ON THE DEVELOPMENT OF CHINA’S MAREKET-MAKER SYSTEM

Factors influencing the effectiveness of the market-maker system

After more than one year in operation, the first nine two-way quoters authorized by the People's Bank of China have played a significant role in activating bond trade in the interbank bond market, raising the bonds' liquidity, and timely and effectively transmitting monetary policies. However, the development of the two-way quoter system is still restricted by several factors.

First, the disequilibrium between rights and obligations deprives some two-way quoters of the initiatives in market-making. Since the establishment of the two-way quotation system, two-way quoters have merely shouldered the obligations of market-making, without enjoying any privileges. In foreign countries, only those excellent market-makers can become primary dealers enjoying honors and preferential policies. In China, market-makers are selected from primary dealers and underwriters, so the number of market-makers is less than that of primary dealers or underwriters. These few market-makers assume the obligation of continuous real quotation without enjoying any preferential policies. This will undoubtedly affect their active and initiative participation in market-making.

Secondly, the strictly set bid-offer spread restricts the flexibility of two-way quoters. The PBC, the central bank of China, stipulates a ceiling for the bid-offer spread of bonds quoted by two-way quoters. The stipulated band of spreads can hardly cover the risks of price fluctuations in the market, and it cannot guarantee the interests of two-way quoters.

Thirdly, the lack of selling-short mechanisms in the market exposes market-makers to huge risks in a unilateral market. The fulfillment of the market-making obligation in a unilateral market may result in enormous open exposure, which will directly lead to substantial losses.

Suggestions to activate market-making of two-way quoters

The limit on bid-offer spreads should be widened for two-way quoters. In the author's viewpoint, the central bank should lift the restriction and evaluate the efforts of two-way quoters in maintaining the liquidity of quoted bonds through such indexes as the average daily bid-offer spread and total turnover, so that the two-way quoters can avert and adjust their quoting risks through the lever of price.

The obligation of market-making should be shouldered by all the underwriters in the primary market and the primary dealers in the open market, as they comparatively enjoy more privileges. With reference to international practices, it is reasonable that all primary dealers are obliged to quote and trade in the money market.

Market-makers should be offered some preferential policies. At the initial stage of bond market development, market-makers have to maintain market liquidity at the cost of some of their own interests. Therefore, two-way quoters should be provided with some preferential policies in bond underwriting and taxation, which, in turn, will motivate the two-way quoters to devote themselves to market-making.

As a symbol of the selling-short mechanism, the domestic market for derivative products should be set up as soon as possible. In view of the development of the domestic market, the central bank should encourage innovations and permit commercial banks to introduce new products. Only in this way, can the whole market realize sound and stable development.

(by Wang Ning & Lou Lei,BOC)