7 Provision of market maker services
Economic objective
The economic objective is to maximise the opportunities for New Zealand citizens and entities to engage in efficient risk sharing.
The motivation for this objective relates to ‘missing markets’. Although the potential to construct derivative contracts of almost infinite variation allows a small number of underlying securities to span a large state space, it is generally considered in the literature that capital markets are incomplete in relation to intergenerational risk and country risk (Shiller 1993). If correct, such unexploited insurance opportunities suggest the possibility that Crown financial policy could improve welfare by issuing appropriate securities. In some circumstances, the sovereign power of the state may confer a comparative advantage on the Crown as a provider of market maker services.
Key insights for policy
It has long been argued in the literature that the risk of default on private debt makes it impossible to create a private substitute for government debt (Tobin 1963 and Stiglitiz 1983). Formal models deriving particular circumstances where safe debt would improve opportunities for risk sharing between current generations and generations yet unborn are available in Fischer (1983) and Peled (1985). Holmstrom and Tirole (1998) present an alternative rationale where government debt is superior to private sector instruments in the provision of liquidity services.
Research on OLG models also suggests tentatively that there may be scope for the Crown to issue output-indexed securities for managing country risk and very long-term debt for managing intergenerational risk (Gale 1990 and Shiller 1993).[26] However, the literature also cautions that financial innovations could have detrimental impact on risk sharing and economic welfare. In particular, it is important to take into account how the issue of new securities would alter the distribution of government expenditure, transfers and taxes across future states of nature. A redistribution of risk across citizens could be welfare reducing.
Summary for market maker service
- Economic objective
- Maximise the opportunities for New Zealand citizens and entities to engage in risk sharing
- CFP objectives
-
- Portfolio policy
- Create and maintain markets for securities that improve risk sharing
- Targets
- lower bound on existing securities (e.g. safe debt) identified as important for risk sharing; and
- issue new securities to bridge missing markets where this would be welfare-improving
- Instruments
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- Long-term debt
- Range of indexed securities
Notes
- [26]An output-indexed security would have the feature that the return payable on the security varies inversely with the level of GDP (or other output measure) of the economy.
