Domestic Bond Markets

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.

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.

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.

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.

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.

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

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.

Market Infrastructure

Robust market infrastructure is indispensable for the smooth functioning of a debt market. These systems should be governed by clear and unambiguous rules and procedures that are soundly enforced and made freely available to interested parties. Such information would enable market participants to understand clearly their roles, responsibilities and liabilities. It also allows market participants to form clear expectations about the operation of the systems in times of stress and the financial risks involved.

An effective regulatory regime should be established to ensure overall systemic safety and stability of the market infrastructure. Various categories of risks should be properly addressed and controlled with the provision of relevant information on a timely basis and by shortening the settlement cycle. In order to achieve a high degree of reliability and integrity, contingency plans should be established for the potential failure of each critical component.

The following elements in relation to the market infrastructure for domestic bond markets have been identified.

Element 16: There should be clear and unambiguous rules and procedures that govern all aspects of the operations of a market infrastructure system. These rules should be made freely available to all interested parties with fair and open access to a system based on objective criteria.

Element 17: The legal enforceability of the system’s rules and procedures in all relevant jurisdictions should be established.

Element 18: An effective regulatory regime should be established with one or more institutions as appropriate, explicitly identified to ensure sound risk management and efficient operation of the systems.

Element 19: The risk management procedures should address the various categories of risks, including principal and liquidity risks. The introduction of delivery-versus-payment procedures substantially addresses the principal risk. Systems should ensure that suitable contingency arrangements are in place in the event that a counterparty is unable to settle an obligation when it becomes due.

Element 20: Assets used for final settlement should preferably not present the holder with credit risk, and where possible should take the form of a claim on the central bank.

Element 21: In order to reduce replacement cost risks, it is preferable for the settlement of trades to take place as soon as possible after the trade has been confirmed. A common benchmark is to ensure that settlement lags are kept to T+3 days or shorter.

Element 22: For effective risk control, systems need to provide relevant information to participants on a timely basis.

Element 23: There should be suitable contingency arrangements to handle system problems caused by internal operations or external service providers.

Liquidity

Bond market liquidity facilitates efficient market pricing as well as economically efficient borrowing and investment decisions. Certain key elements would assist in enhancing the liquidity of domestic bond markets. Accurate and reliable benchmark yield curves enable market participants to price the credit and liquidity of domestic debt issues appropriately. Certainty about reliable pricing for bonds in the domestic market encourages investors and intermediaries to participate in the market. The availability of information on issuer decisions and actions and on market conditions enables better investment decisions to be made and enhances the interest of intermediaries and investors.

A fully competitive trading structure and standardised trading and settlement processes which are efficient and reliable should enhance liquidity by minimising transaction costs. A market with diverse participants is also important in enhancing market liquidity.

The following elements in relation to the liquidity of domestic bond markets have been identified.

Element 24: Accurate and reliable benchmark yield curves enable market participants to price the credit and liquidity of domestic debt issues appropriately.

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 issuance 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.

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.

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.

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.

Element 29: Consideration could be given by the relevant authorities to developing derivatives 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.

Risk Management

Effective risk management by both the issuers and investors is important in fostering the development of domestic bond markets. This is particularly so for the government as the key issuer in the bond market. As a first step, a risk audit should be conducted to accurately assess the risks that an issuer faces. Vulnerability to market shocks could be reduced by properly managing the risks identified. As far as sovereign debt management is concerned, some simple rules for managing risks can be derived from a range of risk management frameworks. The asset and liability management (ALM) approach is one conceptual framework which can be deployed for dynamic as well as static risk management. With financial contracting, bond issuers can also reduce their risk exposure by transferring risks to other market intermediaries.

For an investor to effectively monitor, measure, and control the major risks related to fixed-income investments, a core set of sound risk management practices is a necessity and such practices should be promoted at least among the major public and private bond investors. The Board and senior management of institutions that invest in bonds should formulate sound investment and risk management policies. There should be clear delineation and segregation of duties and responsibilities between risk-taking and risk-monitoring, as well as robust internal control systems.

Credit rating agencies play an important role in bond market development. In order to enhance the credibility of credit rating services, governments should exercise care in designing rating-related policies. In general, governments should avoid setting minimum credit rating requirements for bond issuers and should carefully evaluate the potential implication for the financial system and financial market participants when considering any ratings-based regulations. Credit rating agencies should also be encouraged to maintain the highest possible level of transparency and objectivity in their rating process.

The following elements in relation to risk management for domestic bond markets have been identified.

Element 30: Governments as well as private issuers should conduct a risk audit to identify the exposure of its bond programme to various risk categories such as liquidity, maturity and currency mismatch risks, as well as risks arising from explicit and implicit government guarantees.

Element 31: Governments and private issuers should maintain a debt profile that provides protection against temporary market disruption. Simple rules relating to the maturity and currency structure of debt, and to liquid reserves, can be employed. At a later stage of development, the Asset and Liability Management approach can be used as a conceptual framework for dynamic as well as static risk management.

Element 32: Government and private issuers may try to conduct risk-sharing through financial contracting to hedge against the potential costs arising from adverse market conditions. They could consider using derivatives securities for this purpose but they should fully understand the risks involved and implement appropriate risk management systems.

Element 33: Bond investors should formulate sound investment and risk management policies, with clear delineation and segregation of duties and responsibilities between risk-taking and risk-monitoring, and robust internal control systems.

Element 34: Government should avoid setting minimum credit rating requirements for bond issuers in order not to divert issuance into unregulated channels that may ultimately raise the overall financial risk profile.

Element 35: Government should avoid an over-reliance on credit rating agency assessments and, when considering any ratings-based regulations, should carefully evaluate the potential implication for the financial system and financial market participants, including credit rating agencies.

Element 36: Credit rating agencies should be encouraged to maintain and improve their credibility and reputation by avoiding conflict of interests in their ownership, staffing and decision-making processes; allowing issuers to comment on draft rating opinions when possible; maintaining the highest possible level of transparency and objectivity in the rating processes; and publicly disclosing their policies on unsolicited ratings.

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