In the previous post, we laid out the major phases of the development of the Korean bond market. Here we would like to discuss about some measures that led to today’s success. In fact, a number of factors may explain the successful development of the Korean bond market. But most important of them all is the myriads of institutional approaches taken by the government.
Institutional Innovations for Government Bond Development
With respect to government bonds, particularly treasury bonds, the primary dealer system (June 1999), the delivery-versus-payment system (November 1999), the reopening system (May 2000), and the mandatory exchange trading system for benchmark issues (October 2002) are regarded as the most effective tools that advanced the market.
The primary dealer system, first introduced in 1999, was supplemented by a new policy which required primary dealers to trade 40 percent of their benchmark issues through the electronic trading system platform established in Korea, the Korea Exchange (KRX). Despite initial concerns that this attempt would polarize the market and divide the liquidity between the exchange and over-the-counter (OTC) markets, there is a study (D Park, C Rhee, S Shin, 2006) that reveals it actually reinforced the transparency and liquidity even for the OTC market. Yet, among the many benefits that came with this trading policy, providing a benchmark rate that every market participants could credibly follow should be considered the most important aspect of this system.
The delivery-versus-payment (DVP) system provided the necessary infrastructure to ensure that transactions were executed without posing principal risks to the participants.
The reopening system was essentially designed to establish a benchmark yield curve and to enhance the liquidity on its profile of bonds along the maturity spectrum. After the system was introduced, it increased the depth of newly issued benchmark issues. A study also revealed that this measure contributed to increased on-the-run benchmark issues (K Kang, G Kim, C Rhee, 2004). All in all, these measures considerably lowered the bid-ask spread, which is considered the proxy for gauging market efficiency, from 0.2 percent in 2002 to 0.03 percent in 2008.
Furthermore, the introduction of KTB futures (September 1999), strips and 20-year treasury bonds (March 2006), and inflation-indexed bonds (March 2007) all widened the range of choices for investors and further deepened the depth of the market.
Institutional Innovations for the Secondary Market
In the first part of this article, we focused on the development of Korean treasury securities and the primary market; here, we would like to explain the recent institutional approaches to bolstering the secondary market. Traditionally, the secondary market, where over-the-counter market accounts for 80 percent of the transactions, is marked by a lack of transparency and high transaction fees. Accordingly, there was a growing demand to overhaul the system. In response, in March 2009, the Financial Services Commission (FSC) and other parties formed a coalition to lay a foundation to build a more efficient secondary market. A task force led by the FSC came up with a game plan: establishing an exclusive trading system for bond trading. Finally, in April 2010, the highly anticipated “FreeBond” system opened. It complements the hybrid brokerage model, which involves the usage of voice and online messenger brokerage, by combining it with a trading board that conveys information about the OTC market by relaying real-time quotes, transaction histories, new issuances, etc.
It is known that for an underdeveloped bond market, the government can promote market efficiency by playing an active role. Thus far, the various institutional approaches and fiscal expansion have undoubtedly backed up that assumption. Korea started from scratch, but it eventually worked its way up to one of the largest bond markets in Asia. Nevertheless, Korea still faces several outstanding issues that need to be resolved. While the government bond market grew exponentially, the size of the corporate bond market has remained practically the same for years. Companies should acknowledge the importance of bond financing and should actively seek it more, rather than relying on bank loans. Meanwhile, the government should create a conducive environment for bond investors to make corporate bonds more appealing to them. We hope that the recent infrastructure development, for example the “FreeBond” system, can have positive flow-on effects on the primary market by enhancing its market efficiency in the OTC market. Lastly, it is necessary to overhaul the money market practices prevailing in today’s market. These days, the call money market in Korea, an equivalent of the interbank lending market, mostly operates on the basis of unsecured lending. While its low interest rates and other features may be convenient to the borrower, it could lead to contagion risks if the counterparty defaults on its obligations. Several approaches are being discussed to curb the prevailing excess call money market development, and one of the plans that the government is actively seeking is nurturing the repo market. It is expected to solve the potential problems prevalent in today’s money market.
Despite the several persisting issues, Korea’s experience illustrated here serves as an example for countries where bond markets are not yet fully developed. It is also a call on those investors who are interested in the Korean market.
Donald Lee (DonaldLee.DLee@gmail.com)