Primary Dealers & Market Making

Financial Sector Operations & Policy Department June 9, 2004

Primary Dealers & Market Making

SEACEN/WB/IMF Conference

Hosted by the Central Bank of Sri Lanka

Colombo, June 2004

Thordur Jonasson

2Financial Sector Operations & Policy Department

Structure of presentation

1. Role of financial markets

2. Primary market

3. Primary dealers

4. Market Making


Pricing of Risk in a Liberalized Financial System - I

• The main role of the financial markets is to price risk

• This may be complicated by:– Lack of fiscal discipline– High inflation expectations– Lack of policy consistency– Lack of transparency of public finances– Lack of coordination


Pricing of Risk in a Liberalized Financial System - II

• Leading to:– Variability in demand for bonds which would

attribute to extreme volatility in interest rates– Greater reliance on short-term maturities

• Expectations of market participants may be dominated by memory of great volatility

• Credibility will be attained with consistency over time


Impact on Development

Issues ResultLong-term

Impact

• Ad-hoc or no debt management strategy

• Weak capacity

• Accountability is unclear

• Access to Primary Market

• Illiquid money market

• Custody & Settlement problems

HigherRiskDebt

Management

DebtMarkets

HigherCost

• Greater risk of macro instability

• Government budgetary pressures

• Higher cost of funds to productive sector, SMEs, etc.

• Less access to funds

Higher growth can be achieved by addressing the causes of unnecessarily high risk and cost


The organization ofprimary markets - I

• Common questions: – What is the most efficient way to sell bonds? – What types of investors do we want to reach?– How can we increase competition in the primary

market?– Should we implement a primary dealer system?– Should we have a special distribution channel for

retail / small order clients ?– Should we allow non-competitive bidding?


The organization ofprimary markets - II

• Distribution options:– Auctions– Direct sales using “new” technology– Private placements/syndication– “Tap”-sales– Announcing a price and soliciting public

subscription over a fixed period– Announcing a price and offering sales on tap over

an unlimited period altering the price with varying frequency


The organization ofprimary markets - III

IssuersUser of capital

InvestorsSuppliers of capital

Market infrastructure- trading systems- information systems- brokers- clearing, settlement & custody

Regulation and supervision.- The Central Bank,- The Government- Self Regulatory Organizations

Intermediaries- provide liquidity

- access to investors


Primary dealers – I

• May assist change to a market-based funding environment– Branch networks (bank-based)– Operators of mutual funds– Business relationships with institutional investors

such as pension funds and life insurance– Links to off-shore investors

• Principal / Agent issue


Primary dealers - II

• There are no international standards for Primary dealers and the term itself can be misleading

• Some financial systems may be less suitable for primary dealers– Will the introduction of primary dealers lead to deeper and

more liquid markets?– Rent seeking vs. gain from a more deeper liquid market?– Can the arrangement be removed or reduced through

competition in the future?


Primary dealers - III

• Functions performed may include:– Acting as a channel between debt manager and

investor in the primary market – Performing as bookmakers and distributors by

having dealers that canvass investors’ interest– Acting as providers of immediacy of liquidity to

primary and secondary markets– Acting as providers of asset transformation and

market making services by being willing to hold inventories of government securities

Source: IMF MAE OP/02/02


Primary dealer systemsRights – primary market• Exclusive or privileged access to primary auctions• Exclusive or privileged counterparty for central bank’s open

market operations• Exclusive or preferential access to noncompetitive bids• Information and consultation with the government debt

management agency• Borrowing privileges with central bank, including repurchase

agreements• Exclusive or privileged counterparty for operations with public

debt manager• Underwriting commissions• Usage of the title “primary dealer”


Primary dealer systemsObligations – primary market

• Bid in auctions• Minimum underwriting obligation• Providing authority with market information

and analysis• Participation in money market operations• Compliance to prudential regulation, i.e. a

Code of Conduct• Participation in research• Position reporting to supervisory authority


Primary dealers systemsExamples

Country # Rights/Privileges Obligations

Canada 12 Exclusive counterpary rights for central bank’s omo’s and borrowing privileges with the central bank

To bid in auctions. To make firm two-way quotesTo report to the central bank

Greece 15 Exclusive access to primary aucitons To bid in auctions. To make two-way quotes

Hungary 13 Exclusive access to primary auctionsConsultations with the debt management agency

To bid in auctions. To make firm two-way quotes. To report to the debt agency.

Korea 26 Exclusive access to primary auctions and non-competitive bidding

To bid in auctions. To make firm two-way quotes. To trade a minimum of 2 percent of total secondary market volume

New Zealand none

Sweden 7 Exclusive access to primary auctions and counterparty to central bank’s omo’s

To bid in auctions. To report to the central bank. To contribute with good liquidity in the market

Thailand 9 Exclusive counterparty to central bank omo’s To make two-way quotes

UK 17 Exclusive access to primary auctions and participation in consultation meetings, secondary market dealing with the central bank

To make firm two-way quotes. To report to the central bank. To report trades to the LSE

USA 25 Exclusive counterpart to central bank’s omo’s. Ability to borrow securities intraday form central bank’s portfolio.

To bid in the aution (non-contractual obligation)To report to the central bankTo participate in the Federal Reserve’s omo’sTo provide the Fed with market information and analysis

Source: IMF MAE WP/03/45


Primary marketsImpediments to development - I

• Issues related to debt management– Number of bond series issued– Number of issuers– Instrument design– Using long term instruments for cash management– Auction frequency

• Deciding on instruments and issues very shortly before each auction– High level of market uncertainty regarding amounts and

pricing– Auction process non-transparent


Primary marketsImpediments to development - II

• Payment and settlement infrastructure• Prepayments• Low capitalization of primary dealers• Issues related to monetary policy

implementation• Unrealistic obligations and lack of incentives

for primary dealers• Weak investor base


Secondary market

• Why should an issuer be concerned about secondary market activity?– The more liquid a security is, the easier and less

costly it is for an investor to sell, and therefore the lower the liquidity premium attached to the security when issued

– Public good aspect


Secondary marketOrganization

Central Bank

Commercial Banks

Retail investors

Institutional investors

Offshoreinvestors

Speculators price-makers

nonprice-makers

INTERMEDIARIES

Commercial Banks

Discount Houses

Merchant Banks


Secondary marketsPrimary dealers obligations

• Market making• Promotion of debt among retail

investors• Assisting in the development of the

government securities market• Providing government securities closing

prices and volumes


Secondary marketsMarket making

• Parties agree to make prices to each other for the purchase and sale of financial assets.

• Prices are made:– during pre-agreed times– in agreed volumes– with agreed buy / sell spreads– Quality of pricing should be monitored on an

ongoing basis


Market making

• Market making is a risky business - assets can be bought / sold at short notice– Events may result in loss of liquidity– In turbulent markets spreads widen, and in extreme cases

price making may cease

• Not all financial institutions may have the capacity to be market markets– Two-tier system

• Important to define when quotes can be suspended– Monitoring the bond market on an ongoing basis


Market makingInitiating

• It may be necessary to offer incentives to Primary Dealers (although this is not ideal in the long term)

• Incentives may include:– Access to interdealer broker– Access to non-competitive bids– Securities lending– Access to buybacks/switches– Backstop facilities (should be carefully designed) – Cash remuneration for Market making?


Market makingNon-competitive bids

• Preferential access by primary dealers to ensure that they will get debt stock– Ratio of non-comp bids ranges from 0 to 40%– May include a discount– May be in the form of an “option to buy” the day(s) post

auction

• Retail distribution– Labor intensive– May require prepayment

• Central bank


Market makingSecurities lending

• Allowing short positions can reduce dealer inventories and sustain business during rising interest rates– Debt manager creates stock and retires– Pricing of facility– Can be made cash-neutral by receiving collateral

of other government securities– Collateral practices may need to be strengthened

when transaction volume increases an MRA is important


Market makingBuybacks/switches

• Buybacks– used to manage refinancing risk by reducing maturity

concentration– change debt portfolio composition

• Switches– Offered at the discretion of the debt manager or by reverse

inquiry– Sophisticated debt management tool

• Buybacks and switches increase secondary market activity– Requires a transparent debt management strategy– Avoid speculative/manipulative behavior at all costs


Market makingBackstop & Cash compensation

• Backstops– Not widely used – Could encourage excessive risk taking by Market

makers– Could subject the government to liquidity risk

• Cash Compensation has been used while developing markets– Fees for primary market participation– Fees for market making


Market makingImpediments to development – I

• Tap issues– If securities are freely available on tap or if auctions are

frequent, there is little incentive to trade on the secondary market

• High liquid asset ratios– result in institutions holding more assets than they desire.

• Investor base– Small institutional investor base not motivated to manage

their risks or a reasonable sized investors base but concentrated


Market makingImpediments to development – II

• Small number of dominant market participants– possible collusion and lack of competition

• Weak market participants• Poor payment and settlement systems

– high settlement risks deter trading

• Interbank credit lines too small for trading– irregular and uncertain issuance pattern– difficult for investors to form expectations about future supply


Market makingImpediments to development – III

• Poor price discovery mechanisms– developed markets have published prices, much in the same

way as for shares.

• No hedging mechanisms– no access to rental securities– undeveloped repo markets

• Poorly defined trading conventions– no codes of conduct

• Taxes– eg taxes based on original discount value, transaction taxes,

withholding taxes


Primary dealersClosing remarks – I

• Evaluate whether potential benefits of a primary dealer system outweigh the costs– Is the macroeconomic environment stable?– Is the microstructure of the issuance strategy sufficiently well

designed?– Is the investor base diversified and does it promote liquidity

and stabilize market demand?– Are there competitive, capable and capitalized

intermediaries present?– Is there a business case for being a primary dealer?

• Some countries have not found it necessary to introduce a primary dealer system


Primary dealersClosing remarks – II

• There is a greater chance of development where banks have to manage their own liquidity and there is a competitive market for longer term savings– Segregation of investment and trading portfolios– Mark-to-market, valuation principles

• It is not given that primary markets for Tbills and Tbonds should be treated alike

• The government has an important role to play both as the “client” and as the regulator and supervisor


Thank you!

Questions/comments/suggestions to:

Thordur Jonasson

[email protected]

(202) 458-2165

Primary Dealers & Market Making

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