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Promoting Domestic Bond

Market Liquidity
– with a focus on government bond market –

November 3-5, 2009

Kuala Lumpur, Malaysia

Noritaka Akamatsu
Chair, Financial Sector Community
Asian Development Bank

 Market’s ability to execute a trade (or liquidate a position

in bonds) without a material impact on the price.
– Any market could be subject to some impact, depending on
the size of the trade.
– The impact could be influenced by the anonymity of the
parties to trade.
 Bid-Ask spread
 Turnover ratio.

Govt bonds vs. non-govt

 Govt bonds are low risk and standardized instruments to

facilitate trading and generate liquidity. They are often
used for monetary operations by the central bank.
 Non-govt bonds (e.g., corporate bonds) tend to be highly
heterogeneous and their market, fragmented. It is thus
difficult to find counterparty to sell to for a desired
 The two tend to constitute two quite different markets.
– The annual turnover of highly developed govt bond markets
surpasses 2,000% while that of corporate bond markets
range around modest double digits.
– Govt bond market requires highly sophisticated trading and
settlement systems (particularly, the latter).
Government Bonds Turnover Ratios





Mar- Jun- Sep- Dec- Mar- Jun- Sep- Dec- Mar- Jun- Sep- Dec- Mar- Jun- Sep- Dec- Mar- Jun-
05 05 05 05 06 06 06 06 07 07 07 07
08 08 08 09 09
Local Currency Bond Bid-Ask Spreads
(Survey results)

Government bonds (in basis points)

2004 2006 2007 2008e 2008m

China, People's Rep. of 32.5 7.6 20.0 20.0 15.0

Hong Kong, China 3.0 3.0 8.0 4.0 4.0

Indonesia 140.8 16.9 42.0 19.7 24.5

Korea, Republic of 4.8 1.4 4.5 1.2 1.7

Malaysia 3.5 2.3 1.5 6.7 12.2

Philippines 25.0 25.3 10.0 15.8 19.8

Singapore 5.5 2.7 3.4 20.0 20.0

Thailand 7.3 3.0 6.3 14.2 9.8

Viet Nam na na 20.6 22.5 75.0

Japan 0.8 0.6 0.8 3.5 3.5

Note: e = early 2008, m = mid-2008 5
Source: AsianBondsOnline Survey
Government Bond Spreads-
Deviation from Average Range
2006 2007 2008

China, People’s Rep. of 0-3 >3-10 3-10

Hong Kong, China 0-3 over 10 3-10
Indonesia >3-10 over 10 3-10
Korea, Rep. of >3-10 >3-10 na
Malaysia >3-10 >3-10 over 10
Philippines over 10 >3-10 3-10
Singapore 0-3 0-3 over 10
Thailand >3-10 >3-10 3-10
Viet Nam 0-3 over 10 3-10

Japan na

Source: AsianBondsOnline Survey. 6
Motives for Govt bond
 Liquidity management
 Risk management
 Return optimization

 Liquidity and risk management motives are stronger than

return optimization particularly in a market dominated by
banks and bond dealers instead of buy side investors.

Factors affecting the Govt bond
market liquidity
 Govt as the price taker in the primary market,
 Market fragmentation with many small series,
 Fixed-rate vs. floating / adjustable rate,
 Management of excess bank liquidity,
 Use of govt securities for monetary operations by CB,
 Standardization of transaction conventions
 DVP settlement,
 Diverse market participants / investor base
 Fair market access,
 Accounts, i.e., trading, available-for-sale, held-to-maturity,
 Risk-sensitive prudential rules for market participants,
 Repo and securities lending services,
 GS / interest rate futures,
 Transaction cost (including tax),
 Trading platform and market transparency,
 Upward sloping yield curve, 8

 Market making,
Factors – 1

 Govt as price taker.

– A tight yield cap in the primary market artificially brings
down the yield below the secondary market yield, which
discourages selling of bonds in the secondary market
because it forces the buyer to recognize losses.
 Market fragmentation with many small series
– Makes it difficult to find counterparty to buy or sell specific
series of bonds for the amount needed.
– Consolidate instruments and create benchmarks.
– But this requires a sound cash management capacity.
 Fixed rate vs. floating / adjustable rate
– Floating rate instruments reduce the interest rate risk to
bondholders, thus not motivating them to sell.
– But this choice needs to be considered in a strategic debt 9
management framework.
Factors – 2

 Management of bank liquidity by CB.

– Cash reserves held by banks in excess of a required level
should be kept within a reasonable range (even when
operating with inflation targeting).
– Too much or too little excess creates one-way market in the
inter-bank market, thus stifling the liquidity and increasing
the volatility.
– Requires good projection of government cash flows /
balance that impact on the banking system liquidity and
good coordination between MOF and CB.
 Use of govt securities for monetary operations by CB
– CB’s buying and selling of govt bonds in the secondary
market directly creates market liquidity while enhancing the
usefulness of the bonds for banks in responding to monetary10
Factors – 3
 Standardization of transaction conventions
– quoting convention
– yield calculation method,
– trading units,
– trade agreement format,
– settlement cycles,
– settlement instruction format,
– master repo agreement,
– etc.
 Delivery versus payment (DVP) settlement
– DVP eliminates large part of counterparty risk and enables
each market participant to increase the counterparty
exposure limit, thus enlarging and activating the market.
– Requires synchronization of payments against delivery of 11
Factors – 4

 Transaction cost
– Transaction fees charged by a trading platform operator /
inter-dealer broker and custodian / settlement bank /
system operator,
– Tax, transaction / business tax, capital gains tax, interest
income tax
 Diverse market participants / investor base
– Participants with different risk appetite, inflation
expectation, investment time horizon, etc. buy and sell
bonds for more actively among them.
– Banks, securities companies, life insurers, non-lifes, pension
funds, mutual funds, money market funds, provident funds,
individuals, etc.
– Development of insurance companies and pension funds is
driven by welfare / social security policy and takes time.
Mutual funds could be promoted more quickly, but it may 12
require management of conflict of interest with banks.
Factors – 5

 Accounting of bonds
– Trading, available-for-sale, held-to-maturity
– Mark-to-market motivates dealers and investors to manage
the risk of bond portfolio actively.
– But beware of the latest debate on procyclicality.
 Risk-sensitive prudential rules
– Requirement of adequate capital and liquidity to cope with
risks associated with interest rate, market, etc. motivates
bondholders to manage those actively by trading, especially
when risks are priced / valued at the market.

Factors – 6

 Repo market
– Repo enables active / short-term funding (including market
making) of long-term instruments.
– Requires efficient and safe repo clearing, master repurchase
agreement (MRA),
 Securities lending services
– Enable bond dealers to be more active in dealing at a given
level of inventory of bonds.
 Govt bond / interest rate futures
– Enables bond dealers to hedge interest rate risks, thus
enabling them to hold greater inventory of bonds for active

Factors – 7

 Fair market access

– The trading and settlement systems should provide access
to a wide range of potential market participants as long as
they satisfy appropriate prudential standards.
 Trading market structure
– Need to create a transparent market that can be trusted by
investors that they are getting the best, competitive price
when trade.
– The secondary market architecture should balance well
conflicting interests of different groups of market
participants, particularly dealers and investors.
– Arrangement for bloc trades

Factors – 8

 Market transparency
– The foundation of investor trust.
– But the more transparent, not necessarily the better, and
anonymity is required to reduce the impact cost. E.g., bloc
trades or liquidation of a large position by a major
institutional investor.
– Transparency is not free. Public information (e.g., post-
trade price info of benchmark bonds) should be
disseminated as widely and timely as possible. But private
information (e.g., pre-trade price quotes for non-benchmark
bonds) needs to be kept adequately private.

Factors – 9

 Upward sloping yield curve

– Upward sloping yield curve enables short-term funding of
longer-term investment. Inverted yield curve makes it
difficult to trade along the yield curve, thus stifling the

 Market making
– Systematic dealing of bonds to generate liquidity.
– A primary dealer system is often designed to mandate
market making in a competitive manner so as to narrow the
bid ask spread and encourage overall market liquidity.
– But it is a risky business and requires DVP settlement, well
functioning repo market / securities lending services.
Thank you.