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News recently in from the UAE is that the Central Bank is actively lobbying for the establishment of a bond marketplace in the United Arab Emirates. A domestic bond market is an effective mechanism for raising funding and, for that reason, it can be a positive addition to the financial landscape in any country. Yet, the achievement of a bond market depends on the right institutions and regulatory structures becoming in place perfect from the start off.
What then are the key prerequisites for the establishment and development of a effective bond market?
Bond markets are generally differentiated into a primary market, in which bonds are initial issued, and a secondary market, in which they are traded. In the primary market, the most critical problem is to make certain that the bonds are properly priced.
To elaborate, all corporate instruments are normally priced at a premium to the threat-free yield curve. In most instances, this risk-free curve is the yield at which the sovereign problems its debt. In the UAE, as in other bond markets, sovereigns will need to support the creation of a yield curve by issuing securities of proper maturity. This will be vital to the success of the proposed bond market, and have to happen regardless of whether or not or not sovereigns needs to problem for funding purposes.
The next necessary step will be to develop the yield curve, and in new markets the key issues are frequently concentrated at the shorter end of the curve. This is commonly mainly because banks need to have short-dated instruments to meet their liquid asset requirements, and given that confidence in longer-dated instruments takes some time to build up. In the early stages, dialogue with the institutional investor market is necessary, as sovereigns needs to match supply with demand and to problem at a tenor that meets the liability-matching requirements of the institutional investor.
As the yield curve grows, there is generally a cost to pay, the market may well demand a yield at an earlier point on the curve than that offered by option sources of funding or, indeed, a yield that is more high priced than that provided by these alternatives.
Still, as soon as the threat-totally free yield curve has been established, institutional investors can then cost corporate debt at a premium to the curve. And as the corporate market grows, a corporate credit curve that is in a position to deliver additional pricing information and facts to both issuers and investors will develop. There is, nevertheless, a price involved here too. It is frequently much more highly-priced for the first corporates entering the marketplace to issue debt, and this can cause corporate treasurers to shy away from the bond market and to raise funding from banks or in the equity market instead. As investors come to have an understanding of the corporate issuers, though, and turn into comfortable with the instruments, the spread over the threat-free rate will compress. A good bond market development strategy will take this factor into account, and will identify approaches in which to overcome it.
When the corporate debt marketplace has been established, it will supply an effective mechanism for corporates to raise funding, and for banks to successfully tap into it for the purposes of obtaining Tier II capital.
When establishing this proposed bond marketplace, it will as a result be vital to establish not only a primary market, but a secondary marketplace in which the instruments can be traded as well. Secondary marketplace trading traditionally takes location on an OTC basis, primarily between banks with brokers acting as intermediaries. Massive balance sheets are, following all, needed to trade debt.
Certain markets, yet, trade debt via exchanges, and two of the most successful exchange-traded markets are in Taiwan and South Africa. This is not to say that electronic trading is absent from the OTC bond markets. Electronic platforms such as MTS in the European sovereign bond markets have played an vital function in facilitating trade. Cost transparency is an essential consideration in the secondary market, and some bond markets are renowned for the lack of transparency.
An exchange-traded marketplace such as the one in South Africa would undoubtedly improve transparency, but establishing the right marketplace institutions to guarantee that this will be adequately supported is vital. And 1 of the key decisions to be made at the outset is no matter whether to have main dealers serviced by inter-dealer brokers or an electronic trading platform that is open to the whole marketplace, such as the institutional investors.
Both possibilities have pros and cons. A central counterparty neutralises the credit exposure of 1 counterparty to a different, and thus creates a marketplace that makes it possible for for far more participants. In very simple terms, the much more participants there are in the marketplace, the higher the 'churn', and the higher the 'churn', the higher the liquidity. Liquidity is fantastic for all participants and aiming for a liquid market really should be the cornerstone of any bond market technique.
This means participants will will need to have confidence that, as soon as a trade has been executed, it will be settled and the needed money flows will happen seamlessly. It is hence significant to have a central depository with a central register of ownership, and a payment method that guarantees payment.
It is not, then again, crucial for the marketplace to own the infrastructure. As market infrastructure is high priced, this a game of scale, and it is as a result not only probable but advisable to tap into existing infrastructure providers. If a market does, having said that, construct its own infrastructure, this can make fascinating and profitable outsourcing opportunities.
It is unlikely corporate and bank issuers in the UAE will be able to develop a bond marketplace on their own. The creation of a yield curve, and the decision about whether to have an exchange-traded or OTC marketplace will have to have to be driven in cooperation with the regulatory authorities and other participants.
