SIZE AND HETEROGENEITY MATTER. A MICROSTRUCTURE-BASED ANALYSIS OF REGULATION OF SECONDARY MARKETS FOR GOVERNMENT BONDS

This paper deals with the economics of secondary markets for government bonds.Ultimately, the analysis is shaped by a public policy goal: assessing the elements ofa regulatory framework for these markets. In that regard, the decisive role of marketstructure leads to a critical review of microstructure conclusions relevant specificallyfor government debt markets. It is argued that the nature of information asymmetriesand matching costs in government debt markets determines a bias towards afragmented microstructure at odds both with exchange-like arrangements and withordinary regulatory approaches. Hence, a generic conclusion highlights the risks ofblindly transposing regulatory principles from the equity markets area without dueregard to the specifics of the bond market. As a specific application of this idea, thepaper critically reviews electronic trading platforms that emulate exchange-like orderexecution solutions. More specifically, the paper opposes the hybrid microstructure(pure limit order book plus affirmative quoting obligation) faced by European primarydealers and the arbitrage-based approach to market-making found in US interdealermarkets. The Citigroup disruptive trade in August 2004 is analyzed from thisperspective. Government bond regulation is argued to necessarily depart fromordinary approaches also because it captures the diverse interests of variousgovernmental agencies. As an application of this principle, the paper discusses repoand short-selling regulation in government bond markets. The atypical marketstructure and the multi-agency endeavour around government bond markets raisethe chances of regulatory failures. Nevertheless, it is argued that a reliance oncompetition, integrative infrastructure and basic systemic protections as overarchingprinciples for regulation is consistent with recommendations from relevanteconomic theory. Finally, political economy issues arising in implementation oftransparency, disclosure or retail investor protection will be addressed in the contextof selected country cases