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

Clearing, settlement & depository

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5.4Clearing, settlement & depository

The objective of clearing, settlement and depository operations is surer and quicker availability of securities to the buyer and funds to the seller for their next financial transactions after their trade is executed. Achieving this objective is a key to a liquid secondary market of government bonds. For this reason, moving to a book-entry system from a paper certificate system or even starting a brand-new government bond market with a book-entry system is an established norm. For the same reason, the book-entry system has been computerized, and has been being electronically integrated with clearing (order matching, and confirmation), and settlement (delivery of securities, and payment of fund). Accordingly, a depository, which used to safekeep and record physical certificates for their holders for security and convenience, is now an institution to process and maintain an electronic boon-entry system. As a result, a flow of these back-office processes has been rapidly automated.

Any developing country aiming at a liquid secondary market of government bonds cannot avoid taking this course. Any market can no longer carry out practices and methodologies in a reliable and efficient manner to create and maintain market liquidity such as delivery versus payment (DVP), rolling settlement, securities lending, repos, etc. without a computerized central depository of government bonds.

The actual structure of a country’s clearing, settlement and depository system depends on local factors. Structural choices include one- vs two-tier structures, general vs specialized depository systems, a unit of the central bank vs a self-standing institution, and membership criteria. The central bank is expected to play an important role in making an optimal mix of choices in the view of inducing the largest possible volume of trading activities with a minimum systemic risk under local circumstances.

Information technologies or combination of computer and communication technologies is now presenting new choices to developing countries. A developing country may elect to unbundle clearing, settlement and depository operations and outsource their parts from foreign established depositories to minimize overall costs.

5.5Trading-neutral Accounting & Taxation

5.5.1Trading-neutral accounting

An accounting standard for evaluation of marketable securities influences the trading behavior of the investor. The cost method largely discourages the investor from selling its marketable bonds whose market value has dropped below the acquisition cost, since the sale will cause the investor to realize losses on its income statement. If the government forcefully places bonds at a sub-market rate to myopically save the financing costs of its budget deficit, the investors, which are mostly regulated financial institutions, will be hardly able to sell them in the market unless they realize capital losses; however, they do not need to account for the losses under the cost method if they hold them.

Some countries distinguish securities holdings between trading and investment portfolios, and require the investor to evaluate its trading holding on a lower of cost or market basis. Some other countries more aggressively require the investor to mark its trading portfolio to the market at the end of each accounting period16. The International Accounting Standards 32 and 39, which are increasingly adopted in developing countries, have similar requirements. The mark-to-the market substantially eliminates an incentive not to trade bonds for accounting purposes. It creates little basis against trading, and, therefore, is neutral to trading.

5.5.2Trading-neutral taxation

As has been discussed earlier, securities transaction taxes works against trading. The imposition of withholding tax on interest payments of government bonds complicates the calculation and adjustment of accrued interest between the seller and the buyer of bonds, and consequently impedes trading. It may also fragment the market into segments according to the investor’s tax status, resulting in reduced liquidity of bonds. Different tax treatment between interest and capital gain or loss often creates some preference towards particular issues of bonds over others, depending on the investor’s tax position. The interest as part of capital gain or loss may be treated differently from the outright interest payment. Excessive differentiation of this kind hinders trading.

5.5.3Other preferential treatments

Some of these preferential treatments of government bonds might adversely affect their liquidity. Examples are exemption from statutory reserve and recognition as liquidity assets for capital adequacy ratio purposes. This exemption will create demand for government bonds from banks that are subject to statutory reserve requirements or whose assets are subject to capital adequacy rules. The problem with this is that only banks will benefit from the preferential treatment and most of the issues will be sucked into banks’ portfolio.

5.6Advanced risk management & arbitrage facilities

5.6.1Symmetric functionalities

Advanced capital market facilities of government bonds such as short selling, repos, securities lending, and derivatives (futures, options, and swaps) enhance market participants’ ability of risk management and arbitrage operations. A highly efficient clearing, settlement and depository system is a prerequisite for smooth operation of these facilities. Risk management and arbitrage operations, if permitted, would generate a tremendous amount of trading, and further enhance the price discovery function of the market.

The advanced capital market facilities of government bonds complete a full set of long and short position taking tools in cash and futures markets. This may be called “symmetric functionalities” of cash and futures markets (see Figure 7). With a full-fledged risk management and a rational price discovery mechanism in place, investors and dealers can bid for primary issues of government bonds precisely, and corporate bond issuers and underwriters can issue or underwrite corporate bonds in an efficient manner. In other words, it enables them to take market positions with a reasonably controlled risk under ever changing market conditions.

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

In realty, however, it is extremely difficult for many developing countries to develop such liquid derivatives markets of fixed income products that intended risk management and arbitrage operations can be reasonably performed. It is more realistic to concentrate their efforts on the introduction of short selling, repos, and securities lending. This will enable them to maintain “symmetric functionalities” of the cash government bond market, and enhance market liquidity. Symmetricity is a kind of minimum requirement for a system to serve risk management and arbitrage purposes.

5.6.2Efficiency and systemic risks

As a result of reducing opportunity costs, the whole market system becomes efficient. A trading decision gets quicker. Trading volume increases. A settlement cycle shortens. A bond trade may involve more financial products and counter-parties beyond the bond market. Trading and settlement may involve parties more distant from each other than before. They may be not only across nation borders and in different time zones, but be a half world away. A larger amount of money and/or foreign exchange may be involved. The flip side of the coin is that systemic risks of the financial market also increase, and the whole economy may become less stable and more vulnerable to shocks (see Figure 8-A). The government needs to take more sophisticated measures to monitor, eliminate or contain increasing risks. Conceptually, it needs to shift or bend the risk/efficiency tradeoff line in our favor (see Figure 8-B). An RTGS system17 will make the shift possible.

Figure 8: Market Efficiency and Systemic Risk

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