## anea2021001

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### Executive summary: purpose, scope, and key messages
- Prepared by International Monetary Fund (IMF) and World Bank staff under a project supported by grants from the Financial Sector Reform and Strengthening Initiative.
- Aim: provide emerging market and developing economies with guidance and a road map to support development of their local currency bond markets (LCBMs) and to inform technical assistance missions advising authorities on policies to deepen LCBMs.
- Main messages:
  - Developing domestic debt markets is a complex, path-dependent process requiring multiple and interdependent policy actions across stakeholders (debt manager; central bank; regulators; providers of trading, payment, clearing, and settlement systems; and other policymakers).
  - A country-specific, customized approach is required because countries are at different development levels across relevant dimensions.
  - Six major building blocks for LCBM development: money market; primary market; investor base; secondary market; financial market infrastructure; legal and regulatory framework.
  - The guidance note applies specific indicators to assess stages of development and enabling conditions and provides sequencing advice.

### Empirical findings and headline statistics
- Sample and aggregated trends for a selected sample of 44 emerging markets:
  - Size of marketable government debt: "$6.5 trillion to $13.5 trillion in 2019".
  - Issuance of local currency debt: "$5.9 trillion to $12.1 trillion".
  - Local currency share of total government debt in emerging market and developing economies: "18.9 percent in 2011 to 46.6 percent in 2019".
  - In advanced economies, local currency share of total government debt: "95 percent".
- Observed improvements:
  - More transparent primary market practices and increased issuance of benchmark securities in a number of developing economies.

### Purpose of the analytical framework
- Provide a comprehensive and systematic framework to:
  - Identify gaps in a country’s LCBM.
  - Assess a country’s stage of market development.
  - Identify possible peers for replicable lessons.
- Framework components:
  - Enabling conditions (macroeconomic, fiscal, structural, financial sector soundness, debt management capacity, monetary and exchange rate conditions).
  - Six building blocks with outcome and policy indicators to be rated across four stages: stage one (nascent), stage two (developing), stage three (emerging), stage four (mature).

### Intended users and use cases
- Country authorities and technical assistance providers for diagnostic assessment and reform sequencing.
- IMF and World Bank country teams to identify macroeconomic and financial issues linked to LCBM development and integrate into policy advice.
- Financial Sector Assessment Programs and Financial Sector Stability Reviews to identify vulnerabilities and remedies.

---

### Enabling conditions: diagnostics and key assessment points
- General macroeconomic conditions
  - Objective: Judge whether a track record of sound macroeconomic performance generates investor confidence.
  - Key diagnostic question examples: Has the country maintained sound and stable macroeconomic performance in the past five years? Has the country avoided severe adverse events (sovereign debt restructurings, banking crises) over the past 10 years? (yes/no)
- Financing needs of the government
  - Objective: Assess whether projected fiscal position requires market-based borrowing sufficient to supply government securities. Consider access to concessional external financing and cases where domestic issuance is undertaken solely to develop a market.
- Structure of the economy
  - Objective: Evaluate size of economy, domestic saving base, degree of financial dollarization/euroization, and implications for absorption capacity and feasible market objectives.
- Fiscal and debt positions
  - Objective: Determine whether fiscal and debt positions are sustainable and conducive to LCBM development; highlight risks from high deficits, large external financing needs, and preference for short-term maturities.
- Monetary and exchange rate conditions
  - Objective: Test whether inflation, interest rates, exchange rates, and monetary policy framework are supportive of long-term local currency issuance and money market development.
- Financial sector soundness
  - Objective: Check whether banking sector is well-capitalized, liquid, and capable of acting as intermediary and investor.
- Debt management capacity and operating procedures
  - Objective: Check for statutory responsibilities, medium-term debt management strategy, annual borrowing plan, auction calendar, debt-recording capacity, and operational resources.

---

### Building-block diagnostic framework (overview)
- Six building blocks: (1) money market, (2) primary market, (3) secondary market, (4) investor base, (5) financial market infrastructure (FMI), (6) legal and regulatory framework.
- Indicators:
  - Outcome indicators: current market state (e.g., turnover ratios, size of marketable domestic debt).
  - Policy indicators: de jure and de facto practices (e.g., auction transparency, central bank operating framework).
- Rating method:
  - Most indicators use binary (yes/no) questions; assigned 1 (yes) or 0 (no). Sums determine indicator stage.
  - Composite stage for building blocks with both outcome and policy indicators: equal weighting of simple averages of assigned stages.
  - For FMI and legal/regulatory (policy-only), composite stage is simple average of policy indicators.

---

### Building Block 1 — Money market: outcomes, policy indicators, and common remedies
- Outcome focus: well-functioning short-term securities and repo markets (short-term yield curve up to one year; active treasury bills/central bank securities; active repos/reverse repos).
  - Six binary questions for outcome indicator; benchmarks:
    - Stage 1: 0–1
    - Stage 2: 2–3
    - Stage 3: 4–5
    - Stage 4: 6
- Policy indicators (examples and benchmarks):
  - Monetary policy operating framework (3 yes/no questions; Stage 1: 0 ... Stage 4: 3).
  - Monetary policy operations (5 yes/no questions; Stage 1: 0–1 ... Stage 4: 5).
  - Transparency (6 yes/no questions; Stage 1: 0–1 ... Stage 4: 6).
  - Legal framework for repurchase transactions (4 yes/no questions; Stage 1: 0–1 ... Stage 4: 4).
- Common constraints and remedies (selected):
  - Constraint: structural excess liquidity; Remedy: strengthen central bank liquidity management capacity; improve government cash management and coordination (examples: India, Brazil, Mexico, Malaysia).
  - Constraint: lack of repo-enabling legal/FMI arrangements; Remedies: adopt written master agreements, close-out netting recognition, tax treatment aligned with economic substance, law reform where needed (example: Thailand).
  - Constraint: absence of short-term reference rates; Remedies: collect interbank transaction data and publish aggregated reference rates (overnight, one week, three months, six months, 12 months) daily.

---

### Building Block 2 — Primary market: outcomes, policy indicators, and common remedies
- Outcome indicators (selected):
  - Marketable domestic debt as share of central government total debt:
    - Benchmarks: Stage 1: Less than 25 percent; Stage 2: 25–50 percent; Stage 3: 50–75 percent; Stage 4: More than 75 percent.
  - Stability of domestic market financing (bid-to-cover behaviour): Stage definitions from persistent undersubscription to persistent oversubscription in excess of offered amount.
  - Average maturity and refixing metrics with explicit thresholds:
    - Average time to maturity: Stage 1: Less than 1 year; Stage 2: 1–3 years; Stage 3: 3–5 years; Stage 4: More than 5 years.
    - Percentage of debt maturing in one year: Stage 1: More than 50 percent; Stage 2: 25–50 percent; Stage 3: 15–25 percent; Stage 4: Less than 15 percent.
    - Percentage of debt to be refixed in one year: Stage 1: More than 70 percent; Stage 2: 40–70 percent; Stage 3: 20–40 percent; Stage 4: Less than 20 percent.
  - Issuance across the yield curve: Stage 1: Very short yield curve (less than 1 year) up to Stage 4: Extended and well distributed benchmark yield curve (more than 10 years).
- Policy indicators (selected):
  - Market-based pricing (auction clearance at market rates; Stage 4: always cleared at market rates).
  - Market-based placement mechanisms (share placed by auctions/syndications: Stage 4: At least 80 percent).
  - Predictability and transparency of issuance (8 yes/no questions; Stage 4: 7–8).
  - Government cash flow forecasts (6 yes/no questions; Stage 4: 6).
  - Transparency of auction results (4 yes/no questions; Stage 4: 4).
  - Benchmark bonds (6 yes/no questions; Stage 4: 6).
  - Cash and debt management (5 yes/no questions; stage thresholds: Stage 1: 0–1 ... Stage 4: 5).
- Common constraints and remedies (selected):
  - Constraint: government not price-taking => nonmarket pricing, monetary financing, tapping; Remedies: create fiscal space, phase out nonmarket practices, adopt auctions, limit noncompetitive allocations, expand primary market access, enforce prohibitions on central bank monetary financing (examples: India; Vietnam).
  - Constraint: lack of benchmark bonds and inability to manage rollover risk; Remedies: gradually build benchmarks, use liability management operations (buybacks, switches), increase auction sizes carefully, maintain cash buffers (examples: Hungary, South Africa, Thailand, Mexico).

---

### Building Block 3 — Secondary market: liquidity, transparency, and market making
- Outcome indicators:
  - Market liquidity and depth (three yes/no questions: transaction sizes for banks, for nonbank institutions, securities traded across yield curve). Stage scoring: sum 0–3.
  - Supplemental indicators: daily turnover ratio bands and average bid-ask spread bands for 10-year on-the-run bonds (explicit ranges).
- Policy indicators and features:
  - Pre-trade transparency (3 yes/no questions; Stage 4: all 3).
  - Post-trade transparency (3 yes/no questions; Stage 4: all 3).
  - Market-making duties (6 yes/no questions; Stage 4: 4–6 depending on sum thresholds).
  - Market-making privileges (3 yes/no questions).
  - Trading environment (electronic trading platform, short selling rules for market making, availability and liquidity of hedging instruments).
- Common constraints and remedies (selected):
  - Constraint: thin secondary market, lack of benchmark bonds, buy-and-hold behavior; Remedies: concentrate issuance on benchmarks, reduce auction frequency, improve pre- and post-trade transparency, establish ETPs, securities lending facilities, develop repo and derivatives markets (examples: Peru, Malaysia, South Africa, Thailand).
  - Constraint: inadequate market-making capacity and feasibility of PDs; Remedies: calibrate PD obligations to market stage, provide balanced privileges, evaluate PD performance regularly, consider starting with a single or small number of dealers, provide last-resort securities lending facilities (examples: India, Malaysia, Poland).

---

### Building Block 4 — Investor base: depth, diversity, and incentives
- Outcome indicators (6 yes/no questions; Stage 4: all 6):
  1. Is the banking sector deep and diversified enough to develop a short-term yield curve?
  2. Is the banking sector deep and diversified enough to develop a repo market?
  3. Is the investor base deep enough to meet government funding requirements?
  4. Is the nonbanking sector developed enough to extend the maturities of government securities?
  5. Is the banking sector deep and diversified enough to support the secondary market?
  6. Is there a significant presence of non-buy-and-hold investors?
- Supplemental indicators (banking and nonbank depth ranges with explicit bands):
  - Banking sector assets to GDP: Range 1: Below 50 percent; Range 2: 50–75 percent; Range 3: 75–100 percent; Range 4: Above 100 percent.
  - Share of top three banks in assets: Range 1: Above 90 percent; Range 4: Below 50 percent.
  - Nonbank assets to GDP: Range 1: Below 10 percent; Range 4: Above 50 percent.
  - Share of domestic nonbank investors in government bond holdings: Range 1: Below 10 percent; Range 4: Over 40 percent.
- Policies and practices:
  - Investor relations management (4 yes/no questions; Stage 4: all 4).
  - Domestic institutional investors (4 yes/no questions; Stage 4: all 4).
  - Central bank monetary financing (5 yes/no questions; Stage 4: 5 — prohibition and limits).
  - Foreign investor operating environment (6 yes/no questions; Stage 4: all 6).
  - Buy-and-hold investor mitigation (5 yes/no questions; Stage 4: 5).
- Common constraints and remedies (selected):
  - Constraint: dominance of banks and buy-and-hold behaviour; Remedies: foster contractual savings development, supportive tax/accounting/regulatory frameworks, strengthen CISs, encourage security lending and repo usage by institutional investors, relax mandatory holdings as market deepens (examples: Malaysia, Mexico, Hungary, Thailand).
  - Constraint: central bank financing and lack of prohibition; Remedies: legal prohibitions, limits on temporary advances, disclosure of central bank holdings, restrict central bank participation in primary auctions.

---

### Building Block 5 — Financial Market Infrastructure (FMI): core functions and indicators
- Core FMI systems to assess: government securities issuance systems, security registers, RTGS payment systems, central securities depositories (CSDs), settlement systems, auction platforms.
- Key functional features: dematerialization of securities, DVP settlement, regulatory oversight, interconnectivity (RTGS-CSD-CCP-auction), capacity to process volumes, cost-efficiency.
- Electronic platforms assessment (6 yes/no questions):
  1. Electronic auction system used? (yes/no)
  2. Single electronic register/depository for government securities? (yes/no)
  3. Commercial banks operate an electronic wholesale payment system? (yes/no)
  4. Central bank operates modern RTGS? (yes/no)
  5. Single electronic CSD and/or CCP for government securities settlement? (yes/no)
  6. Electronic interface between RTGS and CSD/CCP and auction systems? (yes/no)
  - Stage thresholds: Stage 1: 0, 1; Stage 2: 2, 3; Stage 3: 4, 5; Stage 4: 6.
- Security registration and dematerialization:
  - Percent of government securities issued in dematerialized form and percent assigned ISIN/CUSIP used as benchmarks; Stage 4: 100 percent dematerialized with ISIN/CUSIP.
- Clearing and settlement risk (CSD and CCP) assessed by explicit yes/no questions on legal protection of payment and transfer finality, DVP1 support, settlement via RTGS, T+0 or T+1 support, guarantee fund stress testing for CCPs, and netting transparency.
- FMI governance, access policies, market segmentation, repo-support features, and transparency of data/publication responsibilities are assessed via enumerated yes/no question sets with explicit stage thresholds.
- Common constraints and remedies (selected):
  - Constraint: fragmented CSDs and manual processes; Remedies: assess FMI against principles for FMI, develop single integrated systems or electronic links, introduce dematerialization law, ensure DVP1 and RTGS interconnectivity, set fair access and cost recovery fee structures, build capacity and contingency planning (examples: Georgia, Honduras).
  - Constraint: insufficient repo-supporting FMI features; Remedies: enable intraday repo, support collateral substitution and pledges, align repo settlement costs with unsecured transactions.

---

### Building Block 6 — Legal and regulatory framework: components and tax
- Key components:
  - Borrowing authority: law should define clear single entity authorized to borrow, roles, liability management powers, and requirement to prepare and publish medium-term debt management strategy.
  - Market regulation and enforcement: legal framework to prohibit market manipulation, enable surveillance and enforcement capacity.
  - Investor protection: segregation and identification of customer assets, supervisory capacity to enforce.
  - Collective investment schemes (CIS): eligibility, governance, disclosure, mark-to-market valuation rules.
  - Tax framework: clear and neutral tax treatment for returns, secondary transactions, repos, securities lending, financial collateral, and derivatives across investor types.
- Tax treatment highlights:
  - Key supply-side and demand-side tax objectives outlined (neutrality, simplicity, competitiveness).
  - Boxed issues: tax treatment of repos (disregard transfer/return for seller; treat repo return as interest), securities lending, manufactured payments, taxation of derivatives (trend toward mark-to-market).
- Common constraints and remedies (selected):
  - Constraint: legal ambiguity limiting liability management operations; Remedies: clarify via subsidiary legislation or legal opinion, reform law to provide operational flexibility with accountability.
  - Constraint: tax impediments deterring investors (including nonresidents); Remedies: diagnostic tax review and reforms to align with international common practice, consider withholding tax and capital gains exemptions to facilitate foreign linkages (examples: Georgia, Vietnam).

---

### Sequencing reforms and reform plan design (Seven-step roadmap)
- Seven steps for designing an LCBM reform plan:
  1. Determine LCBM objectives and policy priorities (examples include increase local funding capacity, broaden investor base, improve monetary transmission).
  2. Establish a coordination mechanism for LCBM reform (high-level committee and technical working groups; Ministry of Finance for leadership and secretariat).
  3. Evaluate enabling conditions and stages of market development across building blocks (use diagnostics and heat maps).
  4. Identify peer groups to benchmark experiences (by income, population, dollarization, monetary regime, financial sector size, LCBM stage).
  5. Identify gaps in each building block relative to peers.
  6. Formulate actions and sequence measures considering capacity and institutional constraints.
  7. Propose targets, deadlines, and assign responsibilities; include milestones, budgets, and monitoring arrangements.
- Stylized sequencing phases described:
  - Phase 1: nascent → developing (focus on short-term instruments, market-based pricing, legal/infrastructure foundations).
  - Phase 2: developing → emerging (lengthen maturities, establish benchmarks, develop repo and derivatives, consider PD systems cautiously).
  - Phase 3: emerging → mature (deepen liquidity, expand investor base, robust PD system, inclusion in international indexes where appropriate).

---

### Risks to financial stability and policy tools during stress
- Benefits of liquid government bond markets: absorb stresses, improve price discovery, facilitate risk pricing.
- Risks of illiquidity: amplify shocks via large price moves, reduce agents’ ability to manage risk, complicate authorities’ monitoring.
- Policy tools during market stress:
  - Adjust securities lending program volumes.
  - Amend collateral policies.
  - Central bank outright purchases/sales to restore price discovery.
  - Simultaneous primary issuance and buyback/exchange operations.
  - Lender-of-last-resort liquidity provision when dealers face funding constraints.
- Foreign participation considerations:
  - Significant foreign participation can cause vulnerability to reversals and exchange rate disruptions.
  - Essential enablers: exchange rate flexibility and deeper FX derivatives markets to hedge currency risk; a strong domestic institutional investor base offsets nonresident reversals.

---

### Primary Dealer (PD) systems: preconditions, design, and implementation steps
- PD rationale:
  - PDs can enhance price discovery and secondary market liquidity when preconditions are met; PD systems are not preconditions for LCBM development.
- Preconditions for PD introduction (selected):
  - Many LCBM building blocks at least in stage 2, preferably stage 3 (not all need be identical).
  - Specific preconditions include: stable macro conditions; adequate legal and supervisory systems; RTGS and DVP settlement; liberalized interest rates; predictable issuance policy; diversified investor base; market large enough to support at least five to six PDs; sufficiently large outstanding debt.
- Typical PD obligations and privileges:
  - Obligations include bidding in primary market, placing securities with final investors, quoting firm prices, reporting activities, and advising the DMO.
  - Privileges include exclusive access to the primary market, securities lending facilities, participation in noncompetitive subscriptions, and a PD title/league table.
- Performance assessment and ongoing calibration:
  - Regular PD performance evaluation with corrective actions and rewards.
  - Rights and obligations should be balanced and dynamically reviewed.
- Steps to introduce a PD system (enumerated):
  1. Assess preconditions.
  2. Assess net advantage.
  3. Canvass intermediaries for interest.
  4. Call for expressions of interest and form a working group.
  5. Coordinate Ministry of Finance, central bank, and market conduct authority.
  6. Formalize PD–authority relationship.
  7. Design PD performance appraisal and reward mechanisms.
  8. Launch PD system once prerequisites met.

---

### Country experiences and selected case examples (selected outcomes and lessons)
- Vietnam: legal reform and Road Map 2017–20; Public Debt Management Law amendment (approved November 2017; effective July 2018) to allow market-based borrowing and modernize issuance, registration, depository, listing, and trading; complementary circulars to support LMOs, PD system, and same-day trading.
- Georgia: tax law reforms (supply-side and technical amendments) and FMI consolidation (Georgian Security Settlement System) integrating CSD and RTGS; tax clarity enabled linkage with Clearstream; full benefits expected over time.
- Malaysia: phased liberalization for foreign investors (withholding tax elimination 2004; hedging allowances 2005; further liberalizations 2007, 2016–17) and development of EPF as a large institutional anchor (EPF assets: 839.6 billion ringgit at end of 2019, or 58 percent of GDP).
  - Foreign investor share rose from "13.5 percent at the end of 2009" to a peak of "35.75 percent in September 2016" and about "24 percent (as of March 2019)".
- India: phased reforms from administered rates to market-based pricing and infrastructure (auctions 1991; 91-day treasury bills 1993; PD system 1995; repos and derivatives late 1990s; Liquidity Adjustment Facility 2000). Weighted average maturity increased from "6.5 years in FY1998" to "8.9 years by FY2003" and further to "10.6 by FY2018".
- Peru, Serbia, Albania, South Africa, Thailand, Honduras, WAEMU examples: illustrate issuance predictability, benchmark building, ETPs, electronic trading desks, market-maker programs, central coordination to avoid fragmentation, and legal/tax reform experiences.
- IMF–World Bank survey of 32 countries: common structural issues include lack of diversified investor base, concentration of banking sector, structural excess liquidity; short-term policy measures can help while structural reforms take time.

---

### Common challenges across countries (summary) and prioritized remedies
- Common challenges:
  - Structural excess liquidity; concentrated banking sectors; underdeveloped nonbank institutional investors.
  - Fragmented issuance (central bank vs government) and poor coordination leading to market fragmentation.
  - Lack of benchmark bonds and predictable issuance calendars; weak cash management and inability to perform liability management operations.
  - Weak or fragmented FMI (multiple CSDs, lack of DVP/RTGS interconnectivity, manual processes).
  - Legal, regulatory, and tax impediments (unclear borrowing authority, lack of legal basis for LMOs, tax distortions for repos and secondary trading).
  - Dominance of buy-and-hold investors and limited market making.
- Prioritized remedies (high-level):
  - Strengthen enabling macroconditions and fiscal space to permit market-based pricing.
  - Improve predictability and transparency of issuance (medium-term debt strategy; annual borrowing plan; quarterly/ monthly issuance calendar).
  - Build benchmark securities via regular reopenings and calibrate auction frequency/size to avoid oversupply and fragmentation.
  - Upgrade FMI: dematerialization, RTGS–CSD links, DVP1 settlement, integrated electronic auction and trading systems.
  - Adopt legal reforms for repo enforceability, close-out netting, financial collateral, and liability management powers.
  - Reform tax frameworks to neutralize distortions (repos, securities lending, secondary sales, collective investment schemes).
  - Develop investor base: promote contractual savings, CISs, supportive tax/accounting/regulatory frameworks, and careful liberalization for foreign investors.
  - Design PD systems only when preconditions are met and calibrate obligations and privileges.

*Source: Executive Summary; Introduction; Part 1. Diagnostics; Part 2. Country Experiences; Appendix 1; Appendix 2; Appendix 5 — anea2021001 (IMF–World Bank analytical note).*

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### Executive Summary

### Purpose and scope
- Prepared by International Monetary Fund (IMF) and World Bank staff under a project supported by grants from the Financial Sector Reform and Strengthening Initiative.
- Aim: provide emerging market and developing economies with guidance and a road map to support development of their local currency bond markets (LCBMs) and to inform technical assistance missions advising authorities on policies to deepen LCBMs.

### Key motivations and economic benefits
- Deep and efficient domestic government debt markets:
  - Increase resilience to shocks in times of financial turbulence.
  - Mitigate currency risk and associated financial distress.
  - Help price risk appropriately and improve portfolio management.
  - Provide a more effective conduit for monetary policy.
  - Help boost long-term economic growth potential.
- Recent crises, including the coronavirus pandemic, underscore the importance of efficient LCBMs to increase economic resilience.

### Main message on complexity and approach
- Developing domestic debt markets is a complex, path-dependent process requiring multiple and interdependent policy actions across stakeholders: debt manager; central bank; regulators; providers of trading, payment, clearing, and settlement systems; and other policymakers.
- A country-specific, customized approach is required because countries are at different development levels across relevant dimensions.

### Analytical framework
- The guidance note provides a comprehensive and systematic framework to:
  - Identify gaps in a country’s LCBM.
  - Assess a country’s stage of market development.
  - Identify possible peers for replicable lessons.
- Six major building blocks of LCBM development:
  - Money market
  - Primary market
  - Investor base
  - Secondary market
  - Financial market infrastructure
  - Legal and regulatory framework
- Applies specific indicators to assess stages of development and enabling conditions.

### Empirical findings and trends
- For a selected sample of 44 emerging markets:
  - Size of marketable government debt more than doubled since 2011: "$6.5 trillion to $13.5 trillion in 2019".
  - Issuance of local currency debt increased: "$5.9 trillion to $12.1 trillion".
- Local currency share of total government debt in emerging market and developing economies:
  - Increased from "18.9 percent in 2011 to 46.6 percent in 2019".
- In advanced economies, local currency share of total government debt is about "95 percent".
- Issuance policies have improved: more transparent primary market practices and increased issuance of benchmark securities in a number of developing economies.

### Remaining challenges and bottlenecks
- Significant scope remains for further LCBM development despite progress.
- Obstacles include:
  - Banking sector and macroeconomic dysfunctions in some countries.
  - Lack of underlying enabling conditions.
  - Implementation bottlenecks in adopting best practices.
- Interdependent nature of reforms and need for supportive actions beyond narrow LCBM agents.

### Policy guidance and use cases
- The guidance note:
  - Discusses commonly faced challenges and provides policy guidance drawing on IMF and World Bank technical assistance, cross-country experience, and a 2019 survey of country authorities.
  - Emphasizes the need to sequence reforms and tailor them to country-specific conditions.
- Intended users:
  - Country authorities and technical assistance providers for diagnostic assessment and reform sequencing.
  - IMF and World Bank country teams to identify macroeconomic and financial issues linked to LCBM development and to integrate into policy advice.
  - Use in Financial Sector Assessment Programs and Financial Sector Stability Reviews to identify vulnerabilities and remedies.

### Organization of the guidance note
- Part 1: Diagnostic framework — enabling conditions and indicators across the six building blocks.
- Part 2: Country experiences — challenges, bottlenecks, and remedies with supporting country cases.
- Final section: Road map and implementation guidance based on Part 1 diagnostics and Part 2 challenges.
- Appendixes:
  - Appendix 1: Selected case studies.
  - Appendix 2: Results from a 2019 survey of country authorities.
  - Appendix 3: Three stylized cases illustrating reform paths.
  - Appendix 4: Discussion of impacts of a deeper domestic debt market on financial stability.
  - Appendix 5: Features and preconditions of a primary dealer system.

*Source: Executive Summary, anea2021001 - Executive Summary*

### Introduction

### anea2021001 - Introduction

### The Work on LCBM Development Up to Now
- Empirical findings on determinants of local currency bond market (LCBM) development:
  - Countries with stable inflation rates and strong creditor rights have more developed LCBMs and rely less on foreign currency denominated bonds (Burger and Warnock 2006).
  - LCBM capitalization in selected African countries is negatively correlated with governments’ fiscal balance and relatively high inflation, and positively related to common law legal origins, quality of institutional setup, and strong democratic political systems (Essers and others 2016).
  - Better macroeconomic performance and stronger institutions help develop stronger LCBMs in Asian emerging markets (Park 2017).
- Specific building blocks and practical conclusions (Árvai and Heenan 2008):
  - (1) Commitment to stable macroeconomic environment, especially prudent fiscal policy, should underpin market development.
  - (2) A sound and transparent public debt management strategy supports secondary market activity.
  - (3) A deep and diverse investor base is required.
  - (4) Poor market infrastructure leads to high transaction costs, slow order execution, and excessive operational risk, inhibiting trading.
  - (5) Secondary market growth is facilitated by effective monetary policy implementation.
  - (6) Reforms should be sequenced to ensure balanced development of all structures supporting the secondary market.
- Stages of LCBM development and priority shifts (Jonasson and Papaioannou 2018):
  - Initial stage: establish a functioning primary market and create enabling conditions for secondary market development.
  - Deepening stage: focus on improving liquidity on the secondary market once basic elements are established and functioning.
  - Maturing stage: develop sophisticated instruments and segments such as derivatives and make the market internationally competitive.
  - Debt managers influence market development via instrument design, issuance patterns, and communication channels.
- Main impediments and policy focuses (Jonasson, Papaioannou, and Williams 2019):
  - Impediments include macro or political instability; financial repression; low domestic savings; paucity of institutional investors; proliferation of government agencies issuing securities; unpredictable issuance policy; and absence of required market infrastructure.
  - Policy priorities: develop credibility of the government as issuer and policymaker; maintain transparency; enhance secondary market liquidity; promote a well-functioning money market, diversified investor base, and appropriate regulatory infrastructure.
- Multilateral and regional initiatives:
  - World Bank and IMF handbook (2001) on policy issues, building blocks, and implementation considerations.
  - Joint pilot program to design reform and capacity-building programs in 12 countries (World Bank 2007). The 12 countries are Bulgaria, Colombia, Costa Rica, Croatia, Indonesia, Kenya, Lebanon, Nicaragua, Pakistan, Sri Lanka, Tunisia, and Zambia.
  - Government Securities Market Development Toolkit for low-income countries (World Bank 2014) using a rating system of 10 government securities market development key performance indicators.
  - Stock-taking of recent global LCBM policy initiatives and trends (IMF and World Bank 2018; IMF and World Bank 2020).
  - Regional reports, including an Asian Development Bank report (2019) on ASEAN+3 trends and good practices.
- Gap identified:
  - Despite extensive work, a more granular description of underlying factors driving market development and country-level challenges was missing; the analytical framework presented in this guidance note aims to close this gap.

### Framework Overview: Enabling Conditions and Six Building Blocks
- Two components of the assessment framework:
  - Enabling conditions: the broader environment shaping feasibility, sequencing, and effectiveness of LCBM reforms.
  - Six building blocks: money market, primary market, secondary market, investor base, financial market infrastructure, and legal and regulatory framework.
- Key conceptual points:
  - Enabling conditions broadly define a country’s development potential and shape policy priorities and sequencing.
  - Strengthening basic functionalities in building blocks can generate virtuous cycles that improve enabling conditions.
  - Structural constraints (for example, small economy size) impose natural limits on domestic market development; securing stable, consistent financing from the domestic market may be the primary objective in such cases.
  - Financial dollarization/euroization reduces ease of issuing local currency assets; a small share of foreign currency deposits/lending supports demand for local currency assets.
- Diagrammatic summary (as described in text):
  - Enabling conditions (general macroeconomic conditions; financing needs of government; fiscal and debt positions; structure of the economy; financial sector soundness; debt management capacity and operating procedures; monetary and exchange rate conditions) influence three markets (money, primary, and secondary) and the investor base.
  - Financial market infrastructure and legal and regulatory environment are largely independent but interact with other building blocks.
  - Feedback loops: e.g., a strong primary market can promote fiscal discipline, improving sustainability in fiscal and debt positions.

### Detailed Enabling Conditions and Key Assessment Points
- General Macroeconomic Conditions
  - Importance: stable macroeconomic environment anchors investor confidence and preserves value of debt holdings.
  - Risk: past severe adverse events (sovereign debt crisis, restructurings, banking sector crises) can have lingering impacts on investor confidence.
- Financing Needs of the Government
  - Government fiscal requirements dictate borrowing and the supply of government securities.
  - In some lower-income countries, availability of grants or long-term concessional borrowing may make issuance of more expensive local debt inadvisable if foreign currency risk is not a concern.
  - Some countries have issued domestic debt solely to develop a domestic market.
- Structure of the Economy
  - Size of the economy and domestic savings base (including contractual saving institutions) affect absorption capacity.
  - Small economies face challenges building a liquid market, consolidating instruments, issuing liquid benchmark bonds, mobilizing large cash volumes, and avoiding concentrated holdings.
  - Low domestic saving rates constrain demand for interest-bearing financial assets.
  - It is easier to issue local currency assets in a country with low levels of financial dollarization/euroization.
- Fiscal and Debt Positions
  - Sound fiscal and debt positions support primary market development.
  - High fiscal deficits, large external financing needs, high stock of public debt subject to market risks, and unsustainable fiscal positions increase vulnerability.
  - Reliance on concessional external loans or nonmarketable domestic borrowings can constrain LCBM growth.
  - Noncompetitive placement methods (interest rate controls, central bank direct lending, accumulation of arrears) may save short-term costs but impede market development and fiscal discipline in the long term.
  - Preference for short-term maturities to save near-term costs impedes market development and raises refinancing risks.
- Monetary and Exchange Rate Conditions
  - Stable inflation, interest rates, and exchange rates reduce investor uncertainty and enhance demand for government-marketable debt.
  - Excessive interest rate volatility and inflation pressures raise yields and reduce investor incentives for long-term local assets.
  - High exchange rate volatility and high pass-through deter investor confidence.
  - Interest rate controls and financial repression may distort market interest rates and undermine long-term market development.
- Financial Sector Soundness
  - A liquid and well-capitalized financial sector is essential since the banking sector is often a large investor and intermediary in LCBMs.
  - Soundness assessed by capital adequacy, asset quality, earnings, and liquidity.
  - Financial sector instability hampers the banking sector’s capacity to support LCBMs.
- Debt Management Capacity and Operating Procedures
  - Clear statutory responsibilities, defined operating procedures, and adequate resources are key enabling conditions.
  - The debt management entity should have trained staff, a supporting organizational structure, and necessary resources.
  - Important tools: medium-term debt management strategy, annual borrowing plan, auction calendar, and debt-reporting procedure supported by robust public debt-recording capacity.
  - For countries with a high stock of nonmarketable debt, a medium-term strategy should consider transitioning toward more marketable instruments.
  - The debt management authority is typically best placed to lead LCBM reforms, though in some countries central banks may have higher capacity and closer market contact.

### Framework to Assess Conduciveness of Enabling Conditions (Checklist)
- (1) General macroeconomic conditions
  - Objective: Assess whether track record of macroeconomic performance generates investor confidence.
  - Key questions:
    - (1) Has the country been able to maintain a track record of sound and stable macroeconomic performance in the past five years? (yes/no)
    - (2) Has the country been able to avoid severe adverse events such as sovereign debt restructurings and banking sector crises over the past 10 years? (yes/no)
- (2) Financing needs
  - Objective: Assess whether government financing needs support LCBM development.
  - Key questions:
    - (1) Does the projected fiscal position of the government require market-based borrowing that generates a sufficient supply of government securities in the LCBM? (yes/no)
    - (2) Is the government anticipating reduced access to or declining disbursements of concessional external financing (grants and loans), which would warrant more domestic borrowing? (yes/no)
- (3) Structure of the economy
  - Objective: Assess whether structure of the financial sector supports LCBM development.
  - Key questions:
    - (1) Is the size of the economy sufficiently large to develop a financial sector that can support the LCBM? (yes/no)
    - (2) Is the domestic saving base large enough to support the demand for government securities? (yes/no)
    - (3) Is the use of domestic currency in the economy widespread enough to have an LCBM? (yes/no)
- (4) Fiscal and debt positions
  - Objective: Assess whether the fiscal position is sustainable and conducive to LCBM development.
  - Key questions:
    - (1) Is the government’s debt position at low or medium risk of overall debt distress based on IMF–World Bank’s low-income countries’ debt sustainability assessment framework, or considered sustainable based on market access countries’ debt sustainability assessment framework? (yes/no)
    - (2) Is the fiscal position of the government sustainable without having to resort to fiscal dominance on monetary and financial policies? (yes/no)
- (5) Monetary and exchange rate conditions
  - Objectives: Assess whether monetary conditions are conducive to LCBM development.
  - Key questions:
    - (1) Is inflation low and stable, and are inflationary expectations well anchored? (yes/no)
    - (2) Are exchange rates aligned with fundamentals, such that investors are not concerned about the risk of large devaluations? (yes/no)
    - (3) Is volatility in short- and long-term market interest rates well contained? (yes/no)
    - (4) Is financial repression (such as through interest rate controls) absent in the financial system? (yes/no)
- (6) Financial sector soundness
  - Objective: Assess whether financial sector conditions are conducive to LCBM development.
  - Key question:
    - Is the banking sector sound and stable, with adequate solvency and liquidity positions? (yes/no)
- (7) Debt management capacity and operating procedures
  - Objective: Assess whether enabling conditions for efficient public debt management are in place.
  - Key questions:
    - (1) Does the legal and institutional framework define a clear responsibility for a single entity to issue debt on behalf of the central government and execute operations related to that debt? (yes/no)
    - (2) Does the entity responsible for debt management have sound governance arrangements and qualified staff? (yes/no)
    - (3) Does the entity responsible for debt management prepare and publish a medium-term debt management strategy? (yes/no)

*Source: anea2021001 - Introduction (IMF analytical note).*

### Part 1. Diagnostics

### Building Blocks of LCBM Development (Part 1. Diagnostics)

### Overview
- Six building blocks analyze development of local currency bond markets (LCBMs) in relation to depth, liquidity, diversity, and resilience: (1) the money market, (2) the primary market, (3) the secondary market, (4) the investor base, (5) the financial market infrastructure (FMI), and (6) the legal and regulatory framework.
- The framework uses indicators representing key functionalities of each building block. Each indicator is assessed from stage one to stage four, summarizing level of functionality.
- Indicators are ordered sequentially from foundational measures to greater sophistication.
- A composite stage at the building-block level can be calculated to help sequence policy efforts.
- Benchmarking at indicator and building-block levels enables identification of peer countries and formulation of LCBM reform plans.

### Determining the Stage of Development
- Two types of indicators:
  - Outcome indicators: show current state of the market in relation to the building block.
  - Policy indicators: analyze current policy and regulatory-associated practices (de jure and de facto).
- Most indicators use several binary (yes/no) questions; countries are rated 1 (yes) or 0 (no) for each question. The sum determines the indicator stage.
- For several indicators (mostly in the primary market), a specific question determines the stage.
- Composite stage calculation:
  - For four building blocks (money market, primary market, secondary market, investor base) that have outcome and policy indicators, a composite stage = equal weighting of the simple average of assigned stages of outcome indicators and policy indicators.
  - For two building blocks (market infrastructure and legal and regulatory framework) that have only policy indicators, a composite stage = simple average of assigned stages of policy indicators.

### The Four Stages of LCBM Development
- Stage one (nascent): the relevant indicator exhibits no functionality.
- Stage two (developing): the relevant indicator exhibits some functionality, but severe shortcomings exist.
- Stage three (emerging): basic elements of the indicator’s functionality are established.
- Stage four (mature): the indicator exhibits a considerable degree of functionality; broadly corresponds to levels and functionalities in LCBMs of advanced economies.
- Note: For the investor base building block, stage four represents functionalities observed in emerging market economies at a more advanced stage of market development.

### Building Block 1: Money Market — Purpose and Rationale
- An efficient money market:
  - Facilitates implementation of monetary policy and strengthens monetary policy transmission.
  - Provides a foundation for maturity extension of government financing.
  - Supports short-term financing and inventory management of market makers in government securities and liquidity management operations of commercial banks.
  - Helps create broader products (for example, floating rate instruments) and hedging tools (for example, interest rate swaps), which can facilitate capital market development.
- Money market segments in this assessment relate to short-term instruments excluding foreign exchange derivatives and interest rate derivatives.

### Outcome Indicator: Well-Functioning Short-Term Securities and Repo Markets
- Rationale:
  - A reliable short-term yield curve and active repo market provide the foundation for issuance of long-term securities and secondary market development.
  - The treasury bill market is often the most liquid and important segment; treasury bills are discount instruments generally at tenors of less than one year.
  - repo markets support market-making, inventory management, liquidity adjustment, investment in longer-term government securities, and reduced reliance on central bank operations as they develop.
  - Size of haircuts applied to government securities should not be set too high or deviate significantly from that imposed on central bank securities.
- Definitions and notes:
  - A repo (or sale and repurchase agreement) is the sale of securities tied to an agreement to buy them back later; a reverse repo is the purchase tied to an agreement to sell back later.
  - Repos are best thought of as collateralized loans; use increased after the global financial crisis because they minimize counterparty credit risks.
  - A liquid money market has active secured and unsecured segments with robust price transparency and trading volumes.

### Policy Indicators — Key Considerations
- Monetary Policy Operating Framework Supportive of LCBM Development:
  - The operating framework affects money market development and defines central bank involvement. Market-based frameworks that use interest rates as operational targets tend to correlate with more active money markets.
  - Transition to market-based frameworks entails costs (for example, higher interest expenses) and potential central bank negative capital positions; authorities need to consider these costs.
  - A market-based framework requires liquidity management across the whole banking sector; excess liquidity not properly managed can undermine incentives to trade.
- Monetary Policy Operations Supportive of LCBM Development:
  - Open market operations are integral to money markets; direct policy instruments (interest rate controls) are harmful to development.
  - High reserve requirements typical under a reserve monetary targeting framework can distort price discovery and put downward pressure on market interest rates.
  - Use of marketable securities in liquidity absorption operations is more conducive to market development than non-marketable term deposits.
  - Competitive price auctions indicate securities are issued at market rates and are more likely to be traded in the secondary market.
- Transparency of Market Information:
  - Publication of short-term reference rates (other than the policy rate) is important; transaction-based reference rates are generally more reliable than quote-based rates.
  - Market pricing information is necessary to construct a reliable short-term yield curve; trading volumes help broaden investor base.
  - Ideally, market pricing should be published daily (by the end of the business day); trading volumes should be published at least monthly.
  - Local banking or market associations, or sometimes the central bank, are best placed to publish reference rates; appropriate measures should ensure reliability.
- Legal Framework for Repurchase Transactions:
  - Written master agreements (for example, Global Master Repurchase Agreement, Master Repurchase Agreement) and their enforceability are crucial.
  - Supportive legislation is often required to recognize ownership rights over collateral and close-out netting upon insolvency-related default.
  - Tax treatment should reflect economic substance (treat repo income and gains as interest income and expenses) and avoid withholding and transaction taxes that distort repo markets.
  - Legal framework should allow substitution and rehypothecation of collateral to ensure operational flexibility.
  - In some countries without robust repo frameworks, sell/buybacks are used but are less efficient and more costly.

### Framework for the Money Market — Outcome and Policy Questionnaires and Benchmarks
- Outcome (1) Well-functioning short-term securities and repo markets
  - Objectives: Assess whether short-term securities and repo markets are supportive of government bond market development.
  - Key questions (yes/no):
    1. Has a short-term yield curve of up to one-year maturity (including treasury bills) been established?
    2. Are treasury bills, central bank securities, or both actively traded in the secondary market?
    3. Are repos/reverse repos actively used in central bank market operations?
    4. Are repos/reverse repos actively used by investors for cash investments, funding, or liquidity management purposes?
    5. Are repos/reverse repos and/or securities lending facilities actively used by dealers for market-making activities?
    6. Is the size of haircuts (defined by the central bank or other regulator) for repo transactions conducive to the use of repo transactions?
  - Benchmarks: Countries are rated as 1 (yes) or 0 (no) on the six questions. The sum of six ratings determines the stage.
    - Stage 1: 0–1
    - Stage 2: 2–3
    - Stage 3: 4–5
    - Stage 4: 6
- Policies/Practices (2) Monetary policy operating framework
  - Objective: Assess whether the operating framework for monetary policy is conducive to money market development.
  - Key questions (yes/no):
    1. Does the monetary policy framework require the extensive use of interest rates as an operational target?
    2. Are authorities willing to accept the costs of market-based operations?
    3. Are there an operational framework and capacity for banking sector liquidity management?
  - Benchmarks: Countries are rated as 1 (yes) or 0 (no) on the three questions. The sum determines the stage.
    - Stage 1: 0
    - Stage 2: 1
    - Stage 3: 2
    - Stage 4: 3
- Policies/Practices (3) Monetary policy operations
  - Objective: Assess whether monetary policy operations are conducive to money market development.
  - Key questions (yes/no):
    1. Do monetary policy operations exclude the use of interest rate controls?
    2. Are excess reserves remunerated at below but close to market rates to avoid undermining incentives to market participants to trade in the market?
    3. Is an interest rate corridor for overnight rates set at a range that does not deter interbank trading?
    4. Are tradable securities used in liquidity absorption operations without relying heavily on nontradable instruments?
    5. Are competitive price auctions used for open market operations by the central bank?
  - Benchmarks: Countries are rated as 1 (yes) or 0 (no) on the five questions. The sum determines the stage.
    - Stage 1: 0–1
    - Stage 2: 2–3
    - Stage 3: 4
    - Stage 4: 5
- Policies/Practices (4) Transparency
  - Objective: Assess the transparency of the money market.
  - Key questions (yes/no):
    1. Is pre-trade quoting information consistently available to participants in the treasury bills or central bank securities market, or both?
    2. Is pre-trade quoting information consistently available to participants in the repo market?
    3. Are key short-term reference interest rates published daily?
    4. Are appropriate measures taken to ensure the reliability of reference interest rates (that is, based on either transaction prices or committed quotes)?
    5. Is trading information on market prices (daily, by the end of business day) and the trading volume (monthly or more frequently) of treasury bills and/or central bank securities published?
    6. Is trading information (such as trading volume) on repo markets published (monthly or more frequently)?
  - Benchmarks: Countries are rated as 1 (yes) or 0 (no) on the six questions. The sum determines the stage.
    - Stage 1: 0–1
    - Stage 2: 2–3
    - Stage 3: 4–5
    - Stage 4: 6
- Policies/Practices (5) The legal framework for repurchase transactions
  - Objective: Assess the legal robustness of repurchase transactions.
  - Key questions (yes/no):
    1. Are written standard master agreements for repo transactions adopted and widely used?
    2. Does the legal framework support legal robustness by allowing full transfer of securities as collateral and close-out netting upon insolvency-related default of a counterparty?
    3. Is the contractual authorization for substitution and reuse of collateral consistent with the broader legal framework?
    4. Is the tax framework conducive to repo market development?
  - Benchmarks: Countries are rated as 1 (yes) or 0 (no) on the four questions. The sum determines the stage.
    - Stage 1: 0–1
    - Stage 2: 2
    - Stage 3: 3
    - Stage 4: 4

*Guidance Note for Developing Government Local Currency Bond Markets — Part 1. Diagnostics*

### Part 1. Diagnostics

### Building Block 2: Primary Market

### Role and Overview
- The primary government bond market lays the foundation for the LCBM.
- The primary market provides the domestic financing to the government.
- The debt manager implements the debt management strategy and establishes the relationship with market participants through the primary market.
- The debt manager can directly influence: the definition of the debt instrument, the auction calendar, and issuance procedures.
- The primary market provides a regular opportunity for two-way communications between the issuer and market participants and plays a fundamental role in promoting development of the domestic market.

### Outcome Indicators
- Marketable Domestic Debt as a Share of Central Government Total Debt
  - Serves as a proxy for the degree of reliance on domestic market borrowing.
  - "A larger share of marketable domestic debt issued in local currency, compared with total debt, is associated with more advanced stages of primary market development."
  - Note: Domestic debt is defined as debt issued in local currency in the local market; local market is defined by the jurisdiction of issuance and not by residency of holders.

- Stability of Domestic Market Financing
  - Defined as a stable overall demand for government securities, often captured by the bid-to-cover ratio.
  - Persistent oversubscription signals healthy demand and is associated with advanced stages of primary market development.
  - Caveat: Persistent high bids-to-cover ratios can be masked by primary dealer obligations or large captive investors.

- Average Maturity of Government Debt
  - A predominance of medium- to long-term security issuance is prima facie evidence of a more mature investor base.
  - An increased share of medium- and long-term marketable securities typically associates with more advanced primary market development.
  - As the market develops, average maturity can be increased by issuance of long-term instruments.

- Issuance across the Yield Curve
  - The yield curve is used as a basis for bond pricing and investor decisions.
  - A relatively long yield curve with adequate liquidity distributed across benchmark maturities typically indicates advanced primary market development.

### Policy Indicators
- Market-Based Pricing
  - Adoption of market-based pricing in auctions signals adherence to transparency and noninterventionist policies.
  - If bond prices are determined by the issuer rather than cleared at market rates, the true value cannot be ascertained and investor attractiveness diminishes.
  - Lower investor demand could result in pressures for monetary financing from the central bank.
  - Market-based pricing is fundamental to extend maturities, establish a yield curve, and develop the secondary market.
  - In advanced stage primary markets, the issuer is a price-taker.
  - Note: "A cap on the interest rate set by the issuer in auctions is a form of nonmarket-based pricing."

- Market-Based Placement Mechanisms
  - Use of market-based issuance mechanisms signals commitment to greater transparency.
  - Issuance on a tap basis or private placements may not facilitate price discovery when compared with issuance by syndications and auctions.
  - Types of placements include: auction, syndication, private placements, and tap sales.
  - Advanced primary markets use auctions as the dominant issuance mechanism; syndications can be useful for new maturities or new types of instruments.

- Predictability and Transparency of Issuance
  - Predictability in timing of issuance enhances transparency and allows investors/intermediaries to prepare balance sheets.
  - Advanced primary markets would publish and adhere to at least a quarterly issuance calendar, including issuance volumes and terms, particularly tenors.

- Government Cash Flow Forecasts
  - Reliable forecasts of government cash flow are critical for predictable and transparent issuance.
  - A well-developed cash management function allows delinking bond issuance from temporary cash shortfalls and supports adherence to issuance calendars.
  - Forecasts should be updated frequently; "the longer the forecast period, the more supportive it is for predictable and transparent issuance."

- Transparency of Auction Results
  - Auction results should include information on bid and accepted amounts; cutoff price; and minimum, average, and maximum prices (yields) of accepted bids.
  - Results should be disseminated as widely as possible on the day of the auction.
  - Advanced primary markets are associated with greater transparency and a tighter time frame in announcement of auction results.

- Transparency of Communication between Authorities and Market Participants
  - Transparency reduces uncertainty and facilitates participation in primary and secondary markets.
  - Authorities should disseminate fiscal information, debt portfolio risk indicators, debt management strategy, and the annual borrowing plan.
  - Regular two-way dialogue improves understanding of supply and demand and execution of issuance programs.

- Fragmentation
  - Proliferation of debt instruments creates distortions in primary market bond prices and reduces secondary market liquidity.
  - Central government should coordinate issuance of its own and guaranteed marketable debt; if central bank issues debt, differentiate tenors and avoid simultaneous market entry.
  - Central government should avoid issuance of nonmarketable debt for financing purposes, except possibly small volumes for the retail sector.

- Benchmark Bonds
  - Aim to increase the size of individual securities at key tenors, fostering liquidity and helping to establish a yield curve.
  - Benefits include increased market competition, reduced liquidity premium, and positive externalities to the broader financial sector.
  - As markets develop, there are more regular reopenings of existing lines at key maturities.
  - Benchmark bonds are usually fixed-rate bullet bonds for key maturity sectors; variable-rate and inflation-indexed bonds can be transitional instruments.

- Cash and Debt Management
  - Cash management is critical for transparent and predictable issuance practices and controlling refinancing risks.
  - Governments may hold cash buffers or use instruments (short-term securities, repo, deposits) to reduce cash flow volatility and manage refinancing risks.
  - Increased size of individual securities from benchmark bonds raises rollover risks; mitigation includes prefinancing, maintenance of proceeds, and liability management operations (buybacks and switches).
  - As the local market develops, the required cash buffer level tends to be reduced, emphasizing efficiency.

### Framework for the Primary Market — Outcomes and Benchmarks
- (1) Marketable domestic debt as a share of central government total debt
  - Objective: Assess reliance on marketable domestic financing (stock).
  - Key question: How large is the stock of marketable domestic debt denominated in local currency as a share of central government total debt?
  - Benchmarks:
    - Stage 1: Less than 25 percent
    - Stage 2: 25–50 percent
    - Stage 3: 50–75 percent
    - Stage 4: More than 75 percent

- (2) Stability of domestic market financing
  - Objective: Assess stability of overall demand for marketable government securities.
  - Key question: What is the level of demand as reflected by the bid-cover ratio?
  - Benchmarks:
    - Stage 1: There is a persistent undersubscription of securities offered.
    - Stage 2: Under-subscription happens on an intermittent and irregular basis.
    - Stage 3: Securities are often well-subscribed.
    - Stage 4: Securities are generally oversubscribed in excess of the offered amount.

- (3) Maturity of local currency marketable government securities
  - Objective: Assess ability to issue long-dated fixed-rate securities and control refinancing and interest rate risks.
  - Key questions:
    1. What is the average time to maturity of outstanding local currency marketable securities?
    2. What is the share of debt maturing in one year as a percent of the stock of local currency securities?
    3. What is the average time to refixing of outstanding local currency securities?
    4. What is the share of debt to be refixed in one year as a percent of the stock of local currency securities?
  - Benchmarks: Average time to maturity
    - Stage 1: Less than 1 year
    - Stage 2: 1–3 years
    - Stage 3: 3–5 years
    - Stage 4: More than 5 years
  - Benchmarks: Percentage of debt maturing in one year
    - Stage 1: More than 50 percent
    - Stage 2: 25–50 percent
    - Stage 3: 15–25 percent
    - Stage 4: Less than 15 percent
  - Benchmarks: Average time to refixing
    - Stage 1: Less than 1 year
    - Stage 2: 1–3 years
    - Stage 3: 3–5 years
    - Stage 4: More than 5 years
  - Benchmarks: Percentage of debt to be refixed in one year
    - Stage 1: More than 70 percent
    - Stage 2: 40–70 percent
    - Stage 3: 20–40 percent
    - Stage 4: Less than 20 percent
  - Final stage for the indicator defined by consolidation of the stages for the four subindicators.

- (4) Issuance across the yield curve
  - Objective: Assess whether the yield curve is well-distributed across key tenors.
  - Key question: What is the structure and length of the yield curve?
  - Benchmarks:
    - Stage 1: Very short yield curve (less than 1 year)
    - Stage 2: Relatively short yield benchmark curve (1–3 years) or longer yield curve but irregular, ad hoc issuance in maturities longer than 3 years
    - Stage 3: Relatively longer benchmark yield curve (4–10 years) and regular issuance in key maturity segments
    - Stage 4: Extended and well distributed benchmark yield curve is built (more than 10 years) and regular issuance in key maturity segments

### Framework for the Primary Market — Policies and Practices (selected indicators and benchmarks)
- (5) Market-based pricing
  - Objective: Assess whether the issuance mechanism adopts market-based pricing.
  - Key question: How are prices determined in the issuance mechanism?
  - Benchmarks:
    - Stage 1: Prices are determined by the issuer.
    - Stage 2: Auctions and/or syndications are frequently not cleared at market rates.
    - Stage 3: Auctions and/or syndications are usually cleared at market rates.
    - Stage 4: Auctions and/or syndications are always cleared at market rates.

- (6) Market-based placement mechanisms
  - Objective: Assess whether issuance adopts market-based placement mechanisms.
  - Key question: What is the predominant placement mechanism for securities?
  - Benchmarks:
    - Stage 1: Less than 20 percent of securities are issued by auctions and/or syndications.
    - Stage 2: 20–50 percent of securities are placed through syndications and/or auctions and the rest through other methods.
    - Stage 3: 50–80 percent of securities are placed through syndications and/or auctions, where syndications are used for new instruments or very long-term bonds.
    - Stage 4: At least 80 percent of securities are placed through auctions and syndications, where syndications are used for new instruments or very long-term bonds.

- (7) Predictability and transparency of issuance
  - Objective: Assess predictability of issuance as reflected in issuance calendar, market consultation, and timing of auction announcements.
  - Key questions (yes/no):
    1. Is an annual borrowing plan published that discloses the gross annual borrowing requirement for the government along with the volume of domestic marketable borrowings for the forthcoming fiscal year?
    2. Is an issuance plan made publicly available in advance at least monthly or quarterly?
    3. Is the aggregate volume of the instruments to be issued disclosed as part of the issuance plan?
    4. Are aggregated volumes for individual tenors disclosed as part of the issuance plan?
    5. Is the market consulted for preparation of the issuance plan?
    6. Does the actual issuance closely match the issuance plan?
    7. Are there transparent, clear, and consistently applied tender rules concerning eligibility criteria for participation, allotment method, treatment of outliers, and whether and when an auction size can be changed?
    8. Are the auction details for issuance announced at least two business days before the issuance?
  - Benchmarks: Countries are rated 1 (yes) or 0 (no) on the eight questions. Sum determines stage.
    - Stage 1: 0–2
    - Stage 2: 3–4
    - Stage 3: 5–6
    - Stage 4: 7–8

- (8) Government cash flow forecasts
  - Objective: Assess how well government cash management supports predictable and transparent issuance.
  - Key questions (yes/no):
    1. Monthly forecasts for the upcoming month
    2. Weekly forecasts for the upcoming month
    3. Daily forecasts for the upcoming month
    4. Quarterly forecast for the upcoming quarter
    5. Monthly forecast for the upcoming quarter
    6. Weekly forecast for the upcoming quarter
  - Benchmarks: Countries are rated 1 (yes) or 0 (no) on the six questions. Sum determines stage.
    - Stage 1: 0–2
    - Stage 2: 3–4
    - Stage 3: 5
    - Stage 4: 6

- (9) Transparency of auction results
  - Objective: Assess degree of transparency of auction results.
  - Key questions (yes/no):
    1. Are auction results announced within one hour of the same business day?
    2. Is information on the bid and accepted amounts provided?
    3. Is information on the cutoff price and the average price (yields) of accepted bids provided?
    4. Are the maximum and minimum prices (yields) of the accepted bids provided?
  - Benchmarks: Countries are rated 1 (yes) or 0 (no) on the four questions. Sum determines stage.
    - Stage 1: 0
    - Stage 2: 1–2
    - Stage 3: 3
    - Stage 4: 4

- (10) Transparency on communication between the authorities and market participants
  - Objective: Assess level of transparency and communication that reduces investor uncertainty and increases participation.
  - Key questions (yes/no):
    1. Is information on the borrowing strategy and risk-management framework produced and updated annually?
    2. Do the authorities engage in regular communication with market participants about borrowing strategy, market preferences, and market conditions?
    3. Is information on in-year government finances, debt portfolio, and primary market activity published monthly?
  - Benchmarks: Countries are rated 1 (yes) or 0 (no) on the three questions. Sum determines stage.
    - Stage 1: 0
    - Stage 2: 1
    - Stage 3: 2
    - Stage 4: 3

- (11) Market fragmentation
  - Objective: Assess consolidation and standardization of marketable securities issuance.
  - Key questions (yes/no):
    1. Are central government and central government guaranteed securities issued in a coordinated framework?
    2. Do the central government and central bank avoid issuing securities in the same tenors?
    3. Does the central government avoid issuance of nonmarketable securities for financing purposes?
  - Benchmarks: Countries are rated 1 (yes) or 0 (no) on the three questions. Sum determines stage.
    - Stage 1: 0
    - Stage 2: 1
    - Stage 3: 2
    - Stage 4: 3

- (12) Benchmark bonds
  - Objective: Assess policy on building benchmark bonds.
  - Key questions (yes/no):
    1. Is there a policy to develop benchmark bonds?
    2. Is there regular reopening of securities issued in key benchmark maturity segments?
    3. Do benchmark bonds constitute more than 50 percent of the gross issuance of local currency marketable bonds?
    4. Is there a target amount on the size of benchmark bonds for key maturities?
    5. Is the size of key tenors large enough to develop a secondary market yield curve?
    6. Is the market consulted at least annually on identifying benchmark bonds?
  - Benchmarks: Countries are rated 1 (yes) or 0 (no) on the six indicators. Sum determines stage.
    - Stage 1: 0–1
    - Stage 2: 2–3
    - Stage 3: 4–5
    - Stage 4: 6

*Source: anea2021001 - Part 1. Diagnostics*

### Part 1. Diagnostics

### Part 1. Diagnostics

### Cash and debt management
- Objective: Assess whether cash and debt management instruments, policies, and capacity are in place to manage rollover risks, including those associated with the use of benchmark bonds.
- Key questions (rated 1 for yes, 0 for no):
  - (1) Do the authorities use cash management instruments to cover short-term cash shortages? (yes/no)
  - (2) Are prefinancing and maintenance of proceeds allowed to deal with near-term redemptions? (yes/no)
  - (3) Do the authorities have effective cash management policies and capacity to manage rollover risks associated with the use of benchmark bonds? (yes/no)
  - (4) Is there a cash buffer to cope with unexpected liquidity needs? (yes/no)
  - (5) Have the authorities engaged in liability management operations (such as buybacks or switch operations)? (yes/no)
- Benchmarks:
  - Countries are rated as 1 (yes) or 0 (no) on the five questions. The sum of the five ratings determines the stage.
  - Stage 1Stage 2Stage 3Stage 4
    0–12–345
- Notes:
  - For those countries without a national currency, the foreign currency used can be seen as the national currency for the sake of this indicator.
  - Maturity in this case is remaining maturity rather than original maturity. Adjusted average time to maturity considers the maturity of central bank debt to finance government securities purchases.
  - According to BIS debt securities statistics, all countries (30 countries) reported the average time to maturity (the average over 2014–18) above three years, while 25 countries reported the average time to maturity above five years.
  - Reference to Debt Management Performance Assessment tool, DPI-11.1 definition of cash flow forecasting and cash balance management.

*Key diagnostic focus*: existence and use of cash-management instruments, legal and operational allowance for prefinancing and maintenance of proceeds, presence of explicit cash buffers, and history of liability-management operations to mitigate rollover and benchmark-related risks.

### Building Block 3: Secondary Market — Market Liquidity and Depth (Outcome Indicator)
- Rationale:
  - Secondary market should provide a cost-efficient and secure platform for trading in a fair and transparent manner, with sufficient intermediaries, standard pricing, and agreed trading times.
  - Secondary market liquidity enables term transformation and price discovery for sovereign and nonsovereign borrowers.
  - Mature LCBM development characterized by high turnover ratio, large transaction sizes, tight bid-ask spreads, and instruments traded across the yield curve.
- Measures of liquidity and depth:
  - Turnover ratio, average transaction size, bid-ask spreads.
  - Liquid bond market: bond trades of reasonable size can be executed in the secondary market (measured by turnover ratio of government securities).
  - Deep market: significant orders at tight spreads; large trades have limited impact on prices.
- Policy indicators and guidance:
  - Pre- and post-trade transparency improve liquidity; advanced stages have pre-trade executable quoting and consistent, timely post-trade information on prices and volumes.
  - Market-making duties (PDs system) can enhance liquidity but are not a precondition; key obligations include two-way quotes within predefined spread and trading volume.
    - Two-way quotes usually mandatory for on-the-run benchmark bonds; indicative quotes may be used during initial phases.
    - PDs should be evaluated regularly; nonperformers can be replaced.
  - Market-making privileges typically include exclusive access to auctions, liability management operations, noncompetitive auctions, and securities and cash-lending facilities; privileges should be proportionate to obligations.
  - Trading environment enhancements: repo market, interest rate derivatives (interest rate swaps and interest rate futures), ability to short sell, electronic trading platforms, securities lending facilities.
    - Covered short selling permitted for market-making; naked short-selling less usual.
    - Interest rate derivatives enable investors to adjust exposures at low cost; short selling can amplify volatility in less-liquid markets.
  - Preconditions: presence of investors with different investment profiles, efficient market infrastructure, regulatory regime, tax systems, and dematerialized government securities.

### Framework for the Secondary Market — Outcome, Benchmarks, and Supplemental Indicators
- Outcome (1) Market liquidity and depth
  - Objective: Assess ability of investors to execute buy-and-sell orders cost-effectively, timely, and with limited price impact.
  - Key questions (rated 1 for yes, 0 for no):
    - (1) Are transaction sizes and trading volumes for key tenors sufficient to meet banks’ demand to buy and sell? (yes/no)
    - (2) Are transaction sizes and trading volumes for key tenors sufficient to meet nonbank institutional investors’ demand to buy and sell? (yes/no)
    - (3) Are securities traded across the whole yield curve? (yes/no)
  - Benchmarks:
    - Countries are rated 1 or 0 on the three questions. The sum determines the stage.
    - Stage 1Stage 2Stage 3Stage 4
      0123
- Supplemental indicators:
  - (4) Daily turnover ratio of the government securities market:
    - Range 1Range 2Range 3Range 4
      —Below 0.5 percent0.5–1.0 percentAbove 1.0 percent
  - (5) Average bid-ask spread of 10-year, on-the-run benchmark bonds (regarding yield):
    - Range 1Range 2Range 3Range 4
      No spread exists, or more than 
      100 basis points
      100—20 basis points20—5 basis pointsLess than 5 basis points
  - Benchmarks:
    - Countries are rated as 1–4 for each of (4) and (5). The sum of two ratings determines the stage.
    - Stage 1Stage 2Stage 3Stage 4
      23–45–67–8
  - Note: This supplementary indicator should be interpreted with a large margin of error because of data limitations; it does not control for the size of individual transactions and the sample is limited to only advanced economies and some emerging market economies.

### Framework for the Secondary Market — Policies/Practices (Pre-trade, Post-trade, Market-making)
- (2) Pre-trade transparency
  - Objective: Assess whether secondary market pre-trade reporting is available.
  - Key questions (rated 1 for yes, 0 for no):
    - (1) Are prices for securities normally available on demand? (yes/no)
    - (2) Are indicative prices quoted daily by market players for government securities? (yes/no)
    - (3) Are firm prices quoted daily by market players for on-the-run benchmark securities? (yes/no)
  - Benchmarks:
    - Sum of three 1/0 ratings determines stage.
    - Stage 1Stage 2Stage 3Stage 4
      0123
- (3) Post-trade transparency
  - Objective: Assess degree of transparency on trade-related reporting.
  - Key questions (rated 1 for yes, 0 for no):
    - (1) Is post-trade information on price and volume for individual securities publicly available daily? (yes/no)
    - (2) Do official sources or price vendors provide regular references for different points in the secondary market yield curve daily? (yes/no)
    - (3) Are the model and methodology for a yield curve model publicly available? (yes/no)
  - Benchmarks:
    - Sum of three 1/0 ratings determines stage.
    - Stage 1Stage 2Stage 3Stage 4
      0123
- (4) Market-making duties
  - Objective: Assess whether market-making duties framework is conducive to promote secondary market activity.
  - Key questions (rated 1 for yes, 0 for no):
    - (1) Are market-making duties proportionate to the conditions of the secondary market? (yes/no)
    - (2) Are market makers required to provide a two-way quote within a reasonably narrow spread? (yes/no)
    - (3) Are market makers required to provide a two-way quote for a certain minimum volume of securities? (yes/no)
    - (4) Are market makers required to provide a two-way quote for a certain minimum number of hours in a day? (yes/no)
    - (5) Are market makers required to provide firm quotes? (yes/no)
    - (6) Are market makers required to ensure a certain minimum turnover in trading? (yes/no)
  - Benchmarks:
    - Sum of six 1/0 ratings determines stage.
    - Stage 1Stage 2Stage 3Stage 4
      0–12–34–56
- (5) Market-making privileges
  - Objective: Assess whether market-making privileges framework is conducive to promote secondary market activity.
  - Key questions (rated 1 for yes, 0 for no):
    - (1) Are market-making privileges and duties designed to be balanced? (yes/no)
    - (2) Is the performance of market makers rewarded by the authorities in access to government securities or debt management operations? (yes/no)
    - (3) Are market makers provided with exclusive access to repo or securities lending facilities by the authorities? (yes/no)
  - Benchmarks:
    - Sum of three 1/0 ratings determines stage.
    - Stage 1Stage 2Stage 3Stage 4
      0123
- (6) Trading environment
  - Objective: Assess whether there is an enabling environment for secondary market trading.
  - Key questions (rated 1 for yes, 0 for no):
    - (1) Is there an electronic trading platform that enables dealers to quote prices to each other in a seamless manner? (yes/no)
    - (2) Is short selling of government securities allowed for market-making purposes? (yes/no)
    - (3) Are hedging instruments (that is, interest rate swaps and interest rate futures) available? (yes/no)
    - (4) Are hedging instruments (that is, interest rate swaps and interest rate futures) with sufficient liquidity available? (yes/no)
  - Benchmarks:
    - Sum of four 1/0 ratings determines the stage.
    - Stage 1Stage 2Stage 3Stage 4
      0–1234
  - Footnote: This supplementary indicator should be interpreted with a large margin of error due to data limitations.

### Building Block 4: Investor Base
- Rationale:
  - A deep and diversified investor base ensures demand for government securities and strengthens market resilience in times of stress.
  - Diverse investor base with different horizons and risk-return preferences (especially institutional investors) helps extend the yield curve and spread government debt risk.
  - Absolute size and structure of the domestic financial sector define domestic absorption capacity and impact market liquidity.
- Outcome indicators: Market Participants
  - Commercial banks typically dominant in developing countries as investors and intermediaries.
  - Size of banking sector relative to economy broadly defines absorption capacity for government securities.
  - Highly concentrated banking sector can undermine banks’ incentives to trade and thus market liquidity.
  - Nonbank investors (pension funds, insurance companies, money market mutual funds, hedge funds) bring differing horizons:
    - Pension funds and insurance companies prefer longer-dated assets to match liabilities, supporting longer-dated issuance.
    - Money market mutual funds prefer shorter-dated securities.
    - Hedge funds emerge later but contribute to liquidity via active trading.
  - A developed investor base: deep and diverse mix of bank and nonbank participants.
- Investor relationship management
  - Active investor relationship management strengthens the investor base by understanding risk-return profiles and constraints of key investors, matching issuances to demand, reducing funding costs, and maintaining market access in times of stress.
  - Advanced markets have mutually beneficial two-way communication between authorities and market participants.
- Domestic institutional investors
  - Diversifying the investor base is a priority.
  - Tax, accounting, and regulatory frameworks should be consistent with developing institutional investors.
  - Collective investment schemes (CISs) encourage retail participation while avoiding market fragmentation.
  - Public pension reforms can increase national savings but should be formulated considering broader implications.
  - Advanced markets typically have supportive policy environment for domestic institutional investor development.
- Direct financing from the central bank
  - Central bank lending to the government is harmful to LCBM development.
  - Practices to prevent monetary financing include:
    - Legislative prohibition of all forms of monetary financing.
    - Legislative imposition of limits of purpose and duration of temporary cash advances.
    - Legislative prohibition of central bank participation in the primary market.
    - Disclosure of central bank holdings of government securities.
  - Monetary financing distorts price discovery, harms secondary market development, affects inflation and external position, and undermines investor confidence.
  - Note: Some central banks of emerging market and developing economies facilitated financing to government after March 2020; such arrangements are expected to be temporary.
- Foreign investors
  - Nonresident participation can enhance the investor base and secondary market liquidity but increases sensitivity to global conditions and potential volatility.
  - Authorities must weigh trade-offs, monitoring, and safeguards for nonresident participation.
  - Nonresident investors typically require sufficient market liquidity, hedging instruments, investor-friendly foreign exchange administrative procedures, and predictable tax frameworks.
  - Inclusion in global indexes signals a well-developed market attractive to foreign investors.
- Buy-and-hold investors
  - Buy-and-hold investor base offers reliable long-term funding but entails trade-offs:
    - Excessive reliance on buy-and-hold investors, especially captive investors, can constrain secondary market activity and hinder investor base diversification.
  - Legal and regulatory frameworks (tax, accounting, bank and financial institution regulations) can contribute to buy-and-hold behavior:
    - Unfavorable tax treatment of secondary sales (for example, on gains attributable to accrued interest), withholding taxes, transaction taxes.
    - Lack of transparency in valuation rules and unclear reference rates for mark-to-market valuations.
    - Liquidity regulations and high investment requirements for pension funds and insurance companies can create hold-to-maturity investment patterns.
  - Advanced markets typically mitigate buy-and-hold behaviors through regulatory and tax design that does not artificially incentivize captive holdings.
- Policy implications (implicit in diagnostics):
  - Promote pre- and post-trade transparency, appropriate PDs/market-making frameworks with balanced privileges and obligations, electronic trading platforms, and hedging instruments.
  - Avoid long-term reliance on central bank financing; ensure legal prohibitions and disclosures.
  - Design tax, accounting, and regulatory frameworks to encourage active secondary market participation and diversify investor base.

*Analytical Note: Part 1. Diagnostics (excerpts on Cash and debt management; Building Block 3: Secondary Market; Building Block 4: Investor Base).*

### Part 1. Diagnostics

### Part 1. Diagnostics

### Framework for Investor Base — Outcomes
- Objective: Assess whether the investor base supports local currency bond market development.
- Key questions (six; yes/no):
  1. Is the banking sector deep and diversified enough to develop a short-term yield curve? (yes/no)
  2. Is the banking sector deep and diversified enough to develop a repo market? (yes/no)
  3. Is the investor base deep enough to meet government funding requirements? (yes/no)
  4. Is the nonbanking sector developed enough to extend the maturities of government securities? (yes/no)
  5. Is the banking sector deep and diversified enough to support the secondary market? (yes/no)
  6. Is there a significant presence of non-buy-and-hold investors? (yes/no)
- Benchmarks:
  - Countries are rated as 1 (yes) or 0 (no) on six questions. The sum of six ratings determines the stage.
  - Stage thresholds:
    - Stage 1: 0–1
    - Stage 2: 2–3
    - Stage 3: 4–5
    - Stage 4: 6

### Framework for Investor Base — Supplemental indicator (1)-1 Depth and diversity of the banking sector
- Objective: Assess the depth and diversity of the banking sector.
- Key questions and ranges:
  1. Size of total assets of the banking sector to GDP (database: IFS)
     - Range 1: Below 50 percent
     - Range 2: 50–75 percent
     - Range 3: 75–100 percent
     - Range 4: Above 100 percent
  2. Share of top three banks in total assets of the banking sector (database: World Bank Financial Structure database)
     - Range 1: Above 90 percent
     - Range 2: 75–90 percent
     - Range 3: 50–75 percent
     - Range 4: Below 50 percent
- Benchmarks:
  - Countries are rated as 1 to 4 on the two questions. The sum of the two ratings determines the stage.
  - Stage thresholds:
    - Stage 1: 2–3
    - Stage 2: 4–5
    - Stage 3: 6–7
    - Stage 4: 8

### Framework for Investor Base — Supplemental indicator (1)-2 Depth and diversity of the nonbanking sector
- Objective: Assess the depth and diversity of the nonbanking sector.
- Key questions and ranges:
  1. Size of total assets of domestic nonbank investors to GDP (database: IFS)
     - Range 1: Below 10 percent
     - Range 2: 10–25 percent
     - Range 3: 25–50 percent
     - Range 4: Above 50 percent
  2. Share of domestic nonbank investors in government bond holdings (database: IMF Sovereign Debt Investor Base for Emerging Markets)
     - Range 1: Below 10 percent
     - Range 2: 10–25 percent
     - Range 3: 25–40 percent
     - Range 4: Over 40 percent
- Benchmarks:
  - Countries are rated as 1 to 4 on the two questions. The sum determines the stage.
  - Stage thresholds:
    - Stage 1: 2–3
    - Stage 2: 4–5
    - Stage 3: 6–7
    - Stage 4: 8

### Policies and Practices — Investor relations management
- Objective: Assess communication practices between authorities and market participants.
- Key questions (four; yes/no):
  1. Do the authorities have a formal investor relations unit that deals with investor relation functions? (yes/no)
  2. Do the authorities engage in regular two-way communications with market participants about borrowing and issuance strategies, market preferences, and market conditions? (yes/no)
  3. Do the authorities reach out to broader investors through investor forums (such as annual investor conferences)? (yes/no)
  4. Is there a dedicated government debt management webpage with content that is helpful to investors? (yes/no)
- Benchmarks:
  - Countries are rated as 1 (yes) or 0 (no) on the four questions. The sum of the four ratings determines the stage.
  - Stage thresholds:
    - Stage 1: 0–1
    - Stage 2: 2
    - Stage 3: 3
    - Stage 4: 4

### Policies and Practices — Domestic institutional investors
- Objective: Assess whether the policy framework supports the development of domestic institutional investors.
- Key questions (four; yes/no):
  1. Are the tax, accounting, and regulatory frameworks consistent with the objective of developing the institutional investor base (pension funds and/or insurance companies) in the government securities market? (yes/no)
  2. Are there policies to strengthen distribution channels for retail investors? (yes/no)
  3. Are there fixed-income collective investment schemes investing actively in the government securities market? (yes/no)
  4. Have there been effective policies to encourage national saving and provide a source of demand for long-term bonds (such as the introduction of funded public pension programs)? (yes/no)
- Benchmarks:
  - Countries are rated as 1 (yes) or 0 (no) on the four questions. The sum determines the stage.
  - Stage thresholds:
    - Stage 1: 0–1
    - Stage 2: 2
    - Stage 3: 3
    - Stage 4: 4

### Policies and Practices — Central bank monetary financing
- Objective: Assess whether central bank government financing is prohibited or appropriately limited.
- Key questions (five; yes/no):
  1. Is central bank lending to the government prohibited by legislation? (yes/no)
  2. If temporary advances to the government are authorized, are they appropriately circumscribed (such as with quantitative limits of about 10–15 percent of previous ordinary fiscal receipts, remunerated against market or policy rates, for exceptional purposes and for limited periods)? (yes/no)
  3. Is the central bank prohibited from participating in the primary market auctions of government securities? (yes/no)
  4. Are the central bank’s holdings of government securities disclosed monthly? (yes/no)
  5. Is the central bank able to reduce its government securities holdings by selling them in the secondary market or rolling them off when they mature? (yes/no)
- Benchmarks:
  - Countries are rated as 1 (yes) or 0 (no) on the five questions. The sum determines the stage.
  - Stage thresholds:
    - Stage 1: 0–1
    - Stage 2: 2
    - Stage 3: 3–4
    - Stage 4: 5

### Framework for Investor Base — Foreign investors
- Objective: Assess whether the operating environment and policy frameworks are conducive to attracting foreign investors.
- Key questions (six; yes/no):
  1. Are foreign investors allowed to invest in government securities without quantitative limits? (yes/no)
  2. Are administrative procedures, if any, related to foreign exchange transactions sufficiently streamlined for foreign investors? (yes/no)
  3. Are the rules on local currency (such as cash balances, overdrafts, and borrowing) supportive of foreign investment in government securities? (yes/no)
  4. Are withholding taxes on interest income and capital gains eliminated for foreign investors? (yes/no)
  5. Are foreign investors able to settle and hold local government securities in the domestic market without opening local currency onshore accounts? (yes/no)
  6. Are foreign exchange hedging markets (foreign exchange forward markets) with sufficient depth and liquidity available? (yes/no)
- Benchmarks:
  - Countries are rated as 1 (yes) or 0 (no) on the six questions. The sum determines the stage.
  - Stage thresholds:
    - Stage 1: 0–1
    - Stage 2: 2–3
    - Stage 3: 4–5
    - Stage 4: 6

### Framework for Investor Base — Buy-and-hold investors
- Objective: Assess whether the regulatory framework mitigates the impact of buy-and-hold behavior among investors.
- Key questions (five; yes/no):
  1. Is the tax framework neutral to the trading activity of government securities (that is, free from withholding taxes, transaction taxes, and the prorating of coupons)? (yes/no)
  2. Are there transparent accounting/valuation rules for the government bond holdings of banks and other institutional investors? (yes/no)
  3. Are reference rates for mark-to-market valuations clearly defined and available daily? (yes/no)
  4. Do the liquidity regulations for banks and implementation avoid excessively discouraging banks from trading government securities? (yes/no)
  5. Are pension funds and insurance companies free to manage their government bond portfolios without minimum holding requirements? (yes/no)
- Benchmarks:
  - Countries are rated as 1 (yes) or 0 (no) on the five questions. The sum determines the stage.
  - Stage thresholds:
    - Stage 1: 0–1
    - Stage 2: 2
    - Stage 3: 3–4
    - Stage 4: 5

---

### Building Block 5: Financial Market Infrastructure (FMI) — Overview
- Rationale:
  - Efficient FMI facilitates smooth flow and settlement of transactions in the money market and the primary and secondary markets, strengthens investor confidence, and stimulates market expansion.
  - The custodial and settlement infrastructure is a major determinant of systemic risk; absent sound securities settlement infrastructure, markets may be exposed to considerable systemic risks.
- Key characteristics of good FMI:
  - Clear legal basis.
  - Delivery versus payment (DVP).
  - Regulatory oversight.
  - Capacity to process trading volumes within chosen settlement cycle.
  - Interconnectivity among core systems (issuance systems, security registers, RTGS, CSDs, settlement systems).
  - Cost-efficiency and convenience to use.

### Performance Indicators — FMI Technology Platforms
- Core FMI systems include:
  - Government securities issuance systems
  - Security registers
  - Real-time gross settlement (RTGS) payment systems
  - Central securities depositories (CSDs)
  - Security settlement systems
- Modern systems support:
  - Electronic payments
  - Fast, low-risk settlement for high volumes
  - Straight-through processing between core systems
  - Improved transparency and anti-money-laundering monitoring
  - Opportunity to establish cross-border links
- Note: In small markets, partial manual and electronic systems may be more cost-effective; assess cost-benefit pragmatically.
- Footnote: Government securities auction systems are included as FMI systems for assessment purposes.

### Dematerialized Securities
- Dematerialized securities:
  - Held as credit balances on securities accounts and typically kept as electronic records.
  - Increase asset safety and support settlement efficiency.
  - Prerequisite for effective clearing and settlement systems.
- Compared with physical securities, dematerialized securities are secure, verifiable, and avoid risks of loss or theft.

### Clearing and Settlement Risk (CSD or CCP)
- Objectives for FMI framework:
  - Minimize counterparty and market risk during clearing and settlement.
  - Ensure “finality” of payments and transfers of dematerialized securities protected by law.
  - CSD should support simultaneous security DVP and have electronic link to central bank RTGS for DVP with final RTGS cash settlement.
- Role of CCP:
  - Can reduce counterparty and market risks depending on robustness of settlement guarantee, ability to call financial resources, and legal enforceability.
- Market risk containment:
  - Reduce time between trade execution and settlement finality (e.g., real-time intraday trading, same-day settlement).
  - More frequent DVP2 or DVP3 netting intraday lowers market risk exposure to netting arrangement.
- Note: Risk that trade settlement fails and the price to replace the bond has increased.

### Governance and Access Policies of CSD and CCP Systems
- Desirable features:
  - Owner/operator with sound reputation and legal mandate to develop system supporting LCBM.
  - Financial capacity to operate, invest, and absorb shocks.
  - Supervisory agency ensuring accountability; assessment against the principles for FMI.
  - Fee structure on a cost recovery basis.
  - Fair and open participation criteria not precluding sound financial institutions and investors.
  - Remote CSD membership (direct or indirect) useful to diversify investor base.
  - Owner/operator subject to supervision and oversight of regulators.

### Market Segmentation
- Risks when multiple CSDs or CCPs exist:
  1. High costs and inefficient transfer of securities between systems.
  2. Different access rules between systems.
  3. Different settlement models (RTGS [DVP1] vs netting models [DVP2 and DVP3]).
- Consequences:
  - Additional costs and inefficiency limit secondary market development.
  - May render repo market unviable.

### FMI Liquidity Support
- FMI should provide collateralization functionality, including:
  - Low-risk, intraday settlement for outright sales.
  - Intraday and overnight repo functionality consistent with a written master repurchase agreement.
  - Intraday collateralized lending arrangements.
- Inefficient FMI could increase repo transaction costs relative to unsecured interbank transactions, undermining repo advantages.

### Transparency (of Data and Information)
- FMI should have legal power and capacity to collect and publicly release data on transactions and categories of holders of securities.
- An electronic registry and CSD can:
  - Extract transaction activity by security, security type, and holdings by sector.
  - Publish aggregated information electronically daily.
  - Support transparency for primary, secondary, and money markets, and release categories of holders of government securities.

### Framework for Financial Market Infrastructure — Electronic Platforms (Assessment)
- Objective: Assess modernity and efficiency of FMI systems (auction, payments, settlement).
- Key questions (six; yes/no):
  1. Is an electronic auction system used to issue securities in the primary market? (yes/no)
  2. Is there a single electronic register or depository for government securities? (yes/no)
  3. Do commercial banks operate an electronic wholesale payment system? (yes/no)
  4. Does the central bank operate a modern electronic real-time gross settlement (RTGS) payments system? (yes/no)
  5. Is there a single electronic central securities depository (CSD) and/or central clearing counterparty (CCP) systems operated for government securities settlement? (yes/no)
  6. Is there an electronic interface between the RTGS and the CSD and/or CCP and auction systems? (yes/no)
- Benchmarks:
  - Countries are rated 1 (yes) or 0 (no) on the six questions. The sum determines the stage.
  - Note: For (5), if market fragmentation between two CSDs/CCPs exists, rating should not exceed stage 2 if there is no electronic interface between the two systems.
  - Stage thresholds:
    - Stage 1: 0, 1
    - Stage 2: 2, 3
    - Stage 3: 4, 5
    - Stage 4: 6

### Efficient and Low-Risk Custody and Settlement — Security registration
- Objective: Assess if infrastructure supports dematerialized government securities and efficient transfers.
- Key questions (percent):
  1. What is the percentage of government securities issued in dematerialized form? (percent)
  2. What percentage of tradable government securities are assigned an International Securities Identification Number (ISIN)/Committee on Uniform Security Identification Purposes (CUSIP)? (percent)
- Benchmarks (stages by dematerialization and ISIN/CUSIP):
  - Stage 1: 100 percent of government securities are a physical security or not registered
  - Stage 2: Less than 60 percent of securities are dematerialized or immobilized
  - Stage 3: More than 60 percent of government securities are dematerialized
  - Stage 4: 100 percent are dematerialized securities with assigned ISIN/CUSIP

### Clearing and settlement risk (CSD and manual FMI processes) — Assessment
- Objective: Assess efficiency of risk-mitigating factors in secondary market transactions where CSD is primary settlement system.
- Key questions (six; yes/no):
  1. Is dematerialization of securities supported by the legal framework? (yes/no)
  2. Is payment finality (often defined in the FMI system rules) protected by law? (yes/no)
  3. Is security transfer finality (often defined in CSD system rules) protected by law? (yes/no)
  4. Does the CSD support delivery versus payment (DVP1) settlement? (yes/no)
  5. Are settlement payments settled through the central bank RTGS payment system? (yes/no)
  6. Does the CSD support T+0 settlement (settlement day plus 1 day)? (yes/no)
- Benchmarks:
  - Countries are rated as 1 (yes) or 0 (no) on the six questions. The sum determines the stage.
  - Stage thresholds:
    - Stage 1: 0–1
    - Stage 2: 2
    - Stage 3: 3–4
    - Stage 4: 5–6

*Source: anea2021001 - Part 1. Diagnostics*

### Part 1. Diagnostics

### Part 1. Diagnostics

### Framework for Financial Market Infrastructure — Clearing and settlement risk (CCP)
- Objective:
  - Assess the efficiency of risk-mitigating factors in secondary market transactions of government bonds (counterparty and market risk) where the CCP is the primary CCP and settlements system for government securities.
- Key questions:
  - (1) Are settlement payments settled through the central bank RTGS payment system? (yes/no)
  - (2) Are net settlement DVP2, DVP3 guaranteed (such as by guarantee fund, members, owner/operators, other)? (yes/no)
  - (3) Has the size of the guarantee been stress tested? (yes/no)
  - (4) In the event of default, is the unwinding of netting arrangements for government security transactions transparent? (yes/no)
- Benchmarks:
  - Countries are rated as 1 (yes) or 0 (no) on the four questions. The sum of the four ratings determines the stage.
  - Stage 1Stage 2Stage 3Stage 4
  - 0–1234

### Framework for Financial Market Infrastructure — Soundness and Operating Environment of FMI: Governance and access policies (of CSD and/or CCP systems)
- Objective:
  - Assess the extent that governance and access policies of the CSD and/or CCP support efficiency and the reduction of associated risks in the government securities market. (It is assumed the central bank operates the RTGS system.)
- Key questions:
  - (1) Does the legal framework define who can own and operate the CSD, CCP, or both? (yes/no)
  - (2) Does the owner(s) of CSD and/or CCP have a sound reputation? (yes/no)
  - (3) Does the legal framework define the role and functions of the CSD and/or CCP (including its incidental function) to support the over-the-counter market, custody, and settlement functions of the government bond markets? (yes/no)
  - (4) Does the systems owner/operator have the financial strength to support the CSD and/or CCP? (yes/no)
  - (5) Are fees based on a not-for-profit/cost recovery basis? (yes/no)
  - (6) Is there supervision and oversight of the CSD and/or CCP, supported by the legal framework? (yes/no)
  - (7) Does the supervisory agency ensure accountability of payment systems, including by requesting periodic reports? (yes/no)
  - (8) Are FMI access rules open to sound financial institutions that are eligible to invest in securities from participation in the CSD and/or CCP?
  - (9) For foreign investors, are direct and/or indirect remote CSD memberships allowed? (yes/no)
- Benchmarks:
  - Countries are rated as 1 (yes) or 0 (no) on the nine questions. The sum of the nine ratings determines the stage.
  - Stage 1Stage 2Stage 3Stage 4
  - 0–23–56–78–9
- Notes (from guidance):
  - The reviewer will have to make a judgment on the system owner’s reputation, objectives, and financial capacity. Adequate capital should be based on the size and on the liabilities of the CSD. The capital should be higher if the CSD acts as CCP or provides lending or credit to participants. Capital for a CCP should reflect its exposures to counterparty failure.
  - Yes, for a central bank, unless there have been very recent, obvious cases that discredit the central bank.
  - The answer is yes for a central bank but only a guide for CSD/CCP that are 100 percent government agencies. For nongovernment FMI owners, the capital should be assessed against the nature and risk profile of their operation.

### Framework for Financial Market Infrastructure — Market segmentation
- Objective:
  - Assess the degree of market segmentation where multiple CSDs and CCPs are used. (If there is only one CSD or CCP, then stage 4 is achieved.)
- Key questions (if there is more than one CSD and/or CCP that settles government securities):
  - (1) Are multiple CSDs and/or CCPs electronically linked for same-day or next-day security transfer? (yes/no)
  - (2) Can financial institutions directly access multiple systems? (yes/no)
  - (3) Do multiple systems use the same settlement model? (yes/no)
- Benchmarks:
  - If yes to (1), assign 4. Otherwise, assign 1 (yes) or 0 (no) on three questions (1)–(3). The sum of the ratings determines the stage.
  - Stage 1Stage 2Stage 3Stage 4
  - 0123

### Repo Markets — FMI liquidity support
- Objective:
  - Assess the services provided by the FMI that support liquidity for securities and cash.
- Key questions:
  - (1) Can the transaction proceed without mandatory predeposit of cash and/or predelivery of securities? (yes/no)
  - (2) Does the CSD, CCP, or both support T+0 settlement? (yes/no)
  - (3) Does RTGS, CSD and/or CCP support intraday repo? (yes/no)
  - (4) Does RTGS, CSD and/or CCP support overnight repo trade settlements? (yes/no)
  - (5) Does the CSD, CCP, or both support security pledges? (yes/no)
  - (6) Are trading and settlements costs of repo transactions comparable to those of unsecured transactions? (yes/no)
- Benchmarks:
  - Countries are rated as 1 (yes) or 0 (no) on the six questions. The sum of the six ratings determines the stage.
  - Stage 1Stage 2Stage 3Stage 4
  - 0–12–34–56
- Note:
  - The assumption is that a securities lending facility can be substituted with a repo agreement.
  - Predeposit cash, predelivery security, or both reduce the settlement efficiency and liquidity and increase the cost of the trading and the market making. However, they do reduce the settlement risk.

### Transparency in the Money, Primary, and Secondary Markets — Transparency (data and information)
- Objective:
  - Assess whether the FMI has the legal power and capacity to collect and publicly release the transactions and securities holders’ data.
- Key questions:
  - Does the FMI have the legal basis and ability to collect and publicly release (directly or indirectly through the authorities) aggregate data on transactions volumes and value (by security and instrument type)?
    - (1) Daily (yes/no)
    - (3) Weekly (yes/no)
    - (3) Monthly (yes/no)
  - (4) Does FMI have the legal basis and capacity to publicly release (directly or indirectly through the authorities) data on security holdings by sector? (yes/no)
- Benchmarks:
  - Countries are rated as 1 (yes) or 0 (no) on the four questions. The sum of the four ratings determines the stage.
  - Stage 1Stage 2Stage 3Stage 4
  - 0–1234
- Footnote:
  - Except for nontradable securities issued to the central bank and other government-related agencies.

### Building Block 6: Legal and Regulatory Framework — overview and objectives
- Core points:
  - A country’s legal and regulatory framework affects the structure, functioning, and development of LCBMs.
  - When the government is the borrower and issuer of securities, legislation and other legal instruments (such as a fiscal agency agreement between the government and the central bank) provide for the ability of the government to borrow, and they provide the authorization of different government entities to operate in these markets, including the role that the central bank undertakes as an agent of the government.
  - Rules and regulations shape the organization of the primary and secondary markets in government securities and influence the roles of different types of market participants.
  - Frameworks should aim at maintaining fair, efficient, and transparent markets, define and enforce fair trading practices, penalize deviations (such as market manipulation and insider trading), and ensure investor protection through adequate rules for depository intermediaries to protect holdings of investors.
  - Effective enforcement depends on the robustness of the regulatory and supervisory framework, the overall quality of the regulator and supervisor, and the resources and independence of the regulator and supervisor.
  - The legal and regulatory framework for FMI and CIS and tax issues should be reviewed together with related discussions in other building blocks.

### Policy indicators and components
- Borrowing Authority:
  - Legal framework should clarify roles and responsibilities of debt management entities.
  - Stipulation in law of objectives of developing domestic debt markets facilitates development.
  - Some debt management operations (such as liability management operations) might require additional legal provisions, e.g., to allow implementation of a PD system.
  - Ideally, the periodic preparation and publishing of a medium-term debt management strategy should be part of the law.
- Market Regulation and Enforcement:
  - Market regulation and enforcement mitigate unfair trading practices (market manipulation, front-running, collusion).
  - Regulations should be backed by adequate enforcement capacity and expertise to monitor trading activities and enforce market conduct rules.
- Investor Protection:
  - Investor rights over securities should be safeguarded.
  - Segregation and identification of customer assets in the books of depositaries is vital.
  - Competent authority should oversee compliance regularly and take prompt corrective measures when needed.
- Collective Investment Schemes (CIS):
  - A robust legal and regulatory framework is key to developing CISs.
  - CIS operators must act in the best interests of clients—minimum standards for eligibility, governance, and operational conduct of CIS operators are needed.
  - Rules governing legal form and structure of CISs and segregation and protection of customer assets are required.
  - Disclosure and periodic mark-to-market valuation for security holdings are important; net asset value determines purchase and sale prices.
  - Valuation methods of CISs should be regulated and disclosed properly.
- Legal Framework for Taxation:
  - Tax impediments to LCBM development should be identified and, when possible, removed.
  - Tax frameworks are a key determinant of investment decisions and liquidity in LCBMs; tax treatment of primary and secondary market transactions should be clear and reasonable.
  - Tax provisions should cover supply-side (tax treatment of government securities) and demand-side (alignment of tax treatment between key institutional investor groups) objectives.
  - Tax treatment should include gains on secondary sales, repo, securities lending, financial collateral, and derivative transactions.

### Framework for Legal and Regulatory Framework — Primary and Secondary market indicators
- Primary Market — Borrowing authority:
  - Objective: Assess whether the legal framework for government borrowing and the development and implementation of a debt management strategy are in place.
  - Key questions:
    - (1) Does the legal framework define a clear and single entity with the authority to borrow? (yes/no)
    - (2) Does the legal framework clearly set out the roles and responsibilities of the debt management entity? (yes/no)
    - (3) Does the legal framework allow the authority to conduct broad debt management operations for risk management (such as liability management operations)? (yes/no)
    - (4) Does the legal framework require the preparation, annual revision, and publication of a medium-term debt management strategy? (yes/no)
  - Benchmarks:
    - Countries are rated as 1 (yes) or 0 (no) on the four questions. The sum of the four ratings determines the stage.
    - Stage 1Stage 2Stage 3Stage 4
    - 0–1234
- Secondary Market — Market regulation and enforcement:
  - Objective: Assess whether the regulatory framework prohibits unfair trading practices and whether the regulatory authority has the power and capacity to enforce it.
  - Key questions:
    - (1) Is there a legal and regulatory framework that applies (inter alia) to the trading of government securities to prohibit unfair practices (such as market manipulation, front-running, and collusion)? (yes/no)
    - (2) Does the competent regulatory authority have the capacity to monitor activities in the government bond market? (yes/no)
    - (3) Does the competent regulatory authority have the power and capacity to enforce market conduct rules? (yes/no)
  - Benchmarks:
    - Countries are rated as 1 (yes) or 0 (no) on the three questions. The sum of the three ratings determines the stage.
    - Stage 1Stage 2Stage 3Stage 4
    - 0123
- Secondary Market — Investor protection:
  - Objective: Assess whether the legal framework to safeguard investors’ ownership rights is in place and whether the competent regulatory authority has the power and capacity to enforce it.
  - Key questions:
    - (1) Are depositary intermediaries subject to rules to safeguard investor ownership rights, such as the segregation and identification of customer assets? (yes/no)
    - (2) Does the competent regulatory authority have the capacity to oversee compliance with the rules described in (1)? (yes/no)
    - (3) Does the competent regulatory authority have the power and capacity to enforce the rules described in (1)? (yes/no)
  - Benchmarks:
    - Countries are rated as 1 (yes) or 0 (no) on the three questions. The sum of the three ratings determines the stage.
    - Stage 1Stage 2Stage 3Stage 4
    - 0123
- Investor Base — Collective investment schemes:
  - Objective: Assess whether the legal framework for collective investment schemes (CISs; such as mutual funds, investment funds) ensures investor protection.
  - Key questions:
    - (1) Does the legal framework set out standards for the eligibility, governance organization, and operational conduct of a CIS operator? (yes/no)
    - (2) Does the legal framework set out rules governing the legal form and structure of CISs and the segregation and protection of customer assets? (yes/no)
    - (3) Does the legal framework require sufficient disclosure to ensure investor protection? (yes/no)
    - (4) Does the legal framework require periodic mark-to-market valuation for security holdings? (yes/no)
  - Benchmarks:
    - Countries are rated as 1 (yes) or 0 (no) on the four questions. The sum of the four ratings determines the stage.
    - Stage 1Stage 2Stage 3Stage 4
    - 0–1234
- Legal Framework for Taxation — tax certainty and neutrality for key primary and secondary market transactions across key investor classes:
  - Objective: Assess whether the legal framework for taxation is supportive of the development and efficient working of the primary and secondary local currency bond markets.
  - Key questions:
    - (1) Does the tax law framework provide clear and sound rules for determining the tax treatment of returns from government bonds (such as interest, discount, and principal) for retail, institutional, and nonresident investors)? (yes/no)
    - (2) Does the tax law framework provide clear and sound rules for determining the tax treatment of secondary market transactions for government securities that will be entered into by investors? (yes/no)
    - (3) Does the tax law framework have clear and sound rules dealing with locally domiciled CISs that achieve tax neutral outcomes for investors (that is, the same as or better tax treatment than direct investments)? (yes/no)
    - (4) Does the tax law framework achieve an effective and efficient tax alignment with respect to investing or trading in financial instruments between key institutional investor groups? (yes/no)
  - Benchmarks:
    - Countries are rated as 1 (yes) or 0 (no) on the four questions. The sum of the four ratings determines the stage.
    - Stage 1Stage 2Stage 3Stage 4
    - 0–1234

### Using the Framework — aggregation and application
- The questions and indicators in the framework allow for a comprehensive assessment of the stage of development of a country’s LCBM.
- With answers to all the questions in each building block, it is possible to aggregate the answers and determine the development stage of the specific building block.
- The framework at this stage assumes a simple average to arrive at the development stage of each building block.
- A comparison across building blocks for a given country helps identify gaps in the market developing process and provides clues to policy priorities.
- After the stages for each indicator have been determined, it is possible to evaluate whether any or some of the building blocks are lagging the others and define which building blocks deserve more attention and prioritization in designing reforms.
- A comparison can also be made relative to other countries; with more country evaluations, it will be possible to evaluate stages of development for each indicator for countries similar to the one being evaluated.
- Further work suggested:
  - Once the framework is tested in practice, better definition of weights for indicators may be possible; at a later stage, an Excel worksheet may accompany the framework to facilitate calculation.
  - Further work could include refining the calibration of the parameters and identifying the appropriate peer groups.

*Source: anea2021001 - Part 1. Diagnostics*

### Part 1. Diagnostics

### Part 1. Diagnostics

### Instruments for central bank monetary policy operations
- A 2013 survey (covering 125 countries) indicates that 34 percent of economies issue securities for monetary policy operations.
- Marketable instruments vary across countries: repo transactions, government treasury securities, and central bank securities are commonly used.
- Regional tendencies noted:
  - Central banks in Latin America tend to use treasury securities.
  - Central banks in East Asia and Eastern Europe tend to use central bank securities.
  - In Africa, evidence is mixed.
- Coordination between the central bank and government is critical to avoid debt fragmentation, unnecessary competition, yield curve distortions, and additional costs.
- Trade-offs and key considerations for instrument choice:
  - The stock of treasury securities available in the market determines feasibility of using treasury securities for monetary operations; some central banks arrange to issue or borrow government securities for monetary policy purposes and use reverse repo transactions with the central government.
  - Market fragmentation: using treasury securities tends to be more conducive to market development; when central bank securities are used, minimize negative consequences (for example, separation of maturities and harmonization in design and auction method). Separation of maturities can be costly where investor demand is concentrated in short-term securities; fragmentation can be significant where sterilization needs are large and central bank securities have medium-term maturities. Price distortions may develop for identical securities issued by central bank and government.
  - Autonomy of central bank operations: central bank securities better preserve operational autonomy. Use of treasury securities (new issuances) requires carefully designed arrangements to ensure central bank discretion over size and timing of issuances; absent legal/institutional safeguards, treasury issuance for monetary purposes could blur the line between government financing and central bank operations. Proceeds from treasury bills issued to accommodate monetary policy are often deposited in a sterilization account with separate reporting and accounting from fiscal treasury instruments.
  - Cost considerations: sterilization costs are usually reflected in central bank balance sheets regardless of instrument. If treasury securities are used and the central bank pays market interest rates to the government on positive cash balances, central bank net income impact is the same as where central bank securities are used. Sterilization costs are ultimately borne by the government. In most countries, central bank profits are transferred to the government after allowing for adequate reserves; lower profits or losses reduce government present or future revenue.
  - Debt considerations: new issuances of government securities for central bank operations increase the level of gross public sector debt (public sector debt net of deposits at the central bank remains unchanged). Central bank securities (liabilities) are not usually considered public sector debt.

### Key tax-treatment considerations for repos (Box 2)
- Ensure that both the transfer and return of the securities are disregarded for the seller to avoid taxable gains or losses.
- Treat as interest (or equivalent) the amount by which the agreed repurchase price exceeds the amount of the initial sale to better align tax treatment with the substance of the repo transaction.
- Ensure taxation of third-party transactions (such as rehypothecation or reuse) for the buyer.
- Clarify the tax law treatment of manufactured payments, which could otherwise be treated as equivalent to the receipt and payment of interest on the securities.

### Supply-side and demand-side tax provisions (Box 3)
- Supply-side objectives for taxation of government securities:
  - Facilitate investment and issuance decisions and enhance primary and secondary market functioning.
  - Identify and remove tax biases against investing in government securities relative to other investment products.
  - Minimize inefficiencies and distortions (including financial transactions taxes and nonstandard third-party tax obligations, such as withholding tax).
- Demand-side objectives / investors to cover:
  - Make markets attractive to investors to channel savings into investment.
  - Avoid penalizing investors (for example, compared with collective investment schemes) by providing concessions for portfolio investors.
  - Consider relative tax efficiencies between alternative investment options.
  - Simplify tax provisions.
- Note on EET pension tax system: (1) contributions are not taxed, (2) pension fund income is exempt, and (3) pension fund payouts are taxed (both pensions and lump sums); operates as a deferral system.

### Framework, building blocks, and interlinks
- The outlined framework identifies indicators associated with best-practice measures for effective functioning of six building blocks; building blocks do not work in isolation and are interdependent.
- Foundational building blocks: financial market infrastructure (FMI) and the legal and regulatory framework largely dictate the composition of the investor base and the structure of money, primary, and secondary markets.
- Progress (or lack thereof) within each building block affects the scope for progress in others; feedback loops reinforce relationships among building blocks and enabling conditions.

### Building Block 1 — Money market: common constraints and remedies
- Common structural issues:
  - Structural excess liquidity, concentrated or fragmented banking systems, lack of instruments, and inadequate market infrastructure impede money market development.
- Difficulties moving to a market-based monetary framework due to limited fiscal space:
  - Limited fiscal space can cause fiscal dominance and financial repression (for example, interest rate controls).
  - Shift to market-based framework entails higher costs (for example, higher interest rates paid by the central bank could lead to a negative capital position), ultimately borne by the government.
  - Possible remedies:
    - Create sufficient fiscal space to allow for market-based monetary policy (for example, India).
    - Seek high-level commitment between government and central bank to move to a market-based framework.
    - Provide support to the central bank if balance sheet rigidities constrain market-based monetary policy.
    - Coordinate with reforms to adopt market-based pricing in the primary market.
- Lack of appropriate instruments to conduct monetary policy:
  - Trade-offs between market fragmentation and autonomy of monetary policy should guide instrument choice.
  - Possible remedies:
    - Determine appropriate marketable instruments (including government securities), considering availability, potential fragmentation, central bank operational independence, and coordination between central bank and government; establish operational capability.
    - Start using repo transactions for central bank market operations where sufficient government securities are available and gradually increase usage to foster repo market development (for example, Brazil).
- Structural excess liquidity discouraging money market trading:
  - Sustained excess liquidity undermines bank incentives to manage liquidity and trade.
  - Possible remedies:
    - Strengthen central bank liquidity management capacity (liquidity forecasting, day-to-day liquidity management, medium-term liquidity framework, effective sterilization of capital flows) (IMF 2012).
    - Strengthen government cash management capacity and undertake public financial management reform if unpredictable government expenditures contribute to structural excess liquidity.
    - Establish close coordination between central bank and government (for example, Brazil, Mexico; Malaysia).
- High concentration of banking system limits active money markets:
  - Structural impediment in small financial systems or undeveloped nonbank financial sectors.
  - Possible remedies:
    - See investor base section for further discussion.
- Counterparty credit risk concerns fragment the market:
  - Weak banking systems lead to tiered trading and fragmentation exacerbated by lack of timely bank balance sheet information.
  - Possible remedy:
    - Eliminate counterparty risk by developing true repo markets based on written master agreements that guarantee access to collateral in the event of counterparty default.
- Legal and FMI gaps hinder repo market establishment:
  - Antiquated, nonenforceable pledges; absence of close-out netting; bankruptcy rulings can undermine repo credibility; repo rates can be higher than unsecured rates due to FMI inefficiencies.
  - Possible remedies:
    - Review legal provisions for repo transactions for ownership rights, close-out netting, and operational flexibility (for example, Thailand).
    - Support repo market with written master agreements and ensure enforceability under the legal system, including law reform where needed.
    - Review bankruptcy legislation to ensure applicability of close-out netting.
    - Review related market infrastructure, including trading and settlement costs of repo transactions to ensure compatibility with unsecured transactions.
- Absence of short-term reference rates impedes yield-curve formation:
  - Short-term reference rates are essential for government bond and derivatives markets and floating rate instruments.
  - Possible remedies:
    - Collect interbank transaction data and publish aggregate volumes and average interest rates transacted on key tenors (for example, overnight, one week, two weeks, three months, six months, and 12 months) by the end of the next business day.
    - Use the treasury bill market for pricing references when money markets are illiquid, recognizing treasury bills are imperfect substitutes for interbank reference rates.

### Building Block 2 — Primary market: common constraints and remedies
- Smoothing redemption profiles requires liability management operations (LMOs), benchmark securities, and improved cash management capacity.
- Challenges in low- and lower-middle-income countries include creating new instruments and establishing longer-tenor instruments.
- The government not behaving as a price taker:
  - High borrowing costs often linked to macroeconomic instability or limited fiscal space; governments may adopt nonmarket borrowing practices (direct central bank financing, nonmarketable securities to public institutions, interest-rate caps), or consider market prices inconsistent with fundamentals; concerns about collusion can discourage market pricing.
  - Possible remedies:
    - Create sufficient fiscal space to allow market-based pricing in auctions.
    - Adopt strategy to gradually phase out nonmarket practices (for example, issuance of nonmarketable securities to central bank or captive investors, interest rate ceilings) coordinated with monetary policy operating framework adjustments (for example, India; Vietnam).
    - Eliminate frequent tapping in primary markets and move toward competitive auction issuance.
    - Establish auction rules to enhance competition and mitigate market dominance by large players; perform detailed analysis of demand profiles and market shares of bidders.
    - Limit allocations to noncompetitive bids to promote better price discovery; set strict limits to private placements and disclose terms and rationale when private placements occur.
    - Establish and enforce limits to (or prohibit) central bank monetary financing of the government (for example, India); see investor base framework for further discussion.
    - Increase the number of institutions with direct primary market access to enhance competition; if primary dealer access is privileged, ensure fair and smooth access of other investor groups through PDs and strengthen regulatory and supervisory frameworks for timely detection and sanctioning of market abuse.
- Auction format note:
  - The uniform price auction format could be the initial choice and later switched to multiple price auctions as the primary market gains experience in the bidding process.

*Source: anea2021001 - Part 1. Diagnostics*

### Part 2. Country Experiences: Common Challenges and Possible Remedies

### Part 2. Country Experiences: Common Challenges and Possible Remedies

### Auctions Are Not Sufficiently Competitive
- Findings:
  - A concentrated investor base or the existence of a single (or several) dominant investor(s), or both, may adversely affect competition at auctions and consequently affect secondary market liquidity.
  - Commercial banks often dominate the primary market if the institutional investor base is shallow, increasing the risk of price collusion.
  - In some markets, there may be a concentration of individual investors, even within the banking system.
  - Single, dominant investors (for example, social security system funds, state-owned pension funds) may be the main source of demand for government securities.
- Possible Remedies:
  - Establish auction rules that enhance competition, mitigate excessive market dominance by a few large players, and help contribute to secondary market liquidity.
  - Consider if auctions should be open only to selected entities or to broader participation.
  - Consider syndications to expand investors’ participation.
  - Consider limitations on the share of a single investor or bidder in the primary market.
  - Carefully and continuously analyze the investor base composition, the demand profile of investors, and the market share of the bidders to design an appropriate auction framework. Scrutiny of bidding behavior after each auction may help to identify potential collusion.
  - Develop the investor base to instill greater competition in the primary market (see investor base section for further discussion).

### Lack of a Predictable and Transparent Issuance Framework, Including as a Result of Cash Management Constraints
- Findings:
  - Irregular and uneven issuance amounts and maturities create market uncertainty.
  - Ad hoc issuance patterns frequently occur under volatile market conditions and in the absence of a strategic framework for government debt management.
  - Capacity constraints to project and manage government cash flows for the budgetary cycle, and a lack of cash management instruments (for example, cash buffer, short-term instruments) could result in erratic issuance patterns.
  - Legal constraints on the use of short-term instruments can cause erratic issuance.
  - Poor communication with market participants could result in an issuance framework that does not match market expectations.
- Possible Remedies:
  - Formulate, publish, and adhere to a medium-term debt management strategy and annual borrowing plan (for example, Brazil, Mexico).
  - Release a debt issuance plan indicating issuance dates, amounts, and maturities regularly.
  - Conduct treasury forecasting and active cash management to enhance issuance, reduce the cost of borrowing, and manage refinancing risk. Absent robust cash flow forecasts, the debt manager could examine historical trends in revenue and expenditure flows, and relevant forward-looking information (for example, Colombia).
  - Establish a cash buffer in the treasury single account to enable a regular and predictable execution of the government’s auction calendar and to better manage refinancing risk (for example, Hungary, Turkey).
  - Allow the use of short-term government securities (for example, treasury bills) to serve as a flexible tool for short-term financing (for example, India) in cases where financing needs are volatile or there are cash management constraints.

### Higher Cost and Lack of Demand for Long-Dated Securities
- Findings:
  - Fixed-rate long-term bonds help mitigate refinancing risks and extend the yield curve, but governments are often unable to place these securities because of high costs, particularly in early stages of market development.
  - Extending maturities is costly for countries with unstable macroeconomic conditions or lacking an institutional (nonbank) investor base.
  - Unrealistic issuer expectations regarding long-term instrument pricing relative to short-term budgetary cycle cost considerations hinder long-term issuance.
  - The lack of an active secondary market, repo, and interest rate derivatives market (for example, interest rate futures and swaps) limits investor interest in long-term bonds.
- Possible Remedies:
  - The issuer (at an early stage of market development, when credibility is not yet established) may have to pay a premium to issue long-term securities.
  - An expanded and diversified investor base, transparency, and predictability will help increase the credibility and offset the higher borrowing costs. The volume of long-term securities issued would depend partly on the government’s available fiscal space to absorb higher interest costs.
  - Authorities in countries where high inflationary expectations persist (despite material improvement of the monetary policy framework) could consider issuing inflation-indexed bonds in limited amounts to enable an extension of maturities. These type of securities could help reduce a large part of the term premium, paving the way for the formation of reference rates for fixed-rate yields on similar tenors (for example, Brazil, Mexico).
  - Develop contractual saving institutions to provide a natural source of demand for long-term bonds (for example, Chile, Mexico, South Africa; see Investor Base section for further discussion).
  - Develop the secondary market by improving pretrading and posttrading transparency (see the secondary market section for further discussion).
  - Develop a repo market that uses long-term bonds as collateral. This will increase the capacity of investors to invest in long-term bonds (for example, Malaysia, Poland; see the Money Market section for further discussion).
  - Develop the interest rate derivatives market to provide investors with instruments to hedge their exposure on long-term bonds (for example, Brazil, South Africa; see the Secondary Market section for further discussion).

### Lack of Appropriate Instruments, Including Benchmark Securities, and Difficulties in Creating New Instruments
- Findings:
  - Several countries, particularly low-income countries, lack a critical mass of benchmark securities in part because of concerns about high refinancing risks related to the bullet maturity of a large benchmark bond.
  - This is particularly problematic when government cash management capacity is weak or when there is limited ability to conduct LMOs.
  - The lack of an adequate stock of benchmark securities impedes liquidity in the secondary market.
- Possible Remedies:
  - Gradually build up a stock of benchmark bonds that cover the life cycle of a security. When reopening securities through on-the-run benchmark issuance, the duration of a security’s issuance, and hence its target size, should be adjusted to ensure that its coupon rate does not go off market, in which case its demand will be affected (for example, India, Kenya).
  - Complement benchmark issuance and reopenings with LMOs (that is, buybacks and switches) to mitigate refinancing risks and improve the liquidity of the off-the-run instruments (for example, Hungary, South Africa, Thailand). Make sure that the legal framework and market infrastructure are supportive of LMOs (see the Legal and Regulatory section and the Market Infrastructure section for further discussion).
  - Increase the size of auctions to promote greater availability of tradable stocks, which would lead to better price discovery. This should be done carefully with a precise understanding of investor preferences and constraints to minimize the risk of potential auction failures (for example, Mexico).
  - Consider reopening long-term instruments in different maturity segments if the coupon is in line with the market conditions in the new maturity bucket, to improve the liquidity of the off-the-run bonds (for example, Hungary).

### Lack of a Representative Yield Curve, Which Tends to Produce Different Perspectives in Markets and the Government Regarding the Costs of Financing
- Findings:
  - The yield curve normally serves as a price reference for the issuer, but its usefulness could be limited if there is limited secondary market activity.
  - Asymmetries in expected yields for specific maturities may arise when there is no diversity in investors’ offering quotes or when a specific investor class dominates.
  - Yield curve distortions can arise when the bond market is fragmented because of different market conventions, tax treatments, and eligibility as a liquid asset of different bond series.
  - A fragmented portfolio, including a large number of series and limited size of the stock of individual bonds, could impede price discovery.
- Possible Remedies:
  - Introduce shorter-term securities to gradually build reference prices along the yield curve. A program of systematic issuance of treasury bills helps to anchor the short end of the yield curve by providing fresh references for short tenors. Shorter-term issuances also support money market development.
  - Develop a government securities benchmark issuance policy, concentrating on amounts of benchmark tenors, and ensure that the benchmark target size is achieved consistently. The lengthening of maturity across key tenors needs to take place gradually, building on shorter tenors that anchor the new maturities being introduced (for example, Georgia, Peru).
  - Syndications could be useful to expedite the creation of benchmark securities, especially for new maturities or new types of instruments. Placement through syndications can allow for a larger initial issuance amount compared with a conventional auction, and provide better clarity for pricing in subsequent auctions while allowing for a more diverse investor base. In addition, the book-building process provides the issuer with some degree of control over the issuance price.
  - Use LMOs to reduce the fragmentation of the government bond portfolio.
  - Standardize the issuance of securities through a harmonized framework of tax treatment and payment conventions.

### Inability to Conduct Liability Management Operations
- Findings:
  - The use of LMOs in some countries could be hindered by the lack of enabling conditions.
  - Common obstacles include the absence of efficient price formation, precarious market infrastructure systems, or inefficient cash management.
  - In some cases, the legal framework may not provide the legal comfort for these transactions to be executed without risks to the debt manager.
- Possible Remedies:
  - See the legal and regulatory, primary market (for cash management), and secondary market (for lack of a price reference) sections for possible remedies. LMOs should be developed alongside the financial market infrastructure.

### Building Block 3: Secondary Market — Overview
- Findings:
  - The evolution of secondary markets is largely dependent on the stage of market development of the other blocks of the LCBM.
  - The functioning of the secondary market is often contingent on the proper functioning of the money market, the primary market, and market infrastructure, and on the composition of the investor base.
  - Challenges faced in developing the secondary market typically stem from problems in developing one or more of the other building blocks.
  - Many emerging market and developing economies tend to have a small number of domestic and international institutional investors.
  - The prevalence of buy-and-hold strategies among investors may be a constraint.
  - The absence of benchmark bonds and an underdeveloped market infrastructure may also be important factors hindering trading in the secondary market.

### Dearth of Adequate Volume of and Properly Priced Instruments that Support Trading, Foster Liquidity, and Deepen the Yield Curve
- Findings:
  - Many countries, particularly low-income countries, do not have enough benchmark securities, which inhibits liquidity in the secondary market.
  - Many countries are unable to build benchmark securities of sufficient size because of concerns related to refinancing risks when a large benchmark bond is redeemed on a single day, particularly if the government’s cash management capacity is inadequate and there is limited ability to conduct LMOs.
  - If securities are not priced at market rates, it would be difficult to develop a representative yield curve.
- Possible Remedies:
  - Reduce the frequency of auctions, and build a large stock of benchmark bonds supported by robust cash management capacity. These actions may be especially relevant for countries with a nascent secondary market.
  - Adopt market-based pricing supported by transparent and predictable issuance.

### Too-High Frequency of Auctions Removes Trading Incentives for Investors
- Findings:
  - Countries that conduct auctions too frequently tend to reduce incentives for trading.
  - A steady supply of securities in the primary market reduces the incentives for market participants to seek those securities in the secondary market.
- Possible Remedy:
  - Reduce the frequency of auctions (see the primary market section).

### The Dominance of Buy-and-Hold Investment Strategies
- Findings:
  - The prevalence of buy-and-hold investment strategies can stem from multiple factors, including a high concentration of the banking system and distortive regulatory frameworks.
- Possible Remedies:
  - Create regulatory frameworks conducive to trading while addressing any structural constraints (for example, high concentration of the banking system; see the investor base section for further discussion).
  - Coordinate with the reform of the primary market. The reform of the investor base could have a larger impact if preceded by a move to market-related issuance rates that transform captive investments into voluntary investment (for example, Malaysia).
  - Increase transparency by publishing a daily yield curve and a list of traded securities. Many investors do not sell their holdings because of low levels of price transparency.

### An Inactive Money Market Reduces Incentives to Trading
- Findings:
  - Without an active money market, it is difficult to develop the secondary market.
  - The absence of a market-based monetary policy operating framework creates high volatility in short-term interest rates, which increases uncertainty for investors and creates a stumbling block for trading.
  - Structural excess liquidity in the banking sector can further impede the development of a liquid secondary market.
  - An underdeveloped repo market impedes market making.
- Possible Remedy:
  - Transition to a market-based operating framework for monetary policy, supported by adequate liquidity management capacity. Establish a supportive legal framework and financial market infrastructure that supports the repo market (see the money market section for further discussion).

### Inadequate Market-Making Capacity of Intermediaries Impedes Market Liquidity
- Findings:
  - It is challenging to maintain an effective PDs system, particularly for countries in early stages of market development.
  - Without an active secondary market (including repo and interest rate derivatives markets), PDs find it difficult to generate a profitable market-making business.
  - A PDs system is not feasible in economies with a small number of financial institutions because it is difficult to establish an effective dealer-broker arrangement to facilitate trades, and the issuer is exposed to the risk of collusion by the PDs.
- Possible Remedies:
  - Countries with a PDs system should calibrate the obligations of PDs as the market develops so that PDs’ obligations are proportionate to the stage of market development and are well-balanced with the privileges afforded. A regular evaluation process will be required to retain the most efficient PDs and to replace the noncomplaint PDs with new entrants (for example, Malaysia [see Appendix 1]; Poland).
  - Create an environment conducive for market-making activities by developing the repo, securities lending, and interest rate derivatives market.

*Source: Part 2. Country Experiences: Common Challenges and Possible Remedies (anea2021001).*

### Part 2. Country Experiences: Common Challenges and Possible Remedies

### Part 2. Country Experiences: Common Challenges and Possible Remedies

### Market-making, liquidity, and secondary market structure
- Challenges:
  - Absence of active secondary markets; initially small trading volumes can require a dealer system beginning with a single monopoly (usually a discount house) or a small number of dealers.
  - Market-making requires inventory capacity and confidence that market makers can perform trades without difficulties.
  - Over-reliance on buy-and-hold behavior can reduce trading and liquidity.
- Possible remedies:
  - Allow short selling of securities for market-making purposes to support market liquidity, pricing efficiency, and risk management, while banning uncovered short sales where necessary to avoid fraud, abuse, or market collusion (footnote 9).
  - Start a dealer system with a single monopoly or a small number of dealers, while allowing other financial institutions to trade and emerge as dealers over time; consider merging a discount house into a wider PD group as markets develop (example: India).
  - Use a call auction or an order-driven auction agency market system where appropriate (more efficient than PD system for countries with a small number of well-capitalized dealers).
  - Offer last-resort securities lending (or repo) facilities via debt management offices or central banks to reduce market-making costs and boost market-maker confidence.

### Lack of transparency in the secondary market
- Challenges:
  - Dominance of over-the-counter trades leads to inadequate pre-trade and post-trade transparency.
  - Authorities often lack a comprehensive picture of secondary market activities.
- Possible remedies:
  - Strengthen pre-trade transparency through an electronic trading platform that allows dealers to quote prices in real time to each other (example: Korea).
  - Require bond dealers to report transactions (prices and volumes) to a centralized agency or designated trade repository (for example, by end of business day). Collect transaction information from the CSD and publish aggregated trade volumes and average yields and/or prices; display information via trading platforms/exchanges and public bond information websites (example: Malaysia). Monitor compliance and impose penalties for noncompliance.
  - Facilitate government bonds listing on local stock exchange(s) while avoiding overly stringent listing requirements that could hamper efficient trading.
  - Publish turnover statistics daily and the most recent traded price.
  - Publish a daily market yield curve.
  - Consider establishing a bond index (for example, by the stock exchange).
  - Promote derivatives market development; active trading in short-term futures benefits pricing along the yield curve and development of key interbank reference rates (examples: Brazil, South Africa).

### Building Block 4 — Investor base
- Challenges:
  - Countries at lower income levels may struggle to develop institutional investors (see Appendix 2).
  - High concentration in the banking sector hinders trading and liquidity, especially in small financial systems or undeveloped nonbanking sectors.
  - Lack of institutional investors (contractual savings sector) constrains the government’s ability to extend debt maturities; public pension and provident fund programs that adopt a pay-as-you-go model (which is unfunded) do not contribute to demand for government securities (footnote 10).
  - Some large institutional investors invest mostly overseas due to absence of suitable domestic financial products, creating asset-liability mismatches (for example, excessive issuance of short-term and medium-term notes versus long-term liabilities).
  - Distortive regulatory frameworks (differential tax treatments, withholding taxes, transaction taxes, coupon taxes not prorated by holding time, excessively high liquidity regulations, mandatory holdings) exacerbate buy-and-hold behavior and reduce secondary market trading.
  - Determining the cost–risk balance of foreign investor participation is difficult; sudden capital inflows before market depth is established can increase financial stability risks.
- Possible remedies:
  - Foster competition in the financial sector and strengthen financial sector oversight to prevent excessive risk taking and manage financial stability risks.
  - Formulate a strategy to develop the contractual savings sector and introduce a supportive tax framework.
  - Facilitate development of collective investment schemes and introduce supportive legal and regulatory frameworks to strengthen investor protection.
  - Consider applying new financial technologies to facilitate retail investor access to government securities markets.
  - Strengthen investor relationship management to identify investor preferences and constraints; design the funding mix with potential demand in mind; ensure institutional investors have access to government securities either directly through auctions or via PDs (market makers).
  - Issue long-term bonds gradually to cater to institutional investor needs while weighing cost–risk trade-offs (examples: Hungary, Thailand).
  - Ensure neutral tax treatment of financial investments and avoid levying taxes on transactions.
  - Review liquidity regulations; assess whether government securities are treated as cash equivalents and whether liquidity standards are set too high; consider gradual relaxation of liquidity regulations as markets develop.
  - Gradually relax mandatory investment requirements for government securities as the institutional investor base matures.
  - Allow institutional investors to repo or, if not possible, to lend securities to PDs for market-making.
  - Assess foreign investor interest considering market development stage, existence of FX hedging markets, and macro fundamentals; simplify investor approval processes, remove tax impediments, and improve access to reputable international CSDs and custodial arrangements (examples: Malaysia, Peru).
  - Allow gradual increases in foreign participation when appropriate; relax minimum holding periods after the domestic investor base matures (example: Mexico).
  - Consider issuance of global depository notes (examples: Costa Rica, the Dominican Republic).

### Building Block 5 — Financial market infrastructure (FMI)
- Challenges:
  - Operational risk from complex operational requirements, manual processes, multiple CSDs fragmenting the market, and lack of staff capacity in low- and middle-income countries (see Appendix 2).
  - High costs of establishing cost-effective FMI that match market development stage.
  - Legal constraints or capacity gaps hinder dematerialization of securities; lack of investor interest can also impede full dematerialization.
  - Unclear legal frameworks for payment finality and transfer of securities ownership increase settlement risk (bankruptcy courts potentially overriding market transactions).
  - Multiple CSDs segment the market, increasing costs and inefficiency of security transfer.
  - Lack of market infrastructure to support repo markets; some FMIs lack functionality for DVP1 T+0 settlement, settlement of both legs of repo transactions on respective settlement dates, and substitution of securities under repo agreements.
  - FMI may lack legal powers to collect transaction data; confidentiality concerns can deter disclosure.
  - Limited investor access to CSD and central counterparty clearing house functions impedes investor base development; establishing links to foreign CSDs can be costly.
  - Difficulties assessing and ensuring sound governance of FMI against good practice.
- Possible remedies:
  - Assess current FMI arrangements against the principles of financial market infrastructure and identify gaps.
  - Communicate with stakeholders to identify functionality and service requirements to support market development.
  - Define an operating model with core functionalities and minimum service requirements.
  - Use a competitive procurement process to select suitable FMI vendor systems.
  - Small countries should undertake cost-benefit analysis of investing in integrated electronic systems versus operating manual processes.
  - Evaluate financial technologies to increase market infrastructure efficiency.
  - Introduce enabling law for dematerialization that recognizes security ownership through credit balances in securities accounts (electronic records).
  - Conduct a gap analysis of registration and custody arrangements versus good practice; decide whether to introduce a new system or upgrade current systems.
  - Offer an efficient, low-cost switching process and incentives to expedite full dematerialization.
  - Ensure the law clearly defines finality of payment and transfer of securities ownership rights and addresses potential conflicts with bankruptcy proceedings.
  - Coordinate stakeholder discussion on operating a single, well-integrated FMI system where justified.
  - Promote open access to settlement systems, develop efficient electronic low-cost bridges between systems, encourage sharing of market activity data, and ensure all systems support the same settlement models during transition (example: Georgia).
  - Where repo markets exist, assess whether FMI supports key functionalities such as DVP1 T+0 settlement, settlement of both legs on respective settlement dates, and substitution of securities under repo agreements.
  - Where repo is not yet introduced, set up procedures and controls and introduce system functionality to process collateralized loans on a T+0 basis; small countries may use manual processes if electronic market costs are too high.
  - Ensure FMI has legal powers to require daily transaction data reporting; determine data for publication after consultation with market participants and regulators.
  - Build FMI capacity to provide aggregate breakdowns of government securities holdings by investor category.
  - Develop access policy for FMI in consultation with central bank, debt management office, and regulators; consider direct access for foreign investors in later-stage markets and carefully weigh cost–benefit of links to foreign CSDs (example: Mexico).
  - Conduct a full assessment of FMI against the principles of financial market infrastructure assessment methodology, or selectively assess high-priority governance issues such as:
    - Transparency in operations
    - Adequate mix of skills and proper oversight
    - Objective of running CSD and central counterparty clearing house
    - Operational and business risks and financial capacity to absorb consequential losses
    - Regular reconciliation between system records and Ministry of Finance records
    - Regular operational audits
    - Business continuity and disaster recovery plans
    - Secure and resilient communication network and system hardware

### Building Block 6 — Legal and regulatory framework
- Challenges:
  - Legal frameworks sometimes do not provide debt management authorities with flexibility to conduct necessary debt management operations; provisions may limit transactions such as buybacks and debt exchanges or restrict parameters (price limits, budget restrictions), creating legal risks.
  - Stringent requirements for use of intermediaries (mandatory trading through dealers or brokers; prohibition of bilateral transactions) can increase transaction costs and hinder secondary market development; mandatory stock exchange trading can deter investors if commissions/fees are significant.
- Possible remedies:
  - Ensure law provides the debt manager with flexibility to define prices, instruments, and transaction types in an agile way while embedding appropriate accountability, if consistent with the overall legal framework.
  - Where ambiguity exists about competence to undertake liability management operations (LMOs), seek clarification through subsidiary legislation or legal opinions until legal reform is possible.
  - Ensure legal framework governing intermediaries balances transparency, cost efficiency, and risk minimization, considering the market development stage; avoid overly stringent requirements at early stages.
  - Address transparency concerns by strengthening dealer reporting requirements and prohibiting unfair trading practices supported by surveillance systems.
  - Enable and facilitate transactions without intermediaries via a defined price tunnel mechanism that renders transactions outside the tunnel void, protecting less-sophisticated investors from abusive or misleading prices.

*Source: anea2021001 - Part 2. Country Experiences: Common Challenges and Possible Remedies*

### Part 2. Country Experiences: Common Challenges and Possible Remedies

### Part 2. Country Experiences: Common Challenges and Possible Remedies

### Inadequate Legal Framework for Taxation
- Problem:
  - Many countries lack a comprehensive tax law framework governing the treatment of domestic government securities, generating material tax impediments to efficient primary and secondary LCBMs.
  - Tax law frameworks may not provide certainty for all key primary and secondary market transactions across all key investor classes.
- Possible remedies:
  - Countries should undertake (1) a diagnostic review of their tax law framework to identify impediments and gaps as they relate to the treatment of LCBMs, and (2) develop and implement necessary tax law reforms so the tax law framework reflects international good practices and remains competitive.
  - Legislative actions will depend on each country’s legal tradition, baseline tax law framework, and underlying fiscal and tax policy settings.
  - Consider legal modalities relating to the issuance and trading of local currency government bonds and associated FMIs to ensure consistency with the country’s overarching legal infrastructure.
  - For facilitating foreign investment, interest withholding tax and capital gains tax concessions or exemptions in relation to returns and gains on local currency government securities that are consistent with international common practice often become necessary to achieve critical investment links between LCBMs and international FMIs.

### Box 4 — Tax Treatment Issues to Be Addressed by the Tax Law Framework
- Supply-Side Tax Treatment Issues (Taxation of Government Securities):
  - Primary Market: Treatment of returns (such as interest and discount).
  - Secondary Market: Taxation of gains (such as on sales), including sale amounts attributable to accrued interest (often treated as interest if tax-favored gains compared with capital gains).
  - Taxation of repos (see Box 1.2).
  - Taxation of securities lending (considerations similar to repos).
  - Treatment of financial collateral (considerations similar to repos).
  - Taxation of derivatives (increasing trend toward mark-to-market approaches).
- Demand-Side Tax Treatment Issues (Investors to Cover Include):
  - Collective Investment Schemes: Tax rules need to be attractive and neutral to investors (channel savings into investment, not put investors in a worse situation than if they had invested directly) while considering treatment of investment management activity to encourage local management of collective investment schemes.
  - Pension Funds: Exempt-exempt-taxed (EET) system or otherwise.
  - Insurance Companies (Life and General): Assess relative tax treatment and neutrality of long-term savings made through a life insurance policy compared with other investment options.
  - Other Investors, including local (for example, financial institutions) and foreign investors (for example, state-owned enterprises, family offices, and so on).
- Note on EET:
  - In an EET system, (1) contributions are not taxed, (2) pension fund income is exempt, and (3) pension fund payouts are taxed (both pensions and lump sums). This system typically operates as a deferral system, with the tax on contributions and pension fund income deferred until payout.

### Part 1. Diagnostics — Using the LCBM Framework to Design Reform Plans
- Overarching guidance:
  - LCBM reform plans should be anchored on the country’s long-term objectives and degree of market development.
  - Plans should include a targeted time frame (for example, three to five years) to achieve intended outcomes.
  - Reform plans should be informed by comprehensive assessment of relevant indicators of each building block and identification of key constraints for market development.
- Building blocks to assess (Figure 3):
  - BB1: Money market
  - BB2: Primary market
  - BB3: Secondary market
  - BB4: Investor base
  - BB5: Financial market infrastructure
  - BB6: Legal and regulatory framework

### Seven Steps for Designing an LCBM Reform Plan
- Step 1: Determine LCBM objectives and policy priorities.
  - Objectives could include, but are not limited to: (1) increasing the local market capacity to provide funding to the public sector, (2) making price discovery more efficient, (3) broadening the investor base, (4) strengthening the monetary policy transmission mechanism, (5) facilitating banks’ liquidity management (and increasing financial resilience), and (6) increasing the sources of funding for the private sector.
- Step 2: Establish a coordination mechanism for LCBM reform.
  - Set up a high-level committee and technical-level working groups comprising main stakeholders: debt management authorities, monetary authorities, relevant regulator(s), FMIs, and private sector participants (for example, banking sector, insurance, and pension fund associations).
  - Working groups should be chaired by main beneficiaries (for example, the DMO or the central bank). High-level committee should be chaired at the ministerial level; Ministry of Finance ideally provides leadership and secretariat.
  - Workshops and events can initiate drafting; reform plans should be realistic, politically feasible, and tailored to administrative capacity.
- Step 3: Evaluate the enabling conditions and stages of market development in every building block.
  - Use diagnostics framework to assess development degree and identify gaps; consider a heat map to prioritize.
- Step 4: Consider identifying peer groups to benchmark experiences.
  - Peer groups may be defined by income and population metrics, geographical proximity, economic structure (for example the degree of dollarization), size of financial sector, monetary policy regime, or stage of LCBM development.
- Step 5: Identify gaps in each building block.
  - Use framework assessment and peer analysis to identify building blocks lagging peers and replicate feasible measures.
- Step 6: Formulate a plan of action and measures needed to close the gaps, considering capacity and institutional constraints.
  - Sequence measures considering interlinks among building blocks; incorporate related ongoing reforms (public debt management, public financial management, supervision).
- Step 7: Propose targets and deadlines, and assign clear responsibilities to relevant agencies.
  - Plan should specify expected outputs and outcomes, sequencing, milestones, budget estimates, and lead agencies for implementation and monitoring.
- Summary checklist:
  1. Determine LCBM objectives and policy priorities.
  2. Establish a coordination mechanism for LCBM reform.
  3. Evaluate the enabling conditions and stage for market development in every building block.
  4. Consider identifying peer groups to benchmark experiences.
  5. Identify gaps in each building block.
  6. Formulate a plan of action and measures needed to close the gaps, considering capacity and institutional constraints.
  7. Propose targets and deadlines, and assign clear responsibilities to the relevant agencies.
- Implementation note:
  - Activities and outputs in the first year may be specified in more detail than those in later years, which will depend on earlier achievements and evolving circumstances.

### Case Study — Vietnam: Improving the Legal and Regulatory Framework to Facilitate Market Development
- Context and challenge:
  - Before 2017 few formal laws and regulations existed to allow for the issuance of market-based government debt.
  - Government approved the Vietnam Bond Market Development Road Map 2017–20, with a vision to 2030.
- Solution:
  - Law changed to allow the government to borrow via the bond market; authority enshrined in the Public Debt Management Law amendment approved by the National Assembly in November 2017 and came into effect in July 2018.
  - New law regulates issuance, registration, depository, listing, and trading of government debt instruments; provides a new framework for the primary dealer system; facilitates a securities lending facility operated by the Vietnam State Treasury.
  - Updated law complemented by circulars (issued in 2018 and 2019) to improve efficiency: Circular 110; Circular 111; Circular 30. These circulars facilitate liability management (through switches and buybacks), primary dealer system functioning, liquidity support offered by the state treasury, and same-day trading for primary dealers.
- Results:
  - Vietnam established a legal framework to underpin a modernized debt management issuance strategy, supporting robust recent growth in the domestic government securities market.

### Case Study — Georgia: Designing and Implementing Tax Reforms to Support Local Currency Bond Market Development
- Context and challenge:
  - In April 2016 Georgia released its Capital Market Development Strategy and Action Plan (Capital Markets Plan) as part of “Georgia 2020.” The Plan identified impediments including unsatisfactory legal and regulatory frameworks, particularly in relation to taxation.
- Solution:
  - Authorities reviewed and reformed the tax law framework governing primary and secondary bond markets, drafting packages of tax law reforms.
  - Reforms focused initially on the supply side (tax treatment of government securities in primary and secondary markets) and then on the demand side (alignment of tax treatment across key institutional investor groups, including mutual and investment funds).
  - Reforms included formalizing tax treatment of returns from local currency bonds for all key classes of domestic and foreign investors and implementing interest-withholding tax and capital gains tax concessions and exemptions consistent with international common practice.
- Results:
  - Georgia now has a tax framework providing clear rules for taxation of returns from local currency bonds (such as interest, discount, and maturity amounts) covering all key classes of domestic and foreign investors.
  - Tax treatment clarity extends to secondary market transactions (gains on secondary sale, repo, securities lending, financial collateral, and derivative transactions for institutional investors).
  - The new regime has helped support establishment of critical investment links between Georgia’s bond market and Clearstream.
  - The full benefits of these tax reforms will take time to manifest.

*Source: Part 2. Country Experiences: Common Challenges and Possible Remedies (anea2021001).*

### Appendix 1. Selected Case Studies

### Appendix 1. Selected Case Studies

### Georgia: Recently Enacted Tax Law Reforms (Package Summaries)
- Package 1 (Rates and Concessions)
  - Government securities benefit from tax exemptions on income and gains (for foreign investors).
- Package 2 (Technical Amendments)
  - Technical amendments remove tax impediments and provide investor certainty, covering:
    - Secondary sales (split between capital and interest components),
    - Taxation of repos (consistent with Box 1.2),
    - Taxation of securities lending (similar to repos),
    - Treatment of financial collateral (similar to repos), and
    - Taxation of derivatives (mark-to-market).
- Outcome
  - A tax framework covering all key classes of investors, including nonresidents, has created conducive legislative conditions to further the aim of deepening the Georgian LCBM.

### Georgia: Financial Market Infrastructure
- Context and Challenge
  - Post-trade infrastructure fragmented between the central bank and the stock exchange.
  - Central bank’s CSD operations were automated; corporate securities segment processes were paper-based and manual.
  - Settlement took multiple days, moderate custody and settlement risk, and weak resilience to disruption.
  - Challenge: enable nongovernment securities segment to operate and be regulated within a single FMI system independent of government securities market.
- Solution
  - In 2018 the National Bank of Georgia collaborated with the Georgian Stock Exchange to establish a public-private centralized FMI system: the Georgian Security Settlement System.
  - The system is a single system including the CSD and auction functionality and is fully integrated with real-time gross settlements.
  - The system supports two CSDs that seamlessly interface between themselves and with the real-time gross settlements system and commercial bank accounts held with the National Bank of Georgia.
  - The system supports efficient transfer of securities between the CSDs and settlement in central bank money for all financial sector security transactions.
  - National Bank of Georgia owns and operates system hardware and network; software rights are shared between the national bank and the Georgian CSD.
  - The National Bank of Georgia is responsible for systemically important FMI functions: system capacity and performance, maintenance and development, and development and maintenance of the primary and secondary DVP sites.
  - The Georgian Stock Exchange operates a CSD business within the Georgian Security Settlement System under a contractual arrangement with the national bank.
  - An international software vendor of FMI infrastructure systems developed the system.
- Result
  - National Bank of Georgia operates the CSD business solely for government securities and securities issued by the national bank.
  - Georgian Stock Exchange operates the CSD business for corporate debt, local currency supranational debt, equities, and other securities.
  - Each CSD can set its own rules and regulations and fees, create new securities, determine investor access criteria, manage corporate actions, use appropriate trading models (over-the-counter or on exchange) and preferred settlement models (DVP1, DVP3), monitor settlements, and regulate activity.
  - DVP1 is the default model for government securities; the Georgian Stock Exchange uses DVP1 and DVP3.
  - Benefits include:
    - Public sector interest maintained via central bank operating system and performing CSD functions for government bonds only;
    - Public sector/central bank kept away from commercial CSD operations (corporate bonds and equities);
    - Increased National Bank of Georgia ownership, reputation, and financial capacity support to boost investor confidence in the FMI, particularly nonresident investors.

### Malaysia: Lowering Barriers for Foreign Investor Participation
- Context, Challenge, and Solution
  - Regulatory reforms progressively eliminated barriers for foreign investors in the LCBM.
  - 2004: authorities eliminated withholding taxes for nonresidents that arise from income on government and corporate bonds.
  - 2005: nonresidents permitted for the first time to sell forward foreign exchange contracts against Malaysian ringgit to hedge receipts and committed outflows for divestments in ringgit assets.
  - 2007:
    - Abolished limit on overdraft facilities extended by authorized dealers to nonresident stockbrokers or custodian banks for settlement of purchase of listed securities.
    - Registration requirements on ringgit-denominated loans to nonresidents eliminated.
  - 2016–2017: central bank measures to enhance onshore foreign exchange market liquidity, granting investors additional flexibility to hedge exposures and liberalizing regulated short selling for residents.
  - More recent initiatives included:
    - Enhancing the repo market by increasing availability of off-the-run securities to be borrowed via repo,
    - Enhancing delivery mechanisms of securities, and
    - Facilitating hedging operations for foreign investors.
- Results
  - Share of foreign investors in the LCBM increased from 13.5 percent at the end of 2009 to a peak of 35.75 percent in September 2016 before declining to about 24 percent (as of March 2019).
  - Composition of investor base broadened with more medium-term and long-term investors, contributing to better market stability.
  - Foreign exchange measures in 2016–17 improved hedging opportunities and the supply of foreign exchange onshore.
  - Turnover in onshore spot, forward, and swap foreign exchange markets improved, bid-ask spreads narrowed, and ringgit volatility declined.
  - Availability of an efficient foreign exchange derivatives market helped attract a wider range of foreign investors and enrich the bond market through greater price discovery and liquidity.

### Malaysia: Development of Preconditions and a Sizable Institutional Investor Base
- Context and Challenge
  - Malaysia moved from a budget surplus environment to developing a government securities market starting in the late 1950s.
  - Need to create preconditions: sufficiently large outstanding volume of securities, stable interest rate environment, relevant market participants, and predictable timetable for regular issues.
- Solution
  - Introduced medium term to long term government securities as investment assets for the Employees’ Provident Fund (EPF).
  - Built domestic long-term capital as anchor to domestic government debt market development and to attract foreign investors.
  - External borrowing comprised only 3 percent of the debt stock at the end of 2019.
- EPF as cornerstone
  - EPF established by EPF Act 1951; compulsory for nearly all formally employed Malaysians.
  - Policy requires that 70 percent of members’ contributions cannot be withdrawn before retirement age of 55; residual 30 percent can be withdrawn only under specific circumstances.
  - Aggregate size: 839.6 billion ringgit at the end of 2019, or 58 percent of GDP.
  - EPF has heavily invested in the bond market and has been guided by provisions in the 1991 act.
- Further development
  - Capital markets authority and central bank have taken measures to develop a deep and broad investor base and asset-management industry—insurance companies, unit trusts, retail funds, and mutual funds—to expand liquidity in the secondary market.
  - Development of a large national fund management and unit trust company (Permodalan Nasional Berhad) in the 1980s supported domestic investor base and investments in Malaysian global securities.

### India: Moving from Financial Repression to Market-Based Rates
- Context and Challenge
  - Before the 1990s, government securities market characterized by administered rates, nonexistent yield curve, moribund secondary market, and captive investor base of banks.
  - Growing fiscal deficits in the 1980s driven by automatic accommodation through ad hoc treasury bills.
- Solution (Phases)
  - First phase (early 1990s): build enabling environment
    - Eliminated automatic monetization and improved fiscal discipline via ways and means advances.
    - Abolished administered interest rates and restructured issuance mechanism to reflect market prices.
    - Auction system for price discovery introduced in 1991; 91-day treasury bills introduced in 1993.
  - Second phase (mid- to late 1990s): build market and institutional infrastructure
    - Primary dealer system set up in 1995 along with a DVP settlement system; floating rate bonds introduced.
    - Repos introduced and foreign institutional investors allowed within specified limits.
    - Ways and means advances arrangement formally replaced ad hoc treasury bills in 1997 (process initiated in 1994).
    - Over-the-counter interest rate derivatives (interest rate swaps and forward rate agreements) introduced in 1999.
    - Liquidity adjustment facility initiated in 2000 as primary instrument for monetary policy operations.
  - Addressed conflict of interest between monetary policy and debt management:
    - Fiscal Responsibility and Budget Management Act in 2003 prohibited the Reserve Bank of India from participating in the primary market.
- Result
  - Share of market borrowing by central government in financing fiscal deficit increased from 18 percent in FY1992 to more than 70 percent in FY2003.
  - Initial increase in cost of debt, which reversed over time.
  - Issuance concentrated on shorter maturities:
    - Bonds above 10-year maturities declined from 76 percent of total borrowing in FY1992 to 16.1 percent in FY1999.
    - Share of securities with maturity below five years increased from 7.4 percent to 41.4 percent of total borrowings over the same period.
  - Government initiated a benchmark building strategy in early 2000s and continued to develop yield curve and increase weighted average maturity of outstanding debt.
    - Weighted average maturity increased from 6.5 years in FY1998 to 8.9 years by FY2003 and further to 10.6 by FY2018.
  - Net issuance of ad hoc treasury bills was brought down progressively from its high of more than 38 percent in the early 1990s to 18 percent at the end of 2019.

### Honduras: Introduction of Electronic Trading Platform for Money Markets
- Context and Challenge
  - Capital market shallow; banking system with persistent excess liquidity.
  - Intermediation in interbank money market weak; banks preferred central bank investment facility over interbank lending.
  - Larger banks found it difficult to trade with new or smaller banks due to lack of collateral.
  - Central Bank of Honduras encouraged secured interbank market development using repo and reverse repo transactions.
  - December 2017 resolution: any credit transaction denominated in domestic currency between institutions in the financial system (interbank loans) may be backed by any government or central bank security, using the Central Bank of Honduras Securities Depository platform or by a fiduciary guarantee.
- Solution
  - Implemented an electronic trading desk to improve liquidity and transparency in repo markets.
  - Platform operates daily from 9:00 a.m. to 12:20 p.m.; limiting trading hours designed to concentrate market liquidity.
- Result
  - Activity on the interbank market improved since implementation in January 2019.
  - Traded volume on the interbank loan market increased from a monthly average of 1.8 billion Honduran lempiras during 2015 to 2018 to nearly 30 billion lempiras during April to July 2019.
  - Electronic trading desk contributed to increased liquidity on the interbank repo market, easier holding of positions financed with repos, and helped bring the average interbank closer to the policy rate despite excess structural liquidity.
  - Contributed to defining the starting point of the yield curve in lempiras.

### Brazil and Mexico: Debt Management and Monetary Policy Coordination (Introductory Context)
- Context and Challenge
  - Central banks of Brazil and Mexico historically conducted monetary policy through issuance of their own securities.
  - Large capital inflows led to significant central bank issuance, generating competition between official issuers and market fragmentation, hindering LCBM development.

*Appendix 1. Selected Case Studies — anea2021001.*

### Appendix 1. Selected Case Studies

### Appendix 1. Selected Case Studies

### Mexico and Brazil: Coordinating Securities Issuance to Avoid Market Fragmentation
- Context and challenge:
  - Dual issuance of central bank and government securities can fragment markets and harm liquidity.
- Country approaches:
  - Mexico (2006):
    - The Central Bank of Mexico agreed to use government securities to manage excess liquidity.
    - The Bank of Mexico and the Ministry of Finance hold quarterly meetings to determine the amount of government securities to be issued.
    - Government securities issued for monetary policy purposes are fungible with securities issued by the government for funding purposes.
  - Brazil (post-2002 Fiscal Responsibility Law):
    - The Fiscal Responsibility Law enacted in 2002 prohibited the central bank from issuing its own securities.
    - Monetary policy is executed through repurchase agreements that use marketable government securities as collateral.
- Result:
  - Monetary policy in both countries is executed using central government securities.
  - The approach avoids fragmentation that arises when two different types of securities are issued.
  - The policy contributes to increased liquidity of government securities without harming the central bank’s capacity to execute monetary policy.

### Peru: Improvements in Issuance Strategy
- Context and challenge:
  - Low secondary market liquidity despite investment grade status in 2008.
  - Main reasons:
    - Fragmented issuance of government and central bank securities.
    - Limited predictability in the primary market related to the auction calendar of the Ministry of Economy and Finance (MEF).
    - Restricted capacity of primary dealers for market making.
  - Auction methodology (hybrid) and referential supply affected price formation and investors’ demand.
  - In 2015 and 2016 the lack of demand and price dispersion obliged the MEF to cancel a substantial number of auctions.
- Solution (since early 2017):
  - Increased communication with primary dealers and main pension funds (AFPs) regarding auction demand.
  - Replaced hybrid auction method with uniform price auction.
  - Reopened benchmark bonds to reduce the number of outstanding bonds.
- Result:
  - Improved transparency and increased secondary market liquidity.
  - The MEF has not been forced to cancel auctions since the reforms were implemented.
  - “Solarize” the overall debt: contribution of 5 percent in 2004 to 61 percent in 2018.
  - Secondary market liquidity increased from a monthly average of 4. 8 billion soles in 2015 to 14 billion soles in 2018.
  - Primary dealers better able to serve clients and cover positions in the secondary market.

### WAEMU (West African Economic and Monetary Union): Improvements in Primary Market Functioning and Issuance Strategy
- Context:
  - Before 2015, issuance operations were less transparent and predictable; absence of regular issuance.
  - Issuance calendars and information often not provided in advance; calls for tenders sometimes released the day before auctions.
  - Countries sometimes competed for liquidity at the same maturity on the same day.
  - Issued amounts frequently substantially larger than announced amounts; auction results not always disclosed timely.
  - Issuance strategies favored long-term amortizing securities rather than a systematic approach to lengthening the yield curve.
- Solution:
  - 2013: Created Agence UMOA-Titres to coordinate regional market issuance and operational aspects (publication of issuance calendars, call for tenders, auction results, market sounding, investor relations).
  - Regulatory measures to promote predictability and transparency:
    - Publication of the quarterly issuance calendar at the start of each quarter.
    - Announcement at least five days before each auction of the amount to be sold and maturities offered.
    - Application of a cap for the issued amount in relation to the announced amount.
  - Strengthened capacity of national debt management entities with IMF and World Bank assistance, including tailored training on domestic marketable borrowing programs and investor interactions; regional training on market fundamentals, issuance techniques, and yield curve development.
- Result:
  - Issuance calendars published at the start of each quarter since 2015.
  - Turnaround time for publishing auction results reduced from an average of two days to about three hours.
  - More regular communications with market participants about borrowing plans and market conditions.
  - Deviations between actual issuance and issuance plans substantially reduced.
  - All eight WAEMU countries now issue securities through several auctions per year (compared with predominant syndication before 2016).
  - Investors regularly purchase across the region; emergence of three- and five-year bullet bonds replacing amortizing medium-term bonds; introduction of small volumes of seven- and 10-year bullet bonds.

### Serbia: Building Benchmark Bonds and Increasing Dinarization
- Context and challenge (as of 2015):
  - Regular issuance of euro instruments and a fragmented dinar (SRD)-denominated government bond portfolio.
  - On December 31, 2015 the share of SRD-denominated government debt amounted to 22.2 percent.
  - Large number of illiquid outstanding instruments; average term to maturity remained low.
  - Public Debt Administration introduced a benchmark issuance program to build liquid benchmark instruments via regular reopenings.
- Solution:
  - Focus issuance on three-, five-, and seven-year benchmark bonds, using reopenings to build stock to the equivalent of about $1 billion.
  - Began liability management exercises before maturity in 2018 to minimize refinancing risks.
  - Changed the debt law to strengthen the legal foundation of bond issuance; removed a formulation that tasked the Public Debt Administration with the reduction of the cost of debt.
  - Modified provisions to enable repo contracts closer to the Global Master Repurchase Agreement.
  - A new Law on Financial Collaterals was approved and implemented in 2018 to strengthen the legal foundation of the repo market.
- Result:
  - Improved secondary market liquidity for benchmark bonds.
  - 10-year benchmark issued in February 2018 and seven-year benchmark issued in January 2019 show annualized turnover ratios of 51 and 113 percent, respectively, during the first half of 2019, compared with the average turnover ratio for all dinar bonds of 39 percent.
  - Bid-offer spreads much tighter for benchmark bonds.
  - February 2020: Public Debt Administration issued a 12-year SRD 19.3 billion bond (approximately $170 million), the longest-tenor dinar issue on record.
  - Improved prospects for inclusion in global bond benchmark indexes; February 2020 J. P. Morgan announced the likely inclusion of Serbian dinar bonds in J. P. Morgan Government Bond Index-Emerging Markets.
  - Dinar share in total outstanding debt increased to 27.7 percent by end-2019.
  - Increased ability of the National Bank of Serbia to implement an independent monetary policy and improved monetary transmission.

### Albania: Market Makers Program
- Context and challenge:
  - Low secondary market liquidity and poor price transparency.
  - High debt-to-GDP ratio (66 percent in 2019) and more than half of debt stock in local currency; secondary market illiquidity raised government borrowing costs.
- Solution (2018 pilot):
  - Ministry of Finance and Economy piloted a market-maker system targeting the five-year fixed coupon bond as the benchmark tenor.
  - Pilot aimed to build issuance outstanding to about 12–13 billion Albanian leks (or $120 million) over six months by issuing the same bond frequently.
  - Market makers (five banks) signed contracts committing each to purchase a minimum of 3 percent of total issuance in six months, quote prices on a best-effort basis, participate in daily fixing by quoting executable prices for 30 minutes per day at a predefined time, and report aggregate trading volumes to the Bank of Albania or the ministry weekly or daily.
  - Ministry established a last-resort securities lending facility to support market makers.
- Result:
  - Secondary market activity of the benchmark bond increased over time, particularly compared with other bonds.
  - Increased trading in other government securities with remaining maturities similar to the five-year benchmark.
  - Reference rate fixing by the Bank of Albania improved transparency and price discovery for the five-year segment.
  - Reduced supervisory liquidity concerns for local investment funds invested overwhelmingly in government bonds.
  - After a successful six-month pilot, the market-maker program was made permanent starting in January 2019 and expanded to include a three-year benchmark tenor.

### South Africa: Electronic Trading Platform (ETP)
- Context and challenge:
  - Structural challenges in government and corporate bond markets contributed to low trading liquidity.
- Solution:
  - 2012: National Treasury formed a Bond Market Development Committee to identify solutions.
  - Recommendation implemented to create an ETP to enable predictable, transparent, enhanced trading.
  - National Treasury designed and implemented the ETP in collaboration with the World Bank.
  - August 2018: Johannesburg Stock Exchange, National Treasury, and partners launched the country’s first ETP for government bonds.
  - Phased inclusion of the full spectrum of government bonds: 14 fixed-rate and eight inflation-linked bonds, with primary dealers quoting two-way prices within predefined criteria.
- Result:
  - ETP allows users to comply with market-making obligations and provides liquidity to government bonds.
  - Increased competition, reduced transaction costs, improved price discovery, and live pricing visibility.
  - Boosted investor confidence and improved market appetite for government securities.

### Thailand: Bond Market Price Transparency
- Context and challenge:
  - Domestic bond market lacked pre- and post-trade transparency; trade reporting standards inefficient and inaccurate.
  - Mark-to-market standards for institutions and mutual funds were not standardized or regulated, risking mispricing.
  - Need for centralized mechanism/database for market information to instill investor confidence.
- Solutions:
  - Late 2005: Thai Securities and Exchange Commission approved the Thai Bond Market Association’s (BMA) license and roles as center for bond market information, trade data collection, and self-regulation.
  - All issuers required to register (with a fee) at the Thai BMA; issuer profiles include bond features, trading information, historical information, and issuers’ news.
  - Securities regulations required all dealers to report intraday secondary market transactions to the Thai BMA (updated to a 30-minute reporting window from time of trade execution in 2012); most dealers use Thai BMA software that automatically reports trades.
  - Thai BMA provides intraday and end-of-day data and a daily market summary.
  - 2006: Thai Securities and Exchange Commission required bond mutual funds to mark to market daily based on Thai BMA’s Bond Pricing Agency end-of-day official price references.
  - Thai BMA publishes daily government bond yield curve and corporate bond yield curves based on reported transactions and market-based/theoretical pricing; interpolated pricing used for illiquid bonds.
- Result:
  - Average daily secondary market trading value increased from 18 billion Thai baht ($520 million) as of 2006 to 90 billion baht ($2.8 billion) in 2019.
  - Primary market for government and nongovernment securities on steady upward trend; Thai Ministry of Finance’s PDMO benefits from Thai BMA’s yield curve for auction pricing and annual issuance strategy.
  - Thai corporate bond primary market reached a historical high of 1 trillion baht ($31.2 billion) in 2019.

### IMF–World Bank Survey on Local Currency Bond Market Development (survey of 32 countries)
- Sample and coverage:
  - Responses from debt management authorities (and monetary authorities for some money market aspects) of 32 countries: 10 in Europe and Central Asia, 10 in Latin America, 7 in sub-Saharan Africa, and 5 in other regions.
- Key findings:
  - Structural issues are prevalent and indicate the long-term nature of market development.
  - Common structural issues:
    - Lack of a diversified investor base.
    - Concentration of the banking sector.
    - Structural excess liquidity in the banking system.
  - Top three secondary market concerns relate to the investor base (see heat map in Appendix Figure 2.1 in source).
  - Addressing structural issues requires time and coordinated efforts across government entities.
  - Shorter-term policies can help, such as adjustments to maturity profiles or types of instruments, and actions to reduce operational and settlement risks may be easier to implement than structural measures.
- Note:
  - The survey reflects views of country authorities and may not capture private sector perspectives; response rates vary by region and no inference about progress from previous years is implied.

*Source: Appendix 1. Selected Case Studies (anea2021001 - Appendix 1. Selected Case Studies).*

### Appendix 2. Survey Results

### Appendix 2. Survey Results

### Money Market
- Structural excess liquidity in the banking system is reported across regions and is most prevalent in sub-Saharan Africa.
- Causes of structural excess liquidity reported include capital inflows (including foreign exchange interventions), fiscal deficits, or a combination of these.
- High concentration in the banking sector impedes money market activity; this is particularly acute in Europe and Central Asia and in sub-Saharan Africa.
- Concerns about counterparty risks in interbank transactions in sub-Saharan Africa segment the market and inhibit trading.
- Market infrastructure deficiencies affect money markets in lower-income countries and in Europe and Central Asia.
- Central bank officials report a need to improve information sharing on cash flows and liquidity management with the government across income levels.
- Better government cash management and government cash flow forecasting are seen as important to support banking sector liquidity management; this is particularly important for sub-Saharan Africa and Europe and Central Asia.
- Appendix Figure and note terminology preserved: DVP = delivery versus payment; RTGS = real-time gross settlement.

### Primary Market
- Regional variation in challenges:
  - Smoothening the maturity/redemption profile is particularly relevant for many sub-Saharan African countries.
  - Creating new types of instruments is broadly important for sub-Saharan Africa and Europe and Central Asia.
  - Issuing benchmark securities is perceived as an important factor across all regions.
- Poor cash management forecasting hinders efficient primary market functioning by undermining predictable and regular issuance practices and debt management strategy execution.
- Coordination of issuances between the central bank and the government is a challenge.
- Implementing benchmark securities is commonly understood to increase liquidity and reduce funding costs, but implementation is hindered by:
  - Poor cash management practices.
  - Inability to conduct liability management operations to manage refinancing risks stemming from benchmark instruments.
- Liability management operations and cash management practices are highlighted as areas for improvement when issuing benchmark securities; market infrastructure, taxation, and issuance procedures also matter.

### Secondary Market
- Deficiencies in the investor base structure prevent secondary market deepening; lack of a diversified investor base inhibits trading across investor types.
- In regions with excess liquidity, the banking sector may act as buy-and-hold investors, further hindering secondary market activity.
- Secondary market development is impaired by:
  - Conditions in the money and primary markets (e.g., structural liquidity reducing incentives to trade).
  - Lack of benchmark bonds in some countries.
  - Lack of securities lending facilities (SLF).
  - Underdeveloped market infrastructure.
  - Prohibition of over-the-counter transactions in some countries (limits trading possibilities despite transparency aims).
- High bid-ask spreads and intermediaries’ fees are key challenges contributing to high market transaction costs.
  - The mandatory use of intermediaries poses challenges for sub-Saharan Africa.
  - Taxation of secondary market transactions is particularly relevant for Latin America.
- Short selling restrictions, limited domestic and international institutional investors, and insufficient regulation/intermediaries are also cited as constraints.

### Investor Base
- Lack of a broader and diversified investor base is a structural problem impeding market development.
- Segments needing further development include pension funds, mutual funds, insurance companies, foreign investors, and retail investors.
- Dominant role of banks in many countries constrains extension of government debt maturities.
- Investor base weaknesses hinder efficient functioning of money, primary, and secondary markets.

### Market Infrastructure
- Market infrastructure is crucial for low- and lower-middle-income countries; deficiencies impede market functioning in many lower-income countries.
- Specific infrastructure concerns include:
  - Multiple central security depositories (CSDs) that fragment the market.
  - Operational risks and settlement risks, including settlement finality not defined in law.
  - Absence of RTGS and absence of DVP in some cases.
  - Net settlement cycles for securities and inadequate access to electronic data/information.
- Staff capacity is reported as a challenge across all income groups.
- Central security depositories: areas for improvement include links between clearing and custody platforms, technology and capacity to provide electronic data, regulation and supervision on CSDs, and reliable, timely, and accurate provision of services.

### Sequencing Policy Reforms (Stylized Cases and Phases)
- A diagnostic assessment should guide the design and sequencing of reform plans informed by policy objectives and current challenges.
- There is a positive correlation between a country’s government securities market development level, overall financial market development, and income level.
- Three stylistic phases illustrate sequencing of reforms as a country progresses:
  - Phase 1: moving from nascent to developing — focus on laying a market-based foundation for the primary market while addressing macro enabling conditions (including fiscal dominance, financial repression, high inflation) and gradually adopting market-based placement and pricing mechanisms.
  - Phase 2 and Phase 3 (described conceptually): progressing from developing to emerging and from emerging to mature, with policy effort levels varying by indicator and potentially overlapping across phases.
- A stylized sequencing across the six building blocks indicates degree of effort required per indicator; lighter shade = relatively less policy effort, darker shade = greater effort. The viability and net benefits of measures should be analyzed case by case.

*Sources: IMF; and World Bank staff.*

### introduction of auction mechanisms supported by auction rules that promote

### anea2021001 - introduction of auction mechanisms supported by auction rules that promote

### Phase 1: Initial market-based issuance and monetary/market infrastructure reforms
- Most issuances at this stage would likely be focused on shorter-term maturities to establish a robust short-term yield curve.
- Adoption of market-based pricing mechanisms aims to:
  - Gradually generate positive real rates of return as the government reaches sufficient fiscal space.
  - Ensure that cost considerations do not jeopardize debt sustainability.
- Timeline and constraints:
  - For many countries, it could take considerable time to achieve these objectives, particularly if the enabling conditions are not in place.
- Monetary policy and money market transition:
  - If the central bank does not adopt an operating framework for a market-based monetary policy, there should be a transition toward using interest rates as an operational target and repos as part of its liquidity management framework.
  - The interbank repo market can also be initiated at this stage if only based on security pledges.
- Legal and market infrastructure priorities:
  - Legal framework should ensure that the authority to borrow and issue government securities is vested in the Ministry of Finance so that there is no debt fragmentation.
  - Authorities should facilitate development of market infrastructure to ensure efficient and secure settlement of transactions in the primary market, including:
    - Developing an electronic auction system.
    - Establishing a central securities depository.
  - Issuance through dematerialized securities should be promoted.
  - Authorities could begin establishing basic trading arrangements.

### Phase 2: Moving from developing to emerging market phase — widening reforms
- Focus expands as primary market for short-term securities is established; macro conditions expected to improve relative to Phase 1.
- Core objectives:
  - Strengthen sovereign debt and cash management capacity by developing an appropriate debt management operating framework.
  - Strengthen the central bank’s liquidity management framework.
  - Develop market intermediaries.
- Primary market evolution:
  - Gradually increase maturity of securities, including refinement of auction procedures to enable a more competitive bidding process and price discovery.
  - Strengthen debt management operating framework to establish transparency and predictability in issuance.
  - Establish market-based pricing mechanism fully during this phase with auctions usually cleared at market rates and auction results disclosed in a transparent manner.
  - Issue securities through market-based mechanisms with little reliance on nonmarketable bonds and private placements.
  - Calibrate pace of maturity extension depending on inflationary environment and dollarization to avoid sudden fiscal pressures from higher interest payments.
  - Use shorter-term treasury bills mainly for cash management and bonds for financing.
  - Later, consolidate securities and establish benchmark bonds in key tenors, including through reopening of securities.
- Secondary market and money market:
  - Support secondary market trades by developing an active interbank market, especially in repos.
  - Require strengthening of government cash management and central bank liquidity management.
  - Monetary policy operating framework needs to gradually encourage banks to reduce reliance on central bank liquidity and incentivize engagement in interbank liquidity operations.
  - Greater transparency in money market transactions should facilitate this transition.
  - As central bank gains more operational independence, authorities need to decide on the use of government or central bank securities for monetary policy implementation while ensuring the market is not fragmented.
- Market intermediaries and primary dealer (PD) system:
  - Establish role of market intermediaries through supporting regulations and improvements in supervision and risk-management framework.
  - Initiation of a PD system can be considered to consolidate distribution and stimulate secondary market — to be assessed carefully because it requires minimum preconditions.
  - Without preconditions, PDs will not add value and risk of collusion increases significantly.
- Secondary market transparency and infrastructure:
  - Initial regulatory focus should be on the over-the-counter market, centralizing reporting of trades to a single agency to improve post-trade transparency and price discovery.
  - Rollout of delivery versus payment settlement system is critical to support secondary market and money market repo activity.
  - Regular publication of reference rates and valuation norms, including mark-to-market accounting for different types of financial institutions, will generate greater trading across investor types.
  - Pricing in the primary market should aim to gradually close the gap with secondary market prices, supported by a relevant yield curve.
  - Standardization of securities and reduced frequency of primary auctions are important to spur greater trades across various types of securities.
- Pre-trade transparency and market-making:
  - With post-trade transparency established, aim to establish pre-trade transparency via electronic trading screen or platform to stimulate market-making activities of intermediaries, including PDs.
  - At a later stage, establishment of exchange trades could consolidate secondary market gains.
- Investor diversification and related reforms:
  - Investor diversification should be linked with broader financial sector development, banking liberalization, and contractual savings sector reforms.
  - Gradually withdraw reliance on buy-and-hold investors, especially banks and public sector agencies, as investor base deepens.
  - Tax policies on government securities should provide a level playing field for all investor types.
  - Nonbank institutions should have equal access to invest in government securities.
  - Issuance should match diverse investor profiles; prudential regulations on asset management of the contractual savings sector should be established.
  - Develop asset-management companies such as collective investment schemes (mutual funds) to attract individuals’ savings to government securities market.
  - Develop a simple interest rate swap market to provide greater flexibility to investors and intermediaries.
  - If foreign investment is desirable, allow it gradually depending on capital account stability, especially for longer-term segment.

### Phase 3: Moving from emerging to mature market stage — deepening liquidity and diversification
- Main concentration: increase trading activity and further diversify investor base.
- Institutional and operational separation:
  - Separation of debt management and monetary policy objectives supported by a clear and transparent institutional arrangement.
  - Ministry of Finance expected to lead all debt management operational decisions regarding the debt management operating framework.
  - Issuance strategy should be anchored by the debt management strategy to impart greater predictability in issuances.
  - Investor relations functions of debt management should be fully functional.
- Yield curve and liability management:
  - Enhance robustness of the yield curve through active benchmark bond issuance policy and promote secondary market activity.
  - Support efforts with liability management operations such as buybacks and switches.
  - In larger countries, aim to build a sizable stock of benchmark bonds for inclusion in international indexes; legal framework should provide flexibility for such operations.
- Strengthening PD system and market-making:
  - Make the PD system more effective through enforcement of market-making obligations, including provision of two-way quotes.
  - Facilitate obligations via clear and balanced allocation of privileges (e.g., access to noncompetitive subscriptions and securities lending facilities).
  - Debt management entity should adopt a system to evaluate PD performance, potentially with a rotation policy to induce greater competition.
  - Consider introduction of exchange-traded funds.
- Money market and legal protections:
  - Major participants in the LCBM should have access to the money market for liquidity purposes.
  - Bankruptcy framework should permit close-out netting of repo positions among market participants in case of default.
  - Allowing rehypothecation of repos should facilitate market making by dealers, with prudential limits to mitigate systemic risks from rehypothecation.
- Foreign investment deepening:
  - Seek to increase share of foreign investment if desirable, supported by allowing foreign investment in short-term securities, improving market for foreign exchange derivatives, providing access to local currency resources, and allowing investors to hold domestic bonds on international central securities depositories.

### Sequencing of policy actions (Building blocks and indicators)
- Money Market
  - (1) Well-functioning short-term securities and repo markets
  - (2) Monetary policy operating framework
  - (3) Monetary policy operations
  - (4) Transparency
  - (5) The legal framework for repurchase transactions
- Primary Market
  - (1) Marketable domestic debt as a share of central government total debt
  - (2) Stability of domestic market financing
  - (3) Maturity of local currency marketable government securities
  - (4) Length of the yield curve
  - (5) Market-based pricing
  - (6) Market-based placement mechanisms
  - (7) Predictability and transparency of issuance
  - (8) Government cash flow forecasts
  - (9) Transparency of auction results
  - (10) Transparency on communication between the authorities and market participants
  - (11) Market fragmentation
  - (12) Benchmark bonds
  - (13) Cash and debt management
- Secondary Market
  - (1) Market liquidity and depth
  - (2) Pre-trade transparency
  - (3) Post-trade transparency
  - (4) Market-making duties
  - (5) Market-making privileges
  - (6) Trading environment
- Investor Base
  - (1) Market participants
    - (1.1) Depth and diversity of the banking sector
    - (1.2) Depth and diversity of the nonbanking sector
  - (2) Investor relations management
  - (3) Domestic institutional investors
  - (4) Central bank monetary financing
  - (5) Foreign investors
  - (6) Buy-and-hold investors
- Financial Market Infrastructure
  - (1) FMI technology platforms (FMI systems framework)
  - (2) Security registration
  - (3) Clearing and settlement risk (CSD and manual FMI processes)
  - (4) Clearing and settlement risk (where there is a CCP)
  - (5) Governance and access policies of CSD or CCP systems, or both
  - (6) Market segmentation
  - (7) FMI liquidity support
  - (8) Transparency (data and information)
- Legal and Regulatory
  - (1) Borrowing authority
  - (2) Market regulation and enforcement
  - (3) Investor protection
  - (4) Collective investment schemes
  - (5) Legal framework for taxation

### Local currency bond market and financial stability considerations
- Liquid government bond markets can enhance financial stability by:
  - Better absorbing occasional market stresses that cause extreme price fluctuations.
  - Limiting financial distortions that increase systemic vulnerability.
- Risks of illiquidity:
  - Can amplify shocks by generating large price changes, unstable price expectations, and greater risk of spillover to other market segments.
  - During heightened uncertainty, illiquid markets can reduce agents’ capacity to manage risk and authorities’ ability to monitor risk.
  - Emerging market and developing economies are more concerned than advanced economies about resilience of government bond markets.
- Policy tools during market stress:
  - Change volume of securities available through securities lending programs.
  - Amend collateral policies that influence liquidity premiums.
  - Central bank direct intervention through outright purchase or sale of securities to restore price discovery.
  - Simultaneous auctions of primary market issuance and buyback or exchange operations to facilitate free entry and exit.
  - Liquidity provision by the central bank through lender-of-last-resort–type operations when securities dealers face funding constraints.
- Foreign participation and exchange rate considerations:
  - Significant foreign participation can lead to sudden nonresident sales of local currency bonds in response to shifts in international monetary or financial conditions, potentially disrupting the exchange rate.
  - Stability of foreign investors in domestic bond markets depends crucially on exchange rate behavior.
  - Greater exchange rate flexibility and deeper derivatives markets for hedging currency risk by foreign investors are essential to safeguard financial stability.
  - A well-diversified domestic institutional investor base can offset destabilizing effects from reversal of nonresident flows.

### Introduction and outline of a Primary Dealer (PD) system
- Role and rationale:
  - PDs can support functioning and development of local currency bond markets (LCBMs).
  - Specificities of PD systems differ by country; several preconditions should be in place before considering a PD system.
  - PD rights and obligations are designed to create competition and ensure adequately functioning primary and secondary markets.
  - A PD system can provide key services and functions to support LCBM development and functioning when appropriately designed for prevailing market conditions and stage of market development.
  - A PD system is not considered a precondition for a well-functioning LCBM.
- Advantages and disadvantages:
  - PDs can enhance price discovery and liquidity of the secondary market.
  - If necessary preconditions are not in place, a PD system can limit competition and be prone to collusion.
- Three main issues to analyze in detail when preparing a PD system include defining eligibility criteria and related design aspects.
- Preconditions for a well-functioning PD system (as listed):
  - (1) stable macroeconomic conditions;
  - (2) appropriate legal and supervisory systems;
  - (3) an adequate payment system;
  - (4) liberalized interest rates (the government must be committed to a market-based mechanism);
  - (5) a stable, predictable, and transparent issuance policy (the government must be committed to transparent debt management practices);
  - (6) a large and diversified investor base;
  - (7) a market large enough to support a sufficient number of PDs to ensure competitive behavior;
  - (8) sufficiently large outstanding debt to create liquid issues;
  - (9) the debt management office’s commitment to developing the market (Silva and Baudouin 2010).

*Source: anea2021001 - introduction of auction mechanisms supported by auction rules that promote (PDF chapter/section).*

### Appendix 5. Primary Dealers

### Appendix 5. Primary Dealers

### Eligibility, Rights, and Obligations of Primary Dealers (PDs)
- Typical eligibility requirements for appointed PDs include access to financial market infrastructure (FMI), management capacity, a capital requirement, credit ratings, and exchange and/or electronic trading platform (ETP) membership.
- Typical PD obligations:
  - (1) bidding in the primary market,
  - (2) placing government securities with final investors,
  - (3) committing to quote firm prices and promote liquidity in the secondary market,
  - (4) facilitating certain debt management operations,
  - (5) advising the debt management office (DMO) on its debt management strategy,
  - (6) reporting on their activities in the secondary market, and
  - (7) developing, through their marketing strategy, new client investment in the respective debt market.
- Common PD rights:
  - (1) exclusive access to the primary market,
  - (2) exclusive access to securities lending facilities offered by the DMO or the central bank, and
  - (3) the opportunity to act as counterpart to the central bank’s operations.
- Common PD privileges:
  - (1) the right to carry the title of PD,
  - (2) inclusion in the PD league table,
  - (3) the right to participate in noncompetitive subscription auctions, and
  - (4) preferential access to lucrative debt management operations.
- Additional notes:
  - Some countries may pay commissions to their PDs, dependent on activity levels.
  - Rights and obligations should be balanced and calibrated based on general considerations, including:
    - (1) PDs need to be focused on an analysis of the LCBM building blocks, the gaps to be filled, and the value added that the PDs can bring to fill the gaps;
    - (2) PDs should be dynamically reviewed, reflecting prevailing market conditions;
    - (3) the DMO should not overburden PDs with excessive obligations;
    - (4) privileges should be carefully calibrated, with privilege rewards being commensurate to the cost of the obligations taken up; and
    - (5) a broad, medium-term perspective needs to be taken on the benefits and costs.

### Performance Assessment Framework
- Objectives of PD performance evaluations:
  - (1) to signal the most important duties and obligations on which the PDs should focus;
  - (2) to be a periodic assessment of how well the PDs discharge their duties; and
  - (3) to constitute a way to encourage good performance.
- Design features:
  - Results should be discussed periodically with individual PDs to reach agreement on corrective actions and reward best performers.
  - Assessment should ensure development and widespread adoption of ETPs and a sound FMI and facilitate enforcement and monitoring of PD obligations.

### Preconditions for Establishing a PD System (LCBM Building Blocks)
- General preconditions:
  - A PD system can help stabilize market demand for government securities, make demand more reliable, and lower borrowing costs.
  - A PD system is incompatible with heavy reliance on concessional or semiconcessional borrowing for a major share of financing needs or with policies that exert control over interest rates (financial repression).
  - LCBM building blocks need to be at least in stage 2, preferably in stage 3, for launching a viable PD system. Not all building blocks need to be at the same stage.
- Money market:
  - Facilitates short-term financing and inventory management, including covering short positions of market makers in government securities.
  - Money market arrangements relating to regulation, transparency, and monetary policy framework and operations should be in a more advanced, developing stage for PDs to be effective.
  - PDs can help deepen the money market by reducing liquidity risk premiums and determining effective short-term rates.
- Primary market:
  - A long-term government commitment to domestic market borrowing, relatively stable and predictable over time, is necessary.
  - Primary market policy indicators that need to be in the developing stage:
    - (1) market-based pricing and placement mechanisms well anchored,
    - (2) issuance strategy allowing liquidity concentration on a few benchmark securities, and
    - (3) transparency over the medium-term debt management strategy.
  - Introduction of a PD system can act as a catalyst to improve issuance practices and concentrate liquidity.
- Secondary market:
  - Requires a properly functioning secondary market with adequate, cost-effective trading infrastructure.
  - An ETP may benefit the PD system by providing a platform for market making.
  - Objective of PD introduction may be to move the secondary market from embryonic/evolving toward developing stage.
- Investor base:
  - A growing domestic investor base is necessary, along with a sufficiently large number of banks, of which at least five to six might act as PDs.
  - PDs can deepen the investor base via distribution channels, marketing expertise, product innovation, advisory services, and market-making.
- Financial market infrastructure (FMI):
  - A safe, sound, cost-efficient, and convenient FMI is required, including access to a CSD, a DVP securities settlement system, and dematerialization of government securities.
  - Introduction of a PD system may require additional investments in the FMI to fill gaps.
- Legal and regulatory framework:
  - Robust legal, regulatory, and tax frameworks are required to ensure fair market practices, define participant roles, safeguard investors, and deter unfair trading practices (market manipulation, front-running, collusion).
  - PDs can catalyze filling gaps in legal and regulatory frameworks relating to participants’ rights and trading practices.

### Modalities and Steps for Introducing a PD System
- Modalities vary by country depending on institutional arrangements, LCBM development stage, enabling conditions, and objectives.
- Common situations:
  - Formalize de facto market makers that already operate as PDs.
  - Systematize and ensure vital functions are consistently performed where they are not yet systematic.
- Steps for introducing a PD system:
  1. Assess that the preconditions for the introduction of a PD system are fulfilled;
  2. Assess that the introduction of a PD system is advantageous;
  3. Canvass financial intermediaries for potential interest, and assess that a minimum number of interested parties exists;
  4. Call for the expression of interest and set up a working group among stakeholders and interested parties to jointly design rights, obligations, preconditions, and a road map;
  5. Coordinate among the Ministry of Finance, the central bank, and the market conduct authority to agree on the respective responsibilities and exchange of information;
  6. Formalize the relationship between PDs and authorities;
  7. Design the PDs performance appraisal system with different performance parameters, weights, and reward mechanism; and
  8. Formally launch the PD system when all steps have been completed and the necessary preconditions have been satisfied.
- Governance note:
  - Preferable that PD rights and obligations are decided jointly between authorities and PDs, potentially via a working group.
  - A road map should identify adjustments to building blocks required before and after formal PD introduction.
  - Consensus among stakeholders should be sought.

### Common Adjustments to LCBM Building Blocks to Facilitate PD Introduction
- Money market:
  - Introduction of backstop cash and securities lending facilities may be necessary when liquidity is insufficient.
- Primary market:
  - Issuance modalities may need to be adjusted to concentrate liquidity in fewer benchmark bonds, complement them with liability management operations, and switch to closed auctions limited to PDs.
- Secondary market:
  - Enhance pre- and post-trade transparency through data collection and publication.
  - Establish a commonly agreed ETP for market makers to discharge obligations effectively.
- Investor base:
  - Strengthen preexisting arrangements using regulation, supervisory practices, and moral suasion to encourage a shift from buy-and-hold to more dynamic holding patterns.
  - Clarify tax code issues, including withholding tax impediments to foreign investor participation.
- Financial market infrastructure:
  - Establish sound and safe clearing, settlement, and custodian arrangements to enable market makers to discharge obligations effectively.
- Legal and regulatory framework:
  - Establish clear market conduct rules to ensure PDs do not misuse privileges or benefit from privileged customer-order information.

### Coordination and Ongoing Assessment
- Coordination between authorities (Ministry of Finance, central bank, market conduct authority) is fundamental to align regulation and conduct with LCBM development objectives and PD arrangements.
- Periodic PD performance assessment should be undertaken as market conditions evolve and priorities shift.
- Authorities should regularly assess whether PD preconditions remain fulfilled and whether PDs contribute to balanced LCBM development.

*Source: Appendix 5. Primary Dealers (anea2021001 - Appendix 5. Primary Dealers)*

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_Source: https://www.imf.org/-/media/files/publications/analytical-notes/2021/english/anea2021001.pdf_