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Chapter 4
Liquidity
1. A liquid market can be broadly defined as one where participants can rapidly execute large-volume transactions with a small impact on prices. Liquid markets tend to be characterised by several standardised bond lines with large volumes on issue relative to the average market transaction size.
2. Bond market liquidity is important because it affects the operation of monetary policy and contributes to financial stability. Outright purchases and repos of securities are important instruments of monetary policy. If market liquidity is not sufficient, central banks might not be able to provide or absorb the necessary amount of funds smoothly through their open market operations. This could produce unintended effects such as excessive price volatility.
3. In addition, bond market liquidity facilitates instruments of financial intermediation, which encourage efficient market pricing, as well as economically efficient borrowing and investment decisions. A liquid market for raising cost effective debt financing on demand provides a valuable financial flexibility. The value of developed debt financing infrastructure is embodied in its liquid issues, the composition of the yield curve, the range of funding instruments and the range of investors. It provides the issuer with a ready capacity for prudent management of its funding risk (i.e. the risk of being able to raise funds as required without penalty). While an issuer could if necessary still raise funding without such infrastructure, a large premium would have to be paid over a long period of time, until the infrastructure was established.
4. Lack of bond issuance is a key reason why many domestic bond markets are illiquid. Many governments have little need to issue bonds because they have generally run budget surpluses. In addition, many companies have preferred other funding sources over bond issuance. Where issuance activity is low, features that could augment bond market liquidity, such as market makers and derivatives markets, tend not to develop. A weak local institutional investor base has also been an impediment to the development of liquid domestic bond markets.
5. This chapter addresses the key elements that would assist in enhancing the liquidity of domestic bond markets. The elements are benchmark yield curves, transparency, market structure and conventions, market access and derivatives markets. It is also recognised that there is some circularity in the development of liquid bond markets in that a critical mass of issuance is required to generate liquidity. However, liquid markets are required for issuance of significant volumes of bonds.
Benchmark yield curve
6. A key feature of liquid bond markets is a benchmark yield curve that is comprised of the yields on several standardised bond issues. Standardised bond issues that are simply structured (e.g. have no redemption or call features) are more easily understood by market participants and can be more readily priced. Therefore, they are more likely to be successfully traded.
7. It is important to note that where funding is not required, bond issuance would imply asset accumulation and management. The tension that arises when governments have no current or prospective funding need but wish to develop the domestic bond market was noted in Chapter One.
8. Accurate and reliable benchmark yield curves promote financial efficiency and use of instruments of financial intermediation. Market participants are more able to appropriately price and hedge other traded financial assets. Certainty about reliable pricing for bonds in the domestic market encourages investors and intermediaries to participate, making it easier for issuers to raise funds domestically.
Element 24: Accurate and reliable benchmark yield curves enable market participants to appropriately price the credit and liquidity of domestic debt issues.
9. Ideally, each benchmark maturity should have a volume of bonds on issue that is sufficiently large relative to the market's total size and the market's average transaction size. By reopening maturities after initial issuance, issuers can create larger benchmark lines and therefore have less market fragmentation without paying risk premia to dealers subscribing to large amounts of securities at one time. Regular issuance into benchmark bond maturities along the entire yield curve also assists the price discovery process, which facilitates the pricing of bond market transactions.
10. Re-opening benchmark lines, however, does increase the likelihood that issuance will be into a benchmark with an 'out of market' coupon, which may be less desirable for investors. In addition, issuance into a benchmark line that already has a large volume on issue may not be successful because there may not be sufficient additional investor demand for that line.
11. There are ways in which the issuer can act in the secondary market to improve the liquidity of the benchmark yield curve. The issuer may facilitate switches by dealers who are seeking to trade in more liquid issues, reducing problems relating to the fragmentation of issues. In addition, the issuer might intervene to purchase maturing bonds before the maturing date and sell new issues, reducing the risk of disruption of refunding operations.
12. Liquidity in bond markets is enhanced when there are liquid benchmark bond lines at key points along the yield curve, for example, 1 year, 2 years, 5 years, and 10 years, although the precise maturities that are important may vary between individual markets. This characteristic facilitates the pricing and hedging of bond market transactions, by catering for investors' varied time horizons.
13. Apart from being liquid, the benchmark bond lines at key points along the yield curve would also need to be appropriately spaced. If the gap between benchmark bond lines is too great, it becomes difficult to accurately price instruments with a maturity somewhere between the benchmark bonds.
14. Once established, a yield curve's length should be maintained by issuance of a new long dated line as appropriate. For example, if the length of the yield curve is around 10 years, a new 10-11 year maturity should be issued in time for its liquidity to be built up before the term to maturity of the existing 10 year benchmark shortens too much.
Element 25: A number of measures could help to build up an accurate and reliable benchmark yield curve. These include regular issuance of bonds at appropriately spaced benchmark maturities along the entire yield curve in order to build up liquidity, large volume issue or suitable re-opening of bond issues to maintain liquidity, and issuance of new bonds of long maturity to maintain the length of the yield curve.
Transparency
15. The availability of information on issuer decisions and actions and on market conditions enables better investment decisions to be made and assists the formulation of government policies. This encourages market participation and therefore liquidity directly, because investors are able to confidently compare information across markets and time. The transparency of relevant public policy also promotes market development.
Primary bond market
16. The interest of intermediaries and investors in a market, and hence market liquidity, is likely to be enhanced when the general strategy of an issuer is known and understood and where any changes in that strategy are communicated in a timely fashion. This may include issuers providing an issuance schedule, an indicative issuance programme, target issuance volumes for bond maturities and intervals between benchmark bond lines.
17. If issuance intentions are pre-announced, market participants are able to formulate strategies to construct optimal portfolios, which is likely to increase interest in a market. Pre-announcement also facilitates when-if-issued trading which may enhance liquidity by reducing bidders' inventory risk at the auction and enabling security prices to be tested in the market.
18. However, pre-announcing all issuance details well in advance of issuance may inhibit issuers flexibility to respond to changing market conditions and corresponding changes in the preferences of intermediaries and investors. For example, if the coupon of bonds is announced well in advance of issuance, changes in market interest rates may result in the bonds having coupon rates considerably 'out of market' which may be less desirable to investors. In particular, issuance strategies for less liquid markets may need to be more flexible to ensure market conditions are conducive to receiving the new issuance.
Secondary bond market
19. The relationship between liquidity and transparency in the secondary market is complex. On the one hand, if the market is too opaque and one cannot accurately see the current market value of securities, investors may exit the market because it would be difficult to accurately value their portfolio. However, if the market is too transparent and the information on order flows is immediately disseminated, some large investors may be deterred from participating in the market for fear of revealing private information. Therefore, it is desirable to protect anonymity of market participants when disclosing transaction information.
20. There may be a role for regulatory monitoring of compliance with transparency standards. Even if severe market corrections occur only rarely, they serve to indicate that at least in the short term markets do not always take account of all relevant information that may or may not be available. In the longer term, markets can enforce transparency through rewarding those participants who comply with recognised and accepted standards and penalising those who do not.
Element 26: Measures should be taken to enhance transparency in the primary and secondary markets to promote market participation, and hence market liquidity. For example, disclosure of information about the general issuance strategy could help market participants to formulate their investment strategies. Also, trade information in the secondary market should be promptly disclosed to the public, with due attention to ensuring anonymity of market participants.
Market structure and conventions
21. There are several market structures and many more conventions that can be adopted. For example, trading infrastructure can comprise over-the-counter (OTC) and/or exchange-based trading. OTC trading can comprise either a primary dealers structure or a market making community. It is important that the structures and conventions that best suits the circumstances of the individual market evolve and that they remain open to change as the market develops. In particular, appropriate market structures and conventions can minimise transaction costs. This is important because these costs reduce the return from trading, which in turn reduces the trading volume and therefore potentially the efficiency of the market.
22. Transaction costs arise partly because participants are fragmented across time and space. In a relatively thin market, one way to cope with serious fragmentation is to restrict trading to certain periods. This allows orders to accumulate and be matched more easily. It also spreads costs by creating economies of scale. Where orders are more frequent and more easily matched, continuous trading may be possible. This allows more flexible trading strategies to be adopted and generates more frequent updates to market conditions, which increases the flow of information.
23. Frequency of issuance also impacts on market liquidity. Frequent issuance can help to reduce the potential disruption to the secondary market as well as the level of execution risk borne by issuers. Less frequent issuance, however, may encourage dealers to be more active in promoting new issues and maintaining secondary market liquidity.
24. Encouraging the emergence of competing dealers by granting certain privileges (such as the right to bid for stock in the primary market) to a group of qualified entities may also help the liquidity of a market although there should be regular evaluation of the respective costs and benefits of this practice. The existence of a recognised group of intermediaries can increase confidence in the market, which increases the order flow and consequently the dealers become more profitable and are able to support more continuous trading. Primary issuance can be significantly assisted by dealers providing underwriting support.
25. Standardised trading and settlement processes which are efficient and reliable should enhance liquidity by mitigating market fragmentation, thus reducing transactions costs and increasing effective supply without having negative effects on market participant heterogeneity. Standardisation of practices over the universe of fixed-income securities may see the manifestation of demands for arbitrage and hedging transactions, thus improving market liquidity.
26. Tick size, the minimum increment in quoted prices/yield, may affect the level of market liquidity. Too large a tick size is harmful to market liquidity because matching supply and demand is more difficult. Too small a tick size may increase operational costs.
27. Transaction taxes are an explicit cost of trading and normally decrease market liquidity. Authorities should count the liquidity impairing effects of these taxes against any revenue they might raise. Withholding taxes on the interest of marketable assets tend to increase transaction costs such as the need to calculate and adjust for accrued interest and may therefore deter investors.
Element 27: Transaction costs should be kept low to enhance trading activities. This can be achieved through maintaining a competitive dealer structure for trading activities and standardising trading conventions and settlement processes. The liquidity impairing effects of taxation should be minimised.
Market Access
28. A market with diverse participants, with a variety of transaction needs and investment horizons, willing and able to buy and trade, is also important in enhancing market liquidity. For example, liquidity would be enhanced by the lifting of regulations which prevent particular investors (for example non-residents) from participating in a market. In this regard, wider financial deregulation to allow greater participation in the financial sector may be important for increasing liquidity in bond markets.
29. A potentially important impediment to market access is lack of information about the structure and functioning of the market. Publication of relevant information generally aids participation and hence liquidity.
Element 28: Market access should be available to diverse participants. Heterogeneity of market participants with a variety of transaction needs and investment horizons would promote liquidity.
Derivatives markets
30. The functioning of related markets can both enhance, and be enhanced, by a liquid bond market. Accurate and reliable benchmark yield curves are capable of underpinning bond futures and other derivatives markets, for example interest rate swap markets. These markets provide additional hedging options for market participants. All other things being equal, liquidity in bond markets will be greater if interest rate risk management is easier for market participants.
31. Repo markets are also supported by accurate and reliable benchmark yield curves. These markets enable intermediaries to finance long positions and to create short positions, allowing them to respond quickly to customer needs. Facilitating the taking of short positions improves the supply of tradable securities and makes bond markets more liquid.
32. However, the development of repo and futures markets may also provide some participants with opportunities for 'squeezing' the cash market. This possibility requires the monitoring of cash, repo and futures markets and entering the markets as necessary, such as through a security lending facility to temporarily alleviate shortages of stock. Measures may include limiting the short selling of financial instruments through increasing margin requirements and preventing short selling below the best offer price.
Element 29: Consideration could be given by the relevant authorities to developing related markets and facilities such as futures markets, swaps markets, repo markets and securities lending facilities as appropriate to facilitate different investors in constructing their investment portfolios and risk management strategies, hence increasing liquidity and trading activities.
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