Developing Asean5 Bond Markets
What Still Needs to Be Done?

This paper examines a range of issues relating to bond markets in the ASEAN5 (Indonesia, Malaysia, Philippines, Singapore and Thailand) - physical infrastructure including trading, clearing and settlement; regulation, supervision and legal underpinnings; and derivatives markets - and finds that the frameworks compare well with other Emerging Markets, following a decade of reform. A number of areas where further enhancements could be made are highlighted. The paper also examines the interrelationship between central bank management of short-term interest rates and domestic currency liquidity, and development of the wider money and bond markets; and suggests some lessons from the recent crisis in developed country financial markets which may be important for the future development of the ASEAN5 markets.


This paper examines a range of issues relating to bond markets in the ASEAN5 (Indonesia, Malaysia, Philippines, Singapore and Thailand) - physical infrastructure including trading, clearing and settlement; regulation, supervision and legal underpinnings; and derivatives markets - and finds that the frameworks compare well with other Emerging Markets, following a decade of reform. A number of areas where further enhancements could be made are highlighted. The paper also examines the interrelationship between central bank management of short-term interest rates and domestic currency liquidity, and development of the wider money and bond markets; and suggests some lessons from the recent crisis in developed country financial markets which may be important for the future development of the ASEAN5 markets.


Three broad factors influence the development of bond markets – the investor base, the issuer base, and financial intermediation. All three can be influenced by policy, at least to a certain extent. For example, policy makers may be able to enlarge the investor and issuer base by reducing barriers to entry, such as information gaps, administrative controls, and monopolistic behavior. In these areas the link between reforms and the desired objectives is indirect at best. This paper focuses on a number of areas most immediately amenable to policy action. Section II considers issues in market infrastructure, monetary operations, and taxation, making use of an IMF questionnaire completed by ASEAN5 countries.2 Section III draws some lessons from the recent global financial crisis and implications for the ASEAN countries. Section IV concludes.

This paper, and the companion paper “ASEAN Bond Market Development: Where Does it Stand? Where is it Going?”, provide an initial assessment of developments in the five ASEAN markets. This paper cannot be comprehensive or prescriptive, but does try to draw out some common themes and point to some issues which all of the markets are likely to face in the coming months and years.

I. Developmental Issues

A. Physical Infrastructure

Market infrastructure in ASEAN5 countries compares well to that in other emerging markets, following a series of reforms in recent years (Annex I). An infrastructure that spreads risk to ensure market integrity and collective interest is important to market development. Against a background of greater macroeconomic stability and financial liberalization, enhanced disclosure standards, capital rules and other statutory and prudential provisions have helped address past infrastructural shortcomings in a pro-active manner. Dematerialization (or at least immobilization) of securities is now common practice in the region. In all countries, wholesale trading usually takes place on a delivery versus payment basis (DvP), reducing counterparty risk.3 In some countries, public trading venues are being developed, which can bring benefits in terms of transparency —although in the majority of countries over the counter (OTC) markets continue to be the main venue to trade government and corporate bonds. In addition, all of these OTC markets, with the sole exception of corporate bond markets in Singapore, have post-trade transparency, mainly as a result of trade reporting obligations imposed by the regulatory authorities.

However, some consolidation and standardization of depository and settlement systems at the local level would increase market efficiency. A central securities depository (CSD) promotes efficiency by reducing the number of securities accounts and connections required by an investor or trader, and economizes on the cash settlement leg.4 Thailand has a book entry system for both government and corporate bonds that is centralized in a single CSD; and Malaysia has a CSD which captures unlisted bonds issued by both the government and corporates. Thus, some of the countries could explore further consolidation of book-entry systems. In addition, the Philippines could consider strengthening key legal concepts in clearing and settlement (such as finality, novation, and netting), by embedding these in the legal framework, rather than having them recognized only in regulations.

Some standardization of market infrastructure across ASEAN would also help promote more intra-regional intermediation. Currently each country has its own market infrastructure, and no linkages have been developed with infrastructures of other countries in the region. For example, none of the CSDs has linkages to the others. Furthermore, only in the cases of Malaysia and Singapore does the local CSD have links with international CSDs.5 The lack of linkages of market infrastructure, in particular clearing and settlement, is a challenge for the region, since it increases transactions costs and might deter investors – whether resident or non-resident - from investing across the region.6 It must be acknowledged, however, that this is a challenge in many regions that are striving towards integration, including in the euro area, and the European Union more widely.

Cross-border investors face an additional settlement risk. In a cross-border transaction, settlement involves a foreign exchange settlement risk in addition to the settlement risk of the bond trade itself. Settlement of a domestic bond normally involves payment in a local currency. Non-resident investors buying/selling domestic bonds will normally need to purchase/sell local currency. As a result, cross-border investors are exposed to the settlement risk of the foreign exchange trade, in addition to the settlement risk of the bond trade itself. In this context, a key problem for foreign investors is the timing difference between the securities and cash movements, and this difference in timing is compounded by the fact that most foreign exchange deals in the ASEAN countries are transacted against the U.S. dollar, which settles after Asia business hours. Thus there would likely be a major benefit from a cross-country clearing and settlement arrangement.

The final report of the Asian Bond Markets Initiative Group of Experts (2010) discusses the development of a cross-border arrangement to address the foreign exchange risk of cross-border bond transactions. It provides a comparative analysis of the benefits of different options for such regional arrangements, in particular comparing the benefits of an Asian International CSD (ICSD) versus those of a CSD linkage. It also includes a high-level feasibility study for these two options. A key finding from this study is that multiple legal and regulatory barriers would need to be removed for any option to be operationally feasible. What is needed now is a development plan that combines both government and market efforts.

In the ASEAN region, Central Clearing Counterparties (CCPs) exist in the context of markets operated by the exchanges. However in the majority of regional countries, bond trading takes place mostly OTC, and settles on a bilateral basis, without the intervention of a CCP. While the benefits of a CCP in terms of management of counterparty risk are clear, the costs of implementing it are significant. CCPs have sizable fixed costs that are characterized by economies of scale; thus a minimum settlement volume is needed to make them economically feasible. In the context of each domestic market in the ASEAN region such costs might outweigh the benefits; however a stronger business case might exist in the context of a regional market. Thus, when considering a regional CSD, the region may also find it useful to consider the implementation of a regional CCP (Box 1).

B. Disclosure

ASEAN5 markets fare well on disclosure requirements, vis-à-vis international best practices (Annex II). The increasing complexity of capital markets, and their ever growing range of products, creates challenges in the efficient dissemination of information. With the increasing sophistication of financial products amid a greater diversity of financial institutions, vulnerabilities are likely to be found where disclosure of material information is insufficient. At the same time, the availability of timely and relevant information on corporate bonds is key for pricing and thus has an impact on liquidity of secondary markets. All countries in the region require the provision of a prospectus at the moment of registration, as well as periodic information during the life of an issue. Furthermore, the implementation by Malaysia, Singapore and Thailand of the common set of standards developed by the ASEAN Capital Markets Forum (ACMF) in 2008 will increase the efficiency and reduce the costs of multi-jurisdictional debt offerings. Such efforts could be followed by the remaining countries in the region.

However, some further improvements could still be made:

  • IOSCO assessments conducted in the region have identified weaknesses in the enforcement of securities regulation, including enforcement of disclosure obligations. Such weaknesses could act as a deterrent to investors.

  • Thailand could consider strengthening disclosure obligations in connection with material events.

  • Some countries could streamline procedures to reduce regulatory costs associated with the offering of securities. In particular, many of the countries could explore whether reductions in their respective deadlines for the review of prospectuses are feasible. In addition, Indonesia could consider the development of “shelf registration” or similar type of streamlined procedures for “seasoned” issuers or “issue programs”, in order to allow issuers to take advantage of market windows and raise capital more quickly.

Central Clearing Counterparties (CCPs)

Central clearing counterparties reduce settlement risk by interposing themselves between every trade, performing multilateral netting, and centralizing collateral management.1 CCPs act as clearinghouses between the trading counterparties. After execution (confirmation) of a trade, they enforce the specific terms of the contract until maturity. They also guarantee fulfillment of the contract (including payment obligations and margin requirements) in order to ensure that a failure of a member does not affect other members. CCPs net exposures across multiple transactions of all clearing members, optimizing their use of collateral and better conserving economic capital.

However, CCPs concentrate credit and operational risk associated with their own failure, which could destabilize financial markets.7 As a result it is critical that they be subject to robust regulation as well as oversight. That is why in tandem with the recommendation to clear standardized OTC derivatives through CCPs the G-20 have recommended that all CCPs be subject to effective oversight by central banks and other supervisors, to ensure they meet high standards in terms of risk management, operational arrangements, default procedures, fair access and transparency. The BIS and IOSCO are currently in the process of reviewing the recommendations for CCPs to ensure their application to CCPs that clear derivatives.

While the crisis has highlighted the importance of CCPs for OTC derivatives and repo markets, the rationale for their implementation (i.e., the reduction of counterparty risk and greater efficiency of clearing and settlement) is applicable to any type of market. Although initially CCPs were developed in connection with exchange-traded derivatives, over time their use in major jurisdictions has expanded to cover also equity, bond and even repo markets. Indeed, CCPs exist in all major equity markets in the world, including the NYSE, Euronext and the LSE. Moreover, in the United States, the FICC (since 1986) and the NSCC (since 1976) act as CCPs in connection with government bonds, corporate and municipal bonds, and, in Europe, LCH. Clearnet (since 1998) offers a multi-market centralized and clearing netting facility for the European government repo and cash bond markets.

In the ASEAN region, CCPs exist in the context of markets operated by exchanges. However in the majority of the countries in the region, bond trading takes place mostly OTC, and settles on a bilateral basis, without the intervention of a CCP. The implementation of DvP in all the countries (for government bonds in some countries, and in others also for corporate bonds) has helped reduce counterparty risk, in particular settlement risk. However, DvP does not eliminate replacement cost or liquidity risk. The magnitude of replacement cost risk might not be negligible, if for example from the time of an initial “failed” trade the market has changed direction, and the party that needed the money (or the securities) has now to enter into another trade to get the money or securities at the new market prices. Liquidity risk involves the risk that the buyer of the securities might need to borrow cash or liquidate assets to complete the payments, or that the seller might need to borrow securities in order to meet its obligations. As indicated, a CCP helps manage such risks.

1/A CCP uses a variety of tools to manage risks, such as capital requirements on members, the posting and maintenance of collateral to prevent a build-up of market exposure (including position limits), and loss sharing arrangements in case posted collateral proves insufficient. In this capacity, it undertakes the following functions: (i) daily valuation of the contract, including the determination/application of “haircuts” and the adjustment of margins according to day-to-day changes in replacement cost (“variation margin on mark-to-market valuations”); (ii) the monitoring of counterparty risk to ensure the compliance of dealers with the terms of the contract; and (iii) if default or termination occurs, initiate settlement to recover net final payments (IMF, 2010).
  • All countries need to complete their processes of convergence with International Financial Reporting Standards (IFRS). Plans are currently in place in all countries that aim to bring the ASEAN5 region fully convergent with IFRS by 2012.

  • The level of disclosure required for private offerings, including those placed directly with institutional investors, could be reviewed, in particular in the context of asset backed securities and other structured products. While private offerings remain a useful practice, authorities could review the extent to which some level of disclosure is needed in those markets, as Malaysia is currently doing.

C. Information Providers

ASEAN5 countries are strengthening the oversight of key information providers, such as credit rating agencies (CRAs) and external auditors (Annex III). This is another area where the region as a whole fares well compared to international best practices.

The existence of good rating agencies is an important element of efficient pricing. While there are local rating agencies in each ASEAN5 jurisdiction, they all use different rating scales and methodologies, which hinders the comparability of ratings across countries. Moreover, domestic rating agencies have yet to build a track record, while international rating agencies assess only the companies that issue cross-border. The authorities could encourage the adoption of a common regional methodology and rating scale, which would provide one more building block to regional integration by making investments across the ASEAN markets easier to compare by investors. These actions should not detract from analyzing the benefits of establishing a regional credit rating agency.

All countries except Singapore have implemented registration regimes for CRAs, as required by the revised International Organization of Securities Commissions (IOSCO) Principles. In some cases this is a recent development, such as in Indonesia, where rules were issued in 2009. However, improvements can be made regarding the regulatory framework applicable to them. In this regard, for example, the Philippines still needs to implement the IOSCO Code of Conduct. Singapore is currently reviewing its system in light of international developments. Following new trends in emerging markets, price vendors are required to register in all countries except Singapore.

External auditors of issuers are subject to oversight by an independent entity -- either the securities regulator or a specialized body created to perform this function. Such oversight is built upon a registration regime that provides the responsible authority with supervisory and enforcement powers over auditors. Furthermore, many of the countries are strengthening such systems of independent oversight, as the revised IOSCO principles now require. In Thailand, the SEC is in the process of establishing an effective supervisory model of independent oversight, which emphasizes supervision of the quality assurance systems of the audited firms. The SEC is putting in place a full on-site inspection program. In Malaysia, a law approved in 2009 created the Auditor Oversight Board, which began operations in April 2010. It will exercise direct independent oversight over external auditors. Such boards have proven to be useful in assisting securities regulators to oversee external auditors. In the Philippines the regulator is working towards improving the monitoring of the quality of external auditors’ work. In Singapore auditors have to register with the Accounting and Corporate Regulatory Authority. Day to day regulation is undertaken by the Public Accountants Oversight Committee.

D. Derivatives

Despite their relatively well-developed securities infrastructure, ASEAN counties show considerable variation in derivatives and repo markets (Annex IV). In Singapore, for instance, interest rate swaps, interest rate futures and bond futures markets provide an outlet for bond investors to hedge their interest rate risks. In other countries, where suitable derivatives are absent, investors would need to engage in more costly cash transactions to replicate what could be done more efficiently using derivatives.8

Derivatives markets rely on two-sided underlying cash markets for reference prices, including the ability to take short positions and to lend securities in repurchase transactions. For example, primary dealers can only make markets effectively if they are allowed to take long and short positions across the yield curve, and they often use derivatives as hedging instruments.9 But the development of interest rate derivatives markets has been constrained by insufficient liquidity of the underlying government bond yield curve. While liquid collateral (including pricing benchmarks) ensures efficient price formation of derivative markets in the initial stage of development, increasingly the depth and liquidity of cash markets themselves have to some extent come to depend on the presence of similarly well-developed derivatives markets.

Despite their considerable growth over the recent past, local derivatives markets are generally underdeveloped in ASEAN5 countries, with the notable exception of Singapore. Out of the five main types of derivatives (foreign exchange, interest-rate, equity10, commodity and credit derivatives) trading of foreign exchange derivatives has recorded the strongest growth over the recent past,11 followed by exchange-traded equity derivatives12 and some OTC interest rate contracts (see Table 1). Deficiencies in prudential regulation and supervisory oversight (e.g., capital rules, disclosure requirements, accounting rules), operational infrastructure (e.g., market trading, clearing and settlement systems, sound risk management), and limited market participation by domestic and foreign institutional investors as well as banks have frequently resulted in a slow development of derivative markets. Some derivatives, such as forward rate agreements as well as interest rate futures and options, which are critical to address the risk-management issues raised by the growing market determination of interest rates, are entirely absent in some ASEAN5 countries.13

Table 1.

ASEAN Derivatives Market Turnover: Notional Amounts1

(daily averages, in millions of USD)

article image
Sources: BIS Triennial Central Bank Survey (2007), WFE Annual Report and Statistics (2009), dXdata, Datastream.

All figures are adjusted for double-counting. Notional amounts outstanding have been adjusted by halving positions. vis-à-vis other reporting dealers. Gross market values have been calculated as the sum of the total gross positive market value of contracts and the absolute value of the gross negative market value of contracts w ith non-reporting counterparties.

outright forw ards and foreign exchange sw aps, currency sw aps and options

forw ard rate agreements (FRAs), sw aps and options.

futures and options.

options and futures on single stock as w ell as equity indices.

Formalized, regulated and demutualized exchanges are leading the growth in ASEAN derivatives markets. The ASEAN region features all the three types of derivatives exchanges:

  • Singapore and Malaysia have fully demutualized exchanges, which offer a wide range of derivative products.

  • Indonesia, the Philippines and Thailand have no or marginal exchange-based and limited OTC derivative trading. Indonesia established the Jakarta Futures Exchange and introduced equity index futures at the Surabaya Stock Exchange. Since 2007 this function has been conducted on The Indonesian Stock Exchange, but trading volumes remain very low due to weak market infrastructure and low investor interest. The Philippines closed the Manila Futures Exchange in 1997. The Thailand Futures Exchange (TFEX) was established in 2004, and currently offers seven financial derivatives products.14

Going forward, ASEAN countries face challenges in developing local derivatives markets. While several countries have taken large strides in developing the enabling legal environment, regulatory obstacles in other countries hinder capital market development (e.g., transaction taxes as well as restrictions on various instruments, short selling, and parties to transactions) (Kramer et. al., 2007; Hohensee and Lee, 2006). The most common issues are:

  • Legal and regulatory frameworks: (i) solid accounting and regulatory standards are needed, grounded in specific derivative laws, including full balance sheet disclosure, the alignment of local accounting standards to IFRS15, and market supervision through self-regulating organizations (SROs); as well as (ii) a tax environment that creates a level playing field for all cash and derivatives trading. Some national laws either ail to identify the regulatory jurisdiction over derivatives or make derivative contracts unenforceable. Furthermore, restrictions on short-selling and securities lending16 impede efficient derivative trading.

  • Infrastructure-related challenges: (i) the implementation of modern trading systems, which executes clearing and settlement through central counterparties and multilateral close-out netting (for assessing margin requirements) based on mark-to-market valuation, and (ii) surveillance systems to detect improvident behavior especially in areas that straddle the cash and derivative markets. Almost all ASEAN countries have advanced clearing and settlement systems with appropriate safety mechanisms for institutional distress and market failures; however, these systems will need to expand to handle larger volumes of transactions going forward.

  • Relatively underdeveloped cash money and bond markets: the use of derivatives as a risk transfer mechanism requires efficient pricing in cash markets as well as a balanced mix of market making/speculative trading (to provide liquidity) and natural hedging demand. Efficient pricing in the cash market benefits the derivatives markets (interest rate swaps or futures) because it allows investors to make more reliable projections of future interest rates. In some ASEAN countries, trading of government debt differs across maturities (due to fragmented issuance), which limits the extent to which sovereign debt markets can provide pricing benchmarks for the private sector.

E. Central Bank Liquidity Management and Market Development

Central bank liquidity management also shapes the development of securities markets. The interaction is through different channels. First, in environments of a persistent liquidity overhang, banks regularly hold high levels of excess reserve balances at the central bank. In these cases, banks rarely find themselves with deficits of cash, rendering interbank transactions largely unnecessary, thereby stunting the growth of money markets. Second, when surplus liquidity in the system is structural, this blunts the incentive for banks to develop securitization markets. And finally, if monetary operations fail to fully offset shocks to the demand for reserve balances, short-term interest rate volatility will hinder the development of a term yield curve, and this in turn will hamper the development of interest and exchange rate forwards and futures.

These channels appear to be operational throughout most of the ASEAN5, albeit to different extents, as all, apart from Singapore, are characterized by a structural surplus of reserve balances. In most of these countries, central bank bills are used to mop up this surplus liquidity (at least partially), though not in the Philippines. A comparison of policy rates and overnight interbank rates shows that central bank liquidity management practices have delivered predictable short rates anchored around the center of the policy rate corridor in Malaysia and Thailand, but more volatility in Indonesia and the Philippines, where rates are normally close to the bottom of the policy rate corridor, suggesting residual surplus reserves in spite of mopping-up operations.17


Thailand: Policy and Money Market Rates

(In percent)

Citation: IMF Working Papers 2011, 135; 10.5089/9781455259403.001.A001


Malaysia: Policy and Money Market Rates

(In percent)

Citation: IMF Working Papers 2011, 135; 10.5089/9781455259403.001.A001


Philippines: Policy and Money Market Rates

(In percent)

Citation: IMF Working Papers 2011, 135; 10.5089/9781455259403.001.A001


Indonesia: Policy and Money Market Rates

(In percent)

Citation: IMF Working Papers 2011, 135; 10.5089/9781455259403.001.A001

The modalities and effectiveness of liquidity management in the ASEAN5 are reflected in the secular behavior of bond rates. A comparison between the short-term money market yields and those of the region’s government bond yields suggests that long yields in Malaysia, Singapore, and Thailand are lower and less volatile than those in Indonesia and the Philippines. While a variety of factors influence long rates, especially inflation expectations, effective reserve money management may be an important contributing factor, since more predictable short rates reduce the risk premium that investors will demand for providing longer term funds.


Ten-Year Bond Yields

(In percent)

Citation: IMF Working Papers 2011, 135; 10.5089/9781455259403.001.A001

Inefficient reserve money management has other implications for market development. For example, liquidity draining operations that do not fully absorb excess liquidity may imply an undesirable influence of the central bank on the term yield curve, especially if central bank bills of different maturities are used. If the central bank does not drain all surplus reserves, then it will in practice be taking decisions on the cut-off rate at various maturities, and therefore deciding on the level and slope of the yield curve. This could drive the yield curve away from its longer-term market equilibrium, and will in any case impede market development.

F. Taxation

In the region, two countries offer withholding tax exemptions for non-residents’ holdings of bonds. Singapore has long been open to foreign investors without withholding taxes or qualitative and quantitative restrictions. In recent years, Malaysia has eased investment restrictions and adopted a more flexible tax regime. With the exception of Malaysia and Singapore, however, ASEAN countries levy taxes on interest income and/or capital gains on local bond holdings by non-resident investors. For instance, Indonesia withholds 20 percent on both interest income and capital gains.18 Thailand has recently revoked the exemption of capital gains and interest withholding tax for government bonds and certain quasi-government bonds granted in 2005.

The case for exempting non-residents from withholding tax is not clear-cut, and the appropriate stance will not be the same for all countries. For instance, an international financial center, such as Singapore, will likely find it more important to attract non-resident business. Attracting non-resident investors may also be useful, as they bring additional and more diversified demand, so increasing depth and heterogeneity and possibly trading techniques, all of which will support market development.19 But for the government (or central bank, or any state-owned entity) as issuer, the net of tax cost of issuance may be more important than the gross yield. A tax exemption for non-residents may increase the overall cost of issuance. That said, the UK government abolished the withholding tax in 1996 when repo was introduced in the UK, to avoid distorting the market, and in the expectation that the delay in receipts (the interest income was still taxable) would be more than offset by reduced issuance yields obtained through enhanced market liquidity.

Taxation can distort pricing signals. Reforming withholding taxes and ensuring comparability of treatment with equity investments may help address the uneven development of capital markets in Asia. Withholding tax applies in all but Singapore and Malaysia20, and in all cases is levied at different levels depending on the nature and residency of the investor. Varying withholding tax levels can complicate yield curve development and repo trading, as well as leading to market distortions.21 In such cases, however, a flat rate (including zero) is the least distortionary.

II. Lessons from the Crisis

The global financial crisis has brought to light a range of weaknesses in developed economy financial markets. While the crisis was triggered by deterioration in asset quality (sub-prime U.S. mortgages and related structured products), it was greatly exacerbated by poor liquidity and risk management by a range of borrowers and investors, including in the securities markets and outside the formal banking sector. As the ASEAN countries seek to broaden their investor and issuer bases, they can draw some lessons from the weaknesses which have been uncovered elsewhere.

Liquidity transformation

Maturity transformation normally takes place in banks, which take short-term (sight) deposits redeemable at par and uses them to make term loans. Because it is important to the functioning of the economy that economic agents can readily use the banking system as a store of value and to make payment transfers, a safety net ensures, as far as possible, that this maturity transformation is undertaken prudently. The safety net typically involves regulation and supervision (both capital adequacy and appropriate liquidity management); access to central bank lending facilities; and a deposit protection scheme to give some comfort to retail depositors.

This maturity transformation became a problem when some banks took on excessive leverage. Both banks and supervisors trusted too much in the ratings of securitized assets and the ability to sell them easily at close to book value. Nor did they recognize the extent of risk from off balance-sheet commitments, such as liquidity lines offered to securitization vehicles. New regulations to control liquidity risk undertaken by banks should mitigate these risks, but it will be important to be aware of unintended consequences. It is possible that in some countries which previously imposed leverage ratios on banks, that such controls pushed business off balance sheet or into unregulated markets, rather than reducing risks in the financial markets as a whole.

In some developed markets, substantial maturity transformation took place outside the banking system, leading to systemic liquidity risk - notably in the U.S. “shadow banking” sector - but without the safety nets imposed on the banking sector.22 The liquidity risks, in particular, appear to have been underestimated, as the ease of selling or refinancing securities in strong markets became taken for granted, and the need for robust liquidity management – which undoubtedly carries a cost – was downplayed. This resulted in widespread market dislocation from 2008, as concerns about counterparty creditworthiness and the demand for precautionary liquidity (and thus its cost) both increased sharply. As the non-banking sector in the ASEAN markets is developed to encourage a wider investor base, it will be important that both issuers and investors are clear what risks they are undertaking, and that regulated entities such as banks are not able to disguise liquidity risks to which they are exposed.

In principle, a clear distinction can be drawn between bank deposits, on the one hand, and other investments (both fixed income and equity) whose value will vary over time depending on credit, term premia and broader economic factors. But in practice the line can become blurred if short-term investments (including loans not intermediated by the banking system) are portrayed or treated as so liquid and of such high quality that they are as good as bank deposits from the point of view of access, and better than bank deposits from the point of view of expected return. In the U.S., the commoditization of some money market instruments meant that investors did not properly appreciate, and so did not adequately price in or allow for, the liquidity and credit risks involved. In particular, the liquidity of some instruments turned out to be excessively pro-cyclical, sparking a run on some investments— similar to a bank run—when investors became worried about access to funds and about credit risk. This was notably the case with money market mutual fund (MMMF) investments23, triparty repo, and cross-border U.S. dollar funding.

This suggests that investors should only rely on the liquidity of money or capital market instruments, to the extent that liquidity providers – whether market makers or banks extending funding back-up to investment vehicles – are in a position to meet any calls on liquidity in adverse circumstances as well as in bull markets. This in turn requires appropriate regulation and supervision. For instance, a pension fund required by its regulator to hold a certain proportion of cash assets should not treat a money market investment as equivalent to a bank deposit.

In addition to ensuring transparency of financial products, and adequate liquidity management by intermediaries, the authorities need also to consider how far financial sector safety nets should extend. Formal protection normally extends only to retail deposits, and protection against fraud by investment intermediaries. Wholesale investments need to rely rather on sound judgment, good regulation and infrastructure, and supportive legal systems.24

As financial markets in the ASEAN region diversify beyond a bank-dominated system, it will be useful to review the extent of both explicit and implicit guarantees, and the authorities’ ability to respond to potential systemic shocks. Moreover, as financial intermediation becomes more balanced and competitive as a result of greater capital market sophistication, the macro-financial linkages are also likely to change, often with major implications for policy makers.

Domestic currency funding

Repo borrowing against non-government securities may be particularly vulnerable. Such borrowing grew in the U.S. after the 2005 amendments to the bankruptcy code, giving greater protection to the use of non-government securities in repo. But the 2008 crisis revealed a problem: the underlying assets—such as mortgage bonds and structured products—may be relatively illiquid and hard to value. Consequently, in the face of a market shock, higher margins may prove difficult to meet, while selling assets into a falling market will cause losses and may lead to financial market distress.

If enterprises increase the use of commercial paper (CP) issuance—as opposed to relationship banking—they should consider what liquidity back-up, if any, might be appropriate. Because bond finance is typically longer-term it is less susceptible to short-term liquidity runs. But if lenders in the CP market become more risk averse in response to an economic shock, corporates may struggle to repay, while renegotiating loans from CP holders – with which the corporate may have no relationship—can prove difficult. Similarly, investors – particularly supervised institutional investors—should not be allowed to treat CP or other short-term private sector debt as if it were the equivalent of a bank deposit.

Offshore funding

The global crisis has highlighted risks in over-reliance on offshore funding, particularly where banks borrow relatively short-term offshore, and in foreign currency, to fund longer-term domestic (or foreign) currency loans onshore. While borrowing short-term from a parent company may appear reliable—because of the connection—it may mask an indirect reliance on the parent’s liquidity strength, which may not be so reliable.

If banks hit a funding problem, they can normally access standing credit facilities (part of the safety net) at the central bank. But if they rely on foreign currency funding, it may not be so easy for the central bank to provide support, though intra-central bank foreign exchange swap arrangements were established in some countries over the past two years, and the ASEAN swap agreement provides some buffer.25


The dominance of OTC derivatives (particular for foreign exchange) requires a careful assessment of some of the key lessons learned from the collapse of derivatives trading during the recent crisis. The main vulnerabilities of OTC derivative markets stem from counterparty and concentration risk. Virtually all OTC trading of interest rate and FX derivatives (swaps and forwards) in ASEAN countries is conducted by a few banks, which implies substantial counterparty risk in the absence of market provisions that would safeguard collective interest and prevent individual failure from translating into systemic crisis. (Only Malaysia has exchange-traded interest rate transactions exceeding those traded through OTC markets and forward rate agreements). In addition to questions surrounding the legality of some OTC products, further improvements of the existing market infrastructure would require a comprehensive netting law in combination with the introduction of a CCP to complement collateral provisions in assessing the adequacy of margins and risk management practices. Nonetheless, standardized contract documentation in compliance with International Swaps and Derivatives Association (ISDA) standards and syndicated trading among investment-grade rated banks are risk mitigants in OTC markets.

The crisis has shown the critical role of market infrastructure in risk management and financial stability. In this regard, the G-20 countries have committed to improve the resilience of derivatives markets by strengthening the associated infrastructure. In particular, the G-20 countries recommended that all standardized OTC derivatives be cleared through central clearing counterparties (CCPs) as a way to better manage counterparty risks. The G-20 also encourage trading of derivatives on exchanges (or other public venues) in order to improve transparency, price formation and liquidity. Finally, the G-20 countries have also recommended that all OTC derivatives trades be reported to a trade repository to improve transparency and price formation. Policy makers could take cues from regulatory proposals to enhance the infrastructure of OTC derivatives markets, such as in the United States, and the 2010 Basel Committee on Bank Supervision (BCBS) paper on “Strengthening the Core Financial Infrastructure and Markets.”

III. Conclusion

In many ways, the ASEAN5 bond markets compare well with other emerging markets. But there is still work to be done. Countries may wish to consider the potential benefits of:

  • Standardizing and consolidating CSDs, while introducing CCPs for fixed income markets.

  • Tightening enforcement of securities regulation, including of disclosure obligations; strengthening disclosure obligations of material events; reviewing disclosure obligations for private offerings in particular in the context of asset backed securities and other structured products, and streamlining registration procedures for offering securities.

  • Improving oversight of credit rating agencies and external auditors.

  • Developing the legal and regulatory framework for expanding the use of derivatives, and adapting the infrastructure systems accordingly.

  • Tightening reserve money management, to reduce interest rate volatility and spur the development of money markets.

  • Reforming withholding taxation for non-resident income from bond holdings.

As the non-bank financial sector develops in the ASEAN countries, the lessons learned from the recent crisis in developed financial markets will become increasingly important. In particular, it will be important to review pre-crisis regulatory frameworks in the light of recent developments to ensure that:

  • Liquidity risk taking does not become excessive, whether by issuers, investors or intermediaries. As a first step, regulators will need to make sure they can identify the liquidity risks to which entities are exposed, and maintain a clear distinction between liquid bank deposits and investments whose value may fluctuate.

  • Repo borrowing remains focused on securities which are likely be liquid, even during periods of financial stress.

Cross-border, cross-currency links do not create risks (such as excessive reliance on financial firms whose own liquidity is uncertain) with which the financial sector safety nets cannot cope.

Developing Asean5 Bond Markets: What Still Needs to Be Done?
Author: Mr. Simon T Gray, Andreas Jobst, Mr. Joshua Felman, and Ana Carvajal