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

Market Infrastructure for Efficiency

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5Market Infrastructure for Efficiency

The inefficiency latent in an existing market infrastructure incurs investors and traders opportunity costs as well as direct costs. The basic ways to reduce these costs are generally found in (a) market making obligations in a dealers’ market (a quote-driven trading mechanism), (b) an expanded 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. 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.

5.1Dealers’ market (OTC)

Bonds can be more efficient in a quote-driven dealers’ market than on an order-driven exchange. Nevertheless, bond dealers need to be obligated to make a market in exchange for a primary dealer privilege to achieve a higher level of market liquidity. The benefits of real-time online trading facilities should be carefully weighed against costs in developing country environments. Post-trade reporting requirements are effective in mitigating market intransparency, which is a conspicuous shortcoming of a dealers’ market.

5.1.1Rationales for quote-driven auction

Institutional investors, rather than individual investors, drive the development of a government bond market. Dealers’ market (an OTC market), where the trading system is quote-driven and the prices of bonds are determined principally by bid/ask quotations that dealers at their own risk, can deal better with institutional orders7.

Dealers in a dealers’ market are market makers, and they normally keep firmly quoted prices for bonds almost always available. The market is constantly kept ready to trade at any moment during trading hours. The trading volume of a cash securities market is considerably asymmetric: the volume swells and shrinks as the security prices rise and decline. By quoting bids or offers for specific debt securities against the prevailing market trend, the dealer provides the specific debt securities with more liquidity and, as a result, makes their price movements orderly. In addition, its readiness to trade at a given yield also constitutes a basis for a yield curve.

Transactions in a dealers’ market are by and large more economical in terms of the total transaction cost, which includes the market impact. The market impact, especially in case of institutional orders, is often the largest component of the total transaction cost. As long as dealers’ flexibility in dealing with large and complex orders is of value to investors and provides much higher liquidity, a dealers’ market remains more cost-efficient to institutional investors.

These dealing activities impose a substantial financial burden on the dealer, and expose it to significant market risks. Therefore, the dealer must have sufficient capital to not only support its inventories but also cushion itself against fluctuations in the value of the bonds in its inventories. In order to mitigate these risks and lower its operating costs, the dealer also needs to posses highly sophisticated expertise in trading and risk management. It is desirable that financial tools like short-selling, interest or currency swaps, futures and options are available for the dealer’s use, though setting up of futures and options markets are unlikely to be realistic in most developing countries.

5.1.2Market making obligations

In market making, dealers of government securities and the government have different goals. Dealers are supposed to maximize their trading profits even at the expense of market liquidity. They do not mind widening bid/ask spreads to reduce risks and maximize a trading margin as long as a marginal profit from a wider spread exceeds a marginal loss from a declined trading volume. The government generally wants to maximize the market liquidity with a narrowest possible bid/ask spread to minimize its debt funding costs in the medium- to long-term, and to optimize the benefits of the government bond market as public goods.

This gap can be narrowed, if not closed, when dealers are exogenously compensated for the risks and costs of market making. Normally, the government obligates a small number of designated dealers (primary dealers) to continuously quote bid/ask prices with a predetermined spread or less for a prescribed trading lot on a firm basis in exchange for a privilege of exclusively bidding for and distributing new issues of government bonds. An oligopolistic nature of primary dealership allows primary dealers to generate profits on the primary market to make up for the market making obligations.

To cause this cross-subsidy mechanism to work, a single regulator should regulate both the primary market and the secondary market of government securities, or the primary and secondary market regulators should coordinate very closely. Primary dealers’ market making obligations should be explicitly and specifically defined, their compliance with the obligation should be regularly monitored, and their actual performance should be reflected in the degree of privilege they can enjoy.

5.1.3Real-time online trading facilities

The dealer in an OTC market traditionally executes trades over the telephone, monitoring video screens displaying market information provided by interdealer brokers and/or information vendors. This telephone trading has been being replaced gradually by video screen-based trading. Real-time online trading on a video screen can be generally linked to order-capturing and order-processing functions, hence considerably enhancing the productivity of trading. This electronically integrated system is called a straight-through processing.

However, stakeholders of the market in a developing country where the installation of the new system is being considered should think twice if the trade volume in the market really justifies costs for the new system. Furthermore, as will be discussed later in Section 6, human intermediation aided with some electronic trading and information facilities could be more effective in enhancing liquidity in the secondary market of government bonds in [certain] circumstances, especially in developing countries.

5.1.4Post-trade reporting

A dealers’ market, though efficient, is also prone to unfairness or even collusion. Therefore, the effective regulation of the market is crucial to maintain investors’ confidence in the government bond market and have them trade frequently. The regulator’s real-time market monitoring linked to the market-wide trading system is rather effective to deter dealers’ unfair or collusive trading. However, the installation of such a generally expensive system is subject to a serious cost and benefit analysis. Some emerging markets probably cannot afford such a system. In that case, the regulator may wish to require dealers to report trade information after the trade or even after the close of a day’s trading, or collect it from the clearing system, and disseminate it to the public before the opening of the next day’s trading. A low-cost trade reporting and dissemination practice is still effective to substantially serve the purpose.

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