20 May, 2022


Bond Scams Were Caused By A Broken Bond Market – Part III

By Arjuna Mahendran

Arjuna Mahendran

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” ~ (Maynard Keynes, The General Theory)

The Central Bank’s annual report for calendar 2015 contained the following paragraph on the operations of the Regional Development Department (RDD): ‘RDD invests excess funds held by it under custodial arrangements in Repo investments. As at 31 December 2015, Repo Investments amounting to Rs.1.40 Bn were found to be uncollateralized… If these investments cannot be recovered, it affects the future functions of the Department and expansion of existing projects. Further, new projects cannot be implemented. If the investments cannot be recovered it will reduce the funding base by an equal amount.

The department had placed a form of deposit called a repurchase agreement (or ‘Repo’), which secures the deposit with some form of security, usually a government bond. Repos are popular with investors who wish to obtain the typically higher rates of interest offered by bonds while affording themselves the convenience of being able to realise the funds before the underlying bond matures. However, in this case the department had failed to check whether the underlying bonds were attached to the Repos. They weren’t. The deposits were thus left uncollateralised. The debt department of the central bank had been aware of such malpractices for several years prior. However these concerns had not been taken into account when the central bank was investing its own funds. When I inquired why central bank funds had been deposited in that manner, the concerned staff told me that they accepted the offer with the highest rate of interest. They said they accepted the highest bid for fear that the auditor-general would fault them if they accepted a lower bid.

What this unfortunate event reflected was a basic lack of coordination between departments of the central bank, in sharing and analysing data related to financial markets under their supervision. The board thereafter took several measures to address the issue. Legal action to recover the lost monies were instituted. The minimum capital for bond dealers was raised from Rs 300 mn to Rs 1 billion. The supervision of bond dealers was transferred from the debt department to another department with specialist supervisory staff. Two new departments for risk management and compliance were created in line with international norms for banking institutions.

The underlying principle adopted was for the risk oversight of operational departments of the central bank to be taken out of the concerned departments and vested in independant risk management and compliance functions, tasked with creating an inter-departmental view of risk mitigation and market regulation issues. New regulations were eventually issued by the central bank in early 2020 to tighten rules sanctioning dealers issuing Repos without attaching the underlying bonds. However, no attempts have been made to modernise the laws governing the bond market, including the Local Treasury Bills Ordinance No. 8 of 1923 and the Registered Stock and Securities Ordinance No. 7 of 1937, which predate the establishment of the central bank by several decades and are unwieldy in a digital trading environment which requires split-second regulatory oversight in real time.

It is noteworthy that the 2017 Commission of Inquiry (COI) to investigate transactions in the bond market in 2015-2016 did not see it fit to inquire into the losses made by the government in Repo instruments despite this being squarely within their mandate. No mention was made by the COI about the legal framework for handling defaults on financial instruments being in urgent need of modernisation. While commercial courts were established to expedite commercial disputes, there has been no concomitant progress on refashioning statutes relating to insolvency and bankruptcy in order to expedite the claims of creditors. This has arguably impeded the issuance of bonds by a wider spectrum of private companies, with investors preferring the perceived safety of government bonds. The COI on the Bond Market, when presented with evidence that successive issues of government bonds were issued without prior public notification in the government gazette, as required by the governing law enacted in 1937, did not pause to reflect on whether it was practicable to enforce such procedures in a modern trading environment. Nor was the wider importance of modernising the legal framework for the effective functioning and regulation of the bond market given due consideration in the COI report. In parliament, central bank matters are reviewed by a committee on ‘public enterprises’ with minimal staffing to review policy and legislation related specifically to government finance. A gaping anomaly is that parliament lacks a standing Treasury Committee to enforce its prerogative as the ultimate source of authorisation for government financial business.

It is clearly evident that the management of the burgeoning public debt of the government has become too big an issue to be managed by a single department of the central bank. The reality is that the existing central bank organisational structure conceived in the late 1940s, and hardly modernised since then, has not kept pace with developments in the financial sector. When it was established in 1950, the central bank had to research the economy and determine appropriate monetary policy, regulate a handful of banks and manage the value of the currency. The issuance and management of government debt was added as an agency function owing to the limited size of Ceylon’s financial sector at the time. Today, on the other hand, with broadly similar functional arrangements as enacted in 1950, it has to supervise over 30 banks and over 50 finance companies, myriad money brokers, bond dealers, currency exchanges etc. Meanwhile net government debt has grown in that period from near-zero to over 80 percent of GDP. Additionally, the task of managing the Employees Provident Fund was thrown in for good measure in 1959 despite protests which rightly pointed out the contradiction inherent in maximising returns for the fund while simultaneously obtaining funding for the government at low cost. In my opinion, the existing organisational structure simply cannot handle the additional workload effectively.

As a consequence, the central bank has not realised its stated goals for modernising the bond market, announced in its annual report for calendar 2016: ‘The (debt department) is in the process of accessing Euroclearability of government securities in order to improve the settlement and clearance of the government securities to foreign investors. This will enable diversification of the foreign investor base, and improve the ease of accessing the government securities market for foreign investors. Also Central Bank is in the process of establishing an electronic trading facility with Technical Assistance of US Treasury department and a Central Counterparty Clearing House (CCP) for government securities along with the required regulatory framework.’ In fact, the central bank has repeatedly said that it would establish a bond trading platform as far back as 2006 but never implemented it. The current system of reporting bond trades ex-post facto on a data-sharing electronic platform is not good enough. Bond market traders will only get active in our market if they are afforded modern delivery-versus-payments (DVP) infrastructure and a reliable trading platform backed by a sound clearing mechanism. The benefits of implementing such modern systems is that they will attract broader participation in bond markets, thereby increasing the supply of funding and result in lower costs of borrowing for the government and corporates. The only realistic solution to curb the extreme volatility in bond interest rates, documented at length in the forensic audit into bond market activity between 2006 and 2016, is to urgently implement a modern trading system. This will iron-out the volatility which caused the ‘unconscionable profits’ alleged to have been made by bond traders as mentioned by the former prime minister in parliament in 2018. Of course, this has to be accompanied by a credible restructuring of government finances and debt management to be a success. But countries with worse financial imbalances than Sri Lanka manage to obtain funding at far better terms by the simple expedient of modernising their capital markets in line with internationally recognised regulatory norms and transactional infrastructure.

Despite several public statements made in recent years about plans for the management of government debt to be transferred to an independent agency, no progress appears to have been made. Whether this is due to bureaucratic inertia or active resistance to change by vested interests, the net result is slow progress on modernising capital markets.

*To be continued…….. 

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Latest comments

  • 5

    When it is apparent that the Bond Scams were caused by a Broken Bond Market – why was it not fixed taking the principal risk taking capability, it is like saying I failed the exam why I forget to take my pen, every vice has its excuse ready, When money is pulled out is there no allerter to stop it

    • 8

      Dear Mr Mahendran,
      I still believe you – however this was instrumental looters to return to power and re-loot the very same nation. That is what we ve been facing in that war torn country today.
      I have no doubt, if changes were added by MR govt, they too would have faced the same setbacks. However, we cant comprehend as to why they dont focus on the bond losses made from 2008 – 2015.

      Dear CT team,

      dont you think that this article is very important to translate into SINHALA/TAMIL and be published accordingly. If anyone would do it, I can bear the costs. This BOND scam issue was instrumental to erode all good steps taken by former govt. Sirisena should not have been the person to get elected as the President of this country – the manner he allowed ALL TIME LOOTER -Rajapakshes to come back is not forgivable in this life.
      It was just a POLITICAL RIVALTRY between two giant parties, just ignoring all promises made before by Sirisena on the stage.

  • 3

    You are a fugitive Arjuna Mahendran – come back and defend yourself.

    • 6

      Mr Abeyratne,

      do you think if the allegations levelled at AM are right, as a right respecting STATE, Singapore govt would let him be free ? It can damage their name. I know Singapore very well. They are bound to the law to the letter. Not even a chewgum would be allowed to eat where that is not permitted in that small country with 5 mio of today s population. People would not stay NODD HEADING cows like.. as is the case in our hell-srilanka, … if AM is to be blamed all along for the losses if claimed, they would react by their own.
      Our country, with the man, being elected by 6.9 mio of votes, today, they seem to have the audacity to ATTACK national cricketers that brought the pride to the country making srilanka a great nation on the international podium.

      At the time, this was set to air by that UNEDCUATED Mahindananda Aluthgamage, former Sports minister, Gotabaya and Mahind could correct it accordingly, if the blant action would not have been out of their knowledge. These mlechcha men should be RAW-CREMATED in a burner, if this country and nation should feel free from high crimes and corruption. Basta.

  • 3

    Mr Mahendran

    There is no point making explanations after all these years. RW took the bullet for you & the cronies are happy with the scraps (maybe more than scraps for some) your S-I-L has given.

    However, if you want to clear your good name, why don’t you return to SL & make your case in public? I am sure the Rajapakse regime would be most understanding & there are lawyers & judges who would see it your way. After all, the money involved in your ‘scam’ is peanuts compared to the mismanagement at the CB all these years. Anyway, did anyone lose out? (apart from, maybe, the citizens of SL) It’s just that your S-I-L had a windfall.

    I am sure you will get a fair hearing if you play your cards right. We even have a ‘reformed’ terrorist who still boasts of murdering hundreds of soldiers but he was pardoned because he helped us to win the war & was even given a seat from the national list in appreciation. Politics can make strange bedfellows, its only the poor citizens who get screwed in this country like no other.

  • 4

    Why is that Sunday telegraph is insulting us, general public by publishing an article written by man who has no credibility. He is accused of masterminding of robbing large scale of money from a central bank of a country.
    He was happy to accept the post of Governor of Central bank of SrI Lanka but doesn’t want to prove his innocence when charge by the court of law same country.
    I can’t see the difference between him and a common criminal.

  • 3

    “Jack” seems to think that CT should not be publishing articles of this sort.
    On the contrary, I think that this is a most valuable service that has been rendered by the website.
    Let me start by saying that I still don’t have an idea of what a “Repo” is. I guess I could figure out a little more if I really tried, but this is not an area of knowledge that I have much desire to delve into.
    On the other hand, I went through it all almost as soon as it appeared, and I was hoping that comments from readers with better understanding of “central-banking” would educate me. There have been many accusations and impassioned cries for prosecution from all sorts of people. One expert was contradicted by another. It is only right and proper that Arjuna Mahendran be allowed to come up with his explanation.
    Your own comment is proof that too many Sri Lankans have already tried him in their minds and that he will not be allowed a fair trial. If we all had the open mind that Raj-UK obviously has, we’ll get somewhere with this.

  • 1

    Mr. Mahendran is indeed a privileged man . During the time he was head of the BOI 2001 – 2004 he reportedly flew ‘home’ to Singapore by UL on first class every weekend to be with his family . The records will show that FDI’s during his term of office were abysmal .
    There are people who have no qualms about enjoying the high life and living off the taxes of the public, in a country where 40% of the population live on less than two dollars per day . Mr. Mahendran is one such pathetic individual with absolutely no conscience.

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