Abstract

A strong primary market in government securities is supported by a liquid and efficient secondary market. Authorities may consider, within the context of the country’s own stage of development and institutional context, the development of a market structure—instruments, transaction types, trading mechanisms, and market intermediaries—that will support a liquid and efficient market.

A strong primary market in government securities is supported by a liquid and efficient secondary market. Authorities may consider, within the context of the country’s own stage of development and institutional context, the development of a market structure—instruments, transaction types, trading mechanisms, and market intermediaries—that will support a liquid and efficient market.

7.1 Introduction

This chapter focuses on the microstructure of secondary markets and the government’s role in the development of market structures—including transaction types, the role of intermediaries, trading mechanisms, and market transparency—that promote efficient price discovery and liquid secondary markets. A principal objective of policymakers is to have well-functioning and liquid secondary markets for government securities. The central bank is interested in efficient interest rate determination; the government debt manager needs low intermediation costs; and the securities market regulator is interested in an infrastructure that promotes efficient, sound, and fair trading, in addition to providing opportunities for market surveillance and an adequate level of consumer protection.

7.2 Types of Transactions in Secondary Markets

The development of secondary markets adds new attributes to government securities and broadens the role and importance of government securities in the financial system. Government securities can have near-money like properties when secondary markets facilitate rapid and low-cost conversion into cash. Bonds can become a medium of exchange for the borrowing and lending of funds. Secondary markets also open avenues for risk management through various types of transactions whose pricing can be derived from government securities markets. These unique features of government securities markets help deepen the number and type of transactors in government securities which, in turn, help achieve the aim of establishing liquid and efficient secondary markets. The design of secondary market transactions and structures—discussed in more detail below—should seek to maximize such attributes and incentives to trade, thereby encouraging the development of secondary markets.

7.2.1 Spot Transactions

Scope for fast liquidation of securities and deployment of cash makes government securities attractive as cash-like investments.110 To effectively compete with money, secondary government securities markets must provide for the immediate purchase and sale of government securities. Such on-the-spot transactions should have the following features: (i) low transaction costs, (ii) widely available and continuous pricing, (iii) wide access to trading systems and intermediaries that provide immediate execution, (iv) safe and rapid settlement of transactions, and (v) efficient custodial and safekeeping services.

A starting point and foundation for the organization of secondary markets—which is necessary to attain the above features—is the standardization of arrangements for “spot transactions.” This usually involves establishing conventions governing when pricing and trade execution services are made available, and the times from execution of trades to their final settlement.

An important design and organizational feature is the time frame from trade execution to settlement. The shorter the gap in time from trade execution to settlement, the more cash-like government securities become. This decision on convention needs to be taken in conjunction with the design and infrastructure of the clearing and settlement systems, which establish limits to what is possible. For instance, a system of automated trade execution that is linked to a system for clearing and settlement and provides settlement against delivery of securities on a real-time basis will allow for almost instantaneous settlement after trade. On the other hand, in cases where bond trades are executed on more traditional stock exchanges, time needed to clear and settle may take up to several days.

In the context of market development, the standard for the time from trade to settlement for government securities will normally need to be higher than that for equity markets. In many countries, for at least a class of government securities, in particular Treasury bills, a T+0 or same-day settlement will be very desirable. So as to be able to process all trades efficiently on a same-day basis, a cut-off time for same-day settlement of trades is sometimes established. For instance, trades that occur during the morning will be settled the same day, while trades executed in the afternoon may be settled the next day (T+1). The capability to work with the technology of such systems and establish a reasonably narrow time gap between trade execution and settlement are important design considerations.111 The immobilization or dematerialization of government securities constitutes a key step in the movement toward shorter settlement cycles.

7.2.2 Repurchase Agreements

In fostering secondary markets, the authorities may wish to develop the use of repurchase agreements (repos), as they serve unique functions for both the private sector and the monetary authority. Borrowing and lending among a range of market participants, including banks, financial institutions, and corporates, can be fostered on a safe and secure basis through the use of repos that reduce both credit risk and transaction costs. Securities dealers use repos to finance their inventories of government instruments that are needed to make markets and provide two-way quotes. For this purpose, dealers lend out (or repo) securities that are in their inventory but are not expected to be immediately sold. Thus, dealers are able to leverage their capital and hold a larger inventory. A central bank can temporarily inject liquidity into the system by buying securities under repo. Because of the many uses of repos, the demand for government securities increases, while the underlying conditions for liquid secondary markets are put in place.

A repurchase agreement is effectively a collateralized loan that is realized through the sale and subsequent repurchase of a security at a specified date and price. More specifically, it is the combination of an immediate sale of a security with the agreement to reverse the transaction at a specified future date. The first leg of the repo begins when one party (the seller) sells a security to the second (the buyer) for cash. In the agreement, the seller is required to buy back the security after a passage of time, typically ranging from overnight to two weeks. This second leg gives the arrangement its name, since the initiating party repurchases the security. In contrast with genuine collateralized loans, however, ownership of the underlying security is transferred to the lender, which, with certain legal differences, makes a repo transaction more secure for the lender. Repos are arranged for short periods, typically up to two weeks, and carry interest rates close to the interbank rate. They can be implemented in a variety of ways, depending on market infrastructure, practice, and country law.

While from an economic perspective a repo is similar to a collateralized loan, from a legal perspective the two types of transactions differ significantly.112 By design, repo transactions may offer more protection to a cash lender than a collateralized loan in the case of insolvency of the borrower. In a repo transaction, the buyer acquires full ownership of the underlying security and, thus, may sell it if the original seller defaults on his or her repurchase obligation. Depending on the market value of the security at that time, the buyer may recover most of the principal amount of the loan, or if the security was purchased at a sufficient discount from the market value, the buyer may be fully compensated for the principal and interest. If there is insufficient value in the security to pay principal and interest in full, the shortfall can be pursued in bankruptcy proceedings, where the buyer will have an unsecured claim against the seller. This mechanism is known as netting.

In developing repo markets, the authorities will want to ensure that a framework is established that governs the following elements of the transaction and addresses the risks that arise (Box 7.1):

Payment and transfer: The seller is required to deliver against payment the security to the buyer on the purchase date, and the buyer is required to deliver the security to the seller on the repurchase date. Payment must be in immediately available funds, and the securities must be transferred on the official book-entry system.113

Default and netting: In settling a default, the net value, or closeout balance, is defined as the difference between the current market value of the collateral security plus margin amounts and the cash borrowed plus interest. This is the amount owed to the lender (or borrower if less than zero). The key advantage in repos is that only net amounts and not the full value of the cash loan will need to be claimed under bankruptcy.114 Netting provisions (as with margins discussed below) depend on the availability of a transparent market value of the repo security on a daily basis. In the absence of a well-functioning secondary market and transparent prices, other arrangements must be made.

Margins: Margin payments are transfers of cash or securities made during the repo contract to reflect changes in the market price of the underlying security, which can reduce potential losses associated with credit risk in the face of a drop in prices. However, margin provisions can only be enforced when secondary markets are sufficiently developed to provide market prices. This hampers their use in new markets.

Risks in Repurchase Transactions

Interest Risk

Interest rate risk results from changes in the market value of underlying securities. This risk increases with (i) the time to maturity of the underlying security and (ii) the length of the repo contract. From the cash borrower’s perspective, a drop in market interest rates would raise the value of the underlying security. If the lender defaults—that is, he is unable to return the security for repurchase—the borrowed funds could be less than the (new) market value of the security, resulting in a loss for the cash borrower. A rise in market interest rates would correspondingly reduce the value of the underlying security. Thus a default by the cash borrower would leave the lender facing a possible shortfall, since the proceeds from the sale of the collateral might not cover the loan principal and interest. Margin payments offer some degree of protection against interest rate risk. While interest rate risk can affect both lender and borrower, the cash lender often protects him- or herself against rising interest rates and a decline in the value of the underlying security by lending less than the full market value of the collateral security.

Credit Risk

Both parties in a repo transaction face risk since the agreement incorporates a future action. Credit (or counterparty) risks stem from the possibility that either party may fail to honor the future transaction, but the nature of repos reduces the potential costs of these events. When the seller (cash borrower) fails to repurchase the security, the buyer (cash lender) has the collateral, which, with netting provisions, greatly reduces his or her cost of the seller’s default. When the buyer (cash lender) fails to resell the security—if, for example, he had earlier sold it to another party and cannot repurchase it for resale—the original seller can keep the cash loan. In both cases, any outstanding balances will need to be settled.

Operational Risk

The consequences of a default are increased if ownership of the repoed security is not transferred on the official registry or subdepository. There are several variations on repo transactions that trade off the protection gained from transfer against transaction costs. For example, in a letter repo, the parties can agree to have the security seller (often a dealer) hold the security on his or her books, but in a segregated account. Triparty repos fall in between traditional repos and letter repos. In this case, a third party, for example, a commercial bank, transfers cash and securities for both parties; it holds the security in trust for the duration of the repo contract; this offers some protection in the case of default but introduces the possibility that the third party may not perform. Because of their added complexity, these options are not recommended for a developing market.

Substitution: The parties in a repo transaction may agree to allow the borrower to substitute replacement securities for a repoed security during the life of a repo contract. There is little disadvantage to the cash lender because he receives another security of equal or higher value as replacement collateral. However, significant benefits accrue to a securities dealer (the cash borrower) because substitution allows him in effect to recall and then sell a security that has been temporarily sold under repo. Particular securities may be in demand and thus command a premium price (or become “special”)—for example, as the security’s maturity date nears and other market participants need to cover short positions. Thus it may be in the dealer’s interest to sell a particular security outright. If the security had previously been repoed, the dealer may then substitute it with a security less in demand. Substitution entails some transaction costs and requires the agreement of both parties.

Interest payments: If interest (or coupon) payments are made on a collateral security during the repo, the buyer is required to transfer the payment to the seller. This provision simplifies the pricing of collateral securities and reduces the incentive for arbitrage transactions as the security nears the coupon payment date. A key consideration is the tax treatment of the repurchase. To promote the use of the instrument and avoid distortions, a repurchase agreement should be treated as a loan that generates interest income or expense.

To standardize these practices, the terms and conditions noted above are provided for in a Master Repurchase Agreement (MRA), which is set up and signed in advance by the parties to the trade in order to enable rapid processing of the transaction.

7.2.3 Derivatives and Risk Management Instruments

Secondary markets can be further developed to provide opportunities for risk management through the development of various instruments whose pricing can be derived from government securities markets. In turn, the use of these instruments by participants further adds to the liquidity in secondary government securities markets. Derivatives and risk management instruments described below can be used to protect the value of an investment or transform income flows from assets (or liabilities) into alternative forms. Futures and forward contracts provide the ability to hedge risks, a strategy that involves choosing assets such that the prices of the assets systematically offset each other. Accordingly, the greater the correlation between the price movements of the underlying investment instrument and the hedge instrument, the larger is the scope for reduction of risk. For example, yields on government securities serve as benchmarks for pricing yields on private securities, and there is usually a complete pass-through of changes in the general level of interest rates on government securities to other fixed-income securities of the same maturity. The generally strong correlation between government and yields on private debt securities means that government securities can be used to hedge general interest rate risks. A brief description of such instruments and transactions is provided below. Annex 7.A to this chapter discusses the management of risks in the development of such instruments.

7.3.3.1 Short Selling

Short selling, the sale of borrowed securities, can promote market liquidity and price efficiency. Short selling allows for sophisticated trading strategies, including arbitrage and hedging, which contribute to efficient price discovery. In addition, dealers can better provide asset and maturity transformation services, which help promote liquidity (see below) where short selling is allowed. However, short selling should not be permitted without the existence of conditions for appropriate risk management of participants. A graduated approach may first permit short selling by dealers that are adequately capitalized and properly supervised before opening up short selling to general participants.

7.3.3.2 Strips

The depth of secondary markets can be enhanced with the development of zero-coupon Treasury derivative securities known as strips. This practice involves separating future coupon payments and principal payment at maturity from a Treasury bond. Investors can then purchase series of coupon payments or principal separately. This can create more demand for government securities because institutions can purchase a stream of future cash flows that match liabilities. Investors who desire only a single future payment can buy at a discount the promise to repay principal at maturity without the risk of reinvesting the coupon payments at some unknown interest rate while avoiding the associated administrative burden. This unbundling of payment streams also allows for the development of secondary markets for zero coupons. In designing the features of securities instruments and securities registration systems, authorities should consider the features necessary for the introduction of strips.

7.3.3.3 Forward Transactions

Forward transactions are commitments made today to make or take delivery of an asset at a future date. Usually such transactions are tailor-made to the needs of the parties involved in the trade. Nonetheless, in markets where forward transactions are permitted, conventions are usually established as to the forward periods for which market intermediaries provide quotations, as, for example, in the case of Spain. Since forward trades involve a future action, there may be a question of the ability of contracting parties to meet such obligations, opening the way for liquidity or credit risk.

A special type of forward transaction is the when-issued market. This involves the sale of government securities before and immediately following the auctions but before settlement. When-issued trading allows dealers to distribute primary issues before participation in the auction. Such trading can deepen the primary market and promote secondary market trading by opening avenues for pre-auction distribution and encouraging price discovery leading into auctions. Preconditions for when-issued trading include a regular pattern of issuance that establishes the trading period, sufficiently deep primary markets so that the likelihood of an auction failure is very small (constant sufficient bid cover), a sufficiently well-developed clearing and settlement system, and adequate regulatory oversight to prevent misuse or uncompetitive practices from emerging.

7.3.3.4 Swap Transactions

Swap transactions provide risk management opportunities by altering cash flows and allow flexible risk strategies tailored to the type of flow. The most basic swap transaction is a fixed-for-floating interest rate swap, involving a net exchange of a fixed-rate stream of income, usually expressed as a spread over the Treasury security corresponding to the swap maturity, for a floating interest rate. The floating rate is usually tied to a short-term interest rate, such as London Interbank overnight rate (LIBOR), or a Treasury bill rate.

7.3.3.5 Futures and Options

Futures and options have become indispensable risk management tools in developed markets. In emerging markets, they can contribute to broadening risk management opportunities and promoting more liquid markets. Futures are standardized contracts involving a commitment to take or make future delivery of a specified financial asset for which the price at delivery is set at the time the contract is entered into. An options contract provides the additional flexibility of allowing an action contingent on some price and may take many forms. For example, a call option allows, but does not require, the option holder to buy a Treasury security at a preset price during the period the option remains valid. A put option allows, but does not require, the option holder to sell a Treasury security at a preset price during the period the option remains valid.

7.3 Features of Market Structures115

There are a number of choices to be considered in developing a government securities market structure. The features of different market structures, including trading mechanism, information systems, and scope for competition, can influence the outcome of price discovery and liquidity. This section discusses the salient features of different market structures at a broad level by examining in particular: (i) periodic versus continuous markets, (ii) dealer markets versus auction-agency markets, and (iii) electronic versus floor-based markets.

7.3.1 Periodic Versus Continuous Markets

As the name suggests, periodic markets involve trading at periodic (or discrete) intervals. A periodic market may also feature execution at a single price—that is, at a price determined by all orders coming to the market at the trading interval.116 Between trading intervals, buying and selling interest is allowed to build, increasing the number of traders present during each trading session (intertemporal consolidation of order flow), thereby improving liquidity and adding to market depth. The execution of trades (multilateral) at a uniform price reduces transaction costs, that is, the bid/ask spread associated with continuous markets (discussed below) is eliminated, which is another important benefit of periodic markets. By centralizing trading, periodic markets provide economies of scale in order handling. The single (uniform) price outcome gives the same execution to all traders (fair treatment) and simplifies the clearing and settling of transactions, reducing costs and the possibility of errors.

In continuous markets, trading goes on without interruptions and trades are executed continuously, permitting more flexible trading strategies than periodic markets. The continuous price discovery process provides contemporaneous information on prices, transactions, and market conditions. There are two basic types of continuous markets: dealer markets and auction-agency markets.

7.3.2 Dealer Versus Auction-Agency Markets

In dealer markets, the random arrival of orders to the market is bridged by intermediaries—dealers—that maintain continuous market conditions. Dealers provide two-way (bid and offer) quotations, supplying a high degree of immediacy to traders that may either buy or sell against those quotations. Dealer markets are often described as “quote-driven” markets, underscoring the dealer’s function in maintaining continuous markets.

Interdealer brokers (IDBs) are a specialized type of market intermediary that provide trade execution services to other market intermediaries in a dealer market. The IDB provides information on the prices and quantities at which other dealers are willing to transact. In so doing, they consolidate information about competing quotations for government securities, thereby encouraging efficient price discovery. In many cases, IDBs keep the identity of the dealer anonymous, which tends to protect intermediaries against execution risk that may arise if other participants are aware of the full extent of the trading interest or inventory position. The IDB earns a fee on each transaction and, therefore, is reliant on large volumes of trading. Accordingly, in developing markets, IDBs can play an important role in educating participants and encouraging trading activity.

Auction-agency markets facilitate the interaction of buying and selling interest of public traders through a centralized auction and agency process. Reflecting this characteristic, these markets are often referred to as order-matching or order-driven markets. Public traders can compete as suppliers of liquidity by submitting limit orders, while those demanders of liquidity can execute immediately by submitting market orders.117

On the other hand, auction-agency markets rely on natural order flow to maintain continuous market trading: liquidity and market depth depend on the random arrival of orders from traders and speculators. If order flow is uneven, the market may become one-sided or imbalanced, and spurious price volatility (deviations of the market price from the underlying equilibrium value) may result. It follows that individual orders will be subject to execution risk as the size of that order increases relative to the depth of the market. Therefore, the average price at which a large order is executed depends on the depth or elasticity of the order book at the time of trade execution. In contrast, dealers insure traders against execution risk by setting quotes in advance.118

7.3.3 Automation and Electronic Market Structures

Electronic technology (computers, telecommunications, and so forth) is rapidly changing all market structures. In general, it has improved the efficiency of markets by (i) replacing the mechanical aspects of trading functions—order routing, order ticket writing, processing, and so on—thereby increasing the operational efficiency of markets; (ii) providing instantaneous information dissemination (real-time information) on market prices and transactions, thereby improving the transparency of markets and increasing competition; and (iii) creating new market structures offering automated trade execution, thereby replacing some traditional functions of intermediaries.

Electronic call and auction-agency market structures potentially enhance market deepening and liquidity. In floor-based auction-agency or call auction markets, very short-run trading in response to order flow (interactive price discovery) is generally confined to the traders on the floor of the exchange (typically called the crowd). By removing the spatial limitations of physical trading floor arrangements, electronic trading expands the potential size of the crowd, promoting deeper and more liquid markets with more efficient price discovery. Consequently, there is a distinct trend away from floor-based call auction and auction-agency markets and toward electronic markets for these types of market structures.

In electronic dealer markets, dealer quotations are centralized onto a screen-based network. Market orders are entered onto the network and executed automatically against the quotations. Compared to decentralized over-the-counter market structures, they offer the following advantages: (i) increased transparency of price and transaction information; (ii) price and time priorities to public traders—trades are executed on a first-in basis, against the best dealer price; (iii) information and intermediary functions that are performed by traditional IDBs are replaced by the centralized quotation system,119 and (iv) the facilitation of real-time auditing of transactions for market surveillance.

An electronic dealer market also changes the nature of traditional OTC dealer markets in a number of subtle ways. Centralized trading with transparent trade reporting reduces opportunities for dealers to compete for internalized (dealer-client) order flow and profit from that information (by transacting with other less-informed dealers). This may lower incentives for dealers to participate in the market, reducing the supply of dealer services. In addition, dealers are unable to differentiate between uninformed and informed traders, as trading is anonymous. As a result dealer quotations may be for smaller size, and bid/ask spreads may be wider in an electronic market, so as to guard against being adversely selected by informed traders. Box 7.2 describes the MTS SpA (Mercato dei Titoli di Stato, or Government Bond Market) in Italy, the country with the most experience with this particular market system.

In summary, each market structure contributes to price discovery and liquidity in different ways. A variety of market structures are present across the range of countries. It follows that the suitability of market structures for a particular country is partly a function of the institutional characteristics of the national market, as discussed in detail below.

7.4 Efficiency and Liquidity Issues in Market Structures

In assessing the choice of market structure with the goals of liquidity and efficiency in mind, authorities should consider frequency of trading, transparency, and competition, all of which have an impact on liquidity and efficiency.

7.4.1 Trading Frequency

Frequency of trading means the choice between a periodic market and a continuous market. The concentration of orders in a periodic market develops liquidity and market depth at the trading interval and reduces price volatility.

In nascent markets, the number of participants may be small, and the trading interest may initially be low. This can occur in secondary markets that are characterized as thinly traded, illiquid, and with a high degree of execution risk. In such circumstances, market efficiency might be improved by a low-trading frequency. The call auction trading feature has the added benefit of equal treatment of orders. The transparency and integrity of the market are high because orders of all participants receive the same treatment, creating confidence in a developing market place. In such situations, trading fixed-income securities on an organized exchange at specific times during the week or even the month could help create a more efficient market.

As the economy develops, the number of factors changing the equilibrium price of bonds will start to increase, accompanied by bond price volatility. Market risk associated with periodic markets therefore rises. The clearing frequency should then be allowed to increase and, at an appropriate stage, become continuous.120 Since in continuous markets trades take place throughout the trading day, price discovery is also continuous and uninterrupted, creating additional confidence in the price. The use of sophisticated trading or hedging strategies needs continuous markets because such strategies require continuous pricing. The continuous pricing mechanism is also capable of absorbing a large amount of information or a large number of variables, whereas the periodic market will have more difficulty producing smooth pricing in such circumstances.

Development of the Electronic Dealer Market: The Case of Italy

MTS SpA is the wholesale interdealer electronic trading market for government bonds in Italy. The Bank of Italy and the Italian Treasury, in collaboration with the primary dealers, launched MTS in 1988. It was created to provide a supportive environment for major policy changes toward more market-oriented debt management, that is, from firm sales of government securities to a conventional auction-based system, among others. In creating MTS, the Italian Treasury played a major role by setting the general framework in which the new market was to operate through a legislative measure. The Treasury held a stake in the management of MTS, which was sold to the major market makers in 1997.

MTS has been extremely successful, currently trading about 90 percent of turnover in Italian government bonds. The success of MTS has led to cloning of the platform elsewhere, especially in Europe. EuroMTS was launched in April 1999 as an international trading system for European benchmark government bonds. In addition, newly established local electronic trading platforms along the lines of MTS include MTS Amsterdam, MTS Belgium, MTS France, and MTS Portugal. Brazil and Korea have also adopted electronic bond-trading systems along the lines of MTS.

MTS is an example of a dealer market with hybrid features. On the one hand, it is a quote-driven, multidealer system in which major market makers are obliged to display bid/offer prices continuously during operating hours. On the other hand, it can be characterized as a centralized cross-matching system as market makers’ quotes are aggregated in a single order book to match best anonymous bids and offers automatically subject to nondiscretionary priority rules. This unique market architecture enables MTS markets to simultaneously benefit from the strengths of two distinct systems: transparency and cost-efficiency of a central electronic cross-matching system as well as liquidity and immediacy of the quote-driven system.

MTS Italy consists of three different dealer groups. The primary dealers are committed to display bid/offer quotes on a continuous basis on selected bonds. They must meet stringent capital adequacy ratios. The specialists in government bonds are selected among the primary dealers and are obliged to display bid/offer quotes on the screens of MTS on a continuous basis. In addition, the Treasury closely monitors their market-making activities in terms of the quality of the two-way price quotes. In the primary market, specialists are committed to subscribe to specified shares of auctions. In return, they are the only dealers entitled to participate in supplementary auctions and are usually the only counterparties selected by the Treasury for buy-back auctions. Dealers cannot enter quotes into the system, and they must trade bonds on the basis of bid/offer quotes placed by the primary dealers and specialists.

7.4.2 Consolidated Versus Multiple Markets

In developing markets, consideration might be given to the benefits and possible costs of competing marketplaces. When order flow is low, it may be beneficial to consolidate trading interest in a single marketplace. Such an approach would prevent the fragmentation of orders that may result in less-efficient price discovery and lower liquidity. On the other hand, competition among marketplaces can encourage competition for order flow that leads to the development of more efficient marketplaces. In addition, different market structures may be tailored to different types of investors. For example, in some countries, auction-agency markets tend to serve retail investors that transact in small amounts, while institutional investors transact in larger block sizes through dealer markets. Accordingly, this issue depends on a number of factors specific to the country context, including the types of investors and transactors, the stage of development, and the incentives for the creation of efficient trading systems. As discussed in Section 7.4.8, efforts to provide consolidated price information can enhance transparency and efficiency when transactions occur across different markets or different intermediaries.

7.4.3 Degree of Security Fragmentation

The degree of security fragmentation may also influence the suitability of market structure for the type of government security. A unique feature of “cash” government securities in comparison with futures or equities is the fragmentation into different issues, each with a different maturity date or coupon rate. In particular, Treasury bills tend to be highly fragmented as they are normally issued with high frequency (weekly auctions) and across the maturity spectrum (for example, with original maturities of 3, 6, and 12 months). Such security fragmentation increases the need for dealers to provide asset transformation services. Dealers, as part of their market-making business, accommodate switches by public traders into and out of maturities of the same security, maintaining a so-called book of long and short positions of outstanding maturities. Accordingly, in countries where the development of auction-agency market structures is promoted, the authorities would wish to reduce the degree of fragmentation to support the liquidity function of those market structures.

7.4.4 Wholesale Versus Retail

In countries where typical investors are small or “retail,” the authorities may wish to promote auction-agency markets because trading is typically in large volume but low value. In this environment, auction-agency markets provide lower-cost transaction services and provide greater transparency and equitable execution owing to the consolidation of order flow and rules governing priorities for the execution of orders. On the other hand, in countries where investors are more typically large institutions, dealer markets may more naturally result. These institutions tend to trade in block sizes (low volume but high value) and prefer dealer markets, which provide insurance against execution risk.

7.4.5 Competition Among Market Intermediaries

Competition in the government securities market between market intermediaries improves liquidity and efficiency. Dealer markets work best when there are sufficient numbers of dealers that can compete for order flow, lowering transactions costs. As a general principle, however, the authorities should not increase the number of dealers if this would result in the entry of unqualified and poorly capitalized participants or perpetuation of lax standards. Accordingly, in countries that lack sufficient numbers of well-capitalized dealers, call auction or auction-agency market structures are likely to be more efficient than dealer markets.

As a transitional arrangement, when trading volumes are insufficient to attract or support competing dealers, or possibly when conditions of adequate capitalization and competition are not met, some countries have in the past assisted in the development of a dealer market structure by beginning with a single (monopoly) dealer or a limited number of dealers.121 Once established, the discount house, operating in the government securities market, attracts order flow in sufficient volumes that warrant the capital investment. Later, as the market develops, the discount house would form part of a broader arrangement—such as the formation of a primary dealer group—encouraging the emergence of competing dealers. Box 7.3 describes the experience of India and Malaysia in assisting market intermediary development.

There are risks to the above strategy. Particularly important factors are the extent and nature of competition and the potential conflicts with policy goals of the central bank. Licensing one or a limited number of discount houses may stifle competition. Thus the establishment of discount houses should form part of an articulated strategy to develop efficient market structures. Even if only one discount house exists, other financial institutions should be permitted to trade in securities and be allowed to emerge as dealers over time, adding to competition. As the market develops and the demand for trading services increases, licensing should be expanded while privileges are reduced, encouraging the development of a market of competing dealers.

Moral hazards for the central bank may arise when it contributes capital to the discount house and provides arrangements supporting the discount house’s operations. The profitable operations of the discount house become a direct responsibility of the central bank, a fact that may distract it from conducting monetary operations to achieve its primary goal of price stability. Thus the participation of the central bank in the formation and operation of the discount house should be carefully considered.

7.4.6 Execution Risk and Secondary Market Liquidity

In nascent markets, there is a high liquidity risk to dealers accommodating customer trades to and from securities inventories, since two-way markets are not yet fully developed. In these circumstances, and to foster the development of nascent, competing dealer markets, the central bank might consider opening a secondary market window to support market making. Typically, under certain conditions, the central bank is prepared to buy or sell securities from those dealers that are supporting secondary market trading. This window tends to reduce liquidity risk, which encourages dealers to supply quotations to the public and maintain continuous market conditions. As markets become more developed and liquidity risk falls, the central bank may withdraw from market-making activity, either by closing the secondary market window altogether or transforming the window for the sole purpose of conducting open market operations or for active debt management policies.

Attention needs to be given to the design and implementation of the window to ensure that operations do not conflict with monetary objectives (by absorbing amounts of securities that result in aggregate liquidity changes) or act to reduce incentives for market making (by setting spreads too narrowly). Box 7.3 lists countries that have utilized a secondary market window.

In the context of auction-agency markets, which may be subject to a higher degree of execution risk, the authorities can play a role as price stabilizer by participating directly in the auction-agency market as an active auctioneer. This role should not be so great as to discourage the emergence of “speculative stabilization” by private sector intermediaries. Nor should it influence price trends. Arrangements, therefore, must be carefully designed so as not to conflict with market development or monetary or debt management objectives. As the market develops and deepens, the price stabilization role of the authorities should likewise diminish and, ideally, be eliminated. Box 7.3 discusses the experiences of countries that have performed this role in auction-agency markets.

7.4.7 Liquidity Risk

To foster a competing dealer market structure in the absence of well-developed funding markets (repo or call money markets), central banks often establish lines of credit with primary dealers. In less-developed markets, this encourages dealers to provide secondary market liquidity and cost-effective execution services. Such lines reduce financing risk that may arise if, after undertaking an inventory position during the course of trading, funding is unavailable (or available only at exorbitant costs) to the dealer. Many countries have collateralized established lines of credit to support primary dealers—for example, India, Italy, Canada, and the United Kingdom. Later, as efficient funding markets developed, the central bank provided only indirect support through the conduct of open market operations (as in the United States and France) or reduced the size of such lines, diminishing their importance (as in Canada) relative to the size of the market.

7.4.8 Transparency

Transparency promotes an efficient and fair markets. Information made available about trading interest and the prices at which market participants are willing to transact is central to efficient price discovery. Such information may include post-trade price and volume, pretrade price and volume, and identity of the market intermediary or client. Depending on the choice of market structure, policymakers may take steps to strengthen or promote transparency.

Transitional Arrangements: Country Experiences

Discount House

In India, the Discount Finance House of India (DFHI) was formed to develop the money market by pooling capital from several financial institutions, including the Reserve Bank of India. In 1994, the Government Securities Trading Corporation (GSTC) was similarly established to develop the bond market. As trading volumes increased, the Reserve Bank of India established criteria (1995) for the development of a group of competing primary dealers. In this arrangement, the GSTC and the DFHI are two in a larger group of dealers under the same obligations and sharing equal access to the same facilities as other members of a primary dealer group.

In Malaysia, the authorities licensed a limited number of discount houses without central bank capital, but with special privileges in order for them to operate efficiently in the money and government securities market. Later, as the market developed, special privileges were removed, and discount houses became part of a larger group of government securities dealers.

Secondary Market Window

Examples of countries that have instituted a secondary market window as a transitional arrangement include Jamaica, Iceland, Thailand, Malaysia, and Nepal. A developed market example is provided by the Bank of England, which had operated a secondary market window for gilt-edged, index-linked instruments to encourage the market to develop for that instrument.

Examples of countries that have participated as price stabilizers in an agency-auction market include Germany, Ireland, and Malta. In Germany, the Bundesbank, on behalf of the government, participates in the market on eight regional exchanges, buying and selling occasionally, as appropriate, to reduce price volatility and provide continuity and stability in secondary market trading. The Bundesbank also participates in the fixing session (call auction). In Ireland, the National Treasury Management Agency (NTMA) acts as a “market maker of last resort,” quoting prices on benchmark bonds listed on the exchange in order to help market confidence and stability (see Horgan 1995). Malta is another example of the central bank performing this function.

Brokerage System

In Poland, the National Bank of Poland (NBP) provided a screen-based IDB system—called Telegazette—for central bank and Treasury bills, with supporting facilities to clear and settle government securities transactions. Dealers appointed by the NBP can communicate their buying and selling interest to the bank via telephone. Bank personnel would display bids and offers to the other dealers in possession of the screen display system. After establishing a functioning market, the NBP has all but closed its facility.

In traditional agency-auction exchanges, for example, there is a level of pretrade transparency (usually to a certain number of incoming orders) and full post-trade transparency, including the identity of the parties to the trade. However, many dealer markets do not require either or pre- or post-trade reporting to a central mechanism nor public reporting of any information. Rather, these systems rely on a strongly connected market intermediary community to organize price discovery informally (through telephone conversation or screen-based systems). Box 7.4 provides the experience of the United States and India.

Transparency Development: Country Experience

The U.S. authorities have chosen to promote transparency through the development by participating intermediaries of an automated reporting system called GovPX. Through GovPX, market intermediaries are required to report pre- and post-trade price and volume information. Pretrade information is available in real time to the public on a consolidated basis (best bid or ask price and total volume), and no identity is attached to the information. Post-trade price and volume information is also available in real time on a trade-by-trade basis without the identity of the trader attached. The GovPX system provides a very high level of transparency.

The Indian authorities have introduced transparency through the depository system and settlement facilities. Price information is recorded through the settlement process and provided to the public at the end of the trading day on a consolidated basis for each issue. This information can instill confidence in investors and encourage efficient pricing.

In the absence of real-time price information and poorly developed counterparty relationships between potential dealers, as well as a lack of available brokerage expertise and clearing arrangements, the authorities may institute a brokerage/trading system, patterned after the market structure of monopoly IDBs. Lending the authority’s name and infrastructure to such facilities can promote confidence among major market participants and develop trading expertise. Moreover, these systems enhance the price discovery process and provide transparency to developing markets. As the market develops, scope for private sector entrants increases, and the need for such a facility may well diminish. Box 7.3 includes the experience of Poland in supporting such facilities.

7.4.9 Development Strategies

As discussed above, caution should be exercised in undertaking direct involvement in market structure that would shift undue risk to the central bank or debt management office. Such practices may interfere with the development of natural liquidity if the authorities are not able to transition to natural liquidity providers. Practice is, therefore, gradually moving away from the authorities providing direct market-making services to the market (thereby absorbing market risk) toward strengthening natural liquidity by design of benchmarks, reducing liquidity risks by providing some form of collateralized borrowing/lending and securities borrowing and lending, and promoting transparency by encouraging market participants to promote price transparency.

7.5 Conclusion: Suitability and Selection of Market Structure

Considering the role of the secondary government securities market as well as its moving parts (different types of transactions, settlement, payment, risks, market intermediaries, investors) and the effects of these choices on efficiency and liquidity, depending on the stage of development, a number of microstructure arrangements are possible:

Annex 7.A Risk Management Issues in Derivatives Market Structures122

The risks associated with the use of derivative instruments require the development of practices and institutions that will help to manage the various types of risks present. In the context of market development, authorities should bear in mind that risk management is carried out differently depending on the type of market structure. In OTC markets, trading, clearing and settlement, risk management, and contingency management are generally dealt with on an informal and bilateral basis. The management of counterparty risk is decentralized and located within individual institutions; there are no formal centralized limits on individual positions, leverage, or margining, nor are there any formal rules for risk and burden sharing or mechanisms for ensuring market stability and integrity. Because of these aspects, intermediaries are responsible for dealing with much of the credit and operational risks that are present. In OTC markets, contracts need to be developed that clearly outline the rights and responsibilities of the trading parties, in order to best ensure the creditworthiness of the parties. Clearance and settlement procedures must be well defined to ensure that trades are completed in a timely and orderly manner. The legal documentation must ensure ownership status of the securities, and the accounting framework must guarantee the proper recording of transactions. Box 7.5 outlines some of the risk elements in OTC derivatives markets and the manner in which they are addressed.

In contrast to OTC markets, organized exchanges are more regulated and centralized, with more clearly defined frameworks for the organization of trading and promotion of market stability. Consequently, practices regarding trading, clearing and settlement, and risk and contingency management are more institutionalized. Exchange trading has four main elements: membership requirements; rules governing conduct (including risk management); centralized trading, clearing, and settlement; and rules that mutualize risk, including loss-sharing arrangements. These rules are designed to ensure market integrity, promote efficient price discovery, and safeguard resources. To maintain market stability and financial integrity, exchanges impose requirements on members that govern soundness, disclosure, transparency, and prudential requirements. Box 7.6 discusses the practices developed in exchange markets to minimize market, credit, and operational risks.

Managing Risks in OTC Derivatives Markets

Market Risks

Market risks in OTC derivatives are managed using such tools as value-at-risk (VaR) models, which measure how much of the firm’s capital could be lost owing to swings in the value of its portfolio, under various assumptions. However, recent developments have revealed limitations in these simplifying assumptions because standard VaR models ignore the confluence of credit and market risk, which can be particularly complicated for options, as option credit exposure varies nonlinearly with the price of the underlying security.

Credit Risk

Counterparty credit risk is frequently managed like other credit risks, namely, “one at a time,” evaluating techniques such as internal ratings, models of rating migration, estimates of default probabilities, and expected loss from spreads on other senior unsecured claims and scenario analysis. Some dealers explicitly mark to market the credit risk in their swap books. A more fundamental approach would be to model the credit risk of counterparties. However, such an approach for credit risk is more difficult than market risk.

Operational Risk

OTC derivatives contracts give rise to operational risks, including the clearing and settlement risks, legal risks, and others. For example, models of derivatives prices may be misspecified, miscoded in management information systems, or may break down unexpectedly, resulting in model risk. Legal risks are an additional element of operational risk, especially risk associated with the use of collateral. While swap transactions may be less prone to difficulties, the enforceability of collateral arrangements can be problematic, particularly in cross-border transactions. Because operational risks are difficult to quantify, market participants have taken several steps to address operational risks, including formalizing and standardizing OTC derivatives transactions, especially with respect to the Master Repurchase Agreement (MRA), limiting exposures to countries where legal risks are pronounced, limiting and reserving against exposures that seem vulnerable to operation risks, and strengthening back-office systems and automating the trade-capture process.

The development of secondary markets requires a framework supported by sound institutions, well-established procedures and operating systems, and intermediaries that can provide the expertise and risk management functions to facilitate efficient and liquid markets. In developing countries, the advantages that auction-agency market structures provide for the design of risk containment systems suggest that risk management instruments (options and futures) should be best placed in an auction-agency market structure.

Managing Risks in Organized Exchange Markets

Market Risk

Market risk is broadly addressed through various arrangements designed to ensure the overall stability and soundness of the exchange and its members. For example, exchanges should impose minimum capital requirements and arrangements for protection of customers’ funds as well as reporting and compliance regulations. Trading activity should be monitored to identify large customer positions or concentrated exposures. Transparency should be achieved by reporting positions, turnover, and price data and by determining daily settlement prices. Some clearinghouses share information and assess members’ net exposure across markets.

Credit Risk

Exchanges that deal with derivatives should have a central counterparty to trades. The clearinghouse, which may or may not be part of the exchange, manages credit risk by serving as the legal counterparty to every transaction. Members’ positions are marked to market daily, and in the case of default, the clearinghouse normally has the right to liquidate the member’s positions; take the member’s security deposit, margin, and performance bonds; attach other assets; and invoke any guarantee needed from the member’s parent company. In the case of insufficient funds, the clearinghouse should be able to invoke loss-sharing rules of the exchange. Regulated trade comparison, clearance and settlement periods, delivery versus payment, and book-entry accounting should be in place to reduce timing delays that may increase potential credit risk.

Operational Risk

Operational risks are reduced through many of the practices that formalize risk management. Trading procedures should be institutionalized and computerized (usually with backup systems), and geographical diversity of counterparties, collateral instruments, and custodial entities should be monitored. In addition, rules may be developed to protect the exchange from activities of nonmembers who operate through members. Legal risks stemming from the enforceability of collateral arrangements should be addressed through a party’s obligations as a member of the exchange, including margins, security deposits, surveys of their financial position, and, ultimately, the ability to access resources available through loss-sharing rules.

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110.

Government securities pay interest and principal and are deposit-like, but are backed by the government rather than a bank. Like deposits or currency, government securities are easily divisible into small units of value when in book-entry form.

111.

The Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) issued a consultative report in January 2001, “Recommendations for Securities Settlement Systems,” that covers the design, operation, and oversight of securities settlement systems.

112.

Since a repo incorporates a future transaction, it raises legal complexities that will differ depending on the country’s legal system. Whether or not more protection is afforded depends on the applicable law. Laws in G-10 jurisdictions generally recognize the intention of the parties to the Master Repurchase Agreements, including netting of outstanding obligations.

113.

As specified in the standard contract, transfer need not take place on the official book-entry system. The parties can agree to another method, including transfer on a subdepository account or through segregation on the seller’s books. This last method is not recommended for new markets.

114.

In some countries, the principle of netting may require a change in bankruptcy law. For netting purposes, the repo contract must be treated as a single transaction rather than separate buy and sell trades. This would elevate the nondefaulting party’s claim above those of other creditors, if the law supports repos.

115.

This section draws upon Dattels 1997.

116.

This type of periodic market is referred to as a “call market” and is the most common form of periodic market.

117.

A limit order is an order to buy or sell contingent on price. A market order is an order to execute a trade of a certain size at the best price available in the market.

118.

This does not mean that in a dealer market there is no price volatility, only that the execution price is known in advance.

119.

It is important to note that in such markets, IDBs themselves might transform to provide some of the infrastructure development, and many continue to perform other roles including trade origination and education.

120.

In situations in which government needs are sizable and the issuance volumes are large and growing, it may be difficult to keep the frequency of trading low even in the early stages.

121.

It is important to stress that the so-called monopoly does not involve an exclusive legal right preventing other dealers from competing. In the context of a nascent market, with insufficient order flow and scarce capital resources, one or a few discount houses—whose role it is to provide liquidity to the secondary market through buying and selling of outstanding securities—are formed (sometimes by the pooling of capital of financial institutions, possibly including some capital ownership by the authorities, and generally supported by a line of credit from the central bank permitting them to function effectively as a market maker and inventory securities).

122.

This section draws on IMF 2000.