IMF International Capital Markets, 2001, Chapter 4 of 6 ... · roles of government securities and...

Introduction

Partly because of their unique characteristics,especially their minimal credit risk, governmentsecurities and the deep, liquid markets in whichthey are traded have come to play important, ifnot critical, roles in facilitating aspects of privatefinance. In particular, they have facilitated thepricing and management of financial risks asso-ciated with private financial contracts. Many ofthese benefits can be seen most clearly in theUnited States, where large, deep, and liquid pri-vate securities markets exist. In Europe (espe-cially in pre-euro Europe) and in Japan, whereprivate debt securities markets are still relativelysmall, government securities markets also haveplayed important roles in facilitating effectivebanking. For example, these securities marketshave provided banks, and financial institutionsmore generally, with the opportunity to usecredit-risk-free government securities to managetheir considerable interest rate risks. Accord-ingly, government securities can be seen as possi-bly providing public-good benefits—beyondthose associated with fiscal policies—by playing arole in financial efficiency and perhaps also infinancial stability by facilitating private riskmanagement.

The major government securities markets inthe United States, Europe, and Japan arepresently undergoing major structural changes.In the United States, the supply of publiclytraded U.S. treasuries is shrinking and is pro-jected to fall to very low levels by 2010. InEurope, the introduction of the euro has meant

that there are now 12 separate sovereign issuersof euro-denominated government securities; 12separate and not necessarily compatible auction-ing, trading, securities clearing and settlementsystems; and no uniform government securitiesbenchmark yield curve. In Japan, the still devel-oping government securities market is presentlybeing challenged by the growing needs of theJapanese public finances and will continue to bechallenged for the foreseeable future.

Structural changes in the major currencyzones raise important questions about how theroles of government securities and their marketsare likely to change, and the implications ofchanges in these roles for both national and in-ternational financial markets. Perhaps the mostfundamental question raised by these structuralchanges—and, in particular, by the possibilitythat U.S. treasury securities and their marketsmight disappear—is: to what extent are govern-ment securities and their markets the source ofunique public-good benefits for which there areno good substitutes?1 Also, are these benefits im-portant enough to warrant official steps to ac-tively promote and maintain highly developed,deep, and liquid government securities marketswhen weighed against the macroeconomic bene-fits of debt reduction? This chapter maintainsthe hypothesis that there are important, irre-placeable benefits to having deep and liquid gov-ernment securities markets—especially whereprivate securities markets are not yet highly de-veloped—and examines financial implications ofongoing changes in government securitiesmarkets.

81

CHAPTER IV

THE CHANGING STRUCTURE OF THE MAJOR GOVERNMENTSECURITIES MARKETS: IMPLICATIONS FOR PRIVATEFINANCIAL MARKETS AND KEY POLICY ISSUES

1It can be argued that most of the private financial public-good benefits associated with the existence of government se-curities originate from the existence of money, which is a government obligation with instantaneous maturity; that is, it isgovernment debt that is the most liquid instrument. This would suggest that a deep and liquid private money marketcould substitute somewhat for providing similar public-good benefits. In some ways, what is now being observed as occur-ring in the United States supports this; that is, markets are increasingly relying on swaps and the swap yield curve, whichoriginates in bank liabilities (money), ultimately backed by central bank funds.

Although there are public policy issues of com-mon concern to all countries (such as the twoabove-mentioned questions), there also are coun-try-specific issues in each of the major currencyareas. The United States presently has the mosthighly developed, deep, and liquid private debtsecurities market in the world—the size of whichis greater than the combined size of all of theother private debt securities markets. U.S. privatesecurities markets have existed for some time.But the accelerated development of, and heavyreliance on, U.S. private markets during the pastfew decades can be seen as having developedalong with the similarly accelerated developmentof the U.S. treasury securities market, especiallyat the longer maturities (10 and 30 years) alongthe yield curve. Most of the financial issues, im-plications, and policy questions surrounding theshrinking supply of U.S. treasuries involve the ex-tent to which private finance and private securi-ties markets have come to rely on U.S. treasur-ies—nationally and internationally—and whetheror not market participants can do without themwithout incurring considerable private and socialcosts and risks to national and international fi-nancial stability. This chapter concludes that pri-vate financial instruments can substitute for treas-uries in most, although not all, of the roles thattreasury securities have provided in U.S. and in-ternational financial markets.

The situation is presently quite different inEurope. Before the introduction of the euro in1999, countries in Europe could be character-ized as having effective, and in some parts of thebenchmark yield curve, deep and liquid govern-ment securities markets. In countries where theauthorities nurtured the development of thegovernment securities markets—most notably inFrance, Germany, and Italy—government securi-ties played some significant role in private fi-nance before 1999, either in private securitiesmarkets or in private banking and asset (pen-sion) management. Moreover, where efficient fi-nancial market infrastructures have developed,

they generally have done so along with the de-velopment of government securities markets.With the introduction of the euro, and the possi-bility and desire (in some places) for European-wide private debt securities markets to play agreater role in European finance, it remains tobe seen whether a full range of effective and effi-cient euro-area private debt securities marketscan develop without the parallel (or prior) de-velopment of a European-wide market for euro-denominated government securities. If deep andliquid securities markets can help to facilitatethe development of private markets, what kindof reforms could be considered in Europe tocapture these potential benefits? In addition, towhat extent could a European-wide governmentsecurities market support the maintenance of fi-nancial stability?

Japan presently has the second largest govern-ment securities market in the world,2 and fiscalpolicy projections suggest that these markets,and the domestic appetite for absorbingJapanese government bond (JGB) issuance, maywell be challenged by the task of financingJapan’s fiscal deficits. A key national policy chal-lenge—recognized by domestic and interna-tional market participants as well as officials—isthe development of the kind of market infra-structure that would make this challenge lessdaunting. Reform measures could also help es-tablish a highly effective, deep, and liquid gov-ernment securities market: one that could, inprinciple, help manage the private financial risksassociated with the difficult task of rebuildingJapan’s financial and corporate sectors, and playthe kind of supportive role that government se-curities have played elsewhere in facilitating pri-vate financial activity. Japan already has takensome steps to modernize the underlying infra-structure of the JGB market. But there are othersignificant, structurally oriented policy measuresthat could improve the efficiency, depth, andliquidity of the world’s second largest govern-ment securities market.

CHAPTER IV THE CHANGING STRUCTURE OF THE MAJOR GOVERNMENT SECURITIES MARKETS

82

2Based on the amount of outstanding public debt securities; see Annex IV.

Although there are no simple answers to manyof these questions, the chapter attempts to atleast clarify them and suggest ways of thinkingabout them. The nest section analyzes the keycharacteristics of government securities andtheir markets and discusses how these character-istics underlie the main roles that governmentsecurities have come to play in domestic and, insome cases, also in international financial mar-kets. The subsequent three sections comprise aset of separate essays that discuss the impact ofrecent structural changes and the importantchallenges associated with them in each of thethree major government securities markets:those of the United States, the euro area, andJapan. Annex IV discusses the size of the majorgovernment securities markets as well as recentand prospective changes in supplies of govern-ment securities.

Key Characteristics and Roles ofGovernment Securities and Their Markets

Key Characteristics

Government securities and government secu-rities markets have several characteristics that,together, distinguish them from private securi-ties. These characteristics may include:

• minimal credit risk;• high liquidity and a wide range of

maturities;• well-developed market infrastructure (in-

cluding supporting repo and derivativesmarkets).

Not all of these characteristics are present, orpresent to the same degree, in all governmentsecurities markets. The U.S. treasury market isprobably toward one end of the spectrum, sincethis market exhibits all of these characteristics.For the major countries’ government securities,the most-shared characteristic is minimal creditrisk.3 This is because the major economies are

reasonably well-managed and diversified, andtheir governments have access to fairly stable taxbases. Perceptions of credit risk on governmentdebt do, however, differ across the major coun-tries, although these differences are small incomparison to corporate credit risk or that ofmany less developed sovereign issuers. In theeuro area, for example, spreads of 10-year gov-ernment bonds issued by member countries rela-tive to German 10-year bonds have remainedfairly stable at less than 50 basis points since theeuro’s introduction in 1999 (Figure 4.1).Moreover, observers note that a major share—onthe order of 20 basis points or more—of thespread of euro-area government securities rela-tive to comparable-maturity German govern-ment securities is accounted for by differencesin liquidity rather than credit risk.4

The high liquidity and range of maturities ofgovernment securities also differ markedlyacross markets. In the United States, there areliquid markets in U.S. treasury securities withthree months to maturity (when first issued) allthe way out to 30-year treasury bonds. In theeuro area, the issuer of short-term benchmarksecurities is generally different from the issuer oflong-term benchmark securities (where the“benchmark” is defined as the lowest-yielding is-sue). At present, for example, French govern-ment securities are the benchmark at severalmaturities below 10 years, while German govern-ment securities make up the benchmark in the10-year segment. In Japan, JGB market liquidityis limited, except for a few issues in the 5- to 10-year segment.

During the past decade or two, market infra-structure—clearance and settlement, repo andderivatives markets, techniques for issuingsecurities, and trading systems in secondarymarkets—has developed to an advanced state inmost major economies. Furthermore, there hasbeen considerable convergence of practices inprimary and secondary government securities

KEY CHARACTERISTICS AND ROLES OF GOVERNMENT SECURITIES AND THEIR MARKETS

83

3Among G-10 countries, Moody’s presently gives seven countries the highest possible rating, and the remaining coun-tries have ratings just slightly lower (see Annex IV).

4See, for example, the Giovannini Group (2000).


84

0

10

20

30

40

50

60

0

10

20

30

40

50

60

–100

102030405060708090

100

1998 1999 2000 2001

1998 1999 2000 2001

1998 1999 2000 2001

Austria

Netherlands

France

Greece

Portugal

Finland

Belgium

Ireland

Italy

Spain

Figure 4.1. Bond Yield Spreads Against Germany for Selected Euro-Area Countries(In basis points)

Source: Bloomberg Financial Markets L.P.

markets in the major economies, mainly owingto initiatives by governments to minimize thecost of the public debt and, more recently inmost countries, to foster the development of se-curities markets more generally.5 For example,authorities in most countries have implementedprimary dealer systems, used auctions for issuingdebt (in contrast to corporate securities mar-kets), and established preannounced issue calen-dars with “benchmark” issues.

Roles of Government Securities in National andInternational Markets

The combination of the above characteristicshas allowed government securities and govern-ment securities markets to play certain roles thatmay not be easily played by private financial prod-ucts and their markets. These roles are: providersof benchmark interest rates for reference or pric-ing in private fixed-income markets; hedging ve-hicles; vehicles for funding financial market posi-tions and managing liquidity; instruments forinvestment and position-taking on the level of in-terest rates; and “near-monies” and safe havens.

Benchmark Interest Rates

Government yield curves sometimes serve asbenchmarks for quoting and pricing yields onprivate (credit-risky) securities. From the publicissuer’s point of view, the key advantage of hav-ing debt securities used as benchmarks is thatthey are heavily traded. This characteristic, intandem with their low default risk, usually meansthe yield is the lowest possible for the particularmarket segment. Benchmark interest rates aremost useful when they allow investors to clearlydistinguish fluctuations in premia for credit riskfrom fluctuations in interest rates. Changes inbenchmark rates are usually passed-through one-for-one to other fixed-income instruments withthe same maturity.

The benchmark role of government securitiescould in principle be important, not just for

quoting yields on private securities but, morefundamentally, for pricing those securities.For instance, a uniform set of discount ratesmight be valuable for discounting cash flows inorder to price claims to such cash flows. In themajor economies, however, government securi-ties are not generally used directly by invest-ment banks to price new issues of securities.Instead, private securities are usually priced byreference to prices of existing private instru-ments that are close substitutes. In Europeanfixed-income markets, the swap yield curveitself is often used as a pricing reference, owingin part to the lack of a uniform benchmarkgovernment yield curve. In less developed mar-kets where a wide range of private debt securi-ties outstanding does not exist, interest rates onbenchmark government securities may beessential for pricing private fixed-income instru-ments and possibly other financial contracts. Inshort-term, fixed-income markets more gener-ally, private obligations are more likely to beindexed to private interbank rates (such asLIBOR) than to rates on short-term govern-ment obligations.

Hedging Interest Rate Risk

Many types of market participants—commer-cial and investment banks, asset managers, andeven nonfinancial firms—demand governmentsecurities for hedging fixed-income risks, prima-rily interest rate risk and maturity mismatches(Box 4.1). Participants in the primary market,including securities dealers, will often sell shortgovernment securities to reduce the risk oflosses on securities inventories if interest ratesrise and bond prices fall. Bond traders buy andsell government securities to manage the riskcharacteristics of their portfolios. Interest ratederivatives dealers buy and sell governmentsecurities to dynamically hedge risks in optionspositions or to balance mismatches in their for-ward-rate agreements (FRAs) and swap books(Box 4.2).


85

5See Inoue (1999) and Annex IV for more details on the major government securities markets.


86

This box provides a simple example of how ashort position in a government security can beused to hedge interest rate risk. For simplicity,the example uses the short sale of a cash secu-rity, although short positions in derivatives con-tracts are often used as well.

Suppose that a securities dealer holds a corpo-rate bond for one week. During the week, thedealer is exposed to interest rate risk—for in-stance, an 80-basis-point rise in interest rateswould lower the bond’s price by about 7 percent(see the table). The dealer can hedge this risk byselling short a government bond: at the begin-ning of the week, the dealer borrows the govern-ment bond and sells it; at the end of the week,the dealer repurchases it and returns it to itsowner. If the price of the government bond falls,the short sale yields a gain, which offsets the lossfrom the long position in the corporate bond.

The effectiveness of the hedge hinges on apositive correlation between the yields on gov-ernment and corporate bonds, as two scenariosillustrate. In the first scenario—a general rise ininterest rates—yields on corporate and govern-ment bonds are perfectly correlated. That is, thespread between corporate and governmentbonds is constant. Government bond prices thusfall in tandem with corporate bond prices andthe gain on the short sale of the governmentbond offsets the loss on the corporate bond.1 Inthe second scenario—a “flight to quality”event—the spread between corporate and gov-ernment bonds widens as market participantssell corporate bonds and buy governmentbonds. That is, government and corporate bondyields are negatively correlated—corporate bondprices fall as government prices rise. In this ex-ample, the short position in the government se-curity is not only ineffective in hedging the interest rate risk associated with the corporate

bond, but it actually adds to the loss on the port-folio. Such losses were reportedly experiencedby fixed-income traders that tried to hedge us-ing treasuries during the market turbulence sur-rounding the near-collapse of Long-TermCapital Management in the autumn of 1998.2

2See IMF (1999).

Box 4.1. Managing Interest-Rate Risk Using Government Securities: An Example

Hedging Interest Rate Risk with a Short Position ina Government Bond1

Scenario 1: General Rise in Interest Rates (Constant Spread)

Day 1 Day 2 Day 3 Day 4 Day 5

(In percent)Yield

Corporate 6.0 6.2 6.4 6.6 6.8Government 5.0 5.2 5.4 5.6 5.8

(In basis points)

Spread 100 100 100 100 100

(In U.S. dollars)Price


Change in valueCorporate 0.00 –1.04 –2.06 –3.06 –4.04Government

(short) 0.00 1.16 2.29 3.40 4.49Portfolio 0.00 0.12 0.23 0.34 0.45

Scenario 2: “Flight to Quality” (Widening Spread)

Day 1 Day 2 Day 3 Day 4 Day 5

(In percent)Yield


(In basis points)

Spread 100 140 180 220 260

(In U.S. dollars)Price


Change in valueCorporate 0.00 –1.04 –2.06 –3.06 –4.04Government

(short) 0.00 –1.18 –2.39 –3.62 –4.88Portfolio 0.00 –2.22 –4.45 –6.68 –8.92

Source: IMF staff calculations. 1Assumes zero-coupon, 10-year bonds with $100 face value.

1In this simple example, the dealer is in fact “over-hedged”—the gain on the short government positionmore than offsets the loss on the corporate bond by asmall margin. In practice, the dealer would probablyset and periodically adjust the size of the short posi-tion so as to more closely match the interest rate expo-sure on the corporate bond.

The usefulness of government securities forhedging interest rate risks derives from the com-paratively high degree of liquidity of these mar-kets and a usually high correlation between gov-ernment yields and yields on private debtcontracts, including bank loans. The reason isthat, for example, the value of a short positionin treasury securities will offset, to a large de-gree, price movements of a long position inother fixed-income instruments, such as corpo-rate bonds.

Position Funding and Liquidity Management

Cash and repo markets in government securi-ties are widely used for funding and liquiditymanagement by a variety of market participants,including proprietary trading desks, bond deal-ers, investors, and portfolio managers (Box 4.3and Box 4.4). Since repo transactions are collat-eralized, borrowing and lending through therepo market occurs at lower rates than on unse-cured loans. Repos create leverage that can beused to take positions and finance securities in-


87

Treasury derivatives contracts are activelytraded both over the counter and on organizedexchanges.1 First introduced in 1977, treasuryfutures were among the earliest exchange-traded financial derivatives. During the 1980sand 1990s, trading in treasury futures on theChicago Board of Trade (CBOT) and theChicago Mercantile Exchange (CME) boomedalong with activity in the cash treasury marketand private securities markets. Today, the majorexchanges offer a variety of contracts—both fu-tures and options on futures—on treasury in-struments. The benchmark contracts have tradi-tionally been long-term bond contracts such asthe CBOT 30-year “long bond” futures.2 TheCME and CBOT also offer futures on shorter-term treasuries: the CBOT lists futures contractson 10-year, 5-year, and 2-year treasury notes, andthe CME lists a futures contract on three-monthtreasury bills.

Recent developments in the cash treasurymarket have significantly influenced the trea-sury derivatives markets. In the cash market,benchmark status has shifted to the 10-year notefrom the 30-year bond; reflecting this shift, posi-

tions in 10-year note futures now exceed posi-tions in 30-year bond futures. In addition, cashinstruments such as agency bonds and bank de-posits have begun to replace treasuries in someroles. At the same time, market participantshave increasingly relied on derivatives such asagency note futures and LIBOR-based OTCinterest-rate swaps for hedging and trading pur-poses. The increased use of swaps for hedgingmay in turn have contributed to upward pres-sure on swap spreads, owing to the increased de-mand to pay fixed rates on swaps in order tohedge long positions in cash instruments.

Experience suggests that agency futures coulddevelop into a viable substitute for treasury fu-tures. In 1975, the CBOT introduced a futurescontract on Government National MortgageAssociation (GNMA) mortgage-backed securi-ties. GNMA futures trading climbed sharplythrough the early 1980s as the contract becamea preeminent hedging vehicle. Trading later fell,however, as the contract’s hedging performancedeteriorated; flaws in the contract’s design havebeen blamed.3 By the mid-1980s, GNMA futurestrading had fallen to negligible levels as hedgersshifted to treasury bond futures and the con-tract was discontinued. In recent years, theshrinking supply of treasury securities has re-vived interest in derivatives on agency securities.In 1999, the CBOT introduced a futures con-tract on a 10-year agency note and in 2000 theCME launched a similar contract.

3Johnston and McConnell (1989).

Box 4.2. U.S. Treasury Derivatives Contracts and Markets

1Schinasi and others (2000) discuss OTC derivativesmarkets.

2Notwithstanding its name, the 30-year futures con-tract is not strictly a claim on a 30-year bond. The sellerof a long-bond futures contract may deliver either (1)any noncallable treasury security with at least 15 yearsremaining maturity from the first day of the deliverymonth, or (2) any callable treasury security that cannotbe called for at least 15 years from that day.

ventories. The extent of leverage dependsmainly on the “haircut,” or discount, applied tothe security used for collateral.6

Investment and Position Taking

Minimal credit risk and relatively low marketrisk in government securities makes them rela-tively safe long-term investments for pensionfunds, insurance companies, and other institu-

tional investors. Moreover, rating agencies andinvestment restrictions (e.g., U.S. EmployeeRetirement Income Security Act “prudent man”guidelines for pension funds) can provide astrong incentive for institutional investors to fo-cus on low-credit-risk bonds with long maturitiesin order to match the maturity of their liabilities.

Speculators and arbitrageurs also use govern-ment securities markets for taking positions on


88

The treasury repurchase agreement (repo)market is a primary nexus for trading, hedging,and financing activities in the U.S. dollar finan-cial markets. As the supply of treasuries has de-clined, various other securities—includingagency, mortgage-backed, money-market, andcorporate securities—have increasingly beenused in repo transactions. Nonetheless, treasur-ies remain the single most important repo in-strument, reflecting their lack of credit risk,their liquid secondary market, and the broadrange of participants in the market, includingthe U.S. Federal Reserve.

In a repo transaction, two counterparties ex-change cash and a security, then later reversethe transaction.1 The initial seller of the securityis said to “repo” the security or engage in arepo, while the initial buyer is said to “reversein” the security or engage in a reverse repo. Ineffect, the buyer lends cash to the seller, withthe security as collateral. The interest rate im-plied by the difference between the purchaseand repurchase prices is known as the repo rate,which is below uncollateralized rates. If the bor-rower (seller) defaults, the lender (buyer) cansell the security to recover any potential loss onthe loan. The credit exposure on the loan thusfluctuates with the market value of the collat-

eral. Market participants mark this exposure tomarket and adjust margin payments and “hair-cuts”—discounts on the underlying collateral—accordingly. Such haircuts can be very low fortreasury securities.

A wide array of institutions participate in therepo markets, including commercial banks,money-market funds, securities dealers, munici-palities, and official institutions. Governmentsecurities dealers are particularly active partici-pants. In February 2001, U.S. government securi-ties dealers were involved in some $2.6 trillion inrepo and reverse repo agreements. Securitiesdealers finance long positions in treasury securi-ties by lending them out in the repo market, ineffect taking a leveraged position, and covershort positions by reversing in securities.2 Gov-ernment securities dealers can obtain zero hair-cuts on treasury securities (implying potentiallyunbounded leverage); that is, their treasury posi-tions can be fully financed in the repo market.

The Federal Reserve is a key official partici-pant in the treasury repo market. Like manyother central banks, the Federal Reserve oper-ates in repo markets to manage domestic mone-tary conditions. The Federal Reserve can alsoengage in repo transactions involving othertypes of securities. In September 1999, it ex-panded the list of collateral instruments that areeligible for its repo operations (as described inthe main chapter text).

Box 4.3. The U.S. Treasury Repo Market

1An overnight repo terminates the next day; a termrepo lasts more than one day. An open maturity orcontinuing repo is rolled over until one counterpartyterminates it. 2See Box 3.3 in IMF (1998).

6See Box 3.3 in IMF (1998).

the level of interest rates. One reason for this isthat one can quickly and cheaply trade in andout of positions in liquid government securitiesmarkets and in related repo and derivativesmarkets in order to take views on the future pathof interest rates or exploit arbitrage opportuni-ties. Trading and investment strategies involvinggovernment securities frequently are oriented to-ward taking advantage of anticipated changes inthe slope or shape of the yield curve. For exam-ple, a trader that expects the yield curve tosteepen (expects long-term bond prices to fallrelative to short-term bond prices) might sellshort long-term bonds and buy short-term bonds.

Government Securities as Near Monies andSafe Havens

Government securities are close substitutes forthe currency of the issuing country. At very short

maturities, government securities have little mar-ket risk and thus are reliable stores of value. As aresult, government securities serve as a mediumof exchange in financial markets—they arewidely accepted as collateral against the futuredelivery of cash (including transfers of centralbank reserves and bank deposits). For example,U.S. treasury securities can be used to settle cer-tain kinds of financial obligations, and Europeangovernment securities can be used as collateralto obtain intraday liquidity (central bank funds)for transactions settled on the European pay-ments system TARGET.

This near-money property has created asafe-haven role, particularly for U.S. treasurysecurities, but also for some euro-denominatedgovernment securities (notably German govern-ment bonds) and, to a lesser degree JGBs, dur-ing periods of financial stress. The safe-haven


89

Treasury securities have three key characteris-tics that give them an advantage over private se-curities for use as collateral instruments. First,treasury securities are virtually free of creditrisk, which is useful because collateralization ismeant to mitigate such risk. Second, there isminimal operational risk in holding treasury se-curities, because treasury markets have a well-developed and smoothly functioning infrastruc-ture. Third, because treasury securities havedeep and active markets, they can be liquidatedquickly and at low cost if the need arises.

Reflecting these characteristics, U.S. govern-ment securities (including treasury and agencysecurities) are second only to cash as the mostwidely accepted and widely used collateral in-struments.1 According to a recent survey, over80 percent of market participants accept U.S.government securities for derivatives transac-tions.2 By comparison, only about 40 percent ac-cept Japanese government bonds (JGBs), and

about 20 percent accept top-rated corporatebonds. U.S. government and agency securitiesalso account for about 40 percent of outstand-ing collateral; by comparison, European govern-ment securities, JGBs, and AAA-rated corporatebonds each account for 5 percent or less.3

The shrinking supply of treasuries has erodedthe advantages of U.S. treasuries over private se-curities as collateral. Treasury securities have be-come more costly to use as collateral as priceshave been bid up. In addition, their market riskhas risen as market liquidity has declined. As aresult of these trends, collateral managers in-creasingly accept private securities, includingcorporate bonds, money market securities, andequities. Private collateral is more challenging tomanage than treasury collateral because privatesecurities involve greater credit, operational,and liquidity risks. Nevertheless, collateral man-agers see little alternative to broadening themenu of acceptable collateral as the supply oftreasury securities falls.

Box 4.4. U.S. Treasury Securities as Collateral

1ISDA (2000b).2ISDA (2000b). 3ISDA (2000b).

role is supported by the use of these markets bycentral banks for monetary policy, foreign ex-change reserves management, and financial sta-bility purposes, since central banks readily de-liver central bank deposits (base money) againstgovernment securities. Specifically, while by defi-nition any liquid asset can be converted into asafe asset by selling the asset and buying a safeasset, during extreme market events when thereis an increase in the aggregate demand forliquidity, the central bank has the most controlover the supply of liquidity. This reinforces thesafe-haven role of government securities.

The Shrinking Supply of U.S. Treasuries:Financial Market Effects and Policy Issues7

The declining stock of U.S. treasury securitieshas already significantly affected the characteris-tics and roles of treasury securities and the treas-ury market. This section discusses the salient fea-tures of recent financial market effectsassociated with the shrinking supply of treasurysecurities, and examines key policy issues. Thesubsequent two sections of the chapter take asimilar approach in discussing government secu-rities markets in the euro area and Japan.

Recent Market Developments

The shrinking supply of U.S. treasury securi-ties seems to have had three main effects in thetreasury market so far: rising corporate interestrate spreads relative to treasury yields; reducedliquidity of the treasury market; and, from aportfolio manager’s perspective, a less reliabletreasury yield curve. In addition, the shrinkingsupply has sparked efforts by other large issuersof bonds to obtain benchmark status, and ithas also presented some possibly significant

changes in the range of assets that the U.S.Federal Reserve will need to put on its balancesheet in the course of conducting monetaryoperations.

Rising Interest Rate Spreads

During the past three years, the widening ofspreads between interest rates on U.S. treasurysecurities and private debt securities has beencaused to some extent by events, such as theLong-Term Capital Management (LTCM) crisis(especially the subsequent deleveraging in fixed-income markets). Spreads also widened in re-sponse to perceptions about rising private creditrisk related to the maturation of the U.S. busi-ness and credit cycles (see Chapter II). However,part of this widening—and perhaps a significantpart—is widely regarded to be related to theshrinking supply of U.S. treasuries and the asso-ciated rise in their scarcity value.8

The confluence of all of these factors, and thedivergence of pricing between treasury marketsand other dollar fixed-income markets, can beseen most clearly in the relative behavior ofyields on private interest rate swaps and on U.S.treasury securities. Beginning in 1997, the pass-through of changes in treasury yields to yieldson other fixed-income securities (that is, the co-movements between them) systematically dimin-ished somewhat. In 1998, the impact of thesestructural shifts was exacerbated by the flight toquality associated with the LTCM-crisis-relatedturbulence. This further pushed up the spreadbetween the swap rate and the U.S. treasury rateas well as the spread between corporate bondsand treasuries. Relative prices and yields werepushed further apart beginning in mid-1999,when the U.S. Treasury announced that it wouldbegin buying back treasury securities in early2000. Overall, from 1997 to 2000, the 10-year


90

7The following discussion draws heavily on Schinasi, Kramer, and Smith (2001). Another major country experiencingchanges in the government securities market is Canada. Debt reduction has been reflected in a substantial decline in thestock of treasury bills, although the stock of longer-term bonds has not fallen. In the money market, private securities is-sues have grown to fill the roles played by treasury bills. At the longer end, marketable government bonds have continuedto serve as a pricing benchmark, investment vehicle, and safe haven although their use in hedging private credit risk hasdeclined. For further details, see IMF (forthcoming).

8See Cooper and Scholtes (forthcoming).

swap spread increased from about 40 basispoints to over 100 basis points.

The rise in the 10-year swap spread is fullyconsistent with reduced reliance on 10-year U.S.treasuries, and increased reliance on 10-year in-terest rate swaps, for hedging market risks oncorporate debt securities. Less hedging in the10-year treasury market would reduce the extentof short-selling and thereby raise the 10-yearbond’s price (and reduce its yield), while in-creased short-selling of the 10-year swap wouldput upward pressure on the swap yield. Eithershift would support wider 10-year swap spreads.

Reduced Liquidity and Greater Volatility

The shrinking supply of U.S. treasury securi-ties appears also to have reduced liquidity inU.S. treasury markets and markets for sometreasury derivatives contracts. This has occurredfor a number of reasons, the most important ofwhich is that the commercial and investmentbanks that deal in these markets have systemati-cally reduced the amount of capital devoted tomarket-making.9 The risk-adjusted return to cap-ital of market-making in fixed-income marketshas declined, in some markets dramatically, inpart because the costs and financial risks associ-ated with owning, maintaining, and hedginglarge inventories of U.S. treasuries have in-creased significantly. As a result, dealers areholding leaner inventories of fixed-income secu-rities, including U.S. treasuries, and are manag-ing their risks more carefully. This has resultedin a reduction in trading activity, marketturnover, and market liquidity.

This reduced market-making and liquidity isreflected in standard barometers of treasurymarket liquidity. Although fewer market-makersmay not necessarily imply reduced marketliquidity, it is noteworthy that the number oftreasury primary dealers is decreasing, and ispresently down by nearly half from its historical

peak a decade ago. Consolidation of large finan-cial institutions recently has significantly re-duced the number of firms making secondarymarkets. At a more technical level, Fleming(2000b) presents various market-derived liquid-ity indicators, including bid-ask spreads and on-the-run/off-the-run spreads for various maturi-ties.10 This analysis shows that bid-ask spreads intreasury bill and treasury note markets ratchetedup in line with the series of events mentionedabove.

The increasingly idiosyncratic behavior oftreasury yields has been reflected in highervolatility of treasury yields (Figure 4.2). This alsohas resulted in increased volatility of privatecredit spreads measured relative to treasury se-curities. For example, the volatility of the 10-yearswap spread has risen markedly from about 2percent to as high as 18 percent since mid-1998.This higher volatility appears to have had varioussources, including the slowing of U.S. economicgrowth. But reduced liquidity in treasury securi-ties as well as the LTCM crisis raised concernsabout market and liquidity risks associated withowning U.S. treasury securities and private fixed-income securities as well. According to marketparticipants, these concerns have led to a situa-tion in which the overall riskiness of treasuries(market, credit, and liquidity risks together) isperceived to be higher now than it was a fewyears ago, owing to increasing market and liquid-ity risks.

Diminished Reliability of U.S. Treasuries

According to a varied group of market partici-pants engaged in a wide range of financial busi-nesses (both buy side and sell side), present con-ditions in U.S. treasury markets suggest that, inseveral of their more important roles, U.S. treas-ury securities have become less reliable or atleast more expensive to use. First, in repo mar-kets, the scarcity of some maturities of treasuries

THE SHRINKING SUPPLY OF U.S. TREASURIES: FINANCIAL MARKET EFFECTS AND POLICY ISSUES

91

9Liquidity in a wide range of financial markets may have been reduced by the growth of electronic trading systems—thatis, the fragmentation of trading activity as more trading platforms have been introduced. See, for example, Committee onthe Global Financial System (2001).

10See Fleming (2000b).

has raised the level of price volatility. Second,the increasing prices of treasury securities com-pared with other fixed-income securities withsimilar maturities has made them more expen-sive to post as collateral to support a range of fi-nancial transactions. Third, the idiosyncratic,supply-demand driven volatility in treasury yieldshas reduced the usefulness of the treasury yieldcurve as a benchmark for credit risk and as abarometer of future economic and financialdevelopments. Finally, the usefulness of treasur-ies for hedging interest rate risks has deterio-rated. “Flight to quality” effects on treasuryprices during major market adjustments, in par-ticular, have become such an important factordriving treasury yield dynamics that co-move-ments with other fixed-income yields tend toreverse at precisely those times when “shorthedgers” rely most on high positive correlations(see Box 4.1).

Private Efforts to Become Benchmark Issuers

Reduced liquidity in the treasury market andthe sensitivity to supply and demand factors oftreasury prices have been the main reasons be-hind the efforts of three U.S. agencies (FreddieMac, Fannie Mae, and FHLB) to establish them-selves as the new benchmarks at certain maturi-ties and therefore capitalize on the lower costsof issuing in those segments.11 Although some ofthe agencies—in particular, Fannie Mac andFreddie Mac—are private, shareholder-owned,profit maximizing firms, they operate under fed-eral charter and have some privileges, includinga credit line with the Treasury and tax benefits.The agencies have announced the regular is-suance of large amounts (around $3–6 billioneach)12 of non-callable bonds in a range of ma-turities, paralleling the Treasury’s practice.Fannie Mae and Freddie Mac have also intro-duced benchmark bill programs, thus more-or-


92

11These agencies are formally known as the FederalHome Loan Mortgage Corporation, the Federal NationalMortgage Association, and the Federal Home Loan Banksystem, respectively.

12See Fleming (2000a).

0

5

10

15

20

25

0

2

4

6

8

10

12

0

10

20

30

40

50

60

Oct. Nov.2000 2001

Dec. Jan. Feb. Mar. Apr. May

Oct. Nov.2000 2001


Oct. Nov.2000 2001


Figure 4.2. Volatility of Government Bond Yields for Selected Countries1

(In percent)

Source: Bloomberg Financial Markets L.P.1Volatility calculated as rolling 100-day standard deviation of

annualized yield on 10-year bonds.

United States

Germany

Japan

less filling out the yield curve. In addition, theinfrastructure for agency securities is developing:they are more widely used in repo operations,some agency issues are strippable, and in March2000, the Chicago Mercantile Exchange, theChicago Board of Trade, and the (electronic)Cantor Exchange launched futures and optionscontracts on agency bonds. The agencies’ com-petition for benchmark status extends beyondthe U.S. dollar markets: certain euro-denomi-nated agency issues are designed to be substi-tutes for euro-area government bonds—theNovember 2000 issue by Freddie Mac of a five-year, €5 billion bond is an example.13 Bid-askspreads for agency securities are currently onthe order of one-half to one basis point for themost liquid securities, compared with about fourbasis points just a few years ago.

Some large corporate borrowers are also posi-tioning themselves as benchmark issuers, includ-ing Ford Motor Credit (with its GLOBUS pro-gram) and the General Motors AcceptanceCorporation. As yet, the corporate markets ap-pear to lack much of the infrastructure and sup-porting markets that underpin liquidity in thetreasury market. Market participants point outthat the development of corporate bond futureswould add liquidity to benchmark corporatebonds and promote their benchmark status. Thecreation of alternative, private benchmarks isalso supported by the development of privatefixed-income indices. In the last two years, majorfixed-income dealers have redoubled their ef-forts to devise and market private credit indices,based on cash bond prices, for use in perform-ance measurement and benchmarking.

Changes in the U.S. Federal ReserveBalance Sheet

The U.S. Federal Reserve currently relies al-most exclusively on U.S. treasury securities for

outright purchases, and on treasury and agencyrepo markets for controlling the supply of basemoney. However, the Federal Reserve Act givesauthority to the Federal Reserve to purchase abroader menu of financial instruments.14

Specifically, the Federal Reserve has express au-thority (under sections 14(b)(1)–(2) of theFederal Reserve Act) to purchase debt issued orguaranteed by the U.S. government or anyagency of the U.S. government, some debt obli-gations of state and local governments, as well asdirect obligations and securities fully guaranteedby a foreign government. It also has the author-ity to purchase not only direct debt obligationsof the major agencies (Freddie Mac, FannieMae, and the FHLB), but also “guaranteed cer-tificates of participation” such as mortgage-backed securities (MBS). On the other hand,there is no explicit authority for the FederalReserve to purchase most other private sector as-sets, including corporate bonds, commercial pa-per, mortgages, equity, or land.

As the Federal Reserve Board is both a majorholder and a major net purchaser of treasuries,it has taken two steps to limit the adverse effectsof its monetary operations on treasury marketliquidity.15 First, in August 1999, the FederalReserve Bank of New York, as manager of theSystem Open Market Account, asked for and wasgiven authority to accept a broader range of col-lateral in repurchase agreements (it did not re-quest permission to make outright purchases ofother assets).16 For such purposes, the FederalReserve Bank of New York currently has the au-thority from the Federal Open MarketCommittee to accept treasury securities (includ-ing strips) as well as direct agency debt, as wellas temporary authority to accept pass-throughmortgage securities of GNMA, FNMA, andFHLMC. Second, the Federal Reserve has estab-lished, as guidelines, caps on its holdings of indi-


93

13See Van Duyn (2000). The yield was quoted relative to the swap curve, not a government benchmark. Freddie Mac hasalso issued three-year and 10-year euro-denominated bonds.

14See Clouse and others (2000).15See United States, Federal Reserve Bank of New York (2000).16See United States, Board of Governors of the Federal Reserve System (2000).

vidual issues of treasury securities, as a percent-age of the publicly held supply, and it has alsoconcentrated its outright purchases in less liq-uid, “off-the-run” securities.

In an environment of shrinking supply of pub-licly held treasuries and trend growth in theFederal Reserve’s holdings of treasuries, undercurrent operating procedures the FederalReserve will likely reach the caps on its treasuryholdings within just a few years. At that juncture,the Federal Reserve will have two main options.First, the Federal Reserve could relax the capson its holdings of treasury securities at addi-tional cost to market liquidity. However, this op-tion would only delay the problem caused by ashrinking supply of treasury securities. The sec-ond option is that the Federal Reserve could be-gin selling its treasury holdings and accumulat-ing alternative assets. This is the only long-termoption if the supply of treasury securities contin-ues to decrease.

The Federal Reserve’s present practice of re-lying almost exclusively on treasury securitiesfor maintaining monetary stability is thereforenot sustainable with a shrinking supply of treas-ury securities. The Federal Reserve will have toconsider broadening the menu of securities thatit uses to conduct its monetary operations, andespecially those it buys and sells to control thesupply of high-powered money. As mentionedabove, the Federal Reserve already has the au-thority to purchase both direct debt obligationsand MBS issued by the large agencies, as well ascertain debt obligations of state, local, and for-eign governments. Paralleling the practice inseveral major advanced economies, the FederalReserve in fact relied heavily on discounting pri-vate financial instruments in the period beforea large stock of U.S. treasury securities existed.There is, therefore, considerable precedent inthe United States and in other countries forcentral banks accumulating private financial as-sets in order to affect the money supply. A likely

reason the Federal Reserve has not recently ex-ercised its authority to purchase outright securi-ties other than treasuries is a concern that thiscould alter the perceived risks from investing inthose securities.17 Additional concerns about us-ing private assets include the possibility of dis-tortions in capital allocation and the implica-tions of the Federal Reserve taking on creditrisk.18 Another option—which may require leg-islative action—is to fundamentally alter theway in which the Federal Reserve controls themoney supply.19 For instance, the FederalReserve could discount assets of banks throughits discount window.

Private Financial and Public-Policy IssuesAssociated with the Shrinking Supply of U.S.Treasury Securities

The potential for the supply of U.S. treasuriesto diminish beyond the point where treasurymarkets are no longer able to fulfill their pres-ent roles raises important issues of immediate in-terest to private market participants and policy-makers. Most issues under discussion in themarkets are relatively technical and oriented to-ward maintaining the profitability—in somecases, the viability—of some of their lines ofbusiness. They immediately involve the questionof whether private substitutes exist or can be cre-ated for pricing and quoting private debt securi-ties, for hedging private financial risk, and forcost-effective and reliable collateralization of fi-nancial transactions. Market participants are al-ready shifting, to some extent, toward using pri-vate substitutes in dollar and euro markets—such as swaps—for price quotation, hedging,and investment. Moreover, they recently have be-gun using private securities and even delivery ofcash in the form of bank deposits as substitutesfor collateral. To a considerable extent, this isbecause dollar fixed-income markets are suffi-ciently developed that reasonably safe private in-


94

17See Clouse and others (2000).18See Greenspan (2001).19See Goldman Sachs (2000).

struments exist for benchmarking, hedging, andto some degree as collateral, at least during peri-ods of normal financial activity. Concerns re-main, however, regarding the availability of sub-stitutes for treasuries as a safe haven duringturbulent periods in U.S. and international fi-nancial markets.

Possible Substitutes for Treasuries as PricingBenchmarks

U.S. treasury securities are one of several ref-erence points used for quoting yields on bothnew and existing fixed-income instruments. Asnoted above, current methodologies for pricingnew issues of private debt securities and dollar-denominated sovereign bonds issued in the in-ternational markets are based on market pricesof existing debt securities that are similar interms of credit risk characteristics, the structureof the security (coupon and maturity), the in-dustry of the issuer, and the issue’s liquidity. Avariety of non-treasury benchmarks—includingswaps, agency securities, and some large corpo-rate issues—could be and are used for referencepurposes. Thus, the science and art of pricingand quotation of fixed-income instruments inU.S. dollar markets are unlikely to be signifi-cantly affected by the shrinking supply of trea-sury securities.

Consequences for Portfolio Management

The shrinking supply of treasury securitiesmay have important consequences for sometypes of investors. First, as treasuries have be-come increasingly expensive for use in repos,and have become less reliable for such purposes(which has led to larger “haircuts”) because ofincreased market risk, market participants haveshifted some short-term liquidity and funding ac-tivities toward high-quality, liquid alternatives tothe treasury bill and repo markets—mainly agen-cies and some low-risk corporate bonds. Second,treasury securities are free of private credit riskand such low-risk investments may be important

for the feasible set of portfolios that investorshave available.20 Third, long-term treasuriesserve an important role for investors with long-term investment horizons—for example, in-vestors that have long-duration liabilities, includ-ing pension funds and insurance companies.

Treasuries also are important to portfoliomanagers because the performance of portfoliomanagers is assessed against benchmark portfo-lios, and all of the main benchmark fixed-income portfolios presently attach a significantweight to U.S. treasury securities. The shrinkingsupply of treasuries is reducing the share thattreasuries have in the main benchmark portfo-lios. There are two main consequences of this.First, other fixed-income market segments, andparticularly the U.S. and European corporatesectors, are receiving higher weights in bench-mark portfolios. This has produced increaseddemand for bonds in these segments of thefixed-income markets. Second, some market par-ticipants report that higher weights on corporatemarkets in benchmark indices may have alteredmarket dynamics in that the price of privatecredit is dependent on the portfolio rebalancingoperations of a wider range (including geo-graphically) of institutions. It is unclear whetherthis has raised or lowered the volatility of inter-est rates.

Overall, the shrinking supply of treasury secu-rities is likely to continue to have important con-sequences for short-term liquidity managementand funding as well as longer-term portfoliomanagement. The consequences for short-termliquidity management and funding appearlargely transitional, and market participants havealready made significant headway in adjustingtheir businesses to the shrinking supply of trea-suries. The consequences for longer-term portfo-lio management appear to be less easily accom-modated. There tends to be a dearth of high-quality, long-maturity fixed-income instrumentsthat are desired by investment managers thathave long-duration liabilities (insurance compa-


95

20See Bomfim (2001), and Reinhart and Sack (2000).

nies and pension funds).21 Managers may needto manage growing “gap risk” caused by agreater mismatch between the maturities of theirassets and liabilities. If these private risks are notwell managed, they could pose financial stabilitychallenges in some national markets.

Possible Substitutes for Hedging Interest Rate Risk

While liquidity in the U.S. treasury market isstill unmatched—and the cost of establishing orremoving positions is still comparatively low—U.S. treasuries have become less reliable, andmore expensive, for hedging interest rate risk.The consensus among market participants is thatthe reduced ability to hedge interest rate risk inthe treasury market does not present a majorconcern during periods of normal financial ac-tivity (that is, when interest rates fluctuate withinnormal trading ranges). A variety of alternativefinancial instruments can be used to managethese risks. Swaps, and to a lesser degree agencyand corporate bonds, have higher correlationswith most other instruments than do treasuries.As a result, a considerable amount of hedgingactivity that had been conducted in the treasurymarket is now being conducted in swaps andcorporate/agency bond markets.

There are, however, two transitional issuesthat remain before hedging in swaps marketscan fully replace treasuries in this role. First, theswaps market is insufficiently “commoditized” tohedge the various risks that have historicallybeen hedged in the treasury market. This ispartly a result of the apparent difficulty in creat-ing liquid markets for traded futures and op-tions markets on nongovernment securities.Some market participants suggest that the swapsmarket needs to mature to a point where partici-pants can freely trade and unwind swaps of allmaturities as easily as they currently trade trea-sury instruments, instead of booking long-termcredit obligations as is currently done. Infra-structure improvements, possibly including acentral clearinghouse, might be needed to deal

with the potential for a buildup of counterpartyrisks. Counterparty risk in swaps is usually smallduring normal times, but could rise sharply dur-ing crises. Some securities traders suggest that aswap futures market could complement theswaps market and help it to serve the hedgingrole, much as the highly liquid market for treas-ury futures has complemented the cash treasurymarkets.

A second, closely related, transitional issueconcerns the relatively lower liquidity of swaps(as well as agency securities) compared with thetreasury market. Most market participants agreethat, over time, liquidity will further migratefrom the treasury market to other fixed-incomemarkets, particularly the swaps market. However,because swaps are bilateral contracts that are not“traded” in a market the same way that treasurysecurities are, some market participants are con-cerned that there may never be the degree ofliquidity in the swaps market that had existed inthe treasury market. In turn, this depends onhow commoditized the swaps market becomes. If“liquidity” in the swaps market—defined as thecost of putting on and removing hedges—doesnot achieve the degree of liquidity that has ex-isted in the treasury market, then there may be apotentially significant effect on pricing in fixed-income markets due to a higher long-term costof “insurance.” This increased cost of hedginghas apparently already reduced the willingnessof securities dealers to hold inventories in pri-mary and secondary markets—and could overtime affect the pricing of initial bond offerings.

Substitutes for Treasuries as a UniversallyAccepted Collateral

The shrinking supply of U.S. treasury securi-ties has made U.S. treasuries increasingly expen-sive to provide as collateral. This increased ex-pense has occurred because treasury yields havefallen relative to the LIBOR curve and becauseheightened market risk and lower liquidity oftreasuries has led to increased haircuts on these


96

21In large part for this reason, the Bond Market Association (2001)—whose membership includes financial institutionsthat are active in U.S. fixed-income markets—has advocated maintaining issuance of 30-year treasury bonds.

securities when they are posted as collateral. Forthese reasons, market participants report thatthey are using fewer treasuries to collateralizetransactions. In their place, they are usingagency securities, high-grade corporate paper,and even cash (bank deposits). This has been akey reason why repo markets in agencies andhigh-grade corporates have flourished recently.

A complementary reason for the richening ofthe menu of acceptable collateral in U.S. and in-ternational financial markets is the recent behav-ior of central banks. Specifically, central banks inthe United States and elsewhere (including inemerging market countries) have expanded themenu of securities that they use for liquidity andreserve management purposes to include othercountries’ government securities, agency securi-ties, supranational bonds, and asset-backed secu-rities. For example, the benchmark for the U.S.dollar reserves of the European Central Banknow includes agency securities. Moreover, in1999 the Bank of England expanded its list of el-igible collateral for open market operations toinclude bonds issued by European EconomicArea governments. It also has become increas-ingly common for central banks to use deriva-tives instruments for specific purposes.

There are important transitional issues inshifting to an environment in which the menu ofacceptable collateral goes beyond governmentsecurities. As government bond supply dimin-ishes, perhaps other securities could be admittedas collateral for settlement systems (with largerhaircuts)—which would then take on some ofthe role as medium of exchange. In any event,probably the key, on-going adjustment is agreater focus on the management of collateralrisk, including the magnitudes of required hair-cuts to compensate for the increased credit andliquidity risks of non-treasury collateral. This ad-justment could pose considerable challenges tofinancial institutions, especially those that haveless sophisticated risk management and controlsystems. It appears likely that these factors will

complement other forces leading to financialconsolidation. Specifically, large institutions withsizable capital bases and sophisticated risk-man-agement and collateral-management systemshave a natural advantage in dealing with riskiercollateral. In addition, the increased reliance onLIBOR-based instruments (swaps) for hedgingand on cash (deposits) for collateral manage-ment implies an expanded role for the majorinternationally active banks in financialintermediation.

Possible Implications for Market Dynamics andthe Supply of Safe-Haven Assets

Government securities may act as a “shock ab-sorber” when there are significant economic orfinancial shocks that cause investors to seek toreduce the riskiness of their portfolios. Duringsuch events, short-term debt is either rolled overat higher prices or not at all, and prices of long-term debt and equity fall sharply. In recent fi-nancial history, the treasury market has been themain safe haven to which investors flee duringmajor market adjustments.

However, it is not at all obvious that the pres-ence of the treasury market necessarily buffersthe amount by which the “price of risk” riseswhen major adverse shocks occur. Having a “safeasset” to move into during crises possibly is asso-ciated with larger changes in asset prices and/orvolumes of private financing than if a safe assetdid not exist. The converse also cannot be ruledout. Further, agency securities and bank de-posits, for example, may be close substitutes fortreasury securities in that these investments ap-pear to contain small amounts of private creditrisk. Overall, the consequences for market dy-namics of not having a large and liquid U.S.treasury market are not clear.22

Reflecting this ambiguity, there are two mainviews among market participants. The first viewis that other instruments will substitute for trea-sury securities in all the roles that they haveplayed. According to this view, U.S. treasury se-


97

22For a discussion of the potential impact on investors of disappearing U.S. treasuries and the availability of portfoliosubstitutes, see Reinhart and Sack (2000).

curities have served as an “anchor” that supportsa broad range of financial activity, and marketswill adapt to a shrinking supply of treasury secu-rities by “shifting the anchor.” According to thisfirst view, the adjustment to a shrinking supply oftreasuries is not a cause for alarm. The secondview is that private financial instruments cannotsubstitute for treasury securities in their role as asafe haven. As a result, the disappearance of alarge, deep, and liquid treasury market will fun-damentally alter the operation of the U.S. finan-cial system and even international finance, espe-cially during periods of stress.23

A key to assessing potential changes in marketdynamics during periods of stress is whetherother instruments could substitute for treasuriesas a safe haven. In U.S. dollar financial markets,possible substitutes for treasury securities as safehavens could include claims on U.S. financial in-stitutions and securities issued or guaranteed bythe agencies in the United States (notablyFannie Mae, Freddie Mac, and the FHLB). Thesupply of agency securities is presently not muchless than the free float of treasury securities.Even agency securities have some private creditrisk, however. Since the magnitude of credit riskwill be time-varying, this magnitude must becontinuously gauged.24

Implications for the International Role ofthe Dollar?

The U.S. dollar is the main currency of de-nomination for international financial tran-sactions, accounting for about 44 percent ofinternational money market, bond, and (cross-border) bank loans as of September 2000.25 Thepredominant role of the dollar in internationalfinancial markets is due to at least three factors.

First, market participants consider the U.S. eco-nomic and financial system to be stable, re-silient, transparent, well-managed, and possess-ing a robust legal and operational infrastructure.Because of this, the risk of an isolated, unilat-eral, and catastrophic collapse in the U.S. econ-omy and financial system is considered to be re-mote. Second, U.S. dollar fixed-income marketsare arguably the deepest and most liquid in theworld. Third, the main intervention tool in for-eign exchange markets by central banks aroundthe world has historically been U.S. treasurysecurities.

Central banks and private market participantshave responded to the shrinking supply of trea-suries by substituting into other U.S. dollar fi-nancial instruments. In light of the historical in-ternational role of the dollar, this raises thequestion of whether that role will shift as finan-cial instruments increasingly substitute for trea-suries in their traditional functions. The pre-dominant view among market participants is thatthe dollar’s role will not shift because the role ofU.S. treasuries in international finance is re-garded largely as due to the role of the U.S.economy and dollar financial markets in interna-tional finance, rather than the converse. Theshrinking supply of treasury securities has al-ready resulted in a shift in the menu of U.S. dol-lar securities that are used to support interna-tional financial activities, rather than resulting ina marked shift in the uses of the major curren-cies in international financial activities.Moreover, the shrinking supply of treasury secu-rities has not reduced the significance of U.S.dollar markets. The groups of market partici-pants that the report’s authors meet with regu-larly almost uniformly believe that the relative


98

23See, for example, Wojnilower (2000).24It may be possible to manufacture a debt security that is virtually risk-free in the form of a high-quality tranche of a

collateralized bond or loan obligation (CBO or CLO). These vehicles pool bonds or loans and issue different tranches ofclaims, differentiated by their seniority of claim to the underlying cash flows. Thus, in principle one tranche could be sen-ior enough that the credit risk is nil. Whether it is feasible to create a large enough supply of this senior-most tranche ap-pears unlikely. The publicly held stock of treasury securities is currently more than half as large as the entire stock of pri-vate corporate debt securities outstanding in the United States. In addition, if it were to serve also as the instrument ofFederal Reserve intervention, then the supply of it would have to grow at least at the rate of base money growth, which hasbeen close to 8 percent on average over the past several decades.

25See BIS (2001).

roles of the major currencies in the future willdepend importantly on how well the respectiveeconomies and financial systems are managed.26

Euro-Area Government SecuritiesMarkets: Challenges in EliminatingFragmented Markets

Prior to the introduction of the euro, somecountries in Europe had effective—and in someparts of the yield curve, deep and liquid—mar-kets for trading government securities denomi-nated in national currencies. These marketsplayed important roles in facilitating effectiveprivate finance, either in private national securi-ties markets—albeit relatively small markets—orin private national banking and asset (pension)management.

The euro’s introduction and the associatedelimination of foreign exchange risk within theeuro area has created benefits in terms of creat-ing a large euro-denominated pool of capitaland liquidity. It also has created the possibility ofintegrated European-wide markets for pricingand trading debt securities, both private andpublic. Some private markets have become moreor less fully integrated—most notably the unse-cured interbank money market and, to a lesserextent, a rapidly growing market for corporatedebt. Government securities markets have re-mained segmented, however. Unified platformsfor government debt trading such as BrokerTecand Euro-MTS have proliferated, but a unifiedsecondary market for trading euro-denominatedgovernment securities is, according to both mar-ket participants and officials, a long way off.

As a result of this national segmentation, theeuro area presently lacks a uniform, benchmarkyield curve for government securities, and is notable to capture some of the potential gains fromhaving a deep and liquid euro-area-wide govern-ment securities market. Moreover, member statesof the euro area are competing aggressively to

become the benchmark yield curve—first at cer-tain maturities and perhaps later at all maturities.To some extent, competition for investor interestis encouraging harmonization of trading plat-forms and market conventions. At the same time,this national competition is encouraging the per-sistence—some would say the entrenchment—ofmarket segmentation along national lines andhas resulted in the fragmentation of euro liquid-ity in national government securities markets.This fragmentation of markets and liquidity ismost likely reducing the efficiency of govern-ment finance and securities markets—by keepingcosts higher than they would be with a fully inte-grated euro-area market. This fragmentation mayalso be inhibiting the rapid development ofother euro-area-wide private debt securities mar-kets. Depending on market conditions, fragmen-tation can either impair or improve financial sta-bility across the euro area, although the balanceof opinion is that closer integration would tendto improve stability.

Recent Structural Changes in EuropeanGovernment Securities Markets

The Single Currency and Fixed-IncomeSecurities Markets

With the introduction of the euro in 1999, theparticipating countries agreed that all new gov-ernment debt issues would be denominated inthe euro. The euro-area countries also agreedthat their outstanding stocks of government debtwould be redenominated from the legacy cur-rencies into the euro. This redenomination fromnational currencies to a single currency createda stock of government securities that is muchcloser in size to the two largest governmentbond markets: the U.S. treasury market and theJGB market.27

At the same time, euro-denominated govern-ment securities markets have become increas-

EURO-AREA GOVERNMENT SECURITIES MARKETS: CHALLENGES IN ELIMINATING FRAGMENTED MARKETS

99

26Truman (2001) reaches the same conclusion.27As discussed in previous International Capital Markets reports, the introduction of the euro also led to rapid integration

of some segments of the euro-area capital markets. See IMF (2000), p. 13.

ingly internationalized. The share of ownershipby nondomestic creditors accounts for aboutone-third of the total outstanding stock of euro-denominated public debt (Table 4.1), amid di-versification of fixed-income portfolios by botheuro-area residents and overseas investors.During the past few years, cash and repo tradingof some euro-area government securities hasbeen introduced on electronic trading systemssuch as e-speed, BrokerTec, and MTS that are ac-cessible to international traders and investors.Foreign participation in national primary mar-kets has also broadened. In France, for example,the number of foreign primary dealers has risenfrom 2 out of 30 in 1989 to 11 out of 18 in 2001.

In the euro area, as in the United States andsome other countries, fiscal discipline has re-duced the outstanding stock of government debtrelative to GDP. Unlike in the United States,however, the attendant financial market conse-quences have been either negligible or muchless important than the other factors drivingfixed-income markets in these countries. The ex-

planation for this is partly that the improvementin fiscal accounts has been uneven across the EUand, on balance, not as significant as in theUnited States. It also reflects, to a large degree,simply the fact that the euro area does not yetrely on securities markets for corporate financeto the same extent as the United States does. Asa result, euro-area corporate finance is not as de-pendent on government securities markets—inthe sense of filling the roles discussed in the sec-ond section of this chapter—as has been thecase in the United States.

Increased Need for a Benchmark Yield Curve andCompetition for Benchmark Status

European private debt securities outstanding,issued in domestic markets and in the interna-tional markets (mainly London), have grown sig-nificantly since the introduction of the euro,from €3.95 trillion at end-1998 to nearly €5.70trillion in 2000.28 Nevertheless, they are stillsmaller than private debt securities markets inthe United States. At end-2000, corporate bondsand commercial paper in the United States to-taled about $7.0 trillion (about €7.5 trillion).29

Moreover, U.S. debt securities markets have his-torically been a viable source of funds for a widerange of (larger) firms, both from the UnitedStates and from other countries. This has not his-torically been the case in most other advancedeconomies—issuance in most domestic marketsoutside the United States overwhelmingly hasbeen by domestic financial institutions. Privatedebt securities have been much more activelytraded in the United States than in euro-areacountries, where traditionally buy-and-hold in-vestors (e.g., insurance companies) have held pri-vate debt securities for long periods of time. TheUnited States also has larger and more activemarkets for mortgage-backed securities, which—in addition to debt securities issued by the Gov-ernment-Sponsored Enterprises (GSEs)—totaled


100

28These figures refer to outstanding amounts of private debt securities issued by private financial and nonfinancial insti-tutions from the EU-15 countries. The source is the Bank for International Settlements. The 2000 figure is for September.The EU-15 figure includes Pfandbriefe securities issued by German financial institutions.

29Figures for the United States are from United States, Board of Governors of the Federal Reserve (2001).

Table 4.1. Euro Area: Holders of GovernmentDebt Securities(As a percentage of total)

Domestic Creditors1___________________________________Other

Financial Other OtherTotal MFIs2 Corporations Sectors Creditors3

1991 83.8 43.4 12.5 27.9 16.21992 82.4 43.7 12.3 26.4 17.61993 78.2 41.4 12.8 23.9 21.81994 80.3 42.8 13.9 23.6 19.71995 78.9 41.2 14.7 23.1 21.11996 78.5 40.2 17.4 20.8 21.51997 76.4 38.8 19.3 18.3 23.61998 73.4 37.0 22.2 14.2 26.71999 69.8 35.2 20.5 14.0 30.2

Source: ECB Monthly Bulletin (various issues).1Holders resident in the country whose government has issued

the debt.2Monetary and financial institutions.3Includes residents of euro-area countries other than the country

whose government has issued the debt.

another $4.1 trillion at end-2000 (€4.4 trillion).Active markets for mortgage-backed securitieshave only much more recently begun to developin some euro-area countries, notably Germany.As euro-area private debt securities markets growin importance for European finance, so too willthe need for reliable benchmarks for pricing pri-vate fixed-income instruments and for a fullerrange of financial instruments (including govern-ment securities) for hedging interest rate riskand managing liquidity and trading positions insecurities markets.

Market liquidity and trading activity are bothusually strongly correlated with the outstandingstock of securities traded in the market. Sizebreeds liquidity and liquidity is a critical deter-minant of benchmarks in fixed-income markets.As a result, market and issue size are key ele-ments to attaining benchmark status. Euro-areasovereign bonds with issue sizes of more than €5billion are eligible for trading on Euro-MTS, thepan-European trading platform. Countries suchas Ireland, Spain, and the Netherlands, whichhave tended to have smaller issue sizes, have insome instances transformed their debt structureinto a comparatively small number of bench-mark issues and/or instituted exchange pro-grams where they substitute “benchmark” bondsfor relatively illiquid securities.30 Smaller coun-tries such as Portugal are also striving to issue inmagnitudes that qualify for the Euro-MTS sys-tem, and are therefore more liquid and thuslead to lower-cost public debt.

Competition for benchmark status in the euroarea has also been reflected in the implementa-tion by countries of measures to boost liquidity insecondary markets for their securities. In France,Germany, and Italy, authorities have promotedelectronic trading platforms and derivatives ex-changes. In France and Italy, authorities alsohave established official repo windows and/ortreasury reopening facilities in order to limit thepotential for secondary market squeezes. Ger-many, France, and other countries have estab-lished or will soon establish official debt manage-

ment agencies to help manage all theseprocesses.

The Emergence of Three Liquidity Pools: France,Germany, and Italy

In European government securities markets,market liquidity is concentrated in the debt in-struments issued by the three largest issuers—France, Germany, and Italy. Debt issued by thesethree countries accounts for almost three-fourths of all euro-denominated public debt(Figure 4.3). The securities issued by these gov-ernments have emerged as the benchmarks incertain segments of the euro-area yield curve.However, because of their relatively small sizecompared to overall euro financial market activ-ity (private and public), no one of these sepa-rate pools of liquidity (markets) can by itself ful-fill all pricing, hedging, investment, collateral,and liquidity needs in the way in which the U.S.treasury market has served for dollar-basedtransactions. It also remains to be seen whetherone vehicle will become the preferred safehaven if a European-wide liquidity or credit cri-sis occurs—particularly if European financemoves more in the direction of European-wide,market-oriented finance and away from bank-in-termediated finance.

Extensive discussions with market participantsin March 2001 indicated that the investor basefor euro-area government securities views theFrench, German, and Italian market segments asthree distinct “habitats” for managing financialpositions and risks. First, market participantsthat want to trade and hedge long-term interestrate risk rely on the German market, becausethe 10-year bund has firmly established itself asthe long-term benchmark for the euro area. Itsbenchmark status partly reflects the very large is-sue sizes—more than €10 billion, and as much as€20 billion for one recent issue. German bondsare, together with U.S. treasury bonds, amongthe most actively traded fixed-income instru-ments in the world, and the bund futures con-tract traded on Eurex is used widely for trading


101

30See Santillán, Bayle, and Thygesen (2000).

and hedging long-term euro-denominated inter-est rate risk.

Second, those investors that want to trade andhedge shorter-term euro-denominated interestrate risk rely heavily on the French market,which is the benchmark for shorter maturities.This reflects the French authorities’ proactiveapproach to encouraging the development of ac-tive money markets in France. By comparison,Germany is seen as having been less proactive inencouraging money markets out of concern thatit could impair the implementation of monetarypolicy. The French authorities’ approach wasembodied in a series of reforms in 1993–94 thatclarified the legal and regulatory framework forrepos and established primary dealerships in re-pos. French money markets now include one ofthe euro area’s deepest and most liquid repomarkets.31

Third, market participants that want to tradecross-country interest rate spreads rely heavily onthe Italian market. The development of theItalian government securities markets wasboosted by the creation in 1988 of a legislativeand operational framework aimed at producinga deep and liquid market. This framework cov-ers aspects of official participation—for exam-ple, Italy’s Treasury participates in the repo mar-ket to offer bonds that might be at risk of asqueeze. It also covers aspects of the marketstructure, which includes primary dealers, spe-cialists, and market-makers. Italy’s well-devel-oped electronic secondary markets, namely theMTS system and Euro-MTS systems, are anotherimportant part of the framework.

Challenges in Developing a European-WideSecondary Market for Euro-DenominatedGovernment Securities

The main challenges in developing aEuropean-wide market for pricing and tradingeuro-denominated government securities are as-sociated with reducing market segmentation andeliminating the fragmentation of euro liquidity


102

31See Deutsche Bank (2000).

Netherlands5% Spain

8%Austria

3%

France19%

Germany22%

Italy30%

Belgium-Luxembourg

7%

Other1

6%

Figure 4.3. Euro-Area Members’ Domestic Public Debt(As a percentage of total euro-area public debt at December 2000)

Source: BIS.1Finland, Greece, Ireland, and Portugal.

within these still separate markets. The benefitsof doing so include capturing the potential ben-efits of having a deep and liquid European mar-ket for government securities and the associatedefficiency and financial stability gains discussedbelow. This section first discusses the sourcesand consequences of fragmentation and thenconsiders options and recent initiatives for re-ducing it.

Sources of Fragmentation

There appear to be at least three sources offragmentation in euro-area government securi-ties markets. First, these markets are fragmentedbecause there are 12 separate issuers. That is,there are 12 separate primary markets for gov-ernment securities, and hence 12 differentcredit risks. These credit risks are highly similaracross the major countries, as evident in theircredit ratings (Table 4.2) and their relativelytight and stable intercountry spreads (which alsoreflect the relative liquidity of different issues)—see Figure 4.1. Credit quality is not perfectly cor-related across countries, however, and marketparticipants are sensitive to changes in the rela-tive creditworthiness of euro-area governments.The segmentation of credit risk is also a matterof international law. Article 103 of the EUTreaty—the so-called “no bailout” clause—statesthat each EU member is responsible for its owndebt and prohibits member states from being li-able for, or assuming, the obligations of othermember states.

A second source of fragmentation is nationalcompetition—rather than coordination and co-operation—among these separate issuers to cap-ture market shares and thereby achieve bench-mark status. By definition, the benchmark issuercan borrow at the cheapest rate available in theparticular market segment and maturity. In or-der to capitalize on this cost advantage andother potential advantages, euro-area govern-ments are competing aggressively to establishtheir government debt as the euro-area bench-mark. Competition for benchmark status is man-ifested in the push by euro-area governments toboost secondary market liquidity in their issues

and concentrate issuance at key points on theyield curve. According to market participants,this competition is providing some benefits, asgovernments are trying to make it easier formarket participants throughout the euro areaand, more generally internationally, to accesstheir markets and use their securities in the vari-ous roles that government securities are poten-tially capable of playing. As a result of competi-tion, some benchmark bonds in some maturitiesare easily traded from anywhere in the euroarea—if not internationally. Moreover, there isan active, although not necessarily efficient, mar-ket in cross-market arbitrage and trading.Competition also has improved the primary mar-kets because it has led euro-area treasuries andfinance ministries to increase the transparencyand predictability of their debt-managementstrategies—for example, by establishing strict is-suance calendars and by announcing the maturi-ties and amounts of issuance well in advance.

Third, there are various structural sources ofmarket segmentation. These include differencesacross countries in legal traditions, issuance pro-cedures and calendars, primary dealer systems,market conventions, and the market infrastruc-ture (Table 4.3). Whereas the unsecured euro-


103

Table 4.2. Sovereign Credit Ratings for SelectedCountries

Foreign Currency Local Currency______________ _____________Moody’s/S&P Moody’s/S&P

Euro AreaAustria Aaa/AAA Aaa/AAABelgium Aa1/AA+ Aa1/AA+Finland Aaa/AA+ Aaa/AA+France Aaa/AAA Aaa/AAAGermany Aaa/AAA Aaa/AAAGreece A2/A– A2/A–Ireland Aaa/AA+ Aaa/AA+Italy Aa3/AA Aa3/AALuxembourg Aaa/AAA NR/AAANetherlands Aaa/AAA Aaa/AAAPortugal Aa2/AA Aa2/AASpain Aa2/AA+ Aa2/AA+

Japan Aa1/AA+ Aa1/AA+

North AmericaCanada Aa1/AA+ Aa1/AAAUnited States Aaa/AAA Aaa/AAA

Sources: Moody’s Investors Service; and Standard & Poor’s.


104

Table 4.3. Public Debt Issuance Procedures in Selected Euro-Area Countries

Auction Types Participants Frequency

Austria Bonds are issued via auction. Issuance Nine Austrian and 18 5-year to 10-year RAGBs (Republic of Austria calendar is announced at year-end of the foreign banks are Government Bonds) are usually issued every previous year. The maturity of a new issue is obliged to participate six weeks (on a Tuesday), except in the month announced one week ahead and the amount in the auction. of August. The typical monthly size is €1 billion.one banking day prior to the auction (Reuters pages OEKB02).

Belgium Bonds are issued via auctions and Open to primary dealers OLOs are issued within three time bands: up to noncompetitive (primary dealer) auctions. and recognized dealers. 5 years; 6–10 years; and 11–30 years, on aNew OLOs (obligations linéaire) can be monthly basis, generally on the last Monday of issued via syndication. Before January 1 the month. Typical size is about €1.5 billion a and July 1 of each year, an issuance month.schedule is published for the coming half-year. The auction details are announced one week ahead (Reuters page BELG and BELE).

France Bonds are issued through a bid-price Open auction via primary 2-year and/or 5-year BTANs are issued on the auction system. A detailed and complete dealers-SVT (Spécialites third Thursday of every month. Average size is auction calendar is published annually for en valeur du trésor). €3–3.5 billion a month. 10-year and 30-year OATs (Obligation assimilable du trésor) and OATs are issued on the first Thursday of every semi-annually for BTANs (Bons du trésor à month. A 10-year OAT is issued at every auction; taux fixe et intérêt annuel). Individual auction other maturities are issued according to market details are announced at the last two trading demand. Average auction size is €3–3.5 billion days prior to an auction (Reuters pages a month.ADJUBTAN and ADJUOAT).

Germany Bonds are issued through competitive BIAG, but anyone can 5-year bobls are issued at three-month auction via the Bund Issues Auction Group purchase securities via intervals in the second or third ten days of the (BIAG) and partly by tap. An issuance a credit institution in month (on Wednesdays) starting in February. calendar (nonbinding) is published on a the BIAG. Typical size is €7 billion. New 10-year/30-year quarterly basis in the last 10 days of the bunds are issued at irregular intervals, month preceding the start of the next quarter although usually every January and July. (Reuters page ESZB/BBK01). Auction details Typically, €5–10 billion is issued each auction, are announced a week in advance (Reuters up to a total issue size of €15 billion.1pages ESZB/BBK02).

Italy Bonds are issued by uniform price auction. Open to eligible primary 18/24-month CTZs (zero-coupon bonds) are The Finance Ministry publishes the auction dealers. auctioned twice a month. Typical size is €4 schedule one year in advance. There is also billion a month. 3- and 5-year BTPs (Buoni del a more detailed quarterly announcement of tresoro poliennali) are normally issued twice a the type of bonds and their maturities. month. Typical size is €4 per billion a month. Auction details are announced three days 10-year and 30-year BTPs are normally issued ahead (Reuters pages DGTA, TESA, BITX, once a month. Average size is €3 billion. 7-and BITY). year CCTs (Certificati di credito del tresoro) are

issued at month-end. Average size is €2 billion.

Netherlands Tap issuance is typical although there are a Via 13 primary dealers Issuance will concentrate on 3-year, 10-year, limited number of Dutch style auctions. (and stock exchange and 30-year maturities. Auctions are held in Auction details are announced on the prior members, if desired). August. Bonds will be reopened regularly and Friday on Reuters page DSTAMENU. A the target volume is expected to be around number of bond conversions of illiquid €2–2.5 billion a month. Benchmark issues will bonds into benchmark issues are likely. have a minimum volume of €10 billion.

Spain Bonds are issued through competitive Open to financial 3-year, 5-year, 10-year, and 15-year SPGBs auction in two rounds of bidding. An annual institutions (primary (Spanish Government Bonds) are auctioned issuance calendar is published. Details of dealers) and nonprivate monthly; 30-year SPGBs are auctioned on a the auction are available on Reuters page investors. bimonthly basis. 5-year and 15-year securities BANCN. are auctioned on the first Wednesday, and 3-

year, 10-year, and 30-year securities areauctioned on the first Thursday of the month.Average size is €1.5–2.5 a month.

Source: Deutsche Bank. 1A portion of the issue amount is invariably set aside for market management operations. The Bundesbank gradually sells the amounts con-

cerned through the stock exchanges. It can also increase the size of new bonds via small taps during the year.

area money market is supported by thesmoothly-functioning TARGET payments system,repo and securities markets rely on a frag-mented network of 14 national and cross-bordersecurities settlement systems (SSSs) and a patch-work of legal and regulatory requirements.32

Cross-border securities transactions often involvesystems that have incompatible settlement lagsor are linked only indirectly.33 Industry groupsand official institutions have also highlighted anumber of shortcomings in the European legalenvironment for collateral.34 These include un-certainty about conflict of law questions andcumbersome rules surrounding the implementa-tion of pledge collateral arrangements.35

Market rules and practices also limit fungibil-ity by limiting the set of securities that can be(for example) used as collateral or deliveredinto futures contracts. Attempts to establish“multi-deliverable” futures contracts for whichthe short position holder can deliver securitiesissued by different governments have been un-successful, partly because of technical problems.(The lowest-credit-quality bond always ends upbeing the cheapest to deliver, and thus the con-tract in effect becomes a single-issue futures.) Inaddition, non-uniform tax treatment of euro-area government securities complicates cross-market transactions and hedging. Finally, repomarkets also lack standard documentation, rais-ing the possibility of documentation mismatchesin cross-border transactions.

Financial Market Consequences of Fragmentation

Fragmentation appears to have three main fi-nancial market consequences.36 First, becausethe benchmark yield curve is segmented—German bunds at the long end and French gov-

ernment securities at the short end of the yieldcurve—liquidity at specific maturities is reducedrelative to what it would be with a unified mar-ket. The effective supply of liquid benchmarkgovernment bonds at (say) the 10-year maturityis not the sum of 10-year issues by all govern-ments. This is because there is only one bench-mark issuer and securities of other issuers arenot fully fungible with it. The effective supply atsome benchmark maturities is limited enoughthat even in the German government securitiesmarket, fragmentation of liquidity has been asso-ciated with adverse market events such assqueezes (Box 4.5).

Second, segmentation of the benchmark maybe impairing the ability of euro-area govern-ment securities to perform the roles discussedin the second section of this chapter. Of course,private alternatives such as swaps can play someof the roles discussed in that section. As notedabove, however, even in the comparatively welldeveloped U.S. dollar private securities markets,private financial instruments are not perfectsubstitutes for government securities and gov-ernment securities markets in some roles. A keyquestion is whether segmentation of euro-areagovernment securities markets is affecting theefficiency and cost of private financial activities.At a general level, market participants reportthat the fragmented legal and operational infra-structure for euro-area securities markets (in-cluding repo and derivatives markets, and col-lateral) may be significant enough that somedeals in fixed-income and repo markets—arbi-trage, position-taking, hedging, and other risk-mitigation trades—that would get done in amore integrated system are not being done inthe current system.37 An important specific cost


105

32Santillán, Bayle, and Thygesen (2000) discuss barriers to integration of euro-area repo and securities markets.33For this reason, some investors use international securities depositories such as Clearstream or Euroclear to put their

holdings in one place.34See ISDA (2000a). See also European Commission (2001).35These shortcomings impinge on efficient and effective collateralization of other transactions—particularly OTC deriv-

atives transactions (see Schinasi and others, 2000).36There also may be nonfinancial market costs and benefits of segmentation. For instance, reduced liquidity may result

in higher fiscal costs of government debt.37For a discussion of the different legal traditions regarding collateral, see European Commission (2001).


106

German government bonds are the de factobenchmark for euro-area government securitiesat the long end of the yield curve (especially inthe 10-year segment). Nevertheless, even atbenchmark maturities of the German govern-ment yield curve, difficulties have occasionallyemerged. One such instance was a squeeze thatoccurred in March 2001.1

The benchmark role of German governmentbonds fueled the growth of the associated fu-tures market as a cost-effective risk managementvehicle throughout the euro area. Frequently,notional amounts of outstanding futures con-tracts, however, exceed the amount of underly-ing bonds outstanding in the cash market, pro-viding ideal conditions for a squeeze. Forexample, prior to the expiration of the March2001 Bundesobligationen (“bobl”) futures con-tract, open interest exceeded €79 billion, com-pared with €43.1 billion of “eligible” or “deliver-able” underlying securities.2 Market participantsclaim that under such conditions, limited trans-parency in the cash market due to fragmentedtrading platforms makes it relatively easy for afew large market makers with superior knowl-edge of order flows to engineer market squeezes,reducing the efficiency of German governmentbond, derivatives, and repo markets.

A large squeeze involving the bobl futures oc-curred prior to the expiration of the March2001 contract. A large market-maker allegedlyused its informational advantage to acquire alarge proportion of the free float of securities el-igible for delivery under the contract.3 To avoid

stiff penalties imposed by the exchange, Eurex,market participants with delivery obligationsfrom short positions scrambled to borrow deliv-erable bobls to meet their settlement obliga-tions, resulting in a significant premium on theeligible bonds in the repo market.4 Whereas therepo rate for similar bonds that were ineligibleto be delivered under the futures contract wasaround 4.8 percent, the repo rate for eligiblebonds was close to zero—meaning that holdersof eligible bonds could borrow cash at a zero in-terest rate in the repo market by providing thebonds as collateral.

Further squeezes near the expiration of fu-ture contracts remain possible. The small size ofthe cheapest-to-deliver (CTD) bond for theSeptember 2001 contract (€7.1 billion) has al-ready prompted some traders to roll some oftheir exposure forward into the December con-tract (see the table). However, currently onlyone bond (compared to five in the March con-tract) with an outstanding volume of €15 billionis eligible for delivery for the December con-tract—though the issuance of an additional eli-gible security in August will raise that amountsomewhat. Concerns about future squeezes havespawned competition to the Eurex futures con-tracts. The London International FinancialFutures and Options Exchange (LIFFE)launched a similar futures contract (based onthe interest rate swap curve) that is not subjectto squeezes because it is settled in cash. Withinthe first two months, open interest for the five-year, June 2001 contract reached about six per-cent of open interest on the comparable boblfutures contract.

In addition to the informational advantagesof large market participants and the small issuesize of many of the underlying bonds relative tonotional amounts of futures contracts, threeother factors may make German governmentbond markets and related derivatives and repo

Box 4.5. Squeezes in German Government Securities Markets

1Other squeezes occurred in 1994, September 1998,and June 1999.

2A delivery obligation arising out of a short positionin a euro-bobl futures contract may only be satisfied bythe delivery of specific debt securities—namely,German federal bonds (Bundesanleihen) and Germanfederal debt obligations (Bundesobligationen)—with aremaining term upon delivery of 4!/2 to 5!/2 years. Thedebt securities must have a minimum issue amount of€2 billion.

3The “free float” of a security is the portion of the is-sue size that is not held by buy-and-hold investors andcirculates freely in the market.

4Eurex demands a fine of €400 per contract (con-tract size of €100,000) on each day during which deliv-ery obligations are not met, plus penalty interest of6.25 percent on the outstanding amount.


107

markets prone to squeezes. First, settlementprocedures in the cash and repo markets forGerman government bonds are not conduciveto arbitrage between futures and cash markets,which would make squeezes less likely.5 Forexample, differences in the delivery time (aslong as T+5 days in the cash market comparedwith T+2 in the futures market) and smallpenalties for failure to deliver in the cash/repomarket compared to the stiff penalties in thefutures market hinder effective arbitrage. It istoo early to judge whether efforts by Eurex tointroduce both cash bond trading and repotrading will attract enough traders to alleviatethis problem.

Second, the basket of securities eligible tobe delivered under German bond futures con-

tracts does not reflect the international use ofthe contract and may be too small—there is alack of fungibility among different bond issuers.If a larger set of securities was eligible to satisfydelivery obligations, it would be far more diffi-cult to initiate squeezes. Rather than expand-ing the set of eligible securities for deliveryunder bobl and bund futures contracts, Eurex,which is partly owned by the large market-makers, narrowed the basket of eligible securi-ties for the bobl contract in June 2000 frommaturities between 3!/2 to 5 years to maturitiesbetween 4!/2 to 5!/2 years of exclusively Germanbonds.

Finally, squeezes in the most liquid bench-mark issues of the euro area could be averted if,for instance, the German government could in-crease the supply of eligible securities. TheBundesbank does, in fact, provide liquidity inthe secondary market for German governmentsecurities, but it is restricted by limits set by theEuropean System of Central Banks. These limitsmay adversely affect the ability of theBundesbank to use repos to increase the supplyof eligible securities to avert squeezes. TheMinistry of Finance could also reopen issues ofeligible securities. Short of “reopenings” in re-sponse to squeezes, the German authorities haverecently increased issue sizes on a five-year bobland on 10-year bunds. If this increase in issue

Bonds Deliverable Into Eurex Bobl Futures Contracts(In billions of euros)

Deliverable Deliverable DeliverableSecurity (Coupon Rate, Maturity Date) into June 2001 into September 2001 into December 2001

Bund (6 percent, January 2006) 12.7 no noBund (6 percent, February 2006) 6.1 no noBobl (5 percent, February 2006) 7.0 no noBund (6.25 percent, April 2006) 7.1 7.1 noBobl (to be issued August 2001) no n.a. n.a.Bund (6 percent, January 2007) no 15.3 15.3Bund (6 percent, July 2007) no no no

Total 32.9 22.4 15.3

Memorandum items:Open interest (5/15/01)

Eurex bobl contract 45.4 1.9 1.4LIFFE 5-year Swapnote 3.0 0.0 0.0

Sources: Eurex; LIFFE; and UBS Warburg.

5If the arbitrage mechanism between cash and deriv-atives markets functions well, squeezes in the deliver-able bonds are less likely, because the repo marketwould provide sufficient liquidity to borrow the deliv-erable bonds. Although arbitrage opportunities occa-sionally exist between the futures and cash markets,market participants are reluctant to engage in theseactivities due to inefficiencies in the repo and cashmarket. For example, according to market partici-pants, immediately prior to expiration of the Marchfutures contract, the difference between the futuresprice and the implied forward price of the CTD bond(the “basis”) was negative 37 cents, whereas it shouldhave been zero.

of fragmentation is that it impairs the efficientuse of government securities as collateral (par-ticularly in repo transactions).38 Partly as a re-sult of these problems, European governmentsecurities accounted for only about 5 percent ofcollateral in use among global market partici-pants at end-1999, while U.S. treasury andagency securities accounted for about 40 per-cent of collateral.39 Finally, fragmentation alsomay raise the cost of cross-market transactionsand hedging.

The third main consequence of segmentationis that it could impair financial stability relativeto what it could be with more unified secondarymarkets, clearing and settlement systems, andsupporting repo and derivatives markets. Lesssegmentation appears to have both costs andbenefits for financial stability. The costs derivefrom the fact that closer integration makes na-tional financial markets more responsive toshocks that originate in other euro-area markets.Thus, in a more unified government securitiesmarket, an economic or financial shock that af-fects pricing and trading activity in one market

segment could more easily translate intochanges in prices and trading activity in othercountries within the euro zone. This suggeststhat local financial institutions may be exposedto a broader range of shocks that will need to bemanaged to preserve financial stability. The fi-nancial stability benefits derive from the fact thatrisks are diversified when they are pooled and, asoutlined above, from the more efficient marketinfrastructure—greater liquidity in both cashand supporting repo and derivative markets, andseamless clearance and settlement for all euro-area government securities transactions.Although it is difficult to measure accuratelythese costs and benefits, the main question issimilar to the other market integration ques-tions. The balance of opinion is that there arenet benefits, including for financial stability, ofcloser financial market integration.

Options for Reducing Fragmentation

There are a number of steps that could betaken to reduce fragmentation of euro-area gov-ernment securities markets.40 In particular, as


108

38See European Commission (1999).39See ISDA (2000b).40The following discussion draws on IMF staff discussions with market participants and official institutions, and pub-

lished reports. See, in particular, the report by the Giovannini Group (2000) for a thorough discussion of approaches toreducing fragmentation. The report apparently gained little support among debt managers, who sought action to improverepo markets and settlement systems.

size became permanent, some of the imbalancebetween cash and futures markets might be alle-viated. Merely introducing the possibility of re-opening issues when squeezes emerge couldhelp to discourage them.

To summarize, the chance of market squeezesin the German government bond market mightbe reduced by continuing the recent policy oflarge issue sizes; enforcing stricter settlementand delivery regulations in the cash and repomarkets; reopening an issue when a squeeze islikely; increasing the basket of deliverablebonds; and introducing cash settlement of fu-

tures contracts.6 In addition, reporting of tradesas either opening or closing trades would im-prove market transparency and allow marketparticipants to better assess the probability of asqueeze. Finally, a large position reporting sys-tem could further mitigate the potential for fu-ture squeezes.

Box 4.5 (concluded)

6Rather than extending the maturity spectrum ofdeliverable German bonds, the basket of deliverablebonds could include government bonds of otherEuropean issuers, although differences in perceivedcredit quality might limit the uncertainty as to whichbond will be cheapest to deliver at maturity.

noted above, there is presently little coordina-tion among member countries about the datesand the frequency with which they issue newgovernment securities (see Table 4.1). Accord-ingly, euro-area governments could better coor-dinate debt issuance techniques, features of gov-ernment securities, trading systems, andsurrounding markets. More specific possibilitiesin this regard include uniform calendars for is-suance, common coupon and maturity dates, asingle primary dealership system, unified legaltreatment of collateral, and a shared real-timeclearing and settlement system.

Another, more radical option that has beensuggested41 would be to reduce the differencesin credit risk among countries—either throughcross-guarantees among member states orthrough the establishment of a single debt-issu-ing authority. This would create a more uniformset of securities and would probably result in rel-atively more liquid markets. The same argumentcould, of course, be applied to any heteroge-neous group of securities issuers. As a result, thiswould be a radical method for creating more liq-uid markets, since a main role of securities mar-kets is arguably to differentiate among differentcredit risks and price the instruments accord-ingly. Another argument against this proposal isthat, as a practical matter, there may be little in-centive for larger, more creditworthy countriesto participate, particularly if it would be difficultfor them to monitor and discipline other bor-rowing countries.

Moreover, this more radical option presentspolitical and legal obstacles that might be insur-mountable. At a technical level, the creation of aunified debt obligation would require amendingArticle 103 of the EU Treaty; the structure of thejoint guarantee would need to be made clearand defined in such a way as to not violatecovenants in existing bond prospectuses and

loan agreements; and the institutional arrange-ments for issuance of the instrument wouldneed to be carefully designed and set up. Finally,in order to maintain uniformity of the issuesover time, the set of participating issuers wouldneed to remain constant over time, which mightcomplicate the admittance of new participantsinto the euro area.

Recent Proposals and Initiatives for ReducingFragmentation

European authorities and market participantsare increasingly aware of these problems. In a1999 report, the Giovannini Group identified anumber of challenges to the integration ofEuropean repo markets, including fragmentedmarket infrastructures, differences in relevantlaws, and inconsistencies in market practicesacross countries.42 The EC’s Brouhns Group hasdiscussed and reported on issues and progress inthe integration and harmonization of Europeangovernment securities markets.43 For example,recent reports by the Brouhns Group documentissuing procedures and calendars, characteristicsof government bond instruments, and primarydealership structures in EU public debt markets,and note key similarities and differences acrosscountries. Industry groups such as theInternational Swaps and Derivatives Association(ISDA) have highlighted relevant documenta-tion and legal issues for the use of securities ascollateral and in repo arrangements.

Key regulatory and legal obstacles to harmo-nized securities markets are being addressed bythe EU Commission’s Financial Services ActionPlan, which was adopted in May 1999. TheAction Plan, to be implemented in 2005, in-cludes more than 40 initiatives and pursues,among other things, the objectives of creating asingle market for wholesale financial services byadvancing a common legal framework for inte-


109

41The Giovannini Group (2000).42See the Giovannini Group (1999). The group, chaired by Alberto Giovannini, is comprised of market participants and

advises the European Commission on financial market issues.43The “Brouhns Group” (formally entitled the European Commission Economic and Financial Committee Group on

EU Government Bills and Bonds) is comprised of public debt managers from the 15 EU member states and representa-tives of the EC and the ECB.

grated securities markets and eliminating tax ob-stacles to financial market integration, particu-larly tax distortions on cross-border financialtransactions.

In March 2001, as part of the Action Plan, theCommission issued a draft Directive on theCross-Border Use of Collateral that would pro-vide legal certainty for cross-border collateral-ized transactions. The directive would create apan-European legal framework for the use ofcollateral to avoid potential conflicts between ju-risdictions. The new EU regime would also en-sure priority of collateral arrangements in thecase of bankruptcy and would clarify which juris-diction’s law would apply for book-entry securi-ties, whose location is difficult to determine.Collateral-takers would explicitly be permitted toreuse collateral for their own purposes underpledge structures. The directive also would sim-plify so-called perfection requirements that col-lateral-takers must comply with to ensure theirrights to the collateral.

The European Commission is also in theprocess of revising the 1993 Investment ServicesDirective (ISD). In November 2000, it issuedconsultative proposals for upgrading the ISDthat, among other things, were aimed at improv-ing the regulatory framework for the trading in-frastructure.44 It is widely being recognized thatthe ISD provisions for “regulated markets” havebecome outdated in light of new trading tech-niques, such as electronic trading, and pressuresfor consolidation of trading, clearing, and settle-ment functions.

To accelerate the implementation of theAction Plan and, more generally, to speed up de-cision making on EU securities regulation, theLamfalussy Report (see Chapter II)45 proposed anew four-level process that would separate politi-cal from technical decisions. If the report’s pro-posals were enacted, draft directives would beimplemented faster and more consistently acrossmember countries. The report also urged thatclearing and settlement systems in Europe

should be consolidated, but it viewed thisprocess as mostly driven by private marketforces. Nonetheless, the Lamfalussy Committeesaw some scope for public policy, primarily toensure open and non-discriminatory access, torule out exclusivity agreements, and possibly tosupervise clearing and settlement systems ac-cording to common European standards.

Despite these recent initiatives and consider-able discussion of the issues, there has been lim-ited progress in reducing sources of fragmenta-tion of euro-area government securities markets,and the consensus in Europe is that the outlookfor progress is also limited. For instance, legalcounsel at major European financial institutionsemphasize the difficulty of changing the na-tional legal traditions. As a result, market partici-pants have begun to seek to address these prob-lems through less onerous approaches, such asdevising common standards for cross-border re-pos in the form of master agreements. In addi-tion, the ECB has convened a EuropeanFinancial Markets Lawyers Group that is examin-ing these and related issues in European securi-ties law.

In summary, increased integration ofEuropean government securities markets facesvarious structural impediments that have re-sulted in slow progress. First, there are limitedincentives for national governments that cur-rently have benchmark status to cooperate in is-suance and share the benefits of that status morebroadly. Broadening the set of credits underlyingthe benchmark security to include lower-ratedcountries could reduce the perceived creditquality of the instrument and increase financingcosts for the current benchmark issuers. Second,as noted above, cooperative arrangements thatinvolved joint guarantees of debt would be prob-lematic for a number of reasons—including thatthey would require amendments to the EUTreaty. The consensus seems to be that suchamendments would take considerable time toput in place. Finally, there are few incentives at


110

44European Commission (2000).45See Committee of Wise Men (2001).

the national level to address the fragmentedclearing and settlement infrastructure for securi-ties markets by allowing mergers, improving link-ages, and increasing the compatibility among sys-tems—particularly as these systems are oftenowned by or part of domestic securities ex-changes.

Japan: Market Infrastructure andExpanding Government Debt Supply

Japan presently has the second largest govern-ment securities market in the world. Theprospects for continued large fiscal deficits inJapan suggest that this market and the domesticappetite for absorbing Japanese government se-curities issuance may face important challenges.Although a growing JGB market and a shrinkingU.S. treasury market might present an opportu-nity for JGBs to take on much greater signifi-cance in international financial markets, thisprospect may be limited for now. The JGB mar-ket’s infrastructure has well-recognized weak-nesses, and a key policy challenge is to improvethe market infrastructure so that the absorptionof government debt will be less daunting. Thissection identifies some of the most importantand recognized weaknesses in the JGB market,what the authorities are presently doing aboutthem, and remaining challenges.

Recent Structural Changes and Issues

Rapidly Growing Debt Supply and Official Effortsto Manage Its Impact

In contrast to other advanced economies, thevolume of government debt in Japan is expand-ing rapidly relative to GDP. The IMF’s WorldEconomic Outlook projects that government debtin Japan will continue to rise over the 2000–05period. In particular, with the fiscal balance ex-pected to remain in significant deficit over thenext five years, the stock of Japanese govern-ment net debt is projected to rise by 50 percent

in nominal terms and by about 16 percentagepoints as a share of GDP to about 60 percent by2006. Gross debt is projected to rise from 130percent of GDP in 2000 to 150 percent of GDPby 2005.

The growing supply of JGBs—and attendantmarket concerns about how smoothly the marketcan continue to absorb such supply—has had sev-eral noticeable effects on the market. For exam-ple, in an environment of near-zero short-terminterest rates and long-term interest rates of be-low 2 percent, growing JGB supply appears to becontributing to market volatility (see Figure 4.2).This may partly reflect concerns about howsmoothly the market can absorb further increasesin supply or shifts in demand—bond prices aremore sensitive to changes in interest rates wheninterest rates are low. In this connection, pastbouts of volatility in the JGB market illustratewhy the market is perceived as driven by techni-cal supply and demand factors rather than funda-mental factors.46 In late 1998, a strong increasein demand for JGBs drove yields on 10-year issuesfrom about 160 basis points at end-June to about80 basis points in mid-November, amid repatria-tion of funds and heightened concerns about thedomestic economic situation and problems inthe banking system. Subsequent concerns thatexpansionary fiscal policy would strongly boostthe supply of JGBs and that purchases in the mar-ket by the Trust Fund Bureau might be cut backsharply contributed to a sharp rebound in JGByields, which reached about 225 basis points inDecember. Later, suggestions (and in February1999, official confirmation) that the Trust FundBureau would continue to buy JGBs, combinedwith injections of public capital into the majorbanks, a reduction in the amount of 10-year JGBissuance from ¥1.8 trillion per month to ¥1.4 tril-lion per month, and an improvement in auctiontransparency owing to the release of the auctionschedule, contributed to a subsequent decline inyields and volatility. This episode remains fresh inthe minds of many market participants, particu-larly in light of the pickup in supply of JGBs and

JAPAN: MARKET INFRASTRUCTURE AND EXPANDING GOVERNMENT DEBT SUPPLY

111

46See IMF (1999), Chapter II, p. 23.

continued strong purchases by Japanese banks inthe recent period (see Chapter II).

In addition, large JGB issuance seems to havecompressed spreads of corporate bonds relativeto JGBs, as Japanese corporate bond yields havedeclined by more than JGB yields (see ChapterII). This compression can be attributed to twofactors. First, lingering economic and financialimbalances in Japan together have caused pri-vate financial market activity to stagnate. As a re-sult, corporate bonds have become relativelyscarce, especially high-quality bonds. Second, in-vestor appetite for credit spreads has increasedunder low interest rates. Third, the perceivedcredit quality of the Japanese government hasdeteriorated relative to other high-rated issuersof yen-denominated bonds. For example,whereas a highly rated euro-dollar bond tends toyield 15–30 basis points more than the corre-sponding U.S. treasury, top-rated euro-yen bondsfrequently yield less than the corresponding JGB(Figure 4.4).

The Japanese authorities have recently takena number of steps to mitigate the impact of ris-ing JGB supply on pricing in the JGB marketand help ensure smooth financing of futuredeficits. For example, the Ministry of Finance(MOF) has reduced issuance of long-maturitybonds relative to the supplies of short-maturitybonds, in order to diversify maturities. As a re-sult, the average maturity of government debt is-suance has shortened from 6.4 years in 1989 toaround five years in 2000. Looking ahead, thelengthening of the average maturity of plannedissuance in FY2001 to five years and four monthsmay put upward pressure on longer-maturityJGB yields. Meanwhile, to enhance liquidity infive-year benchmark issues, four-year and six-year bonds have been discontinued from thecurrent fiscal year. Several structural improve-ments to the JGB market also have been imple-mented in the past two years: the securitiestransaction tax was abolished in April 1999;coupon-bearing JGBs held by nonresidents wereexempted from withholding tax under certainconditions starting September 1999 and furtheradministrative changes were introduced in April


112

–401997 98 99 2000 01

–20

0

20

40

60

80

100

Figure 4.4. Japan and United States: Euromarket Spreads over Government Bonds(In basis points)

Source: Bloomberg Financial Markets L.P.1The U.S. dollar AAA-rated bond is issued by the International Bank for

Reconstruction and Development (World Bank) and the yen AAA-rated bond is issued by the European Investment Bank (EIB). Calculated as a five-day moving average.

AAA U.S. dollar spread1

AAA yen spread1

2001;47 real-time gross settlement (RTGS) wasintroduced in January 2001;48 and the Bank ofJapan (BOJ) introduced procedures for JGB de-livery failures in money market operations inMay 2001.49

Lack of Foreign Investor Participation

Notwithstanding efforts of the Japanese au-thorities to address the shortcomings in the JGBmarket, foreign investor interest in the marketremains muted. According to a range of marketparticipants, this lack of interest reflects (in ad-dition to the current very low yields) the costsand perceived risks associated with imperfec-tions in the market’s underlying financial infra-structure, and the perception that the JGB mar-ket is presently driven primarily by technicalfactors rather than fundamental economic fac-tors. For example, in their formation of JGByield expectations, analysts are heavily con-cerned with cash flows of major JGB investors—since that affects the flow demand for JGBs andthe ability to absorb new issues—and compara-tively little weight appears to be placed on eco-nomic fundamentals. Because it is difficult tounderstand many of these technical factors,when international investors want to increasetheir yen exposure (in order to avoid underper-forming benchmark indices) they often prefer tobuild up positions in the offshore euro-yen mar-ket rather than the domestic JGB market. Thishas tended to limit liquidity in the domesticmarket, and probably has tended to raise JGByields relative to other high-rated, yen-denomi-nated bonds.

Accordingly, although increased debt issuancehas resulted in a growing share of Japanesefixed-income instruments in global indices, inter-

national fixed-income investors have continuedto hold underweighted positions in JGBs (rela-tive to benchmark portfolio weights). Japan’sweight in the Merrill Lynch Government BondIndex had risen steadily to 24 percent at end-March 2001; similarly, JGBs had a 27 percentweight in Salomon Smith Barney’s WorldGovernment Bond Index. But despite these largeand rising weights of JGBs in benchmark bondindices, foreign investors have reportedly beenhesitant to raise their holdings to near bench-mark weights. As a consequence, non-Japaneseinvestors hold less than 6.5 percent of all JGBs—much lower than is the case for the correspon-ding government securities markets in theUnited States or the euro area (see Table 4.1).

Remaining Challenges in Creating an Effective,Deep, and Liquid JGB Market

Notwithstanding the efforts of the Japaneseauthorities to improve the infrastructure for theJGB markets, in the view of market participants(and, in some instances, also the authorities) anumber of key shortcomings remain. These in-volve the withholding tax; the clearing and set-tlement infrastructure; the structure of issuance;and the repo market.

Remaining Shortcomings in the Infrastructure

It is well known in the markets and by the au-thorities (as discussed below) that the withhold-ing tax fragmented the market and reduced JGBmarket liquidity. This is because, in the past, thedesire to circumvent the withholding tax has ledto the creation of a secondary market in whichsome entities subject to the withholding taxfailed to reregister acquired JGBs under their


113

47There are entities other than nonresidents that are exempt from the withholding tax. For example, entities exemptfrom income taxes are also exempt from the withholding tax. Currently, the government withholds 20 percent of couponpayments on JGBs held by taxable entities. The withholding tax consists of 15 percent income tax and 5 percent localtaxes. Profits on the sale of bonds are tax-exempt, while profits on the redemption of discount bonds are subject to 18 per-cent withholding tax at the source at issuance.

48Also in January 2001, the Japan Securities Dealers Association introduced a fail rule for JGB transactions amongdealers.

49The Bank of Japan also disclosed which JGB issues it was holding, so that market participants could better gauge thesize of the privately held stock of each issue.

own names in the official name registry.50

Instead, they reportedly “borrowed” the namesof tax-exempt investors by trading the “Letter ofTransfer” (L/T—also known as the “name regis-tration form” (NRF)), which normally instructsthe BOJ to change the name of the owner of asecurity following a trade, but is kept blank to fa-cilitate further trades.51 The blank form couldbe treated as a bearer bond and was cleared andsettled against cash (although not necessarily si-multaneously), while leaving the JGBs registeredin the original name.

Measures to circumvent the withholding taxhave also introduced additional risks into trad-ing and holding JGBs. First, they have intro-duced additional counterparty risk into someJGB trades. For instance, an insolvent namelender would still be recognized by the Bankof Japan as the official owner of the JGB, expos-ing the name borrower to credit risk. In addi-tion, these practices have introduced deliveryrisk as NRFs cannot in practice be exchangedon a delivery-versus-payment basis. Second,foreign investors see the withholding tax as in-creasing market risk on JGBs, because foreigninvestors tend to sell one issue before thecoupon payment and buy another whosecoupon payment is further in the future. Whenshifting JGB holdings across issues, the investoris exposed to significant market and liquidityrisk. As noted above, the authorities have intro-duced procedures that allow nonresident in-vestors to obtain exemption from the tax.

According to market participants, however, satis-fying the conditions to maintain tax-exempt sta-tus in Japan is costly.52

There are also a number of remaining short-comings in the clearing and settlement infra-structure. Many JGB transactions are settled onan RTGS basis, with settlement at T+3.53 Whilesome of these transactions in Japan are settledon a delivery versus payment (DVP) basis underRTGS, it is not unusual, according to marketparticipants, for large clients to insist on con-firming receipt of cash payment prior to releas-ing the bond in a given transaction. This appar-ent violation of the JGB settlement guideline setby the Japan Securities Dealers Association re-duces some of the purported benefits of anRTGS system because it exposes the intermedi-ary and the counterparty to credit risk andforces them to fund their position for the dura-tion of the unsettled transaction (usually a fewhours).

In addition, JGB transactions involving foreigncentral banks and primary offerings are still con-ducted on a non-RTGS basis (they are settled at3 p.m. each day). As a result, all related transac-tions need to be completed in the few remaininghours of the day before the RTGS system shutsdown at 6 p.m., causing concern among marketparticipants that a dealer may not be able to de-liver securities to a customer during this smallwindow of time. However, settlement failures, de-spite being accepted among brokers, are frownedupon by some market participants, and proce-


114

50JGBs are either registered under the ultimate holder’s name in the name registration system or are held by participat-ing institutions for their clients in the book entry system of the Bank of Japan. See Ohashi and Milligan (1998). Since theimplementation of the recent tax reforms, the vast majority of JGBs are held by participating institutions for their clientsor for themselves in the book-entry system.

Interest on registered bonds held by financial institutions is not exempt from withholding tax if the calculation periodbegins during or after January 2001. Accordingly, it is now impossible to circumvent the withholding tax by trading NRFs.

51The L/T is an instruction issued (to the Bank of Japan) upon trade of a JGB to change the name of the owner of thesecurity.

52According to the amended Special Taxation Measures Law, as of April 1, 2001, nonresidents of Japan or foreign (non-resident) corporations are exempt from withholding tax on interest payments on JGBs held with non-Japanese operations(branches or operational bases outside Japan) of foreign financial institutions under certain conditions. Foreign financialinstitutions must be approved as qualified foreign intermediaries (QFIs) by the National Tax Administration and as for-eign indirect participants of the JGB book-entry system by the Bank of Japan before they take deposit of JGBs from non-residents through their non-Japanese operations.

53For comparison, settlement occurs at T+1 (one day after execution of the trade) in the U.S. and U.K. government se-curities markets and T+3 (three days after the trade) in most euro-area government securities markets.

dures that apply to JGB settlement failures inJGB-related money market operations were onlyrecently announced by the BOJ.54 To avoid set-tlement failures, repo traders expecting a deliv-ery at issuance or from a foreign central bank—typically involving large transactions—have beenforced to wait until the delivery is made beforethey can sell that bond to a third party. This wasviewed as a cause of JGB market illiquidity, oftenreflected in the premium the market placed oncertain bonds in the market for repurchasingagreements. As market participants demandedthe desired bonds, the premium on these bondsbecame large. In fact, according to dealers, onmany occasions repo rates have become nega-tive, so that lenders of bonds were paid to bor-row cash against their bonds.

Adding to these problems, the JGB repo mar-ket is fragmented. Although Japanese marketshave been gradually moving toward the interna-tional standard BMA/ISMA master agreementfor repos, non-uniform tax treatment of in-vestors and transactions has perpetuated threeforms of repo markets in Japan: gensaki, for saleand repurchase of bonds; taishaku, for unse-cured bond lending55; and genkin tampo tsukitaishaku, for bond lending using cash as collat-eral. In addition, some large holders of JGBsseemingly resist lending them out. Dealers seethis as reflecting the lack of a “repo culture”among such investors.

As a result of the fragmentation and lack ofdevelopment of the repo market, establishingshort positions, and borrowing and lending gov-ernment securities more generally, is not asseamless in Japan as in some other advancedgovernment securities markets. Market partici-pants suggest that segmentation of the JGB repo

market has also contributed to an erosion of thearbitrage relationships between cash and futuresmarkets. In a repo transaction, the borrower ofcash typically pays a positive interest rate whilelending a bond for collateral at the same time.In Japan, this relationship inverts quite regu-larly. For example, rumors that some public sec-tor investors would not be executing repo trans-actions over the millennium changeoverprompted the repo rate for the cheapest todeliver (CTD) bonds to decline even furtherthan its already low level.56 At one point, bond-holders would be paid more than 2 percent in-terest for borrowing cash in return for lendingtheir bonds. For some perspective, during therecent squeeze in the German governmentbond market (see Box 4.5), repo rates did notdrop below zero (although prevailing short-term rates were also much higher in Germanythan in Japan).

JGB market fragmentation also exists in thesense that there is often a very large number ofdifferent bond issues. For comparison, the issuesize of a single tranche of a 10-year Germanbund typically amounts to around 5.8 percentof total issuance during the fiscal year. By con-trast, the comparable figure in Japan is only1.7 percent. Reflecting this, in May 2001 therewere 76 different issues of JGBs with originalmaturities of 10 years. Of the many issues out-standing, among the most actively traded issuesis the cheapest issue that can be delivered (theCTD bond) to settle JGB futures contracts. Therelatively small issue size of the CTD bondwhen compared to open interest in the futurescontract has led on occasion to significant dis-tortions of the yield curve. For example, inJune 1999 open interest in the futures market


115

54Settlement failures are allowed and are routine in most of the well-functioning clearance and settlement systems.Moreover, other central banks permit settlement failures of its counterparties: for example, the ECB sets guidelines forfailures, with penalties for the first failure and exclusion from the panel of counterparties at the third failure. The BOJ re-cently announced procedures that apply to JGB settlement failures in JGB-related money market operations, including sus-pension of offers to the counterparty for a certain period.

55The taishaku market evolved as a way of circumventing the securities transaction tax that would be charged on gensakitransactions. Liquidity in this market is impeded by the inability to deliver a similar but different bond at maturity of thetransaction, as is common in other repo transactions.

56See Shigemi and others (2001).

(¥15 trillion) exceeded the amount outstandingof the original CTD issue (¥8 trillion). As deliv-ery failures in settlement for futures contractsare not recognized in Japan, market partici-pants were keen to obtain the CTD bond tosatisfy their obligation under the futures con-tract. The resulting sharp price increases of theoriginal 10-year CTD bond caused a 20-yearbond to become CTD, thus affecting the shapeof the yield curve. In March 2001, reopeningswere introduced, which will reduce the numberof different issues of bonds. The authoritiesexpect that this will improve JGB marketliquidity.

Possible Steps to Improve Infrastructure andIncrease Market Depth and Liquidity

Internationally active market participants haveexpressed skepticism about whether recent re-forms to the withholding tax regime will reducethe actual and perceived costs of investing inJGBs. QFIs in Japan will need to shoulder the ad-ministrative burden and responsibility of identi-fying and maintaining individual accountrecords of foreign investors.57 Foreign investorsor (on their behalf) QFIs are also still requiredto supply a “statement of the holding period”one day prior to each coupon payment for eachJGB they own in order to satisfy exemption sta-tus, which maintains the administrative burdenfor obtaining the tax exemption. The current re-form also aims to shut down the NRF market bysubjecting all investors recorded in the nameregistration system to withholding tax on allcoupon payments after June 20, 2001. It is un-clear whether foreign investors selling their tax-exempt holdings in the NRF market prior to thisdate will see the recent reforms as sufficient toincrease their participation in the regular book-entry JGB market.

The simplest approach to these problemswould be to abolish the withholding tax. It hasbeen suggested that the Japanese tax authoritiesmay be reluctant to sacrifice tax fairness and thepossibly higher total tax revenues associated with

the withholding tax. At the same time, the with-holding tax increases borrowing costs by frag-menting the investor base and reducing marketliquidity. It is conceivable that, as has happenedin many other countries, the savings in borrowingcosts from abolishing the withholding tax wouldoutweigh the loss of the revenue from the tax.Short of abolishing the withholding tax, steps tomake it easier to obtain and maintain exemptioncould significantly increase the attractiveness ofthe domestic market to foreign investors andthereby potentially broaden the investor base.

In addition, market participants view settle-ment practices in the JGB market as unnecessar-ily complicated, and are eager to see them re-vised. The BOJ has announced that it willimplement RTGS for foreign central bank JGBsales within the year and that it will shift newJGB issuance to RTGS by the middle of nextyear. In addition, the attractiveness of the JGBmarket could be enhanced—some say signifi-cantly—by encouraging the full use of DVP set-tlement practices and reducing the settlementperiod below T+3. Transaction costs could be re-duced and market liquidity enhanced if theprocess—beginning from a trade on through tothe change of ownership at the registrar—couldbe simplified by straight-through processing.

According to market participants, two addi-tional market design changes could help to im-prove the ability of investors to manage fixed-income risk and therefore possibly reduce thecost of the public debt: a legal environment thatis supportive of stripping of JGBs and inflation-indexed JGBs. Present monetary policy in Japanputs most of the risk in one tail of the distribu-tion of interest rates. This had produced consid-erable “convexity risk,” which in turn has mademany international investors shy away from allyen-denominated instruments. The introductionof inflation-indexed government securities andpermitting investors to strip existing governmentsecurities (a “strips” market) would enable in-vestors to better manage yen-denominated fixed-income risks. While inflation is not a present


116

57See Shirakawa (2000).

risk, future inflation risk is much more uncer-tain. Similarly, a strips market would make it eas-ier to arbitrage price differences between similarinstruments that have been unusually large inthe past and have continued to be significant incomparison to other countries. For example, asshown in Figure 4.5, the yield difference be-tween two 10-year bonds issued two monthsapart but maturing on precisely the same daywas around 5 basis points in May 2001 butreached as high as 22 basis points in 1999, com-pared to 2 basis points for a similar pair ofGerman government bonds. The lack of legalcertainty associated with stripping coupon pay-ments from principal payments discourages arbi-traging such extreme price anomalies away.

Improvements to the market infrastructure, asnoted above, would no doubt add liquidity tothe repo market as well as to the cash market, in-cluding by broadening the array of participantsin both markets and by increasing the availablesupply of benchmark securities. Other officialsteps could help as well. Market participantshave raised the possibility of a securities lendingfacility operated by the BOJ, which could lendliquidity to the bond market and help preventthe emergence of squeezes. Similarly, while theMinistry of Finance has on occasion reopened abond issue when its market price returned topar value, it does not presently operate a securi-ties lending facility (it introduced reopening inMarch 2001, which the authorities expect willenhance the liquidity of the JGB market).

In conclusion, these measures wouldstrengthen the infrastructure for the JGB mar-ket, encourage broader participation in the mar-ket, and help to improve its depth and liquidity.This would have at least two significant benefits.First, a deeper and more liquid JGB marketwould contribute to the smooth financing of fis-cal deficits going forward—an important macro-economic issue in light of the rapid increase infinancing needs that is likely to occur in the pe-riod ahead. Second, an improved JGB marketwould yield significant benefits for Japanese fi-nancial markets. It would enhance the publicbenefits from the growing JGB market, including

REFERENCES

117

–5

0

5

10

15

20

25

30

1999 2000 2001

Figure 4.5. Japan and Germany: Yield Spread on Government Bonds with Similar Maturities(In basis points)

Source: Bloomberg Financial Markets L.P.

JGB: Difference between 1.8 percentand 1.4 percent coupon 10-year bonds,maturing June 22, 2009Bund: Difference between 4.75 percentand 4.125 percent coupon 10-year bonds,maturing July 4, 2008

by improving the usefulness of the JGB marketas a benchmark for credit risk, as a market forhedging and managing interest rate risk, and (asregards improvements to the repo market) as amarket for funding. Moreover, a more liquidmarket and resilient market infrastructure, intandem with broader participation, could workto reduce concerns about potential market insta-bilities that might be associated with a growingsupply of JGBs.

ReferencesBank for International Settlements, 2001, Quarterly

Review: International Banking and Financial Market

Developments (Basel, March).

Bomfim, Antulio N., 2001, “Optimal Portfolio

Allocation in a World Without Treasury Securities,”

Finance and Economics Discussion Series No.

2001–11 (Washington: Board of Governors of the

Federal Reserve System).

Bond Market Association, 2001, “Maintaining the 30-

Year Benchmark Bond Benefits the Economy and

Taxpayers,” Treasury Debt Management Position

Paper No. 2001–01 (Washington).

Clouse, James, Dale Henderson, Athanasios

Orphanides, David Small, and Peter Tinsley, 2000,

“Monetary Policy When the Nominal Short-Term

Interest Rate Is Zero,” Finance and Economics

Discussion Series No. 2000–51 (Washington:

Board of Governors of the Federal Reserve

System).

Committee on the Global Financial System, 2001, The

Implications of Electronic Trading in Financial Markets

(Basel: Bank for International Settlements).

Committee of Wise Men, 2001, Final Report of the

Committee of Wise Men on the Regulation of European

Securities Markets (Brussels).

Cooper, Neil, and Cedric Scholtes, forthcoming,

“Government Bond Market Valuations in an Era of

Dwindling Supply,” BIS Working Paper (Basil: Bank

for International Settlements).

Deutsche Bank, 2000, Deutsche Bank Global Markets

Research, Deutsche Bank (August).

European Commission, 2000, Communication on

Upgrading the Investment Services Directive (Brussels:

Commission of the European Communities).

———, 2001, Proposal for a Directive of the European

Parliament and of the Council on Financial Collateral

Arrangements (Brussels: Commission of the

European Communities).

Fleming, Michael J., 2000a, “The Benchmark U.S.

Treasury Market: Recent Performance and Possible

Alternatives,” Economic Policy Review, Vol. 6, No. 1

(April), pp. 129–145.

———, 2000b, Treasury Market Liquidity (unpublished;

New York: Federal Reserve Bank of New York).

Giovannini Group, 1999, “The EU Repo Markets:

Opportunities for Change,” Euro Papers No. 35

(Brussels: European Commission). Available via

the Internet: http://europa.eu.int/comm/

economy_finance/document/europap/

eup35en.htm

———, 2000, Report on Co-ordinated Issuance of Public

Debt in the Euro Area (Brussels). Available via the

Internet: http://europa.eu.int/comm/economy_fi-

nance/document/euro/giovannini1100_en.htm

Goldman Sachs, 2000, “Why the Fed’s Open Market

Operations Must Be Changed,” U.S. Economics

Analyst, September 1.

Greenspan, Alan, 2001, “The Paydown of Federal

Debt,” remarks before the Bond Market Association,

White Sulphur Springs, West Virginia, April 27.

Inoue, Hirotaka, 1999, “The Structure of Government

Securities Markets in G-10 Countries: Summary of

Questionnaire Results,” in Market Liquidity: Research

Findings and Selected Policy Implications (Basel: Bank

for International Settlements).

International Monetary Fund, 1998, World Economic

Outlook and International Capital Markets: Interim

Assessment, World Economic and Financial Surveys

(Washington).

———, 1999, International Capital Markets:

Developments, Prospects, and Key Policy Issues, World

Economic and Financial Surveys (Washington).

———, 2000, International Capital Markets: Develop-

ments, Prospects, and Key Policy Issues, World

Economic and Financial Surveys (Washington).

———, forthcoming, “Management of the

Government Debt: Implications for Monetary

Policy Implementation and Financial Markets,”

Canada—Selected Issues (Washington).

International Swaps and Derivatives Association,

2000a, Collateral Arrangements in the European


118

Financial Markets: The Need for National Law Reform

(London).

———, 2000b, ISDA 2000 Collateral Survey (London).

Johnston, Elizabeth T., and John J. McConnell, 1989,

“Requiem for a Market: An Analysis of the Rise and

Fall of a Financial Futures Contract,” Review of

Financial Studies, Vol. 2, No. 1, pp. 1–23.

Ohashi, Kazunari, and Jan Milligan, 1998, “A Case for

Reforming the JGB Market,” Financial Market

Discussion Paper No. 98–1 (London: Chief

Representative Office in Europe, Bank of

Japan).

Reinhart, Vincent, and Brian Sack, 2000, “The

Economic Consequences of Disappearing

Government Debt,” Brookings Papers on Economic

Activity: 2, Brookings Institution, pp. 163–220.

Santillán, Javier, Marc Bayle, and Christian Thygesen,

2000, “The Impact of the Euro on Money and Bond

Markets,” ECB Occasional Paper No. 1 (Frankfurt:

European Central Bank).

Schinasi, Garry J., R. Sean Craig, Burkhard Drees, and

Charles Kramer, 2000, Modern Banking and OTC

Derivatives Markets: The Transformation of Global

Finance and Its Implications for Systemic Risk, IMF

Occasional Paper No. 203 (Washington:

International Monetary Fund).

Schinasi, Garry J., Charles F. Kramer, and R. Todd

Smith, 2001, “Financial Implications of the

Shrinking Supply of U.S. Treasury Securities,” IMF

Working Paper 01/61 (Washington: International

Monetary Fund).

Shigemi, Yosuke, S. Kato, Y. Soejima, and T. Shimizu,

2001, “Market Participants’ Behavior and Pricing

Mechanisms in the JGB Markets: Analysis of Market

Developments from the End of 1998 to 1999,”

Financial Markets Department Working Paper E-

Series (Tokyo: Bank of Japan).

Shirakawa, Masaaki, 2000, “The Reforms in the

Japanese Government Securities Market,” Financial

Markets Department Working Paper E-Series

(Tokyo: Bank of Japan).

Truman, Edwin M., 2001, “The International

Implications of Paying Down the Debt,” Policy

Briefs No. 01–7 (Washington: Institute for

International Economics).

United States, Board of Governors of the Federal

Reserve System, 2000, Minutes of the Federal Open

Market Committee (Washington, March 21).

———, 2001, Federal Reserve Bulletin (Washington, May).

United States, Federal Reserve Bank of New York,

2000, Announcement of Changes in the Management of

the System Open Market Account (SOMA) (New York,

July 5).

Van Duyn, Aline, 2000, “Freddie Mac to Offer

Premium,” Financial Times (London), November 28,

p. 30.

Wojnilower, Albert M., 2000, “Life Without Treasury

Securities,” Business Economics (October), pp. 10–15.

REFERENCES

119

IMF International Capital Markets, 2001, Chapter 4 of 6 ... · roles of government securities and...

Documents

Transcript of IMF International Capital Markets, 2001, Chapter 4 of 6 ... · roles of government securities and...