Liquidity and Transparency in the Danish Government Bond Market
Jens Verner Andersen, Financial Markets, and Per Plougmand Bærtelsen, Market Operations
Summary
During the autumn of 2003 a number of new initiatives were introduced in the Danish government bond market, such as electronic trading and market making. In cooperation with the market participants Government Debt Management at Danmarks Nationalbank established the wholesale market, MTS Denmark. Concurrently with the transition to electronic trading, a primary dealer system was established which, inter alia, comprises a market-making obligation in the wholesale market. In the market for government bonds on the Copenhagen Stock Exchange a price-quote scheme was launched where Government Debt Management has concluded an agreement with a number of banks which have committed themselves to quoting current bid and ask prices in Danish government securities.
At the same time, the initiatives have enabled the introduction of Danish government securities on international electronic trading platforms, such as BondVision and TradeWeb, where securities dealers electronically distribute government bonds to major investors connected to the electronic trading platforms.
The market implications of the initiatives are described in the following based on the initial experience. The new initiatives have modernised the Danish government securities market. Prior to executing a deal, it is now possible to view tradeable prices and connected amounts. This has made the market more transparent. In addition, the market has become more liquid and a larger part of the trading is now conducted electronically.
So far, experience shows that in the wholesale market, MTS Denmark, there are current tradeable prices for around 95 per cent of the time from 8.30 am to 5.00 pm. In the benchmark securities, the market participants can normally currently trade more than kr. 100 million at the best bid/ask price.
Furthermore, as a result of the launch of the price-quote scheme in the market for government bonds on the Copenhagen Stock Exchange there are now tradeable prices for around 95 per cent of the opening hours of the trading day, contrary to previously when pre-trade information was only rarely available. Since the launch of the price-quote scheme, interested investors have been able to currently trade kr. 4-6 million at the best bid/ask price. New trading facilities have made it easier for small investors on the Copenhagen Stock Exchange to execute deals directly in the bond market.
New initiatives in the market for danish government securities
The market for Danish government bonds has changed in recent months. Previously, trading took place predominantly via telephone, while an essential part of the trade volume is now traded on electronic trading platforms[1]. Some of the most important initiatives that have changed the infrastructure of the market for government securities are described in the following. The description is not an exhaustive review of the market structure and all available market platforms in the market for Danish government securities.
Introduction of MTS in the wholesale market
On 4 November 2003 the wholesale market for Danish government bonds opened on the trading platform MTS[2]. A primary dealer system was established in connection with the introduction of electronic trading. The key obligation is to quote current prices for at least five hours a day in all government securities of the type bullet loans with a remaining maturity of more than 13 months. In order to meet the conditions of the primary dealer agreement, the participants must quote simultaneous bid and ask prices within certain maximum spreads. At the same time, the participants on the quoted prices must be prepared to trade for a minimum amount reflecting the wholesale nature of the market. At present, 13 banks, including several foreign banks, are primary dealers in Danish government securities. The introduction of electronic trading and market making in the wholesale market has enabled the market participants to buy and sell government securities on a current basis for considerable amounts without significantly influencing price formation.
Introduction of electronic trading platforms for institutional investors
During the autumn of 2003 Danish government bonds were introduced on international dealer-to-customer trading platforms such as TradeWeb and BondVision. The dealer-to-customer markets enable e.g. institutional investors to trade securities with banks and securities dealers. The suppliers of the electronic trading platforms have typically concluded agreements with securities dealers and banks as well as institutional investors on connection to the trading systems. Thus, banks and securities dealers can distribute government bonds from the wholesale market, and institutional investors have electronic access to trade Danish government securities.
The market structure differs from MTS Denmark and the market for government bonds on the Copenhagen Stock Exchange in that it comprises quote-on-request systems. On specific request from an institutional customer contemplating buying or selling, the counterparties invited by the institutional customer to participate will quote a price[3].
A number of securities dealers participate on both platforms, and competition among dealers typically results in price quotes with narrow bid and ask spreads.
Price-quote scheme in the market for government bonds on the Copenhagen Stock Exchange
On 1 December 2003 a special segment for Danish government bonds was established on the Copenhagen Stock Exchange. At the same time a price-quote scheme was launched whereby six banks have concluded an agreement with Government Debt Management on quoting current prices for at least 95 per cent of the time from 9.00 am to 4.30 pm in the government securities that are included in the primary dealer system. In order to meet the requirement of the price-quote scheme, the participants must quote concurrent bid and ask prices within certain maximum spreads. At the same time, the participants on the quoted prices must be prepared to trade for a minimum amount. By placing orders for minimum kr. 1,000 the six banks, other members of the market for government bonds on the Copenhagen Stock Exchange and investors[4] may all influence the best bid and ask price.
In addition, new trading facilities have been introduced, e.g. automatch where matching buy and sell orders are automatically matched without one party having to confirm the deal first. This has, for instance, enabled retail investors to execute deals electronically and directly on the Copenhagen Stock Exchange without the investor's banker having to confirm the deal in advance.
The consequence of the new initiatives for liquidity and transparency in the market for government securities
The new market structure has existed for almost half a year and the market implications may be analysed based on the initial experience. In general, trading in the market for government securities is now more concentrated on a few markets where several participants concurrently set the prices. Basically, trading in a market with more concurrent buyers and sellers will boost market efficiency.
At the same time, the expansion of electronic trading has provided investors in Danish government securities with current access to information on tradeable prices in the market. Access to more and better pre-trade information enhances the transparency in the market and reduces the barriers to trade.
A number of different aspects of liquidity and transparency are considered in the following in order to gain a more comprehensive picture of the consequences for the market for government securities.
Trade volume is often used as the only indicator of market liquidity. However, Fleming (2003), among others, attaches more importance to other indicators for assessing market liquidity.[5] Thus, trade volume exclusively expresses the volume of executed deals, while liquidity generally expresses the possibility of trading should the need arise at a given time. A market may therefore be liquid even with a relatively modest trade volume. Several dimensions are used to assess the liquidity and transparency in the market. The liquidity ratios applied are described in Box 1.
Order coverage
In a liquid market tradeable prices are registered on an ongoing basis. The longer the system comprises tradeable prices, the better the opportunity for the investor to buy or sell government securities. The key ratio of order coverage is used as an indicator.
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Definition of key liquidity ratios
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Box 1
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In this article, the assessment of the transparency and liquidity in the government bond market is based on four key ratios: order coverage, spread, depth and trade volume. Individually the four key ratios are of limited information value, but taken as one they contribute to creating an overall picture of liquidity and transparency development in the trade in government bonds. Order coverage states the percentage of the trading day with concurrent bid and ask prices in the trading system. The investor is thus informed about the percentage of the trading day in which the investor can trade (buy or sell) an instrument. Spread is calculated as the time-weighted average of the difference between the bid and ask price during the interval of the trading day with order coverage, i.e. concurrent bid and ask prices. The spread captures the cost of buying an instrument and selling it immediately after. The unit is calculated in 0.01 price points (ticks). Depth expresses the amounts tradeable at the best bid and ask prices. Like the spread, depth has information value only when concurrent bid and ask prices are present in the system. Depth indicates to the investor the size of the amounts immediately tradeable at the best prices. The correlation between order coverage and spread is illustrated in the Chart below. The x-axis shows the time during a trading day while the y-axis shows the prices tradeable during the trading day. While these three key ratios indicate the possibilities of trading in government bonds, trade volume shows the amount actually traded for in the government bonds. |
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| Order coverage on MTS Denmark in 4 per cent 2008 on 16 january 2004 | |
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| Note: In this Chart the reported prices are determined as forward-looking averages for intervals of 5 minutes. If no order coverage occurs during an observation period of 5 minutes the Chart will show no order coverage during the entire observation period. The Chart thus illustrates that in "intervals without order coverage" there have been times without concurrent bid and ask prices for shorter or longer intervals. Source: MTS Denmark. |
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MTS Denmark
The development in order coverage on MTS Denmark shows that the market participants are able to see tradeable prices in the relevant government securities for around 95 per cent of the time from 8.30 am to 5.00 pm, cf. Chart 1. The drop in order coverage between Christmas and New Year is attributable to the suspension of the primary dealers' market-making obligation during that period.
| Order coverage in danish government securities on MTS Denmark in the period as from 4/11-2003 until 31/3-2004 |
Chart 1
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| Note: Danish government securities on MTS Denmark comprise all bullet loans with a remaining maturity of more than 13 months. The total order coverage is calculated as a simple average of the included securities in the time from 8.30 am to 5.00 pm. | |
| Source: MTS Denmark. | |
The order-coverage level reflects the characteristics of the primary dealer system. The primary dealers have an obligation to quote prices for five hours a day in the time from 9.00 am to 4.30 pm, which may explain that the order coverage on MTS Denmark is not 100 per cent. In the time from 9.00 am to 4.30 pm the order coverage is, however, almost 100 per cent, indicating that the primary dealers typically quote prices for longer than required in the agreement, cf. Box 2.[6]
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Use of price generators for quoting current bid and ask prices
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Box 2
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Electronic trading is primarily introduced in markets where standardised products are traded. Government bonds are precisely such a standardised product traded across national borders and priced in relation to other countries' government issues. German government bonds typically form the basis of price formation in Europe. The introduction of electronic trading has enabled the introduction of automatic price generators that quote bid and ask prices in Danish government securities during the day. Price quoting is typically executed on the basis of similar euro-denominated government bonds and government bond futures plus a spread. Price generators are primary used to save resources. One dealer can take care of several markets since the price generator will currently quote prices across markets and execute updates. Only for short time spans, e.g. around the release of key ratios, publications, etc., price quoting is frequently suspended due to the uncertain price formation. |
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The participants on MTS Denmark are able to see tradeable prices from the wholesale market via their direct links. Furthermore, there is public access, against a fee, to the real-time information via international market information suppliers. On MTS Denmark's website the information is available with a lag of 15 minutes[7].
The Copenhagen Stock Exchange
The development in order coverage in the market for government bonds on the Copenhagen Stock Exchange is shown in Chart 2. In connection with the launch of the price-quote scheme a considerable shift is seen where order coverage grows from less than 10 per cent to more than 90 per cent of the trading day.
| Order coverage in danish government securities on the copenhagen stock exchange in the period as from 31/3-2003 until 31/3-2004 |
Chart 2
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| Note: Danish government securities include bullet loans with a remaining maturity of more than 13 months. The total order coverage is calculated as a simple average of the included securities in the time from 8.30 am to 5.00 pm. | |
| Source: The Copenhagen Stock Exchange. | |
The shift reflects the changed market structure. Previously, the system contained prices e.g. during the short intervals when Government Debt Management executed tap issuances and buy-backs. Following the launch of the price-quote scheme six banks now have an obligation to quote current tradeable prices.
Similarly to MTS Denmark, the order-coverage level reflects the contents of the price-quoting agreement. As stated above, each participant in the scheme must quote prices on the Copenhagen Stock Exchange for 95 per cent of the time between 9.00 am and 4.30 pm. It appears from Chart 2 that from 8.30 am to 5.00 pm there are tradeable prices for approximately 95 per cent of the time.
Via their links, members of the Copenhagen Stock Exchange's market for government bonds have current access to view tradeable prices. In addition, some banks offer their customers access to view tradeable prices in real time via the web bank, in some cases for a fee. Furthermore, the prices are available with a time lag of 15 minutes on the Copenhagen Stock Exchange's website.[8]
The higher order coverage in the market for government securities means that the investors have better access to pre-trade information, which enhances market transparency.
Spread between best bid and ask price
The difference between best bid and ask price is the cost of buying an instrument and selling it immediately after. The difference can be interpreted as an expression of the efficiency of the price formation; the narrower the spread, the more efficient the price formation. The spread is e.g. determined by trading costs, the number of market participants and differences in maturity.
MTS Denmark
The development in spreads in the different maturity segments in the wholesale market MTS Denmark has been relatively stable since the introduction, cf. Chart 3. For securities in the maturity segments up to and including 10 years the spread is less than five ticks, equivalent to 0.05 points.
| Bid-ask spreads on mts denmark in benchmark securities and 7 per cent 2024 in the period as from 4/11-2003 until 31/3-2004 |
Chart 3
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| Note: The spread is calculated as a time-weighted average between best bid and ask price. | |
| Source: MTS Denmark. | |
The bid-ask spread is the same as in other wholesale markets for government bonds. The evolution of a more efficient Danish wholesale market for government securities is primarily attributable to the introduction of electronic trading and related market making. This has provided for more efficient trade execution by the market participants. At the same time, the launch of the MTS trading platform has contributed to attracting more international interest in Danish government securities.
In addition, Chart 3 shows that the spread widens as the maturity increases, reflecting the greater market risk associated with securities with longer maturities. It appears that 7 per cent 2024 differs from the other benchmark securities due to its special nature inter alia as regards maturity. The bond therefore requires price quoting for smaller amounts, resulting in a wider spread.
The Copenhagen Stock Exchange
Chart 4 shows the development in bid-ask spreads in the market for government bonds on the Copenhagen Stock Exchange. In general, the bid-ask spread is between 10 and 20 ticks for the various maturity segments.
| Spread in benchmark securities and 7 per cent 2024 on the Copenhagen stock exchange in the period as from 1/12-2003 until 31/3-2004 |
Chart 4
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| Note: The spread is calculated as a time-weighted average between best bid and ask price. | |
| Source: The Copenhagen Stock Exchange. | |
The spreads observed are an indication of the competition among all participants in the market, including the six banks that have an obligation to quote current prices. Other members of the market for government bonds on the Copenhagen Stock Exchange can enter bid and ask prices, which contributes to narrowing the spread. In addition, the introduction of new trading facilities has enabled investors to place their own orders directly in the system. Orders from investors thus affect the spread if the bid price entered is maximum kr. 1,000 and if the bid and ask prices narrow the spread between the best bid and ask price.
Market depth
Depth is a third indicator of liquidity. Depth is here calculated as the time-weighted average of the amount of bonds entered at the best bid and ask price.
MTS Denmark
The depth in the wholesale market on MTS Denmark is shown in Chart 5. It appears that on average during the entire trading day it is possible to buy or sell on a current basis for around kr. 100-150 million in the 5- and 10-year benchmark securities at the best bid and ask prices. The depth of the 2-year benchmark issue is somewhat greater, around kr. 300-350 million, which reflects less risk in the shorter maturity segments.
| Depth of best prices of benchmark securities and 7 per cent 2024 on MTS Denmark in the period as from 4/11-2003 until 31/3-2004 |
Chart 5
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| Note: The depth is calculated as a time-weighted average of tradeable volumes at best bid/ask price. | |
| Source: MTS Denmark. | |
The Copenhagen Stock Exchange
Chart 6 shows the development of depth in the market for government bonds on the Copenhagen Stock Exchange. It appears that government securities may be bought or sold in the benchmark segments and 7 per cent 2024 for around kr. 4-6 million at the best bid and ask prices. Equivalent depth applies to the other government securities included in the price-quote scheme.
| Depth of best prices of benchmark securities and 7 per cent 2024 on the Copenhagen stock exchange in the period as from 1/12-2003 until 31/3-2004 |
Chart 6
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| Note: The depth is calculated as a time-weighted average of tradeable volumes at best bid/ask price. | |
| Source: The Copenhagen Stock Exchange. | |
Total trade volume on the electronic trading platforms
Since the launch of the new measures the trade volume on the electronic platforms (MTS Denmark, the market for government bonds on the Copenhagen Stock Exchange, TradeWeb and BondVision) has increased, cf. Chart 7. The increased trade on electronic platforms is attributable to the introduction of new electronic trading platforms and to the inclusion of new participants, which has led to increased trade volume.
| Total electronic trade volume in danish government securities on MTS Denmark, the copenhagen stock exchange, tradeweb and bondvision and trade volume reported to the Copenhagen stock exchange in the period as from 31/3-2003 until 31/3-2004 |
Chart 7
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| Note: Danish government securities include all bullet loans with a remaining maturity of more than 13 months. All members of the Copenhagen Stock Exchange's market for government bonds are obliged to report all trades to the Copenhagen Stock Exchange. This trade volume appears from the reported trade volume. Not all participants on MTS Denmark are members of the Copenhagen Stock Exchange's market for government bonds. For TradeWeb and BondVision the figures are the average daily turnover calculated on the basis of monthly observations. |
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| Source: MTS Denmark, Copenhagen Stock Exchange, TradeWeb and BondVision. | |
In addition, Chart 7 shows that the trade volume compiled on the basis of reports to the Copenhagen Stock Exchange is rather consistent. The new initiatives have left the group of dealers subject to a reporting requirement to the Copenhagen Stock Exchange unchanged, but the new trading platforms have attracted several international banks that are active in the market for Danish government securities. For instance, the new market participants in connection with the introduction of MTS Denmark have contributed more than one third of the total trade volume on MTS Denmark.
On this basis the Chart indicates two general trends. Firstly, a large proportion of the trade via telephone among former and present market participants now takes place via electronic trading platforms. Secondly, the new measures have boosted the total trade volume as new market participants – that are not subject to a reporting requirement to the Copenhagen Stock Exchange when trading among themselves – account for a large proportion of the trade volume in the wholesale market.
[1] For more information on electronic trading and market making, see Danish Government Borrowing and Debt 2002, Chapter 9: Electronic Trading and Market-Making in Danish Government Bonds.
[2] For more information on the introduction of Danish government securities on MTS, see Danish Government Borrowing and Debt 2003, Chapter 9: MTS Denmark and the Primary Dealer System for Danish Government Securities.
[3] On TradeWeb, a maximum of five counterparties can be asked during a bid session, while on BondVision a maximum of four counterparties can be asked.
[4] Retail investors must place their orders via their bank or securities dealer, for example directly via their web bank.
[5] Fleming, Michael J. (2003), Measuring Treasury Market Liquidity, FRBNY Economic Policy Review.
[6] The characteristics of the primary dealer agreement for Danish government securities are in line with the requirements in other countries' government securities markets.