IV. Money and Secondary Government Securities Markets
- International Monetary Fund
- Published Date:
- December 2008
Money and government securities markets are considered together because their development is so closely intertwined.24 Banks dominate the vast majority of smaller economy financial sectors and they will almost always dominate both sides of money and secondary government securities markets. Most policies aimed at building one market develop the other as well. Further, the same infrastructure is typically used to conduct transactions in each market.
The available data suggest that the potential for further development of these markets in most smaller economies is considerable (Annex II). The main stylized facts are as follows:
The very limited amount of available information suggests that, as a whole, money markets in smaller economies compared with those in emerging market countries are quite thin and offer a narrower range of products. Overnight interbank cash transactions tend to be the main product in smaller economies.
Only about a quarter of smaller economies have secondary government securities markets sufficiently developed to attract trading by foreign institutions, and only a few have even fairly active markets.
The amount of secondary government securities market trading in relation to GDP is quite low, and likely lower than that needed to have an important economic impact.
Secondary government securities market trading volume in smaller economies has increased substantially, but remains a tiny fraction of the amount in emerging market countries.
Money and government securities market development follows three broad stages that have qualitatively different development policy implications.25 Policies at the most basic level tend to focus on government measures to remove impediments and develop the banking system. Once regular trading begins, the central bank, in close coordination with the government and banks and NBFIs, facilitates development by shifting to market-supporting monetary operations. Market players themselves take the lead for formal and sophisticated markets, with the central bank using market-based monetary operations and public agencies working together to ensure stability.
Basic Level: Interbank Deposits
At the outset, the money market comprises interbank deposits and there is little or no trading of government securities. Some banks may be excluded owing to counterparty credit risk concerns. Transactions are informal and usually overnight. In many smaller economies, structural excess liquidity undermines funding demand and induces institutions to buy and hold government securities. Money markets thus provide only a limited scope for bank liquidity management and risk allocation, and do not improve monetary policy transmission because they are not developed enough for market-based instruments. The government issues domestic debt exclusively to local institutions by a simple auction or even on a required basis, sometimes at nonmarket clearing interest rates. The secondary market is limited to a few occasional transactions by local banks or NBFIs.
Market Development Policy Strategy
At this level, market development policy objectives need to be realistic and tailored to the local circumstances. The main benefits from these markets are (1) basic monetary policy transmission, (2) some degree of interest rate variation to convey information regarding market tightness and inflation expectations, and (3) a minimal degree of bank liquidity management. The market development strategy should be based on the balance of these benefits against the costs of the allocation of scarce human and financial resources, including those needed to maintain financial stability as markets develop. The weighing of the benefits and costs should be founded on a realistic analysis of the potential and limits of domestic financial market development.
The authorities will generally lead the market development effort. Typically, market participants are not in a position to lead because they are small in number and size and less aware of market practices. Further, it may not be in the interest of individual market participants to develop the markets if they are earning rents from a dominant position. The government can remove market impediments and improve the legal framework and infrastructure, and the central bank can make monetary operations and the infrastructure more market-supportive (IMF, 2005a).
Enhancing banking sector competition to the extent possible is crucial because banks are the major players in the money and secondary government securities market. Banking sector development is generally a precursor to financial market development (Chinn and Ito, 2005). Privatizing state-owned banks, which often do not respond to market incentives and are thus less willing to be involved in the markets, offers the benefit of promoting market development. In Costa Rica an uneven playing field between state and private banks held back financial sector development in the past. The mixed strength of banks in the Kyrgyz Republic has limited money market development. Bank supervision should be improved to ensure that banks undertake proper risk management and thus help reduce or eliminate credit risk in interbank transactions.
Foreign bank entry should be given consideration. Foreign banks can bring in not just more capital but also expertise and technological know-how. However, in some smaller economies with underdeveloped financial markets and fiscal dominance, foreign banks tend to limit their operations to buy and hold purchases of highly profitable government securities, to the detriment of private sector credit or interbank operations. Foreign banks can also create vulnerabilities by bringing highly sophisticated instruments into countries with ill-adapted supervisory frameworks.
Market-Friendly Monetary Operations
Monetary operations should be made market-friendly to the extent possible (IMF, 2005a; and Gray and Talbot, 2006). Direct monetary instruments, such as changes in liquid asset ratios and credit growth limits, and static policy interest rates, will impede money market development. In the West African Economic and Monetary Union (WAEMU), the absence of central bank bills, reflecting concerns over central bank profitability, as well as of treasury bills, has hindered the development of the money market. A move from direct to basic indirect monetary instruments, such as central bank bills or deposit auctions, will help foster money market development (Baliño, Enoch, and Alexander, 1995), as was the case in The Gambia during the late 1980s and early 1990s. If the central bank limits money market development by intermediating between banks, it can motivate banks to transact with each other by widening its spreads. Interbank loans in the Eastern Caribbean Currency Union were guaranteed by the Eastern Caribbean Central Bank at a fixed interest rate and collater-alized; this guarantee was later dropped.
Infrastructure Designed for Local Circumstances
Market infrastructure can be tailored to support development at reasonable costs. Markets in many smaller economies could be too small for some sophisticated elements of financial market infrastructure, such as an RTGS, CSD, registry, or electronic trading platform, to be worthwhile. However, there are options to improve the infrastructure in support of market development, most involving the central bank. For example, the central bank can create a simple central custody system for dematerialized government securities with a spreadsheet that matches orders and can have the power to settle orders through the payment system, given legal recognition of dematerialized securities and finality rules. Although simplified approaches are second best and can pose operational risk, they warrant consideration.
Upgrading the Market
The policy decision to aim to upgrade depends largely on the viability of more developed markets. The decision must be carefully considered in terms of the number and size of the market players. An active money market and a government securities market are simply not viable if the number of banks is too small to form both sides of market transactions, or if banks are too small to actively manage their liquidity.
Intermediate Level: Markets with Regular Trading of Securities
At this stage, the money market is active while secondary government securities trading is limited and informal. Money market trading involves central bank or government securities. Banks and sometimes NBFIs will account for the bulk of market activity. The maturity spectrum of securities is wide enough to form a yield curve.
Market Development Policy Strategy
Markets with regular trading provide a wide array of benefits. They can (1) improve the monetary transmission mechanism by making market-based operations possible, (2) reduce the need for monetization of government deficits, (3) reduce the cost of fiscal financing, (4) enhance bank liquidity management, (5) foster interest rate variation and price discovery, (6) develop the institutional infrastructure for other markets, and (7) provide a risk-free interest rate for other financial markets and products.
The fixed costs of paying for a moderately sophisticated market infrastructure will often be outweighed by these benefits. The number and size of potential market players at this level and the considerable potential benefits can make the fixed costs of sophisticated market-supporting infrastructure and the allocation of government resources worthwhile.
Sufficient government capacity is a key element for market development. The implementation of market development policies should take into account the often multiple demands on the time of key officials that can slow or even preclude the implementation of market-supporting measures.
The authorities must work closely with banks and other market players. Banks should be sophisticated enough to be able to help the government form a forward-looking vision of where markets could go. An example of a comprehensive approach is in the Ninth National Development Plan of Botswana. Mozambique has formulated a comprehensive financial sector reform program, including measures to build capacity, focusing on strengthening the banking sector and enhancing the capacity of the central bank, improving financial accountability and transparency, strengthening public debt management, and improving money and government bond market efficiency and depth.
Financial Sector Competitiveness and Stability
Market development is facilitated by government policies aimed at making the entire financial sector as competitive as possible. A financial sector large and competitive enough for participants to regularly take both sides of market transactions is crucial. Policies to boost financial sector competitiveness can include bank privatization, allowing foreign bank entry in some form, and possibly liberalizing the capital account.
A lack of investment opportunities can lead to a buy-and-hold strategy on the part of institutional investors that limits secondary market development. Growth of pension funds and other institutional investors such as insurance companies will contribute to the development of government securities markets. In addition, developing the equity market (Chapter V) and corporate bond markets, and, under the right conditions, allowing foreign investment can help here.
An upgrading of bank and NBFI supervision is often required to eliminate interbank credit risk and ensure overall bank soundness. Good supervision promotes financial stability more generally, which is needed to get investors involved in financial markets. Supervisors must be especially diligent in requiring proper risk management systems of banks, NBFIs, and intermediaries. Further, government regulators and the central banks must devote appropriate staff and training to monitoring the possibility of systemic problems.
Role of the Central Bank
The central bank can help initiate measures to deepen the markets. At least, the central bank can monitor the market carefully, stay in close touch with the market players, and provide market data. The central bank may consider forming a market committee of the most active participants in the interbank market. Enforcement of market association rules can be reinforced by the participation of the central bank, but its role should be more that of an observer. The central bank can initially serve as a market maker, providing a wider spread and withdrawing as soon as market conditions allow. A matching system run by the central bank can also help facilitate price formation early on.
Market-Supportive Monetary Operations Framework
The monetary operations framework can be designed to induce banks to manage liquidity by transacting with each other rather than with the central bank. Money market development is boosted by a reserve requirement framework designed to motivate banks to transact with each other (Gray and Talbot, 2006). The introduction by the National Bank of Azerbaijan of required reserve averaging in 2005 helped develop the interbank money market. Limiting standing facilities to overnight maturity will give banks incentive to transact with each other at all other maturities. Diminished reliance on central bank liquidity fostered the development of the money market in Tunisia. Standing facilities can be designed to set an interest rate corridor wide enough to make it worthwhile for banks to find other bank counterparties rather than tap a standing facility, but narrow enough to limit interest rate volatility. However, the central bank may need to intervene to limit volatility within the corridor owing to the thinness of the money market.
Treasury bill issuance can be oriented toward market development. The longer the maturities at which these securities are auctioned, the more incentive banks will have to manage their liquidity by trading with each other rather than buying government or central bank paper. In Serbia, the reduction in the number of central bank bill maturities and lengthening of treasury bill maturities helped foster the money market. Uganda’s move to more market-based operations helped smooth interest rate volatility. In some smaller economies, the use of treasury bills as the main monetary instrument (Guyana, Mozambique) could eventually boost secondary market development.
The central bank should use a detailed liquidity forecast, prepared in close cooperation with the government, to maintain stable short-term monetary conditions (Schaechter, 2000). The lack of a liquidity forecast has impeded money market development and monetary operations in many smaller economies (IMF, 2005a). A liquidity forecast helps money market participants better understand the shocks coming to the market and enhances central bank short-term intervention policies. The receipts and expenditures of governments that do not actively manage the cash balances in their accounts in the central bank are key components of the liquidity forecast. Active cash management targeting very low fluctuations in the target cash balance helps limit the impact of government transactions on market liquidity. Disclosure of the central bank’s liquidity forecast and the basis for monetary policy decisions gives banks more information on which to base market decisions.
Structural Excess Liquidity
Structural excess liquidity undermines the demand side of the money market and induces banks to buy and hold government securities. Structural excess liquidity can be defined narrowly as the amount of liquidity that commercial banks hold with the central bank above that needed for required reserves and for payments, or, more broadly, as the amount of liquid assets on their balance sheets that under more favorable credit circumstances would be loaned out. In WAEMU countries, banks use government securities as an alternative to excess reserves rather than to manage risk and liquidity, and changes in excess liquidity seem to drive market tightness. In Albania, increased credit demand during 2005 led to a shift from excess liquidity to a shortage that helped increase money market activity.
Sterilization and credit infrastructure policies are usually the most appropriate. Credit market deficiencies are the root cause of structural excess liquidity in most smaller economies. In the short and medium term, structural excess liquidity can be absorbed by the one-off issuance of long-term government securities over and above financing needs to fiscalize the costs, and the depositing of these proceeds at the central bank (Saxegaard, 2006). This will require a judgment as to whether the benefits of greater market development outweigh the fiscal costs of sterilization. Policies to improve credit infrastructure to induce banks to lend at interest rates that borrowers are willing to pay run a gamut of issues, including the legal framework and creditor rights, and are highly country specific (Bossone, Honohan, and Long, 2001).
Government Debt and Cash Management Strategy
The elimination of central bank financing of the government opens the way to government securities market development. Shifting from statutory central bank financing to issuance of treasury bills boosted the stock of government securities in WAEMU.
Primary issuance can be designed to foster market development. Issuance procedures designed to take into account the needs of institutional investors can help promote secondary market trading. Forced allocation of government securities to local investors should be avoided, and competitive auctions that promote the development of a market-based clearing mechanism for interest rates should be introduced. In the absence of a sufficiently large number of potential bidders, private placements may be necessary in the initial stages. If private placements are needed they can be done through competitive bidding, as was the case in Jamaica in the late 1990s.
Limiting the number of separate government securities issues facilitates secondary market trading, as does a transparent schedule. Irregular issuances and a lack of transparency have impeded market development in WAEMU countries. In Chile, a shift to standardized bullet central bank bonds facilitated the creation of a yield curve. In Jamaica and Hungary, a lengthening of government security maturities enhanced the stability of government financing. The lengthening of government security maturities from one to seven years in 2005 in Zambia and the new five-year government bond in Ghana have attracted substantial investor interest including from foreigners. An issuance calendar improves transparency and predictability, as was the case in Chile. The indexing of government bonds to inflation or the exchange rate, as was done in Israel, can boost market development, but such issues should be limited in number and designed as simply as possible.
A government debt and cash management strategy run by a specialized department within the ministry of finance can enhance market development. The centralization of the debt management function in Jamaica led to a considerable strengthening of debt management strategy.
A single treasury account at the central bank is indispensable for effective liquidity forecasting. A single account for all budget revenues and expenditures greatly improves liquidity forecasting because government cash flows tend to be the most volatile elements of the forecast. Further, better expenditure controls from a single account can reduce arrears, which are a serious impediment to secondary treasury bill market development. A single treasury account is facilitated by an RTGS for high-value transactions connecting all major commercial banks and the treasury, as well as a small payments clearing system.
Regular trading of a variety of securities affords more infrastructure options that can improve market efficiency. These should be designed with more than one market in mind. Even when no formal market-maker arrangements are in place, active banks can post bid and offer prices electronically based on informal agreements. Clearing can be facilitated by a CSD in which investors have accounts. Another CSD option is a two-tiered structure in which the investors’ securities are held with a custodian (most often a bank) that safekeeps securities for its customers and may provide various other services (cash management, securities lending, safekeeping of securities issued abroad, cross-border payment services). This requires a sound legal framework for securities settlement and custody and proper regulation and supervision of the custodians.
Sophisticated Level: Formal and Continuously Trading Markets
These markets are more formal, with many banks and NBFIs dealing more or less continuously. They encompass the trading of repos and possibly other derivatives and a market-based monetary policy. Thus, the money markets provide the full potential array of benefits in the areas of liquidity and risk management, monetary policy transmission and transparency, and broad market development. The secondary government securities market is reasonably deep and liquid. Foreign institutions are key players. Importantly, the money and government securities markets are inextricably linked via infrastructure, contracts, and monetary operations.
Market Development Policy Strategy
Formal and continuously trading markets provide a variety of extra benefits.26 They enhance the liquidity management and the portfolio risk-return trade-off of banks and NBFIs. Monetary policy benefits from a stronger monetary transmission mechanism, enhanced transparency, and the options of an interest rate operating target and repo instrument. Government financing is less expensive and can benefit from market signals. Developed money and government securities markets boost financial development generally by providing a yield curve, economies of scale for institutional infrastructure, derivative markets, and the attendant risk transfer capabilities. These markets facilitate the absorption of capital inflows. Finally, policymakers benefit greatly from the relatively impartial information provided by market prices.
The increased sophistication and dynamism of markets means that market players must take the development lead. The markets are simply too complicated for government to drive reform. However, government must monitor markets closely and regularly communicate with market players to understand how it can help with market development.
Meanwhile, the authorities must take the lead to maintain systemic financial stability. In most cases, government intervention would usually not be warranted in the event that nonbank market players become insolvent, unless their failure would have systemic implications.
Monetary and Fiscal Coordination
A market-based and transparent monetary framework is crucial for money and government securities markets to develop to their full potential. The central bank should be operationally autonomous, free of political interference, and large enough to have an effective research department and do effective liquidity forecasting. Either an interest rate or money operating target can be used. The use of repos collateralized by government securities as the main monetary instrument will help develop this key market, as well as the secondary government securities market. Disclosure of the central bank’s liquidity forecast and policy views and intentions helps market participants distinguish short-term liquidity management operations from operations aimed at implementing policy changes.
A forward-looking and market-supportive strategy for government debt and cash management is also needed for sophisticated markets (IMF and World Bank, 2003). The objective of market development is typically given a high priority along with the goals of stable and inexpensive government financing. Buyback and reopening can eliminate illiquid securities and standardize current outstanding bonds. Regular communication with market players is crucial so that every aspect of securities issuance is market-friendly.
Many countries have adopted a primary dealer system for government securities markets. Primary dealers can foster secondary government securities market development by acting as market makers, committing to regular participation, and providing transaction data to the central bank. In return, they may get privileged access to central bank open market operations or other advantages. A number of emerging and developing countries either have adopted, or are in the process of adopting, primary dealers (Arnone and Ugolini, 2005). Some countries introduce primary dealers in the initial stage of market development, such as Jamaica in 1994, whereas others wait until their markets deepen. Arrangements between primary dealers and the debt managers should be designed carefully so that the dealers are not seen as favored, and their obligations, privileges, and supervision designed carefully to avoid undermining market efficiency or limiting competition. The choice of using primary dealers for many smaller economies will be based on whether there are enough participants in government securities auctions for the authorities to reduce the number further by establishing a primary dealer system (a minimum of five to seven dealers is suggested).
Regulation and Supervision
Money markets must be monitored and supervised because they can potentially impact systemic stability. The policy areas here encompass lender-of-last-resort support; a regulatory framework covering issuance, trading, payment and settlement, and intermediaries and custodians; and the risk management systems of banks and NBFIs, which should be tailored for the markets.
As markets become more sophisticated, associations of market players can improve market efficiency and stability. Associations, as discussed in the preceding chapter, can establish a set of trading procedures (rules) that formalize the commitment to provide continuous prices. These should involve fully transparent pricing for all market participants. A well-developed code of conduct that sets out transparent rules for market behavior, rules for market making, and the conventions for trading and settlement can help ensure market efficiency and stability. A formal market-making agreement can be appropriate as trading moves from fixed periodic postings to a continuous basis. The market-making commitment is based on an agreement between banks, and in some cases reinforced by a primary dealer agreement with the central bank.
Specialized Institutions Can Boost Market Development
Market makers are intermediaries that agree to continuously quote buy and sell prices, thus enhancing market liquidity. They must have sufficient capital to maintain an inventory and sustain losses in the event of market turbulence. Market makers can be provided incentives by the authorities if their role in boosting market liquidity brings important externalities (Gray and Talbot, 2006). These incentives can include exclusive access to market information, a dealing relationship with the government debt management office or central bank, cheaper access to government security auctions, and the right to borrow securities or take short positions in securities in order to be able to respond quickly to customer buy orders.
Financial market infrastructure should support continuous trading. Money market prices and transactions are typically reported electronically and cleared via the RTGS. Securities are held in dematerialized form in a CSD. Money, government securities market clearing, and settlements are linked. A custodian can serve as the CSD and provide other services, such as cash management, securities lending, safekeeping, and cross-border payments. Electronic trading systems can help deepen the market because these make it possible for several market participants in different locations to interact at the same time on a single platform. Government encouragement of the development of a standard repo agreement can help develop secondary market trading.
At the same time the market infrastructure should minimize the risks (CPSS, 2001, 2002, and 2004). Legal protection of netting and collateral arrangements are important here. Settlement risk can be eliminated by a delivery-versus-payment procedure. Operational risk is significantly reduced by electronic platforms that allow for straight-through processing. Developing contingency procedures can foster the safe transmission of payments and securities in the event of disruptions.
The upgrading of infrastructure should be market-led, with the authorities intervening to remove impediments or address potential systemic risk issues. Intervention can be needed when the interests of those controlling key elements of the market infrastructure diverge from the broad objective of market development.