Market Participants' Behavior and Pricing Mechanisms in the JGB Markets -- Analysis of Market Developments from the End of 1998 to 1999 --

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.