In order to minimize cost and risk over the medium to long run, debt managers should ensure that their policies and operations are consistent with the development of an efficient government securities market. An efficient market for securities provides the government with a mechanism to finance its expenditures in a way that alleviates the need to rely on the central bank to finance budget deficits. Moreover, by promoting the development of a deep and liquid market for its securities, debt managers, in tandem with central banks and supervisors and regulators of financial institutions, and market participants can achieve lower debt service costs over the medium- to long-term as liquidity premia embedded in the yields on government debt wane. In addition, where they have low credit risks, the yields on government securities serve as a benchmark in pricing other financial assets, thereby serving as a catalyst for the development of deep and liquid money and bond markets generally. This helps to buffer the effects of domestic and international shocks on the economy by providing borrowers with readily accessible domestic financing, and it is especially valuable in times of global financial instability, when lower quality credits may find it particularly difficult to obtain foreign funding. Governments should exercise particular care in borrowing in external markets.
Experience suggests there is no single optimal approach for developing an efficient market for government securities. OECD countries, for example, have established government securities markets using a wide range of approaches involving different sequencing of reforms and speed of deregulation. But, experiences in developing these markets in many countries demonstrate the importance of having a sound macroeconomic policy framework, well-designed reforms to adopt and develop market-based monetary policy instruments, and careful sequencing in removing regulations around the capital account.
Portfolio diversification and instruments
The government should strive to achieve a broad investor base for its domestic and foreign obligations, with due regard to cost and risk, and should treat investors equitably. Debt issuers can support this objective by diversifying the stock of debt across the yield curve or through a range of market instruments. Such actions could be particularly beneficial to emerging market countries seeking to minimize rollover risk. At the same time, issuers need to be mindful of the cost of doing this and the market distortions that might arise, since investors may favor particular segments of the yield curve, or specific types of instruments. And, in less-developed markets, the nominal yield curve may extend only to relatively short-term securities. Attempting to extend the yield curve quickly beyond that point may be impractical or infeasible. This has led some emerging market countries to issue large amounts of longer-term inflation-indexed debt and floating-rate debt, since such debt may be attractive to investors in countries where government indebtedness is high, and the credibility of the monetary authorities is low.
As investors seek to diversify their risks through buying a range of securities and investments, debt managers should attempt to diversify the risks in their portfolios of liabilities by issuing securities at different points along the yield curve (different maturity dates), issuing securities at different points during the year (rather than issuing a large amount of securities in a single offering), offering securities with different cash flow characteristics (for example, fixed coupon or floating-rate, nominal or indexed) and securities targeted at specific investors (for example, wholesale or retail investors, or in certain circumstances, domestic and foreign investors). In so doing, debt managers should strive to treat investors equitably and, where possible, develop the overall liquidity of their debt instruments. This would increase their attractiveness to investors, and reduce the liquidity premium that investors demand, as well as reduce the risk that the pricing of government securities could be significantly affected by the actions of a small number of market participants. A well-balanced approach aimed at broadening the investor base and spreading rollover risks, while at the same time recognizing the benefits of building liquid benchmark issues, should contribute to the objective of lowering debt costs over the long run..
Offering a range of debt management instruments with standardized features in the domestic market helps make financial markets more complete, which enables all participants to better hedge their financial commitments and exposures, thus contributing to reduced risks premia and vulnerability in the economy more generally.
Where appropriate, issuing instruments with embedded options (such as savings bonds, which are redeemable by the bondholder on demand) may also contribute to instrument diversification. However, even where valid reasons exist for issuing such securities, debt managers should exercise considerable caution to ensure that the risks inherent in embedded options and other derivative instruments are integrated in the risk management framework, and that the instruments and risks are well understood by the issuer and other market participants.
Primary market
Debt management operations in the primary market should be transparent and predictable. Regardless of the mechanism used to raise funds, experience suggests that borrowing costs are typically minimized and the market functions most efficiently when government operations are transparent---for example, by publishing borrowing plans well in advance and acting consistently when issuing new securities---and when the issuer creates a level playing field for investors. The terms and conditions of new issues should be publicly disclosed and clearly understood by investors. The rules governing new issues should treat investors equitably. And, debt managers should maintain an ongoing dialogue with market participants and monitor market developments so that they are in a position to react quickly when circumstances require.
To the extent possible, debt issuance should use market-based mechanisms, including competitive auctions and syndications. In the primary market for government securities, best practice suggests that governments typically strive, where feasible, to use market-based mechanisms to raise funds. For domestic currency borrowings, this typically involves auctions of government securities, although syndications have been successfully used by borrowers that do not have a need to raise funds on a regular basis, or are introducing a new instrument to the market. Governments should rarely cancel auctions because of market conditions, or cut off the amounts awarded below the preannounced tender amount in order to achieve short-run debt service cost objectives. Experience has shown that such practices affect credibility and damage the integrity of the auction process, causing risk premia to rise, hampering market development, and causing long-run debt service costs to increase.
Secondary market
Governments and central banks should promote the development of resilient secondary markets that can function effectively under a wide range of market conditions. In many countries, debt managers and central banks work closely with financial sector regulators and market participants in this regard. This includes supporting market participants in their efforts to develop codes of conduct for trading participants, and working with them to ensure that trading practices and systems continuously evolve and reflect best practices. It can also include promoting the development of an active repo market, in order to enhance liquidity in the underlying securities, and minimize credit risk through collateralization.
A government can promote the development and maintenance of an efficient secondary market for its securities by removing both taxation and regulatory impediments that hinder investors' willingness to trade securities. These include removing possible regulations that provide captive funding from financial intermediaries to the government at low interest rates, and modifying tax policies that distort investment in and trading of financial and non- financial assets. In addition, government approaches to regulating financial markets and market participants often include a wide range of disclosure and supervision requirements to reduce the risk of fraud, and limit the risk that market participants may adopt imprudent asset and liability management practices that could increase the risk of insolvency and systemic failure in the financial system.
Central banks play a crucial role in promoting the development and maintenance of efficient markets for government securities through the pursuit of sound monetary policies. By conducting monetary policy in a way that is consistent with their stated monetary policy objectives, central banks help to increase the willingness of market participants to engage in transactions across the yield curve. Central banks are increasingly implementing monetary policy using indirect instruments that involve transactions in government securities. Proper design and use of such instruments have typically played an important role in contributing to deep and liquid markets for these securities. For example, day-to-day open market operations to implement monetary policy can foster adequate market liquidity, thereby contributing to well-functioning financial markets.
The systems used to settle and clear financial market transactions involving government securities should reflect sound practices. Sound and efficient payments, settlement, and clearing systems help to minimize transaction costs in government securities markets and contain system risk in the financial system, thereby contributing to lower financing costs for the government. Agencies responsible for the payments, settlement and clearing systems for financial transactions normally work closely with market participants to ensure that these systems are able to function well under a wide range of trading conditions.