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Development of Korean G-Bonds Market and Electronic Trading System of the KSE

Development of Korean G-Bonds Market and Electronic Trading System of the KSE.  Overview of Korean G-bond Market  Reform of Korean G-bond Market  KSE’s Electronic Trading System for G-bonds (KTS)  Evaluation of KTS. July 25, 2000 Korea Stock Exchange.

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Development of Korean G-Bonds Market and Electronic Trading System of the KSE

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  1. Development of Korean G-Bonds Market and Electronic Trading System of the KSE  Overview of Korean G-bond Market  Reform of Korean G-bond Market  KSE’s Electronic Trading System for G-bonds (KTS)  Evaluation of KTS July 25, 2000 Korea Stock Exchange

  2. I. Korean G-Bonds Market at a Glance Primary Market ▣ Type of Bonds - 5 Categories •G-bonds, Municipal Bonds, Special bonds, Financial bonds and Corporate bonds - Outstanding amount: 356.0 bil. USD (May 2000) •G-bonds: USD 59.6 billion (16%) •Corporate bonds: USD 107.2 billlion (30%) •Special bonds: USD 78.6 billion (22%) •Financial bonds: USD 102.1 billion (29%)

  3. Primary Market ▣ Market Size - Total volume of G-bonds outstanding at the end of ‘99 was 61 trillion won(USD 51 bil.), about 14.3% of GDP G-bonds Outstanding/GDP Korea (‘99) US(‘98) Japan(‘98) UK(‘98) 14.3% 40.0% 54.7% 33.6% Source: Bank of Korea - The Korean G-bond market is small relative to the size of economy due to the sound fiscal policy to minimize fiscal burden.

  4. Primary Market ▣ Primary Issuance - The funding requirement for the government had been kept low until the currency crisis. • Following the crisis, the G-bond issuance has increased. Volume of G-bond Issuance (in KRW trillion) ‘98 ‘96 ‘97 ‘99 TBs 1.9 2.1 12.4 18.6 FESBs 2.0 1.3 - 3.9 HNBs 2.4 2.8 2.5 3.6 Grain Security* 2.5 1.3 2.0 2.3 PLCBs 0.1 0.1 - 0.1 Total 8.9 7.5 17.0 28.5 *Grain Security was merged into Treasury Bonds category in 1999

  5. Primary Market ▣ Domestic Government Bonds - 4 types of G-bonds are being issued. • Treasury Bonds (74%), • FES Bonds (14%), • NH Bonds (12%), • PLC Bonds (-) - Maturity: 1, 3, 5 years • Average remaining maturity(end ‘99) was 2.3 years. • 3-year Treasury Bond is a benchmark issue - Interest payments are made either quarterly at coupon rate or at maturity at annual compounding rate. 1-year TB 3-year TB 5-year TB 1999 26% 64% 10% 1st half, 2000 37% 41% 22%

  6. Primary Market ▣ Auctions - Basic Issuing Methods • Treasury Bonds & FES Bonds : competitive auctions · 1st Mondays: 1-yr, 2nd Mondays: 3-yr, 3rd Mondays: 5-yr • NH Bonds : compulsory sales • PLC Bonds : on demand. - Multiple Price (conventional) Auctions •BOK administers auctions as a fiscal agent to the MOFE. •Electronic tender • Annual auction calendar is announced at the end of a year • Average volume of TB auctions: 0.5-1.0 trillion won • Open to only Primary and Preliminary Primary Dealers with ceiling of 30% per dealer. • Non-competitive bids: 20% of the total volume offered  Single price (Dutch) auction to be introduced later this year

  7. Secondary Market ▣ Market Structure - The Exchange (KSE) and the OTC market - Traditionally, OTC-based Market - KSE launched an electronic trading platform for Inter-dealer trading in G-bonds. ▣ Trading volume (in USD bil., %)

  8. Secondary Market Investment Trust Other financial institutions Banks Household Foreign 50% 18% 18% 13% 0.2% ▣Investor Base Gov’t bond holdings by investor types (June ‘99) - Insignificant role of foreign investors • Exchange rate risk • Liquidity risk • Interest rate risk

  9. II. Reform of the Korean G-Bond Market Government’s Commitment  A Task Force organized (Feb. ‘98.) - Consists of experts from public and private sectors, and academia.  Task Force Report issued (Nov. ‘98.) - Absence of benchmark yield - Underdeveloped secondary market  International Work Shops held (June ‘98. & Nov. ‘99) ”Comprehensive Plan for Development of Gov’t Bond Market” (Nov. ‘98) “A Plan for Modernization of Bond Market Structure (May ‘00)

  10. Problems Recognized... ▣ Lack of liquidity - Captive buyers: 2/3 of G-bonds held by banks and ITCs - Tradition of setting cut-off prices: buy & hold until maturity - Market fragmentation: too many issues (0.7 trillion per issue) • 12(1yr)+312(3 yr)+512(5 yr) = 108 issues - Lack of dealing capacity ▣ Short-term maturity - Average maturity: less than three years (2.5 years) - Term-mismatch between liability and investment - Preventing the development of a yield curve ▣ Lack of infrastructure - Credibility and transparency of credit rating are lacking

  11. Reform Measures - Earlier ▣ Development of a benchmark bond and yield - Increasing issuance amount of 3-year TBs -Simplifying the types of G-bonds (Grain  Treasury) ▣ Introduction of Primary Dealer System (July ‘99) ▣ Launch of IDB Network (Mar. ‘99) - KTS of Korea Stock Exchange ▣ Reform of issuing process of government bonds(‘99) - Abolishing the practice of setting cut-off price - Enhancing the regularity of issuing cycle

  12. Reform Measures - Recently ▣ Implementing Fungible Issuance (May ‘00) - 2nd & 3rd months of a quarter for 3 & 5-year TBs ▣ Allowing an additional IDB (June ‘00) - Korea Money Broker Corporation ▣ Applying Mark-to-market practice to all bond portfolios held by trust funds (July ‘00) - Contributes to activating bond trading

  13. Reform Measures - Scheduled ▣ Diversifying Auction Procedures (Oct. ‘00) - Dutch auction procedure to be introduced: “Winner’s Curse” ▣Expanding Maturity Spectrum from 5 to 10 years (Oct. ‘00) - Increasing the portion of 5-year TBs up to 40% in 2nd half - Introducing 7 or 10-year TB in 2nd half ▣ Improving the infrastructure of secondary Market - Enhancing credibility and transparency in credit rating ☞ KSE to set up a joint-venture with a major foreign credit rating agency - Allowing establishment of additional inter-dealer brokers - Revision of tax law to activate Repos and securities lending

  14. Primary Dealer System in Korea ▣Chartering Primary Dealers “Setting up a Primary Dealer System for TBs in Korea”(Mar. ‘99) - Granting dealership for G-bonds to commercial banks (Oct. ‘98) - Application for primary dealership (Feb. ‘99) • 69 applicants were designated as “Preliminary Primary Dealers” - 3-month test period (April - June ‘99) • Market-making and trading at the KSE’s Inter-dealer market - Selection of the first batch of PDs (July ‘99) • Selected from each industry group (banks & brokers) in proportion • Based on the performance during the test period • 24 PDs (2 foreign), 6 Preliminary Primary Dealers(30% of PDs) •Selection Criteria ☞ Underwriting performance in auctions (50%) ☞ Market-making performance in the Exchange and OTC(50%)

  15. Primary Dealer System in Korea(cont’d) ▣Obligations of Primary Dealers - Underwrite at least 2% of G-bonds - Maintain 2% market share of G-bonds trading - Required to make a market in government securities by quoting two-way prices in on-the-run issues of T-bonds. - Provide the market information to the debt manager - Present quotations to individuals and non-dealer customers  Performance review on a semi-annual basis  Primary dealership review on a annual basis

  16. Primary Dealer System in Korea(cont’d) ▣Obligations of Preliminary Primary Dealers - No market-making obligation - Required to maintain 1.5% of market share in auctions and secondary market, respectively. ▣ Privileges of PDs or PPDs - The prestige coming with the status of being a PD or a PPD - Exclusive access to the G-bond auctions and non-competitive bids

  17. III. Electronic Trading System of KSE Establishing an Inter-dealer Market at KSE - As a preparatory measure for the introduction of PD system, the government designated the KSE as the trading platform for the government securities dealers (Feb. ‘99). - In April 1999, KSE divided its existing automated bond trading system into two sub-markets: •a general bond market •an inter-dealer market for G-bonds - KSE’s G-bond inter-dealer market was used as trading platform during the 3-month probation period of PDs, while a project to develop a new electronic trading system commenced. - In April 2000, KSE’s new, fully automated trading platform called “KTS” was put into operation.

  18. Developing KTS ▣Utilizing existing trading facility (Mar. ‘99 ~Mar. ‘00) - Semi-electronic system developed in 1996 - The probation period of PD system commenced(Mar. 29, ‘99) ▣Developing a New Trading System - System Development Team organized (May ‘99) - Mock trading (March ‘00) - System launched (April 3, ‘00) * Developer: KOSCOM

  19. Characteristics of KSE Inter-dealer Market ▣A wholesale market specialized in G-bonds ▣ A market supporting market-making function of PDs ▣ Participation is limited to the PDs and GBDs - PDs: 24, PPDs: 6, GBDs: 48  Introduction of “Special Participants” (June ‘99) - KSE, as a membership organization, revised its Constitution to allow non-member PDs and GBDs (banks) into its market by granting them ‘Special Participants’ status. • Regular members: access to all products • Special Participants: access to G-bonds trading only

  20. Major Features of the KTS ▣Multi-functioning - Market operation & Information dissemination ▣User-friendly - Fully automated, web-based system ▣Transparent - Real-time disclosure of quotation & trade information ▣Swift - From order placement to trade confirmation within 3 seconds ▣Reliable - Firewalls, fingerprint-reader, digital signature & certification, etc.

  21. Dealers Servers Dealers Terminals Server KTS KTS System Configuration Internet

  22. Internal HUB Switch HUB Switch HUB ... Primary Firewall Secondary Firewall ... Switch HUB Switch HUB ... DMZ Workgroup HUB External HUB System Security

  23. Operation of the KTS - Products ▣Traded Products: Government Bonds(TBs & FESBs) - Issues liable for market making (“Market-making Issues) • On-the-run issues by maturity • Designated by the MOFE • PDs must quote two-way prices on a continuous basis - Non-market making issues • Off-the-run issues of TBs & FESBs (designated by KSE) • One-way quotes

  24. Operation of the KTS - Participants ▣Market Participants (78) - By membership types • Members: 47 brokerage firms • Special participants: 31 commercial & merchant banks - By functions • Primary Dealers(24): Market-making (required) • Preliminary Primary Dealers(6): Market-making (optional) • Dealers(48): No market-making

  25. Operation of the KTS - Orders ▣Types of Orders - Market making orders • Placed on ‘market-making issues’ by PDs • Displayed on the screen •Only two-way quotes allowed (One-way MM orders are recently allowed, but they are not included in market making performance) - Trade orders • Placed by all participants in applying to MM orders • Unsuccessful orders are automatically cancelled  Quotations are made in prices

  26. Operation of the KTS - Orders (cont’d) ▣Order Entry - Orders submitted through order input box in order book window · Order book window displays five best bid and ask prices with aggregate quantities. - Changes, suspensions, or cancellation of quotations can be made in the same window by clicking relevant command buttons. ▣Quotation Spreads - Bid & ask spreads of two-way quotes are set at 400 bp from previous closing rates.

  27. Operation of the KTS - Transactions ▣ Trading - Trading hours: 9:00~ 15:00 (May 2000) - Trading unit: KRW 1 billion (USD 0.9 million) - Auto-matching of orders - Trading Rules • Auction by multi-prices (no call auctions) - Principles of Auction • Price Priority · Time Priority - Transaction fee • 2.5/1 million of trading value based on the face value  50/1 mil. in OTC market • No membership fee

  28. Operation of the KTS - Clearing & Settlement ▣ Clearing - Conducted electronically on a multilateral netting basis - Results are displayed on screens on a real-time basis ▣ Settlement - T+1 settlement on a DVP basis - Cash payments • Made via the KSE account at the BOK(BOK-wire) - Securities delivery • Executed by the book-entry system of the KSD - Anonymity • Counter parties are not disclosed even after trades are executed

  29. Operation of the KTS - Clearing & Settlement ▣Joint Compensation Fund: A Device for Settlement Guarantee - Contributed by members as certain % of trading value with maximum ceiling of 100 billion won. • Stocks: 0.001% of trading value • Futures: 0.00015% of notional value • Options: 0.001% of option premium • G-bonds (special participants): 1/4 of a regular member’s contribution in lump-sum

  30. IV. Evaluation of KTS Successful so far... 2000.1 2 3 4 5 6 total 1.52 (32%) 0.65 (38%) 1.80 (42%) 2.67 (34%) 5.50 (44%) 4.54 (41%) 16.68 (39%) KTS 5.26 (66%) 3.27 (68%) 1.06 (62%) 2.46 (58%) 7.04 (56%) 6.57 (59%) 25.66 (51%) OTC ▣Enhanced concentration of market liquidity <Monthly turnover of benchmark issues(in KRW tril.)> ▣Reduced bid/offer spreads • 1-year: 2 bp, • 3-year: 3-4 bp, • 5-year: 7-10 bp ▣ Price quotations in IDM are perceived as key determinants of future prices of G-bonds

  31. Success Factors ▣ Government’s initiative to develop G-bond market - KTS was established in line with a series of Gov’t policies to reform domestic bond market. ▣ Competitiveness of the Screen-based Trading - Electronic trading platform eliminated costs and time related to the search for counterparties, making G-bond trading faster, cheaper and more transparent than before.

  32. Impediments to More Active G-bond Market ▣ Inactive market making activities by PDs - Market squeeze by ‘Bond Market Stabilization Fund’ - Few incentives to active dealing - Loose administration of PD activities in initial stage - Lack of facilities to support dealing activities of PDs (repo, securities-lending)

  33. Future Improvements ▣ Providing dealing funds to PDs - 2-3 trillion Won to be loaned at low cost (call rate-1%p) by the government and the Korea Securities Finance Corp. ▣ Strict enforcement of Regulation by the Government - Reshuffling current PDs according to relevant regulation - Overseeing of PDs compliance with obligations in the secondary market ▣ Changing G-bond futures settlement from cash settlement to physical delivery ▣ “G-bond Fund” to be allowed - Lifting investment ceiling in G-bonds (30%) by Invest Trusts & Mutual Funds ▣ Setting up a repo market (KSE)

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