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Market Participants' Behavior and Pricing Mechanisms in the JGB Markets

-- Analysis of Market Developments from the End of 1998 to 1999 --*1

April 19, 2001
Yosuke Shigemi
Sotaro Kato
Yutaka Soejima
Tokiko Shimizu

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  • *1This paper is an English translation of the Japanese original released in March 2000.


Enhancing market liquidity and efficiency in government bond markets is a central issue which needs to be addressed so as to ensure that the yield curve, which acts as the benchmark for yen interest rate instruments, is smoothly determined and reflects prevailing market prices. An efficient government bond market is indispensable from the standpoint of financial policy operations in order (1) to secure reliable information which reflects market participants' outlook on interest rates, and (2) to carry out smooth market operations using government bonds. However, there are various problems with respect to the government bond markets, related to both market structure and the behavior of market participants, and thus they are vulnerable to stress. The experience of summer 1999, where a widespread decline in market liquidity was observed in the government bond markets prompted in part by a shock which materialized in the repo market, is still fresh in our minds.

In this paper, we explore various developments in Japanese government bond markets, focusing on the connection between the behavior and incentives of market participants and the effect they have had on market liquidity. More specifically, we examine the various problems (pricing difficulties and the impact on earnings, for example) faced by market participants and the accompanying decline in the market making activities, based on quantitative analysis and the results of questionnaire and interviews conducted by the Financial Markets Department.

The key points are as follows.

Macro dynamics and behind-the-scenes working of micro-mechanisms

Macro Dynamics

Concern over the supply and demand of JGBs was mounting between the autumn of 1998 and the end of the year. In December 1998, the long-term interest rate rose by 105bps in one month, marking the highest rise in 20 years. This was prompted in part by the announcements made by leading figures with regard to fund management by the Trust Fund Bureau. The markets were in turmoil in June 1999, when the change in the most active bond futures contract was delayed. Just before the change in the most active contract, there was a sudden switch in the cheapest to deliver issue (hereafter, CTD issue), and the lending rate for the issue rose above 1 percent. In August 1999, the lending rate for the CTD issue rose above 2 percent. This occurred against a backdrop of moves to avoid the super-long (20-year) government bond, which was hampered by poor liquidity, to become the CTD issue, and a decline in the efficiency of the repo market as a result of concerns over the Y2K problem. Thus, the non-arbitrage relationship between the cash, futures, and repo markets and market liquidity deteriorated.


In the background to the above-mentioned macro dynamics, there was a global tendency among market participants engaged in arbitrage trading to withdraw from the markets, prompted by the near collapse of LTCM in the summer of 1998. As a result of the decline in the ability of market participants to supply market liquidity, structural problems came to the fore once again. The increased pessimism of market participants over the certainty of market developments, due to concerns over the Y2K problem and the liquidity problem in the cash market amplified the vulnerability of JGB markets, such as pricing mechanisms heavily relying on futures and the immature repo market. The costs associated with market making rose, along with a decline in the effectiveness of hedging and an increase in inventory risk. As a result, the market mechanisms which compensate for a decline in market liquidity did not come into play, and market liquidity declined further. The low level of price sensitivity on the part of investors, which had been pointed out for some time, is considered to have been another reason why the liquidity supply mechanism within the market failed to function.

An examination of micro-mechanisms

Under these market developments, many dealers were confronted by the limitations of their pricing methods. The pricing methods employed by the majority of participants are broadly divided into those based on (1) cash prices for similarly dated issues, (2) CTD issue price, calculated from the futures price, and (3) yield information from other markets, such as the swap market. The relative performance of each of these methods differed when the futures and repo markets experienced unstable market conditions between June and September 1999. While the performance of pricing methods based on futures and swaps deteriorated, the performance of a method based on cash prices for similarly dated issues showed relative improvement, which agrees with the views obtained from market participants through our questionnaire.

Furthermore, when considering dealer pricing behavior and investor behavior, it is necessary to give careful thought to bias originating in the characteristics and attributes of individual issues. We thus conducted our analysis using a spline curve to eliminate this bias. While there is only a small element of bias when pricing on-the-run issues which enjoy high liquidity, there is a strong tendency to attach a relatively low price to issues with remaining life close to CTD issues, influenced by futures prices. This induces the tendency for issues with remaining life close to both sides of CTD issues to be priced relatively high. There is also a tendency for low coupon bonds such as the JGB 207th issue to be priced cheaply, reflecting the low level of liquidity.

Issues for further discussion

As a result of the series of studies undertaken for this paper, we observed that in the background to macro-market developments such as an increase in volatility, a deterioration in the non-arbitrage relationship, and a decline in market liquidity, micro mechanisms exists, such as a reduction in positions accompanying difficulties over pricing and hedging by market participants, and a decline in the market making activities. Light is shed on the relationship that the macro-market environment, comprising market prices and market liquidity determined as an aggregation of micro trends among a diversity of market participants, was in its turn influencing the incentives and behavior of market participants.

There are two issues in the JGB market which need to be addressed in the future. First, in attempting to improve the efficiency of JGB markets, as well as creating a more balanced relationship between the cash, futures, and repo markets, it will be necessary to eliminate factors that hinder the liquidity supply function within the market. Second, in monitoring macro-market developments, it is important to enhance our understanding of the interplay with background micro mechanisms, and the factors influencing the functioning of the market. In this regard, it is important to enhance the capacity and organization necessary for conducting appropriate analyses. The aim of these efforts is to contribute to securing information on interest rates which accurately reflects the prevailing market prices, which is indispensable from the standpoint of monetary policy and improving the effectiveness of market operations. It is important that both market participants and the related authorities play an active role in these efforts.