Legal and Regulatory Framework for Developing Domestic Debt Markets

1. Legal and Regulatory Framework for Developing Domestic Debt Markets June 8-11 , 2004 Colombo, Sri Lanka Noritaka Akamatsu Financial Sector Operations and Policy Dept. The World Bank

2. Characteristics of Govt Debt Market • Gov’t bonds are special securities. • Largely a market for professional participants. • Bonds are securities while being a close substitute to bank loans. • Banks are active participants while institutional investors are an important source of demand; • Who should regulate whom? • Settlement risks are a major concern due to the volume and size of transactions. • Only recently started being better organized with electronic trading and information platforms. • Etc.

3. Objectives of Securities Regulation- IOSCO - • The protection of investors; • Ensuring markets fair, efficient and transparent (efficient price discovery); • The reduction of systemic risk (maintenance of confidence in the financial system); Q. Do these apply to govt bond market as well as to corporate securities market?

4. IOSCO Principles • The Regulator • Self-regulation • Enforcement • Regulatory Cooperation • Issuers • Collective Investment Schemes • Intermediaries • The Secondary Market

5. The Uniqueness ofGovt Debt Market The special nature of government securities requires special regulations. • The issuer is also the regulator – conflict of interest? • MOF should retain certain rule making authority. • MOF may delegate other regulatory activities. • The securities are exempt from regular prospectus requirements. • No disclosure??

6. Legal Authority & Accountability --Who does what? MOF • Public Finance • Debt Management •  Legislation Primary market and primary dealers Financial Market Regulator Central Bank • Market intermediaries • Collective investment • Secondary market  Monetary Policy  Settlement systems?

7. Sources of Investor Rights • Budget and public debt law • Governmental audit law • Securities law • Central bank law • Bankruptcy law • Property ownership law • Secured transactions (or collateral) law • Contract law • Tax law • Capital repatriation law

8. Other important laws • Banking law • Insurance law • Pension law • Investment company law

9. Legal Components ofPublic Debt Management • Clear borrowing authority to issue public debt; • A description of the process by which the legislation enables the government to issue debt; • A description of the internal management process and the delegation of legal authority; • The legal status of the different types of government securities.

10. Regulatory Tools ofPublic Debt Management • Borrowing Limits • Gross or net? Net please ! • Internal Management • Transparency and Accountability (to the parliament) • Disclosure

11. Tool 1 - Borrowing limits • Legislations on a specific ceiling on total debt or net borrowing; • Net please ! • Requirement of specific approval for issuance by the legislature; • Not transaction by transaction please ! • limitations on government guarantees. • How about implicit guarantees?

12. Tool 2 - Internal Management • Defining debt management office’s role, function and organization. • Front office, middle office and back office. • Giving debt manager sufficient latitude, while ensuring accountability, to execute debt management efficiently. • Delegation of the borrowing authority to line officers (particularly those of the front office).

13. Tool 3 -Transparency & Accountability • Requirement of record-keeping and reporting; • Issuance and management of debt subjected to audit and internal control procedures. • Accountability ultimately to the parliament

14. Tool 4 - Disclosure • Disclosure on government’s financial condition, its future borrowing plans, etc.; • Special requirement on disclosure with respect to international issuance.

15. Tools for Debt Manager • Terms of instruments • Access to the market

16. Terms of the Instrument Government should have the authority to issue various bonds: • Issued as registered or bearer bonds; • But registered bonds … • Represented in physical or book-entry form; • But book-entry form • Have short-, medium-,or long-term maturities; • Coupon or discount or indexed. • Some callable,

17. Primary Market Access • Fair, not necessarily equal, access • Potentially justifiable cases of differentiated access and exclusivity: • Institutions with ability to settle and distribute. • Allocation to institutional investors • Primary dealer system Consistent with public debt management objectives?

18. Primary Dealer System • When is it useful? • Typical privileges and obligations: Privileges: • Exclusive participation • Exclusive counterparties for Central Bank Obligations: • Committed purchase • Market making • Obligations for PDs should be useful for MOF to meet debt management objectives while privileges should compensate the cost of meeting the obligations.

19. Legal and Regulatory Framework for the Secondary Bond Market

20. The status of “exempt securities” should not jeopardize the integrity of the secondary market. Effective regulation should include: • Regulation of market intermediaries • Prudential requirements • Regulation of the secondary market and self-regulation • Market conduct and surveillance • Transparency requirements • Secured transactions

21. Secondary Market Structure and Regulation Over the Counter (OTC) Exchange Electronic Trading System IDB Require intermediaries of post-trade reporting, record keeping, and audit trail requirement Impose requirements for reporting, record-keeping, fair access and risk management

22. Regulation of Market IntermediariesParticularly when market is poorly organized • Set minimum entry standards; • Require to comply with standards for internal organization and control; • Require initial and ongoing capital; • Require proper management of risk; • Require high standards of conducts; • Provide procedures for dealing with the failure of an intermediary. Q.Need special regulation for inter-dealer broker (IDB)?

23. Three-Tier Regulatory Approach Regulatory Authority • oversees broker/dealers and SROs to ensure compliance with regulations and directly regulates where necessary. SRO • regulates members and, where capable, enforces compliance with regulations and its rules, subject to regulation and supervision by the regulator. Broker/Dealer • has regulatory obligation to supervise employees and enforce compliance with regulations, SRO rules and its house rules.

24. Pros and Cons of SROcompared to government regulator Pros of SRO: • possess better expertise and more market information; • respond market changes more quickly; • are more familiar with the problems and more able to find solutions; • have more incentive to promote information sharing among members.

25. Cons of SRO • An SRO might transform into a cartel and jeopardize competition, • Unable to enforce its rules and impose sanctions for non-compliance due to conflict of interest, • Scarcity of institutional and human resources may constrain the quality of oversight; • With limited competition in securities markets, SROs not enough to ensure safe and efficient markets.

26. Oversight on SRO • Ensure that SRO rules are fair and based on stability and efficiency principles. • Assess SRO entry and sanctioning criteria, and ban discriminatory and unfair practices • Ensure SRO information, monitoring and sanctioning systems are compatible with fair competition • Ensure that SRO rules and operations are not detrimental to small participants and consumers

27. Q. Is SRO Viable in Bond Market? • The extent to which the market is organized matters • OTC vs Exchange • ATS, ECN or electronic trading platforms • Inter-dealer broker • Extent to which competition exists among organizers of the market matters. • SRO vs. Trade Association • ISMA vs. BMA

28. Legal and Regulatory Framework for Settlement Legal framework should support: • the enforceability of trade contract, • the protection of customer assets (against insolvency of custodians and intermediaries), • dematerialization of securities and the transfer of securities by book entry, • netting arrangements and securities lending, • arrangement for achieving DVP, • rules addressing the consequences of a participant’s default

29. Legal and Regulatory Framework for Settlement - 2 Regulation and oversight • Central bank and financial regulator should cooperate with each other and with other relevant authorities. • The objectives and responsibilities of the regulators with respect to C&S system should be clearly defined and publicly disclosed. • The regulators should gather information on C&S system and assess the operation and design of the system.

30. Sequencing of the Regulations on Government Securities Market • Be cautious of over-regulation • Professional investors – what if individuals participate? • Clarify regulators and their responsibilities • Who regulates/supervise what? --Regulatory gaps or overlaps. • Develop a framework to match the different stages of development of the government securities market.

31. Conclusions Key elements of a legal framework are: • Clear borrowing authority and its clear delegation • Rules for the issuance of government securities • Clearing and settlement system rules • Rules governing the organization and functioning of the primary and secondary markets • Rules setting out the legal status of government securities

32. Thank You!Noritka Akamatsu