Sri Lanka controversial primary dealer’s license could be cancelled: CB Governor

COLOMBO (EconomyNext) – The license of a gilt dealership connected to his family could be revoked if a probe faults the firm over controversial transactions, Central Bank Governor Arjuna Mahendran who is to go on leave while the investigation is made, said.

Sri Lanka has been rocked by allegations that Perpetual Treasuries, a gilt market dealer connected to Mahendran’s son-in-law engaged in a series of deals in the secondary and primary government securities market based on insider information that interest rates would go up on February 27.

Dealer License

Mahendran said if a committee that is investigating the issue found fault with the firm its primary dealer license may be cancelled.

"But I do not want to pre-judge (the report by the investigating committee)," he said.

Licensed primary dealers are allowed to bid at the primary auction of Treasury securities and they also have access to a lender of last resort window of the Central Bank.

Mahendran said he will go on leave and handing over operations to Senior Deputy Governor P Samarasiri while a committee investigates the matter.

"But I will be in Sri Lanka and available to assist the investigation in anyway," he said.

President Maithripala Sirisena ordered a probe into alleged irregularities in bond markets last week, and members of the investigating committee was named by Prime Minister Wickramasinghe.

There had however been concerns by opposition parties that they were all lawyers with no in depth knowledge of gilt markets and connected to the United National Party and his old school Royal College.

Wickramasinghe is due to make statement in parliament on the issue Tuesday.

Unusual Trades

Perpetual Treasuries was seen selling among other securities, 7-year bonds, in the forward markets on or around February 26 dealers have said, to be bought back the following week at a profit when rates went up.

The firm also made unusually large bids, especially for an independent primary dealer at an auction of illiquid 30-year bonds, including a 3.0 billion rupee bid which was backed up with financing from a state bank. The firm is alleged to have made bids of 2.0 billion rupees on its own account.

After calling bids for only a billion rupees of 30-year bonds, the Central Bank accepted 10 times the volume and half of t went to Perpetual Treasuries, with 3.0 billion at 12.5 percent.

The weighted average yield at 11.73 percent was also sharply higher than the 9.3 and 9.6 percent rates at which 30-year bonds were sold through private placements in recent months.

Also on Friday, the Central Bank tightened monetary policy closing a 5.0 percent window where excess cash was parked, pushing the floor overnight rate to the 6.5 percent window, shifting the entire yield curve upwards.

The move came days after the regular monthly monetary policy statement on Tuesday 24 February.

No Wrongdoing

Mahendran denied wrongdoing related to the 30-year bond auction, and said the Central Bank decided to move into a fully auction-based system abandoning private placements, which could have led to some of the outcomes.

"I am very clear in my mind that I have not done anything wrong," he said. "We have changed the earlier system of having private placements.

"Auctions will now be the norm, private placements will be the exception."

Bond market participants however were not told clearly last month that the Central Bank would move to a pure auction based system or that a large volume would be accepted.

Mahendran said "messaging may have got garbled," but in the future, auctions would determine the interest rate.

He said 10 billion rupees was accepted because the government was in need of extra cash.

Mahendran said there were instances in the past where the Central Bank has accepted sharply higher volumes that offered including a recent Treasuries auction where 2.0 billion rupees was offered and 13 billion accepted.

But market participants have been unhappy even earlier that the Central Bank’s practice of offering lower volumes and accepting higher volumes mislead the market and following the latest event that it also leaves room for someone with inside information to make bids at high rates.

More Transparency

Such practices were also followed in dollar bond auctions. By offering small amounts to the market, the debt office intended to lull market participants into the false belief that only a little money was needed and then snap up all the bids that came at low prices, dealers believe.

Though this created uncertainty at the first auction where larger volumes were accepted, but dealers later bid expecting higher amounts to be accepted.

But sudden very large volumes can still surprise dealers.

It also may result in the government paying higher than necessary rates. In the controversial 30-year auction, so-called ‘dummy bids’ placed by several dealers without much expectation that they would be hit at above 11 percent and also 12.5 percent, were also accepted.

Analysts say the debt office should also have borrowed more short term money where there was greater liquidity and willingness to lend, instead of selling 30-year bonds and committing the government to high interest rates for a long period.

If rates fall soon with foreign dollar borrowings by the government large profits can be made by holders of long-bonds by dumping them on long term insurance or pension funds.

If fiscal policy will get better in the next few years and inflation will also be low, the supply of long bods should be reduced so that the yield curve is flat as possible, if not inverted, economic analysts say.

Most markets participants agree that going for a pure auction based system better, but rates would have perhaps been lower if the process was well communicated and also stronger indications given about the planned sovereign bond sale.

The closing of the 5.0 percent window was also good, but best practice demands that such monetary tightening should be done within the regular monthly policy statement, analysts say.

In order to make markets transparent and not leave room for insider dealing, analysts say the debt office should communicate the exact borrowing requirement.

The debt office should also publish cut-off rates. The Central Bank stopped publishing cut-off rates in the 1990s and reporters and dealers now have to call many market participants to find the cut-off yield and even that is an estimate.

Another option is to abandon the current multiple price auction and go for a single price auction, with non-competitive bids are also allowed like in the United States.

The Employees Provident Fund could also be allocated all or part of the bonds on a non-competitive basis, which will also clear allegations that it is mis-used for financial repression.

Update II