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Market-making activities solve problems of dominant size

As a fund that is negotiating the uncharted waters of a young pensions industry, the €656m AZ Obligatory Pension Fund of Croatia has won the Best Innovation Award for its bold move in becoming a market maker in government bonds.
The Croatian pension system was reformed in 2002, the changes closely resembling those previously introduced in Poland and Hungary .
The new system consists of three pillars: the first pillar being the old pay-as-you-go system, the second being obligatory pension funds (OPFs) and the third voluntary pension savings.
There are now four OPFs in Croatia. The largest - AZ - accounts for 41.3% of the market.
The state regulatory agency has imposed investment limits on OPFs and, as the whole system is still in its infancy, these limits are of necessity very rigid.
The rules set out a very prescriptive framework for asset allocation decisions, and as a result OPF portfolios are largely bond funds. Over the past four years, OPFs have continuously held about three-quarters of their assets in Croatian government bonds, and AZ is no exception.
However, in the early years of the pension reforms, the market for these bonds was highly illiquid. And AZ's comparatively large size - compared with the total market, it is 10 times larger than leading bond dealer Pimco in the US - meant that its market impact cost would have been enormous. This in turn would have made it almost impossible for the fund to manage the duration of its bond portfolio. The use of interest rate derivatives as an alternative is not allowed.
Faced with this problem, AZ turned it into an opportunity: the fund became a market maker in domestic government bonds. Apart from some of the banks it is still the only institutional investor in Croatia that does this.
AZ put this market making strategy into practice as follows. First, it set up a market-making department and began quoting on the local bond curve with a spread of 30 basis points for quantities of €1m.
Then trading contacts were established with major institutional clients, both at home and abroad. These included some 40 investment funds, insurance companies and building societies within Croatia , and 21 foreign banks that traded Croatian bonds.
The fund began to produce reports on bond prices, which were sent daily to clients. It now has a pricing page on Bloomberg.
According to AZ, this strategy has yielded several benefits, both for its own operations and for the bond market as a whole. From AZ's point of view, the market impact cost has fallen. At present, it holds a huge 14% of all domestic government bond issues. But its market-making activities have overcome the problems of holding such a huge share of the market.
In addition, the market has become more competitive: bid-ask spreads have tightened and trading volumes have increased. Before AZ established its market making department domestic banks were quoting spreads of 100bps on volumes of €500,000. Once AZ entered the market, spreads rapidly tightened to 30bps, while the average trading volume is now €1m. Meanwhile, bond market turnover increased to €3.97bn in 2005 from €640m in 2002.
The reduction in bid-ask spreads has given a direct boost to AZ's bond portfolio performance.

In addition, because AZ has gained access to information which is not usually available to end-users, there is now improved monitoring of asset flows as well as better information about market positioning. Continuous communication with its clients has made AZ more aware of the thought processes behind the construction of clients' portfolios, and this has improved the fund's ability to predict market trends.
AZ's positioning on primary issuances has also improved. It previously experienced problems in obtaining large volumes of primary bonds as issuances in Croatia are made through bank syndicates.
Now AZ's involvement in the secondary market has prompted the ministry of finance to set aside a predefined tranche of bonds for pension funds from primary issuances.
These benefits have all been achieved in line with additional flexibility on bond portfolio construction.
From a standing start, AZ has now become the largest market maker in the Croatian government bond market. In the first eight months of this year alone it was responsible for 41.8% of all bond trades on the domestic market.
By engaging in market making, AZ has not only won direct and indirect benefits for its fund performance, but has also helped the growth and development of bond markets in Croatia.

Highlights and achievements
As a young pension fund in a fledgling industry, AZ has been able to innovate radically through its activities as a market maker in government bonds.
In terms of the Croatian bond market AZ is a ‘bull in a china shop', and as a major investor in illiquid securities its market impact cost was enormous.
By making its own market in bonds, AZ has not only reduced this cost, but brought about lower spreads and increased trading volumes, which has not only boosted its own portfolio performance but also advanced the market as a whole.
It now has better access to primary issuances because the finance ministry allocates a proportion of bond issues to pension funds.
Subsidiary benefits include improved monitoring of asset flows and better market positioning. And communications with institutional clients have given AZ a better ability to predict market trends.

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