Primary Dealers & Market Making

1. Primary Dealers & Market Making SEACEN/WB/IMF Conference Hosted by the Central Bank of Sri Lanka Colombo, June 2004 Thordur Jonasson Financial Sector Operations & Policy Department

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. Issues Result Long-term Impact • Ad-hoc or no debt management strategy • Weak capacity • Accountability is unclear HigherRisk DebtManagement • Greater risk of macro instability • Government budgetary pressures • Higher cost of funds to productive sector, SMEs, etc. • Less access to funds HigherCost • Access to Primary Market • Illiquid money market • Custody & Settlement problems DebtMarkets Higher growth can be achieved by addressing the causes of unnecessarily high risk and cost 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. Issuers User of capital Investors Suppliers of capital Intermediaries - provide liquidity - access to investors • Regulation and supervision. • The Central Bank,- The Government- Self Regulatory Organizations • Market infrastructure • - trading systems • information systems • brokers • - clearing, settlement & custody 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 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”

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. Offshore investors Retail investors Central Bank Speculators Institutional investors Commercial Banks 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@worldbank.org (202) 458-2165