Lessons on Govt. Debt Market Abuses

In last four articles, I covered pricing and issuance of govt. securities in open market (1), major policy initiatives taken to develop govt. securities market during the past 80 years (2), macroeconomic benefits of govt. debt market development (3) and major factors behind fluctuations in govt. securities markets (4). This 5th article is intended to share some background for reforming the abuse-hit markets in the public interest.

Background for Market Abuses

l Nature of Abuses

Securities market abuses are the issuances and trade of securities in violation of laws, rules and best practices/market ethics to gain undue advantages for profit. Insider dealings (trade based on unpublic or stolen information), creation of market shortages/squeezes to push prices, pumping and dumping (pushing up prices and selling at the peak) and collusive price fixing are well-known market abuses.

Outdated regulation, poor internal controls of regulators and market participants and their abused conduct are the major reasons for such abuses.

Undue Profit

Markets perform on profit motive. However, profiting through market abuses is unlawful and unethical. The controversial issue here is the calculation of profit based on accounting standards. Some dealers use accounting standards to inflate profit to show the market dominance whereas some hide actual profit. As securities trades are involved in frequently volatile prices on various trading instruments on each trade, the valuation of trades is a highly judgemental exercise. Securities held in portfolios are involved in marked-to-market valuations of unrealized profit/loss (under various standards such as trading, held-to-maturity and available for sale) where there is no cash inflow. The profit estimation of completed trades is easy as it is the realized buy-sell price margin. In general, unusually high profit earned fast raises public concerns over possible market abuses as such profit is considered as loss/cost to some others. Therefore, independent forensic audit is necessary to establish the profit gained through market abuses. However, there is no controversy about detrimental impact of market abuses on market development.

 Abuses in Finance

In general finance, long periods of clam in any market or institution signal the possibility of many dark corners of abuses prevailing without being detected because the network is so strong to cover up them for own benefits. The regulators generally fail to detect or reveal such abuses until they burst at some point. The regulators also cover up them by falling behind the confidentiality and contagion risk as such revelation will badly discredit their track records. Financial abuses/scandals in Sri Lanka are mostly burst in unauthorized deposit-taking business. Others are rarely revealed. Global financial literature is full of stories of abuses.

Bursts of financial abuses provide immense opportunity to clean up the system with new rules, regulations and people for another round of journey. For example, the past 10 years in global finance have been spent on cleaning up the mess and roots of the global financial crisis 2007/09 that hit the world due to abusive financial innovation and accounting taken place in banking systems since 1990s, despite armies of regulators.

Abuses in Sri Lankan Govt. Securities Market

Media reports during the past four years and the Report of the Presidential Commission issued on December 30, 2017 have revealed concerns over a massive scale of abuses in government securities market at both primary and secondary layers. Until the revelation of such information since March 2015, the public thought that the market from which nearly 50% of govt. debt was raised and traded as at end of 2014 was governed and participated by divine-like persons to the best interest of the public because neither any information on market irregularities nor state audit or investigation was reported. In opposite, as the stock market was widely transparent, some thought, based on some market reports, that the stock market was abusive.

The markets are about the transparency, trades, leverage, market capitalization and profit. As at end of 2014, stock market capitalization was nearly Rs.3 trillion (stocks at current market prices). The outstanding stock of Treasury bills and bonds (face value) was Rs. 4 trillion as at end of 2014 (nearly Rs. 5 trillion as at end of 2017) constituting one half of govt. debt where nobody knows the market capitalization or leverage or transactions or market price movements. This itself shows possible market abuses, especially issuance of govt. securities involving govt. funds.

Hope for Forensic Audits and Judiciary

In the case of alleged abuses and irregularities of the market by both the CB and market participants, nobody is still worried about cleaning up the marketplace. The government and CB have spent nearly one year to commence two forensic audits recommended by the Presidential Commission to establish the extent of the abuse and those who involved in, as part of the investigation process for prosecution purpose.

However, such forensic audits are planned and governed by those who abused the market in the CB. Meantime, the public who may not know the meaning of forensic audits wait for those audits to clean up and develop the market in order to derive its economic benefits (see my article in Daily News on February 20, 2019). Some political leaders unreasonably wait for law enforcement authorities and judiciary to clean up the market speedily, despite their completely different roles and processes.

Further, the Monetary Board without exercising its powers to implement even slight recommendations and findings of the Presidential Commission on market abuses has reinstituted both abused officials and systems. Given the wide purview of general powers of regulators, the CB does not need new laws to punish the abused. When regulators want to punish those they dislike, they somehow do it. Therefore, so-called “intermediaries” and officials who were instrumental in preparing the background for market abuses and gave false evidence as revealed from findings of Presidential Commission and contradictions of evidence provided at various investigations under oath continue with promotions, despite general standards of fitness and propriety tests. So long as the Monetary Board is represented by those intermediaries, the relevant CB officials are not able to initiate their supervisory actions as they are to avoid risks to their carrier positions.

No New Measures for Market Development

All investigations and professional views expressed during the past four years relate to irregularities and abuses alleged to have taken place in the govt. securities market during the past decades. The most have not read the Presidential Commission Report carefully and but talk on their initial imaginations. Such investigations, although intended to punish fraudsters, will also assist in developing the market if reform initiatives are taken based on the lessons from the investigations. This is the responsibility of good governments as they are funded by the govt. securities markets at fair costs to taxpayers. 

However, even market development and transparency initiated after 2015 (e.g., procurement of electronic issuance and trading and systems) with a lot of resistance have now been suppressed to facilitate the old system of the market dealers.

The US experience in Market Abuses

Govt. securities market abuses are not new to the world. The best learning outcome is the irregularities/abuses of a large securities primary dealer, Salomon Brothers (which merged with Travelers Group in 1997 who merged with Citicorp in 1998), during 1990 and 1991 in the US and reform process initiated in response.

Market Abuse by Salomon Brothers

The abuse was the submission of bids to competitive (multiple price) auctions to receive awards of Treasuries in excess of 35% of the auction amount. One of the US auction rules was the maximum amount of bids submitted by or accepted from any one bidder or related bidders limited to 35% of amount of the auction available to the public (This limit was not applicable to Federal Reserve Banks and foreign official institutions). This limit was intended to control any one party from taking too much from an auction and manipulating the price in the secondary market. However, Salomon Brothers abused the rule by submitting unauthorized customer bids along with own bids to secure awards higher than 35%.

This abuse which had been carried since 1990 was publicized through market rumour on unusual events surrounding the auction of two-year Treasury notes on May 22, 1991. In addition to state investigations, Salomon hired an outside counsel to conduct its own investigation. Accordingly, on August 14, 1991, Salomon disclosed that it had placed unauthorized bids at five auctions in excess of 35% limit to obtain a greater amount of the auctioned securities. Salomon's internal investigation revealed that, from late July 1990 through August 1991, Salomon had submitted unauthorized customer bids and bids in excess of the amount authorized by the customer in five Treasury auctions. However, awards in excess of 35% in two auctions were prevented due to proration of successful bids at the cut-off/bid stop-out yield. Salomon’s practice was to credit successful/awarded unauthorized customer bids to Salomon’s account as purchases from those customers.

Similar Rule-Abuses in Sri Lanka

At the Presidential Commission in Sri Lanka in 2017, evidence came that primary dealers also submit unauthorized customer bids at yield rates higher than what the customer authorizes where the yield margin (discount) on successful bids is the immediate profit to primary dealers. In the event such bids are rejected due to such unauthorized yield rates going above the cut-off yield, the customer loses the investment opportunity. The bidding on behalf of other dealers and bidding in pockets through acting in concert by dealers above prevailing market conditions also are similar market abuses.

The auction rule for dealers to submit bids minimum 10% of the auctioned amount in Sri Lanka also is grossly abused by primary dealers by submitting “dummy bids” (bids at excessive yield rates to be rejected) where the CB as the regulator and issuer took no action to prevent it. This rule is to ensure that primary dealers mobilize funds and channel to auctions to satisfy govt. funding needs. The Monetary Board-controlled EPF which made directed bids up to 2015 also started making “dummy bids.” However, all supplied funds at directed yields to private issuances that are now under forensic audit as recommended by the Presidential Commission.

Professional study

While relevant authorities investigating the abuses to be punished in law, Secretary to the Treasury, Chairman of Securities and Exchange Commission and Chairman of Federal Reserve Board who are the top officials involved in market regulation studied the market conduct and submitted a joint report on January 22, 1991 to the US government with recommendations to further develop the market. They did not collaborate with media and politicians to destabilize the economy and the government. The report was undisputable due to their top official positions.

The Report that consisted of 171 pages covered Background on the Treasury securities market, Treasury securities market issues, the events involving Salomon Brothers and alleged government securities market abuses, background on the Government-Sponsored Enterprise

securities market and the primary dealer system.

In the report submission letter, they noted “The recent widely publicized events involving abuses in the government securities market have prompted us to undertake a thorough review of the market that the federal government relies upon to meet its borrowing needs. The Federal Reserve Bank of New York was a full participant in this review, and its views are reflected here as well. Our recommendations for legislation and changes in policies are contained in this report. We believe that these reforms will improve the fairness and efficiency of the market, to the benefit of taxpayers and investors alike. We urge the Congress to move swiftly in enacting our legislative recommendations.”

The Report also stated among others that “The Agencies (Fed, SEC and Treasury) do not believe that the government securities market is flawed or broken in any fundamental economic sense. However, serious problems have arisen, and these problems suggest that various aspects of the efficient operation and regulation of this marketplace can be improved. Indeed, the events described above suggest several specific areas for improvement, including better enforcement of auction rules and more effective methods of preventing and alleviating “short squeezes.” The improvements recommended in this report include some basic reforms that are designed to lessen the potential for fraud and misconduct and to increase the Agencies’ ability to detect such misconduct when it occurs.”

If a similar official study is done for Sri Lanka independently, it would state that “the government securities market is flowed and broken in all fundamental economic sense and laws where the monetary policy has unlawfully become rather debt management policy. Serious problems suggest the need for revamping the market to set up a modern market with separated responsibilities between the Treasury, regulators and monetary policy in law.”

Few remarks

In this background, a series of reform measures were introduced in the US to further deepen the market and improve the efficiency, liquidity and price discovery. Reforms included steps aimed at broadening participation in auctions, stronger enforcement of auction rules, more formal surveillance of Treasury market, changes to Treasury auction policies and modifications of requirements for primary dealers.

As a result of market development, the US government securities market now has a live and transparent yield curve that drives not only US financial markets but also financial markets of many countries through capital flows. It also effectively provides for fast transmission mechanism for the monetary policy and a market benchmark for the term structure of interest rates for the economy.

Therefore, current revelations in Sri Lanka should be of high priority if the Sri Lankan government wishes to resolve the public debt problem at least next decade. The debt problem will not be resolved unless govt. securities market is deepened and fair with best practices of regulation and surveillance where fiscal front is disciplined through the market mechanism.

However, the government is not seen taking any policy initiatives while letting the CB to do the needful. It is like waiting for a thief to come back with ways to stop thefts. The recourse to old system of privately issued debts in disguise of so-called hybrid system to reduce the cost through the state captive funds at the control of primary dealers will only worsen the prevailing debt problem at a higher cost to the public in future soon. If the economists of the government go with so-called professional international economists of the CB in relation to govt. securities market, it is advisable that the government goes back to pre-1977 economic bureaucracy too for the whole economy. Those who manage debt in market abuse would migrate to their foreign residencies soon by leaving all debt and market problem with the new generation of residents.

(The writer is a former Deputy Governor of the CB and chairman and member of 6 Public Boards with nearly 35 years of public service. He authored 5 economics and financial/banking books and more than 50 published articles.)