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Friday, July 21, 2023

Advantages To Procedural Changes In Bond Market?

From my recent Torrens Zoom call, I ran into questions about procedures in the government bond markets. The main question was whether I saw potential changes to the markets to improve things. The second was more of a concern about the complexity and opacity of the bond market.

Procedural Improvements

On the question of “can we do things in a better way?,” I am interpreting this in the narrow sense of just looking at how governments issue bonds (or not…), and how the central bank interacts with the bond market, without any changes to “real world” programmes. (I am only discussing floating currency sovereigns, as I would argue that being non-sovereign means that the country is facing serious real world constraints that need to be addressed.)

The initial response to this question would have to be: what country are we talking about? Each country has its own procedures and legal environment. For example, the debt ceiling in the United States is extremely dumb — but a U.S.-specific phenomenon. The euro is floating currency, but the countries stuck inside the euro face a problematic fixed exchange rate framework that would take too long to discuss herein.

From my perspective, most of the procedural differences between countries does not matter too much from an end user perspective. To the extent that there are silly things like the debt ceiling in other (non-euro) developed countries, I never really ran into them.

Putting aside the euro framework, the only framework problem I see is the ambiguity in default risk. In practice, a default is politically unthinkable (outside the euro periphery…), and so default risk discussions are largely a waste of time. A country could end the nonsense at a stroke by having the central bank issue bonds, and the fiscal arm of the government “borrow” from the central bank (that it owns). Other than the name of the issuer of the bonds, nothing would change in the actual economy, since the cash flows going to/from the consolidated central government would not change.

The only “problem” with this is that fiscal conservatives cannot tell campfire ghost stories about default risk. Since that is exactly what they want to do, they would fight tooth and nail against the reform. One is then in the position: do you want to have a vicious political fight about a policy that changes nothing in the real economy?

Why Issue Bonds?

The end of bond issuance is an idea floated by some MMT proponents. There are two distinct issues involved.

  1. Should the government pay interest on its liabilities, or should all liabilities pay (near) 0% interest (like currency)?

  2. Change the structure of the liability from bonds to some new saving instrument?

These are distinct because the government can issue bonds/bills in a permanent zero interest rate environment (although having a small positive yield of 0.25% or so would grease the wheels of the system).

There is no space herein to discuss permanent 0% rates, rather I am interested in the structure question. Although the government can issue new savings instruments to households (things like Canada Savings Bonds already exist), this is not enough to account for the very large stock of government liabilities (typically more than 60% of GDP). Pension funds, insurance companies, mutual fund companies, large corporations are non-bank firms that control a significant portion of private assets, and they need a liquid credit risk free product for both investment and liquidity management purposes.

On paper, the government could dump all its non-currency liabilities on the banks (“bank reserves”), but that would mean that the banking system would be stuck intermediating the entire stock of government liabilities. They would need to borrow from private sector entities to finance their “money” holdings — which is a commercial disaster for the banks, putting them at a huge disadvantage versus non-bank finance. One could try to make such a system work, but it would require a total rebuild of the entire financial system — which would almost certainly be bypassed via moving activity to foreign developed countries that would pick up the financial business.

Alternatively, private firms could bank with the central bank. However, this poses the risk of largely wiping out the private banking system. Although some academics enjoy conjuring fantasy worlds where everything is intermediated by public market securities, in the real world, private credit markets rely on credit lines with banks as a form of backup liquidity. Those credit lines can only be economically meaningful in the presence of a vibrant formal banking system that is implicitly backstopped by the central bank.

Is the System Too Complex?

The government finance system arguably looks complex to outsiders — but it is simple with respect to the rest of the financial system. From the perspective of a fund manager, a central government bond is just another bond with a CUSIP that fits into its existing trade settlement infrastructure. Changing liability structures makes the liability more complex for the buyers, not less.

Although pieces of bond issues can be bought in $1,000 increments in Canada (although my broker imposes a $5,000 minimum, which is typical), the minimum trade size for a wholesale quote is either $1 million or $2 million (I do not know, since we would not even think about that small a transaction). It is a wholesale market, with no effort made to integrate small investors. This is unlike things like futures and options and markets, which are actually more complicated instruments to analyse, yet they welcome retail investors to try their luck.

Government finance involves delegating to individuals the authority to slosh large amounts of money around the financial system. Given human nature, there are a lot of rules covering what may or may not be done, and we see greater complexity in things like how tax authorities operate. The reason why government finance seems more complex is that almost no effort is made to educate the general public about it, on the basis that they generally do not interact with the system. Instead, they allocate money to fund managers or insurance companies to deal with the complexity.


One complaint about fixed income markets is that they are opaque. This reflects the reality that they are wholesale markets, and regulators see limited need to protect small investors with greater disclosure requirements. The lack of data is annoying to outsiders, but the participants in the market have deep enough pockets to pay for the access to data. In any event, it is unclear that most people need anything more than the fitted bond yield series provided by central banks, as it seems unlikely that most people are about to start relative value trading.

Another issue is the opacity of central bank dealings with counterparties. Although one needs to be concerned about cronyism, transactions are commercially sensitive. Access to transaction data would give extremely valuable information on the risk exposures of market participants, and their interests could easily be compromised by timely disclosures. Giving gangs of speculators ammunition to squeeze entities with potential weak hands does not benefit anyone other than those speculators.

Integration with Private Financial Markets

The current system is best understood as a policy of integrating government liabilities with private credit markets. This helps boost the local financial industry versus foreign competitors, and has a macro-prudential benefit. In a financial crisis (in a currency sovereign), central government debt is the only asset class that is free from default worries. Government bond prices appreciate, which stabilises private portfolios, breaking the downward doom spiral. (This is a light paraphrase of Minsky’s views.)

This attracts the ire of populists on the left and right. However, being pro-financial crisis does seem like a limiting political platform in most democracies.

Concluding Remarks

Although the details of the structure of the government bond market evolved via historical accidents, the framework does fit the needs of the financial system as it intermediates the interactions between the central government and the non-financial sectors. Any attempt to reform would have to address the economic requirements that are met by the current structure.

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(c) Brian Romanchuk 2023

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