Draft: June 8, 2003 Developing Efficient Market Infrastructure and Secondary Market of Government Bonds in Developing Countries

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DRAFT: June 8, 2003

Developing Efficient Market Infrastructure

and Secondary Market of Government Bonds

in Developing Countries

on Developing Government Bond Markets
in Sub-Saharan Africa

June 17-19, 2003
Johannesburg, South Africa
Tadashi Endo


The World Bank

To keep investors’ trading costs enough to maintain an active secondary market of government bonds, financial support to the market infrastructure should be more broadly-based across the economy. Public awareness/consensus about the roles of a government bond market is needed for this policy. An expected repo market performs economically useful functions in a developing economy, and is significantly effective in generating the liquidity in the market. Human intermediation by salespeople equipped with some electronic devises is expected to remain effective in creating and maintaining liquidity in the secondary markets of government bonds under most emerging market environments.

Table of Contents

1 Introduction 5

2 Capital Market Profile peculiar to Developing Economy 5

3 Demand- & Supply-side Principles for Market Liquidity 6

4 Why Does Efficiency Matter? 7

4.1 Impact of trading on an investor’s return 7

4.2 The investor’s trading needs 9

4.3 Macroeconomic functions 9

4.4 A quantitative example of public benefit 11

4.5 The basis for efficient primary markets 11

4.6 An anatomy of trading costs 13

4.6.1 Components of trading costs 13

4.6.2 Positive externalities of securities trading 14

4.6.3 “Market failure” in developing country circumstances 16

5 Market Infrastructure for Efficiency 17

5.1 Dealers’ market (OTC) 17

5.1.1 Rationales for quote-driven auction 18

5.1.2 Market making obligations 18

5.1.3 Real-time online trading facilities 19

5.1.4 Post-trade reporting 19

5.2 Expanded repo market 20

5.2.1 A prerequisite for market making 20

5.2.2 A jump-up of trading volume 21

5.2.3 Limited participation 22

5.2.4 Regulation and supervision 23

5.2.5 Legal, tax and other issues 23

5.3 Electronic trading systems (ETSs) 24

5.3.1 Limited roles of an ETS in trading 24

5.3.2 Five major types of ETSs 25

5.3.3 Market and product suitability to an ETS 26

5.4 Clearing, settlement & depository 26

5.5 Trading-neutral Accounting & Taxation 27

5.5.1 Trading-neutral accounting 27

5.5.2 Trading-neutral taxation 28

5.5.3 Other preferential treatments 28

5.6 Advanced risk management & arbitrage facilities 28

5.6.1 Symmetric functionalities 28

5.6.2 Efficiency and systemic risks 29

6 Salespeople and Brokers for Liquidity 30

6.1 Liquidity vs efficiency 30

6.2 Mediocre players 31

6.3 Network effects 32

7 Conclusion 33

List of Tables

Table 1: Reinvestment of Current Coupon Bonds 9

Table 2: 3- to 5-year Government Bond Spreads in Selected Developing Countries 11

Table 3: Externalities of Trading Costs 14

List of Figures

Figure 1: Capital market in a developing economy 6

Figure 2: Liquid Secondary Market of Government Bonds & Efficient Primary Markets of Government and Corporate Bonds 12

Figure 3: Costs per Time Unit of Market Development 17

Figure 4: Singapore Government Securities Turnover (Outright & Repo) 21

Figure 5: Trading Action Circle 25

Figure 6: Components of Broking 25

Figure 7: “Symmetric Functionalities” of cash and futures markets 29

Figure 8: Market Efficiency and Systemic Risk 30

Figure 9: Mediocre and Visionary Players 32


Appendix 1 34


New technologies have been allowing developing countries to leapfrog some hard problems that are time-consuming to resolve or hopelessly entangled with other parts of the society and get to an advanced stage of capital markets. This is typified by the electronic trading system, and the electronic clearing, settlement and depository system. In fact, the introduction of the both systems has drastically rationalized some key elements of the capital market working in favor of developing countries.

However, capital markets in many developing countries remain illiquid primarily due to problems on the supply- and demand-sides of the markets.

Besides the supply- and demand-sides of the market, there are some market infrastructure elements of government bonds that will significantly contribute to market efficiency or liquidity if they are designed and/or structured sensitively enough to development country realities. The failure in addressing such market infrastructure elements often results in the misallocation of capital market development costs, a repo marker unworkable to facilitate market making obligations, and the underutilization of human intermediation.

This note will analyze these elements and provide policymakers in developing countries with guidance on policy actions for making their government bond market more efficient and/or liquid. Sections 2 and 3 will first outline a capital market profile peculiar to developing economies, and demand- and supply-side issues of their capital markets. Section 4 will show how critical low trading costs are for market efficiency by demonstrating that trading per se is neutral to total returns, and will address externality issues of trading costs. Then, Section 5 will elaborate the benefits of market making obligations in a dealers’ market and an expanded repo market for market liquidity, followed by brief reviews of electronic trading systems, clearing, settlement and depository, accounting, taxation, risk management and arbitrage facilities in light of emerging market environments. Finally, the effectiveness of human intermediation in the creation of liquidity in the government bond market will be analyzed.

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