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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
3Financial Sector Operations & Policy Department
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
4Financial Sector Operations & Policy Department
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
5Financial Sector Operations & Policy Department
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
6Financial Sector Operations & Policy Department
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?
7Financial Sector Operations & Policy Department
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
8Financial Sector Operations & Policy Department
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
9Financial Sector Operations & Policy Department
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
10Financial Sector Operations & Policy Department
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?
11Financial Sector Operations & Policy Department
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
12Financial Sector Operations & Policy Department
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”
13Financial Sector Operations & Policy Department
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
14Financial Sector Operations & Policy Department
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
15Financial Sector Operations & Policy Department
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
16Financial Sector Operations & Policy Department
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
17Financial Sector Operations & Policy Department
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
18Financial Sector Operations & Policy Department
Secondary marketOrganization
Central Bank
Commercial Banks
Retail investors
Institutional investors
Offshoreinvestors
Speculators price-makers
nonprice-makers
INTERMEDIARIES
Commercial Banks
Discount Houses
Merchant Banks
19Financial Sector Operations & Policy Department
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
20Financial Sector Operations & Policy Department
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
21Financial Sector Operations & Policy Department
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
22Financial Sector Operations & Policy Department
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?
23Financial Sector Operations & Policy Department
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
24Financial Sector Operations & Policy Department
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
25Financial Sector Operations & Policy Department
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
26Financial Sector Operations & Policy Department
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
27Financial Sector Operations & Policy Department
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
28Financial Sector Operations & Policy Department
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
29Financial Sector Operations & Policy Department
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
30Financial Sector Operations & Policy Department
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
31Financial Sector Operations & Policy Department
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
32Financial Sector Operations & Policy Department
Thank you!
Questions/comments/suggestions to:
Thordur Jonasson
(202) 458-2165