Sri Lanka bond market insider dealing allegations to be probed: Ministers

COLOMBO (EconomyNext) – Alleged insider dealing in Sri Lanka government securities markets by a firm connected to the family of Sri Lanka Central Bank Governor will be probed, government ministers said.

"We have faith in the governor of the central bank," Deputy Economic Policy Minister Harsha De Silva said responding to questions at a Sri Lanka Law Conference whether alleged insider deals in gilt markets would be probed.

"We expect the governor to make sure that he carries out an appropriate investigation into whatever the incidents that people say have taken place."

There has been rising concerns in bond markets over controversial deals made over the past week by Perpetual Treasuries, a firm connected to Arjun Aloysius, the son-in-law of Governor Arjuna Mahendran.

Deputy Minister De Silva said the matter had already been discussed with Prime Minister Ranil Wickramasinghe and the Governor. The Prime Minister is the Cabinet minister in charge the Economic Policy Ministry under which the Central Bank falls.

"So we are quite open and transparent, because we do not want to have any negative impact on the markets by various rumours," the Deputy Minister said.

"We will make a statement in parliament or deal with in it in a more appropriate way."

De Silva said an inquiry had already taken place and he had seen the fact sheets.


Many market participants do not believe that Governor Mahendran deliberately leaked information to create a situation which would undermine his own credibility and give rise to a political bombshell for the new administration, but the possibility of such events occurring had been raised earlier.





There had been objections to Mahendran’s appointment originally due to the relationship with Perpetual Capital group and concerns have been raised by members of the public and others that problems could crop up, despite a recent resignation of his son-in-law from the firm.

Perpetual Capital group had been involved in controversial stock market deals with the Employees Provident Fund which have been questioned before.

Cabinet spokesman, Health Minister Rajitha Senaratne told reporters after the weekly news briefing that any allegations over bond dealing would "definitely" be probed and he had also raised concerns over earlier controversial deals.

"Because I have cautioned the government before his appointment," Minister Senaratne said. "The Prime Minister gave an assurance that if there are any allegations we will investigate and take necessary action."

Under the previous administration, no probes have been conducted over serious allegations of securities fraud.

The controversial deals involve two separate sets of transactions where profits of hundreds of millions of rupees are alleged to have been made in a matter of hours or days.

Secondary Market

One set of deals involve the sale of mostly 7-year bonds one week forward in the secondary market shortly before the Central Bank said Friday it was closing a 5.0 percent window where excess cash was deposited from March 02.

The previous administration had made a back-door 150 basis point policy rate cut by starting the 5.0 percent window and limiting access to its standard 6.50 percent window to three days a month in a September 2014 decision, which lowered overnight rates below 6.5 percent for most of the month.

The closure of the 5.0 percent window tightened monetary policy and pushed overnight interest rates above 6.5 percent. It is not clear why the move was not announced on Tuesday with the regular monetary policy statement.

Governor Mahendran said the removal of the 5.0 percent window brought Sri Lanka back to international practice and a visiting International Monetary Fund mission had raised the issue and the anomaly was corrected Friday.

When interest rates rise the price of bonds fall, generating a loss to their holders.

The longer the tenor of the bond, the bigger the loss to the holder and greater the profits to the seller.

Market participants say Perpetual Treasuries sold bonds mostly on Thursday before bond prices fell.

The allegation is that the firm aggressively engaged in these trades, including selling bonds forward that it did not have, to ‘short the market’ because it had prior knowledge that interest rates would go up on Friday.

A series of one week forward sales of 7-year bonds were also made at prices ranging from 7.95 percent to 8.05 percent on Thursday, dealers say.

Short selling is technically not allowed in Sri Lanka, under central bank guidelines where forward trades are expected to be made with bonds actually in a seller’s portfolio, though the practice is common in most markets.

On Tuesday after yields went up in the weekly Treasuries markets and bond markets became active again the firm bought back bonds at lower prices at yields around 8.80 percent and lower to cover its short, dealers believe.

The price rapidly fell to around 8.10 percent as it started to buy. Market participants estimate about 2.0 billion rupees of such deals may have been made.

The deals in the secondary market could also include the sale of at least one billion rupees of close to one year maturity at 6.50 percent to a large private bank when the weighted average one-year bill yield the previous week was 6.13 percent, market participants say.

One year average auction yields rose to 6.99 percent at Tuesday’s auction.

Primary Market Shock

The second controversial transaction involves a 30-year primary Treasury bond auction held last Friday, where average yields moved up to 11.73 percent from the 9.30 to 9.60 levels bonds had been sold in off-auction placements.

At the last public auction in May 24, 2014 the weighted average yield was 11.75 percent.

Central Bank Governor Mahendran said the average yield moved to 11.73 percent which was around the same as the 11.75 percent at the last public auction held before the 5.0 percent window was introduced in September.

After offering only one billion rupees to the market, the Central Bank accepted bids of 10 billion rupees, 10 times the original offer. Compared to recent off-auction placement rates of 9.6 percent, the weighted average yield was up over 200 basis points.

Governor Mahendran said because there were 20 billion in bids, higher than expected, a higher volume was taken because the government had funding needs. There was no immediate comment from the firm.

The cut-off or the highest yield at which bids were accepted went up to at least 12.50 percent last Friday, market participants say. Dealers who submitted so-called ‘dummy bids’ at those levels were also allocated bonds.

The sudden spike in long bonds yields left the market shell-shocked and killed all activity for the entire day Monday till the end of the Treasuries auction on Tuesday.

It is alleged that Perpetual Treasuries bought at least 3 billion rupees worth 30-year bonds at 12.5 percent, funding the purchase with money borrowed from a state bank through a buy-sell deal.

Markets participants say only an investigation would reveal the true extent to the deals made last week.

Soon after the 30-year auction, there were buyers at around 12.0 percent giving a firm that was allocated 3 billion rupees of bonds instant profits of 116 million rupees. A one percent drop would give profits of about 230 million rupees.

Volume Knowledge

Sri Lanka’s central bank, which sells bonds on behalf of the Treasury, has had a habit of accepting higher amounts than the offered volume which is originally communicated to the market.

In international bond sales by Sri Lanka and even in the domestic listed debenture sales, sellers usually communicate the volume and sometimes say an additional tranche will be taken if the first volume is oversubscribed.

Market participants say accepting higher volumes – especially many times the original offer – mis-directs the market and breaks the terms of the original offer-acceptance principles of contracting and it amounts to a shifting of goalposts.

It also leaves room for insiders to profit when other market participants do not have equal knowledge of the actual borrowing requirement, they say. The biggest losers would be genuine buyers of long term bonds such as insurance and pension funds.

To eliminate the possibility of insider knowledge and make markets function better, the actual borrowing requirements perhaps with a ‘green shoe’ option for an extra volume, could be communicated, market participants say.

Though small increases may not matter, big increases, especially in illiquid long bonds can have severe repercussions, such as killing all market activity for several days or leading to the demand for much higher yields in subsequent auctions as happened last week.

It may take weeks for the market to recover fully from such shocks and rates to stabilize, though analysts agree that market interest rates have to move up especially to keep the exchange rate stable, with the additional spending outlined in a revised budget in January.

Update I

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