Short Term Financing by yxx13897

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									         Financial Markets:
Short-Term and Long-Term Financing
                  Adolfo Barajas
                   IMF Institute

                   IMF Course on
   Financial Markets and New Financial Instruments
              Brasilia, Feb. 2-13, 2009
                                                     1
             Overview of Lecture
I.    Money Market Instruments
          Domestic Money Markets
          International Money Markets

II.   Capital Market Instruments
          Debt and Fixed-Income Instruments
          Equity Instruments

III. Examples of New Instruments: Structured
     Notes

IV. Financial Market Development
          Case Study The U.S. Commercial Paper Market
                                                        2
I. Money Market Instruments




                              3
  The Two Main Building Blocks of
        Financial Markets

Lenders...            …and Borrowers!




                                    4
         What Do Lenders Want?

• Lenders desire control over the use of their
  funds and assurances that they will be repaid.

• They like:
    Short maturities
    Collateral
    Covenants



                                                   5
        What Do Borrowers Want?

• Borrowers want the freedom to undertake
  projects that are risky and may not pay off.

• They like:
    Long maturities
    No collateral
    No restrictive covenants



                                                 6
 The Money Market — Capital Market
            Distinction
• A casual observer sees only a difference in the
  maturity of the securities.

• But, there are more significant differences in
  between short-term and long-term markets.

• Where do the differences come from?
   • Maturity-collateral trade-off;
   • Capital structure (debt vs. equity).
                                                    7
    The Maturity-Collateral Trade-off

• Short-maturity financial instruments that are
  largely unsecured (with one notable
  exception)

• Long-maturity instruments that are partly- to
  fully-secured

    Give borrowers sufficient freedom to pursue
    their plans

    Give lenders sufficient protection            8
Domestic Money Markets




                         9
      Characteristics of Domestic Money
                    Markets
• The money market includes financial instruments
  with maturities of 12 months or less

• Instruments must be reissued frequently, “rolled
  over” (low liquidity risk)

• Mainly large, safe, well-known borrowers:
     government, big banks, and blue-chip firms

• Reputation for repayment is essential for the money
  market to function (low credit risk)
                                                     10
       Money Market Instruments

   Government                   Banks
• Treasury Securities   • Inter-Bank Loans
• Agency Securities     • CDs
• Repos                 • Bankers Acceptances



  Nonbank Firms             Derivatives
• Commercial Paper      • Money Mkt Futures
• Money Market Funds    • Interest Rate Options

                                                  11
                Agency Securities

• Quasi-private government agency debt for funding
  national priorities (such as Fannie Mae in U.S.).

• Agency securities traditionally carry “implicit”
  government guaranties and trade at small yield
  spreads over Treasuries.

• Agency securities are sometimes considered close
  substitutes to Treasury securities.

                                                     12
       Repurchase Agreements (Repos)

• Party A sells a security to Party B with a legally
  binding agreement to buy back the security on a
  specified future date at a specified price.
• A repo is a collateralized loan.
• The difference between the selling and buying
  price is the interest rate.
• “Reverse repo” describes the lender’s transaction:
  Party A’s Repo is matched by Party B’s spot
  purchase and forward sale (Reverse Repo).
                                                  13
                      Mechanics of Repos
•    First leg of Repo                   •   Second leg of Repo
                   Sells 100                            Pays 100 cash
                   worth of                               plus Repo
                                                           rate, 4%
                   Security
    Party A                    Party B
     Cash                       Cash     Party A                        Party B
     Taker                     Holder
               Pays 100                               Sells the
                cash for                              security
              the security

                                         •   Party B has earned 4% interest on
•    Party A has now 100 cash, against       its lending;
     which it has delivered 100 worth    •   Party A has paid a lower rate of
     of security to which Party B has        interest for the borrowing than
     full title.                             might have been the case if it had
                                             raised unsecured finance.
                                                                          14
       Repurchase Agreements (Repos)
• Repos are used by financial institutions to fund their
  securities portfolios/inventories

• Repos can be used to build up leverage (constrained
  by “haircuts” that reduce exposure to market risk)

• While repos are commonly done with government
  securities, any security can be used for this purpose
  --but liquidity is important!
     ABS, MBS
     some EM eurobonds
                                                   15
          Repurchase Agreements (Repos)
• In economic terms: a collateralized loan

• In legal terms: an outright purchase or sale of securities,
  plus a binding commitment to reverse the transaction

• If the legal system interprets repos as collateralized loans,
  and a borrower defaults:
     uncertainty about the ownership/liquidation of the securities
     restricts the development of the repo market

• Law needs to make explicit that, in case of default in a repo
  transaction, the money lender becomes the owner of the
  securities.                                                16
       Repurchase Agreements (Repos)
Generally repo loans are overnight, though a term
 repo market also exists, for example:

    Term Auction Facility (Federal Reserve) The Fed uses repos
    (and reverse repos) to temporarily add (drain) balances from
    the banking system
     • Auction mechanism: dealers bid on borrowing (or lending) interest
       rates.
     • Maturity: typically overnight, rarely longer than 14 days (up to 65
       days)
     • General collateral: Treasury securities, direct US agency obligations,
       agency MBS.
     • Triparty settlement: clearinghouse holds accounts and prices collateral.
                                                                        17
          Bankers Acceptances (BAs)
• An acceptance is a letter of credit issued on
  account of an importer

• Banker “accepts” it when the exporter issues a
  draft to collect revenues before goods reach the
  importer; can be then traded in secondary market

• But their role has declined as other instruments
  have gained popularity
                                                     18
  Negotiable or Jumbo Certificates of Deposits
                    (CDs)
• Large CDs—$100,000 minimum—created in the
  U.S. as an innovation to get around deposit rate
  ceilings

• Tradable instrument that created “wholesale”
  market for bank CDs

• Market peaked in importance in 1980s and is now
  relatively unimportant.

        Other Instruments Did a Better Job!
                                                 19
           Commercial Paper (CP)

• Unsecured debt of 1 - 270 days of maturity issued
  by major corporations

• Rated by major rating agencies

• Firms pay off maturing CP by rolling it over—
  effectively converting it to long-term debt

• Usually backed by bank lines of credit

• Defaults are infrequent, but they happen!
                                                  20
    Banks: Natural Choice for CP Dealers?
• Banks already have relationships with potential corporate
  issuers

• Banks also have retail distribution networks

• But, does becoming a money market dealer interfere with the
  core lending business?
     Money market support diverts capital from lending function
     Customers who issue money-market instruments will need
     fewer loans

• Upshot: commercial banks may be reluctant to enter this
  business (see Case Study reading)
                                                             21
     Asset-Backed Commercial Paper
• Innovation that allows lower-rated firms to gain
  benefits of CP

     Firms securitize cash flows such as accounts
     receivables

     Firms set up “funding subsidiaries” that issue the CP

     Investment banks provide credit enhancements and
     underwriting support

     Could be used to jump-start CP market in EM
                                                             22
               ABCP Conduit
                   —Basic Structure—

                                       The conduit
           The
                                         issues
         conduit
                                       commercial
          buys
                                         paper
          assets

                        Special
Assets                  Purpose                      Investors
                        Vehicle
                         (SPV)




                                                             23
 Asset-Backed Commercial Paper (ABCP)

• In developed financial markets, ABCP appeared
  after the CP market matured.

• In emerging markets, ABCP can be a way to
  create a CP market;
     Investment banks’ names and credit
     enhancements help the acceptance of CP,
     ABCP issuers, becoming known to the
     market, graduate to regular unsecured CP.
                                                 24
  Outstanding Value of Commercial Paper




Source: Federal Reserve Commercial Paper Data   25
Money Market Mutual Funds (MMMFs)
Provide the link between the money market and
  households

   • Demand for CP exploded in mid-70’s when households
     shifted from deposits to MMMF
   • Alternative to bank deposits
        MMMFs may have checking, ATM, debit features

   • MMMFs are not covered by deposit insurance

   • Banks offer “Money Market Deposit Accounts” that
     offer slightly lower yields than true MMMFs but are
     covered by deposit insurance
                                                           26
         Are Money Market Funds Safe?

• Money market fund shares are priced at $1 each, with interest
  being paid in new shares

• If the net asset value falls below $1 per share—perhaps from
  a CP default—this is called “breaking the buck”

• This can also happen in a low-interest-rate environment,
  when the yield drops below management fees

• The market consequences of “breaking the buck” are so
  severe that money market fund companies pay to avoid it

                                                             27
  Major Components of the U.S. Money
            Market, 2007
                     Volume outstanding, in $ Billion

Repurchase agreements                                   1,150.2
Small-denomination time deposits*                       1,164.4
Large-denomination time deposits*                       2,155.7
Eurodollars                                               530.3
Treasury bills                                            911.5
Commercial paper                                        2,252.5
Savings deposits                                        3,874.8
Money market mutual funds                               2,390.0

* Small denominations: < $100,000
Source: Bodie, Kane and Marcus, Investments (2008).

                                                            28
International Money Markets




                              29
  The International Money Market (IMM)

• Recall that the money market is a place for only
  the biggest and the best-rated players.

• Many large domestic firms and banks (as well as
  governments) are known to international lenders.

• It has proved easy for these players to issue
  money-market instruments outside their home
  country.
                                                     30
          The Eurocurrency Market

• Definition: market for bank deposits, loans, and
  bonds denominated in a currency other than that
  of the country in which the bank or the
  borrowing firm are located.

• Two important facts:
  • It’s not part of the foreign exchange market;
  • It’s not located only in Europe, though it did start
    there.

                                                      31
            What’s the Point of the
               Euromarkets?
• Escaping the regulators—to some extent!

• International borrowing is done in places and
  currencies that are not under the control of the
  national authorities of the borrower or lender.

• The IMM is an “offshore” market.

• The lower regulatory burden translates into lower
  costs of funding for borrowers.
                                                     32
         The Main IMM Instruments

• Euro-commercial Paper (ECP),
    unsecured, short-term bearer debt,
    issued by specialized investment banks that also
    commit to making a market in ECP.

• Euro medium-term notes (MTNs),
    as with domestic MTNs, very flexible in amount and
    maturity.


                                                       33
          Summary: Money Market
• The money market is shaped by the maturity-
  collateral tradeoff

• Security and convenience are the key demands of
  borrowers and lenders

• Government bills, repo, and (asset-backed)
  commercial paper are main instruments

• Money market mutual funds enable the money
  market to borrow from the large pool of household
  wealth.
                                                34
II. Capital Market Instruments




                                 35
           The Maturity-Collateral
             Tradeoff Revisited

• In the money market, borrowers mostly issue
  unsecured debt but at the cost of having short
  maturities

• In the capital market, borrowers accept the demands
  of lenders for collateral in order to obtain longer-
  term financing

• Or, they provide ownership/control rights via
  issuance of equity

                                                     36
              Debt Instruments

• Bonds and Debentures

• Syndicated Loans

• High-Yield Bonds (“Junk Bonds”)

• Asset-Backed Bonds

• Eurobonds

                                    37
           Bonds and Debentures

• A bond is a promise to pay a series of cash
  flows
• Bonds are secured by claims on firm assets

• Debentures are unsecured, long-term debt

• Can be subordinated to other debt,
    first-in-line debt is known as “senior” debt,
    subordinated debt is paid off after senior debt.

                                                       38
            Junk Bonds --
 Non-Investment Grade Debt Securities
• Bonds are typically rated, investment and non-
  investment grade
• The latter market developed in the high-interest-rate
  environment of the 1970s and 1980s

• Risky, yes…but
     part of the risk stems from the fact that many lesser-
     known firms can issue such bonds
     some of these firms may be good risks

• Some firms use junk bonds as a disciplining and
  signaling tool
                                                              39
              Asset-Backed Bonds
• A bond is simply a promise to a series of cash flows.

• Cash flows can be packaged into a bond and sold to
  investors.
    Similar assets (such as credit card receivables and
    auto loans) are pooled and claims to these cash flows
    are sold.

• The process of packaging may make otherwise
  unattractive cash flows look much more appealing.

• More on these instruments in the lecture on
  Securitization and Structured Finance.            40
              Equity Instruments

• Common Stock – an ownership claim on the
  firm’s assets and earnings, but with lowest
  priority

• Preferred Stock – ownership claim similar to
  common stock but with higher priority
     just after the bondholders,
     before common stockholders
     sometimes offer constant dividend           41
        Depository Receipts (DRs)

• DRs allow firms to access larger foreign
  capital markets, without being listed abroad

• A firm’s shares are purchased and held by a
  financial intermediary

• Receipts for the shares are issued by the
  intermediary, and these receipts are traded

• Gives small investors easier access to foreign
  stocks
                                                   42
 The Control Function of Equity Shares

• Shares confer voting rights to select the Board
  of Directors and the management team

• “One share, one vote” puts control in the hands
  of large shareholders

• Small investors can use proxy votes or rely on
  institutional investors to assert their interests

• Some companies issue shares with no voting
  rights—“B Shares”
                                                      43
                  Dividends

• Dividends are any kind of payment made to
  the stockholders

• Modigliani & Miller say that dividend policy is
  irrelevant to firm value—which is true if a
  change in dividends is not associated with a
  change in the firm’s assets

• Dividend changes associated with the firm’s
  use of its assets have a powerful impact on the
  stock value
                                                44
      Share Repurchases: A Popular
         Alternative to Dividends
• Dividends are permanent; buybacks can be
  used to distribute “windfalls”

• Managers signal their optimism and belief that
  the shares are underpriced

• Tax treatment of dividends and capital gains
  may differ

• Repurchases tend to increase the value of
  managers’ stock options
                                                 45
              Capital Structure:
         Equity or Debt…or Neither?

• Capital structure: the mixture of debt and equity
  that a firm uses to finance its assets and investment
  projects

• The objective of firm managers is to maximize the
  firm’s value

• Is there a way to finance a firm that will maximize
  its value?
                                                    46
         Modigliani & Miller Theorem

• In an “ideal” world, capital structure is irrelevant to
  the value of the firm—there is no “best” way to go

• The value of the firm is related only to the assets
  and the cash flow of the firm

• How the assets are financed doesn’t matter

• However, in the real world (with taxes, asymmetric
  information, and bankruptcy costs), there are some
  financial strategies that affect firm value
                                                     47
          Asymmetric Information

• Firm managers know more about their firm’s
  value and investment opportunities than
  investors

• The managers also have incentives to act in
  their own interest at the expense of investors’
  interests

      Investors interpret the firm’s actions in
      light of this conflict of interest
                                                    48
     How Investors Interpret a Stock Issue

• Investors think: “The firm must be issuing new
  equity because it believes that its stock is
  overvalued”

• Therefore the stock price usually falls in response,
  lowering the benefit of the issue

• This effect will occur even when the firm is telling
  the truth that it has good growth prospects.

                                                    49
     How Investors Interpret a Debt Issue

• Debt is rated by outside agencies such as Moody’s
  or Standard & Poor’s, so there is less concern that
  the managers are taking advantage of overvaluation

• But increasing the debt of the firm raises the
  riskiness of the equity—the leverage effect

• Even a debt issue can aggravate the owners of the
  firm!

                                                   50
The Pecking Order Theory




                           51
              A Pecking Order
          for Corporate Financing
• Internal financing--using retained earnings--
  is best, and used first, because there are no
  information problems
• When a firm needs external financing, it uses
  debt whenever it can

• If firms have extra internal funds—not used for
  paying dividends or for investment—they pay
  down their debt

                                               52
    At the Bottom of the Pecking Order:
                  Equity
• Equity financing is used only as a last resort,
  or in special cases, such as
    startup firms;
    high-growth firms

• This is true even where the stock markets are
  very efficient!

• Equity serves primarily a control function, not
  a financing function
                                                    53
      Evidence: financing of non-financial
       enterprises in developed countries




• Retained earnings are the main source of financing
                                                     54
• Bank loans are the main source of external financing.
        Summary: Capital Market

• The capital market is distinguished from the
  money market by use of collateral, covenants
  and control rights in the instruments

• Capital market instruments will generally
  develop after the basic money markets have
  been introduced, but corporate bond and equity
  markets may take a very long time

• Asset-backed bonds are a promising way to
  begin development of bond markets
                                                 55
         Summary: Capital Market

• Equity markets play an important role in
  controlling management actions

• As with the money market, enabling
  households to become lenders is an important
  step in developing the capital market,
  especially the stock market—and mutual funds
  can also do the trick here


                                             56
III. Examples of New Financial
Instruments: Structured Notes




                                 57
             Structured Notes

Structured notes are bonds with embedded
  derivatives. They are:
• used for hedging and risk taking; and
• tailored to investors’ needs

Some investors, such as insurance companies,
  may not be allowed to directly take positions
  in derivatives;
  they can do so through structured notes (which
  are classified as bonds)
                                               58
                     Structured Notes
Investors selling embedded options—in search for yield

• Simplest example: a callable bond
     The issuer has the option to redeem (or call) the bond early
     In effect, investors sell a call option to the issuer and receive an
     option premium in the form of a higher coupon rate

     Investors are exposed to the risk that interest rates rise
  without benefiting from declining interest rates
     The borrower benefits from greater interest rate volatility;
  the investor benefits from greater interest rate stability

                                                                    59
     Cash-Flow Structure of a Callable Bond

                    At issue: principal




Issuer/dealer                                Investors
                Regular coupon payments:
                 fixed coupon plus option
                         premium



                  At redemption: principal

                                                    60
                   Other Structured Notes
Range-accrual notes (“range notes”)
• Typically these notes specify a high and a low accrual rate (higher
   rate paid for every day that the reference interest rate is within a designated range,
   otherwise the lower rate is paid).

Convertible bond
• Contains provision that allows the bondholder to convert it into a
  predetermined number of shares (issuer sells call option, lower coupon).
• Number of shares is the conversion ratio (cr).
Reverse convertible
• Structured note where investors sell an embedded equity put option.
• If the equity price < strike price, issuer will likely exercise option
  and deliver to the investor a predetermined number of shares (or the
  cash equivalent) instead of repaying the principal value.         61
              Structured Notes

Investors buying embedded options:

• Principal-protected notes

  investors participate in the upside of the equity
  market while being largely protected against
  downside risks.



                                                  62
    Equity-Linked Note with Principal Protection


                       At issue: principal




Issuer/dealer                                      Investors
                Regular coupon payments: fixed
                  rate minus option premium


                  At redemption: principal plus
                 max (0, change in equity price)


                                                          63
IV. Financial Market Development




                               64
Building a Framework for Financial Market
              Development




                                            65
      Financial Widening and Deepening

• Financial market development takes place in two
  main ways:
    Widening: borrowers and lenders design new types
    of contracts to govern their financial relationships;
    Deepening: borrowers and lenders increase the
    amount of transactions, using existing contracts.

• Both widening and deepening reflect increased
  ability and willingness to enter into financial
  contracts.
                                                      66
  It Takes Two Hands to
Develop Financial Markets!




                             67
      Which Hands? Whose Hands?

• The Invisible Hand: the market’s own power
  to develop and regulate itself, based on the
  needs of the borrowers and lenders.

• A Helping Hand: the regulator’s power to
  assist and facilitate where appropriate, and its
  power to limit and direct market forces where
  needed.


                                                     68
      How to Use the Helping Hand

• Find out about the borrowers and lenders in the
  economy
  • Who are the borrowers?
  • Who are the lenders?
  • What are their particular needs?

• Look for the obstacles that prevent borrowers
  and lenders from making contracts

• Remove the obstacles, or find ways around
  them
                                                  69
         The Helping Hand - Government
Asymmetric information might create a role for
 government regulation

Governments can:
  • provide necessary conditions for market development
     •   creditor rights and contract enforcement
     •   infrastructure
     •   regulations
     •   stable macroeconomy
  • intervene to correct market failures that limit market
    development
  • coordinate and direct future market development
                                                       70
       Borrowers, Lenders, Regulators
         Still May Not Be Enough
• Suppose that regulators are able to improve
  conditions in the market that make borrowers
  and lenders able and willing to introduce a new
  instrument.

• Then the instrument is issued, and…the
  lenders hold it to maturity—you have a buy
  and hold market.

• There’s still something missing!

                                               71
Liquidity Providers:
Traders and Dealers




                       72
             Liquidity Providers

• Lenders may have the need to sell a security
  before maturity—but to whom?

• Providing this liquidity is a valuable service,
  but the providers must be able to make a living
  by offering it.

• Specialized liquidity providers, who do not
  have the same constraints as borrowers and
  lenders, have found a way to profit from
  providing this service.
                                                 73
           Favorable Risk Profile

• Liquidity providers earn a living by taking on
  the liquidity risk of other players and
  transforming it into another risk—often,
  market risk.

• If a security has high credit risk also, then a
  liquidity provider can manage the market risk
  well and still lose, because of defaults.

• A security must have an attractive overall risk
  profile, in the eyes of the liquidity provider.
                                                    74
               Putting It All Together
Financial markets develop when the following happen:

   • Borrowers and lenders are willing and able to make
     contracts

   • Liquidity providers can make sufficient profits by
     trading the securities created by borrowers and lenders.

   • Regulators understand the needs of borrowers, lenders,
     and liquidity providers and act to meet these needs.
                                                        75
Case Study: the U.S. Commercial Paper
                Market




                                   76
          Development of the
     U.S. Commercial Paper Market

• Trading started in the early 1800s.

• Why? Until the mid-1980s, “unit banking”
  laws applied in many states:
    state (not federal) banking regulations
    no interstate banking was allowed
    most states did not allow multiple branches

• Individual banks could not keep up with the
  credit demands of large manufacturing firms     77
             Development of the
        U.S. Commercial Paper Market

• Banks were not able to shift funds from areas with
  excess liquidity to areas with liquidity needs.

• These conditions led to the creation of alternatives
  to bank intermediation.
    commercial paper market
    corporate bond market


                                                   78
      CP Market Developed Slowly,
         Then Growth Exploded


• In 1970, CP accounted for 23 percent of all
  money market instruments.

• In 1989, CP accounted for over two-thirds of
  the market.

• What happened?


                                                 79
    Three Factors Boosted the CP Market
• High U.S. interest rates starting in the 1970s,
      motivated firms to start looking for cheaper sources
     of funds.
• Interest rate ceilings on bank deposits
     with increasingly higher interest rates, market rates
     were soon well above deposit rate.
• Minimum denomination of Treasury bills was
  raised to $10,000.
      small investors (households) were denied access to
     high-yielding investments.
                                                       80
New Innovation in 1974: Money Market
      Mutual Funds (MMMFs)

• Free from bank regulations (not bank deposits).

• Minimum investment was as low as $250.

• CP was the most popular investment choice of
  MMMFs.

• Instant success!

                                                 81
                     Some Lessons
• Money markets will sometimes arise spontaneously to meet
  the credit needs of the economy.

• But assistance from regulators is often necessary to
  overcome obstacles to market development.

• Dealers are essential to the money market, and banks are
  natural candidates to become money market dealers.

• Asset-backed commercial paper may be a good first step
  toward developing a CP market.

• Money market funds are the key funnel of household
  savings to the money market.
                                                         82
Bond Market Development




                          83
             U.S. Bond Market




Total outstanding = 208% of GDP.   84
         Still a Developing Market
• The bond market is still in need of
  development, even in most financial centers;
  • Largely an OTC market
  • Low liquidity
  • Difficult to trade in many issues

• Least accessible market for the individual
  investor who wants to buy and hold

• Two Main Issues for Development:
  • Ratings
  • Accurate pricing                             85
       Rating Agencies and Bond Pricing
• Most bond markets need locally-based ratings providers

• Ratings agencies need time to establish their credibility

• Borrowers have to be willing to subject themselves to
  ratings

• Bonds are mostly traded OTC
     individual investors must rely on dealers
     prices are not publicly reported
     dealer markups on bonds to individual investors can
    be large                                          86
Stock Market Development Issues




                                  87
                Casino Culture?

Stock markets are often seen in the same light as
  a casino:

   • Game of chance;

   • Investors play for the big short-term gain;

   • Little relationship between the activity in the
     casino and the real economy;

   • Outcomes may be rigged by big players.
                                                       88
            Stockholder Society

Stock markets connect Wall Street and
  Main Street:

  • Stockholders want long-term gains;

  • The market processes information about the
    financial performance of firms;

  • The market passes information about the
    stockholders’ wishes back to the corporate
    managers.
                                                 89
      Going from Casino to Market
• The market must be made fair,
     manipulative practices must be defined,
     and made illegal!

• The market must be made open—information
  must be disclosed about
    firms listed on the exchange,
    trades and positions, if they are large enough to
    move the market
    prices.
                                                   90
  The Mutual Fund in the Stockholder
               Society
• Individuals usually don’t have the time or
  expertise to monitor their stock investments.

• Individual investors in a firm don’t have the
  incentive or the clout to influence the
  managers of the firm.

• Mutual funds concentrate the stockholdings of
  many investors, giving them expertise in
  stocks and influence over managers.
                                                  91
             Example #1:
      Primary / Secondary Markets

U.S. Government bond market: before 1975, the
  Treasury sold notes and bonds on an ad-hoc
  basis during its quarterly refinancings.

  • Its issues varied widely in maturity from
    quarter to quarter;

  • The dealers did not know what was going to be
    issued, or how much.
                                                92
            Example #1 (cont.):

In 1975, the Treasury began issuing debt on a
  regular schedule and announcing the amounts
  to be auctioned.
  • Allowed dealers to be prepared;
  • Maximized the market’s ability to absorb the
    debt issuance.

Upshot: by developing the primary market, the
 secondary market for bonds improved.
                                                   93
        Example #2: Derivatives Markets

The introduction of Treasury bill and bond futures
  contributed greatly to the liquidity of the government
  securities markets.
   • Portfolio managers are more willing to hold the
     securities because they can hedge their exposure.
   • They can combine futures with spot positions to
     synthesize positions with minimal transaction costs.

Bottom line: lack of development may be caused by a
 problem or condition in another market or market
 segment.                                         94
      Developing Individual Markets

• Regulators are often asked to develop markets
  for particular instruments.

• First, ask whether the appropriate
  infrastructure to support this market is in
  place.

• Second, ask about borrowers and lenders
  (think about the previous slides).

• And, ask one more question...
                                                  95
        Does Every Country Need
    Its Own Set of Financial Markets?

• All nations should have access to the full set of
  financial services and products.

• Markets can exist in all sizes, but there may be
  efficiency and market liquidity gains from
  combining or linking smaller markets.

• Markets now depend less on having a specific
  location (Wall Street) and more on having a
  communications network.
                                                  96
         Financial Depth & Development,
                      Comparative statistics

                                Financial Depth, 2006
                               Latin America vs. Other Regions

            Private credit by deposit money banks and other financial institutions to GDP
            Stock market capitalization/GDP
  200%

  180%

  160%

  140%

  120%

  100%

   80%

   60%

   40%

   20%

   0%




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Source: World Bank.                                                                            97
         Financial Depth & Development,
                                         Comparative statistics
                                    Financial Structure Indicator, 2006
                                    (Stock market size as a percentage of total financial depth)
   80%




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   40%




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Source: World Bank.                                                                                              98
            Financial Depth & Development,
                                        Comparative statistics
                              Size of Stock and Bond Markets, 2006
                                                (As a percentage of GDP)
180%


160%
   Stock market capitalization/GDP
140%Private        bond market capitalization to GDP
   Public bond market capitalization to GDP
120%


100%


80%


60%


40%


20%


 0%
       Argentina    Brasil   Colombia   Chile   Mexico   Peru     China    United Germany    New      Singapore   United
                                                                          Kingdom           Zealand               States



  Source: World Bank.                                                                                                 99
         Financial Depth & Development,
                               Comparative statistics

                            Degree of Stock Market Activity, 2006
                                 Latin America vs. Advanced Economies

         Stockmarket turnover ratio             Stock market total value traded to GDP

180%


150%


120%


90%


60%


30%


 0%




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   Source: World Bank.                                                                       100
                    Conclusions
• Financial market building blocks: Borrowers,
  Lenders, Liquidity Providers, Regulators

• Regulators can make conditions attractive for the
  other three players to fulfill their roles

  • Assess the infrastructure needs of the market

  • Find the obstacles that limit willingness or ability of
    players to participate

  • Remove or mitigate obstacles, or find alternative
    ways to meet players’ needs
                                                        101
                     Conclusions
• Sequencing primary and secondary market development
  depends on the specific state and needs of the market

• Regulators can develop secondary markets by working with
  the securities industry to draft rules for the smooth
  functioning of broker-dealers

• In the bond market, rating agencies and price transparency
  are critical factors

• In the stock market, the move from a casino culture to a
  stockholder society is a key step in development
                                                         102

								
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