A proper set of the demand and supply sides of a bond market is a primary prerequisite for bond market liquidity. A well-organized market infrastructure is often secondary to them.
Public awareness/consensus about the roles of a government bond market is a key to reduce the overall trading costs of government bonds. Trading per se is neutral to total returns, and never pays for trading costs without additional risk. Therefore, it is critical to keep trading costs low for market liquidity. Due to a public goods nature of capital markets, a public support is essential to bring down the direct costs of trading.
Key market infrastructures for market efficiency are market making obligations in a dealers’ market and an expanded repo market, followed by an electronic trading system, an electronic clearing, settlement, and depository, and position-neutral accounting and taxation. As the market develops, the policymaker needs to introduce advanced risk management and arbitrage facilities into its government bond market, while balancing between market efficiency and increasing systemic risks.
“Mediocre” investors are an indispensable basis for liquidity. They need brokers for active trading. Interdealer brokers should be considered as a liquidity enhancement measure if a market size justifies them. Under emerging market environments, 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.
Appendix 1 Fixed-Income Products and Types of Electronic Transaction Systems
Compiled from "Review of Electronic Transaction Systems for Fixed-Income Markets", The Bond Market Association, December 2001
* European securities are not classified into sovereign, corporate, etc.
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The World Bank and International Monetary Fund, 2001, Development Government Bond Markets: A Handbook
1 This note was originally presented to the Third Regional Workshop on Development of Government Bond Market in t Middle East & North Africa that was held in Tunis, Tunisia on June 17-18, 2002, and the Fourth Regional Workshop on Development of Government Bond Market in Sub-Saharan Africa that was held in Johannesburg, South Africa on November 10-12, 2003, and subsequently revised. The views here are those of the author and do not necessarily reflect the views of the World Bank.
2 For more detailed analyses and discussion on the peculiarities of emerging markets, please refer to my note “Capital Market Profile peculiar to Developing Economy”.
3 If the issuers (the governments) and the investors shared the savings equally, the calculated savings will be a half of those in the table, which are 25% of the prevailing spreads.
4 Institutional investors often pay a premium for bonds of particular issuers (“names” in the market jargon) that are scarcely available in the market if other elements of a bond are equal for the purpose of investment portfolio diversification.
5 The structure of a bond may have specific tax, accounting and/or regulatory implications to the issuer and/or investors.
6 Market impact is the effect of the positions bought or sold on the price paid or received for a security. If an order lot is large relative to the actual liquidity, the order will be executed only at a price low or high enough to meet the required volume of demand for or supply of the security. The difference between the executed and initially quoted prices is called the market impact or price impact.
7 This discussion assumes that a country has at least several outstanding issues of government bonds. In a country with one or two outstanding issues, a call market or batch trading system may work better.
8 Ngiam, Kee-Jin and Lixia Loh, “Developing Debt Markets in Singapore: Rationale, Challenges and Prospects”, Asia-Pacific Development Journal, Vol 9, No. 1, June 2002. The Government of Singapore expanded the repo market participants but limited it to financial institutions. This is probably because Singapore, which has graduated from a developing country status, has a large number of foreign financial institutions on an on-shore or off-shore basis.
9 Such criteria should be objective and fair to avoid discriminating against classes of market players and introducing competitive distortions, and should be clearly stated and publicly disclosed so as to improve certainty and transparency.
10 For example, the central bank provides no liquidity to broker/dearlers.
11 Direct participants in clearing and settlement systems like commercial banks settle across the books of a settlement institution (usually a central bank), while indirect participants like broker-dealers settle across the books of direct participants.
12 In a conventional net settlement of interbank funds, a single settlement failure could affect settlement of other transactions that were netted and are supposed to concurrently settle. In RTGS, every transaction is settled individually on a continuous, transaction-by-transaction basis throughout the processing day, so that settlement of each transaction is unrelated to that of other transactions, and transactions are processed one after another from early in the day; and, therefore, whole payment system is much less prune to systemic risk.
13 Hold-in-custody or letter repo, delivery-out repo, tri-party repo, four-party repo, and buy/sells and sell/buys.
15 No reliable data of the market share of ETSs is available, because ETSs do not want to disclose their market shares. Salomon Smith Barnet estimated screen-broked trading at more than 40% of US Treasury bonds in 2000 (Salomon, 2000), and an interdealer broker reckoned in October, 2002 that more than 90% of Yen/US$ forex, and more than and 15-20% of JGBs were being screen-broked.
16 In the United States, for example, FASB Nos. 107 and 113 require corporations including financial institutions to disclose their financial asset holdings on a mark-to-the-market basis.
17 See Footnote Error: Reference source not found
18 My argument in this section was developed through my email discussions with Mr. Naoki Yokoyama, Chairman of SBI Asset Management Co., Ltd. in Tokyo, Japan.