## wp1874 — Introduction

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### Role and objectives of sovereign (public) debt managers
- Primary objectives:
  - ensure that the government’s financing needs and financial obligations over the medium- to long-term are met at the lowest cost consistent with a prudent level of risk;
  - establish a sustainable debt service profile consistent with the government’s medium-term debt repayment capacity;
  - identify, measure and manage debt portfolio risks;
  - attain efficient cash balance management so as to minimize the cost of carry;
  - promote the development and efficiency of domestic primary and secondary markets for government securities;
  - broaden the investor base and diversify available funding sources.
- Broader approach:
  - Debt managers may undertake a sovereign asset and liability management approach where significant financial assets exist.
- Preconditions for LMOs and risk management:
  - clear legal mandate;
  - well-articulated debt management strategy;
  - robust framework for measuring debt portfolio risks.

### Liability Management Operations (LMO) — uses, limits, and strategic guidance
- Definition and purposes:
  - Broad range of non-distressed, market-based sovereign debt transactions undertaken to secure funding, affect the debt portfolio profile and address debt portfolio risks.
  - Primarily used in non-distressed situations, but can be employed in sovereign debt restructuring and voluntary re-profiling to improve maturity structure and/or reduce credit spreads.
  - Can amend bond terms to include revised pari passu provisions and enhanced collective action clauses (CACs).
- Strategic guidance:
  - LMOs are facilitators of smooth implementation of the debt management strategy and should not be viewed solely as opportunistic or cosmetic transactions.
  - LMOs introduce additional risks: counterparty credit risk, reputational risk, liquidity risk, operational risk — and should be implemented within a risk control framework governed by the debt management strategy.
- Typical LMOs and practice notes:
  - Pre-financing, buybacks (reverse auction, bond exchange, outright purchase), sinking funds, contingent credit lines, combinations of operations.
  - Reverse auctions: government announces maximum amount; competitive offers accepted in descending order by yield until fair-value price or fair price plus premium is reached.
  - Bond exchanges: can be competitive-offer or fixed-rate; volume exchanged is market-determined; communication of LMOs must be managed to avoid undue volatility.
  - Outright purchases: resource intensive; often used near maturity; avoid opportunistic ad hoc buybacks unless justified by funding cost advantages.
  - Sinking funds: rigid and largely substituted by LMOs; mandatory sinking funds not typically advocated.

### Major sovereign debt portfolio risk categories (salient risks and measures)
- Rollover/refinancing risk:
  - Measures: Average time to maturity (ATM); redemption profile analyses; practical guideline — consider a ceiling on how much debt should mature in the subsequent 12 months and limit maturities by quarter to avoid concentration.
  - Empirical survey shift: Survey #1 – 2007, 33 percent of debt managers acknowledged refinancing risk; Survey #2 – 2012, 66 percent saw refinancing risk as a risk to manage.
- Interest rate risk:
  - Measures: Average time to re-fixing (ATR); duration and convexity (Macaulay duration formula provided); VaR and Cost-at-Risk (CaR).
  - Example: Assuming a normal distribution, the 99 percent VaR for a portfolio can be defined as VaR_T = 2.33 x σ_T.
  - Derivatives: can re-profile cash flows and hedge market risks but raise additional liquidity needs (margin calls, collateral); option measures include delta, gamma, vega, rho.
- Exchange rate risk:
  - Measures: share of foreign currency debt (symbolic formulas in source preserved) and foreign-currency-debt-to-reserves ratios (symbolic formulas in source preserved).
  - Approaches: mean-variance optimization for currency composition; VaR methodology for FX exposure; investor base composition critical (some governments maintain reserve cushions covering up to 18 months of maturities).
- Funding liquidity and market liquidity risks:
  - Funding liquidity: liquidity gap and survival period; cash buffers and contingent credit lines as mitigants.
  - Market liquidity metrics: traded volumes, turnover ratios, bid–ask spreads, bid–ask spread over duration, volatility of volumes and costs, distortions in interpolated yield curve, repo specialness, yield spreads to government-guaranteed bonds.
  - Investor Base Risk Index (IRI) construction: (1) historical correlations between changes in investor holdings and bond yields; (2) risk scores per investor; (3) aggregate investor base score.
- Sovereign and counterparty credit risks:
  - Sovereign credit risk: credit ratings, credit premia, CDS spreads, spread to core-sovereign, contingent claims approach (CCA).
  - Counterparty credit risk: depends on default probability, future potential exposure, recovery value; Expected Loss = Default Probability × Credit Exposure × Expected Loss Given Default.
  - Risk management prerequisites: ISDA and collateral agreements; margin calls mitigate counterparty credit risk; exposures can change rapidly with downgrades and market stress.
- Contingent and fiscal risks:
  - Explicit CLs: legal/contractual obligations (guarantees, SOE obligations).
  - Implicit CLs: non-contractual but likely support (bailouts, disaster relief).
  - Policy responses: general guarantee policy; credit risk fees; time-bound guarantees; register and disclose explicit CLs; quantify expected cost and maximum probable loss; include budget provisos; transfer guarantee fees to a notional special fund; report to Parliament/public regularly.
- Legal risk:
  - Arises from contract interpretation and applicability of laws; examples include pari passu litigation (Argentina) and lack of legal provision for derivatives (Belgium) — policy implication: explicit mention in public debt laws of derivative permissions.
- Operational risk:
  - Endogenous to the DMO: transaction errors, failures in internal controls/systems, insufficient expertise, security breaches, foreign paying-agent mishandling.
  - ORM requirements: culture of risk awareness at senior management level; embed operational risk into day-to-day treasury operations; transition to comprehensive risk management and integrated systems as portfolio complexity increases.

### Risk measurement evolution, frameworks, and tools
- Evolution:
  - Market-based measures from asset management adapted to sovereign debt management.
  - Modern approaches include density forecasts and likelihood ratio tests combined with diagnostic tests for risk-model evaluation.
- Tools and frameworks:
  - Medium-Term Debt Management Strategy (MTDS);
  - Sovereign Portfolio Risk Analyzer and Optimizer (SoPRAnO).
- Analytical methods:
  - Stochastic analysis and CaR (methodologically related to VaR) to simulate yield curves and estimate interest-rate pricing and interest-rate risk.
  - Deterministic scenarios combined with stochastic simulations to calculate expected future interest costs and risk quantiles (e.g., absolute and relative CaR).
- Measurement caveats:
  - Duration depends on discount rate choice; using market rates can produce variable duration measures and may force locking in long-term rates when rates are high.
  - Mitigations: fixed discount rates for duration calculation or simpler measures such as share of portfolio subject to repricing over set periods (example: Denmark 2003 methodological change; Sweden 2015 methodology change).

### Sovereign Asset and Liability Management (SALM) — objectives, benefits, and country practices
- SALM objectives:
  - Consolidate sovereign balance-sheet risks; detect exposures from a consolidated public-sector portfolio perspective; analyze correlations among sources of cost and risk; identify currency and interest-rate mismatches; quantify net risk positions.
- Benefits:
  - Uncover hedges, identify cash flows available to service net debt, inform long-term macroeconomic and developmental objectives.
- Implementation challenges:
  - Governments often lack full financial balance sheets; main governmental asset (taxing power) not a standard financial item; public policy objectives may override pure optimization.
  - Market structure, monetary policy, and fiscal constraints affect SALM feasibility.
- Country practices (selected examples):
  - Canada: Ministry of Finance authority, day-to-day management delegated to central bank; regular coordination meetings.
  - New Zealand: manages local- and foreign-currency assets and provides derivatives for government entities.
  - Mexico: reduced external debt in 2006 by issuing domestic securities and using proceeds to acquire FX from the central bank.
  - Uruguay: used LMOs to reach 45 percent of debt denominated in local currency and to issue benchmark-sized bonds without increasing outstanding debt.
  - Sweden: used issuance plus derivatives to adjust duration — issued domestic debt with duration of 4.6 years and then used derivatives to lower duration by 1.1 years to achieve 3.5 years.

### Guidelines for debt portfolio management — institutional, governance, and MTDS
- Institutional foundations:
  - Clear legislative framework establishing authority/responsibility of the DMO, allocation and separation of responsibilities, hierarchical delegation, and oversight mechanisms.
  - Modern DMO structure often organized as front-, middle-, and back-office for role separation and operational risk management.
- Middle-office and risk management:
  - Continuous monitoring of exposures, stress tests, risk tolerance thresholds; significant changes in risk profile should prompt MTDS review.
- Medium-Term Debt Management Strategy (MTDS):
  - Transforms objectives into operational guidelines and targets (e.g., ATM targets); improves transparency, anchors decisions, and forms basis for reporting and evaluation.
- Targets and communication:
  - Guidelines can be qualitative, quantitative, or mixed; use of intervals to avoid frequent adjustments; hard quantitative targets require developed bond and derivatives markets.

### Cash management, TSA, and cash buffers — objectives and trade-offs
- Cash management objectives:
  - Provide flexibility for temporary fiscal shocks; determine whether cash balances are policy targets; support monetary policy implementation; conduct market transactions to meet cash balance targets; support domestic market development or avoid impeding it.
- Treasury Single Account (TSA):
  - Centralizes government cash balances; main account typically at the central bank; daily sweeps from ministries’ accounts; prerequisite for modern cash management.
- Cash buffers:
  - Typical composition: transactions buffer and safety buffer.
  - Size determinants: debt manager’s LMO needs; maximum financing needed if capital markets disrupted for several months; investor comfort that obligations will be honored; flexibility for pre-financing; use for contingent liabilities or buybacks.
  - Trade-off: opportunity cost because sovereign funding cost typically exceeds return on buffer given upward-sloping yield curves.

### Market development, primary dealers, and auctions — sequence and operational design
- Market development stages:
  - Stage I: Initial — short average maturities, limited secondary liquidity, emphasize short-term securities and dematerialization, consolidate issuance.
  - Stage II: Deepening — build benchmark yield curve, standardize instruments, develop interbank and repo markets, strengthen institutional investor base.
  - Stage III: Maturing — well-functioning primary market, liquid secondary market, derivatives and sophisticated infrastructure in place.
- Primary dealer (PD) systems:
  - Role: provide dependable demand, promote secondary market activity, provide two-way quotes, improve price discovery and liquidity.
  - Preconditions: debt issuance strategy, attractively designed securities, adequate investor base, government commitment to market development.
  - Typical PD obligations and entitlements: auction participation, secondary market quotation commitments, reporting, exclusives (non-competitive subscriptions), access to securities lending facility, advisory role.
  - Phased approach to PD implementation: Phase I (Preparation) → Phase II (Testing) → Phase III (Best Effort PD) → Phase IV (Full PD).
- Auctions — principles and formats:
  - Auctions predominate for domestic securities. Key design dimensions: pricing (uniform vs multiple pricing), bidder eligibility, types of bids (competitive and non-competitive).
  - Uniform-price (Dutch) auction: all successful bids at cut-off price; multiple-price (discriminatory) auction: winners pay their bid prices.
  - Global practice: in a study of 41 countries, 56 percent used multiple-price; 22 percent used uniform-price; 22 percent used both.
  - Non-competitive bids (NCB): used to attract less-specialized investors; amounts often limited to protect price discovery.
  - Tap sales and other variations: useful for retail programs and flexible cash planning but risk undermining auctions if used erratically.
- Repo/securities lending facility:
  - Recommended as a safety net for market makers to borrow bonds to cover delivery obligations; pricing should be unattractive except as a last resort.

### Operational and legal prerequisites for advanced instruments and derivatives
- Derivatives use:
  - Most developed DMOs use derivatives; few emerging markets do so.
  - Preconditions: legal framework (ISDA, CSA), accounting clarity, operational capacity (front/middle/back office), real-time market information, collateral management capability.
  - Risks and controls: minimum counterparty ratings, exposure limits, collateral posting, independent calculation and confirmation of cash flows, awareness of valuation/accounting mismatches (mark-to-market vs nominal accounting).
  - Exchange-traded vs OTC: exchange-traded reduce counterparty/operational risk via CCPs; OTC offers customisation and can be appropriate where cash markets are less developed; CCPs and electronic trading platforms blur distinctions.
  - Credit risk pricing and xVA considerations: ISDA/CSA features influence valuation and pricing via CVA, FVA, etc.; rating triggers have costs and potential systemic implications.
- Counterparty selection and collateral:
  - Careful selection via minimum ratings, legal documentation, credit lines, and rotation; collateral mitigates credit risk but creates funding needs.

### Sovereign debt dynamics and DSA equations (analytical tools)
- Debt projection identity and decomposition:
  - Variables defined and equations provided to project debt-to-GDP ratios forward using r, g, π, pb, and as.
  - Debt-stabilizing primary balance formula presented: pb = d * [r – π (1+g) - g] / [(1+g).(1+ π)] - as.
  - Exchange rate effects incorporated: additional term α ε (1+r) / [(1+g).(1+ π)] * d_{t-1}, where α = share of FX debt and ε = nominal exchange rate depreciation.

*Source: wp1874 - Introduction (IMF Working Paper), pages 6–94.*

### Introduction ...........................................................................................................

### Introduction

### I. Sovereign Debt Portfolio Risks
- A. Rollover/Refinancing Risk (page 10)
- B. Interest Rate Risk (page 12)
- C. Exchange Rate Risk (page 17)
- D. Funding Liquidity and Market Liquidity Risks (page 19)
- E. Sovereign and Counterparty Credit Risks (page 21)
- F. Contingent and Fiscal Risks (page 22)
- G. Legal Risk (page 28)
- H. Operational Risk (page 29)

### II. Salient Features of a Sovereign Debt Portfolio Risk Management Framework
- A. Decisions on Overall Debt Portfolio Structure (page 30)
- B. The Application of Market-Based Indicators in Debt Management (page 32)
- C. Adoption of a Sovereign Asset and Liability Management Approach (page 34)
- D. Guidelines for Debt Portfolio Management (page 37)

### III. The Role of Liability Management Operations in Managing Sovereign Debt Portfolio Risks
- A. Rollover/Refinancing Risk Management (page 43)
- B. Interest and Exchange Rate Risk Management (page 48)
- C. Funding Liquidity and Market Liquidity Risk Management (page 50)
- D. Management of Sovereign and Counterparty Credit Risk (page 52)
- E. Management of Guarantees and Other Contingent Liabilities (page 55)
- F. Management of Legal Risk (page 57)
- G. Management of Operational Risk (page 57)
- H. Selected Liability Management Operations Used by Debt Managers (page 58)

### IV. Interactions of Sovereign Debt Portfolio Management with Fiscal, Monetary Policy, and Financial Stability
- A. Fiscal Policy (page 60)
- B. Monetary Policy (page 63)
- C. Financial Stability (page 65)
- D. Cash Management (page 68)
- E. Institutional Factors (page 72)

### V. Sovereign Debt Portfolio Management and Domestic and International Market Access
- A. Role of Domestic Markets in LMOs (page 75)
- B. Role of International Capital Market Issuance in LMOs (page 81)

### VI. Sovereign Debt Management in Times of Debt Distress
- A. Sovereign Debt Restructuring (page 86)
- B. Role and Determinants of Market Access (page 89)
- C. Strategies for Regaining Market Access (page 91)
- Figure: Stylized Timeline of a Sovereign Debt Restructuring (page 89)

### VII. Concluding Remarks (page 92)

- Tables listed in the unit:
  - Table 1. Sources of Fiscal Risks (page 26)
  - Table 2. Selected SALM Country Cases (page 37)
  - Table 3. Liability Management Operations Used by Debt Managers (page 58)
  - Table 4. Debt Management Channels to Financial Stability (page 67)

- Boxes listed in the unit:
  - Box 1. Selected Elements of Guarantee Policy (page 27)
  - Box 2. Legal Risks—Argentina and Belgium (page 29)
  - Box 3. Content of a Debt Management Strategy Document (page 39)
  - Box 4. Debt Managers’ Use of Derivatives (page 49)
  - Box 5. Can Sovereigns Use Extendible Bonds to Reduce Liquidity Risk? (page 52)
  - Box 6. Credit Risk Related to Derivatives (page 55)
  - Box 7. Deriving Debt Sustainability Analysis Equations (page 62)
  - Box 8. The Organizational Structure of a Modern Integrated Debt Management Function (page 74)
  - Box 9. Common Pitfalls of First-Time Issuers (page 84)

- Appendices listed in the unit:
  - Appendix 1. Key Aspects of Government Securities Market Development (page 101)
  - Appendix 2. Primary Dealers (page 112)
  - Appendix 3. Implementing Auctions of Government Securities (page 126)

*Source: wp1874 - Introduction (IMF Working Paper), pages 6–94.*

### INTRODUCTION

### INTRODUCTION

### Role and objectives of sovereign (public) debt managers
- Main concerns of a sovereign (public) debt manager:
  - (1) ensure that the government’s financing needs and financial obligations over the medium- to long-term are met at the lowest cost consistent with a prudent level of risk;
  - (2) establish a sustainable debt service profile consistent with the government’s medium-term debt repayment capacity;
  - (3) identify, measure and manage debt portfolio risks;
  - (4) attain efficient cash balance management so as to minimize the cost of carry;
  - (5) promote the development and efficiency of domestic primary and secondary markets for government securities;
  - (6) broaden the investor base and diversify available funding sources (see IMF and WB, 2014).
- Debt managers may undertake a broader sovereign asset and liability management approach to consolidate sovereign balance-sheet risks where significant financial assets exist (Das et al., 2012).
- Preconditions for LMOs and risk management:
  - clear legal mandate;
  - well-articulated debt management strategy;
  - robust framework for measuring debt portfolio risks.

### Liability Management Operations (LMO)
- Definition: broad range of non-distressed, market-based sovereign debt transactions undertaken by debt managers to secure funding, affect the debt portfolio profile and address debt portfolio risks.
- LMOs can indirectly impact:
  - the fiscal position (timing of cash flows);
  - the measurement of debt (particularly through derivatives);
  - the conduct of monetary policy and operations.
- LMOs uses and purposes:
  - primarily used in non-distressed debt situations, but can be employed in sovereign debt restructuring and voluntary re-profiling to improve maturity structure and/or reduce credit spreads (Missale, 1999; Missale, Giavazzi, and Benigno, 1997; Steneri, 2004).
  - can be considered to amend bond terms to include revised pari passu provisions and enhanced collective action clauses (CACs) to mitigate holdout creditor behavior.
- Strategic view: LMOs are facilitators of smooth implementation of the debt management strategy and should not be viewed solely as opportunistic or cosmetic transactions.

### Major sovereign debt portfolio risk categories
- Rollover/refinancing risk (ability to refinance at maturity; loss of market access; low investor appetite).
- Market risk:
  - interest rate risk;
  - exchange rate risk.
- Liquidity risk:
  - (i) funding liquidity risk — difficulty for the sovereign to raise funds in a short period to service debt;
  - (ii) market liquidity risk — investor faces rapid declines in trading volume for bonds.
- Credit risk:
  - (i) sovereign’s own credit risk;
  - (ii) counterparty credit risk.
- Legal risk: uncertainties related to applicability or interpretation of contracts, laws, and regulations.
- Contingent risk: potential financial claims against the government under certain circumstances.
- Operational risk: transaction errors, failures in internal controls and systems, legal shortcomings, security lapses, or natural disasters.

### Risk measurement evolution and frameworks
- Sovereign debt management adopted market-based measures of risk first developed in asset management (Papaioannou, 2006).
- Modern approaches:
  - density forecasts and likelihood ratio tests (combined with additional diagnostic tests) for risk-model evaluation (Papaioannou, 2011).
- Tools and frameworks referenced:
  - Medium-Term Debt Management Strategy (MTDS);
  - Sovereign Portfolio Risk Analyzer and Optimizer (SoPRAnO).

### Key descriptive and quantitative indicators (overview from sections I.A–I.H)
- Rollover/Refinancing Risk
  - Average time to maturity (ATM) often used; captures speed at which debt portfolio matures in nominal terms.
  - ATM formula (as presented): 
    -  = = = n n t PP ATM 11 . / . τ τ τ τ τ
    - where τP = the principal payment at time τ counted from the current period until the principal payment occurs.
  - Shortcomings: ATM is an average and can hide concentration of redemptions; commonly complemented by redemption profile analyses.
  - Practical guideline: consider a ceiling on how much debt should be allowed to mature in the subsequent 12 months; consider limiting maturities by quarter to avoid concentration.
  - Empirical survey shift: Survey #1 – 2007, 33 percent of debt managers acknowledge refinancing risk as a risk to manage; Survey #2 – 2012, 66 percent saw refinancing risk as a risk to manage.

- Interest Rate Risk
  - Average time to re-fixing (ATR) used to measure exposure to interest-rate refixing risk.
  - ATR formula (as presented in source): 
    - ATR_t = [complicated formula in source text with variables ATR_t, P^v_t, P^f_t, s, t, θ_v, θ_f].
  - Traditional bond metrics: duration and convexity (Macaulay duration presented with formula):
    - Dm (Macaulay duration) = ∑_{t=1}^T (t · PV(Ct)) / ∑_{t=1}^T PV(Ct)
  - VaR example: Assuming a normal distribution for market movements, the 99 percent VaR for a portfolio can be defined as VaR_T = 2.33 x σ_T, where σ is the standard deviation of the portfolio’s value and T is the time period over which the standard deviation of returns is calculated.
  - Cost-at-Risk (CaR): x percent-quantile of the cost distribution (e.g., absolute CaR at 95 percent indicates maximum debt service costs within that probability; relative CaR = absolute CaR − average debt service costs).
  - Use of derivatives: can re-profile cash flows and hedge market risks, but raise additional liquidity needs (margin calls, collateral). Measures for options include delta, gamma, vega, rho, and position size.
  - Mark-to-market measurement and VaR used for cross-instrument assessment and hedge effectiveness.

- Exchange Rate Risk
  - FX risk associated with volatility in exchange rates and impact on interest and exchange rate cost for foreign currency debt.
  - Share of foreign currency debt indicator shown in source (symbols preserved in source):
    - d_t^fc = D_t^fc / D_t = D_t^fc / D_t^dom + D_t^fc = ∑ e_{t,j} D_{t,j}^{fc} / ∑ e_{t,j} D_{t,j}^{fc} + ∑ e_{t,k} D_{t,k}^{dom}  (symbols as in source)
  - Foreign-currency-debt-to-reserves ratio indicator presented: d_t^res = P_t^{fc} / R_t = ∑ s_{t,j} X_{t,j} / ∑ s_{t,k} X_{t,k} (symbols as in source).
  - Approaches: mean-variance optimization for currency composition (Swedish National Debt Office, 2003); VaR methodology for active management of the FX exposure.
  - Investor base matters: debt held mainly by foreign private investors increases vulnerability to sudden stops even if debt is local currency; some governments maintain reserve cushions covering up to 18 months of maturities.

- Funding Liquidity and Market Liquidity Risks
  - Funding liquidity risk: inability to raise funds through borrowing in the short term; liquidity gap and survival period used as measures.
  - Liquidity risk elasticity formula (as presented):
    - LRE_t = (NV_t / V_t) Ξ_t / (NV_t / V_t) ??? (symbols preserved from source)
    - NV_t = current value of net assets; V_t and L_t = current values of assets and liabilities; Ξ = liquidity premium on the sovereign’s funding cost.
  - Market liquidity metrics: traded volumes, turnover ratios, bid-ask spreads, bid-ask spread over duration, volatility of volumes and costs, distortions in interpolated yield curve, repo specialness, yield spreads to government-guaranteed bonds.
  - Investor Base Risk Index (IRI) construction steps:
    - (1) historical correlations between changes in investor holdings and bond yields;
    - (2) risk scores for each investor based on previous correlations;
    - (3) investor risk index by assigning an aggregate score to the investor base (Arslanalp and Tsuda, 2012).

- Sovereign and Counterparty Credit Risks
  - Sovereign credit risk measured via credit ratings, credit premia, CDS spreads, spread to core-sovereign, and contingent claims approach (CCA).
  - Counterparty credit risk in derivatives depends on probability of counterparty default, size of future potential exposure, and recovery value.
  - Expected Loss formula (reduced form): Expected Loss = Default Probability × Credit Exposure × Expected Loss Given Default.
  - Risk management prerequisites for derivatives: ISDA and collateral agreements; margin calls mitigate counterparty credit risk. Exposures can change rapidly with downgrades and market stress.

- Contingent and Fiscal Risks
  - Guarantees and contingent liabilities (CLs) are potential financial claims that may crystallize into actual liabilities, affecting the debt portfolio and borrowing plan.
  - CLs categories:
    - Explicit CLs: legal/contractual obligations (e.g., guarantees for borrowing, SOE obligations).
    - Implicit CLs: non-contractual but likely government support (e.g., bailouts, disaster relief).
  - Policy and institutional responses to CLs:
    - Create a general policy for government exposure to CLs covering types, circumstances, authority, risk-sharing, and fees.
    - Ensure budgetary transparency and discipline: identify, register, disclose explicit CLs; quantify expected cost and maximum probable loss; include budget provisos for sums falling due.
    - Apply financial risk management techniques to price guarantees and design pricing/premium mechanisms.
  - Table 1 (sources of fiscal risks) enumerates direct liabilities, explicit contingent liabilities, and implicit liabilities (as summarized in source).
  - Debt managers monitor explicit CL exposures and consider potential implicit CL triggers such as lax supervision and ALM weaknesses in SOEs and the banking sector.

### Scope and organization of the primer
- Purpose: serve as a reference guide to public debt-portfolio risk identification, measurement and management, including local currency bond market development.
- Practical considerations addressed include:
  - (i) desirable composition of a debt portfolio;
  - (ii) issuance strategy including currency selection;
  - (iii) cash buffers;
  - (iv) assessment of market liquidity;
  - (v) determination of LMOs including bond buybacks and exchanges;
  - (vi) use of derivative instruments to mitigate debt portfolio risks.
- Additional topics: roles of underwriters, credit ratings, government bond markets, primary dealership systems, auction frameworks, and coordination with fiscal, monetary, and financial stability policies.
- Paper organization (sections referenced):
  - Section I: main sovereign debt portfolio risks, measurement, and rationale for mitigation;
  - Section II: process and strategic choices in applying a risk management framework and arguments for portfolio indicator targets;
  - Section III: LMOs to manage debt portfolio risk;
  - Section IV: coordination of debt management with fiscal, monetary, and financial stability policies;
  - Section V: role of domestic and international markets in LMOs;
  - Section VI: debt management under normal and distressed conditions;
  - Section VII: concluding remarks.

*Source: wp1874 - INTRODUCTION (IMF working paper content provided).*

### Box 1. Selected Elements of Credit Guarantee Policy

### Box 1. Selected Elements of Credit Guarantee Policy

### Determining the appropriate means of support
- To determine what would be the most appropriate form of government support for the proposed beneficiary and activity, the following general principles could be applied:
  - Budget support: If the support is initiated on social grounds and is not expected to deliver a positive cash flow, funds would be made available through the budget.
  - On-lending: If the beneficiary is a general government entity, and the project is expected to generate a positive cash flow, funds would be made available as credits (on-lending).54 For on-lending, a market interest rate reflecting the credit risk could be applied. However, if on-lending is extended to sub-nationals or to SOEs, the viability of both the project and the entity should be ensured.
  - Government guarantee: If the beneficiary is an individual person, a private company, a public company or a subnational government outside the general government sector, and the following criteria are met, a government guarantee would be considered:55
    - The project is considered important, from a public policy perspective, and is expected to generate a positive rate of return for the project sponsor considering any costs associated with the guarantee.
    - The beneficiary is considered financially viable at the time of issuance, based on a sound assessment of the beneficiary’s financial past performance and future prospects.
    - The project may not be able to be financed at a reasonable price without a government guarantee. This could include large-scale projects that require long-term financing, projects involving appreciable political risks, and projects that are difficult for the market to assess due to their unique character.

### Conditions and terms of government guarantees
- The issuance of a government guarantee should be based on a comprehensive risk assessment that is documented in a report; the borrowing cost of the underlying guaranteed loan should reflect the borrowing cost of the government.56
- A credit risk fee reflecting the difference between the borrowing cost of the government and the borrowing cost of the beneficiary without the government guarantee being typically applied.57,58
- The guarantee should be time-bound and related to a project.
- The terms of the guarantee should be so as to minimize the fiscal risk for the government to the extent possible, and should grant the government the right to appropriately monitor, control, and recover the fiscal risk.59
- The terms of the guarantee should comply with applicable legal frameworks, including domestic and international legal instruments, such as EU state aid rules.

### Financial planning and budgeting for guarantees
- Government guarantees should be well integrated with the macro-fiscal framework and the annual budget. The following principles apply to the financial planning and budgeting for guarantees:
  - Considering that government guarantees present a potential claim to the government, the total amount of outstanding guarantees should be subject to an overall limit in line with macro-fiscal objectives and a sustainable level of debt. If the limit on guarantees is not part of the budget code, the government could propose a limit as part of the budget proposal for Parliament’s approval.
  - A provision for potential payments for called guarantees should be included in the contingency of the Ministry of Finance’s budget. The amount to be taken into account should be based on a regular risk assessment of the portfolio of government guarantees.
  - Guarantee fees should be transferred to a notional special fund, and payments on called guarantees could be paid out of the notional special fund.
  - If guarantee fees are exempted in part or in full, a corresponding provision is usually included as expenditure in the budget of the sponsoring ministry within its expenditure ceiling, and transferred to a notional fund.
  - Estimates of potential losses for implicit contingent liabilities should be included as part of the notes to the budget. Also, some estimate of the likelihood of the occurrences of the events leading to losses associated with the implicit contingent liabilities should be detailed.
  - Reporting on guarantees to Parliament and to the public should be comprehensive and on a regular basis.
  - The required resources, both in terms of human capital and systems, should not be underestimated.

### Legal Risk
- Debt managers face various legal risks, ranging from uncertainty related to legal actions to the applicability or interpretation of contracts, laws, and regulations.60 Legal risks may also arise from weaknesses in the legal framework for debt management, as well as from lapses in compliance with relevant substantive and procedural legal requirements for debt management, e.g., compliance with the terms of issuance or with applicable legislation regarding the procedures used for such issuance.
- Debt managers could face legal risks in the context of broader legal claims resulting in judgments or arbitration awards against the government and implications for the sovereign balance sheet.
- Bond contractual provisions should be able to provide sufficient protection and flexibility to a country. Although sovereign bonds, particularly international sovereign bonds, often contain a number of provisions that, depending on their drafting, offer protection to the sovereign vis-a-vis its creditors, e.g., CACs, particularly aggregated CACs, there are also provisions that could present legal risks depending on their scope, e.g., waiver of immunity, events of default and cross-default, and interpretation, e.g., of pari passu.
- Other aspects that must be carefully monitored include interest rate conventions, e.g., the use of indexation to inflation, currencies or commodities, authority to enter into contractual agreements, or compatibility of terms with legislation (Box 2).

*Source: Authors.*

### Box 2. Legal Risks—Argentina and Belgium

### Box 2. Legal Risks—Argentina and Belgium

### Argentina: pari passu clause interpretation and consequences
- Conventional reading: pari passu clause ensures that no priority ranking is established for unsecured creditors (Buchheit and Pam, 2004).
- 2013 U.S. District Court interpretation (following an earlier Belgian case): treated the pari passu clause as an obligation for Argentina to make rateable payments to a holdout creditor each time it pays its restructured bondholders.
- Injunctions issued by the U.S. District Court:
  - Forbid any financial intermediaries from collaborating with Argentina in paying exchange bondholders unless they are notified that the holdouts have received ratable payment.
- Aftermath and legal developments:
  - Argentina settled with its holdout creditors in 2015.
  - Subsequent rulings of the New York courts have to an extent limited the interpretation of the 2013 decisions to the specific “course of conduct” of Argentina.

### Belgium: structured currency options, legal issues, and legislative gap
- Transactions described:
  - Belgian Treasury and several investment banks entered into complex derivative trades—structured currency options—combining currency and interest rate swaps and foreign exchange options, sometimes integrated into leveraged structures.
  - Objective: generating financial profits by taking advantage of expected convergence in FX and interest rates among future EMU Member States.
  - These transactions had no link with the management of risks in the debt portfolio.
- Problems that arose from mid-1992 onward:
  - Large marked-to-market loss on the trades.
  - Two legal issues emerged:
    - Whether the trades were valid given their speculative nature.
    - Whether banks had disclosed the risks of the transactions in a manner commensurate with the level of sophistication of the Belgian Treasury.
- Settlements and outcomes:
  - Disclosure issue: settled out of court with an investment bank reportedly paying around $100 million.
  - Validity issue: could not be addressed because there was no provision in the Public Debt Law at the time requiring the prudent management of risks in the debt portfolio.
- Policy implication / recommendation:
  - Need for explicit mention in national public debt laws of whether derivative transactions are allowed or not.

*Source: Spink and Magee, 2013; and United Nations Conference on Trade and Development (UNCTAD), 2015.*

### H. Operational Risk — definition, sources, and management imperatives
- Definition and distinguishing feature:
  - “Operational risk” refers to a wide variety of risks faced by debt managers that can disrupt debt service.
  - Unlike market or credit risk, operational risk is mainly endogenous to the debt management office (DMO) (Storkey, 2011).
- Examples of operational risk sources:
  - Transaction errors in executing and recording transactions.
  - Inadequacies or failures in internal controls, systems, and services.
  - Insufficient expertise of staff.
  - Reputational risk.
  - Security breaches, terrorism, and natural disasters affecting DMO operations.
  - For foreign currency-denominated debt: mishandlings by the foreign paying agent, the foreign clearing house and the foreign custodian agent.
- Characteristics and escalation with complexity:
  - Hard to identify, measure, monitor, and report due to multiple sources and link to scope of government debt activities.
  - Even less-advanced DMOs can face substantial operational risks from mishandling transaction data, databases and spreadsheet-computations, mismanagement of key personnel, and disruption of routine processes.
  - Increasing portfolio complexity (e.g., use of derivatives) raises operational risk and requires transition to comprehensive risk management and integrated debt management systems.
- Operational Risk Management (ORM) framework requirements:
  - Takes time and effort to identify risks and adopt mitigation techniques in a constantly-changing environment.
  - Requires a culture of risk awareness and understanding at senior management level.
  - Operational risk needs to be made clear to all staff and embedded into day-to-day operations of treasury (Storkey, 2011).

### II. Salient features of a sovereign debt portfolio risk management framework — key elements
- Decisions on overall debt portfolio structure:
  - Debt managers evaluate borrowing strategies over the analysis horizon using detailed information on current debt portfolio and its risk, and expected path of the primary balance (anticipated government revenues and expenditures and economic growth).
  - Assessment should consider vulnerabilities among primary dealers and liquidity squeezes (in particular relating to the repo market).
  - Strategies’ cost and risk performance are evaluated under relevant risk/stress scenarios (IMF-World Bank, 2009).
  - Strategic benchmark: reflects desired short- vs. long-term mix and diversification of investor base; differs from asset manager approach by reflecting government’s preference on cost-risk tradeoff (Wheeler, 2004).
  - Practical considerations include debt management philosophy and goals, formation of a yield curve with liquid benchmark maturities, market access, domestic debt market development, and availability of hedging instruments.
  - Strategy robustness: should be robust under a wide range of economic scenarios and time horizons (Wheeler, 2004).
- Analytical tools and measures:
  - Efficient frontier analysis can inform cost-risk tradeoffs though sovereign debt portfolio optimization is not widely applied.
  - Stochastic analysis and CaR (methodologically related to VaR) can simulate yield curves and estimate interest rate pricing and interest rate risk (Bolder, 2003; Papaioannou, 2009; United Kingdom DMO, 2006).
  - Deterministic scenarios of future interest rates combined with stochastic simulations are used to calculate expected future interest costs and related interest rate risk; risk measured as the highest costs or largest increase in costs expected at a set probability level.
- Constraints and real-world frictions:
  - Debt managers, especially from LICs, sometimes face funding and political challenges that render the debt management function passive and impede consistent application of a debt management framework.
  - Lack of hedging instruments by banks, especially for exchange rate risk, limits sovereign debt portfolio transformation into local currency exposure.

### B. Application of market-based indicators in debt management — issues and practices
- Market-based indicators are useful but not fully adopted by debt managers.
- Duration and discount-rate dependence:
  - Many debt managers choose not to rely on duration or “modified” duration for setting portfolio targets.
  - Fundamental shortcoming: duration depends on the level of discount rates used—duration falls (rises) when the discount rate rises (falls), causing measurement variability.
  - Using market interest rates as discount rates can lead to varying duration even when portfolio structure is unchanged and could force debt managers to lock in long-term rates when rates are high.
- Mitigation approaches:
  - Use of a fixed discount rate or simpler risk measures such as the share of the debt portfolio subject to repricing over a set period.
  - Example: Denmark introduced a methodological change in 2003 by using a fixed rather than a floating discount rate for Macaulay duration; Sweden changed its duration methodology in 2015.
- Accounting and valuation issues:
  - Full adoption of market-based indicators might require alternative presentation of sovereign liabilities to apply an economic value on outstanding debt and account for valuation changes.
  - Sovereigns applying cash budgeting do not account for the economic value of their debt.
  - Accrual accounting principles (IPSAS, INTOSAI) include accrued interest but do not capture market valuations; accounting for derivatives has become more advanced with market valuation.
  - The universe of accounting (cash, accrual, national standards, ESA 2010) does not fully reflect market valuation of liabilities.
- Currency composition and optimization:
  - Comprehensive guidance for choosing optimal interest rate and currency structure for external debt is not yet established.
  - Practical focus: correlation between debt charges and the domestic primary balance—i.e., potential spillover of debt service volatility into budgetary volatility.
  - Operational rules often aim to minimize volatility of debt service costs or match foreign currency debt composition to export revenues or reserves.
  - Optimum currency composition often determined by quantitative optimization exercises balancing projected debt servicing costs and risk-adjusted return of the country’s assets (international reserves and projected primary balances), subject to constraints.
  - Alternative approach: link optimum composition to traded vs. non-traded goods share in GDP (rule followed by Uruguay).

### C. Adoption of a Sovereign Asset and Liability Management (SALM) approach
- Distinct features for sovereign ALM:
  - Governments often do not compile a full financial balance sheet; many assets are tangible; main governmental asset (ability to tax) is not a typical financial item; government is a large domestic market player; public policy objectives go beyond portfolio optimization.
- SALM objectives and benefits:
  - Detect sovereign risk exposures from a consolidated public-sector portfolio perspective.
  - Analyze financial characteristics of the balance sheet, identify sources of costs and risks, quantify correlations among sources.
  - Monitor and quantify impacts of exchange rates, interest rates, inflation, and commodity prices on assets and liabilities.
  - Uncover interest-rate and currency mismatches, highlight net risk positions requiring management, and identify cash flows available to service net debt.
  - Facilitate long-term macroeconomic and developmental objectives (economic diversification, export market broadening, reducing dependence on key imports).
  - Can identify long-term fiscal challenges such as unfunded social security liabilities.
- Implementation challenges and policy interactions:
  - Monetary policy objectives affect SALM strategies by influencing market risk management and the size of instruments; liability-side strategies aim at minimizing debt service cost subject to prudent risk.
  - Fiscal policy objectives that limit annual debt service costs may constrain duration and currency composition of public debt.
  - Structure of international and domestic capital markets shapes SALM feasibility; many developing countries face illiquid or shallow domestic markets and limited hedging instruments.
- Interaction with public debt management (PDM):
  - PDM and SALM strategies should be clearly coordinated.
  - A well-articulated PDM strategy with specificity and clear explanation of analysis and rationale increases investor and public assurance.
  - Debt manager may act as “residual risk manager” for the public sector, implying the need to regard public sector entities’ needs as constraints and to analyze public debt on a net basis.
- Effects and cautions:
  - Potential implications of an ALM strategy on macroeconomic objectives (inflation, financial stability, resilience) should be assessed in parallel with benefits from consolidated portfolio management.
  - SALM concepts are applied at least partially in many countries even without explicit SALM objectives.

### Selected SALM country practices (high-level examples)
- Canada: decision-making authority for both assets and liabilities assigned to the Ministry of Finance; day-to-day management delegated to the Central Bank; coordination via regular meetings.
- New Zealand: manages local currency and foreign currency assets and provides derivative transactions for government entities.
- Australia: allocation of assets between portfolios and funds may consider broader government priorities; coordination by responsible ministry.
- Hungary, Uruguay: coordination via regular meetings between entities involved in SALM.
- Mexico: reduced external debt in 2006 through issuing domestic securities and using proceeds to acquire FX from the central bank, which in turn redeemed its securities to reduce negative carry-costs.
- Denmark: manages consolidated government debt position by considering assets of government funds and guidelines for government-guaranteed entities on exchange rate risks and loan types.
- Turkey: manages currency composition of international reserves based on maturity structure and currency composition of government FX liabilities.
- Finland, Turkey: management of central government debt and cash reserves on a net basis.

*Source: Lu, Yinqiu, Michael Papaioannou, and Iva Petrova, 2012, “Sovereign Risk and Asset and Liability Management—Conceptual Issues”, WP 12/241 and country websites.*

### D. Guidelines for debt portfolio management — institutional and governance foundations
- Key institutional features:
  - Debt management strategy typically based on sound institutional structure and governance arrangements supported by a legislative framework that clearly establishes the authority and responsibility of the DMO.
  - Governance guided by clear allocation and separation of responsibilities and accountabilities, hierarchical delegation rules, and possibly a committee for efficient decision-making and oversight.
  - Modern DMO often encompasses front-, middle- and back-office functions for separation of roles and responsibilities.
- Legal framework importance:
  - Appropriate legislative framework promotes operational discipline, transparency, and accountability, which are critical to achieving sustainable debt.
  - Design of legal framework involves interactions among legal competencies; balance is needed between flexibility and adequate controls and safeguards (Addo Awadzi, 2015).
- Middle-office and risk management responsibilities:
  - Development of a risk management framework that includes all relevant risks; continuous monitoring of exposures and risk tolerance.
  - Stress tests to assess potential effects of macroeconomic and financial shocks, including extreme events.
  - Significant changes in risk profile may prompt review of debt management strategy; correlation between risks of additional loans/issuances and existing portfolio should be considered.
  - Exercise benefits from ALM approach that considers consolidated public balance sheet risks, including contingent liabilities and natural hedges (IMF–World Bank, 2009).
- Medium-Term Debt Management Strategy (MTDS):
  - MTDS transforms debt management objectives into operational guidelines and targets (for example, average time to maturity).
  - Formulating targets enhances transparency, guides operational work, anchors decisions, facilitates investor communication, and forms a basis for control, reporting, and evaluation of debt management activities.

### Box 3. Summary of a Debt Management Strategy Document

### Box 3. Summary of a Debt Management Strategy Document

### The Objectives and Scope
- Describes the objectives for debt management, the scope of the medium-term debt management strategy (MTDS), and the types of risks being managed under the MTDS.

### The Existing Debt Portfolio
- Provides the historical context for the debt portfolio, describing changes in its size (including relative to GDP) and composition through time.
- Includes changes in relevant market variables and commentary on significant events in the evolution of the debt.

### The Environment for Debt Management Going Forward
- Describes the environment for debt management in the future, including:
  - fiscal and debt projections,
  - assumptions about exchange and interest rates,
  - constraints on portfolio choice, including those related to market development and the implementation of monetary policy.

### The Medium-Term Debt Management Strategy
- Analysis and transparency
  - Describes the analysis undertaken to support the recommended debt management strategy, with the assumptions used and limitations of the analysis clearly stated.
- Recommended strategy and rationale
  - Sets out the recommended strategy and its rationale, describing the desired debt composition and the core arguments for such composition.
  - Includes discussion of the key risk factors that influenced the choice of strategy.
- Implementation and targets
  - Describes progress to be made toward the desired composition over the planning horizon (three to five years).
  - Specifies ranges for the key risk indicators of the portfolio and the financing program.
- Non-quantifiable risks and market development
  - Outlines specific measures or projects planned to manage non-quantifiable risks and/or support debt market development (for example, plans to introduce new debt recording systems or a primary dealer framework).
- Review and contingency
  - Outlines the periodic review process to check whether key assumptions continue to hold and that the MTDS remains appropriate.
  - Highlights the process to be followed if circumstances change significantly outside the regular review cycle.

### Guidelines and Targets
- Qualitative and quantitative expression
  - The guidelines can be expressed in qualitative and/or quantitative terms.
  - Many governments express the guidelines as quantitative targets, such as for interest rate risk.
- Use of intervals and stability
  - Targets are often set with intervals to avoid frequent or short-term adjustments that could result in high transaction or other costs and potentially increase operational risk.
  - Generally, guidelines remain reasonably stable over time to help ensure predictability in debt management, thereby contributing to cost minimization.
- Directional guidance
  - It is common to express guidelines as directions without a firm quantitative target; in practice many governments use a combination of qualitative and quantitative targets.
  - Hard quantitative targets generally require developed bond and derivatives markets and the ability and appropriate instruments to manage the debt according to the targets (flexibility in the primary market, liability management operations, derivatives).
  - Hard targets give more precise market communication and evaluation but can force costly transactions or be exploited by markets if wrongly formulated.
  - Qualitative or semi-quantitative targets provide flexibility to take market circumstances into account, useful depending on the stage of market development or uncertainty in the market environment, but they give less precision to the market and may introduce an uncertainty premium.

### Benchmark Portfolio and Currency Mix
- Benchmark portfolio role
  - Strategic decisions can be embodied in a benchmark portfolio representing the desired or optimal portfolio given objectives and risk constraints.
  - The benchmark should be well defined in terms of notional size, instruments, debt composition, and rebalancing rules.
- Currency considerations
  - Considerations in selecting the currency mix include liquidity and currency risks.
  - The DMO could hold cash buffers in the main intervention currency or in specific currencies to facilitate debt servicing.
  - The DMO should consider whether other major liquid currencies may be held for natural hedging.
- Operational approaches
  - Some sovereigns have set up passive, rule-based benchmark portfolios against which the debt manager funds at different dates to take advantage of favorable market conditions.
  - A discretionary margin can be applied where the debt manager may deviate from currency composition or duration targets.

### Market Development and Sequencing
- Market development constraints
  - The stage of government securities market development may cause bottlenecks in instrument choice and market absorption.
- Strategic sequencing
  - Governments transitioning rapidly in market reforms need to prioritize initiatives that advance the market and realistically consider the time horizon of different initiatives.

*Source: World Bank and IMF, 2009.*

### Appendix 1).

### Appendix 1)

### The role of liability management operations in managing sovereign debt portfolio risks
- Liability management operations (LMO) refer to a broad range of market-based transactions undertaken by debt managers and creditors in the context of debt management strategy to affect the debt profile and debt portfolio risks. 87 88
- LMOs either involve changing the structure of sovereign debt that is already issued, by undertaking direct transactions, or apply financial contracts that affect the structure and riskiness of the debt portfolio.
- LMOs can be undertaken to include enhanced CACs and pari passu provisions to existing bonds to address holdout creditor risk.
- While the paper primarily discusses LMOs in non-distressed situations, LMOs can also be used in cases of loss of market access (LMA) or to help mitigate market pressure on government bonds; distressed LMOs can be part of a debt restructuring (IMF, 2014 and 2015).
- Debt managers use LMOs to reach desired portfolio structure to achieve cost savings and increase yield curve efficiency; LMOs introduce additional risks: counterparty credit risk, reputational risk, liquidity risk, operational risk.
- LMOs in IMF-supported program countries can be applied before and during a program to reduce debt portfolio vulnerabilities, including refinancing risks from re-profiling or face-value cut restructurings that restore debt sustainability and market access.
- Voluntary re-profiling via LMOs (e.g., improving maturity structure) can calm markets and reduce credit/risk premium spreads for sovereigns with heightened stress but retained market access.
- Key determinants of potential debt crises include size and currency composition of the debt portfolio, its maturity structure, and investor base.
- LMOs are implemented within a risk control framework governed by the debt management strategy, aiming to change exposures to a desired risk profile by changing outstanding debt structure or hedging associated risks.
- Traditionally, exposures to interest-rate and exchange-rate movements are managed by LMOs, including hedging strategies such as currency swaps when a loan is contracted in one currency and swapped into another. 90
- Debt managers operate based on risk tolerance thresholds; breaches (due to market risk, rollover/refinancing risk, liquidity and credit risks) typically trigger LMOs such as market-based exchanges or swaps of existing debt for new debt under arbitrage-free conditions (zero net present value under the market yield curve) plus fees. 91

### A. Rollover/Refinancing risk management
- Debt managers can manage refinancing risk through:
  - Borrowing plans that avoid concentrations of maturities.
  - Amortizing bonds. 92
  - Debt exchanges of bonds with short ATM to longer ones.
  - Pre-financing of maturing bonds.
  - Buying back bonds before maturity.
  - Issuance of short-term debt. 93
  - Reimbursements on maturity date made out of the Treasury Single Account.
  - Sinking funds earmarked to the repurchase of government debt.
  - Contingent credit lines. 94
  - Combinations of these operations. 95
- Pre-financing (issuing a destination bond through reopenings ahead of redemption of the source bond) can smooth redemptions but entails a cost of carry and added credit risk when proceeds are invested before use.
- Buying back securities prior to redemption is a common approach to reduce rollover risk; cost considerations (buyback premium) and benefits (lower funding costs via enhanced liquidity) are analyzed in a cost–risk tradeoff.
- Three main variants of buyback operations:
  - Reverse auction
  - Bond exchange (bond conversion/debt-bond swap/bond switch)
  - Outright purchase (bond buyback)

Reverse Auction
- Conducted like a public offering but for purchase instead of sale of bonds. 97
- Government announces maximum amount or range for purchase; reserves right to reject individual bids outside a predetermined cut-off yield (or price). 98
- Competitive offers accepted in descending order by yield until fair-value price, or fair price plus premium (determined by the debt manager), is reached, subject to maximum purchase amount.
- Reverse auctions avoid locking in a purchasing price higher than fair market price. 99
- One pricing mechanism: indicate buyback price for each targeted bond and price new issuance via a Dutch auction; tender ranks proposals from minimum to maximum interest rate; final price determined by cut-off interest rate which determines coupon of new bond. This combined exchange+tender is also called an accelerated tender and a new issue.
- Reverse auctions are resource intensive to the Treasury unless simultaneous new issuance occurs; if proceeds of new issuance are less than amount paid for buyback, shortfall funding risk arises. 97

Bond Exchange
- In a bond exchange, government buys back particular bonds while payment is made by issuing a new bond. 101
- Exchanges can be combined with reopening operations so newly issued bonds used to pay for exchange can be a reopened issue; reduces amount maturing on a specific date and can replace illiquid issues with liquid benchmark issues.
- Two common exchange methods:
  - Competitive-offer format: exchange ratio determined by bids submitted by market participants; participants submit bids on amount to exchange (offers in terms of a price ratio).
  - Fixed-rate format: exchange ratio predetermined by government according to prevailing secondary-market prices at announcement.
- After announcement, holders have specified time to accept; volume exchanged is market-determined; no certainty of buying entire targeted volume.
- To be cost-neutral, auction cut-off should be set so swap values of buyback and new bond are at least identical.
- Pre-announcement communication of LMOs should be carefully considered to avoid undue volatility. 103 104

Outright Purchase (Bond Buyback)
- Debt manager can buy back bonds in the secondary market at prevailing price. 105 106
- Outright purchases are resource intensive and typically used in markets with good secondary market liquidity.
- Some sovereigns conduct discreet buybacks in small volumes, responding to reverse inquiries or at fixed-price tenders; may contact primary dealers or brokers and retire purchased bonds.
- Buyback timing is situation specific; buying too far in advance of maturity can reduce outstanding amount and diminish trading interest; buying within sight of maturity is generally effective. 96
- Debt managers normally avoid opportunistic/ad hoc buybacks to avoid surprises for investors, but opportunistic buybacks may be considered when funding costs are lower than trading levels of outstanding securities due to low liquidity premia.

Sinking Funds
- Sinking funds explicitly require contractual payments into an escrow account over and above debt service payments; could be exercised via an embedded call.
- Sinking funds are fairly rigid; measured between interest cost and interest earned the cost is negative, adding to overall financing cost.
- Sinking funds have largely been substituted by LMOs, which are more economical and flexible but more susceptible to political economy pressures under fiscal constraints. 107 108
- Mandatory sinking funds are typically not advocated from a liability management perspective; historical issues include cornering and market distortions. 108

Country practices and examples
- South Africa uses LMOs to improve market liquidity, reduce refinancing risk, increase issuance amounts when borrowing needs are low, maintain international market presence, broaden investor base, and align issuance strategy with chosen portfolio.
- Sweden, Hungary, and Belgium actively use LMOs to manage refinancing risk by purchasing domestic government securities prior to maturity. 109
- Uruguay, Mexico, Iceland, and Brazil have used LMOs as part of exchange offers when launching international bonds. 111 112
- Italy has regularly used buybacks since 1995 and bond exchanges since 2002. 109 110
- Brazil is one of the most active users of LMOs, with several transactions every week and a large LMO schedule announced regularly. 112
- Uruguay used LMOs to achieve 45 percent of its debt denominated in local currency (debt de-dollarization) as stated in its debt management strategy within a relatively short time, and to issue benchmark-sized bonds and provide liquidity across the yield curve without increasing outstanding debt. 111

### B. Interest and exchange rate risk management
- Asset-liability management matching foreign-currency debt and foreign-exchange reserves involves practical decisions: interest cost to be hedged requires income from foreign-currency assets to be accessible by (or transferred to) the Ministry of Finance to cover debt-service on foreign-currency debt.
- Practical difficulties arise because currency and maturity structure of foreign-exchange reserves may not match debt manager preferences, potentially preventing robust hedges or constraining debt manager or reserve manager policy choices. 114
- Canada, Denmark, and New Zealand adopt approaches where composition of external debt (currency and interest-rate exposure) reflects composition of foreign-exchange reserves. 115
- Use of interest-rate and exchange-rate derivatives by debt managers is largely strategic and involves setting clear objectives (Box 4).
- Derivatives should not be used to "earn money" by taking positions against debt portfolio targets based on future expectations to decrease debt service costs. 117
- Within a well-specified debt strategy, derivatives can:
  - Separate funding decisions from optimal portfolio composition decisions.
  - Reduce cost of borrowing.
  - Manage portfolio risks (interest-rate risk and refinancing risk). 118
  - Adjust currency composition of liabilities.
- Debt managers determine transaction purpose to select appropriate instruments and structures and assess liquidity risk implications, including the need to post collateral under a two-way "Credit Support Annex" where both parties post collateral when out-of-the-money.
- If apparent market mispricing is observed, derivatives can be used to temporarily deviate from a strategic benchmark rather than changing borrowing plans or the strategic benchmark.

*Source: wp1874 - Appendix 1).*

### Box 4. Debt Managers’ Use of Derivatives

### Box 4. Debt Managers’ Use of Derivatives

### Operational capacity and implementation options
- Debt managers need adequate internal capacity for:
  - front-office execution,
  - middle-office strategic analysis,
  - back-office settlement for managing derivative transactions and their associated risks and collateral management.
- Capability is built over time; interim options when the case for derivatives is strong:
  - outsourcing or appointing agents for particular aspects of transaction execution,
  - settlement,
  - collateral management,
  - ongoing risk management.

### Prevalence and legal/market prerequisites
- Most developed market debt managers use derivative instruments for debt management purposes.
- Only a handful of emerging markets use derivatives for debt management.
- Several emerging markets are taking steps to develop the legal environment needed to support derivative markets and are addressing:
  - illiquidity of the underlying cash market,
  - deficiencies in prudential regulation,
  - restrictions on market participation.

### Risk management, reporting, and operational requirements
- Real-time market information is needed for:
  - evaluating potential new transactions,
  - resetting rates periodically,
  - determining required collateral movements,
  - remunerating posted collateral.
- Independent calculation and bilateral confirmation of cash flows is essential.
- Collateral considerations:
  - Debt managers monitor the market value of the swap portfolio and receive collateral determined by a rating-dependent threshold value.
  - Counterparties pledge additional collateral when the market value exceeds the threshold value.
  - Two-way collateral agreements can create funding needs and costs and depend on a legal framework that allows delivery of collateral.
  - Using a rating trigger during times of market stress could be hard and have negative systemic implications.
- Counterparty agreements may contain triggers by which a swap may be terminated if the counterparty’s credit rating falls below a certain level.

### Accounting and communication challenges
- There are sometimes inconsistencies in the accounting treatment of derivatives (often mark-to-market) and underlying bonds (often nominal value), complicating:
  - communication,
  - evaluation of the risk reduction that derivatives were intended to help achieve.

### Credit risk management for derivatives
- LMOs, on-lending, and/or acquired assets in the sovereign balance sheet may involve derivatives, requiring debt managers to manage their credit risk exposure.
- Creditworthiness assessment:
  - A certain creditworthiness/credit risk is typically assigned to the counterparty (or the specific obligation), often based on a credit rating, to inform credit decisions.
  - Ratings inform uncertainty (default probability and recovery rate) used to evaluate expected loss and translate into credit exposure.
  - Relying on ratings has become more complicated because of resolution frameworks in many jurisdictions and different ratings for different instruments, increasing the need for debt managers to analyze risks related to derivatives more carefully.
- Collateral posting is often used to manage counterparty credit risk.
- Cash management credit risk is usually managed through rating requirements, limits, follow up and use of collateralized instruments such as reverse repos and tri-party repos.
- ISDA Master Agreement and other legal documents governing margin collateral serve as main instruments to manage credit risk in derivative transactions.
- Developments in trading agreements and pricing:
  - Key aspects in ISDA and CSA agreements are incorporated in derivative pricing and valuation via xVA (CVA, FVA, etc.).
  - Collateral affects both mitigation of credit risk and the pricing/valuation of derivatives.
  - Rating trigger features are associated with costs, which are paid by the holder of the swap.

### Strategic use of derivatives by sophisticated DMOs
- Some DMOs (including the Danish, German, Dutch, and Swedish Debt Management Offices) use derivatives, especially swaps, to:
  - reach desired debt portfolio exposure in a cost-effective manner,
  - separate funding from exposure,
  - exploit comparative advantage (e.g., issuing long maturities),
  - diversify the portfolio across instruments and markets to achieve target risk profiles.
- Example: Sweden issued domestic debt with a duration of 4.6 years and then used derivative instruments to lower the duration by 1.1 years, achieving a desired debt portfolio duration of 3.5 years.

*Source: International Monetary Fund and World Bank, 2014.*

### Box 6. Counterparty Credit Risk Related to Derivatives

### Box 6. Counterparty Credit Risk Related to Derivatives

### Counterparty selection and legal documentation
- Debt managers carefully select counterparties for derivative transactions by applying requirements such as minimum credit rating, use of legal documentation (such as that of the International Swaps and Derivatives Association, ISDA), demonstrated market share, assignment of credit lines to each counterparty, weights for individual transaction types, and rotation of counterparties.
- The understanding and negotiation of ISDA agreements require, in addition to credit risk management, legal competence.

### Limitations of derivatives versus direct funding
- Debt managers generally acknowledge that derivatives do not offer a perfect substitute for direct funding, because derivatives include new types of risk (for the same level of market risks).
- Example: a positive swap spread, measured by the cost difference of a euro area borrower issuing a bond in USD and swapping into euros, compared to direct funding in euros, is not always deemed sufficient justification. It has to be “sufficiently positive,” that is, to prove a compensation for the added risk of the swap transaction and cost of managing the positions.

### Credit, operational, and valuation challenges; common controls
- Derivatives entail credit risk to the counterparty and operational challenges with valuation and day-to-day management.
- Common controls include:
  - transacting only with counterparties with a minimum credit rating;
  - applying exposure limits to individual counterparties.
- Collateral management is important and has increasingly become common. It helps reduce credit risk, but raises further challenges with valuation, posting, and remuneration.
- Lower-rated sovereigns face additional complexity in that they themselves may have to pledge collateral, which also affects the cost-effectiveness of using derivatives in debt management and liquidity.

### Exchange-traded derivatives versus OTC derivatives; role of CCPs and electronic platforms
- Exchange-traded derivatives reduce counterparty and operational risk through centralized clearing mechanisms, and are considered more transparent, liquid, and accessible to a broader range of market participants.
- Over-the-counter (OTC) derivatives:
  - are easier to develop, grow organically, do not require fully developed underlying cash markets, and are more customized.
  - can offer public debt managers greater flexibility to customize risk-reduction transactions to the specific risks in their portfolios.
- The distinction between exchange-traded and OTC derivatives is becoming less clear as electronic trading platforms, which, along with central counterparty clearing houses (CCPs), provide most of the execution and risk management benefits of exchange-traded derivatives, are developing rapidly (Cecchetti, et al., 2009).
- Even for bilaterally-traded OTC derivatives, CCPs can be used to mitigate the counterparty credit risk.

### Enabling environment and introduction of derivatives in emerging markets
- The basic components for the derivative market to function are similar to that of OTC fixed-income markets.
- Providing the enabling environment, including an adequate legal and regulatory framework, helps protect against counterparty risk in OTC trades and improves transparency and disclosure.
- Such efforts could enable emerging market countries to introduce derivatives at an earlier stage in their development, as they would not have to wait until cash markets are liquid enough to support an exchange-traded derivatives market.

*Source: Authors.*

### Box 7. Deriving Debt Sustainability Analysis Equations

### Box 7. Deriving Debt Sustainability Analysis Equations

### Debt dynamics projections
- Variables defined:
  - Y = nominal GDP
  - D = end-period nominal public debt stock; d = debt-to-GDP ratio, D/Y
  - PB = nominal fiscal primary balance; pb = PB/Y
  - AS = nominal asset sales, privatization receipts, etc.; as = AS/Y
  - r = average nominal interest rate on the debt
  - I = nominal interest bill, assumed for simplicity to equal r times the previous period debt stock
  - g = real GDP growth rate
  - π = inflation (measured by GDP deflator)
- Assumptions:
  - Analysis is period by period on an annual basis, with subscripts t, t-1, etc.
  - For simplicity r, g, and π are assumed to be constant in the equations below.
- Debt identity and derivation:
  - D_t = D_{t-1} + I_t – PB_t – AS_t = D_{t-1}(1+r) – PB_t – AS_t
  - d_t = D_{t-1} (1+r) / Y_t  -  PB_t/Y_t  -  AS_t/Y_t
  - d_t = D_{t-1} (1+r) / [Y_{t-1} (1+g).(1+ π)]  -  pb_t  -  as_t
  - d_t = d_{t-1} (1+r) / [(1+g).(1+ π)]  - pb_t  -  as_t
- Use:
  - "This is the equation used to project debt ratios forward year by year, based on the five variables r, g, π, pb, and as."

### Contributions of different factors
- Change in debt ratio:
  - Increase in debt ratio = d_t – d_{t-1}
  - = d_{t-1} (1+r)/[(1+g).(1+ π)]  - pb_t  -  as_t  - d_{t-1}
  - = d_{t-1} [1 + r – (1+g).(1+ π)] / [(1+g).(1+ π)] - pb_t  -  as_t
  - = d_{t-1} [r – π (1+g) - g] / [(1+g).(1+ π)] - pb_t  -  as_t
- Decomposition of the increase in the debt ratio (identified breakdown):
  - Contribution of real interest rate = [r – π (1+g)] / [(1+g).(1+ π)] * d_{t-1}
  - Contribution of real growth = -g / [(1+g).(1+ π)] * d_{t-1}
  - Contribution of primary balance = - pb_t
  - Contribution of asset sales, etc. = - as_t
- Use:
  - "This decomposition can be used both to analyze why observed changes in the debt ratio in the past took place, as well as to understand why future projections of debt ratios take the path that they do."

### Debt-stabilizing primary balance
- Condition for stabilization (assume dt = dt-1 = d and r, g, π, as constant):
  - pb = d * [r – π (1+g) - g] / [(1+g).(1+ π)]  -  as
- Definition:
  - "This is known as the 'debt-stabilizing primary balance' and is one measure of the overall fiscal burden represented by the debt stock."

### Debt dynamics with exchange rate movements
- Extended increase in debt ratio including forex effects:
  - Increase in debt ratio = d_{t-1} [r – π (1+g) – g  +  α ε (1+r)] / [(1+g).(1+ π)] - pb_t  -  as_t
- Additional definitions:
  - α = share of foreign exchange denominated debt in the total
  - ε = nominal exchange rate depreciation
- Contribution of exchange rate depreciation:
  - α ε (1+r) / [(1+g).(1+ π)] * d_{t-1}

*Source: wp1874 - Box 7. Deriving Debt Sustainability Analysis Equations (extracted content).*

### Appendix 1):

### Appendix 1)

### Macroeconomic, Market Structure, and Market Liquidity Indicators
- Macroeconomic variables to monitor:
  - (1) GDP growth and inflation
  - (2) fiscal balance and public debt to GDP ratio
  - (3) current account and level and volatility of capital flows
  - (4) share of household savings to GDP
- Market structure indicators:
  - (1) debt securities statistics
  - (2) yield curve and structure of benchmark instruments
  - (3) composition and diversity of the investor base
  - (4) foreign holdings of local bonds
  - (5) types of fixed-income instruments
  - (6) derivatives market and types of hedging instruments
- Market liquidity indicators:
  - (1) volume of outstanding benchmark instruments
  - (2) size of transactions and turnover ratios
  - (3) bid–ask spreads
  - (4) bid to coverage ratios
  - (5) accepted ranges of bids in the primary market
- Note: "The higher the coverage ratios and/or the tighter the accepted ranges, the better the competition, demand, and liquidity." (footnote 164)

### Cash Management — Objectives and Policy Considerations
- Cash management has implications for debt management and a wide range of policy issues. (section header D; footnote 165)
- Five policy considerations:
  - Provide flexibility to accommodate temporary fiscal shocks, thereby minimizing their impact on orderly budget execution. (footnote 166)
  - Determine whether the level of cash balances is a policy target; minimizing idle cash reduces the economic cost of borrowing and requires cash flow forecasts and efficient budget execution. (footnote 167)
  - Support monetary policy implementation: cash management should contribute to the smooth implementation of monetary policy by the central bank.
  - Conduct market transactions to meet cash balance targets in a way that enables sound financing of any deficit or the management of excess resources.
  - Support or impede domestic market development (Williams, 2010). (footnote 168)
- Distinction from budget execution:
  - Budget execution ensures the budget is managed within agreed financial limits and controls cash releases linked to resource availability.
  - Cash management ensures government liquidity to fund expenditures and meet obligations as they fall due; planning ahead and cost-effective use of cash avoids cash rationing. (Lienert, 2009) (footnote 169)
- Interactions and constraints:
  - Cash management is closely related to rollover/refinancing and liquidity risks management (see sections III.A and B). Banking regulations, e.g., the Basle III Liquidity Coverage Ratio requirement, could impact decisions on cash balances. (footnote 165)

### Treasury Single Account (TSA) and Government Banking Arrangements
- Government banking arrangements are critical to:
  - (1) ensure tax and non-tax revenues are collected and payments are made correctly and timely
  - (2) optimally manage government cash balances to reduce borrowing costs or maximize returns on surplus cash
- A TSA:
  - Is a prerequisite for modern cash management and an effective tool to establish oversight and centralized control over government cash resources. (Pattanayak and Fainboim, 2011)
  - Centralizes government cash balances; in most advanced countries, nearly all revenues are consolidated daily in a TSA under Treasury control. (footnote 171)
  - Main bank account is held at the central bank for receiving revenues and making payments.
  - Payment models when establishing a TSA:
    - Centralized payments: all disbursements made directly from the TSA main operational account at the central bank (with few exceptions).
    - Decentralized payments: spending ministries make payments from commercial bank accounts with daily sweeps into the TSA.
  - Daily operation:
    - Balances in ministries’ bank accounts swept into the TSA each day.
    - Government cash manager ensures only a minimum end-of-day balance remains in the TSA main account at the central bank.
    - Temporary cash surpluses are usually remunerated by the central bank or placed in financial market instruments. (footnote 172)
- Coverage and scope:
  - Coverage should extend to all government-funded entities and special accounts.
  - Public corporations not discharging a government function should remain outside the TSA to preserve commercial autonomy.
  - Public companies discharging a government function should be designated as government units per the Government Finance Statistics Manual 2014 and integrated with the budget and TSA.
  - Forecasting focus: flows through the TSA must be the focus of the forecast; ideally, forecasts of daily cash flows across the TSA should be available for at least three months ahead and monitored close to real time.

### Cash Flow Forecasts, Debt Issuance, and Cash Buffers
- Forecasts of future cash flows are essential for active cash and debt management and planning debt issuance:
  - Debt managers need to know what to borrow and when; necessary for planning future borrowing and decisions on instruments (bills vs. bonds), considering demand, supply, and price information.
  - Intermediaries and end-investors may need a steady flow of T-bonds or shorter-term instruments for liquidity management; needs vary throughout the year.
  - Link issuance dates with redemption dates to maximize rollover opportunities and avoid concentrating maturities on heavy cash outflow days (e.g., salary payments or yearly PIT refunds of overpayments). (footnote 173)
- Cash management and refinancing risk:
  - Building a cash buffer to meet upcoming maturities has an opportunity cost because the sovereign’s funding cost is higher than the return on the buffer due to typically upward sloping yield curves. (footnote 174)
  - Trade-offs must be assessed between cost and risk reduction benefits of buffers. (footnote 175)
- Typical cash buffer composition:
  - (1) transactions buffer for unanticipated falls in cash balances stemming from volatility and forecasting errors
  - (2) safety buffer for unanticipated falls in cash balances from sudden disruptions in capital markets when no issuances would be possible
  - Size determinants:
    - Debt manager’s needs for debt and liability management operations
    - Maximum financing needed if capital markets were disrupted for several months and no issuance could take place
    - Providing comfort to investors that obligations will be honored
    - Flexibility to allow inflows from possible pre-financing
    - Use for contingent liabilities and/or for buybacks of outstanding maturities (these last three factors relate directly to LMOs). (footnote 177)
  - Additional options:
    - Formal measures should be used to determine ranges for investing funds. (footnote 174)
    - Trading strategies exploiting the shape of the yield curve could produce a positive carry but introduce funding and duration mismatches. (footnote 175)
    - Access to contingent credit lines from multilateral and bilateral agencies could serve the purpose of cash buffers to deal with exogenous shocks. (footnote 176)

### Institutional Factors and Organizational Options for Debt Management
- Transparency and accountability:
  - Debt management objectives should be clearly defined and publicly disclosed.
  - Measures of cost and risk adopted should be explained.
  - Legal authority to borrow should state who is authorized to undertake transactions on the government’s behalf.
  - Organizational framework, mandates, and roles for debt management need clear specification to grant operational independence to execute strategies and objectives. (section header E)
- Organizational alternatives:
  - Public debt management functions can be located in:
    - the Ministry of Finance (MoF)
    - the central bank
    - an autonomous debt management agency (DMO)
  - Consolidation of debt management functions in the same authority can enhance efficiency.
  - Responsibility should not be spread across several government departments or multiple MoF departments unless compelling effectiveness reasons exist. (Wheeler, 2006)
  - In most OECD countries, responsibility is centralized either within the MoF or in a DMO outside the ministry.
- Types of DMOs and governance:
  - Two common DMO types:
    - Office established outside the MoF but reporting to the minister of finance; legislative options range from specific legislation to broader government regulation. (footnote 179, 180)
    - Office located within the MoF or treasury.
  - An office outside the MoF requires sound governance arrangements and formal monitoring by its principal; governance can include boards of directors or advisory boards and internal/external audit arrangements.
  - Risks of weak oversight: OECD officials have noted oversight can be weak due to small oversight staff and insufficient training in debt management. (Currie, Dethier, and Togo, 2003)
- Guidance for developing and emerging market countries:
  - For countries beginning to develop government debt management, arguments favor building competency within the MoF and setting up an autonomous DMO once adequate capacity is developed. (footnote 181)
  - Key constraints for emerging markets:
    - Limited degree to which debt management policy can be implemented independent of other policy bodies (notably monetary authorities)
    - Challenges in developing government securities markets affect governance and DMO location decisions
  - If the debt manager cannot influence debt composition or is compromised by other policy-makers, the value of an MTDS and accountability of the debt manager become questionable. (Currie, Dethier, and Togo, 2003)
- Typical internal organization:
  - Many DMOs adopt front, middle, and back office structures with separate reporting lines to the head of the debt office, mirroring leading corporate and banking treasuries and reserve managers of central banks. (Wheeler, 2004) 

*Source: wp1874 - Appendix 1)*

### Box 8. The Organizational Structure of a Modern Debt Management Office

### Box 8. The Organizational Structure of a Modern Debt Management Office

### Organizational principle
- Modern debt management offices are organized around the separation of responsibilities among the front, middle, and back offices.
- The separation facilitates specialization and effective operational risk management.

### Key functions
- Senior management (supported by internal audit and compliance)
- Front office: primary issuance and execution, internal and external, and all other funding operations, including secondary market transactions (debt and cash), portfolio management and hedging transactions
- Middle office: policy and portfolio strategy development and accountability reporting; Internal risk management: policies, processes, and controls
- Back-office: transaction recording, reconciliation, confirmation and settlement; maintenance of financial records and database management

*Source: Wheeler, 2006.*

### Box 9. Common Pitfalls of First-Time Issuers

### Box 9. Common Pitfalls of First-Time Issuers

### Common pitfalls observed among first-time sovereign issuers
- Issue size:
  - The size of the issue was too large in relation to the intended use of proceeds.
  - Issues were large enough to support liquidity, but larger than what could be put to near-term use by the issuer, resulting in high carrying costs.
- Instrument structure:
  - Bullet bonds were issued.
  - In small economies, the repayment and rollover risks were magnified by the bullet structure of bonds.
  - These risks could have been reduced by using amortizing bonds.
- Inadequate preparations and market timing:
  - Preparations were inadequate; several first-time issuers could have achieved better pricing by preparing more thoroughly and providing more precise information on the intended use of the proceeds.
  - A few issuers went to market without strong fundamentals or at periods of unfavorable market conditions, or without appropriate selection of lead managers and/or pre-deal roadshows (in some cases without any roadshows) and shortly after obtaining a credit rating.
  - This resulted in a higher cost of the raised funds (higher interest rates) than could have been achieved through more careful fulfillment of economic preconditions for debut issuance, concerted efforts to obtain a better rating, and greater patience while building investor demand.

### Operational pre-issuance steps and strategic analysis
- Preconditions and early analysis:
  - Debt managers face several risks before the issuance of international bonds, so a number of preconditions must be met and initial actions should be taken well in advance.
  - A debt sustainability analysis is helpful in identifying potential risk of sovereign debt distress; it should evaluate future payment capacity under different macroeconomic scenarios, budgetary constraints, and the use of the proceeds.
  - A comprehensive medium-term debt strategy exercise is important to assess impacts of the external bond on the cost-risk tradeoffs of the debt composition, including exchange rate risk and refinancing risk.
- Recommended operational steps before issuance:
  - Solid preparation of the legal aspects involved.
  - Proper marketing of the country and of the transaction, which includes securing the best possible credit rating by at least two of the three major international credit rating agencies.
  - An investor relations program to deepen communication channels with investors and other stakeholders.
  - Hiring financial advisors who can provide independent advice (from the lead managers) at the issuance.
  - Depending on the economic stage of the country in the process, these steps can take several months to be accomplished.

### Investor relations, market monitoring, and market perception
- Role and benefits:
  - The debt manager usually starts monitoring, on a regular basis, the secondary market dynamics of the international bond to gauge market perception of the country that could have an impact on other areas of the economy.
  - Active investor relations could help improve market perception, reduce the yields traded on the market, and increase appetite for a potential new bond.
- Practical activities:
  - Deal and/or non-deal roadshows are crucial for engaging with existing and potential investors to articulate the government’s macroeconomic objectives, policies, and possible issuance intentions (deal roadshow), as well as to gain feedback on investor demands.
  - Good book runners usually help with preparations; capacity to go through the due diligence process is critical for a successful international bond issuance, as well as preparations for road shows.

### Managing refinancing risk and liability management
- Preemptive measures:
  - Establishing a sinking fund, where money is put aside regularly to repay the bond.
  - Active liability management operations to exchange the instrument about to mature to new longer-term securities.
- Post-issuance scrutiny:
  - Once a bond is issued, economic performance and policies will be subject to closer scrutiny by stakeholders (international investors or the press), calling for careful policy decisions and communication.

### Institutional capacity and operational expertise
- Human capital and structure:
  - Issuing an international bond requires specific institutional and operational debt management expertise, highlighting the importance of hiring and retaining qualified personnel.
  - An appropriate debt management structure should be in place, empowered by appropriately-skilled labor, which also gives investors the confidence that debt management is a priority.
- New actions and decisions:
  - Debt managers should be aware that issuance will generate a series of new actions and decisions to be taken and plan staffing and institutional arrangements accordingly.

*Source: Das, Papaioannou, and Polan, 2008.*

### REFERENCES

### REFERENCES

### Sovereign debt management, risk measurement, and ALM
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### Policy frameworks, IMF/World Bank guidance, and debt sustainability
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### Market structure, auctions, primary dealers, and liquidity
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### Operational guidance, cash management, legal frameworks, and institutional arrangements
- Abramov, Anatoly, Alin Mirestean, and Michael G. Papaioannou, 2017, “Sovereign Portfolio Risk Analyzer and Optimizer (SoPRAnO) – User Manual,” mimeograph (Washington: International Monetary Fund).
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### Credit risk, ratings, restructuring, and market access
- Bank for International Settlements, 2000, Principles for the Management of Credit Risk, Basel (Basel, Switzerland: Committee on Banking Supervision).
- Bank for International Settlements, 2011, “The Impact of Sovereign Credit Risk on Bank Funding Conditions,” CGFS Papers No. 43, Committee on the Global financial System, July.
- Moody’s Investors Service, 2013, “Sovereign Defaults Series,” October 7.
- Dubois Pelerin, Emmanuel, Mark Puccia, and Laura Feinland Katz, 2009, “Rating Implications of Exchange Offers and Similar Restructurings,” (New York: Standard & Poor’s).
- Das, Udaibir S., Michael G. Papaioannou, and Christoph Trebesch, 2012, “Sovereign Debt Restructurings 1950–2010: Literature Survey, Data, and Stylized Facts,” IMF Working Paper 12/203 (Washington: International Monetary Fund).
- Guscina, Anastasia, Michael G. Papaioannou, and Sheheryar Malik, 2017. “Assessing Loss of Market Access: Conceptual and Operational Issues,” IMF Working Paper (forthcoming).
- Spink, Christopher and Joan Magee, 2013, “Argentina Plots Escape from New York,” International Financing Review (IFR), Issue: 1999, 31 August to 6 September.
- Steneri, Carlos, 2004, “Uruguay Debt Reprofiling: Lessons from Experience,” Georgetown Journal of International Law, Vol. 35, No. 4, pp. 795–814.
- Lim, Cheng Hoon, Carlos Medeiros, and Yingbin Xiao, 2005, “Quantitative Assessments of Sovereign Bond Restructurings,” mimeograph, International Capital Markets Department (Washington: International Monetary Fund).

### Research on interest rates, fiscal dominance, and theoretical foundations
- Friedman, B., and V. Roley, 1980, “Models of Long-Term Interest Rate Determination,” The Journal of Portfolio Management, Vol. 6, No. 3, pp. 35-45.
- Chadha, Jagjit S., Philip Turner, and Fabrizio Zampolli, 2013, “The Interest Rate Effects of Government Debt Maturity,” BIS Working Papers No. 415, June.
- Blommestein, Hans J. and Philip Turner, 2012, “Threat of Fiscal Dominance?” BIS Working Papers No. 65, May.
- Missale, Alessandro, 1999, Public Debt Management (Oxford: Oxford University Press).
- Missale, Alessandro, Francesco Giavazzi, and Pierpaolo Benigno, 1997, “Managing the Public Debt in Fiscal Stabilizations: The Evidence,” NBER Working Paper No. 6311, December (Cambridge, MA: National Bureau of Economic Research).
- Agénor, Pierre-Richard, 2001, “Benefits and Costs of International Financial Integration—Theory and Facts,” Policy Research Working Paper 2699 (Washington: The World Bank).
- Culp, C.L., 2001, The Risk Management Process, (New York: Wiley).
- Marrison, Christopher, 2002, The Fundamentals of Risk Measurement, (Boston: McGraw Hill).

### Country-specific legal/operational documents and other institutional reports
- Macedonia, FYR of, 2009, “Rulebook on the Manner and Procedure for Issuance and Payment of Government Securities,” Official Gazette of the Republic of Macedonia 99/2005; 35/2007; 132/2007, 68/2009 and 131/2009, Skopje. Available at: http://www.finance.gov.mk/files/u4/rulebook_gs_04_11_2009.pdf.
- Swedish National Debt Office, 2003, “Analysis of Foreign Currency Debt Structure,” Central Government Borrowing: Forecast and Analysis, February.
- Swedish National Debt Office, 2015, Central Government Debt Management—Proposed Guidelines 2016–2019, Reg, no. 2015/995, September (Stockholm: Swedish National Debt Office).
- Swedish National Debt Office, 2016, Basis for Evaluation—Central Government Debt Management 2015, Dnr 2016/79, February (Stockholm: Swedish National Debt Office).
- Swedish Ministry of Finance, 2014, Guidelines for Central Government Debt Management 2014 (Sweden: Ministry of Finance).
- Swedish Ministry of Finance, 2015, Guidelines for Central Government Debt Management 2015 (Sweden: Ministry of Finance).
- World Bank and International Monetary Fund, 2009, “Developing a Medium-Term Debt Management Strategy (MTDS)—Guidance Note for Country Authorities” (Washington: World Bank and IMF).
- Institute of International Finance (IIF), 2014, Sovereign Investor Relations, 2014, Evaluation on Investor Relations and Dissemination Practices by Key Emerging Market Borrowing Countries, October (Washington: IIF).
- Piga, Gustavo, 2001, “Derivatives and Public Debt Management,” International Capital Markets Association.
- Peiris, Shanaka J., 2010, “Foreign Participation in Emerging Markets’ Local Currency Bond Markets,” IMF Working Paper 10/88 (Washington: International Monetary Fund).
- Wheeler, Graeme, 2004, “Sound Practice in Government Debt Management” (Washington: The World Bank).
- Togo, Eriko, 2007, “Coordinating Public Debt Management with Fiscal and Monetary Policies: An Analytical Framework” (Washington: The World Bank).
- United Nations Conference on Trade and Development (UNCTAD), 2015, Trade and Development Report, 2015 (New York and Geneva: United Nations).
- Gray, Simon and Runchana Pongsaparn, 2015, “Issuance of Central Bank Securities: International Experiences and Guidelines,” IMF Working Paper 15/106 (Washington: International Monetary Fund).

*REFERENCES (as listed in the source PDF).*

### Appendix 1: Key Aspects of Government Securities Market Development

### Appendix 1: Key Aspects of Government Securities Market Development

### Basic preconditions for sustained government debt market development
- Stable macroeconomic environment or sustained implementation of macroeconomic stabilization, especially if a country is at an early stage of economic development.
- Minimization of fiscal dominance, which may occur when the scale of the government’s financing requirement undermines the effectiveness and credibility of monetary policy. The extent of fiscal dominance may be mitigated by the statutory limits on central bank financing of the government or by other measures that enhance the independence of the central bank.
- Liberalized interest rates and firm commitment to market funding of government borrowing requirements.
- Policies that encourage the growth of domestic savings and the development of organizations and entities that manage the increasing wealth. The intention should be the creation of a broader investor base that will be interested to invest in the domestic government debt market.
- Note: lack of adequate development or weaknesses in one area, for example, secondary market growth, could slow the move to the next stage.

### Market development stages (overview)
- Stage I – Initial Stage of Market Development: severe shortcomings in primary market functioning, negligible secondary market liquidity, fragile macroeconomic fundamentals, fiscal dominance, and common shortcomings across five main areas: Primary market; Investor base; Market infrastructure; Regulatory environment; Monetary policy and operations.
- Stage II – Deepening of Markets: basic elements established, but secondary market liquidity and depth remain inadequate; needs stable macroeconomic environment and minimized fiscal dominance.
- Stage III – Maturing Markets: development approaches advanced country levels; well-functioning primary market; secondary market deep and liquid in normal times; focus on derivatives and international competitiveness.

### Stage I – Initial Stage of Market Development

I.A. Primary market
- Average maturity of government debt tends to be short.
- Firmly establish issuance of short-term securities before moving to medium- and long-term securities; avoid spreading issues thinly in low demand environments and avoid compelling holding of long-term fixed-rate securities at below market rates.
- If small stock of domestic debt is combined with significant external debt, consider increasing share of domestic debt in overall debt strategy while carefully evaluating costs, benefits, and risks.
- Securities linked to short-term interest rates, indexed to inflation, or foreign exchange rates can help lengthen average maturity and extend the yield curve.
- If persistent high inflation or refinancing risk is a problem, authorities may evaluate issuing floating rate or inflation-indexed bonds, bearing in mind that in an unstable macroeconomic environment they entail considerable risks.
- Debt fragmentation is typical:
  - Consolidate debt issuance to one agency to reduce number of public debt instruments and increase their size.
  - Scale back issuance of nonmarketable debt. Nonmarketable debt should be issued at market rates and have provisions for early redemption, especially retail products. (Footnote: Nonmarketable securities tend to deter the development of market liquidity. At this stage, liquidity is minimal and therefore the market needs to be provided with marketable and fungible securities to the extent possible.)
  - Refrain from opening new issues at every auction.
  - Appropriately adjust frequency of primary auctions as the market develops.
  - High auction frequency reduces “demand tension”; less frequent auctions can heighten demand due to higher opportunity risk.
- Transparency and communication:
  - Provide timely information on government finances, debt portfolio, borrowing strategy, and data on primary and secondary market activity.
  - Collect and publish reference rates for government securities.
  - Publish an auction calendar (usually monthly or quarterly in this stage) while retaining flexibility to fix amounts and/or maturities until one or two weeks prior to the auction.
  - Hold regular consultations with market participants about borrowing strategy, market preferences, and market situation.

I.B. Investor base
- Build a diverse investor base by gradually diminishing reliance on captive sources of funding. Interest rates should be liberalized and no investor group required to hold government debt at below market rates. High reserve requirements and liquid asset ratios should be reduced. (Footnote: This needs to be implemented in a sufficiently cautious manner, especially if captive sources of demand include domestic investors to a significant degree.)
- Promote competition in banking sector and eliminate privileges of state-owned banks where applicable.
- Build domestic institutional investor base by creating favorable legal and regulatory framework for mutual funds and contractual savings sector.
- Retail instruments:
  - Retail securities should have yields reflecting market rates less marketing and administration costs; early redemption penalties should reflect these factors.
  - Remove disincentives for trading (e.g., requirements to invest in nonmarketable securities and other portfolio allocation restrictions). Strict quantitative limits on asset holdings are not recommended.
- Underdeveloped contractual savings sector (pension funds, life insurance) noted.
- Low share of foreign investors at this stage; general advice is that participation of nonresidents is not advisable because of risk of sudden reversals causing boom–bust asset price patterns if markets are shallow and illiquid.

I.C. Market infrastructure
- Establish foundations for depository and settlement procedures; dematerialize government securities through registry of securities accounts and set up depository to handle settlement between securities accounts. Dematerialization improves liquidity by reducing transaction costs and settlement times.
- Develop a strong and transparent legal and regulatory framework for issuance, trading, and settlement to ensure investor confidence and reduce systemic risk.
- Promote organized trading facilities and market microstructure arrangements suitable to the stage, including specifying transaction types, role of intermediaries, trading mechanisms, and market transparency with timely reporting requirements of secondary market transactions to promote price discovery, reduce settlement risk, and enhance liquidity.
- Interbank market tends to lack liquidity or be excessively volatile; develop infrastructure for interbank market with special emphasis on repo markets. Authorities could promote master repurchase agreements and facilitate settlement and trading procedures. Central bank can foster repo activity by using these instruments for open-market operations rather than using unsecured facilities or issuing central bank paper.

I.D. Regulatory environment
- Establish clear borrowing authority for the government including internal procedures for debt management, transparency and accountability requirements, and disclosure procedures.
- Establish a regulatory body for secondary market activity. Effective regulation should include: (1) regulation of market intermediaries, (2) market conduct regulation and market surveillance, and (3) transparency requirements.
- Establish clear legal and regulatory framework for payment and settlement process for government securities.
- Review tax policies in context of market development; seek tax neutrality and as a first step eliminate transaction taxes for government securities trading.

I.E. Monetary policy and operations
- Remove liquid asset ratios and reduce high reserve requirements; such requirements provide captive investors and do not help development of secondary markets.
- Central bank should gradually move away from conducting monetary policy through rules-based instruments and create conditions for money market-based instruments such as a liquid interbank market.
- As interbank market develops, monetary instruments should be less accommodating to encourage active liquidity management by banks and more reliance on the interbank market.

### Stage II – Deepening of Markets

II.A. Primary market
- Government should have a clear and consistent strategy for issuing government securities that provides a medium-term horizon for investment strategy of market participants.
- Objective to lengthen average maturity of domestic debt; if short-term securities are well established, issuance can be extended to medium- and long-term securities.
- Address debt fragmentation and build a benchmark yield curve by:
  - Discerning market preferences through consultations; standardizing debt instruments to reduce fragmentation (different bond types, coupon rates, maturities, issue sizes, frequencies, on-the-run vs off-the-run); developing appropriate maturity distribution for benchmark issues; determining appropriate size and frequency of benchmark issues.
  - Use reopenings and buybacks to build size and life cycle of benchmark issues by eliminating inactive issues and standardizing outstanding bonds.
  - Resolve problem of multiple public agencies issuing public debt before moving to Stage III. Central bank should refrain from issuing its own securities unless necessary for liquidity management and, if so, restrict issuances to the short end of the yield curve (say, under a month).
- Do not issue nonmarketable debt in Stage II; convert outstanding nonmarketable debt into securities bearing market interest rates.
- Improve transparency of debt management and increase/refine public data and information. Use risk management techniques such as stress tests and evaluate contingent liabilities and implicit contingent liabilities.

II.B. Investor base
- Further strengthen institutional investor base (pension funds, insurance companies, mutual funds); ensure sound regulatory and supervisory practices for institutional investors, with particularly strong frameworks for pension plans.
- Ensure retail investors of mutual funds and insurance companies are informed and educated about market risks.
- Consider easing limits on investment in foreign securities by institutional investors to achieve appropriate portfolio diversification.
- Consider gradual capital account liberalization only with sustainable macroeconomic policies, systematic approach to safeguarding financial stability, strong prudential regulation and supervision, and improved liquidity in government securities market.
- Adopt gradual approach to foreign participation by liberalizing sale of long-term securities first.
- Liberalize short-term flows only based on thorough analysis of: (1) experience with foreign investors, (2) macroeconomic policies and conditions affecting financial sector stability, (3) state of development and risk exposures of institutions and markets, and (4) prudential and governance infrastructures, and the observation of relevant standards.

II.C. Market infrastructure
- Prerequisite: establishment of securities accounts (dematerialization). Focus on reducing settlement period and introduce real-time gross settlement (RTGS) with delivery versus payment (DVP). (Footnote: To ensure fungibility of securities, sufficient bridges among settlement facilities should exist. For example, if inter-bank or professional fund managers settle through one system and retail investors through another, e.g., stock exchange, securities should be able to settle through both systems.)
- Develop sub-depositories as a key precondition for expanding investor base and trading activity. Develop regulations for clients’ accounts in event of sub-depository bankruptcy; ability to transfer accounts between sub-depositories encourages competition, separation of clients’ accounts from sub-depositories’ own business, reporting requirements, and a code of good practices.
- Promote interbank market development and active trading in repo market. Toward end of deepening stage, consider establishment of derivatives markets and instruments.

II.D. Regulatory environment
- Maintain coherent legal and regulatory framework, continuously adapt to changes in primary and secondary market infrastructure, participants, instruments, payment, and settlement processes.
- Regulatory functions may reside with different authorities; typical structure may involve central bank or MoF regulating primary markets and primary dealers, while securities regulatory authority regulates market intermediaries in secondary market. (Footnote: See Appendix 2.)
- Promote industry bodies to deal with transaction conventions or business conduct standards.
- Develop adequate tax policy for new instruments; if active foreign participation is desirable, consider eliminating tax withholding for foreign investors.

II.E. Monetary policy and operations
- Eliminate high liquid asset ratios. As interbank market develops, central bank should rely more on money market instruments.
- Encourage active liquidity management by banks by widening corridor for standing facilities and reducing frequency of credit or deposit auctions.

### Stage III – Maturing Markets

III.A. Primary market
- Primary market is well established underpinned by sound debt management framework; authorities have no difficulties issuing long-term securities and their share in outstanding government debt is increasing.
- Government securities are issued in a limited set of benchmark maturities and in relatively large size. Minor problems with debt fragmentation due to irregular maturities may remain but are expected to be retired.
- Authorities engage in regular reopening and buyback operations to increase fungibility of benchmark issues.
- Authorities should complete standardization of instruments if fragmentation remains, continue building a benchmark yield curve, and further refine debt management practices with special focus on risk management framework.

III.B. Investor base
- Characterized by a diverse investor base; domestic institutional investor base is developed and nonresident investors typically allowed to invest in both long-term and short-term securities.
- When considering allowing foreign investors into derivatives markets, conduct a thorough analysis.
- Continue strengthening domestic institutional investor base via improved financial sector regulation and supervision.

III.C. Market infrastructure
- RTGS and DVP for securities settlement should be established.
- Focus on increasing sophistication by developing derivatives markets to provide hedging vehicles and enhance spot market liquidity.
- Mitigate risks associated with derivatives and risk management instruments by:
  - Strengthening supervision capacity to assess derivatives risks.
  - Promoting development of risk management capacity in financial institutions, including mandating hiring and training of skilled personnel.
  - Strengthening accounting rules to properly measure risks.
  - Strengthening reporting by financial institutions on derivatives risks and disclosure of counterparty exposures.

III.D. Regulatory environment
- Legal and regulatory framework for primary and secondary markets is fully established; focus on improving effectiveness of enforcement and developing regulation for new instruments, techniques, and markets.
- Full mark-to-market requirements should be in force in this stage.
- Continuously adapt regulation related to new risk management instruments and derivatives.

III.E. Monetary policy and operations
- Central bank mostly relies on money market operations for implementation of monetary policy, supporting further deepening of secondary government securities market.
- Interbank market should be liquid and well-integrated with other financial market segments including secondary government securities and foreign exchange market.
- If central bank issues central bank bills for monetary policy, consider closer coordination with debt management authorities to overfund the budget instead of issuing its own bills, allowing monetary policy through outright sales and purchases of government securities.

*Appendix 1: Key Aspects of Government Securities Market Development – wp1874*

### Appendix 2: Primary Dealers in Domestic-Bond Auctions

### Appendix 2: Primary Dealers in Domestic-Bond Auctions

### Introduction
- Primary dealers support the primary market for government securities by providing a consistent, dependable source of demand via their distribution network and proprietary inventory.
- They can broaden and deepen market participation, promote secondary market activity, provide two-way quotes for selected benchmark issues, improve price discovery and liquidity, and service the retail market.
- Under a primary dealer (PD) system, the debt manager and the group of primary dealers pursue a common strategy to support effective functioning and development of primary and secondary markets for government securities.
- Country experience is mixed: primary dealer systems have been adopted or considered to develop more liquid secondary markets, but motivations differ across countries (for example, in the United States primary dealers are primarily counterparts for execution of monetary policy).
- In Europe, the introduction of the euro, internationalization of capital flows, and adoption of electronic interdealer trading platforms (e.g., MTS) were drivers for new types of primary dealer systems that included international banks and imposed quotation obligations.
- A primary dealer system is not a panacea; it works best when latent market forces exist and can be catalyzed. For smaller markets, participation of international banks can release those forces, but increased international investor participation requires coordination with financial stability and exchange rate policies.
- The debt manager should negotiate with counterparties and use incentives (e.g., fees from syndicated issuance and privatizations) rather than regulate; higher leverage allows more onerous PD obligations.
- There is no optimal number of PDs; selection depends on country specifics. In smaller markets, a number between 6–8 primary dealers is often sufficient.
- Minimum eligibility requirements typically include capitalization, dealing capacity, distribution capacity, addressing counterparty risk in clearing and settlement, and appropriate internal infrastructure (e.g., electronic auction system).

### An Outline of a Primary Dealer System
Commitments or obligations and entitlements or privileges of primary dealers are typically formalized in bilateral agreements (often with limited legal enforceability). Essential categories of commitments or obligations include:

- Participation in auctions
  - Participation is both an entitlement and an obligation.
  - Alternatives for commitment include:
    - Setting a minimum share for bidding in auctions (relatively soft; dealers can position bids to miss being filled).
    - Requiring a minimum share of the auction allocation (stricter; could apply to each auction).
    - Requiring a minimum share in allocations across several auctions (e.g., a minimum share per month or quarter).
  - The sum of minimum shares would only apply one-third or half of the total auction, as each dealer buys a different share.
  - Smaller markets are prone to collusion or “cornering”; countermeasures include caps on allocation per bank.
  - Some countries differentiate minimum auction requirements by instrument type and dealer market power.

- Secondary market quotation
  - Quotation commitments can help break a vicious circle of low liquidity and wide bid-offer spreads.
  - Quotation rules generally refer to:
    - The quotation platform (international platforms facilitate international bank participation; multiple platforms can fragment liquidity).
    - Minimum daily quoting time (may be short initially and expand; dealers may voluntarily quote longer).
    - Minimum or standard volume for quotes (typically small but contributes to depth over time).
    - A maximum spread between bid and offer (often dependent on maturity; inside spread from several market makers will generally be smaller).
  - Quotation obligations require dealers to take additional market risk and commit capital and human resources.
  - The debt manager must commit to regular, predictable supply (e.g., announcing auction volumes or volume ranges before each auction) and avoid cancelling auctions except in extraordinary circumstances.

- Role of supervisory and law-making authorities
  - Improve market infrastructure: legal environment, clearing and settlement systems, and broad market access including for international investors.

- Instrument promotion towards investors
  - Primary dealers can produce economic research and financial strategic analysis, link sovereign issuers with large investors (e.g., roadshows), and promote foreign and domestic bond issuance.

- Trade activity reporting
  - Reports provide insight into secondary market development and activity of key players (interdealer and dealer-client trades).
  - Interdealer activity could be reported directly from electronic platforms, but coherent trade statistics from dealers avoid definition issues and double counting.

Entitlements or privileges commonly considered for primary dealers (to balance commitments and maintain voluntary participation):

- “Primary dealer” brand
  - Right to carry the ‘primary dealer’ brand is highly valuable and used for market profiling.
  - Publication of rankings of primary dealers is common; evaluation should include quantitative and qualitative criteria (e.g., market promotion).

- Participation in auctions (entitlement)
  - Exclusive auction access for primary dealers is often the key entitlement; initial system creation may allow flexibility for candidate dealers.

- Direct financial benefits
  - Non-competitive subscriptions allow PDs to purchase additional bonds at the weighted average price of the auction for a short period after the auction (from a few hours up to a few days).
  - Preferred or exclusive counterpart status for other debt management operations (e.g., joint-lead-management roles in syndicated transactions, access/advice on buybacks and exchanges, roles in privatizations).
  - Rotation of certain benefits among performing primary dealers where only one or a few banks are needed (while syndicate managers should be selected for placement power).

- Securities borrowing facility
  - To support market making without excessive inventory, PDs need access to bonds to cover short positions, normally via the repo market (central bank) or a repo/securities lending facility provided by the issuer as lender of last resort in nascent markets.
  - Access to such facilities is generally exclusive to primary dealers.

- Advisors to the debt manager
  - Primary dealers serve as prime market contacts and advisors, providing ongoing market feedback and influencing debt manager decisions.

### Stylized Preconditions for a Primary Dealer System
- 1. Debt issuance strategy
  - A government must have a strategy for issuing government securities and provide a medium-term horizon for the investment strategy of primary and secondary market agents.

- 2. Financing instruments
  - A minimum set of attractively designed securities should be available, including different maturities and benchmarks; instruments could include index-linked securities for portfolio diversification and risk management.

- 3. Investor base absorption capacity
  - An adequate number of end investors is necessary; the government should estimate potential demand among individuals and the financial sector and fine-tune supply to meet demand.

- 4. Governments’ commitment to market development
  - The government must be committed to secondary market development, refraining from intervening directly in the market (e.g., limiting or avoiding direct retail sales) to guarantee that PDs and other participants will not compete directly with the government in retail placements.

*Appendix 2: Primary Dealers in Domestic-Bond Auctions.*

### 5.  Commitment to accept market-determined outcomes

### 5.  Commitment to accept market-determined outcomes

### Market-determined outcomes — key principles
- Authorities must stimulate primary and secondary market setups that allow competitive forces to play a dominant role.
- Primary dealers should be initiators of a market and providers of additional liquidity and transparency for better price discovery and resource allocation, not captive holders of government securities.

### Primary dealer arrangement and market prerequisites
- Arrangements between primary dealers and debt managers must be carefully designed; the auction is the central mechanism for primary market allocation.
- Sufficient debt and potential secondary-market trade volume must exist to support a profitable, unsubsidized group of competing primary dealers.
- An adequate number of active participants and enough volume of government securities are important to justify a primary dealer system.
- Providing secondary market price information, even non-committed, is the most important step toward creating a market-making group.
- Debt manager support mechanisms include securities lending facility (SLF) or repo operations and the adoption of a Global Master Repo Agreement with market makers.
- Debt managers may issue bonds in excess of the allocated amount to be kept in the Treasury’s account at the central securities depository.

### Phased implementation toward a full Primary Dealer (PD) system
- When prospective PD candidates cannot fully commit, a phased approach is recommended with key measures and policies as preconditions for each phase.
- Proposed four phases (covering several years) toward a full PD system:
  - Phase I — Preparation.
  - Phase II — Testing Period.
  - Phase III — Primary Dealership “Best Effort Basis.”
  - Phase IV — “Full” Primary Dealership.

### Phase I: Preparation — steps and reporting
- Step 1. Reporting
  - Establish direct, formalized reporting relationships to follow market developments.
  - Reporting should cover three areas: primary market, secondary market, and research/market promotion.
  - Primary market reporting: distribution of auctioned bonds among investors and the books of bidding parties (order and allocation book information).
  - Secondary market reporting: trade volumes (OTC and electronic platforms), separating buy and sell transactions, instruments, maturities, and investor categories (including geographic).
  - Research/market promotion reporting: analytical publications and promotional activities by banks (reports, investor meetings, etc.).
  - Participating institutions: international banks, domestic banks, investment advisors, and other professional parties willing to provide reports.
  - Only reporting institutions would be eligible to participate directly in domestic auctions.
  - Confidentiality assurances: trade statistics released only in aggregated form with sufficient delay.
  - Required actions by the debt manager:
    - Review and adapt a proposed reporting template;
    - Present the draft to key market players and finalize with feedback;
    - Invite market participants to become PD candidates and formally name PD reporting institutions;
    - Prepare internal processing of reports into aggregate statistics;
    - Define internal and external output.

- Step 2. Adapting issuance to stimulate secondary and primary local market demand
  - Review auction frequency to create benchmarks with sufficient size and differentiation in maturities.
  - International market likely main market initially; domestic market to absorb shorter maturities such as Treasury bills and Treasury bonds up to five years.
  - Limit domestic auction frequency to enable secondary market distribution.
  - High transparency of issuance plans (e.g., indicative supply calendar per quarter with a range around the target amount).
  - Define maturities of domestic issuance in line with domestic investor balance-sheet considerations (e.g., ALM needs of domestic banks).

### Phase II: Testing Period — assessment and engagement
- Step 3. Regular meetings
  - Regular meetings foster dialogue, increase debt manager awareness of market problems, and solicit views on new features.
- Step 4. Assessment of readiness of market participants and debt manager
  - Testing period could run over a 1-year period.
  - Institutions signing up for regular reporting provide activity reports enabling the debt manager to assess preparedness for Phase III.

### Phase III: Primary Dealership — “Best Effort”
- Step 5. International custody and settlement of local bonds
  - Establish connectivity between the domestic central securities depository and an international settlement institution to facilitate international participation.
- Step 6. Define incentives for PDs to undertake market-making
  - Introduce a non-competitive part to an auction as an incentive for market makers.
  - Periodic ranking of the most active market-makers’ voluntarily quoting; create a top-list for access to the non-competitive auction.
  - Example mechanism: eligible market-makers allowed to buy for, e.g., 3 working days after the initial auction an additional amount of up to, e.g., 25 percent of their initial allocation at the average auction price.
  - Primary Dealer Performance Appraisal — typical evaluation activities:
    - (i) Primary market activity: share of securities bought at auctions; duration-weighted systems; decide inclusion of buybacks/exchange auctions and T-bills.
    - (ii) Secondary market activity: market making obligations, reporting trades, ranking by secondary-market turnover share; separate evaluation for participation in repo operations.
    - (iii) Other (qualitative) criteria: advisory quality, cooperation, technical and human resources for debt manager support, analytical outputs.
  - Appraisal features: transparent, comprehensive, feasible; predefined evaluation period (6 months, 1 year, etc.); public PD ranking; predefined criteria and weights; neutrality across PD types.
- Step 7. Establish a daily fixing for key Treasury bond maturities
  - Participating dealers provide indicative, non-committal quotes at a defined time.
  - Calculate and publish an average quote after removing outliers for each key maturity on a multi-contributory page and directly to the debt manager.
- Step 8. Introduce an agreement for a light version of a PD system
  - Formalize rights and obligations through standardized bilateral contracts between the debt manager and each PD, emphasizing voluntary and contractual aspects.

### Phase IV: “Full” Primary Dealer System — commitments and market infrastructure
- Distinguishing features of Phase IV
  - PDs quote firm two-way prices in benchmark bonds.
  - Requires an electronic trading platform, some consolidation of existing government securities, and a securities lending facility.
  - Number of PDs must be calibrated to expected activity volume and debt manager objectives.

- Step 9. Liability management operations for government securities
  - Consolidate a high number of bonds into fewer benchmark bonds to improve liquidity and price discovery.
  - Reconsider key maturities and refine Treasury-bill issuance.
  - Define benchmark size and benchmark replication.
  - Consider exchanging loans to government bonds (on market terms) to increase market liquidity.

- Step 11. Introduce a repo/securities lending facility
  - Repo/securities lending allows market makers to borrow bonds short-term to cover delivery obligations when they lack initial positions.
  - Borrowing periods range from one day to a few weeks, but cannot cross a new issuance date of the bond.
  - The facility should be a safety net with unattractive rates for market makers (example: if interbank 2 weeks money is 5 percent and repo rate of 4 percent is demanded, that is a spread of 1 percentage point).
  - In developed repo markets, use of the facility may be rare; in smaller borrowers the facility may receive more use.
  - Actions needed to implement the facility include establishing operational terms, eligible participants, and pricing (details not provided in the excerpt).

*Source: IMF Working Paper — "5.  Commitment to accept market-determined outcomes" (wp1874).*

### 1. Review legal circumstances to implement such a facility, with the participation of supervisory

### wp1874 - 1. Review legal circumstances to implement such a facility, with the participation of supervisory

### Repo/Bond Lending Facility: implementation steps and conditions
- Review legal circumstances to implement such a facility, with the participation of supervisory authorities, especially if any new laws are required, and assess the form that is most legally suitable for the facility.
- Once the repo/bond lending facility is legally feasible, adjust the documentation or prospectus for new bonds, i.e., create new bonds with its final size as of the start.
- Prepare standardized bond lending/repo documentation.
- Define the conditions at which institutions can participate:
  - (i) the institutions need to be primary dealers; and
  - (ii) the cost of borrowing bonds needs to be more expensive than a potential repo, inducing use only as a safety net or for short periods, and be expressed as a spread (below money market rates—1 percent could be considered as a start).
- Make a public announcement explaining the instrument and the process.

### Primary dealers, quoting obligations, and selection
- Distinctions between market makers and primary dealers:
  - PDs commit to bid for and achieve on average a minimum share of the auctions; dealers will effectively commit some of their capital to government securities.
  - Quoting rules will be introduced, moving from market making without preset rules towards quotes that are monitored and driven by performance measurement.
  - Selection among market makers is done to end up with a limited, but sufficient, number of primary dealers, including foreign dealers.

### Auctions of government securities — overarching principles
- Auctions are the predominant issuance mechanism for domestic government securities; alternative mechanisms include syndication, tap systems, and private placements.
- Auction rules are shaped by three main dimensions: (i) pricing, (ii) eligibility for bidder participation, and (iii) types of bids (competitive and non-competitive).
- Country-specific factors (level of development of secondary markets, composition of investor base, existence of captive demand) play a central role in determining the appropriate auction model.

### Transparency, predictability, and pre-auction practices
- Issue government securities by auction in a transparent and predictable manner and in large individual issues at regular intervals.
- Electronic auction systems offer benefits in clearing time depending on number, types and location of bidders.
- Pre-auction sound practices:
  - Provide medium-term debt management strategy (MTDS) and an annual borrowing plan (ABP).
  - Publish auction calendars (practices vary from monthly to annual calendars) and information on auction dates, maturities, and amounts.
  - Conduct pre-auction consultation: regular meetings with primary dealers and bilateral consultation with PDs a few days before auction announcement to gauge demand.
- Auction execution and decision making should avoid surprises; governments should strive to be price-takers and avoid opportunistic behavior (e.g., selling more than initially announced or rejecting bids except in exceptional circumstances).
- Establish investor relations, internal and external reporting, and a formal market consultation group chaired by the debt manager.

### Auction frequency and issuance size
- Auction frequency should be specified based on the expected role of the secondary market and government cash management needs.
- Frequent auctions may reduce incentives to use the secondary market; adequate issuance size provides more reliable price discovery and can reduce execution risk.

### Allowing multiple bids and price discovery
- Allowing investors to submit multiple bids enables banks to submit an entire demand schedule, enhancing price discovery and potentially increasing bid volumes.
- Multiple bids reduce execution risk by allowing finer discrimination between bids to accept or reject.

### Determining cut-off rates and allocation rules
- Debt managers seek to avoid cancellation of Treasury auctions except in extreme circumstances.
- Some countries define rule-based allocation, e.g., rejecting bids that are more than [x] basis points away from the weighted average price of the lowest half of the bids by value (with [x] being published in each prospectus).
- Reserve prices are difficult to implement due to potential signaling effects that may cluster bids around the reserve price.
- Example practices:
  - Spain: PDs must bid for at least 3 percent of the auction (there are only 21 PDs/market makers); the minimum price bid is defined in terms of a spread below the clearing price of the auction (the spread varies with maturity).
  - Singapore (MAS): each PD obliged to tender for an equal share; MAS may adjust its purchase according to the specified difference between auction cut-off and secondary market yields; where auction cut-off yield is more than 25 basis points below or above market yield, MAS may vary subscription amount; higher performing PDs are given priority in MAS’ liquidity operations.

### Auction format: uniform-pricing vs multiple-pricing
- Uniform pricing (Dutch auction): cut-off price determined and all bids at cut-off or above are met at the cut-off price; allocation can be pro-rata if bids exceed the volume offered.
- Multiple pricing (discriminatory or pay-as-bid): bids at the cut-off price or above are met at the prices offered by individual bidders; issuer obtains the maximum price each participant is willing to pay.
- Behavioral and revenue implications:
  - Studies show bidders tend to bid more cautiously in multiple-price auctions; uniform pricing tends to encourage more aggressive bidding and broader participation.
  - The trade-off lies between potentially higher demand under uniform pricing and potential revenue differences when allocating at the cut-off price.
- Global practice (study of 41 country cases):
  - 56 percent used multiple-price;
  - 22 percent used uniform-price;
  - 22 percent used both.
- Choice depends on investor base, risk of “winner’s curse,” risk of losing the auction, secondary market liquidity, and availability of reference rates or hedging instruments.
- Examples of uniform-price use: inflation-linked bonds in South Africa and the U.K.; Brazil has used uniform pricing to encourage greater bidding.

### Tap sales and other variations
- Tap sales: government securities sold on an ongoing basis when financing needs arise and markets are favorable; price can be changed depending on demand.
- Tap distribution useful for retail bond programs, flexible cash planning, and tapping markets when demand is unpredictable.
- Erratic tap sales can harm competitive bidding and undermine auctions; use tap sales carefully and based on prevailing market conditions.

### Use of non-competitive bids (NCB)
- NCB is often integrated into auctions; price for NCB depends on pricing system (average or highest yield from competitive auction).
- Distinction between closed auctions (restricted to primary participants, e.g., PDs) and open auctions (broader participation).
  - Closed auctions can incentivize PD performance and enhance distribution and market making.
  - Open auctions can enhance competition, especially where many non-primary dealer banks exist.
- NCB can attract less specialized investors (e.g., retail investors, public sector funds) and serve as an incentive for PDs.
- NCB formats:
  - Pre-auction NCB: bidders present bids before the competitive auction.
  - Post-auction NCB: decision to submit NCB bids taken after auction results are released; post-auction NCB is prevalent to motivate dealers and is often tied to dealer performance.
- To protect competitive auction price discovery, amounts allocated to non-competitive bidders are often limited to a smaller fraction of the total auction amount; individual limits may secure the non-professional character of NCB and prevent dominating roles.
- Example: U.S. Treasury permits non-competitive bidding for small investors but imposes rules to minimize inappropriate use (a bidder bidding competitively for own account may not bid non-competitively for own account in same auction).

*Italic: IMF Working Paper (content unit: wp1874) — Appendix 3 excerpts on implementing auctions and related market practices.*

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_Source: https://www.imf.org/-/media/files/publications/wp/2018/wp1874.pdf_