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The Sovereign Debt Market Explained

The number of headlines focused on sovereign debt these days can be mind bending, but all for good cause. Every day I see articles posted written by a slew of commentators, and I wonder how many of these people even know what they are talking about in the first place, never mind the people actually reading them.

For FX traders, understanding the basics of sovereign debt is a must. Shifts in their supply or demand can have a direct impact on the currencies to which they are related. Changes in yields generally have the opposite effect in terms of currencies and I have seen too many traders get put in the dark when it comes to why these shifts are occurring in the first place.

Learning these basic principles is step 1. Step 2 is pricing, and how changes in sovereign debt yields, bond auctions, etc., impact the value of currencies.

I recently came across a site that I haven't browsed through in quite some time, (Organisation for Economic Co-Operation and Development), and noticed they had a fairly good summary of the basics in sovereign debt. Below is the rundown taken from “Core Topics in Debt Management“; if you are looking for more, the source page has a massive inventory of articles outlining the topic. Enjoy:

Core Topics in Debt Management (Introduction)

In order to minimise cost and risk over the medium to long run, debt managers should ensure that their policies and operations are consistent with the development of an efficient government securities market. Developing a government securities market is a complex undertaking that depends on the financial and market system development of each country. The essential pillar in developing a government securities market is a market oriented funding strategy, including adherence to basic market principles like: broad market access, transparency, effective regulatory frameworks.
The above policy issues are classified by the following sub-categories:

  • Primary Market
  • Secondary Market
  • Post Trading
  • Repo Market
  • Issuing in Foreign Currency
  • Multilateral Debt
  • Developing Domestic Bond Markets
  • Cash Management
  • Retail Debt
  • Legal Issues and Conventions


Primary Market

The primary market is the market where government securities are first issued and sold, typically by means of some form of tender or auction process. A well-functioning primary market is crucial to develop reliable distribution channels. Responsibility for establishing a primary market rests with the national government and the choice of primary market procedures is a dynamic process that depends on each country's initial conditions and on subsequent developments. Policy topics include:

  • Organisational framework of the government securities primary market (primary dealership, systems for direct access to retail investors, and so on);
  • Issuance strategies;
  • Issuance methods (auction procedures, direct issuance, syndicates);
  • Dealer competition;
  • Auction bidding strategies;
  • Buyback and exchange operations;
  • Investor base and relationships.


Secondary Market

Secondary markets are markets where government securities are traded after they have been issued or sold on primary market. A liquid secondary market is an important source of price signals and is therefore essential for the orderly funding of government financing requirements, especially in less-developed markets. The government plays an important role in the development of secondary market structures (e.g. the types of negotiations that are allowed, roles for dealers and intermediaries, trading mechanisms, market transparency, regulations, and so on) guided by the objectives to ensure an efficient price discovery process and to improve the liquidity of securities. Policy topics include:

  • efficiency and liquidity of secondary markets;
  • regulated and non-regulated market segments;
  • role of information in trading;
  • B-to-B and B-to-C trading;
  • Order-driven versus quote-driven markets;
  • organisational innovations (such as ATS and other OTC segments) and their implications for debt management policy;
  • the role of derivatives instruments for hedging trading strategies;
  • concentration versus segmentation of markets;
  • trading conventions;
  • trading and post-trading


Post Trading

An efficient securities settlement system is a principal component of the infrastructure necessary for developing government securities markets. The settlement system affects the degree of confidence investors have in the market infrastructure, determines whether trading in the primary and secondary markets flows smoothly and influences the capacity of markets to expand. Settlement procedures depend on country circumstances and the degree of automation. But irrespective of the approach, policy makers should try to minimise the various risks in the system and, where necessary, improve settlement procedures.

This policy area reviews the major policy issues involved in developing a government settlement and describes its main components, including the types of securities accounts, central depository systems, the different settlement arrangements and the role of central counterparties. Issues related to cross-border mergers and acquisitions among different national and international central depositories in the EU will be addressed.


Repo Market

The repo market is a way of borrowing or lending government bonds for cash, with the bonds as collateral. Dealers in government securities use repos to manage their liquidity, finance their inventories and construct their different trading strategies. To that end, dealers lend out securities in their inventory but are not expected to be sold immediately. Because of the many uses of repos, this facility may affect the demand for government securities as well as the liquidity of secondary markets.

This policy area addresses the different types of repotransactions and highlights the risks and benefits that are associated with the development of repo markets.


Issuing in Foreign Currency

By opening the market to foreign investors, governments can further broaden and diversify the investor base. Issuing in foreign currency may be an effective way to address this goal. However, the development of government bond markets, and in particular their currency composition, has recently received much critical attention, partly because of their link with financial crises. As a result, the structure and composition of government debt in terms of currency is subject to more rigorous scrutiny in terms of fiscal and financial vulnerabilities.

A special attention is devoted to the main challenges faced by the emerging debt markets. So this policy area includes such topics as:

  • rationale for issuing in foreign currency in advanced economies;
  • restructuring of foreign currency sovereign debt;
  • latest innovations in foreign currency issuance.


Multilateral Debt

In this area you find documents addressing specifically emerging markets problems associated with multilateral debt. Among them, multilateral debt relief as part of a broader agenda which includes an appropriate analysis of the role played by a) bilateral resources, b) international negotiations and agreements, c) private sector financial resources, d) policies aimed at strengthening governance and improving domestic absorptive capacity.

Although emerging market economies have become more resilient to individual shocks, multilateral financing institutions continue to work to improve the framework for crises management and resolution. This activity helps prevent debtor countries and market participants from placing excessive reliance on the financial support provided by the multilateral institutions.

For countries benefiting from multilateral financial assistance, the definition of sound exit strategies from multilateral debt is essential to avoid the prolonged use of multilateral resources. This includes better program design, macroeconomic and structural conditions to achieve debt sustainability, more effective conditionality and a careful consideration of the timing to regain market access.

Experience with recent sovereign external debt restructuring suggests that a more comprehensive approach to sovereign debt restructuring is needed. Progress has been achieved in introducing Collective Action Clauses in the international bond issues of emerging market economies. Some advanced countries have played a role in leading by example.

Despite the progress achieved, more work is still required on timely, orderly and effective restructurings that ensure an appropriate involvement of the private sector.

Developing Domestic Bond Markets

One of the significant areas in debt management, especially for emerging countries, is the development of domestic capital markets. This issue, following the recent international financial crises, has increasingly attracted the attention of policy-makers making rise the issuance of policy recommendations and guidelines by both multilateral and regional organisations. In this section you can find a description of the challenges encountered by many governments and an analysis of the key ingredients for accelerating the development of bond markets such as effective benchmark functioning, ample liquidity and low transaction costs, safe and efficient market infrastructure, regulatory systems that ensure low barriers to funding and investment, good availability of reliable information, transparency of accounting, and sound market practices. In particular, a great attention will be put to illustrate the critical government's role, as an issuer, regulator, coordinator and promoter, in formulating and setting up the development roadmap.

Cash Management

This policy area explains why good or best practices for government cash management are for sound debt management. Government cash management may be defined as the strategy and associated processes for managing cost-effectively the government's short-term cash flows and cash balances, both within government, and between government and other sectors.

More specifically, this policy area addresses the main objectives of efficient government cash management:

  • keeping to a minimum the volume of idle balances held in the banking system, and the extra costs associated with that;
  • reducing risk – operational, credit and market risk;
  • adding flexibility to the ways in which the timing of government cash inflows and outflows can be matched;
  • supporting other financial policies;
  • the necessity for an effective collaboration between the sovereign debt manager and the central bank.


Retail Debt

Some countries have a long tradition in issuing retail debt, even though the importance of retail relative to overall debt has been shrinking during the last years. However the share of retail debt varies significantly across countries.

Distribution is a key factor featuring the retail debt issuing activity. Differently from wholesales instruments, retail ones are placed also through banks, post offices, Internet, or even shops and supermarkets. In increasingly competitive financial markets, this type of direct debt selling has to pay a great deal of attention to product innovation, brand equity, benchmarking, strategic market position, etc. Some product features can only be introduced or developed by a public institution; for example, fiscal incentives (tax credits). Other factors that influence the design of retail public debt products concern the macroeconomic environment, interest rates and the general economic and institutional context.

In several advanced markets the sale of retail instruments is evaluated purely in terms of economic cost effectiveness. Other countries, including many emerging debt markets, take into account also social goals such as financial education and encouraging savings.

Moreover, the introduction of dematerialised products and the use of electronic retail systems require addressing additional technical and economic issues. In this respect governments need also to take into account social and cultural sensibilities, including such issues as the imagined fiscal or collateral value of physical tangibility.

All the above mentioned topics are addressed in this policy area.

Legal Issues and Conventions

This policy area focuses on specific legal issues arising in debt transactions, particularly those involving external sources of funds and the conventions supporting derivatives activity.

It's worth noting that:

  • a good legal support plays a crucial role in the negotiation and implementation of all financial arrangements because, in the final analysis, financial arrangements have legal implications for both borrowers and lenders;
  • surveys have revealed that there is a lack of awareness in developing countries and economies in transition about the legal aspects of debt and financial management. This lack of awareness has, in conjunction with other factors, led to the inability of many countries to successfully manage their finances and/or repay their debts.

Source: Organisation for Economic Co-Operation and Development


The Economist has a great interactive map outline global debt by country. To view it, click here: