer broker screens has been made available to the public. Before then, information was only available to those dealing on the screens.
As noted in the introduction, the figures discussed here pertain only to central government debt. In some countries, the debt of other levels of government also is significant.
The recent increase in bank holdings in the United States is analyzed by Rodriguez (1993).
The data for Sweden are problematic, owing to a change in the basis for reporting. The reported figure for foreign holdings for 1992 includes all debt in foreign currency plus foreign holdings of domestic currency debt, while data for earlier years are not broken down in this way.
Data were not available for Italy, and French data were only available for 1992. The maturity of government debt is a flawed measure of the term of the debt, but better measures such as duration are generally unavailable.
In addition to the countries discussed in this section, other countries, including Italy, Canada, Spain, and Finland, have primary dealer systems in place.
See Mullins (1992).
See section on Liquidity in the Secondary Market for a discussion of interdealer brokers.
Since the Japanese Government pays a commission on both the auctioned and the syndicated share, the commission does not result in the price on the syndicated tranche being higher than on the auctioned tranche. See Kroszner (1993) for details of the syndication process.
For the ten-year Bund, about 30 percent each is sold through the syndicate and the tap and 40 percent is sold at auction. Kroszner (1993) contains details on the German bond consortium and the issuance of government bonds in Germany.
BTFs denote Bons du Trésor à taux fixe; BTANs, Bons du Trésor à taux annuel; and OATs, Obligations Assimilables du Trésor.
On the New York Stock Exchange, for example, designated specialists in particular stocks are charged with maintaining continuous and orderly markets. In return for this, these specialists have privileged access to the order flow in the stocks.
In addition to formal tap sales, in many cases central banks purchase part of the debt issued by the government and subsequently sell debt in the secondary market. Such operations bear some resemblance to tap sales, although central banks often segregate securities used for open market operations from those held for investment.
Uniform-price and discriminatory systems have a variet) of other names. The terminology of Bikhchandani and Huang (1993) is followed here.
Canada, however, uses syndicates for its inflation-indexed Real Return Bonds, which it began to issue in 1991.
See Pirrong (1993) for some background on the U.S. when-issued market.
See Pirrong (1993).
The table involves a number of distortions. The U.S. data exclude transactions not involving primary dealers. The German data exclude OTC and offshore transactions, which are substantially more than half—perhaps 80–90 percent—of trading volume. The French data include repurchase agreements.
See Kroszner (1993) for more information on the JGB benchmark.
In some cases, the new tranche of the reopened security is not identical to the existing security until after the first coupon has been paid.
A reverse repo is the other side of a repo. It entails purchasing a security and agreeing to resell it in the future.
Continuing repo contracts are contracts that can be terminated at any time by either party.
Data from the Board of Governors of the Federal Reserve System (1994a), Tables 1.41 and 1.43.
The tax rate paid by the seller of the bond is 0.01 percent of the transfer price for financial institutions and 0.03 percent for other sellers. The transaction tax is applied at both ends of the Gensaki, both on the sale and on the subsequent repurchase.
Data from Bank of Japan (1993), pp. 83, 171. Government debt outstanding excludes debt held by the Government and the Bank of Japan.
Bonds issued by foreign issuers in the U.S. domestic market are known as “Yankee bonds.”
See Box 3 for a discussion of withholding taxes and their effect on borrowing costs.
See Evans (1993).
These bills are issued by the Bundesbank for monetary policy purposes and not to finance the federal deficit.
See Sargent (1993).
“Financial Centre Germany: Underlying Conditions and Recent Development,” Monthly Report of the Deutsche Bundesbank, March 1992, pp. 23–31.
See “Administrative Arrangements Regarding the Auction of Government of Canada Securities,” Bank of Canada Review (Summer 1993), pp. 71–76.