June 9, 2004 Financial Sector Operations & Policy Department 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 1.Role of financial markets 2.Primary market 3.Primary dealers 4.Market Making

Financial Sector Operations & Policy Department 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

Financial Sector Operations & Policy Department 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

Financial Sector Operations & Policy Department 5 Impact on Development IssuesResult Long-term Impact Ad-hoc or no debt management strategy Weak capacity Accountability is unclear Access to Primary Market Illiquid money market Custody & Settlement problems Higher Risk Debt Management Debt Markets Higher Cost 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

Financial Sector Operations & Policy Department 6 The organization of primary 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?

Financial Sector Operations & Policy Department 7 The organization of primary 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

Financial Sector Operations & Policy Department 8 The organization of primary markets - III Issuers User of capital Investors Suppliers 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

Financial Sector Operations & Policy Department 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

Financial Sector Operations & Policy Department 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?

Financial Sector Operations & Policy Department 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

Financial Sector Operations & Policy Department 12 Primary dealer systems Rights – 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”

Financial Sector Operations & Policy Department 13 Primary dealer systems Obligations – 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

Financial Sector Operations & Policy Department 14 Primary dealers systems Examples Country#Rights/PrivilegesObligations Canada12Exclusive counterpary rights for central bank’s omo’s and borrowing privileges with the central bank To bid in auctions. To make firm two-way quotes To report to the central bank Greece15Exclusive access to primary aucitonsTo bid in auctions. To make two-way quotes Hungary13Exclusive access to primary auctions Consultations with the debt management agency To bid in auctions. To make firm two-way quotes. To report to the debt agency. Korea26Exclusive 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 Zealandnone Sweden7Exclusive 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 Thailand9Exclusive counterparty to central bank omo’sTo make two-way quotes UK17Exclusive 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 USA25Exclusive 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 bank To participate in the Federal Reserve’s omo’s To provide the Fed with market information and analysis Source: IMF MAE WP/03/45

Financial Sector Operations & Policy Department 15 Primary markets Impediments 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

Financial Sector Operations & Policy Department 16 Primary markets Impediments 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

Financial Sector Operations & Policy Department 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

Financial Sector Operations & Policy Department 18 Secondary market Organization Central Bank Commercial Banks Retail investors Institutional investors Offshore investors Speculators price- makers non price- makers INTERMEDIARIES Commercial Banks Discount Houses Merchant Banks

Financial Sector Operations & Policy Department 19 Secondary markets Primary 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

Financial Sector Operations & Policy Department 20 Secondary markets Market 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

Financial Sector Operations & Policy Department 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

Financial Sector Operations & Policy Department 22 Market making Initiating 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?

Financial Sector Operations & Policy Department 23 Market making Non-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

Financial Sector Operations & Policy Department 24 Market making Securities 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

Financial Sector Operations & Policy Department 25 Market making Buybacks/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

Financial Sector Operations & Policy Department 26 Market making Backstop & 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

Financial Sector Operations & Policy Department 27 Market making Impediments 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

Financial Sector Operations & Policy Department 28 Market making Impediments 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

Financial Sector Operations & Policy Department 29 Market making Impediments 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

Financial Sector Operations & Policy Department 30 Primary dealers Closing 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

Financial Sector Operations & Policy Department 31 Primary dealers Closing 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

Financial Sector Operations & Policy Department 32 Thank you! Questions/comments/suggestions to: Thordur Jonasson (202)