Solving the conundrum of emerging market illiquidity

May 2023 Updated

A view from the CDB AG Collateral Conference

Developed markets are plagued by negative interest rates, anaemic economic growth and poor returns on capital. But despite this, investors are not clamouring for increased exposure to emerging or frontier markets, especially not local currency bonds issued onshore in those markets. As a result, local markets can remain undeveloped, illiquid and unequal to the task of financing local development.

A liquid cash market is a pre-requisite for attracting foreign investment and one way of getting it is to create a repo market so that market-makers know they can fund their activity and narrow the bid-offer spread.

The developed market’s regulatory push to increase the use of collateral and central clearing has not been good for emerging market assets. “We have created a situation where emerging markets are now more locked out of the system than they were before,” says Philip Buyskes, the CEO of Frontclear, a financial markets development institution established in 2016 to create more stable and inclusive interbank markets in emerging and frontier markets. “If you are a bank in Latin America or Africa, no one wants your bonds as collateral or as HQLA. And if emerging market bonds are not used as collateral then they will remain illiquid and local banks will have limited market access.”

To break this vicious circle, Frontclear guarantees counterparty credit risk in emerging markets in both over the counter and exchange traded markets, covering repos, derivatives, securities lending and trade finance instruments. This allows the large global banks to operate in places where they would not otherwise. A case in point is Ghana where Frontclear worked with SG to guarantee a repo using local bonds as collateral. “We are now on the cusp of creating a fully functioning repo market in little over twelve months,” says Buyskes.

Repo transmission

The focus on money markets and the very shortest part of the curve challenges existing development theory. This posits that governments should establish five- and ten-year benchmarks, which then allows a credit curve to be built with yields for corporate and other issuers determined by the risk free rate plus a credit spread. But this is not enough in a global financial system that now places a premium on liquidity and eligibility.

“Liquid local bond markets are very important for local economies,” says Gursu Keles, Principal Trader at the European Bank for Reconstruction and Development in London. “Repo markets are really important as they allow local banks and other agents in the economy to manage their risks within their own markets. Once you have established repos you can then develop interest rate swaps markets, which further allow policy makers to anchor their short-term curve. Repos also bring in local pension funds and corporates into the money markets.”

Establishing an overnight interest rate via a functioning repo market is a key building block of a yield curve. Without these benchmarks, it is difficult to use floating rate products and their derivatives, which allow for interest rate hedging. And if investors cannot hedge these risks in what they perceive to be volatile markets, they will likely stay away. “A good repo market lowers the bid offer spread for dealers, and reduces the carry cost of securities,” says Kritika Amarnath, Executive Director at Morgan Stanley International in London. “Liquidity matters but you also need an established cash bond market and an FX market, which will then drive the rest.”

Amarnath believes the illiquidity besetting emerging markets financing is largely due to an inability for these assets to be funded by typical secured funding investors. If the demand for funding emerging market assets is there, then banks such as Morgan Stanley will add those assets to collateral schedules in its central liability stack. The question then becomes how to increase the demand.

Amarnath sees two key areas of change that would make an impact. Firstly, collateral eligibility should be based on ratings rather than individual issuers. This would increase transparency and consistency of how emerging market securities are considered in the overall collateral mix. Secondly, she believes that those investors that have an emerging markets long-only mandate need to also accept emerging market assets as collateral. “If you own it then you should accept it as well,” she says.

For Buyskes, another solution is for large institutions to establish local operations. Without the global banks and other institutions that operate the global market infrastructure being present in these markets, it is hard to increase liquidity into them. “There is demand for exposure to these fast-growing economies, but we find that custodians and other market infrastructure players are just absent,” he says. “To get more emerging market liquidity, you need scalable, triparty solutions. I cannot say this enough.”

But relying on foreign institutions can be a risk for emerging economies. When global risk appetites change, international banks, insurance companies, and other institutional investors tend to pull back from emerging markets and regroup in their home markets. To that end, developing a deep, liquid local investor and institution base is critical. “A domestic investor base needs to be as diverse as possible,” says Keles. “It is good to have foreign investors, but it is sporadic and related to global risk appetites. It is better to have a broad and deep local investor base, in particular pension funds.”

All markets are different. And it would be wrong to assume that there will be a simple formula for bringing liquidity into emerging markets. But even so, if institutions and regulators were able to be more flexible when detailing the collateral they would accept, this would provide a huge boost in demand for emerging market assets, bringing liquidity, fresh demand and development to these markets.