Domestic Bond Markets

	Table of Contents
p. 5 of 13 BACK | NEXT Cover Page Introduction Executive Summary Chapter 1: Government Policies Chapter 2: Regulatory Framework Chapter 3: Market Infrastructure Chapter 4: Liquidity Chapter 5: Risk Management Working Papers Workshop Participants Appendix 1: Introduction Appendix 1: Executive Summary Appendix 1: Findings and Recommendations

Chapter 2
Regulatory Framework

28. The regulation and supervision of bond markets, intermediaries, institutional investors and other market participants must include systems and procedures to protect investors, to promote sound business practices, and to address systemic risk issues. Since there is a wide array of institutional arrangements governing the operation of bond markets around the world, there is considerable diversity in the regulatory framework applicable to bond markets and the intermediaries serving those markets. Many economies have several authorities responsible for the regulation and supervision of bond markets. National government bonds, municipal bonds, and corporate bonds are likely to have differing regulatory requirements and several supervisory bodies could be involved in their regulation. Bond market regulation is also complicated by the diversity of bank and non-bank intermediaries providing financial services to issuers and investors.

Investor Protection and Fiduciary Responsibilities

29. An important goal in developing a regulatory framework for domestic bond markets is investor protection. Investors need full, timely and accurate disclosure to make informed investment decisions. This requires clearly defined market rules and high transparency standards. Market rules should specifically include procedures to deal with misrepresentation, fraud, and mechanisms for investors to seek redress. In more mature markets, the main focus is on the disclosure of information rather than on the merits of the issuer ("merit regulation"). Under the full-disclosure approach to regulation, investors rather than the regulator have the responsibility for evaluating the merits of an investment. As a practical matter, investors often rely on private analysts, credit rating agencies, brokers, investment advisors, or other securities market professionals to evaluate the available information about an issuer or the securities being offered. In the absence of adequate accounting, auditing, and financial reporting, it is not possible for the securities markets to properly value a security. In nearly all emerging markets, greater emphasis is now being placed on the adequacy of accounting, auditing and disclosure standards. Nevertheless, "merit regulation" is still employed in some fashion in many emerging debt markets.

30. Regulators should not rely too heavily on one component of the regulatory scheme. Where possible, government regulation and supervision should be supplemented by external compliance checks. This includes an annual external audit requirement, adequate internal controls and compliance procedures, and the judicious use of external credit ratings in the administration of prudential and fiduciary standards.

Element 7: There should be an environment for full, timely, and accurate disclosure of information material to investment decisions. A combination of tools such as on-site inspections, off-site surveillance, internal and external audit along with a strong code of conduct and high fiduciary standards are needed to ensure the adequacy of safeguards for the protection of investors. High and internationally accepted accounting standards should be adopted in the market.

31. There should be a clear differentiation of private placement and public offering to assess the appropriate level of regulation required. Privately offered debt securities might be exempt from full public disclosure requirements if offered to only a limited number of investors (e.g. less than 30). Likewise, a special class of debt securities could be exempt from the disclosure requirements applicable to a public offering if the security is made available only to a limited number of sophisticated investors which are clearly defined in terms of size, income, or other objective criteria (e.g. U.S. 144A offerings to Qualified Institutional Buyers).

Element 8: For the vetting of applications for exemption of securities from public offering disclosure requirement, there should be objective criteria to differentiate between public offering and private placement and to distinguish sophisticated institutional investors from other investors.

32. Institutional investors and contractual savings institutions are important investors in the bond markets, but they will not flourish without public confidence in their soundness. They might best be regulated by the application of high prudential standards and governance principles that recognise the importance of fiduciary obligations. This might include such concepts as the "prudent man rule" which is widely employed in the U.S., U.K. and in a number of other countries to give guidance in the administration of fiduciary obligations. Under this concept, a fiduciary would be expected to discharge his duties with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.

33. Another way to regulate institutional investment and contractual savings is by employing investment guidelines administered by regulatory authorities such as an insurance commission or the supervisor of pensions. In devising such investment guidelines, regulators often rely upon an external credit assessment provided by credit rating agencies, but as discussed later in Chapter Five, care needs to be exercised when incorporating reference to credit ratings into rules and regulations. Also, high fiduciary and prudential standards should be used to supplement the use of investment guidelines. How institutional investment is regulated has implications for investor protection, bond market efficiency, and development.

Element 9: The regulation of institutional investment and contractual savings institutions should include good governance principles that promote high fiduciary standards in the provision of trust and investment management services.

Transparency, Efficiency, and Fair Markets

34. In view of the diversity of bank and non-bank participants in the bond market, defining roles, responsibilities, and objectives of the relevant regulatory authorities is essential for a well-organised market. Defining respective roles and responsibilities to minimise overlap and conflict is sometimes complicated by the existence of financial conglomerates that engage in banking, securities, and other financial services as well as serving in the capacity of dealer or broker in debt instruments.

Element 10: Clarity in the roles, responsibilities, and objectives of the regulatory authorities is essential in maintaining transparency and public confidence, as well as in reducing the potential for gaps and overlaps in the coverage of regulation and supervision. An open and transparent rule making process is necessary to encourage public comment and to facilitate compliance.

35. Transparency in secondary market price reporting and trading activity is important to the valuation of securities. It contributes to pricing efficiency and thereby aids in establishing a market-based yield curve. Securities market surveillance and reporting is normally the front line responsibility of the stock exchange or dealers association as a self-regulatory organization (SRO), with a securities commission or similar regulatory body acting in an oversight capacity. Price and volume information may be more difficult to obtain if trading primarily takes place over-the-counter among institutional investors.

36. The appropriate level of disclosure of large exposures and position concentrations, risk management techniques, and the use of derivatives by market participants can be useful for enhancing market transparency and stability. It can also help impose strong market discipline on an institution to manage its activities and risk exposures in a manner that is both prudent and consistent with stated business objectives. This will reduce counterparty risk and improve the safety of secondary market operations.

37. A properly functioning debt securities market requires that objective criteria be established and adhered to for the listing and de-listing of debt securities on the stock exchange or other trading facility. In some less developed markets, de-listing standards are not always enforced out of concern for possible adverse effects on investors. However, this can also contribute to a loss of confidence in the market in the event that sound corporate governance principles or financial reporting obligations are not being observed.

Element 11: Regulation should promote transparency in trading and price reporting and to deter manipulation and unfair trading practices. Where debt securities are listed on stock exchanges or other trading facility, objective criteria for the listing and de-listing of debt securities should be established.

38. All intermediaries should be registered, regulated and supervised by an appropriate regulatory authority and uniform standards applied to all market instruments and intermediaries. It is important to prevent regulatory arbitrage between products and markets. This requires adequate procedures for monitoring compliance and enforcement of applicable rules and regulations. An open and transparent rule-making process can help clarify the roles, responsibilities, and objectives of regulators. There should be adequate notice of rulemaking. In this regard, financial regulators should consider having a formal announcement of proposed rule-making on a regular basis in a government gazette, register or similar publication which would be accompanied by the text of the proposed rule or rules inviting public comment for a specified period of time. If adopted, the text of the final rule should be published with advance notice specifying the date for initial compliance.

39. The regulation and supervision of intermediaries can be enhanced with the aid of SROs and an internal compliance office within the firm. Particularly challenging tasks for emerging markets include coming to grips with the special problems associated with mark-to-market accounting and the need to evaluate credit risk in an environment where the quality of information disclosure may not be sufficient to meet market needs.

Element 12: All intermediaries should be registered, regulated, and supervised by an appropriate regulatory authority. The regulatory authority should establish uniform regulatory, compliance and enforcement standards for intermediaries. In general, the authority should as far as possible strive to avoid impeding market innovation through their regulatory measures. When different regulatory authorities are involved in the regulation of intermediaries, there should be enhanced co-operation between these authorities to avoid unnecessary duplication and overlap. SROs can be effectively used to enhance the regulation of market intermediaries.

40. Laws and regulations should make a clear distinction between bank deposit, deposit substitute, money market instrument, and longer term fixed-income securities issued in the form of notes or bonds. This is important in the context of allocating regulatory responsibilities, the taxation of financial instruments and, in some instances, for the establishment of reserve requirements at deposit-taking institutions. The legal definition of debt securities would normally cover notes and bonds with maturities of one year or more but it could also include short-term debt instruments such as commercial paper. In this regard, commercial banks tend to play a larger role in the money market and government securities markets while investment banks, merchant banks, and securities firms more often serve as intermediaries in the capital market for private debt and equity securities. With respect to dealing (i.e., acting as market maker) in government debt securities, both commercial banks and non-bank dealers and brokers commonly play a significant role in the market. The use of the stock exchange or a bond dealers association as a front-line SRO with government oversight would also meet this criterion.

Element 13: The legal and regulatory framework should clearly differentiate between bank deposits, money market instruments and debt instruments and set out the respective applicable regulatory regime. It is important to define debt instruments carefully to avoid the creation of potential regulatory gaps or unequal regulations of similar financial products.

Maintaining Stable Markets and Minimising Risk

41. Credit ratings are often used as a regulatory tool. One of the most important risks for bond market participants is a potential default in the payment of principal and interest on fixed-income securities. It is important that regulators have adequate criteria for recognition of a credit rating agency. In this regard, the Basle Committee on Banking Supervision in its June 1999 consultative paper on a New Capital Adequacy Framework suggested that regulatory authorities responsible for supervising external credit rating institutions (i.e. credit rating agencies), evaluate such institutions taking into account objective criteria, including:

1. objectivity,
2. transparency,
3. credibility,
4. international access,
5. adequacy of resources, and
6. recognition by a national regulatory supervisory authority using criteria (a) through (e).

Element 14: Sound criteria should be established for external credit assessment institutions used in the administration of prudential and other regulatory standards.

42. Stock exchanges, dealers associations, clearing organisations and others perform self-regulatory functions. Different approaches are found in different countries. For SROs to be effective, the government regulatory authority must have a clear legal mandate to exercise oversight to ensure that the front-line regulator (the SRO) performs its duties in a competent, fair and transparent manner. SROs should also be encouraged to implement strong codes of conduct for their members.

43. In general, the key elements of effective self-regulation would include:

1. the capacity to enforce compliance with applicable laws and regulations and SRO rules;
2. a governing structure that reflects the public interest and provides fair representation of the SRO membership;
3. rules designed to protect investors and facilitate the efficient execution of transactions;
4. rules that do not impose unnecessary burdens on competition;
5. a fee structure that is reasonable and allocated equitably among members, issuers, and other users of SRO facilities;
6. the capacity to conduct enforcement and implement disciplinary procedures that are fair;
7. the ability to impose sanctions on members for rules violations;
8. the capacity to train market professionals and educate investors; and
9. a clear legal mandate for the government regulator to ensure that the SRO is properly meeting its obligations to investors, issuers, and members.

Element 15: There must be a clear legal mandate for the government or the regulatory authority to exercise appropriate and adequate oversight in order to ensure that self-regulatory organisations are performing their duties in a fair and transparent manner. Good governance of self-regulatory organisations, for example, balance of interest between members and non-members, should also be encouraged to instil confidence in their regulatory and disciplinary functions.

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