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Primary Dealers & Market Making. SEACEN/WB/IMF Conference Hosted by the Central Bank of Sri Lanka Colombo, June 2004 Thordur Jonasson. Structure of presentation. Role of financial markets Primary market Primary dealers Market Making. Pricing of Risk in a Liberalized Financial System - I.

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primary dealers market making

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

structure of presentation
Structure of presentation
  • Role of financial markets
  • Primary market
  • Primary dealers
  • Market Making
pricing of risk in a liberalized financial system i
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
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



Long-term Impact

  • Ad-hoc or no debt management strategy
  • Weak capacity
  • Accountability is unclear



  • Greater risk of macro instability
  • Government budgetary pressures
  • Higher cost of funds to productive sector, SMEs, etc.
  • Less access to funds


  • Access to Primary Market
  • Illiquid money market
  • Custody & Settlement problems


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

Impact on Development
the organization of primary markets i
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 of primary markets ii
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 of primary markets iii


User of capital


Suppliers of capital


- 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
primary dealers i
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
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
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 systems rights primary market
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 systems obligations primary market
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 systems examples
Primary dealers systemsExamples

Source: IMF MAE WP/03/45

primary markets impediments to development i
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 markets impediments to development ii
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
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 market organization





Central Bank






Secondary marketOrganization







Commercial Banks

Discount Houses

Merchant Banks

secondary markets primary dealers obligations
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 markets market making
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
  • 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 making initiating
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 making non competitive bids
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 making securities lending
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 making buybacks switches
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 making backstop cash compensation
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 making impediments to development i
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 making impediments to development ii
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 making impediments to development iii
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 dealers closing remarks i
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 dealers closing remarks ii
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
Thank you!

Questions/comments/suggestions to:

Thordur Jonasson

(202) 458-2165