Hi! I am Nina Lasala, former Treasurer of the Philppines. This blog is meant to be an open forum for investors, fellow finance professionals, and other interested parties to discuss the state of Philippine Debt Management.

Wednesday, March 09, 2005

A Businessworld Article on FIE vs. OTC by Noel G. Reyes

MANILA, PHILIPPINES | Wednesday, March 9, 2005
By Noel G. Reyes

Even as the battle against the Bangko Sentral's third-party custodianship rule rages, monetary authorities and their allies are set to open a new battlefront in their fight to introduce new measures meant to reform the local capital market, but which the other side criticizes as reversals, at best, and crass opportunism, at worst. This time, the monetary authorities set their sights on fixed-income exchange (FIE) against the current practice of over-the-counter (OTC) trading for government and corporate bonds.
OTC trading, in its most basic sense, refers to the system wherein bond dealers transact trades over the telephone. Today's actual OTC trades have evolved from this primal description. In today's practice, OTC trades involve electronic trading systems, such as the system run by Bloomberg, currently used by local traders. Notably, developed bond markets abroad, mainly in the US, also use OTC trading.
Using this OTC trading platform, plus Bloomberg interface, local bond traders have developed market benchmarks such as MART1, currently used as the benchmark for short-term interest rates by banks in repricing their loans and derivative instruments. Market participants further point out that this system has helped develop a deliverable on-the-run market -- referring to the so-called secondary bond market where government bonds bought at auction can be traded by bondholders among themselves. The benchmarks generated by the current system have expanded to include three-year and four-year interest rates.
Coupled with the Bureau of the Treasury's registry of scripless securities (RoSS) system, the current OTC system of local bond traders has turned into a true DVP (delivery-versus-payment) settlement system. Developed by the Treasury, RoSS is an electronic record of all debt obligations of the Republic, all kept in scripless form (i.e., not in certificate form). DVP, meanwhile, refers to the system wherein the buyer and seller exchange cash and securities ownership simultaneously ("kaliwaan" in the local lingo).
Into this situation, the market reformers at the Bangko Sentral decided that a more formal market arrangement is required, in the form of the fixed-income exchange. This FIE "was conceived as a comprehensive financial market structure that will provide an electronic platform for trading, clearing and settlement, and depository and custodianship of fixed-income securities and derivatives," according to the handbook of the Philippine Stock Exchange, one of the investors in the Philippine Dealing System Holdings Corp., the parent company of the FIE.
The FIE's proponents criticize the present OTC trading system as non-transparent, among other things, and further blame the resulting noncompetitive trading system for the wide bid-ask spreads in government securities in the secondary market. Extremely wide bid-ask spreads connote a highly inefficient and illiquid market. These proponents argue that their FIE system would help narrow this spread, although by what mechanism they could not say.
"In case the public does not know it yet, we would like to inform all women and men from all walks of life that the Bangko Sentral ng Pilipinas (BSP) is divesting the BTr of the electronic record of scripless debt of the Republic," stated a manifesto issued by BTr staff. "Ruled as legal by the Department of Justice, the divestment is in favor of the fixed-income exchange (FIE) and third-party custodians "
While the FIE is envisioned to provide the hallmark functions of an exchange -- from price discovery, to transparency, better market access and delivery-versus-payment -- market participants argue that the present system already accomplishes these functions and, more importantly, does so at no additional cost to the participants. In contrast, the FIE will exact its pound of flesh by charging exchange fees as well as custodianship fees through its wholly owned Philippine Depository & Trust Corp.
Those who oppose the FIE's establishment further note that market liquidity may even suffer since the FIE would exclude some current market participants from trading directly in the new exchange. The FIE's accomplishment of the price discovery function is seen to be, at best, at par with the current system; it may even be of poorer quality should the OTC market run parallel to it, as the latter would sap liquidity from the exchange.
Another weak point of the FIE is that, upon implementation, it would be incapable of true DVP. As such, market participants feel this would be a reversal of the current system which already incorporates DVP.
Further, market participants note that the FIE has failed to address issues concerning credit and anti-money laundering. The latter imposes a constraint on the FIE, banning it from venturing beyond bond trades done among banks. That would then call to question the FIE's avowed goal of deepening and widening the market for bonds, which would necessitate the inclusion of more participants.
These then are the criticisms against the FIE. Just like the third-party custodianship rule, the establishment of the FIE is seen as an imposition of additional costs on the market in exchange for limited to zero additional benefits. Against the current OTC system, which already uses an electronic platform and a DVP system of settlement, the FIE's purported advantages remains ambiguous. It would take a lot of convincing before local bond traders believe that the FIE can actually deliver a better service and not only create rent for a select few.


Anonymous dr. feelgood said...


congratulations to your site! there is finally a venue for finance professionals to openly discuss issues regarding capital markets development.

going back to the article you posted, counterparty credit risk is a major reason as to why the market choses to trade bonds via OTC. to simplify, let's say i am trading for a major bank and i have a someone calling me asking to buy securities and this buyer is from a very small bank.

the risk to me as the seller is that my counterparty does not pay for the trade.

now an exchange would theoretically solve this problem by making the exchange my counterparty. however, as anyone who does business in the philippines knows, the strengh of the exchange lies in the ability for the exchange to guarantee that a failed transction can be reparied.

this is the rude awakening that we all had to deal with when the PSE and the BW Resources scandal broke out. but this another matter altogether.

going back to the concept of a FIE, the exchange is capitalized at PhP 500 million. the market for government securities runs in the trillions. a single transaction for a major commercial bank could easily exceed 500 million. for the FIE to avoid a PSE like scandal, the exchange has to be well capitalized.

now, new concepts in OTC trading have come around and are (in my opinion) better suited to emerging markets like ours since participants cannot afford to capitalize an exchange following a central counterparty pattern. these are crossing networks. these crossing networks (e.g. instinet) are OTC systems that provide the market with the transparency (they do provide last done info and thus give traders the ability to do a proper mark-to-market of securities) and price discovery of an exchange yet afford participants the flexibility to choose and negotiate the terms of the transaction.

i guess what i am trying to say is that with the advances in technology available to us, choosing between conventional exchanges and OTC markets need not be the only options for the industry to consider. there are other methods that can be looked into and evaluated. these platforms can be deployed via the Internet, thus widening the participation and improve liquidity by including QIBs such as retirement funds, insurance companies and other participants like rural banks (i know that this is something that BAP members might not be all that excited about but it is an open forum after all).

1:30 PM

Anonymous Anonymous said...

Its about time, somebody is making sense! I hope other professionals, especially in the banking and finance sector would share their thoughts about this FIE issue.

As small as it is, people can be oblivious about its serious effects due to its complexity. People should know that the future of our children and our children's children are at stake if this thing will just be another fiasco.

And so I am calling all the brightest people around to shed light and contribute their thoughts regarding this FIE issue so that "ordinary" people like me can understand what BSP is trying to run down our throat. If it hurts so much then, as a tax-paying citizen of this country, I have the right to say NO.

I hope our politicians are also listening.

4:40 PM

Anonymous Anonymous said...

The problem in this country is that the BSP Governor is vested with too much power and is not answerable to anyone. Imagine what that power can do...

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