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The Central Bank Bond Fiasco

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Controversy has plagued the recent Central Bank bond issue, where it is alleged that Governor Arjuna Mahendran’s son-in-law Arjun Aloysius had advanced information which was used to extract massive profits in ‘judicious’ trading.  Aloysius is reported to have sold several 5-10 year bonds at low interest rates and reinvested in the 30 year bond which had an unprecedented high interest rate of 12.5%.  According to those familiar with such transactions, if the Government had a serious cash-flow issue then the answer is to go for short term borrowing.  One does not, accordingly, go for long term borrowing at high interest rates.  Interestingly, the general complaint against the previous regime was that it was borrowing on high interest rates.  
Perhaps one of the biggest problems about bonds is general ignorance on the part of the public about the terms and the ins and outs of this kind of trading.  This is as good an opportunity as any for all concerned citizens to educate themselves.

Primary dealers
A primary dealer is appointed by CBSL(Central Bank of Sri Lanka) as the agent who buys and sells government securities (Treasury Bills 3,6,12 months or Treasury Bonds 2,3,4,5,6,8,10,20,30 years) to the General Public, Corporates, Insurance Companies etc. The Primary dealer is also known as a market maker. This is because most clients seek the Primary Dealer’s advice regarding rates when they buy and sell their Government Securities. There are Bank Primary Dealers and also Non-Bank Primary dealers in Sri Lanka. A list of the dealers and their contact details are available in the daily papers in Sri Lanka. The capital requirement for a Primary Dealer license is at present Rs 400 million.

Primary Dealers are similar to stock brokers and are required to open outstation branches and also educate and update the public by holding seminars and workshops.

Trading in Government Securities has two types of transactions. They are known as Primary Market and Secondary Market. Primary market is the purchase and sale of Government securities from CBSL(Central Bank). Secondary Market is the sale and purchase of securities from all other type of clients (individuals, corporates etc).

Earning income
Primary Dealers earn income by buying and selling Government Securities. They also earn income by funding a portfolio of their own.

Example I:
Purchase of Rs 100 million 02 Treasury bond at 12.50% and selling to a client at 12.40%. This difference of 0.10% is the profit earned multiplied by the period of the Treasury bond (to earn a Capital Gain the Primary Dealer has to sell the purchased Bond at a lower rate). Profit is Rs 200,000.00 (estimate).

Example II
Funding Profit: The Primary Dealers owns Rs 2 Billion government securities and therefore earns an annual interest of 12% and if funds are borrowed at an annual rate of 8% the annual profit is in the region of Rs 80 million.

Making losses
If a Primary Dealer purchases a Government security at low yield and sells at high yield they make a capital loss. This is the reverse of the Example I
Further if a Primary Dealer owns a Portfolio of Government securities at a low yields and funds at high yields a loss is made. Reverse of Example II
Also if a Primary Dealer Purchases a Government Security at 10% and if the rate of the same security is higher the next day or even in the same day the Primary Dealer incurs a mark to market capital loss.

The Perpetual Securities Scandal
The above company is a Primary Dealer owned by Arjuna Aloysius. The Governor, by way of allaying suspicion of insider trade said ‘my son-in-law is no longer a director; he resigned before I was appointed’.  It does not matter whether Arjuna Aloysius is a director or not.  What is pertinent is that he controls the company.  

Arjuna Aloysius is a well-known stock market manipulator and his sale of pumped up shares to the EPF is known and recorded. This too is pertinent.

Information is KING in Bond markets. If an individual or organization has prior information regarding interest rates movements they can earn billons of rupees.  Billions of rupees were made on this Bond.  That’s pertinent too.

Did ‘Perpetual’ make rogue profits?
There are questions that need to be asked.  It seems that Aloysius knew that Bond rates would increase a week before the ill fated auction as his company sold forward dated Bonds to the market. It is very easy to check his company’s sales of Bonds by checking their daily report and speaking to other Primary dealers. This will reveal that he sold bonds which he did not own and bought them at a higher price for the same sale date after the 30 year Bond auction results were announced.

The Central Bank announced a 30 year Bond auction for the 27th of February for Rs 1 Billion rupees. On the 27th Feb morning the Central Bank inquired from all dealers regarding their bidding rates which is always done in a informal way and the also informed the dealers that they expect the auction rate not to exceed 9.75%.

What is most important to note is that there is trust between the Central Bank and the Primary dealers. If that trust is broken and Primary Dealers do not trust the Central Bank on guidance on interest rates this leads to higher bidding rates by Primary Dealers and a huge cost to the Government of Sri Lanka as they are the only borrower of Government Securities. SL Government borrowing on Government securities is close to Rs 1 trillion.  An increase of 1% will add an additional Rs 10 billion in interest.
After discussions with CBSL ended the Primary Dealers placed their Bids for the auction which was for Rs 1 Billion. Never in the history of Bond market auctions has the amount offered been increased.

What happened next?  When the auction results were announced the amount accepted had been increased to a astounding Rs 10 Billion, ten time the original amount required!

Perpetual Securities had obtained Rs 4 billon plus securities at rate of 12.50%.  They had placed a last minute bid thru Bank of Ceylon for Rs 3 billion. Now why should anyone place a bid for Rs 3 billion when the Central Bank is offering only Rs 1 billion? It looks like they would have had had information that the offered amount would be increased.

This incident netted Perpetual a profit of Rs 1 billion or more in a span of just one week.

Further CBSL to justify their claim in increasing the acceptance amount to Rs 10 billion are using the excuse that previously CBSL had made private placements to captive sources (EPF and ETF) and that this will not be done in the future hence the increase. The captive sources placements part is true, but CBSL did not need to increase the amount if they had offered the correct the requirement of Rs 10 billion at the auction.  Surely, CBSL could not have ‘figured out’ in a matter of days that it required ten times what it had just indicated it needed!  At best it indicates incompetence and the Governor should resign on that count alone. At worst, it smacks of complicity in a shady deal.  

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