Ebook Developing the Government Bond Market in Korea after the Financial Crisis: Performance Evaluation Using Micro-data
Since the Asian financial crisis of 1997 the government bond market in Korea has achieved an outstanding improvement in terms of the size and the institutional arrangement. The government bond market has grown in size as the issuance of government bonds increased dramatically to finance the efforts of much needed financial restructuring and economic recovery in the aftermath of the financial crisis. In addition, in response to the needs to reduce the cost of issuing and servicing the enormous amount of government bonds, the Korean government took measures to enhance the institutional framework and the infrastructure for the government bond market. These reform efforts resulted in the introduction of the Dutch auction system to replace the old compulsory underwriting system, the primary dealer system, the DVP(delivery versus payment) settlement system, the reopening system, the marking-to-market system, the repurchase agreement market, the KTB(Korea Treasury Bond) STRIPs and so on.
One of the institutional reform measures was the introduction of the Korea Exchange Government Bond Market (hereafter the KRX market) in March 1999. The KRX market, which was based upon an electronic trading platform, was established with the intention of enhancing the transparency and the liquidity in the secondary market for government bonds. As a result of establishing the KRX Market, the secondary market for government bonds in Korea has been divided into two markets: the OTC market and the KRX market. In order to boost the trading activities in the KRX Market, the government also introduced the compulsory trading requirements in October 2002 mandating that the primary dealers (PDs) should trade benchmark issues of the governments bonds in the KRX market.
Traditionally, the over-the-counter (OTC) trading where bonds are traded between dealers through different forms of voice message system has been the dominant form of bond trading. The recent trend among the developed countries, however, is the one towards the electronic trading platform replacing the voice message system. A good example of the electronic trading platform for bond trading can be found in the EuroMTS and the MTS (Mercato dei Titoli di Stato) system of individual European countries. It is widely understood that the electronic trading system enhances efficiency of the secondary bond markets by reducing the transaction costs and by making the trading process transparent.
As a result, it is expected that the imposition of the mandatory trading requirements to boost trading activities in the KRX market will be helpful in enhancing transparency and efficiency of the overall government bond market in Korea. On the other hand, however, it is also argued that introduction of the KRX Bond Market and imposition of the mandatory trading requirements may undermine the efficiency of the government bond market by restricting the trading activities of the primary dealers and by dividing market liquidity between the OTC market and the KRX market. Thus, whether the imposition of the exchange trading requirements has been beneficial to the entire government bond market in Korea remains an empirical question.
In this paper we evaluate the effects of introducing the electronic trading system for government bonds and imposing the trading requirements on the KRX market and the OTC market using the intraday trading data for government bonds. The main findings of this paper are as follows.
First, introduction of the KRX market and imposition of the mandatory trading requirements have been effective in increasing the trading volume of the KRX market and the trading share of the KRX market in the entire secondary market for government bonds. The trading requirements on benchmark issues have also boosted transactions of non-benchmark issues although these are not covered by the trading requirements. In addition, the exchange trading requirements on primary dealers have also helped to bring in other players into the exchange market. The bid-ask spreads on government bonds in the KRX market has also fallen after the measures to boost trading activities in the KRX market were taken.
Second, the increase of the trading volume in the KRX market did not come at the expense of a lower trading volume in the OTC market. In consequence, we can conclude that the introduction of the exchange trading requirements for benchmark issues was helpful in improving the overall quality of the entire secondary government bond market in Korea.
Third, the volatility of the KRX market as well as the OTC market decreased significantly since the introduction of the exchange trading requirements. Yet, various measures of volatility demonstrate that the OTC market is more volatile than the exchange market. In addition, the volatility measures such as the daily standard deviation of transaction prices and the intraday range of transaction prices displayed quite a few abnormal values in the OTC market. Further analysis reveals that these abnormal values can be ascribed to lack of transparency in the OTC market rather than to fundamental macroeconomic shocks.
Fourth, the MEC (market efficiency coefficient) estimated from the intraday trading data and the execution costs derived from the estimates of the MEC demonstrate that the exchange trading requirement has not only improved the liquidity and the efficiency of the KRX market but added greatly to the efficiency and liquidity of the OTC market.
This paper is organized as follows: Chapter II summarizes the changes in the government bond market in Korea after the financial crisis including the introduction of the KRX Government Bond Market and the imposition of the exchange trading requirements. Chapter III investigates the effects of imposing the exchange trading requirements on the KRX market and the OTC market using intraday trading data. Chapter IV analyzes the effects of the mandatory trading requirements on the liquidity and the transparency of the secondary government bond markets in Korea by estimating the MEC and the execution cost using a micro data. Chapter V presents our conclusions.
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