Euroclear
Jan Grauls
24 March 2023
The fastest growing asset class on the Collateral Highway is Japanese Government Bonds, says Jan Grauls, product manager of collateral management services at Euroclear, who explores the factors driving its increasing use and acceptance
Image: Jan Grauls
Japanese Government Bonds (JGBs) are a highly rated, highly liquid asset class. Japan’s outstanding debt is twice the size of its economy. Historically, most of that debt has been issued, held and traded domestically. Over the past decade, the perception of the JGB market, as domestically focused, has increased as the Bank of Japan (BOJ) — similar to other central banks around the world — undertook an extensive programme of quantitative easing by the outright purchasing of JGBs.
According to the BOJ’s latest Flow of Funds Accounts that were published in December 2022, the central bank owned ¥535.62 trillion (US$3.92 trillion) of JGBs by market value at the end of September. This represented 50.3 per cent of the total JGB issuance of ¥1.07 quadrillion. This is up from 49.6 per cent at the end of June 2022 and an increase from 10 per cent ownership in 2012.
In some specific cases, the BOJ owns 100 per cent of certain individual issues such as the 368th 10-year issue that was sold in October 2022. This is evidence that the BOJ is vigorously following its yield curve control policy to keep the 10-year part of the yield curve from rising too much in the face of the recent rate rises.
However, a different dynamic is emerging which flies in the face of the perception that the JGB market is almost entirely Japanese. Holdings of JGBs by foreign institutions have been steadily increasing over the past decade. According to BOJ data, the proportion of the total JGB market (including FILP bonds and T-bills) held by foreign financial institutions has risen from 5.7 per cent in March 2010 to 14.1 per cent in December 2022. It reached a high of 14.4 per cent in March 2022. In absolute terms, this represents an outright increase in foreign holding of ¥123 trillion (US$957 billion).
There are both macro and micro reasons for this change. On the macro side, a series of fiscal, monetary and structural reforms that were enacted a decade ago by the late Prime Minister Shinzo Abe (called Abenomics), have brought about fundamental changes to the Japanese economy across several vectors.
A key element of the so-called third arrow structural reforms was an intent to increase the internationalisation of Japan’s economy. In financial services, this has manifested itself by Japanese financial institutions going out, while foreign financial services firms have come in. As a result of this, JGBs have assumed a greater role not only in capital structures, but also in general financial operations.
At the same, the global need for high quality liquid assets for use as collateral for uncleared and cleared margining has increased dramatically, not least due to the successive waves of Uncleared Margin Rules (UMR) rolling out over the last five years. The use of JGBs as collateral in Euroclear has doubled since 2021 and across the different business lines of repo, securities lending and UMR. JGBs have therefore become the largest sovereign collateral.
Is it a misconception to think that the BOJ has taken the liquidity out of the JGB market?
The BOJ now owns half of all the JGBs, which they have bought to force a large amount of liquidity into the Japanese market in the hope of stimulating consumption. However, recent statistics from the BOJ indicate that despite the growth of the Bank of Japan’s holdings, the proportion of foreign-held JGBs has also been increasing.
What intrinsic qualities do JGBs have that make them particularly suitable for use in collateral?
JGBs provide a number of intrinsic qualities that make them particularly suitable for use in collateral. Firstly, the asset class is a sovereign collateral, which means that there is a lot of trust in the bonds. Secondly, JGBs have become a very large market and are very liquid, so counterparties can be quite confident that they can sell the asset if things go wrong. Another advantage that market participants identify is that these bonds are quite cheap in the sense that they are abundant.
Generally, any financial institution that is involved in some way in Japan also tends to hold or have access to a large stock of JGBs. In the past, these institutions might have struggled to find ways to use this stock, but now because JGBs are being used more internationally, there are many more avenues to place them with counterparties.
Why are JGBs being used more internationally?
The increase in the international use of JGBs is due to several factors. Historically, market participants would have been less willing to accept the asset class because, in doing so, they would be accepting something that they are not very familiar with and that is denominated in yen — so there is a currency risk to manage. These were also less prevalent in the Japanese market at that time, which would not ease liquidation if things went wrong.
Euroclear’s assessment is that we are seeing greater use of JGBs as collateral. A growing number of international firms have activity in Japan and are comfortable in trading those assets. Vice versa, there is a scaling number of Japanese firms that are finding their way into international activity. These are using their domestic stocks of JGBs and convincing their counterparties to accept them. Euroclear is a platform that is the ideal place for these firms to meet and transact.
Have there been any specific regulatory changes or is this part of a long-term trend?
There has been a long-term trend towards greater JGB use in collateral, but UMR has accelerated that adoption. UMR has prompted a lot of trading relationships that were previously unsecured to become secured by collateral. The majority of these trading relationships are between, for example, Japanese clients and their international trading counterparties. A lot of the collateral that has been exchanged within those relationships is now JGBs. That has certainly contributed to greater interest in using JGBs.
What are the challenges that people might need to be aware of when considering increasing the use of JGBs in their collateral stack?
When increasing the use of JGBs in a firm’s collateral stack, this presents an obvious challenge of managing inventory related to operating hours. The Japanese market opens in the middle of the night in Europe and is even more challenging with respect to the US. But even then, Euroclear has the capacity to move JGBs out of and into the domestic Japanese market in size and on the same day. There are some challenges around managing an asset class that is in yen, as there is currency risk involved. Additionally, there can be some quite onerous documentation requirements in the local language.
However, following the clarification of the fiscal treatment of securities financing transactions, Euroclear was able to work with our Japanese depository to significantly reduce the burden related to the required certification to hold JGBs as collateral in Euroclear. This simplification of documentation has been an important catalyst for growth in the use of JGBs on the Collateral Highway and it has unlocked significant pools that were, previously, out of reach.
Euroclear has also made it easier to pledge JGBs by giving legal clarity on the validity of such a pledge. If a firm wants to have a pledge on Japanese collateral, it is not sufficient to just have good documentation with a counterparty. Firms would also need comfort that the pledge complies with Japanese law.
Euroclear worked to set up a structure — and get the necessary legal opinions on that structure — to enable clients to feel comfort that if they were pledging collateral, this pledge would be fully compliant with Japanese law. This further increases liquidity and their foreign usage. JGBs’ safety, liquidity and ease of use are three characteristics that make them ideal collateral and why they are so popular on the Collateral Highway.
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