Chapter

Chapter 5 Developing a Primary Market for Government Securities

Author(s):
International Monetary Fund
Published Date:
September 2001
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A well-functioning primary market for government securities is essential for the orderly funding of government financing requirements, the foundation for a secondary market, and a source of price (interest rate) signals in many less-developed markets. The government has the responsibility for establishing a primary market. Its choice of procedures will depend on country circumstances.

5.1 Introduction

The selection of selling procedures or distribution channels for government securities encompasses a number of policy decisions. The selection should, to the extent possible (i) ensure cost-effectiveness; (ii) encourage participation from a relatively wide range of investors, including foreign institutions; (iii) maximize competition; (iv) minimize placement risk; and (v) foster transparency. For most advanced economies, the main sales technique is typically auctions. For countries in the early stage of debt-market development, selling may take the form of syndication, tap sales, underwriting, or private placement. Whether to use primary dealers and, if so, how the dealers are to be chosen and organized, are important related questions.

By making government securities straightforward in design, tailoring their maturities to meet market demand, and announcing borrowing plans in advance, the government can make its securities more attractive. There is also the question of the choice of auction administrator, which may be the Treasury or an agent of the Treasury, such as the central bank, a debt management office, or other organization. (See Chapter 3, A Government Debt Issuance Strategy and Debt Management Framework, and Chapter 4, Developing Benchmark Issues.)

By providing securities accounts (i.e., book-entry custodial services), the government can facilitate the issuance of government securities and make their trading and lending more feasible than if they were kept in paper form. (See Chapter 8, Developing a Government Securities Settlement Structure.) Primary market participants must be sufficiently creditworthy to fulfill their responsibility to purchase government securities. Supervision is needed for this purpose as well as for general oversight of government securities market operations. (See Chapter 9, Legal and Regulatory Framework.)

5.2 Techniques for Marketing Government Securities

Auctions have become the predominant distribution technique for government securities in industrial countries because they have proved to be more cost effective and transparent than other methods. For the same reasons, when financial systems in developing countries have reached a certain level, auctions have also become the main distribution procedure for issuing government securities in these countries. Other selling arrangements (syndication, underwriting, and tap sales) may prove more appropriate than auctions in the early stages of market development.

5.2.1 Auctions70

Governments in both developed and developing countries are increasingly using auctions as their main distribution channel for selling government securities. (See Table 5.1.) There are two main types of auctions, multiple price and uniform price, each with advantages and drawbacks. Governments need to be aware of the features of each type, such as their revenue potential and vulnerability to noncompetitive behavior (manipulation) by bidders, when selecting an auction procedure. Other types of auctions are largely a combination of these two.71

Table 5.1.Methods of Issuance of Government Securities in Selected Developed and Developing Countries
Frequency
CountryIssuance MechanismBondsBills
Developed Markets
CanadaMultiple-price auction in general and uniform price for inflation-linked bondsMonthlyWeekly
FranceMultiple-price auctionMonthly (1st Thursday OATs, 3rd Thursday BTANs)Weekly
GermanyMultiple-price auctionQuarterly (2-, 5-year bonds)Weekly
ItalyMultiple-price auction (bills), uniform-price auction (bonds)Every 15 daysEvery 15 days
JapanMultiple-price auctionMonthly
SwedenMultiple-price auctionEvery 15 days (nominal bonds), on tap (index-linked bonds)Every 15 days
United KingdomMultiple-price auction (gilts and bills, Euro notes and bills), uniform-price auction (index-linked)Quarterly (conventional gilts, index-linked gilts, Euro notes)Weekly (national currency bills), monthly (Euro bills)
United StatesUniform-price auctionMonthly (2-year notes), quarterly (5-, 10-year fixed principal notes), semiannually (10-, 30-year indexed notes and bonds, 30-year fixed-principal bonds)Weekly (13-, 26-week bills), quarterly (52-week bills)
Emerging Markets
BrazilMultiple-price auctionMonthlyWeekly
HungaryMultiple-price auctionEvery 15 daysWeekly
Rep. of KoreaMultiple-price auctionQuarterly (3-, 5-year fungible bonds)
MalaysiaMultiple-price auctionIrregular (2- to 21-year bonds, 3- to 7-year floating rate)Irregular
MexicoMultiple-price auctionWeekly (3-year floating rate bonds); biweekly (3-, 5-year inflation-indexed bonds)Weekly
PolandMultiple-price auctionEvery 1–4 months (fixed-rate 2-, 5-year bonds), quarterly (1-, 3-year floating-rate notes), irregular (10-year floating-rate bonds)Weekly

In multiple-price auctions, the issuer orders bids by price in descending order and accepts the higher bids until the issue is exhausted. Each winning bidder pays the price it bid. In uniform-price auctions, the issuer, as in multiple-price auctions, orders bids in descending order and accepts those that allow full absorption of the amount up for issue. In uniform-price auctions, however, all successful bidders pay the price of the lowest successful bid. In both techniques, the lowest accepted price is the cut-off price.

Multiple-price auctions have advantages for the issuer. They maximize revenue for a given demand curve, as the issuer obtains the maximum price each participant is willing to pay, and the issuer thereby obtains the consumers’ surplus.72 In a uniform-price auction, by contrast, since successful bidders pay only the lowest (marginal) price regardless of what they were initially prepared to pay, the consumers’ surplus is shared between the issuer and the bidders.

There are studies, however, that suggest that the selection of auction procedure can influence the demand curve for securities.73 Multiple-price auctions tend to shift the demand curve down and to the left for a given quantity. Bidders bid more cautiously (i.e., offer lower prices) in these auctions, because bidders who paid higher prices could face larger capital losses if the trading in these securities starts below the marginal price set at the auction. This is known as the “winner’s curse.” The “winner’s curse” can be an important problem in emerging markets where price volatility may be high. The “winner’s curse” does not arise in uniform-price auctions. Uniform-price auctions tend to minimize uncertainty, encourage broader participation, and, everything else being equal, make bidders more willing to pay higher prices than they would pay in multiple-price auctions.74

The susceptibility to noncompetitive behavior is another factor that needs to be considered in the selection of an auction technique. On the one hand, multiple-price auctions can encourage competitive bidding, because each bidder is aware that it will have to pay the price it bid, not just the minimum accepted price. This circumstance can minimize the risk of manipulation at the auction. On the other hand, it is possible that uniform-price auctions, being simpler, could reduce the need to prepare for the auction and encourage more participation, thus reducing incentives to collude.

The study by Bartolini and Cottarelli (1997) confirms that multiple-price auctions are more widely used in practice than other auction techniques. (See Table 5.2.) In a survey of auction techniques in 42 countries using auctions, multiple-price auctions were the most common, accounting for 90 percent of the countries in the survey. In recent years (post 1997), some countries, including the United States, have adopted the uniform-price auction method as a result of their assessment of the net benefits of this technique over multiple-price auctions.

Table 5.2.Auction Techniques for Selling Government Securities
Bidding Method
Uniform PriceMultiple PriceOtherTotal
Discount88
Price221124
Yield1010
Total239142

Experience in developing countries suggests, however, that the choice of auction technique is less important for the functioning of the government securities market than other factors, such as the way the market is liberalized and how competition is developed, including entry of foreign institutions.

5.2.1.1 Participants in Government Securities Auctions

Auctions are an open issuing channel that allows broad participation, which generally means more competition, and is, therefore, desirable from the point of view of the issuer. Nonetheless, trade-offs exist when determining the degree of participation, and governments need to be aware of policy options and their implications.

In general, auctions tend to become more open in terms of participation as the bond market develops. However, some governments want to promote broad participation, including retail bidding, from the start, in order to broaden the investor base as much as possible, stimulate competition in the financial sector, and develop financial products and markets. This approach usually works well in countries with low levels of competition in the financial sector. By opening the auction to a wider range of participants such as pension funds, mutual funds, and securities houses, governments can foster increased competition among the banking sector and improve the auction’s results.

At the other extreme, some countries have opted to establish narrow participation in auctions by appointing a group of intermediaries that will on-sell securities to other financial institutions or final clients. Narrow participation usually implies granting benefits to a select group of professional market participants, e.g., primary dealers, in exchange for their distribution capabilities. (See Section 5.3.) This group may be selected because they hold accounts at the central bank, they are most willing to promote the sale of government securities to their clients, or they are most likely to make a secondary market in government securities. Narrow participation makes auction processing simpler and less costly. However, these advantages are becoming less significant as auctions become increasingly automated.

There are also intermediate arrangements for participation in auctions. Some countries allow financial institutions and institutional investors to participate in auctions but explicitly exclude retail investors. Others have set up a system allowing indirect participation through third-party bids, wherein retail investors, or final investors in general, participate in the auction through a financial institution, usually paying the average price of the auctioned securities. Even in those countries that allow open participation in auctions, not all potential bidders will wish to bid at the auction. Nonparticipants will have alternatives of buying from a primary dealer.

Participation in government securities auctions may also vary depending on the maturity of the auctioned securities. Typically, banks are more interested in short-term securities to match their short-term liabilities, while pension funds and insurance companies prefer longer-term securities.

Wider participation in auctions results in more competition, yielding better price and allocation outcomes for the issuer. However, if the auction is open to participants other than banks, the regulation and supervision of those participants and the security of payment systems become important issues.

5.2.1.2 Competitive Auction Bids

For an auction to be meaningful, it is essential that auctions be run on a competitive bidding basis. In many emerging countries, where state-owned commercial banks, pension funds, and insurance companies are prevalent, if these institutions are major investors and auction participants, the government must make clear the need for competitive bidding on the basis of the institution’s own commercial requirements. If these institutions either are required to accept the government’s issuing price or are able to set a unique offering price, the auction becomes a fiction.

One important consideration in auction design is whether to establish ceilings on competitive bids. Ceilings on maximum possible allocation per bidder are considered anti-cornering instruments, useful to prevent manipulation of the auction by one large participant. However, not many countries use bidding limits.75 On the other hand, typically governments impose minimum bid amounts primarily for operational reasons. If a government decides to establish a minimum bid amount, the amount should strike a balance between a high figure that might discourage participation and a low figure that would increase the administrative costs of the auction. This decision will ultimately depend on the government’s vision of a desirable market structure. If the government intends to develop a market with heavy retail participation, the minimum size of bids will naturally be lower than if the intention is to develop a wholesale, professional market.

As a rule, ceilings per bid are helpful to ensure competition among bidders and to protect the integrity of the auction. However, they appear to be easier to apply in mature markets than in frequently cash-strapped emerging countries. The application of minimum limits is an operational issue and will depend largely on each market’s operational capacity.

5.2.1.3 Noncompetitive Auction Bids

Noncompetitive auction bids are a more efficient way to encourage retail participation than having a large number of retail investors bidding competitively on their own. The total of all noncompetitive bids is usually capped by an upper limit in order to allow the price at the auction to be determined by a sufficiently large number of competitive bids. Noncompetitive bids may also be subject to individual caps to ensure their retail nature. (A sample of noncompetitive bid limits is shown in Table 5.3.) Where central banks are permitted to participate in government securities auctions, the central bank may be a noncompetitive bidder. For transparency, central bank participation should be made clear to the market before the auction.

Table 5.3.Noncompetitive Auction Bids and Limits on Bid Amounts, in Selected Developed and Developing Countries
CountryNoncompetitive BidsLimits on Bid Amounts
Developed Markets
FranceSmall quotas allowed, after competitive tenders
GermanyNo limits
JapanFor 10-year bonds, only financial institutions whose share in syndicate is less than 3 percent can bid



2-, 4-, 6-year bonds; share reserved varies
40% of total issue times the bidder’s share in the syndicate



Each participant can bid up to 500 million yen
United KingdomPrimary dealers and others eligible to participate



Index-linked auctions
Limit: 0.5 percent of auctioned amount for primary dealers, $824,000 equivalent for others



10% of amount offered is reserved for primary dealers, allocated according to participation in previous auctions
United StatesMaximum: $5 million
Emerging Markets
Hungary10% of competitive bids
Korea20 percent of newly issued Treasury securitiesAn individual or corporation can subscribe up to 1 billion won
MexicoNoncompetitive bids are only allocated if there are leftovers from the competitive process
Sources: France, Germany, Japan, United Kingdom, and United States data are from Bank of international Settlements (BIS 1999); Hungary and Mexico data are from J. P. Morgan (1997); and Korea data are from Ministry of Finance and Economy, Seoul, South Korea.

Securities are normally allocated to noncompetitive bidders at a weighted average price of the successful competitive bids in the case of a multiple-price auction or at the cut-off, or marginal price, in a uniform-price auction. Sometimes access to noncompetitive bids is granted as a benefit for being a primary dealer. (See Section 5.3.) Such access can be useful for bidding on behalf of retail clients.

5.2.1.4 Frequency of Auctions

The timetable for auctions is a function of debt management decisions and a desire to promote a secondary market. Too frequent auctions may lead to small auction volumes, less meaningful price information results, or even too many issues in the market for liquid secondary market trading.

A typical issuing pattern for government securities is a weekly or biweekly Treasury bill auction.76 Longer-term instruments such as Treasury notes or Treasury bonds can be issued at longer intervals (monthly or quarterly). A quite common practice is to set a fixed day of the week for bond auctions, thereby leaving secondary market trading on the other days unobstructed by the auction. Such auction scheduling may also be helpful in providing more comparable measurement of yield curve points when the secondary market is not very active.

5.2.1.5 Announcement of Government Borrowing Requirements and Borrowing calendar

For transparency purposes and to build credibility, governments should regularly disclose their forecast for public sector borrowing requirements, as well as an overall estimated issuance figure for the year and a borrowing calendar. (Sec Chapter 3, A Government Debt Issuance Strategy and Debt Management Framework.) There is a trade-off that should be recognized between the flexibility of tapping the market when conditions are favorable and the benefits of transparency attained by announcing the borrowing calendar. This problem can be minimized by disclosing broad information about borrowing requirements yearly or quarterly, but making known information on the amount to be auctioned only days before the auction.

The government has a number of options regarding what information to disclose immediately before the auction. The issuer can, for instance, announce the exact amount of the issue, and then accept bids at any price until the issue is covered. Alternatively, it can announce a tentative amount to be issued, but retain some flexibility in terms of final allocation. Alternatively, it can decide not to announce what amount will be issued and test market demand. In the latter case, when there is a high level of market uncertainty, the authorities may decide on a minimum price below which bids will not be allocated (an undisclosed cut-off price). At other times, the authorities may need to consider whether to announce this cutoff price publicly. This will sometimes be a useful guide for the market, but it risks encouraging all bids at that minimum price. Some countries (e.g. Italy) have made use of automatic formulas to eliminate discretion from the decision to accept or reject certain outlying bids.

The best long-run procedure to build market confidence, in most cases, is to announce the exact amount tendered and accept bids at any price until the issue is covered. While this may result in unexpectedly low prices at some auctions, the resultant greater market confidence should reduce the risk premium on government securities and, therefore, result in lower rates.

5.2.1.6 Announcement of Auction Results

As much aggregate information as possible should be disclosed after the auction. No information should be disseminated that might identify individual bidders.

Aggregate data of special interest for the market are the amount of bids, the allocated amount, and the weighted and marginal prices (yields). Typically, as markets develop, the announcement of details becomes more transparent, and this in turn improves confidence in the market.

5.2.2 Syndication of Government Securities Issuance and Underwriting of Government Securities

In small economies, market participants may sometimes be only two or three institutions, too limited a number for the government to run an auction since these institutions can easily collude and force the price against the issuer, or simply agree not to participate in the auction. Under such circumstances, the government can try to achieve cost-effectiveness by appointing a group of institutions which, for a negotiated fee, will subscribe to its bond issues and then sell them on to other retail or institutional investors. This is usually known as syndication.

Syndication is most useful when the demand for government securities is very uncertain, which is frequently the case in many developing countries, since it helps minimize placement risk. Syndication can also play an important role when the government is trying to launch new debt instruments and needs a supporting arrangement to introduce them in the market. However, syndication can also have disadvantages in terms of transparency, which is the reason why, even in emerging markets, auctions are often preferred. The main disadvantage of syndication is that it involves a negotiation regarding price and fees between the government and the banks and other financial institutions that will subscribe to the issue. In contrast, auctions do not involve negotiation and are more transparent.

An alternative government securities issuance method that governments can use under conditions of uncertain demand is underwriting. In an underwriting arrangement, the government establishes a minimum price at which the underwriter, for a commission, subscribes to the entire issue. Since commission is charged, the government has to consider whether underwriting is worth the price, as is the case of syndication.

At early stages of market development, syndication and underwriting can be suitable ways to ensure success in the issuance of government securities. However, these forms of issuance are normally phased out as the market develops and demand for bonds becomes more stable.77 The use of primary dealers is usually considered a more competitive arrangement for the issuance of government securities than the use of syndication or underwriting. Primary dealers tend to shrink commissions when markets become more competitive in order to maintain market share, while the fees negotiated in a syndication remain fixed for the agreed-upon period (typically one year).

Specific situations in developed countries have also favored, for practical reasons, the use of syndication instead of auctions. This is the case in some smaller European countries after the introduction of the Euro. Since their government securities no longer have benchmark status and governments are no longer certain about investors’ demand, they have had to employ syndications to minimize placement risk.

5.2.3 Tap Sales of Government Securities

Tap sales can meet many of the Treasury’s government securities issuance objectives in a flexible way. With tap issues, the government announces the availability of a certain amount of securities to be sold, and bids are received during a specified period. Tap sales can be set at a fixed price or at a minimum price that can be changed depending on demand conditions. Their main advantage is flexibility, as the government can decide to tap the market when conditions are most favorable.

The use of tap sales is sometimes also closely linked to the government’s cash management capabilities. If these capabilities are limited, tap sales can help provide timely access to funds. When demand for government securities is unpredictable, as is the case in many developing countries, tap sales can adapt to demand more readily than auctions. Tap sales also have the advantage of attracting retail investors and broadening the investor base.77

Tap sales are often found in combination with auctions, but governments should be aware of potential conflicts in doing so. The expectation that tap sales will follow the auction could undermine the amount of bids received or the quality of price information obtained from the auction. As the market will be unsure of what amount will in the end be issued, but certain that securities will be available at a later date, participants may have an incentive to bid lower prices.78 If the rate on the tap issue is fixed, this can inhibit the potential for price increases in the secondary market, and may cause the issuer to pay a higher yield than would otherwise be necessary.

Auctions can make the market more dynamic than passive tap sales. In addition, provided there is an announced schedule, auctions tend to be more transparent and superior to tap sales in terms of pricing, thereby minimizing borrowing costs.

5.2.4 Private Placement of Government Securities with Banks and Other Market Participants

Governments face a trade-off between adapting their government securities issuance techniques to a possibly wide range of investor preferences and standardizing products as much as possible to promote liquidity. In their attempt to meet market needs, governments sometimes design securities targeted to a specific investor or group of investors, such as pension funds or insurance companies. If conducted with banks, private placements are very similar to a syndication. Issues placed directly with investors can at times be convenient for the issuer as a safeguard in difficult market conditions.

On the negative side, private placements do not contribute to market liquidity as much as other issuance techniques, since bonds placed privately are usually held to maturity by buyers and rarely traded. For this reason, private placements can be less cost effective and contribute less to secondary market development than auctions or tap sales.

5.2.5 Combination of Government Securities Issuance Techniques

Most countries prefer to use a combination of the techniques described above. This is probably the most practical approach, provided it is organized consistently so that it does not lead to market segmentation. In combining different issuance methods, it is essential to maintain consistency and to recognize that issuance techniques should support the efficient functioning of the government securities market structure. Countries that rely on primary dealers will probably want to issue government securities on a regular basis, with an announced calendar and relatively low frequency, in order to encourage the primary dealers’ role. Countries with limited cash management capabilities may adopt tap sales to issue securities when market conditions are favorable. In the very early stages of market development, countries may find it useful initially to rely on syndication or underwriting to facilitate the development of their government securities markets. Subsequently, they may find it more cost effective to shift to auctions and primary dealers.

5.3 Role of Primary Dealers in the Issuance of Government Securities

Many governments have designated a primary dealer group of specialized intermediaries with a series of obligations and privileges to assist in developing the government bond markets. (See Table 5.4 for a sample listing of primary dealers and their obligations.) The main role of primary dealers is to participate in the primary (issuing) market of government securities, ensure the absorption of newly issued securities, and distribute securities to final investors, particularly to wholesale markets dominated by institutional investors where liquidity is especially valued. Primary dealers are also frequently required to be market makers, i.e., to provide two-way prices for some or all securities, in order to enhance liquidity in the market. Depending on how they are set up, primary dealers can bring more competition and more capital to the market. Setting up a primary dealer system can also facilitate the changeover from the usage of captive sources of government funding, common in many developing economies, to a system of government finance that is market based.

Table 5.4.Primary Dealers In Selected Developed and Developing Countries
CountryNumberObligations/Comments
Developed Markets
Canada12 for T-bonds
  • Participation in auctions above a threshold

10 for T-bills
  • Participation in auctions above a threshold

20 distributors
  • Participation in auctions

France20
  • Act as market makers on secondary markets

  • Need to minimize bid/ask spreads based on preset limits

Italy32; among which, 15 market makers
  • Primary dealers are required to take up stock in the auctions

  • Market makers are, in addition, required to provide 2-way quotes.

Sweden10
  • None since 1998; dealers not required to quote 2-way prices

United Kingdom16
  • Provide tight bid/ask quotes

  • Have 1% average market share on 6-month rolling basis

United States37
  • Not obligated to make markets for each other or customers

  • Required to make reasonably good markets with Federal Reserve’s trading desk

Emerging Markets
Brazil (under consideration)
  • Starting to provide 2-way prices

Rep. of Korea24
  • Provide bid/ask quotes with minimum volume and maximum spread

  • Minimum trading requirement — 2% of total secondary market interdealer trading every 6 months

  • 2% minimum underwriting requirement every 6 months

Malaysia12
  • Make secondary markets

Mexico6
  • Quote 2-way prices on a continuous basis

Poland (under consideration)
  • Considering more formal arrangements, and market making through electronic systems

Sources: Data for Canada are from the Bank of Canada; for France, Italy, Sweden, United Kingdom, and United States, data are from Bank of International Settlements (BIS 1999); for Brazil, Hungary, Malaysia, Mexico, and Poland, data are from J. P. Morgan (1997); for Malaysia data are from Arab-Malaysian Merchant Bank (2000); for Korea data are from Ministry of Finance and Economy; and for Poland data are from OECD 2000.

The main risk involved in designating a group of privileged financial institutions to serve as primary dealers is the possibility of collusion. This risk is especially relevant when the few firms willing to be primary dealers form a bidding cartel to force down prices. They may also keep intermediation margins too wide and thereby depress demand from final investors. Setting up a primary dealer system in a country with a small financial sector could also be detrimental for market development because of the greater likelihood of collusion when fewer institutions are participating. In addressing this problem and as ways to introduce more competition, governments could authorize foreign financial institutions to be primary dealers and open up auctions to institutions—both domestic and foreign—with different investment preferences.

Primary dealers are only one way to distribute government securities. In fact, although most developed countries have set up a system of primary dealers at some point in the development of their domestic securities markets, several countries have succeeded without them.80 The development of electronic trading systems and the Internet can play a useful role in the issuance and absorption of government securities, and, over time, could reduce the role of primary dealers in the government securities market.

5.3.1 Obligations of Primary Dealers

The obligations of primary dealers, beyond auction participation, can vary considerably. Dealers may be required to comply with auction quotas, act as market makers in government securities, or provide the government with information about market conditions.

The principal obligation of a primary dealer is to support the government in the sale of government securities. The government designates a group of primary dealers mainly to take advantage of their distribution capacity. Most countries require primary dealers to take a certain amount of securities at government auctions. Many of them also set a requirement for a quarter, a year, or a minimum per auction, which normally is a function of the primary dealer’s size or its share in the secondary market. Others do not specify a quantitative amount and expect a commitment from primary dealers to bid at auctions. The strictness of the arrangements depends on market conditions and could change over time. Applying strict requirements to bid at auctions when the market is thin can become burdensome for primary dealers, and often needs to be offset by granting some privilege or incentive. Some countries have progressively tightened requirements as the market has developed. The more mature a market becomes, the less the need for strict requirements to bid at auctions, as those markets typically enjoy larger demand and more diversified participants.

Primary dealers are usually required to act as market makers. Market-maker arrangements can be either strict—an obligation to quote firm prices and to observe specific bid/ask spreads along the entire yield curve—or flexible—an obligation to quote tentative prices for certain, usually benchmark, securities. Alternatively, in some countries, the government requires primary dealers to quote (at least) one-way prices on a continuous basis. Especially when markets are developing and price volatility is high, market-making requirements should not be too strict, as primary dealers can face significant losses and disengage from market-making activity.

One of the more difficult issues to resolve in a primary dealer arrangement is the width of any required bid/ask spread and trade size. If spreads are too wide, the obligation will become meaningless and liquidity will not be improved. If spreads are too tight and volatility is high, there is a risk that the market will not attract buyers because of potential losses. The size of the spread will also be related to the volume of business. Primary dealers must cover certain fixed costs before making a profit. The larger the number of transactions, the smaller the spread needed to cover costs.

In emerging markets, an obligation for primary dealers to quote firm prices under all trading conditions can be unrealistic. Governments thus need to be in close communication with primary dealers and possibly allow spreads to widen or trade sizes to narrow at times when the market becomes unsettled. In some cases, different types of institutions can be allowed to specialize in different market segments or bond maturities depending on their expertise or customer base. The requirement to quote firm prices could also be limited in the early stages of market development to the bigger and more liquid benchmarks. As the market matures, the obligation of quoting firm prices may require that each primary dealer be assigned a mix of benchmark and off-the-run securities, with periodic rotation of the mix. These considerations need to be made in the context of specific market conditions.

As the market develops and volatility decreases, the market-making obligation can be tightened. The spread may be reduced and the number of securities for which the dealer is required to quote two-way prices may be enlarged. Even in emerging countries, some governments (e.g., Czech Republic and Turkey) are of the view that primary dealers should not be given any special privileges in exchange for their market-making function, as the bid/ask spread already provides them a sufficient award. Other countries (e.g., Australia and New Zealand) maintain that, given the development of their markets, variety of participants, and trading volume, market making should develop naturally and the government should not provide any special incentives.

The third major obligation of a primary dealer is to provide the issuer with information about market conditions and market preferences, particularly for when-issued11 trading—i.e., trading of a security before it is actually issued. Information can be communicated during periodic meetings between the primary dealers and government officials. In the early stages of market development, primary dealers can be required to report on market conditions to the government on a weekly basis. As the market matures, less frequent reporting could suffice. Primary dealers can also be required to post quotes on electronic information systems.

Finally, some countries also require primary dealers to help develop a retail market by maintaining a network for marketing securities to final investors.

5.3.2 Incentives/Privileges for Primary Dealers

In return for obligations assumed, primary dealers may receive a number of privileges. These privileges are probably justified in nascent, possibly volatile markets. As markets mature, the case for privileges becomes weaker and the issuer should be prepared to phase them out. In a mature market, governments should avoid giving primary dealers privileges other than the recognition of their special designation or status or, at most, some informational advantages from meetings with the Treasury or the central bank. Other incentives, such as those discussed below, should be restricted to the early stages of market development.

Primary dealers can be granted the exclusive right to bid at auctions of government securities, bid on a noncompetitive basis, or purchase securities on tap. Sometimes they are given exclusive access to second rounds in auctions or the right also to be a primary dealer for central bank monetary policy operations. Some governments have granted primary dealers exclusive access to auctions to reward them for their role in distributing government securities and providing liquidity to the market. This exclusivity gives them a commercial advantage and helps them earn a mark-up from selling government securities to final investors. These kinds of privileges are justified in nascent markets and under volatile market conditions, but should be understood as temporary, and therefore periodically revised. The government should consider phasing them out and broadening access to auctions as soon as market conditions allow.

In the secondary market, primary dealers are sometimes given exclusive access to blind interdealer broker screens. This access allows them to take or unwind positions without disclosure (thus the term “blind”). Anonymity in an environment of dealing with financial institutions with similar credit rating as their own allows primary dealers to manage their positions more actively with confidence that the trade will be honored than if the counterparty were known.

Primary dealers at times are permitted to perform a wider range of activities than other traders, including central bank repos, short selling, or coupon washing trades.81 At times, primary dealers have privileged access to credit lines from the central bank or have the facility to obtain securities on repo from the central bank. Tax rebates have also been given, although generally only in the initial stages of market development, with the disadvantage of requiring government outlays, and counting as unequal treatment to market competitors who have not been granted this privilege.

In sum, although primary dealers may seek a variety of privileges, it is questionable whether authorities should grant them or grant them all. By giving privileges to a specific group of institutions, governments discourage market participation by others, thereby impairing longer-run market development. Central bank credit lines to primary dealers in effect are equivalent to an easing of monetary policy. While they may facilitate bidding at the auction, their extension could undermine monetary policy objectives.

Repurchase agreements and borrowing/lending of government securities are important instruments to support any dealer operation, primary or not. Borrowing securities is used by market participants to cover short positions (a sale when the seller does not own the security) and is a practice recommended by the Group of Thirty as a way to minimize settlement risk (the risk that a seller does not deliver the security at the settlement date).82Standards for these types of operations must be in place in the very early stages of securities market development. (See Chapter 7, Developing Secondary Market Structures for Government Securities.) Lending of securities can be especially useful when transactions are settled same day (T). A primary dealer asked at the end of the day to sell a security which is not in the inventory may have difficulty finding the security in the market for reasons of timing. If settlement were T+1 or over, the dealer would have more time to find the security but this would have other risk implications. (See Chapter 8, Developing a Government Securities Settlement Structure.) Treasuries sometimes commit to assist primary dealers in managing their securities through the possibility of tap sales or bilateral trades if there is a supply/demand mismatch or a corner.

5.3.3 Eligibility Criteria for Primary Dealer Designation

Eligibility criteria for being designated a primary dealer usually include a sound financial capacity, measured in terms of capital requirements; adequate management skills; technical capacity; active market presence, measured by trading activity; and willingness to provide information to the authorities. Financial capacity requirements are crucial, as the obligation to quote two-way prices exposes primary dealers to major market (interest rate) risks. To maintain market efficiency, the selection criteria need to reviewed and adjusted as appropriate.

Most of these criteria can be quantified in terms of auction participation, trading volume, and capacity to quote two-way prices. Participation in auctions should be measured in terms of volume taken rather than in terms of volume of bids. More weight is usually given to participation in long-term than short-term auctions. Trading volume criteria focus on a number of benchmark issues, both in the OTC market and, if available, in the electronic market. Trading in nonbenchmark issues should also be also taken into consideration, although with a lower weight. The capacity to quote two-way prices takes into account both the number of days the institution is quoting and the volume per trade. The final evaluation is based on a performance index of this series of quantitative indicators.

No primary dealer should be admitted who is not supervised adequately or does not meet supervisory requirements, especially the requirement for adequate capital. Selection criteria should be as transparent as possible so that candidates are aware of their potential obligations as primary dealers and to allow other market participants who meet these criteria to be considered to be designated primary dealers.

Recognizing the benefits of having a diversified base of primary dealers with different businesses and customer bases, some countries have introduced quotas to ensure that different types of institutions are represented. For instance, a percentage of primary dealers’ licenses is sometimes distributed according to the proportion of certain types of institutions (commercial banks, security houses, investment banks) in the applicants’ pool. Within each type of institution, primary dealers are selected based on the performance index of criteria noted above. Outside this group, the other primary dealers could be selected purely on performance regardless of type of institution.

In evaluating the performance of primary dealers, especially in the early stages, the government needs to find a balance between evaluating too early and too often (with the risk that primary dealers will not have time to learn the business) and too infrequently (with the risk of hampering competition). Evaluating how good a job a primary dealer has done is not always easy, especially if there are no electronic information systems to compile trading volume data.83,84 Sometimes even book-entry systems cannot provide information on trading by institution. Also, the performance of some obligations (bids, bid/ask spreads) cannot be measured through a book-entry system, which usually provides information on ex-post trades but not on ex-ante quotes.

It is essential to maintain a competitive primary dealer market structure in which new entrants can challenge current participants, particularly if the latter try to exploit an oligopoly advantage. Some countries have used a trial period during which interested institutions provisionally act as primary dealers. After this period, those that have been active according to agreed-upon criteria are formally designated as primary dealers for a specific time, ranging from one to two years. The remaining institutions can continue to apply to become a primary dealer. After every year or two, the list of designated primary dealers would then be reviewed, allowing the most active outsiders who meet the eligibility criteria to replace the relatively inactive primary dealers.

Some countries (e.g., the United States) use the same financial institutions for primary dealers that the central bank uses for monetary policy operations, but two sets of primary dealers are possible, one for the issuing government and one for central bank market operations, with each having distinct privileges and obligations. One set of primary dealers with dual purposes of issuance and support to central bank operations would require increased coordination between the issuer and the central bank. (See Chapter 2, Money Markets and Monetary Policy Operations.) In addition, using the same group of primary dealers for central bank open market operations and for the issuance of government securities discriminates against security firms and investment banks since the requirements of the open market operations bias these operations to heavily capitalized banking institutions with accounts in the central bank.

Active secondary market trading could develop among those financial institutions enjoying primary dealer status. (See Chapter 7, Developing Secondary Market Structures for Government Securities.) While banks may be large holders of long-term government securities, they typically have more interest in the short end of the maturity spectrum. Other participants, such as investment banks and securities houses, are likely to be more active in developing the government securities market, and these institutions might be attracted by primary dealer status. Authorities will also have to weigh the participation of foreign institutions as primary dealers, with its obvious advantages (more competition/more capital) and disadvantages (political sensitivities/more difficult superνision/taking advantage of an incipient market).

While extending the designation of primary dealers beyond banks is desirable, doing so can raise settlement problems. (See Chapter 8, Developing a Government Securities Settlement Structure.) In addition, if there is a broader group of institutions serving as primary dealers, supervisory authorities will need to ensure the creditworthiness of each type of institution in a way that maintains competition for securities trading among the different types of institutions.

Market size will usually be a determining factor in deciding the appropriate number of primary dealers. Too few primary dealers can be detrimental to competition, while too many could eliminate the incentive to take on that role.

Finally, the legal or formal status of a primary dealer can take different forms in different countries. At one extreme, some countries (e.g., Turkey) designate primary dealers under a contract stating the rights and obligations of the parties, while others expect primary dealers to maintain reasonable cooperation in their operations with the Treasury and the central bank.

5.4 Conclusion

By tailoring the maturities of government securities to meet market demand and announcing borrowing plans in advance, the government can make its securities more attractive for trading. (See Chapter 3, A Government Debt Issuance Strategy and Debt Management Framework; Chapter 4, Developing Benchmark Issues; and Chapter 6, Developing the Investor Base for Government Securities.)

The principal objectives in designing a well-functioning primary market for government securities is to ensure that the government’s borrowing requirements are met in an orderly, reliable, and cost-effective manner; that the issuance of government securities allows broad participation; and that the issuance techniques are administered in a transparent mode.

Developing a primary market is a dynamic process that depends on a country’s initial conditions and on the sequencing of reforms. As always, countries have followed different approaches and no size fits all. However, general considerations such as choice of issuance of government securities technique, participation, competition, and transparency are important considerations for developing a well-functioning primary market.

The most common technique of issuing government securities is auctions. Many developing countries are already running auctions as their main mechanism for the issuance of government securities. However, results are often far from satisfactory because of insufficient demand or because the small number of participants have the ability through collusion to set a low price. Governments, therefore, should try to encourage broader participation as a first step to bringing more competition to auctions. Broader participation can be achieved in many ways, including allowing nonbanking financial institutions (pension funds, mutual funds, other institutional investors, retail and foreign investors) to participate directly in auctions. The simplicity of uniform-price auctions over multiple-price auctions could encourage more participants to bid. Lowering minimum bid limits or launching a marketing campaign to retail segments can bring in more interest from retail investors. Applying ceilings to individual bids will help maintain competition among the different participants and protect smaller investors.

Another important consideration to improve auction results is the credibility of the government as an issuer. Credibility can be enhanced by such basic actions as providing accurate information about the government’s projections for borrowing requirements for the year and net and gross issuance projections, by providing frequent updates as the year progresses, and by announcing the auction calendar on a timely basis. Information on auction results at an aggregate level, which enables participants to learn about the minimum accepted price, the amount issued, and the average price at the auction, tend to reduce uncertainty and encourage participation. Establishing clear and transparent rules about auction procedures and adhering to them is also essential to gain confidence in the markets.

The government can also facilitate participation at government securities auctions by promoting the development of a secondary market through ensuring availability of needed infrastructure. Improving money market development, and establishing a repo and a when-issued market in which participants can obtain some information about price levels at the auction, should improve the prospects of achieving successful auctions.

Operational considerations, such as allowing sufficient time between auctions to create an appetite for a security, or fundamental improvements in the government securities market structure, such as issuing securities at market prices or reducing reliance of the government on captive sources of funding, can also improve auction results.

Some developing countries, typically at earlier stages of government securities market development, do not use auctions, or use them in combination with other distribution techniques such as tap sales or syndications. In such cases, the advantages in terms of transparency and pricing that an auction can bring make it worthwhile to move to auctions to issue government securities as soon as government cash management capabilities improve.

In the case of countries using syndication to sell government securities, governments might want to explore the possibility of distributing through primary dealers. Use of these dealers is considered a more competitive arrangement, as they tend to reduce their commissions in order to maintain market share, while the fees negotiated in a syndication remain fixed for the agreed-upon period. As the market develops, the government should reduce primary dealers’ privileges and open up auctions to broader participation.

Bibliography

For a review of auction theory, see Sundaresan 1996 and Sundaran 1997.

A combination of the multiple-price and uniform-price auction involves, for example, an auction where bids at the marginal price are allocated at the marginal rate and the rest of the successful bids are allocated at an average between the marginal rate and the highest bid.

The consumers’ surplus in this case refers to the forgone proceeds that a government incurs when it offers securities at a price that is lower than the marginal price of each bid.

Uniform-price auctions may produce greater revenue on average, but they present greater uncertainty about revenue at any given auction (see Malvey et al. 1995).

Canada and the United States have increasingly used such limits. In the case of Canada, the limits also apply to dealers’ customers.

Weekly auctions are quite common for Treasury bills in some countries, and it is not clear whether this impairs trading in the secondary market. Other factors such as who buys at the auction—dealer versus end-buyer—also determine how actively T-bills will be traded.

Germany used a government bond syndication as a natural complement to federal government securities auctions until the end of 1997.

At other times, tap sales may be reserved for primary dealers as an incentive for them to develop the bond market.

Another issue is what to do when not all the bonds have been sold in the auction. The issuer needs to consider how to make available the remaining amount with minimum market impact.

Australia, Germany, Japan, New Zealand, and Switzerland, for example, are countries that do not have primary dealers. But even some of those countries have relied on a group of intermediaries to support the development of their government securities markets, e.g., with the syndication in Germany.

Coupon washing trades refer to the possibility of exploiting different tax treatments, for instance, between domestic and foreign investors.

When evaluating a primary dealer, the Treasury also needs to distinguish real trades from those taking place only to inflate performance figures.

Interdealer broker screens and MTSs (electronic market for government securities in Europe–see Box 7.2 in Chapter 7) have been actively supported by governments not only for their important benefits for market development, but also because such technology facilitates the proper evaluation of the performance of primary dealers, especially the obligation of quoting firm prices.

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