Archive for the ‘Debt markets’ Category

History and future of fixed income markets (in UK)..

March 1, 2019

Nice speech by Rohan Churm, Head of Foreign Exchange Division of Bank of England.\

The United Kingdom is home to one of the oldest financial centres in the world. Starting from within the
confines of London’s square mile – The Square Mile – but now spread widely around the country, the
United Kingdom has also become one of the world’s leading financial centres. In doing so it has been
central to centuries of innovation and evolution in the financial system.

The Bank of England’s first foray into fixed income markets came at its inception, in 1694, when it raised
£1.2m over 12 days, in order to lend to the government. This was an innovative way for the government of
the time to fund a war effort. But the original Royal Charter explained that the Bank was founded to
‘promote the public Good and Benefit of our People’. That aspect of the Bank’s mission has remained
timeless, even as the financial system has radically changed. That the Bank today can deliver its mission is
testament to how it has also innovated and evolved alongside financial markets and their participants.

If it feels like financial market participants must constantly adapt in order to thrive, then it would be helpful to
know we are not alone in this experience. It brings to mind the ‘Red Queen hypothesis’, which arose as the
academic field of evolutionary biology drew on the literature of Lewis Carroll. This idea was originally
proposed by US academic Leigh Van Valen. It posits that organisms that survive in a constantly changing
environment have themselves adapted and evolved. In Lewis Carroll’s book ‘Through the Looking Glass’,
the Red Queen warns Alice that it “takes all the running you can do, to keep in the same place. If you want
to get somewhere else, you must run at least twice as fast as that.” No doubt some of you can identify with
that as you consider how the City has changed over your careers, arguably innovating more rapidly than
ever before.

The Bank of England innovated in 1725 with the introduction of printed bank notes – moving away from the
handwritten ones.1 In the 19th century its lender-of-last-resort operations were novel and groundbreaking.
More recently, operational independence to set monetary policy and the new responsibilities for
macro-prudential regulation have significantly changed the shape of the Bank.

As we meet today at the London Stock Exchange (LSE) it is worth reflecting on how exchanges have
evolved. Not least because the LSE now has 14,500 listed debt securities and is hosting a fixed income
forum! When the Bank was founded in the 17th century stockbrokers would meet in the coffee houses of
Change Alley in order to exchange information and strike trades. Prices were first transmitted via the electric
telegraph in 1830. Today, in many markets algorithms ‘meet’ in a server centre to trade within fractions of a
second. Despite this, coffee shops are thriving.

He points that automation has been limited in debt markets:

at their core, FX and equities markets are based on homogenous instruments. As one moves towards
related but potentially bespoke products, such as FX and equity options, trading is far less automated.
The logic applies to fixed income markets, where bespoke aspects to bonds are often a central feature. A
typical large bank may have more than one thousand unique debt instruments associated with it, varying
across currency, coupons, maturity dates, optionality, and seniority, to name some dimensions. This
compares to ultimately only one equity claim.

This feature of fixed income markets is not a bug. It reflects product innovation that allows debt instruments
to suit the preferences and constraints of the investor, which ultimately lowers costs for the borrower. But it
does reduce liquidity. Most obviously, for any given amount of debt, more debt instruments means smaller
sized individual issues available to trade in the market. The bespoke characteristics also lead to market
segmentation as any individual investor may only be willing to buy a subset of bonds from a given issuer.
And from a practical perspective, investing in automated trading, with potentially bespoke programming, is
less likely to be worth it for small and unique issues with non-standard characteristics.

This means that fixed income markets remain somewhat slower.

Saying that, electronic trading is now a very standard part of fixed income markets. Automated trading has
also increased markedly, in particular in standardised or liquid instruments such as government bond futures
or on-the-run US treasuries.

Electronic trading is also increasing for corporate bonds. Our market intelligence suggests that around 50%
of all gross notional in the European corporate bond market is now being traded electronically. This has been
helped by the electronification of the corporate bond ecosystem, including the pre-trade, execution and the
post-trade phase of the trade lifecycle. And we have also seen growth of electronic trading platforms,
serving the dealer-to-dealer, dealer-to-client, and all-to-all segments.

Also discusses what next for Fixed income markets…


The next big idea of macroeconomics: Linking human psychology with debt markets?

July 31, 2018

Noah Smith in this piece wonders how come the 2008 crisis has not led to any new  thinking/development in macroeconomics.

Macroeconomics tends to advance—or, at least, to change—one crisis at a time. The Great Depression discredited the idea that economies were basically self-correcting, and the following decades saw the development of Keynesian theory and the use of fiscal stimulus. The stagflation of the 1970s led to the development of real business cycle models, which saw recessions as the efficient working of the economy, and central bank meddling as likely only to cause inflation. The painful recessions of the early 1980s saw a shift to so-called New Keynesian models, in which monetary policy is the central stabilizing force in the economy.

The housing bubble that peaked in 2006, the financial crisis of 2008, and the Great Recession that followed constitute another crisis. So far, however, it has produced mostly evolution, rather than revolution, in economists’ conception of the business cycle. The bubble and the following crisis convinced macroeconomists that recessions often emanate from the financial sector—an idea that had often been resisted or overlooked before. There was immediately a flurry of activity, as economists hastened to shoehorn finance into their standard models. Some now believe that the addition of finance will allow New Keynesian models to forecast crises before they happen; others are, understandably, sceptical.

For instance this paper by Jordi Galli says New Keynesian Macro, which was the dominant framework before crisis, is working fine even post-crisis with modifications.

Smith points to this paper (slides discussed in Nobel Symposium as well) by Pedero Bordalo, Nicola Gennaoli, and Andrei Shleifer which could be the next big thing to look at in macro:


How to establish a local bond market and avoid the original sin? Lessons from Germany..

March 19, 2018

Interesting speech by Andreas Dombert of Bundesbank. She spoke at this conference organised by South African Central Bank.

She says countries should avoid borrowing in other markets which is also called as Original Sin in economics. They should try and develop their own bond markets:


Liquidity in government bonds – differences in sovereigns and colonies

December 2, 2016

This is a superb paper which looks at bond markets in colonies and sovereigns:

In a recent paper, we study the pricing of government debt in a setup that provides both insightful institutional parallels, and an empirically much friendlier environment (Chavaz and Flandreau 2015). During what some economists call the ‘first globalisation’ era (1870-1914), 68 countries raised funds in sterling on the London Stock Exchange (LSE). With good reason: London was home to the most astute sovereign underwriters, and an ample supply of capital. Countries on the gold standard would not have to worry about exchange rate risk when they borrowed in sterling. The London market had many liquid instruments. Among them, the British government’s quasi-perpetual ‘Consol’ reigned over the largest and most liquid secondary bond market worldwide.

One unique feature of the London government bond market of the time was that it was split roughly equally between truly sovereign countries – like Argentina or Greece – and colonies of the British Empire, such as Canada or Jamaica. As with pre-crisis Eurozone members, the fiscal sovereignty of colonies at that time is best described as ambiguous. By law, colonies ran their own budget with either a quasi-full autonomy (in the case of self-governing dominions such as Canada and the Australian colonies), or a limited one (for Crown Colonies such as Jamaica). In reality there was a widely-held perception that London would prevent default, maybe by doing ‘whatever it takes’. Bond prospectuses never explicitly stated this as policy but, as British parliamentarian (and future prime minister) Benjamin Disraeli emphasised after the 1857 Sepoy mutiny in India, it would be very difficult not to bail out, in some way, a colony that threatened to default.

The consequence at the time it was that credit risk was hardly priced for colonies. This was later confirmed by econometricians (Accominotti et al. 2011). Despite this, colonial spreads over the British Consol averaged about 1%, or 100 basis points. They also varied substantially across time, and between colonies.

When investigating liquidity, a convenient feature of LSE quotations is that they provided precise information on the range in which transactions were expected to take place for any given security – not a true bid-ask spread, but a kind of measure of liquidity. We discovered that this range is a solid proxy for measuring bid-ask spreads at that time.


The results just show this as well. Colonies did not face credit risk but faced illiquidity risk:

Our conclusion – backed by institutional analysis, historical evidence and econometric tests – is that colonies’ semi-sovereignty significantly decreased the severity of information asymmetries between issuers and primary market investors, and among secondary market investors. In turn, this resulted in two paradoxes of semi-sovereignty.

  • Because of different information asymmetries, the two foreign debt markets (sovereigns and colonies) were characterised by different underwriting technologies. Sovereigns typically tried to buy the services of prestigious merchant banks to circumvent the pre-commitment problem inherent to sovereign borrowing (Flandreau and Flores 2009). Deep-pocketed bankers not only lent prestige at issuance, but also stood ready to promote liquidity in the secondary market. Given the absence of severe information asymmetries for investment in the colonies, this was a much less attractive business in the case of colonial debts, and merchant banks soon disappeared from colonial issuances. Instead, colonies used a variety of unusual intermediaries such as second-tier commercial banks or broker-underwriters, both with little means or interest in promoting liquidity. This is the first paradox of semi-sovereignty: it lowered credit risk, but at the price of higher illiquidity risk.
  • For related reasons, the two markets had different clienteles. The absence of asymmetries of information made colonial bonds a natural habitat for those in search of securities free from adverse selection, like insurance companies, commercial banks, and uninformed rentiers who were seeking to cash in coupon payments. This is the second paradox of semi-sovereignty: the lack of adverse selection further worsened bond liquidity by attracting investors that rarely traded.

The parallels between Eurozone and colonial bonds are important. They suggest that the pricing of liquidity and credit in government bond markets may be ‘always and everywhere an institutional phenomenon’. Our historical evidence suggests that investigating the microstructures of sovereign debt markets – their logic, operation, and segmentation – might help in interpreting bond price movements. For policymakers, our research may provide an encouragement to investigate which institutional features can explain the survival of the British imperial architecture, while that of Eurozone was deemed fragile enough to allow destructive liquidity-credit feedback loops.



What are Kangaroo bonds?

September 15, 2016

Michelle Bergmann and Anna Nitschke of Reserve Bank of Australia (who else) has a note on this.

These are bonds issues by foreign companies to raise Australian Dollars. Interestingly, they are useful for cross-currency swap purposes:


European govts issue long term bonds to capture gains from ultra low interest rates…

May 12, 2016

Ireland issued 100 year bond followed by France and Spain issuing 50 year ones.

More interestingly, Spain issues a bond minus a govt:


This Is where bad bankers went to Prison in Iceland…

April 4, 2016

Just like Iceland, its jail too is in a pretty picturesque place.


Nothing makes sense anymore in global debt markets..

November 17, 2015

A team of Bloomberg columnists have this piece on global debt markets:


Moody’s tries to save itself

May 21, 2008

FT has done a detailed analysis of Moody’s modelling error that gave top rating to complex financial instruments.

The article is only for subsribers but alphaville blog provides some ideas of what was going on. I found this pretty shocking:

Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch triple A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower.

Four notches lower? This is simply unacceptable. Even if there was a model error (which is quite common) one can’t get a lower rated product become a super rated category. And one can still understand these things happen at a fund but how can they happen at a credit rating agency. Surely, there is back-testing and other kinds of risk assessment tests which would have separated wheat from the chaff. As I had asked earlier, What were the risk managers doing?

What is also shocking is this:

On discovering the error early in 2007, Moody’s corrected the coding glitch and instituted methodology changes. One document seen by the FT says “the impact of our code issue after those improvements in the model is then reduced”. The products remained triple A until January this year when, amid general market declines, they were downgraded several notches.

So despite finding the error, the products remained AAA till the crisis happened. This from a credit rating agency is just not accepted. And on top of this we have to hear such fancy/lofty statements:

“The integrity of our ratings and rating methodologies is extremely important to us, and we take seriously the questions raised about European CPDOs. We are therefore conducting a thorough review of this matter.”

Actually none of this is new. I remember reading a lot of material in time of Enron and Worldcom meltdown. Very similar things happened then and it is sad that nothing has changed.

The blame lies with people and not models per se. I just fail to imagine that the error wasn’t known. You have a lot of people verifying the initial documents and it doesn’t require rocket science to figure out the problem that a subprime asset has got a AAA rating. If it was a standalone crisis surely more would have come out about why thesedeals were taken up. Now because the crisis has affected all, the blame is being shifted to other factors like poor markets, models (as if they were created in vacuum) etc.

Credit Rating Agencies are supposed to be really honest in their conduct as lots of market activity depends on them. And it is not good that they also follow the path of other financial intermediaries. On this you might also like to read a superb article by Roger Lowenstein very nicely titled- Triple A failure.

Importance of legal system

January 7, 2008

The importance of an effective legal system is well known. I came across this excellent paperfrom Shleifer et al on the same.

The team discusses why people do not believe in legal system and how badly it effects economic activity. One should check out the way they explain how a capitalist goes on to hire a manager given different legal system.

The main finding of the paper is:

The question addressed in the following sections is how to get more people to use the legal system? We believe that court and police reforms should not be the starting point, since those reforms are likely to take a long time. The legal system must begin to be used with the existing courts and police. To do so, legal reform should begin with the adoption of legal rules that the courts find usable, and that private parties find cheaper to rely on than other methods of resolving disputes. Such rules should have several obvious but important characteristics.

First, bad rules — that keep people from using the legal system because they prohibit, or fail to support — legitimate market activity, need to be abolished.

Second, the new rules should to the extent possible follow business practice, thereby enabling private parties to continue their business activities but to rely on courts rather than crime to resolve disputes.

Third, the new rules should help the courts resolve disputes by telling them what to do in the cases where existing laws are most conspicuously incomplete. In particular, courts, with their extremely limited resources, should be able to verify whether violations of these rules have occured.

G-Sec yield curve is a public good

June 5, 2007

I had mentioned about this interesting report from RBI that covers India’s Financial Markets.

I was going through it over this weekend and I found this chapter on Government Securities was quite good. Sometime back a friend of mine had posed a question why do we need a G-Sec market and how does a secondary market in G-Sec help financial markets help. This paper does answer the same.

The need to develop the government securities market emerges from the three roles it seeks to play, i.e., for the financial markets, for the Government and for the central bank .

  • From the perspective of an issuer, i.e., the Government, a deep and liquid government securities market facilitates its borrowings from the market at reasonable cost. A greater ability of the Government to raise resources from the market at market determined rates of interest allows it to refrain from monetisation of the deficit through central bank funding. It also obviates the need for a captive market for its borrowings.
  • For the central bank, a developed government securities market allows greater application of indirect or market-based instruments of monetary policy such as open market (including repo) operations. A greater recourse to the market by the Government for meeting its funding requirements expands the eligible set of collaterals, thereby enabling the central bank to conduct monetary policy through indirect instruments. The expanding quantum of eligible collaterals has imparted flexibility to central banks of many developing economies in their conduct of monetary policy, especially in sterilising the capital flows.
  • The government securities market serves as the backbone of fixed income markets through the creation of risk-free benchmarks of a sovereign borrower. Ipso facto, it acts as a channel of integration of various segments of the financial market. 

The last of the three reasons is perhaps the most important and least understood.

We use government bond yields to calculate equity premiums and price most of the other securities depending on the bond market. So, if this market is liquid and there is active trading it ensures price discovery and helps price risk of other financial instruments in a dynamic manner. The report rightly says that G-Sec yield serves as a public good for the financial markets.

%d bloggers like this: