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

The basis for efficient primary markets

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4.5The basis for efficient primary markets

A liquid secondary market of government bonds is the basis for the efficient primary markets of both government and corporate bonds (see Figure 2).

The pricing of a new issue of government bonds in the primary market is based substantially on the conditions of their secondary market. The more certain the price discovery in the secondary market, the more precise the pricing can be. A material saving in issuing costs may be achieved by a combination of a narrower bid/ask spread, a smaller market impact and a less liquidity premium as illustrated in Section 4.4. Hedging instruments derived from the liquid secondary market will make the primary market further efficient.

Reliable government bond yields benchmark the pricing of new issues of corporate bonds, which is further adjusted for credit risk, liquidity risk, scarcity value4, and other factors5 unique to an issue. In addition, a liquid government bond market lays a ground for hedging instruments that issuers, intermediaries and large investors at the time of offering. Otherwise, the pricing of corporate bond issues would be erratic and uncertain; and, consequently, engagements in new issues of corporate bonds would involve a fair amount of risk to issuers, intermediaries and large investors. This uncertainty would leave corporate bond issuance expensive and may decisively impede the development of a corporate bond market.

When policy measure are taken to enhance market efficiency, the policy weights of the primary and secondary markets for efficiency are largely equal in a government bond market, while the policy weight of the primary market is overwhelming in a corporate bond (see Figure 2). The efficiency of the primary market is critical for the overall efficiency of a corporate bond market, because the trading of corporate bonds is characteristically limited.

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

A liquid secondary market of government bonds is the basis for the efficient primary markets of both government and corporate bonds. The policy weights of the primary and secondary markets for efficiency are largely equal in a government bond market, while the policy weight of the primary market is overwhelming in a corporate bond

4.6An anatomy of trading costs

Even though trading costs have to be low enough, many developing countries fail in doing so. Such a failure is quite attributable to some common causes of a “market failure”, including market power, externalities, and adverse selection. This view leads to a policy supporting market infrastructures by the government budget and/or socially more broadly-based resources than just market players. To this end, public awareness of common interests in the government bond market should be promoted, and public consensus on a more aggressive budgetary support should be formed.

4.6.1Components of trading costs

Trading costs have to be low enough in order to constantly meet the investor’s trading needs as well as deliver the macroeconomic benefits.

Trading costs consist of (i) brokerage commissions or bead/ask spreads, (ii) market impact6, (iii) fees payable to the regulator, the clearing house, the depository, etc., (iii) transaction taxes, and (iv) opportunity costs. Brokerage commissions or bead/ask spreads are the most visible trading costs. Market impact is often the largest component of trading cost for a large transaction and for a large investor.

Opportunity costs are usually not included in trading costs. However, opportunity losses arise from not being able to trade immediately whenever the investor or trader wants to. They are apparently costs that need to be reduced to make the market more liquid. In fact, most subjects that are commonly discussed for the enhancement of market efficiency fall into this category. They are more incurred if the market lacks or is imperfect in (a) a quote-driven trading mechanism (dealers’ market), (b) a repo market, (c) an electronic trading system, (d) an electronic clearing, settlement, and depository including a book-entry system, and (e) position-neutral accounting and taxation (see Section 5).

4.6.2Positive externalities of securities trading

A failure in making the market efficient is interestingly similar to a “market failure”. It is quite attributable to some common causes of a market failure, including market power, externalities, and adverse selection. We can typically see positive externalities in securities trading and market failures in bearing trading costs. A self-interest seeking behavior of a market player significantly affects the efficiency of the whole market, going beyond its own interest. Even within the government, different branches such as the debt management office, the monetary policy administrator (the central bank), the fiscal authorities (the ministry of finance), the prudential supervisor, and the market regulator, have different self-interests in the government bond market, and their interests often conflict each other.

summarizes conceivable causes and possible remedies of the failure for each of the five trading cost elements. The possible remedies will be combinations of the mandated behavior approach and the incentive approach.

Table 3: Externalities of Trading Costs

Trading Cost Elements

Causes of Failure


Brokerage commission or bid/ask spread

Market power


Primary dealership


Monitoring & supervision

Market impact

Adverse selection (trade only when a market risk is small)

Primary dealership

Preferential funding

Central bank liquidity



Market power

Public goods

Operational transparency


Externalities (within the Govt)

No transaction & w/h taxes

Opportunity costs

Imperfect flow of information


Private sector mechanism with governmental cooperation or coordination

Market intermediaries think twice before taking an initiative for making the market efficient by cutting back on their own brokerage commissions or bead/ask spreads. This is because an elasticity of a commission or spread cut to a trading volume is uncertain, and because there will be a time lag between a commission or spread cut and a trading volume pickup, if any. Primary dealership generally helps cope with this chicken-and-egg situation (see Section 5.1.2). In competitive environments where intermediaries are sensitive to their own reputation in the marketplace, even post-trade dissemination of trade data such as prices and volumes at or after the close of the market gives market intermediaries a commercial incentive to narrow the spreads under competitive environments (see Section 5.1.4).

The market maker’s adverse selection impairs the market’s ability to dissipate market impact. The market maker may well minimize its market risk exposure by selecting smaller orders to execute. For the same reason, it may be less willing to trade with the investor when the market is volatile. Primary dealership with market making obligations is effective in alleviating this problem.

Market makers are usually granted access to competitive funding enabling them to support their inventories of marketable bonds in a commercially viable manner. An expanded repo market serves such a purpose well (see Section ‎5.2). In some countries, the central bank provides market-making support through a “secondary market window”. It engages in trading of government bonds with private sector dealers to induce the liquidity into the market, hence accommodating the market maker’s position taking.

Fees payable to the regulator, the clearinghouse, the depository, etc. may be so expensive due to limited economies of scale that investors may be discouraged from trading actively. It is not an uncommon practice in emerging markets to charge the fees to the investor every time it trades to financially support the market infrastructure. This is probably because most governments developing a brand-new market infrastructure in their economy are fiscally constrained, and they are influenced by the trend in developed markets of converting the market infrastructure into for-profit organizations. The government or its fiscally independent agencies charge fees to individual trades in a relatively small and low-volume market to build up and support the market infrastructure.

Since a liquid secondary market of government bonds is intended to serve a country’s public interests (see Section 4.3), fees charged for trades apparently have externalities. It is more appropriate to finance the market infrastructure substantially by the government budget and/or more socially broad-based resources than just market players. The costs are meant to be spread out across all segments of the economy that benefit directly or indirectly from well functioning capital markets including government bond market at least until the market has reached a full-fledged stage. To counter-balance an uncompetitive nature of market institutions, it is also imperative to require the operators of the market infrastructures to keep their operations transparent in accordance with stated disclosure rules.

Securities transaction taxes, like other types of trading costs, can obstruct price discovery and price stabilization, increase volatility, reduce market liquidity, and inhibit the informational efficiency of financial markets. This is because returns on short-term instruments and short-term transactions of long-term bonds are highly and negatively sensitive to securities transaction taxes.

Opportunity costs of trading also arise from imperfect flow of information. Market information generates trading, and then trading generates a new piece of market and trade information. Traditionally, private sector institutions are operationally more effective in this area. Therefore, this task may be outsourced to the private sector under governmental supervision.

4.6.3“Market failure” in developing country circumstances

There is a market failure in developing and maintaining a capital market in developing countries. Today, it is widely recognized that the capital market serves public interests as much as it does private-interests. Particularly, that is the case with the government bond market. Capital markets in developing countries have been hastily established for public interests. The public outside the marketplace also benefits in many ways from information flows that the market constantly generates. However, the market players can hardly charge the public outside the market for most of the benefits. The public is not ready to pay the “true price”. This is a market failure. The market failure of capital market services unavoidably imposes unproportionately heavy economic burdens on the marketplace. The burdens take form of high trading costs. The government bond market is far more sensitive to transaction costs.

The market failure is more serious in developing countries. It is not necessarily unique to emerging markets. Nonetheless, we do not see the problem in most developed countries. The reason for the market failure in developing countries is presumably that developing countries are engaged in building up the capital market in a much smaller economy in a much shorter period under much higher and tighter specifications than many developed countries did in the past. In addition, the capital market is much more expected to serve public interests than before. The costs of capital market development per time unit (e.g. a year) in developing countries today must be higher than that in developed countries yesterday (Figure 3), resulting in a higher cost of capital market development per trade.

This is a highly possible mechanism other than supply- and demand-side problems, through which capital markets in many developing countries have been stuck in illiquidity. A suggested remedy is that market infrastructures in developing markets should be more financed by the government budget and/or socially broader-based resources than just market players. For this, public awareness of common interests in the government bond market (more generally the capital market) should be promoted, and public consensus on a more aggressive budgetary support to the market infrastructure should be formed.
Figure 3: Costs per Time Unit of Market Development

The slopes of the two triangles diagrammatically represent the costs of market development per time unit (e.g. a year) in developed and developing countries. They can be translated in per trade cost of capital market development. The per unit costs must be higher in a developing country today than in a developed country yesterday.

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