Recommendations for the design of liquid markets

INTRODUCTION

This note presents a list of general principles and more specific policy recommendations for the creation of deep and liquid government securities markets,¹( partly based on the findings of the Study Group on Market Liquidity under the auspices of the Committee on the Global Financial System (CGFS) of the G10 central banks.²⁾Many factors affect market liquidity. Institutional factors such as securities law, the regulation and supervision of dealers, and accounting rules are important. Equally, environmental factors such as the macroeconomic situation and changes in the issuer's creditworthiness play a role. The main focus of this note, however, is on "markets", especially on market design.

Following the recent financial crises, there seems to be a growing consensus that deep and liquid financial markets, especially government securities markets, are needed to ensure a robust and efficient financial system as a whole.³The guidelines identified in this note are not intended as a code of good practice. Rather, the objective is simply to distil from the experience of mature markets a set of principles and recommendations that might be of assistance to other countries in their efforts to develop and secure properly functioning government bond markets.

It must be emphasised that this note does not advocate that governments increase their borrowing merely for the sake of promoting bond market liquidity. Rather, the guidelines apply to any financing needs of governments.

The structure of the note is as follows. In the first section, the question of why particular attention should be paid to government securities is discussed. In the second section, five guiding principles for the design of deep and liquid markets are identified. In the third section, five policy recommendations for the enhancement of market liquidity are listed: ⁴ 1) ensuring an appropriate distribution of maturities and issue frequency so as to establish large benchmarks at key maturities; 2) minimising the liquidity-impairing cost of taxes; 3) ensuring the transparency of sovereign issuers, issue schedules, and market price and trade information, with due attention being paid to the anonymity of market participants; 4) ensuring safety and standardisation in trading and settlement practices; and 5) developing repo, futures and options markets. In the last section, the role of central banks is discussed.

¹ In this note, deep and liquid markets are defined as markets where participants can rapidly execute large-volume transactions with little impact on prices. This definition is also used in the Study Group (BIS (1999a), Market Liquidity: Research Findings and Selected Policy Implications, Basel, May).

²Following a decision by the Committee on the Global Financial System (at that time the Euro-Currency Standing Committee) in December 1997, the Study Group, composed of central bank economists and market analysts, conducted research on the determinants of market liquidity. Their report (BIS (1999a)) was published on 3 May, 1999.

³Following the globally observed financial market turmoil, several forums, such as APEC, are trying to formulate sound practices to develop government securities markets.

⁴The order in which these principles and recommendations are listed should not be taken to imply that some are more important than others. Their relative importance is likely to differ significantly from one national market to another.