1

Developing the Government Bond Market in Korea

after the Financial Crisis:
Performance Evaluation Using Micro-data
Daekeun Parka, Changyong Rheeb and Sung Hwan Shinc,

October 2006

Abstract
To develop the secondary market for government bonds, the Korean government took a unique
strategy of developing an exchange market based on an electronic trading platform in addition to the
OTC market even though there was the risk of dividing the liquidity between two markets. We
evaluated the effects of introducing the electronic trading system for government bonds and imposing
the trading requirements on the KRX market and the OTC market in Korea using the intraday trading
data for government bonds from both of the markets. Our analysis confirms that the liquidity of the
KRX market has improved significantly after the imposition of the trading requirements. What is
more, these benefits did not come at the cost of the OTC market. On the contrary, our analysis using
the intraday trading data shows that the liquidity and the transparency of the OTC market has improve
as well after the imposition of the trading requirements though there is still some room for
improvement in the transparency of the OTC market..

I. Introduction

Since the Asian financial crisis of 1997 the government bond market in Korea has achieved an
outstanding improvement in quality as well as in quantity. The government bond market has grown in
size as the issuance of government bonds increased dramatically to finance the efforts of much needed
financial restructuring and economic recovery in the aftermath of the financial crisis. In addition, in
response to the needs to reduce the cost of issuing and servicing the enormous amount of government
bonds, the Korean government took measures to enhance the institutional framework and the
infrastructure for the government bond market. These reform efforts resulted in the introduction of the
Dutch auction system to replace the old compulsory underwriting system, the primary dealer system,
the DVP(delivery versus payment) settlement system, the reopening system, the marking-to-market
system, the repurchase agreement market, the KTB(Korea Treasury Bond) STRIPs and so on.
Among the institutional reform measures was the introduction of the Korea Exchange Government
Bond Market (hereafter the KRX market) in March 1999. The KRX market, which was built upon an
electronic trading platform, was established with the intention of enhancing the transparency and the
liquidity of the secondary market for government bonds. As a result of establishing the KRX Market,
the secondary market for government bonds in Korea has been divided into two markets: the OTC
market and the KRX market. In order to boost the trading activities in the KRX Market, the
government also introduced the compulsory trading requirements in October 2002 mandating that the

primary dealers (PDs) should trade benchmark issues of the governments bonds in the KRX market
alone.
Traditionally, the over-the-counter (OTC) trading where bonds are traded between dealers through
different forms of voice message system has been the dominant form of bond trading. The recent
trend among the developed countries, however, is the one towards the electronic trading platform
replacing the voice message system (BearingPoint, 2005). A good example of the electronic trading
platform for bond trading can be found in the EuroMTS and the MTS (Mercato dei Titoli di Stato)
system of the individual European country. It is widely understood that the electronic trading system
enhances efficiency of the secondary bond markets by reducing the transaction costs and by making
the trading process transparent. As a result, it is expected that the imposition of the mandatory trading
requirements to boost trading activities in the KRX market will be helpful in enhancing transparency
and efficiency of the overall government bond market in Korea. On the other hand, however, it is also
argued that introduction of the KRX Bond Market and imposition of the mandatory trading
requirements may undermine the efficiency of the government bond market by restricting the trading
activities of the primary dealers and by dividing market liquidity between the OTC market and the
KRX market. Thus, whether the imposition of the exchange trading requirements has been beneficial
to the entire government bond market in Korea remains an empirical question.
Finding the answer to this question will have important implications for other Asian economies
that try to develop the domestic bond markets. Recently, there has been a great deal of discussions and

efforts to develop bond markets in Asia driven by the realization that the Asian financial crisis of 1997
could have been avoided or mitigated had there been well developed bond markets in the bank
dominated Asian countries. In developing the domestic bond markets, Asian countries can take a
strategy of introducing and developing the exchange market based on an electronic trading platform at
an early stage instead of trying to develop the OTC market. Such a strategy is worth taking only if the
benefit of greater transparency in the exchange market could more than offset the cost of dividing
liquidity between the exchange market and the OTC market.
Christodoulopoulos and Grigoratou(2005) evaluated the effect of introducing HDAT, an organized
trading venue based on an electronic trading platform in Greece by measuring liquidity in the Greek
Government Securities Market. HDAT was introduced because of the limited transparency, liquidity
and efficient in the OTC market where the bid-ask spread occasionally exceeded 500 basis points.
Calculating six different measures of liquidity using micro data, they found that liquidity in the
Government Securities Market has been enhanced significantly. They did not, however, evaluate the
effect on the liquidity in the OTC market due to limited availability of data.
In this paper we evaluate the effects of introducing the electronic trading system for government
bonds and imposing the trading requirements on the KRX market and the OTC market in Korea using
the intraday trading data for government bonds from both of the markets. The main findings of this
paper are as follows.
First, introduction of the KRX market and imposition of the mandatory trading requirements have

been effective in increasing the trading volume of the KRX market and the trading share of the KRX
market in the entire secondary market for government bonds. The trading requirements on benchmark
issues have also boosted transactions of non-benchmark issues. In addition, the exchange trading
requirements on primary dealers have also helped to bring in other players into the exchange market.
The bid-ask spreads on government bonds in the KRX market has also fallen after the measures to
boost trading activities in the KRX market were taken.
Second, the increase of the trading volume in the KRX market did not come at the expense of a
lower trading volume in the OTC market. In consequence, we can conclude that the introduction of
the exchange trading requirements for benchmark issues was helpful in improving the overall trading
activity of the entire secondary government bond market in Korea.
Third, the volatility of the KRX market as well as the OTC market decreased significantly since
the introduction of the exchange trading requirements. Yet, various measures of volatility such as the
daily standard deviation of transaction prices and the intraday range of transaction prices demonstrate
that the OTC market is more volatile than the exchange market. In addition, these volatility measures
displayed quite a few abnormal values in the OTC market.

Further analysis reveals that these

abnormal values can be ascribed to lack of transparency in the OTC market rather than to fundamental
macroeconomic shocks.
Fourth, the MEC (market efficiency coefficient) estimated from the intraday trading data and the
execution costs derived from the estimates of the MEC demonstrate that the exchange trading

requirement has not only improved the liquidity and the efficiency of the KRX market but added
greatly to the efficiency and liquidity of the OTC market.
This paper is organized as follows: Chapter II summarizes the changes in the government bond
market in Korea after the financial crisis including the introduction of the KRX Government Bond
Market and the imposition of the exchange trading requirements. Chapter III investigates the effects
of imposing the exchange trading requirements on the KRX market and the OTC market using
intraday trading data. Chapter IV analyzes the effects of the mandatory trading requirements on the
liquidity and the transparency of the secondary government bond markets in Korea by estimating the
MEC and the execution cost using a micro data. Chapter V presents our conclusions.

II. Changes in the Government Bond Market in Korea

Growth of the Government Bond Market after the Currency Crisis

Before the currency crisis of 1997, the government bond market in Korea was in a rather stagnant
state. Because of the emphasis on a healthy fiscal balance, the volume of bond issuances fell far short
of the amount needed for an active secondary market to develop. The old regime of compulsory
underwriting under which government bonds were issued at yields-to-maturity lower than the market
interest rate provided little incentive for the secondary market to develop (Kang, Kim and Rhee,
2005).
After the financial crisis, however, issuance of government bonds rose dramatically boosted by the

need to support the efforts of financial restructuring and economic recovery. As we can see from
Figure 1, the outstanding amount of government bonds 1 which stood at 25 trillion at the end of 1996
has increased almost eightfold to 205 trillion by the end of June 2005. As we can see in Figure 2, the
government bond market was much smaller than the corporate bond market before the currency crisis
with the outstanding volume of government bonds amounting to a third of that of corporate bonds.
After the currency crisis, however, the outstanding amount of government bonds has grown
continuously to surpass that of corporate bonds by the end 2003. Figure 2 shows that new issuance of
government bonds in 2004 has grown sevenfold to 75.8 trillion compared to 11trillion in 1997.
(Figure 1 and 2 about here)
(Table 1 about here)
Alongside the quantitative growth, the qualitative aspect of the government bond market has also
improved significantly through institutional reforms and infrastructure build-ups. The efforts to
develop government bond markets have been driven by the need to reduce the cost of issuing and
servicing government bonds whose amount has grown dramatically to support the efforts of
restructuring financial system in the aftermath of the financial crisis. Table 1 summarizes some of the
major policy measures taken by the government to develop government bond markets in Korea

Introduction of the KRX Electronic Bond Trading System

One of the reform measures taken by the Koran government to improve the government bond
market was the establishment of the KRX Government Bond Market in 1999. The KRX market was

initially set up exclusively for trading among government bond dealers. Later, brokered trading
through securities companies was allowed. The secondary market for government bonds in Korea
comprises two markets: the OTC market operated by the Korea Security Dealers Association (KSDA)
and the KRX market operated by the Korea Exchange. 2
The KRX Government Bond Market adopted an electronic trading platform named the KRX
Electronic Bond Trading System (the KTS). In general, secondary markets for bonds have developed
in the form of an OTC market rather than a centralized exchange. In the OTC market, final investors
who wish to trade bonds search for the best price quote by making calls to several dealers and make a
deal with the dealer who offers the best price quote. The inefficiency and the obscurity that arise from
the typical search process in the OTC market have lead to the recent trend in the developed markets
such as the U.S. and Europe that more and more bond transactions are executed through electronic
trading systems.

Introduction of the Mandatory Exchange Trading Requirements

When it was first established in 1999, the trading in the KRX market was so sluggish that the
KRX market was not able to perform the function of price discovery properly. In October 2002, the
government imposed trading requirements on the primary dealers of government bonds to activate
trading in the KRX government bond market making it compulsory for the primary dealers to make all
the trades of benchmark issues and at least 20% of the trades of government bonds in the KRX market.

In January 2003, the mandatory trading requirements were strengthened with the minimum trading
proportion raised from 20% to 40%.3
The imposition of mandatory exchange trading requirements has been effective in activating
transactions in the KRX market.4 According to Figure 3, the transaction volume of government bonds
in the KRX market, which was almost negligible before October 2002, has increased greatly after the
imposition of the trading requirements.
(Figure 3 about here)
Figure 4 shows that the share of the KRX bond market in the secondary trading of the benchmark
issues has also risen after the imposition of the trading requirements. The KRX bond market used to
have a mere 10% share in the secondary trading of benchmark issues but the share has risen to 50% after
the government introduced the mandatory exchange trading requirements.
(Figure 4 about here)
The mandatory exchange trading requirements have also been effective in increasing the trading
volume of non-benchmark issues in the KRX market. Figure 4 shows that the share of the KRX bond
market in the secondary trading of non-benchmark issues also rose from 10% in September 2002 to
25% in January 2003 although non-benchmark issues were only partially subject to the mandatory
trading requirements.
Imposition of the trading requirements on the primary dealers has also contributed greatly to
attracting other players to the KRX bond market. According to Figure 5, the share of the KRX bond
market in the government bond trading of the primary dealers rose from 30% in April 2002 to

approximately 50% in January 2003. Figure 5 also shows that the share of the KRX market in the
government bond trading of the dealers who are not primary dealers has also grown from 3% in April
2002 to 20% in April 2005. Such a phenomenon well demonstrates the characteristic of bond markets
that liquidity attracts liquidity. That is, the higher liquidity in the KRX bond market resulting from
increased participation of primary dealers has also attracted other dealers to the exchange market.
(Figure 5 about here)
The fact that trading requirements were able to attract other participants to the exchange market
can be also verified from Figure 6 that shows the trading volumes in the KRX market by different
types of dealers. As we can see from the figure, it is not the transaction between primary dealers but
the transaction between a primary dealer and a non-primary dealer that has the largest trading volume
in the exchange market.
(Figure 6 about here)

Reduction in the Bid-Ask Spreads

The benefit of developing the electronic trading system for government bonds can be also
confirmed by taking a look at the bid-ask spreads in the KRX market. As we can see from Figure 7,
the bid-ask spreads that used be over 18 bps before the trading requirements were introduced has been
reduced to 3.5 bps in 2005.5 Normally, the bid-ask spreads are used as an indicator of market liquidity.
(Figure 7 about here)

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III. The Trading Requirements and the Government Bond Market

Chapter II demonstrated that the introduction of the electronic trading system and the imposition
of the mandatory trading requirements were effective in enhancing the trading activity and the
liquidity of the exchange market. However, if these benefits were available at the cost of the OTC
market in terms of a reduced trading volume or a lower level of liquidity, then we cannot conclude that
the introduction of the electronic trading system was a definite benefit to the government bond market
as a whole.
As mentioned in the introduction, one of the most important objectives of introducing the
electronic trading system was to enhance the efficiency and the transparency of the OTC market as
well as the exchange market by ensuring more transparent dissemination of the transaction prices. In
this chapter, we present a variety of measures of market performance calculated using the intraday
trading data from the KRX market and the OTC market to assess the effects of the electronic trading
system on the transparency and the efficiency of these two markets.

Transaction Volume
Figure 8 shows the monthly transaction volume of the Korea Treasury Bonds (KTBs) and the
Foreign Exchange Stabilization Fund Bonds (FESFBs)6 in the KRX market and the OTC market for
the period from January 2000 to April 2005. In addition, the solid line in the figure shows the share of
the KRX market in the monthly turnover of the KTBs and the FESFBs in the entire secondary market.

11

Table 2 presents the annual turnover of the KTBs and the FESFBs in the KRX market and the OTC
market together with the share of the KRX market.
(Figure 8 about here)
(Table 2 about here)
If we take a look at Figure 8, we can observe a dramatic increase in the transaction volumes of
the KTBs and the FESFBs in the KRX market after the introduction of the exchange trading
requirements. The annual transaction volume of the KTBs and the FESFBs in the KRX market
amounted to 42.6 trillion in 2002 but it has skyrocketed to 207.9 trillion in 2003. As a result of
the dramatic increase in the transaction volume, the share of the KRX market in the entire secondary
market turnover has also risen from 11.0% in 2002 to 31.4% in 2003.
Figure 8 and Table 2 also demonstrate that the monthly turnover as well as the yearly turnover in
the OTC market has also increased noticeably after the imposition of the trading requirements. The
fact that not only the transaction volume of government bonds in the KRX market but that in the OTC
market has also increased after the imposition of the trading requirements supports the argument that
the introduction of the electronic trading system and the imposition of the trading requirements have
contributed to enhancing the trading activities in the entire secondary market for government bonds.

Turnover Ratio
The fact that the imposition of the exchange trading requirements on benchmark issues has been
effective in invigorating the trading activities in entire secondary market for government bonds can be

12

also verified from Figure 9 that shows the monthly turnover ratio of the KTBs and the FESFBs in the
KRX market and the OTC market and from Table 3 that presents the yearly turnover ratios. 7
Both of Figure 9 and Table 3 clearly demonstrate that the turnover ratio of the KTBs and FESFBs
in the KRX market has increased significantly after the imposition of the exchange trading
requirements. For example, the yearly turnover ratio for government bonds in the KRX market has
risen from 59.6% in 2002 to 246.7% in 2004 and is still on the rising trend. Meanwhile, the turnover
ratio in the OTC market decreased only slightly even though the exchange trading requirements for
benchmark issues have been put in place so that the overall turnover ratio in the entire secondary
market for government bonds has also increased. Once again, such findings can be interpreted to
indicate that strengthening the trading activities in the KRX market was achieved without sacrificing
the trading activities in the OTC market.
(Figure 9 and Table 3 about here)

Standard Deviation of Transaction Prices

In order to assess the effect of the exchange trading requirements on market volatility, we
calculated the standard deviation of the transaction prices 8 using the intraday transaction data available
from the KRX and the KSDA. Figure 10 shows the estimated daily standard deviation of the
transaction prices quoted in terms of the yields to maturity for the 3-year KTBs for the period between
May 2000 and February 2005. Instead of presenting the standard deviation for individual bonds,
Figure 10 shows the mean of the standard deviations for the entire 3-year KTBs with remaining term

13

to maturity of no less than 30 months.9

(Figure 10 about here)
Figure 10 clearly demonstrates a clear difference in the volatility of the transaction prices in the
KRX market between the two periods divided by the introduction of the trading requirements: the
volatility of the KRX market as measured by the standard deviation of the transaction prices fell
precipitously after the trading requirements were put in place.
Figure 10 shows that the volatility of the transaction prices in the OTC market has decreased as
well after the imposition of the trading requirements. It should be clear why the OTC market has
become less volatile when the trading requirements were put in place in the KRX market and not in
the OTC market.

It is because the implementation of the trading requirements provided the

participants in the OTC market with a reliable reference price for government bonds. Although the
transaction prices in the KRX market had been available to the participants of the OTC market before
the implementation of the trading requirements, the KRX government bond market had been too thin
and too volatile for the market participants to accept the transaction price in the KRX market as the
equilibrium price that correctly reflects the market demand and supply. After the implementation of
the trading requirements, however, the KRX market has become more active and less volatile so that
the participants in the secondary market began accepting the transaction prices in the KRX market as
the market price that accurately reflected the demand and supply condition and began using them as a
benchmark for their transactions. Use of a common reference price for the deals in the OTC market

14

naturally resulted in convergence of the transaction prices in the OTC market. This demonstrates how
the introduction of the trading requirements did not only help improve the liquidity and the efficiency
of the exchange market but also enhance the stability and the transparency of the OTC market.
Although the OTC market has become less volatile, we can still find quite a few extreme values
for the standard deviation in the OTC market. Looking at Figure 10, we can tell that the OTC market
is more volatile than the KRX market. In addition, we can observe quite a few excessive values in the
standard deviation of the transaction prices in the OTC market. An excessive value of the standard
deviation indicates that at least one of the transactions was conducted at an abnormal price during that
day. Existence of such outliers in the intraday transaction prices may be interpreted as a piece of
evidence of the shortage of transparency in the OTC market.
It is still possible to argue that these outliers occurred as a result of new information shocks
creating turbulence in the entire bond market. We conclude that such an argument cannot explain the
existence of these outliers for the following reasons.
First, we calculated the daily standard deviation for each individual bond and identified that dates
on which the standard deviation has excessively large values. Examining these dates, we found that
the dates on which each individual bond has extremely large values of standard deviation do not
coincide with the dates on which other bonds have extremely large values of standard deviation.
Therefore, it is difficult to conclude that these outliers were caused by common economic shocks that
affected the entire bond market simultaneously.
Second, we investigated whether there were any macroeconomic events that would have had a

15

significant effect on the government bond market on the dates when the outliers for each individual
bond occurred but failed to find any meaningful macroeconomic events that could explain the
occurrence of the outliers.
Third, we also examined whether the transaction price of the benchmark issues showed abnormal
movements on the dates when the outliers for each individual bond occurred but failed to find any
significant movement in the benchmark issues.

For example, the daily standard deviation of

transaction prices of the 3-year KTB, KR1035017P32, was 0.27 on 17 August 2004, which is almost
ten times the average daily standard deviation. To see whether there had been any macroeconomic
shock on that particular day, we investigated the movement of the transaction price of the benchmark
issue for the 3-year KTB on that day.

During that particular day, the transaction price of the

benchmark issue changed only by 3 bps, which by no means can be regarded as a dramatic change. In
addition, we found that on that day there was a 22.6 billion worth of bloc trading of the
KR1035017P32 at the yield to maturity of 4.5% which was far above the average transaction yield on
that day.
As is illustrated by the case explained above, the majority of the outliers cannot be attributed to
macroeconomic shocks that affected the entire government bond market simultaneously. On the
contrary, it is lack of transparency in the OTC market that is responsible for most of the outliers.
Although various reform efforts have been made to improve the transparency and the efficiency of the
government bond market including the OTC market, existence of the outliers in the OTC market

16

indicates that there still is a lot of room for improvement.

Range of the Intraday Transaction Prices

Besides the standard deviation of transaction prices, market volatility can be assessed by the
range of transaction prices as well. Figure 12 shows the range of the intraday transaction prices
calculated as the difference between the maximum and the minimum of the intraday transaction prices
for the 3-year KTBs issued in 2002. As was the case with the standard deviation of the intraday
transaction prices, the intraday range of the transaction prices in the KRX market has decreased
significantly when the exchange trading requirements were put in place. Figure 12 also shows that the
mandatory trading requirements ware effective in reducing the volatility in the OTC market as well.
Yet, as we can see from Figure 12, the OTC market is much more volatile than the KRX market and
produces quite a few outliers.
(Figure 11 about here)

The Intraday Day Pattern of Transaction Volume and Market Volatility

Figure 12 shows the transaction volume of the KTBs accumulated for the entire year of 2004 for
each 20 minute interval. The transaction price is calculated as the transaction price of the portfolio of
the entire KTBs traded during 2004. According to Figure 12, the intraday pattern of the trading
volume has a U-shape with the volume decreasing noticeably around the lunch time of 12:00-13:00.
(Figure 12 about here)

17

Figure 13 shows the standard deviation of the transaction prices of the KTBS for each 20 minute
interval. The standard deviation was calculated as the standard deviation of the transaction prices
during each 20 minute interval in each day averaged for the entire year of 2004. The standard
deviation of the transaction prices in the KRX market as presented in Figure 14 does not show any
particular pattern of intraday fluctuation. On the other hand, the standard deviation of the transaction
prices in the OTC market shows abnormally high values during the lunchtime of 12:00-13:00.
Coincidence of the low trading volume and the high volatility of transaction prices in the OTC market
could be the result of some market participants conducting abnormal transactions by taking advantage
of the low trading activities in the OTC market during the lunchtime.
(Figure 13 about here)

IV. MEC and the Execution Cost

Liquidity can be broadly defined as the degree of easiness with which an asset can be converted
into cash. It can be measured by how long it takes to convert an asset into cash through a sale at a
reasonable price or how much it costs to convert an asset into cash through a sale within a short
amount of time. The cost of turning an asset into cash is called the execution cost. The execution cost
not only includes the obvious cost like commissions and taxes but the cost arising from the market
impact effect in the case of large orders. In order to measure the market execution cost rather than the
mere cost of individual transaction, all these implicit costs have to be included in the calculation of the

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execution cost.
Various measures have been adopted to assess the liquidity of an asset or an asset market
including the bid ask spread, the quote size, the transaction volume, the transaction frequency, the
frequency of price quotes, the price impact coefficient (sometimes known as the Kyle Lambda), and
the yield spreads between on-the-run issues and off-the-run issues (Downing and Zhang 2004, Das,
Ericsson and Kalimipalli 2005). In this paper, we use the market efficiency coefficient (MEC)
developed by Hasbrouck and Schwarz (1988) to estimate the execution cost in the government bond
market and evaluate the effect of developing the KRX bond market on the liquidity of the secondary
market for government bonds in Korea.
The MEC is defined as the ratio between the variance of the long run rate of return and the time
adjusted variance of the short run rate of return. Specifically, the MEC is defined as:

MEC

var( RL )
,
q var( RS )

(1)

where R L and R S denote the long-run rate of return and the short-run rate of return respectively and

q stands for the number of short-run periods comprising the long-run period. If we denote the
closing transaction price of each short-run period as P0 , P1 , , Pt , , Pq , we can get the following
identity:

19

Pq
PT
P
P
1 2
P0
P0 P1
Pq 1

(2)

Taking the natural logarithm on both sides of Equation (2), we can derive the following relation
between the long-run return and the short-run returns:

R L R S ,t

(3)

t 1

In general, if the market is efficient, the short-run rates of return will follow a random walk
process with independent and identical probability distribution and as a result the value of the MEC
will be equal to one. But just as Roll (1984) had shown, if there exist some execution costs,
successive price changes will have a negative serial correlation and as a result the MEC will be
smaller than one even if the market is efficient. Therefore, assuming that the market is efficient, we
can evaluate the size of the execution cost by calculating the value of MEC. In practice, Hasbrouck
and Schwarz (1988) showed that the execution cost can be derived from the MEC using the following
equations:

C [0.5 var( RS ) (1 MEC )]1 / 2 , if MEC 1 and

(4)

C [0.5 var( RS ) ( MEC 1)]1 / 2 , otherwise

In this paper, we use the intraday trading data from the KRX Government Bond Market and the
OTC market to estimate the MEC and the execution cost in each market on the condition that each

20

market is efficient. In order to calculate the MEC, we chose one hour as the length of the short-run
period and took the closing transaction price of each one hour interval as the transaction price of that
period.
The KRX Government Bond Market is in session from 9 am to 3 pm. Since the KRX market is
based on an electronic trading system, the transaction details including the transaction time are
recorded with accuracy.
In the OTC market, dealers are required to report the specifics of each transaction to the KSDA
through computer terminals within 15 minutes after the transaction is conducted. However, since the
transaction time is not included as a part of the report, we can only identify the time when each
transaction is reported. Thus, we estimated the transaction time by taking off 15 minutes from the
reporting time. Yet, since the regulation allows quite a few exceptions to the 15 minute reporting
requirement, quite a number of transactions in the OTC market are reported after 3 pm even if the
transactions have been conducted between 9 am and 3 pm. For these transactions, there is no way of
estimating the transaction time and as a result we excluded the transactions reported after 3 pm from
the analysis.
In order to calculate the MEC it is necessary to choose the length of the long run and the short
run. The rate of return for one hour has been chosen as the short run rate of return whilst the rates of
return rates for four days has been chosen as the long term rates of return. Given that only the
transactions that took place between 9 am and 3 pm are included in the analysis the long run

21

corresponds to 24 hours (4 days multiplied by 6 hours a day) implying that the value of q in Equation
(1) should be 24.10
We estimated the MEC and the execution cost for twelve benchmark issues of the 3-year KTBs
and twelve benchmark issues of the 5-year KTBs. The 3-year KTBs and the 5-year KTBs issued
between May 2000 and January 2003 maintained the benchmark status for three months after the
initial offering and those issued after January 2003 maintained the benchmark status for six months.
(Table 4 about here)
(Figure 14 about here)
Table 4 and Figure 14 present the estimates of the MEC and the execution cost for twelve
benchmark issues of the 3-year KTBs. Table 5 and Figure 16 present the estimates for twelve
benchmark issues of the 5-year KTBs. For most of the issues, the estimated value for the MEC is less
than one. Table 4 and Table 5 also present the result of testing the null hypothesis that the successive
short-run rates follow a random walk process. Lo and MacKinlay (1988) showed the following test
statistic asymptotically has a standard normal distribution when the null hypothesis is true:
z (q )

nqM ( q )
2( 2q 1)( q 1) / 3q

(5)

where M (q ) denotes the estimator of the MEC. The test result shows that in all but a few cases, the
null hypothesis of random walk can be rejected.
(Table 5 about here)
(Figure 15 about here)

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As we can see from Figure 14 and 15, the values of the MEC in the KRX market rose
dramatically after the imposition of the trading requirements. As a matter of fact, we can find a few
cases where the null hypothesis of random walk cannot be rejected in the KRX market after the
imposition of the trading requirements. Table 6 and Table 7 compare the averages of the MEC and the
execution cost for the period before the trading requirements were imposed and the period after. As
we can see from these tables, the KRX market had values of the MEC lower than those of the OTC
market and values of the execution cost higher than the OTC market before the imposition of the
trading requirements. After the imposition of the trading requirements, however, the values of the
MEC have risen to become larger than those of the OTC market and the values of the execution cost
have fallen to become smaller than those of the OTC market. Therefore, we can conclude that the
mandatory trading requirements were effective in enhancing the liquidity and the efficiency of the
KRX market and the OTC market but that they were more effective in enhancing the liquidity and the
efficiency in the KRX market.
We can also observe from Figure 15 and 16 that the MEC of the OTC market have also risen
significantly after the imposition of the trading requirements. The increase in the MEC and the
decrease in the execution cost in the OTC market can be also confirmed from Table 6 and Table 7 that
compare the averages of the MEC and the execution cost for the period before the introduction of the
trading requirements and the period after the introduction of the trading requirements. These findings
confirm our earlier proposition that the trading requirements have contributed to enhancing not only

23

the liquidity and the transparency of the KRX bond market but those of the OTC market. That is, the
imposition of the trading requirements enabled the transaction prices in the KRX market to reflect the
supply and demand condition of the government bond market more accurately and thus contributed to
enhancing the liquidity and the transparency of the OTC market as the participants in the OTC market
began using the transaction prices in the KRX market as the reference prices for their own deals.
(Table 6 about here)
(Table 7 about here)

V. Conclusion

To develop the secondary market for government bonds, the Korean government has taken a
unique strategy of developing an exchange market in addition to the OTC market even though there
was the risk of dividing the liquidity between two markets. The rationale for taking such a strategy is
that the KRX market based on the electronic trading platform will be able to facilitate the price
discovery process of the secondary market and thereby enhance the transparency of secondary market
transactions. In addition to adopting the most advanced electronic trading system, the government
introduced and strengthened the exchange trading obligations on the primary dealers to boost trading
in the KRX market.
Our analysis using the intraday trading data in the KRX market and the OTC market demonstrate
that the Korean government took the right strategy. Various measures of market performance confirm

24

that the liquidity of the KRX market has improved significantly after the imposition of the trading
requirements. What is more, these benefits did not come at the cost of the OTC market. On the
contrary, our analysis using the intraday trading data shows that the liquidity and the transparency of
the OTC market has improve as well after the imposition of the trading requirements though there is
still some room for improvement in the transparency of the OTC market.
Our findings do not necessarily imply that introducing an electronic trading platform in the form of
an exchange market at the cost of diving liquidity between the two markets is not the best solution. If
transparency can be achieved, concentrating liquidity in the OTC market would be the best solution.
Past experience, however, shows us that achieving transparency in the OTC market is not easy.
Another problem with the Korean approach is that the mandatory trading requirements place heavy
burdens on primary dealers. In response, the government is planning to provide benefits to primary
dealers by providing them with a quota for non-competitive bids based on the market making and
trading activities in the KRX market
The Korean experience will be useful for Asian countries that try to develop their own domestic
bond markets. Recently, there has been a great deal of discussion and effort to develop regional bond
markets in Asia. (Ito, 2004, Park and Park, 2004 and Oh, Park, Park and Rhee, 2003) The necessity
of developing regional bond markets in Asia originates from the realization that the Asian financial
crisis of 1997 could have been avoided or at least mitigated had there been well developed bond
markets in the bank dominated Asian countries.

As is pointed out by many including Asian

25

Development Bank(2003) and Eichengreen and Luengnaruemitchai (2004), bond markets in Asia are
small and underdeveloped except for a few countries. One of the lessons from the Korean experience
is that these Asian countries should build up and develop the secondary market for government bonds
based on an electronic trading system in the beginning rather than trying the develop the OTC market.

26

Reference

Asian Development Bank, 2000, Government Bond Market Development in Asia, March.
BearingPoint, 2005, The Electronic Bond Market 2005.
Christodoulopoulos, Thanasis N. and Ioulia Grigoratou, 2005, "Measuring Liquidity in the Greek
Government Securities Market," Working Paper No. 23, Bank of Greece.
Das, Sanjiv R., Jan Ericsson and Madhu Kalimipalli, 2005, Liquidity and Bond Markets, Journal of
Financial Issues, volume II, Superintendendia de Banca, 91-104..
Downing, Chris and Frank Zhang, 2004, Trading Activity and Price Volatility in Municipal Bond
Market," Journal of Finance, pp. 899-938
Eichengreen, Barry and Pipat Luengnaruemitchai, 2004, Doesn't Asia Have Bigger Bond Markets?"
Paper presented at the BIS/KU conference on Asian Bond Market: Issues and Prospects on March
22-23..
Hasbrouck, Joel and Robert A. Schwartz, 1988, "Liquidity and Execution Costs in Equity Markets,"
Journal of Portfolio Management 14, 10-16.
Ito, Takatoshi, 2004 Promoting Currency Basket Bonds, T. Ito and Y.C. Park (eds.) Developing
Asian Bondmarkets, Asia Pacific Press, 67-89.
Kang, Kenneth, Geena Kim and Changyong Rhee, 2005 "Developing the Government Bond Market in
Korea: History, Challenges and Implications for Asian Countries," paper presented at the AEP,
October 7-8, 2004, Columbia University.

27

Lo, Andrew W. and Craig A. MacKinlay, 1988, Stock Market Prices Do Not Follow Random Walks:
Evidence from a Simple Specification Test.", the Review of Financial Studies, spring, pp. 41-63.
Oh, Gyutaeg, Daekeun Park, Jaeha Park and Changyong Rhee, 2003, Building a Settlement
Infrastructure for the Asian Bond Markets: AsiaSettle, paper presented at Workshop on East
Asias Strategy for Regional and Global Financial Cooperation on 11 October, 2003, Seoul.
Park, Daekeun and Yung Chul Park, 2004, Creating Regional Bond Markets in East Asia, T. Ito and
Y.C. Park (eds.) Developing Asian Bondmarkets, Asia Pacific Press, 16-66.
Roll, Richard, 1984 "A Simple Implicit Measure of the Effective Bid-Ask Spread in an Efficient
Market," Journal of Finance, 1127-1139.

28

Table 1. Policy Measures to Develop Government Bond Markets in Korea

August 1998

Announcement of Government Bond Market Stimulus Plan

March 1999

Establishment of inter-dealer market (IDM)

July 1999

Enactment of primary dealer system

September 1999 Introduction of government bond futures

November 1999 Introduction of DVP system
February 2000
March 2000

Introduction of inter-dealer brokers (IDB)

Securities financing facilities for primary dealers

May 2000

Introduction of the reopening system

August 2000

Switch from multiple price auction to Dutch auction

October 2002

Introduction of exchange trading requirements for benchmark issues

January 2003

Strengthening obligations of primary dealers

2006

Introduction of KTB STRIPs and 20 year maturity government bonds

Table 2. Yearly Turnover of KTBs and FESFBs

Year

The KRX Market

The OTC Market

The KRX Market

Turnover (billion won)

Turnover(billion won)

Share

(A)

(B)

A/(A+B) %

2000

21,644

251,305

7.9

2001

10,100

443,066

2.2

2002

42,600

343,222

11.0

2003

207,930

453,939

31.4

2004

358,400

707,7,73

33.6

2005*

110,630

250,191

30.7

Source: Financial Supervisory Service, Monthly Bulletin, various issues

Note: The numbers for 2005 are based on the data from January to April only.

29

Table 3. Yearly Turnover Ratio of KTBs and FESFBs

Year

KRX Market

OTC Market

Overall Market

2000

41.2%

478.0%

519.1%

2001

16.9%

743.0%

759.9%

2002

59.6%

480.2%

539.8%

2003

197.8%

431.7%

629.5%

2004

246.7%

487.2%

734.0%

2005

305.8%

414.7%

720.4%

Source: Financial Supervisory Service, Monthly Bulletin, various issues

Note: The numbers for 2005 are based on the data from January to April only.

Table 4. Estimates of the MEC and the Execution Cost (3-year Bonds)
Item

Benchmark Period

KRX MEC OTC MEC KRX C(%) OTC C(%)

. KTB00-10

2000.5.12~2000.8.1

0.296***

0.113***

0.105

0.254

KTB00-12

2000.8.16~2000.11.6

0.042***

0.282**

0.266

0.075

KTB01-1

2001.1.10~2001.2.12

0.063*

0.165*

0.475

0.099

KTB01-6

2001.7.5~2001.10.4

0.044***

0.192***

0.310

0.113

KTB0644-0504

2002.4.3~2002.7.1

0.164***

0.375**

0.105

0.063

KTB0562-0507

2002.7.11~2002.9.25

0.082***

0.138***

0.128

0.094

KTB0520-0510

2002.10.2~2003.1.3

0.520*

0.471**

0.052

0.063

KTB0510-0601

2003.1.8~2003.2.28

0.684

0.515

0.023

0.034

KTB0450-0603

2003.3.5~2003.8.28

0.552**

0.630*

0.042

0.040

KTB0450-0609

2003.9.3~2004.2.26

0.509**

0.384***

0.051

0.065

KTB0475-0703

2004.3.3~2004.9.8

0.940

0.645*

0.016

0.044

KTB0375-0709

2004.9.10~2005.3.9

0.753

0.596**

0.034

0.050

Note: *, ** and *** denote that the null hypothesis that the successive short-run returns follow a random walk
process can be rejected at the significance level of 10%, 5% and 1% respectively

30

Table 5. Estimates of the MEC and the Execution Cost (5-year Bonds)
Item

Benchmark Period

KRX MEC OTC MEC KRX C(%) OTC C(%)

KTB0820-0508

2000.8.23~2000.10.12

0.215**

0.079**

0.192

0.170

KTB0715-0604

2001.4.11~2001.4.20

0.129

0.016

0.275

0.286

KTB0625-0607

2001.8.17~2001.10.5

0.004*** 0.211**

0.739

0.174

KTB0690-0701

2002.3.6~2002.3.21

0.004*

0.887

0.160

KTB0717-0704

2002.4.10~2002.7.5

0.072*** 0.138*** 0.329

0.149

KTB0615-0707

2002.7.19~2002.10.4

0.146*** 0.416*

0.206

0.108

KTB0577-0710

2002.10.9~2003.3.7

0.329*** 0.228*** 0.112

0.134

KTB0475-0803

2003.3.12~2003.9.4

0.528**

0.295*** 0.084

0.138

KTB0450-0809

2003.9.9~2004.3.4

0.416*** 0.154*** 0.087

0.206

KTB0500-0903

2004.3.10~2004.6.11

0.307**

0.204*** 0.075

0.102

KTB0450-0906

2004.6.15~2004.12.9

1.109

0.619*

-0.024

0.059

. KTB0350-0912

2004.12.14~2005.3.25

1.124

0.554*

-0.036

0.093

0.330

Note: *, ** and *** denote that the null hypothesis that the successive short-run returns follow a random walk
process can be rejected at the significance level of 10%, 5% and 1% respectively.

Table 6. Averages of MEC and Execution Cost of 3-year KTBs

Period

Variable

Entire Market

Exchange Market

OTC Market

Before

MEC

0.235

0.193

0.277

(0.153)

(0.187)

(0.109)

0.135

0.165

0.106

(0.085)

(0.093)

(0.070)

0.693

0.782

0.604

(0.144)

(0.107)

(0.124)

0.033

0.026

0.040

(0.010)

(0.006)

(0.007)

imposing the
trading

C(%)

requirement
After

MEC

imposing the
trading
requirement

C(%)

31

Table 7. Averages of MEC and Execution Cost of 5-year KTBs

Period

Variable

Entire Market

Exchange Market

OTC Market

Before

MEC

0.206

0.118

0.294

(0.173)

(0.079)

(0.201)

0.300

0.433

0.167

(0.243)

(0.289)

(0.064)

0.567

0.755

0.379

(0.372)

(0.426)

(0.196)

0.074

0.030

0.117

(0.071)

(0.065)

(0.049)

imposing the
trading

C(%)

requirement
After

MEC

imposing the
trading
requirement

C(%)

Figure 1. Outstanding Amount of Government Bonds

32

Figure 2. Ratio of the Outstanding Amount to GDP

Figure 3. Trading Volume in the KRX Market and the OTC Market

33

Figure 4. Share of the KRX Market for Benchmark and Non-Benchmark Issues

Figure 5. Share of the KRX Market Trading by PDs and non-PDs

34

Figure 6. Types of Trading by Trading Partners (Benchmark Issues)

Figure 7. Bid-Ask Spreads of Benchmark Issues

35

Figure 8. Monthly Transaction Volume of Government Bonds

36

Figure 9. Monthly Turnover Ratio of Government Bonds

Figure 10. Standard Deviation of Transaction Price

37

Figure 11. Range of Intraday Transaction Prices

Figure 12. Transaction Volume of KTBs for Each 20 Minute Interval

38

Figure 13. Standard Deviation of Transaction Price for Each 20 Minute Interval

Figure 14. Estimates of the MEC and the Execution Cost for 3-year KTBs

39

Figure 15. Estimates of the MEC and the Execution Cost for 5-year KTBs

40

a) Department of Economics and Finance, Hanyang University

b) Department of Economics, Seoul National University

c) Corresponding Author, Department of Management, Hongik University, sshin@kfiri.co.kr
Although twenty one kinds of government bonds have been issued since 1949, only three kinds of bonds are
currently issued including the Korea Treasury Bonds, the Korea Treasury Bills and the National Housing Bonds.
The Foreign Exchange Stabilization Fund Bond has been consolidated into the Korea Treasury Bond since
November 2003.
2

The exchange market for government bonds was initially operated by the Korea Securities Exchange, which

later merged with the Korea Futures Exchange to become the Korea Exchange.
3

The mandatory trading requirements have been further strengthened as the minimum trading proportion was

raised to 50% in June 2004. We still focus on the introduction of the mandatory trading requirement in October
2002 and strengthening of the requirement in January 2003 because due to limited data availability we do not
have enough observation to discuss the effect of the strengthening of the requirement in June 2004.
4

No attempts have been made to control the impact of other environment changes such as macroeconomic

events or regulation changes because as we can see from Table 1 there has been no significant environmental
change during the sample period after the introduction of the mandatory trading requirements.
5

In the Korean OTC bond market, despite the existence of interdealer brokers, most trades are made directly

between dealers through price negotiation by voice or by MS messenger. Therefore, there is no effective
platform that aggregates price quotes and no information on price quotes is publicly available in the form of
data.
6

Although the Foreign Exchange Stabilization Fund Bond is no longer issued since it has been consolidated into

the Korean Treasury Bond in November 2003, there still remain some outstanding issues.
7

Turnover ratios are calculated as the market turnover divided by the outstanding amount at the end of each

period.
8

Transaction prices are quoted in terms of the yields to maturities in the KRX market as well as in the OTC

market in Korea. Although they are quoted in yields, we will still use the term transaction prices in this paper.
9

We used bonds with a remaining maturity of less than 30 months because bonds with a short remaining term to

maturity are not liquid.

10

The choice of 4 days for the long run is somewhat arbitrary. We also calculated the MEC and the execution

cost by setting q to be equal to 12 (two days) instead of 24 (four days) and got similar results.