HISTORY
AND DEVELOPMENT
Shortly after the beginning of the Latin
American debt crisis in 1982, a small secondary trading market for sovereign
loans gradually began to develop among commercial banks. While major money
center banks continued to hold loan assets and participated extensively in
frequent debt restructurings by debtor nations, some smaller commercial banks
preferred to sell their non-performing LDC loans and end their relatively
minimal exposure to developing countries. Other banks wished to rearrange their
credit portfolios by exchanging loans they had made to one debtor country for
another bank's loans to a second country. For accounting and other reasons,
sellers tended to be either non-U.S. financial institutions or U.S. regional
banks rather than U.S. money center banks. In 1983 and 1984, a small group of
enterprising traders began to conduct the highly specialized business of
intermediation between sellers and buyers of LDC loans. Trading activity increased substantially in
1986 and 1987 after several debtor countries (Chile and Mexico) adopted
debt-for-equity exchange programs as part of their debt restructuring packages.
Specifically designed to operate as a permitted exception to the usual rule that
payments under syndicated loan agreements had to be made pro rata to all members
of the lending syndicate, these programs allowed debt holders to exchange their
debt claims for equity in state-owned or other companies, or for other local
assets. Trading activity continued to grow after 1987, as commercial banks in
the United States and elsewhere increased their loan loss reserves, making it
more commercially viable to sell loans at less than face value. The implementation of the
Brady Plan in 1989-90 further accelerated the growth of the LDC debt trading
markets, as the announcement of each successive agreement-in-principle set off a
new wave of loan trading as well as trading of the proposed new instruments on a
when-issued basis. In addition, the liquidity of the EM marketplace was greatly
facilitated, as each completed Brady restructuring resulted in the issuance of a
large face amount of new Emerging Markets debt securities, which were
specifically designed to be more easily tradable than defaulted loans.
By 1990, it was apparent that what had
started as sporadic, highly individualized loan sales transactions had developed
into a large, sophisticated trading market with many active participants from
the commercial banking and broker-dealer communities. The new Brady bonds also
encouraged the entry of broader classes of investors into what had become known
as the Emerging Markets. By 1998, after over a decade of defaults, all major
Brady restructurings had been completed, signaling the transformation from an
unsecuritized loan market to a bond market and paving the way for many former
debtor nations to re-enter the voluntary global capital markets. During the 1990's, the market for Emerging
Markets debt grew not only in volume, but also in the types of instruments
traded, the number of trading houses and investors involved, and the size of the
market in relation to others worldwide. The investor base for Emerging Markets
instruments expanded from its traditional investors to include many crossover
investors from the more mainstream high-yield and high-grade investment areas.
Investors were drawn to the Emerging Markets
during this period by high yields and high growth potential as well as by a
general market trend toward positive economic and political reforms and
improving economic performance in many Emerging Market countries. Despite these
encouraging trends, however, investments and trading opportunities throughout
the Emerging Markets all share certain characteristics and present some common
risks. In addition to customary risks stemming from the issuer's economic or
financial performance and its capacity to service its payment obligations,
investments in Emerging Markets involve a variety of cross-border risks such as
legal and regulatory uncertainty, enforcement difficulties, foreign exchange
fluctuations and restrictions and the possibility of currency devaluations or
changes in government or government policies. These cross-border risks are
magnified in the Emerging Markets by the emerging characteristics of each
country's political structure, regulatory and legal system and economy.
Although the higher yields available in
Emerging Markets investments generally reflect the significant nature of these
risks, the volatility of such investments at times has been considerable, and in
fact at times outright daunting for many investors more accustomed to the
relative stability and greater predictability of the more traditional markets in
developed countries. Despite improving fundamentals in many EM
countries (accompanied by numerous credit rating upgrades), the growth of the
Emerging Markets trading industry since 1990 has been punctuated by a series of
market events that emphasized the potential volatility and riskiness of Emerging
Markets investments. A long period of growth in both trading
volumes and asset values was interrupted in 1994, first by the market's adverse
reaction to rising general interest rate levels in the spring and then by the
sharp decline in investor confidence that occurred after Mexico's peso
devaluation in mid-December. The Mexico devaluation set in motion a so-called
'Tequila effect' of contagion that depressed market values throughout the
Emerging Markets during early 1995. Following the massive rescue package
organized for Mexico by the U.S. and other G-7 nations, however, investor
confidence in the Emerging Markets recovered significantly by mid-1995, and
trading volumes and asset prices, as well as capital flows, showed considerable
growth for the next several years. Sovereigns and other Emerging Markets
issuers generally took advantage of favorable market conditions from 1996
through early 1998 to refinance a portion of their stock of debt, and investors
increasingly sought the higher yields available in local currency instruments
and more market-oriented dollar-denominated assets. Local currency asset values
fell sharply following the onset of financial and economic difficulties in
Southeast Asia in mid-1997. By mid-1998, market contagion had spread these
difficulties to Russia, which in turn led to a severe, and more general,
contagion throughout the Emerging Markets in the latter half of 1998. The
resulting loss of investor confidence eventually led to Brazil's January 1999
devaluation of the real.
Market trading volumes, which had grown rapidly in the 1990's, peaked at U.S. $6 trillion in 1997 and then fell off sharply after the Russian default in mid-1998, as investors re-evaluated the volatility and returns on Emerging Markets investments and dealers reduced their trading lines.
Despite rising interest rate levels and growing concerns about the private sector's role in resolving sovereign financial crises (the so-called 'burden-sharing' debate), 1999 and 2000 were generally characterized by increased trading activity and growing investor confidence in the Emerging Markets, sparked in large part by Brazil's rapid economic recovery, Mexico's upgraded credit rating to investment grade and Russia's successful 'London Club' debt restructuring.
By 2005, secondary market trading volumes had rebounded to U.S.$5.485 trillion, and the market was characterized by the steady retirement of Brady bonds through the issuance of global bonds, Eurobonds and local markets instruments. Despite Argentina's massive default in December 2001, the EM trading and investment market in the 2002-2005 period was characterized by continuing improvement in credit fundamentals, a decline in market contagion and large inflows of investment funds from other asset classes. By 2005, trading in local market instruments had increased to over 47% of total trading activity.