Development of Private Repo Market Seminar material

Japan – ASEAN Financial Technical Assistance FundTechnical Assistance for Developing Bond Markets in Thailand Development of Private Repo Market Seminar material 21st February, 2007

Active Private Repo market is crucial to liquid bond market Misunderstanding of perception of risks of repo Low understanding on repo Misunderstanding of perception of profits andcosts of repo Low use of repo Flexible and easy BOT repo (to be closed thisyear) Low needs of repo Regulatory environment. Market environment: lowering interest rate, flat yield curve and low demand of funds

Size of Thai money market • Size of Thai money market is small compared to Japan (as proportion against banking sector asset). • Especially, size of interbank borrowing and lending is small, while repo with central bank being relatively large. Note: Average during 2006. Thai data includes commercial banks, and Japanese data includes domestic banks.

Structure of Thai money market Guaranteed deposit (incl. from fin. Institutions) Short-term lending (bilateral repo, BOT repo) Bank of Thailand Buying/ selling of dollar mixed with currency swap Mid-term swap (1 yr) Larger Domestic Banks Short-term lending (mostly O/N clean loans) Short-term lending (bilateral repo, BOT repo) Foreign Banks Smaller Domestic Banks Securities Houses Nonbanks Short-term debentures Short-term lending (mostly O/N clean loans) Investment Nonbanks (some) Insurance Pension GSB Funds

Overviews of money position of banks • Most banks are in net lender position, although two banks are net borrower in interbank and money market, mostly through short-term USD asset holding. • Domestic banks utilize currency swap market whereby they mostly sell baht spot and buy USD. • However, some banks are still in net borrower position, or in a small lender position, which might create liquidity concerns during crisis. Interbank and Money Market Items plus Repo with BOT (million baht) (Note) As of September 2006 (9 months financial statement). List includes all banks operating in Thailand except for foreign banks and retail banks.

Structure of interbank marketConcentration on short-term • Statistics show that nearly 80% of interbank transactions are either O/N, T/N and call, being very short-term in nature. • Although net borrower banks usually wishes longer term borrowing (according to interviews), these needs are not met. • In Japan, proportion of overnight loans (in comparison with term loans) has ranged from 30% (2002) to 60% (1998). Interbank Outstanding in Thailand

Structure of interbank marketMost transactions are non-collateralized • According to interviews, among the interbank loans outstanding, almost all of them are clean (non-collateralized). • “Collateralized” loans seem to be limited to “buy/sell-back” type of transaction. • In Japan, around 54% of call loans are with collateral. Proportion of collateralized loans among call loans (Note) Thailand’s data is based upon market interviews, and not based on statistical facts. Japan’s data is as of Sept. 2006.

Repo players (present and potential) in Thailand

Potential repo players in Thailand • Players with sufficient government bond holding are potentially eligible for repo (for borrowing). • Government bond holders are not limited to banks, but include insurance and “other” institutions, which might mean diversity of holders base (Table A). • For middle and small sized banks (= ex-top 4), most of them (except for new comers such as TISCO and KK) have as much government bonds as the amount of interbank borrowing amount, which means opportunity for them to utilize repo when borrowing (Table B). Unit: million THB Table A Average of July – December 2006 Bonds available for repo Table B Financial statement data as of Sept. 06 and “bank only” (not consolidated) basis

Scope of analysis • Analysis 1: Risk analysis • Analysis 2: Profit analysis • Analysis 3: Manipulation analysis Potential profit of repo Guaranteed deposit (incl. from fin. Institutions) Short-term lending (bilateral repo, BOT repo) Bank of Thailand Buying/ selling of dollar mixed with currency swap Mid-term swap (1 yr) Potential risk of not using repo Larger Domestic Banks Short-term lending (mostly O/N clean loans) Potential needs for repo (Borrowing of specific securities & short-sell) Short-term lending (bilateral repo, BOT repo) Foreign Banks Smaller Domestic Banks Securities Houses Nonbanks Potential profit of repo Possibility of manipulation by short-selling Potential profit of repo Possibility of manipulation by short-selling Short-term debentures Short-term lending (mostly O/N clean loans) Investment Nonbanks (some) Insurance Pension GSB Funds

Key results of analysis • Large banks may manage to refinance even when there is market crisis (e.g. whereby credit lines given to the bank by counterparties decrease by 55%). Analysis 1 Risk Large banks • These parties may not be able to refinance and thus cannot survive when there is market crisis (e.g. these banks can only refinance O/N position when credit lines given to the bank by counterparties decrease by 55%). Smaller banks Securities houses Nonbanks • As short-term investment tool, banks, funds and institutional investors may earn 1.5 times larger profit by repo (30 days) compared to clean loan (O/N rollover) during steeper yield curve (e.g. 2.42% p/a on net basis*, March 2003). Analysis 2 Profit Management of cash • By borrowing O/N and lending 30 days by repo for 300 million baht, bank, funds and institutional investors may earn 144 thousand baht during steeper yield curve (e.g. 0.59% p/a on net basis*, March 2003). Carry trade • By lending bond by repo and reinvest the cash collateral 60 days for 300 million baht, banks, funds and institutional investors may earn 102 thousand baht (e.g. 0.42% p/a on net basis*, March 2003). Securities lending Analysis 3 Manipulation • Single transaction would not move the price of the whole market. • However, when there are changes in fundamental factors, adjustment (correction) may happen triggered by large transactions (which appears to be “manipulation.” * Net basis: profit per annum after subtracting SBT and TSD fee, and adding extra profit from spread between borrowing and lending (in case of a credible party lending to a less credible counterparty).

Analysis 1: Risk

Analysis 1:RiskBenefit of repo against risk • Repo can almost eliminate counterparty credit risk. • Thus, repo will enable lending/borrowing for longer-tenure, in comparison with clean loans. • In Japan, 25% to 30% of repo are “term” transactions (longer than O/N). Clean loans Lender Borrower Credit risk Repo Credit risk to the counterparty is transformed into the risk of price change and credit of collateral (T-bond). Lender Borrower Collateral

Analysis 1: RiskAssumed merits from repo to mitigate risk * Level of risk is also relevant with BOT’s policy on emergency loans which might be supplied to banks under crisis.

Analysis 1: RiskStress environment: some banks may fail to roll over • Under stress, Thai banks need to rely on (i) intimate counterparties, and (ii) sales of tradable assets in order to access to financing. • Intimate counterparties may also be in stress. Usually, stressed banks have to rely on collateralized loans. • Sales of assets is restrained by, due to stress, the decline of price or difficulty of selling large volume at once or within one day. • In Japan, the late 1990s seen several cases of bank default, with some large banks deflating due to failure in debt rollover. Experience of 1997 crisis in Thailand During the 1997 crisis… • Market in general was tight with two-digit interest. • Large banks had affluent liquidity, thus were ready to lend out short-term money • However, borrowers, including foreign banks, had difficulty in terms of cost and volume, due to • Absence of money market brokers that match the demand and supply. • Thus banks need to negotiate with each bank with time and cost. • Implication: • Market structure has not changed much after the crisis (subdivision of market between large liquid banks and smaller borrowing banks, and lacking of intermediary except for BOT). (Source) NRI’s schematization based on public sources.

Analysis 1: RiskCountermeasures for liquidity risk • Smaller local banks, nonbanks and securities houses tend to be in less advantageous position in liquidity risk management. This means they would be better off using repo (if they have enough government bond holding). Intimate counterparty Sellable liquid asset Access to swap market Foreign bank Not enough holding to cover borrowing YES YES Enough holding to cover borrowing Large local bank YES YES Not enough holding to cover borrowing Smaller local bank YES YES NO Some nonbanks / securities houses: Not enough holding to cover borrowing Nonbank Securities house YES

Analysis 1: RiskPremises of calculation • Premises of calculation: • Stop of new lending in interbank and money if liquidity crisis happens • Borrowings will be made so as to finance the day’s cashouts (debt payment). • Items other than interbank and money market items are assumed to be no change

Analysis 1: RiskAssumption of credit lines for two types of bank • Premises: • All credit is on clean basis (for PD and non PD without repo), with 75% O/N and 25% T/N. • Credit limits of PDs are assumed to be 3 times larger than current outstanding. • Credit limits of non PDs are assumed to be the same as current outstanding. • Credit limit of non PD with repo are: clean loan limit is 95% of clean loan limit of above (considering the additional exposure due to possible price decline of repo collateral bonds (here assumed as 5%) as clean exposure), and repo credit limit is the same as the clean loan limit above, and this limit decreases to 3/4 in crisis. • Credit limit from BOT is set at the maximum level during the past 7 years, and is not supposed to decrease during crisis. • BOT repo is removed. Credit line and sellable asset of PD Credit line and sellable asset of non-PD (without repo) Credit line and sellable asset of non-PD (with repo) Unit: million THB

Analysis 1: RiskAssumption of present liabilities for three types of bank PD’s liabilities (money market) Non-PD’s liabilities (money market) Non-PD with repo liabilities (money market)

Analysis 1: RiskSmaller banks may not be able to fund current position • If there is a liquidity crisis, whereby (1) credit limit decreases to 55% of usual (except for BOT), and (2) sellable gov't bond value to decrease by 30%, non-PDs will face liquidity shortage. • Result depends on credit limit given to such non PDs. If they fully utilize the limit that they are given, then difficulty becomes large. Amount payable and funding and net position of non PD (Normal times) Amount payable and funding and net position of non PD (Crisis times) Cannot fund overnight position by 50 million THB Unit: million THB

Analysis 1: RiskNon-PDs funding situation • Under the calculation premises adopted, non PDs are not able to refinance T/N position if credit limit decreases to more than 55% (in times of liquidity crisis). • Note: Non PDs may survive with the issuance of short-term debentures, if (a) the non PD is credible enough to issue such papers, and (b) preparation period is shorter than the length of survival. Percentage of credit risk limit decrease and corresponding survival days Unit: million THB

Analysis 1: RiskEffects of repo for non-PDs • If non-PDs can utilize repo, they will be able to fund even in liquidity crisis. • They can extend the borrowing tenure. • They can avoid the sudden decrease or closure of credit line given from commercial banks. Amount payable and funding and net position of non PD using repo (Crisis times) Survive much longer Unit: million THB

Analysis 2: Profit

Analysis 2: ProfitProfit Opportunities • According to NRI’s interviews with Thai market participants, preconditions for active repo market seem to be steep yield curve and relatively high interest rate. • If such preconditions have materialized, risk and opportunity costs of “not using repo” (but using other means) will also materialize.

Analysis 2: ProfitBenefit of repo in terms of profit and risk • Large banks and investors (with plenty liquidity) can benefit from cash management with repo (short-term investment). • If borrow O/N and lend longer tenure (carry trade; using repo), banks and investors can maximize the profit while minimize the liquidity and credit risks. • Liquidity risk (of rolling over O/N repo borrowing) depends on the liquidity of repo market. Profit from carry trade O/N borrow & 1M lend With repo * Liquidity risk depends on the liquidity of repo market O/N borrow & 1W lend Without repo O/N borrow & O/N lend Roll over availability (when crisis) T/N 1W O/N More than 60 days

Analysis 2: ProfitBenefit of repo in terms of bond lending #1 • Availability of “special collateral” repo market (“specials” market), whereby dealers can borrow specific series of bonds, is critical for dealers’ activities. • It is useful for (1) dealing with settlement fails, (2) hedging risks of position taking, and (3) speculation using short-selling. • Curing of fails is important for dealers’ activities: • Increased risk of large and/or chronic fails deter dealers from responding to clients’ orders with short settlement period, which actually happened in the U.S. in the 1960s (which was the motivation for the FRBNY to develop the lending facility). • Especially in times when the market is in heavy stress (due to exogenous shocks such as terrorism, or market shocks such as one-way price moves and lost liquidity), curing of fails is critical in facilitating market making activities. Dealers Need “Specials” Market for … • Dealing with Fails: which occurs by the following reasons: • Operational or system errors • Another fails, connected to one another and making “loop” or “daisy chain” • Low or lack of availability of specific bonds that needs to be delivered (e.g. in case of short-selling), including “squeeze” • Hedging risks of position taking • See “Analysis 3” (benefits of short-selling) • Speculation • Using short-selling

Analysis 2: ProfitBenefit of repo in terms of bond lending #2 • Repo rate for “specials” is lower than that for “general collateral” repo (whereby the cash lender does not designate the specific series of collateral securities). • Especially when the demands for specific bonds are high, the rate will be lower (sometimes below 0%), which implies that the lending fee is higher. Price Difference of “Special” and “General” Repo Repo Interest Rate • Spread can be considered a fee for borrowing a specific security • “General collateral” repo rate ≒ Overnight basic interest rate • “Special collateral” repo rate 0% • Sometimes rates get high when the bond is not readily available in the market • Unusual stress of the market, which accompanies critical short squeeze or chronic fails

Analysis 2: ProfitCurrent possible earnings from repo-related transactions • Level and steepness of yield curve changes the profitability of transactions using repo. • High yield: good for management of cash and securities lending • Steep yield: good for carry trade, mid-short term management of cash and securities lending Assumed Yield Curve (1) Flat Case Observed in Oct. 2006 Assumed Yield Curve (2) Steep Case Observed in Mar. 2003

Analysis 2: ProfitAssumption • Calculation assumes the profit amount of a large bank (PD) for transaction tenures of 1, 7, 30 and 60 days. • Repo • Lending: to smaller banks, BOT repo rate + 25bp • Borrowing: from large banks, BOT repo rate + 5bp • Clean loan • Lending: to smaller banks, interbank rate (published by BOT) + 20bp • Borrowing: from large banks, interbank rate (published by BOT) • Calculation includes the fee paid to TSD (for collateral management service of repo) and SBT. • SBT rate is calculated as 3.3%. This rate is expected to decrease according to the decision of the cabinet.

Analysis 2: Profit1. Management of cash • Under high yield, management of cash becomes easier and interbank lending earns as much gains as repo (because of lower interest of rolling over overnight, rather than term). • In addition, repo is with lower risk. • Under steep yield, repo can earn much more gains than interbank lending (O/N rolling over). (Note) All calculations here assumes repo trades with value of 300 million THB. SBT and fee for TSD (in case of repo) is already deducted from earnings. Flat Case Steep Case Tenure (days) Tenure (days)

Analysis 2: Profit2. Carry trade • Under steep yield curve, profitability of carry trade (funding short-term and lending longer term) greatly increases. • Here we assume the case of a PD, whereby borrowing yield is lower than lending yield (because of credit differentials between the PD and the counterparty borrower). • Below case shows the profit of a carry trade whereby a bank borrows O/N (rollover) and lends at term (7 to 60 days) with the transaction value of 3 million baht. Profitability of carry trade reaches higher in the case of March 2003, when the yield curve was steep. Profit of carry trade Tenure (days)

Analysis 2: Profit3. Securities lending • Combination of bond lending and cash management (using the cash obtained from bond lending) would earn high profit if yield level is high. • The profit come from (i) bond lending fee (assumption is 30bp p/a, according to Japan and US markets experiences), plus (ii) the spread between borrowing and lending yield (here we assume the case of a large player, whereby cash borrowing yield is lower than cash lending yield (because of credit differentials between the bond lender (cash borrower) and the counterparty). Profit of securities lending and cash management Tenure (days)

Analysis 3: Manipulation

Analysis 3: ManipulationAssumed impact on bond market • Single transaction would not move the whole market price. Thus generally, manipulation risk with bond lending and short-selling is negligible. • When there is price change, it mostly affect all series of bonds, which is not possible with just a single transaction. • However, when there are changes in fundamental factors, adjustment (correction) may happen triggered by large transactions. • If the transaction is unusually large (e.g. 500 million THB), there is a possibility that this could be realized by short-selling (although same thing can be done with long-selling as well). • This might appear to be “manipulation” to some players.

BOND A BOND A Principal Amount 10 billion Market Value @\99 Principal Amount 10 billion Market Value @\99 Analysis 3: ManipulationBetter price discovery by short-selling #1 • Without short-selling, the dealer would show the price much higher (for selling) / lower (for buying) than the market value, in order to avoid the risk of position taking (either short or long). Request for selling Request for buying * Assume the dealer is supposed to keep its position square for both cases.

Analysis 3: ManipulationBetter price discovery by short-selling #2 • For dealers, short-selling is essential for (1) making markets, (2) taking positions and (3) making deliveries.

Analysis 3: ManipulationBasic questions related to “manipulation” ? Question 1 • Is it possible to manipulate the price of a single series for long time, apart from the market level? Question 2 • Is it possible to manipulate the whole market by a few transactions, apart from fundamentals?

Analysis 3: ManipulationOverview of bond market in the past • There are three cases of large price movements in one day (20~30bp move), which may be explained either by (i) changes in stock market, (iii) changes in forex market, and (ii) other changes in fundamentals.

Analysis 3: ManipulationOverview of bond market in the past • Daily yield changes exceed 20 bp on the following dates: • October 10, 2003 • November 6 to 14, 2003 (intermittently) • November 26, 2003 • December 17, 2003 • April 5, 2004 • May 10, 2004

Analysis 3: ManipulationQuestion 1: Move of single series may not impact much. • In either cases, yield moves of single series have strong correlations with the moves of other series. • Although T-bills have weaker (but still strong) correlations. • Also, there are no cases whereby the price of a single series moves by over 20bp and others by less than 10bp. • Therefore, price fluctuation tends to occur in the whole market, rather than for a single series. Correlation of yield moves of T-bills and T-bonds in October * Date here indicates maturity date of the series.

Analysis 3: ManipulationQuestion 1: Generally, it is difficult to change whole market • In many developed countries, government does not have any pre-trade restrictions for short-selling of bonds, because: • Impacts of speculative activities are limited for bonds (see below) • Restrictions tend to discourage trading * The Bond Market Association (TBMA) notes that “bond markets generally are not as susceptible to the types of abuses that the short sale rules are intended to prevent,” mainly because “bond prices (particularly in the investment grade context) depend significantly on applicable interest rates and are less likely to be affected by short selling activity.” (TBMA, “Re: File No. S7-23-03, Short Sales”)

Analysis 3: ManipulationQuestion 2: Comparison with market fundamentals #1 • Market fundamentals was not directly affecting the yield moves. • However, during this time, market uncertainty exist due to the following factors, which is assumed to have added the volatility of price under year end effect. • US interest rate hike (from June), corresponding shift of fund to foreign markets from Thai, large supply of corporate bonds, expectation of policy rate hike. • Fundamentals, in some cases, cause delayed (but large) reaction to the whole T-bonds market in Thailand. Comparison with shorter maturity paper, stocks and policy rate Comparison with exchange rate Note: BOT Monetary Policy Committee held in Oct. 28 FOMC held in Oct. 28

Analysis 3: ManipulationQuestion 2: Comparison with market fundamentals #2 • Market fundamentals do not seem to be affecting the yield moves. Comparison with shorter maturity paper, stocks and policy rate Comparison with exchange rate Note: BOT Monetary Policy Committee not held during this period FOMC not held during this period

Analysis 3: ManipulationQuestion 2: Comparison with market fundamentals #3 • On October 10, 2003, yield of government bonds has risen as much as 31 bp, which mean the fall of price, as follows. Intraday price movement of three most liquid T-bond series Between dealer and investor Wash trades? Dealer to investor

Steps to vitalize private repo • Smooth elimination of BOT repo and utilization of PDs • See next page. • Enhancement of risk management of banks, nonbanks and securities firms • Management of liquidity risk (not relying heavily on O/N clean loans) • Management of credit limits (lines) based on risks (e.g. setting different standard for clean loans and repo) • Smooth migration into deposit insurance scheme for banks • In order for banks to focus more on credit risk management. • Harmonization of repo standards between banks and asset management companies and clarification by both SEC and BOT • Lessening of restriction for funds to enter into reverse repo (expected to be announced by SEC soon) • E.g. Setting guidelines referring to available reference prices, maximum tenure, etc.

(reference) Possible impact of BOT repo removal • Since most banks are in net lender position in the interbank and money markets, BOT repo removal may not directly change the liquidity risk of banks. • On the other hand, with the removal, lending patterns of non PDs will have to change. Some of the money previously lent to BOT will be shifted to other commercial banks, with (preferably) improvement of risk management styles and enlargement of credit limit. • Current credit limit of commercial banks may not be large enough to shift the lending from BOT to other commercial banks. Interbank and Money Market Items plus Repo with BOT (million baht) (Note) As of September 2006 (9 months financial statement). List includes all banks operating in Thailand except for foreign banks and retail banks.

Development of Private Repo Market Seminar material