Primary Dealers

1
Primary Dealers Market Making

• SEACEN/WB/IMF Conference
• Hosted by the Central Bank of Sri Lanka
• Colombo, June 2004
• Thordur Jonasson

2
Structure of presentation

• Role of financial markets
• Primary market
• Primary dealers
• Market Making

3
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

4
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

5
Impact on Development
6
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?

7
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

8
The organization ofprimary markets - III
9
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

10
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?

11
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
12
Primary dealer systemsRights primary market

• Exclusive or privileged access to primary
  auctions
• Exclusive or privileged counterparty for central
  banks 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

13
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

14
Primary dealers systemsExamples
Source IMF MAE WP/03/45
15
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

16
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

17
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

18
Secondary marketOrganization
INTERMEDIARIES
non price- makers
price- makers
Commercial Banks Discount Houses Merchant Banks
19
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

20
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

21
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

22
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?

23
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

24
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

25
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

26
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

27
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

28
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

29
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

30
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

31
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

32
Thank you!

• Questions/comments/suggestions to
• Thordur Jonasson
• tjonasson_at_worldbank.org
• [phone]