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

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5.2Expanded repo market

An expanded repo market underpins the liquidity of the secondary market bonds. An expanded or open repo market is a repo market in which the participation is open to commercial banks as well as non-bank institutions. A market making mechanism works well only when it is backed by an active repo market, which is expanded to a number of capital market players. The expansion of repo market participation is more needed in developing countries because the number of commercial banks is generally very small.

5.2.1A prerequisite for market making

Market making is almost impossible without a repo market in place. Bond dealers occasionally need to sell short to abide by their firm offers, and to cover their short positions in a repo market. Otherwise, bond dealers would have to keep an inventory of government bonds for every foreseeable trading need. This practice would be too costly to bond dealers, if not impractical. Furthermore, if many bond dealers do this, it will suck up the liquidity of government bonds from the market and ultimately will defeat the purpose.

Then, a repo market must be active so that bond dealers’ market making may be sustainable. It is too risky for bond dealers to commit themselves to keeping firm offer prices posted unless they are able to cover their short position in a repo market whenever necessary. Thus, a bond dealer’s market making ability is dependent on the liquidity of a repo market, among other things.

Nevertheless, repo markets in some developing countries are not active. The possible reasons for the inactivity of a repo market include: first, the participants of a repo market is limited to commercial banks or their equivalents and their number is small; second, they tend to be on the same side of the market, because they are institutions of the same category and their funding positions are more or less the same; and third, they defer using a repo market until the lines of credit for interbank market funding have been exhausted, in case the interbank loan market is on an uncollateralized basis.

A repo market can be made liquid by expanding its participants beyond commercial banks. A repo market is set up normally by the central bank of a country to manage the liquidity of the banking system. The central bank tends to limit the eligibility to participate in the repo market to commercial banks that it regulates. However, a repo market can be multi-functional if the eligibility for participation is expanded. It will allow or facilitate the central bank to conduct open market operations, cash-rich investors to make a flexible, highly secure, and high yielding money market investment, bond dealers to fund their inventories or trading positions, or to cover their short positions, commercial banks to arbitrage between interbank markets and open markets, and so on. The convergence of these financial needs on a repo market will generate a fair amount of trades of government securities.

The expansion of repo market participants beyond the banking sector is more needed in developing countries than developed ones. The number of financial institutions is often too small in developing countries. A larger number of participants are obviously needed to generate liquidity in a repo market.

If it is open to non-bank institutions, the repo market will allow non-bank intermediaries such as broker-dealers to participate more actively in the primary market of government securities. Broker-dealers may offer repos to their corporate customers as a high-quality short-term investment product for cash management. State-owned enterprises and private-sector corporations would be able to invest their temporary surplus funds more flexibly and favorably. A repo is safer than bank deposits, because their lending to broker-dealers through repos is secured directly by the credit of the government. This product will eventually compete with commercial banks' term deposits, and may create pressure to improve their operational efficiency. The other side of this transaction will be broker-dealers’ financing tool at a competitive cost for their inventory of government securities.

5.2.2A jump-up of trading volume

An expanded repo market also increases trade volume of government securities considerably, and hence enhance price discovery in the market. The US Treasury bond repo market, The UK’s open gilt repo market and Japan’s Gensaki market are examples of expanded or open repo markets that support the liquidity of outright markets of government securities.

This is not the case only with large developed markets. The Government of Singapore liberalized the repo market by (i) lifting size restriction in November 1999, (ii) expanding the market to offshore banks and non-residents in May 2000, (iii) carrying out its own SGS repo program in November 2000, and (iv) allowing non-residents to borrow in the repo market without size restriction in December 2000. As a result, not only the trading volume of the repo market but also that of the outright market jumped up in and after 20008 (Figure 4).

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

Source: Monetary Authority of Singapore

Note: Singapore Government Securities include all Treasury Bills and Government Bonds

5.2.3Limited participation

The benefits of the openness of a repo market have to be balanced against the need to limit participation in different market infrastructures to those with the necessary expertise, powers and financial resources. A broad participation is a tradeoff with increased systemic risk.

For example, the openness requires non-bank institutions to have access to the depository and/or the settlement bank of government securities, which are the central bank in many countries. However, such non-bank institutions are not necessarily under direct regulation and supervision of the central bank. They may pose additional systemic risk to the systems that are crucial to the national economy. This is partly responsible for some central banks being hesitant to expand the scope of repo market participants.

Therefore, it is prudent to limit the participation in these market infrastructures to only qualified institutions according to certain criteria9. In some countries, broker-dealers are allowed to open clearing and settlement accounts with the central bank on a limited basis10. Some other countries adopt tiered settlement arrangements for broker-dealers11.

The introduction of a real time gross settlement (RTGS) system12 can mitigate the conflict between a broader participation and increased systemic risk, because an RTGS is designed to eliminate default risk of participants. Therefore, the payment system regulator, which is usually the central bank, may feel it less concerned to grant well-qualified non-bank institutions direct access to the depository and the settlement systems.

5.2.4Regulation and supervision

The expansion or openness of a repo market may give rise to a jurisdictional issue over the repo market, depending on the legal framework of financial markets in a country. In many countries, a repo market is intended primarily for liquidity management in the banking system. As such, the central bank usually regulates and supervises the repo market as an interbank market. As the market is expanded to non-bank institutions, the regulatory and supervisory responsibilities over the repo market may get complex if a country has a specialist regulator for its capital markets. Market players with different regulators rule may coexist in a repo market.

In such a situation, it is harder for the government to effectively regulate a financial market by regulating its participants (institutional regulation). Such a commingled market can be better regulated by regulating functions that market participants perform (functional regulation). Even before the regulatory philosophy over financial markets is fundamentally re-oriented, the central bank and the capital market regulator need to coordinate more closely and to be flexible to each other on jurisdictional issues to run an expanded repo market smoothly.

5.2.5Legal, tax and other issues

A legal, tax, credit, or accounting rule may unexpectedly form a bottleneck to the liquidity of an expanded repo market, and hence the government securities market. Their implications to repo transactions in a local and/or cross-border context should also be carefully examined. A standard repo contract should be structured so that no legal, tax, credit, and accounting may hinder repo transactions.

The economic viability of repo transactions is highly sensitive to even a minute impediment, since most repo transactions are of short-term. For instance, the imposition of a small transaction tax can distort a repo market, if it does not damp the entire repo market.

The compatibility or consistency of a repo contract with other financial products or with foreign currency repos may matter to the liquidity of a repo market. This is because arbitrage is a driving force for the liquidity of short-term markets, and the incompatibility may constrain the investor’s ability to arbitrage between a repo market and other short-term markets. The cross-border compatibility helps generate a foreign demand for investment in a country’s repo market for the purposes of cross-border arbitrage or short-term forex management.

A safe choice of repo contract type in the international context is the TBMA/ISMA Global Master Repurchase Agreement. However, this choice does not warrant domestic compatibility. A repo transaction can take the legal form of a repurchase agreement, a securities lending transaction with a cash collateral, a collateralized loan, or a buy/sell and sell/buy. It can also have different settlement and custodial arrangements13 that have different credit implications to a lender of cash.

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