2. Lecture outline Primary dealers Central Bank and primary dealers Foreign companies as primary dealers Primary market Secondary market Repo market

3. Primary dealers As we have discussed, one of the ways to minimize debt servicing cost is through microstructuring. Market players do not want to buy big bulks of government debt because it is associated with increased risk. To overcome this, the government uses primary dealers who buy and keep big amount of government bonds on their accounts. Two targets of micro-structured finances:  Increasing the profitability of entire market  Increasing the share of government in this profitability

4. Primary dealers In microstructuring the government limits its debt in a few large issues with the most popular maturity periods The liquidity is achieved through increasing the volume of trade Primary dealership helps to increase ability of the market to absorb large volumes of the public debt issue

5. Primary dealers Primary dealers serve as wholesalers of the government bonds which they keep in their accounts. This is done in exchange for receiving certain privileges from the government Investors come to primary market only if they can sell other assets in the secondary market. Primary dealers provide this opportunity for appropriate remuneration As we discussed, liquidity is everything for investor. For this reason, the government targets liquidity as prerequisite.

6. Primary dealers Premium for liquidity that the government should receive is not immediate. It goes through market mechanism which involves primary dealers Primary dealers are financial institutions which have the right to buy public debt directly from the government. In some countries, this right is given also to other market participants. They help to minimize the cost of issuing public debt Primary dealers are like tax officers. But unlike tax officers they receive money from people and organization who are not obliged to give funds to the government. They do this on the voluntary basis.

7. Liquidity of the market Liquidity is set by the government. For example, if the government issues bonds worth USD10 billion, the market is less liquid than in the case the government issues USD 100 billion worth bonds. The amount of the issue and hence liquidity is not decided by primary dealers. They serve simply as instrument to circulate the issues among the market players. For this they use various marketing tools. In this sense primary dealers are market makers

8. Liquidity of the market Nowadays the market becomes internet based and this eliminates the need for primary dealers. However, the share of tradable assets on the market is significant. The owners of tradable assets still need the primary dealers to place orders and sell their assets. Another reason why the primary dealers will be demanded – aim of the Central Bank to avoid monetization of public debt. In the developing countries, the CB prints money to finance budget deficit. In the countries where there is a well- functioning market, the central bank can delegate its function to primary dealers.

9. Central Bank and primary dealers To help primary dealers the Central Bank extends to them large credit lines so the primary dealers would have enough liquidity to buy big bulks of the government bonds However, these funds are spent on buying government bonds under the repurchase agreements with primary dealers. Central Bank is not allowed to buy the government bonds directly on the primary market. It can only swap old paper for new ones. Central Bank can use the primary dealers as instruments in its monetary policy (especially anti-inflationary policies).

10. Central Bank and primary dealers Secondary market creates opportunity for the Central Bank to run open market operations Buying or selling the government bonds to primary dealers, the CB run its monetary policy with the greater flexibility This way the CB can decrease or increase the banking reserves. Here the effectiveness of this policy entirely depends on the ability of primary dealers to provide fair price and quantity.

11. Foreign companies as primary dealers Why does in many countries the share of foreign companies in primary dealers exceed 50 percent?  Foreign companies help to circulate the government bonds outside the country. The total number of primary dealers is small: on average 15 for the whole North America and EU. This is another motivation to cooperate on the market of primary dealership.

12. Primary dealers: the fewer the better? The reason for small number of primary dealers is that the number of large financial institutions is itself small In Canada, six commercial banks possess 95 percent of the total banking capital and these banks are the only institutions which can provide primary dealership Another reason is that large financial companies tend to merge over time, so are primary dealers.

13. Primary dealers: the fewer the better? So in what case the selling price will be highest: auctions with fewer or more bidders? The concept of “winner’s curse” suggests that when the number of bidders is high, the effect of winner’s curse is strongest and bidder become very conservative. J.Bulow and P.Klemperer in their “Prices and the Winner’s Curse,” (1999) suggest that this conservatism results in lower maximum price than in the case of fewer bidders. Likewise, having small number of primary dealers increases maximum price of bond sold and therefore minimizes cost of debt servicing for the government

14. Primary market In the primary market the government makes deals with primary dealers. Sellers and bidders try to maximize their profits The government can use the following methods of placing the offers:  Syndicating  Tap  Competitive auctions

15. Syndicating In this method the government directly deals with syndicate of large banks and financial groups. There are no other players. The limited number of participant does not allow to run tenders or auctions. Syndicating is about the bargaining between monopoly (the government) and oligopoly (syndicate), which determines the final price. Syndicating does not provide the cheapest debt to the government. For this reason, when the issuing activity of the government is high, it is advised to use the methods such as tap and competitive auction

16. Tap and auction Unlike in syndicating, tap does not allow bargaining Price is fixed by the government. The issue is focused on the non-tradable securities and may last very long. Auction is the only way to allow competition among the participants and thus decrease the cost of borrowings. Unlike in syndicating, the auction allows the investors to get profit by reselling securities. However, syndicating is attractive in terms of increasing liquidity of the market because it allows to sell significant number of bonds in short time.

17. Forward market Government bonds market is complete only if it consists of pre-auction market, auction, post-auction market and repo market. In pre-auction market the trade happens with yet to be issued papers. The contract are forward contracts. Those, who expect interest rate to fall,-buyers of bonds. Those who expect interest rate to increase- sellers of bonds. Primary dealers learn from these forward contracts about the real price of government securities and try to decrease the winner’s curse.

18. Forward market On the other hand, primary dealers may manipulate with market expectation to earn profit For example, assume that the primary dealer starts to sell bonds on pre-auction market by signing forward contracts. Other who see this also start doing this even at a lower price. In the auctions the primary dealers receive money by this forward contract and buy again bonds at current price which will be cheaper that in pre-auction market. If the primary dealer buys the biggest share of traded bonds at auction, other dealers may be left without necessary securities. This is called “short squeeze”.

19. Short squeeze Primary dealers short of bonds have to buy or borrow bonds in the post-auction or repo market. If demand on the repo market is greater than supply, the interest on bonds will be lower In some countries (e.g. Austria, Belgium, Germany, Ireland, Spain, Netherlands, Portugal, etc) due to the effect of short squeeze, pre-auction markets are forbidden.

20. Secondary market In the post-auction market, primary dealers have two targets:  To trade and receive revenue by selling new bonds  To trade with investor on their demand, but under the conditions set by the government and central bank. Second target makes primary dealer a market maker. Depending on how interest rate will change, the primary dealer may even face the risk of being bankrupt To minimize the risk, primary dealers uses various instruments: changes quotes, spreads, etc.

21. Repo market Primary dealer may have to borrow bonds in repo market for the following reasons:  Sold out bonds and could not buy enough to provide under the contract  Has to provide bonds (not yet received) sold at pre-auction market  Need to borrow for another credit contract  Failed to provide securities in time and now need to correct this failure Central bank, institutional investors and other act as providers of repo agreements on this market.

22. Repo market The main provider is Central Bank which has its own interest – to control money supply through open market operations For example, if Central Bank plans to decrease money supply, it does so by providing so called matched sale-purchase (MSP) agreements. Under MSP agreement, primary dealer buys government bonds and is obliged to sell it back to the Central Bank at agreed period. In turn the Central Bank collects cash from primary dealers and effectively decreases money supply in the whole economy.

23. Thank you for your attention!