Chapter

Chapter 2. Definition and Findings

Author(s):
Marco Arnone, and Piero Ugolini
Published Date:
February 2005
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In simple terms, a primary dealer system is an agreement between two major stakeholders in the domestic government debt market—the debt manager and a group of dealers—to pursue a common strategy in support of the functioning and development of primary and secondary markets for government securities. Primary dealers are financial intermediaries selected to perform a specialized role in the market for government securities. Generally, in exchange for specific privileges, primary dealers agree to perform specific obligations or functions in the operation of markets for government securities.

Following from this definition, their role includes

  • (1) acting as a channel between debt manager and investor in the primary market (e.g., by participating in auctions);

  • (2) performing as bookmakers and distributors by having dealers that canvass investors’ interest and distribute securities ahead of auctions through when-issued markets;

  • (3) acting as providers of immediacy of liquidity to primary and secondary markets;

  • (4) acting as providers of asset transformation and market-making services by being willing to hold inventories of government securities and allowing investors to swap among various outstanding issues of government securities on a continuous basis, helping to bring liquidity to the market;

  • (5) promoting continuous markets and efficient price discovery by organizing dealers in the setting of an appropriate market structure that can encourage efficient price discovery;

  • (6) acting as agents and relationship managers educating investors about the attractiveness of government securities as an investment; and

  • (7) being advisors to the government by forming and taking appropriate strategies for the development of products and markets.

Selection criteria for primary dealers typically include financial strength as indicated by adequate capitalization, an active role in government securities markets, and financial expertise such as skilled management and staff, together with access to appropriate technology.

Obligations generally include one or more of the following requirements:

  • (1) participation in the primary market in a substantial and consistent manner;

  • (2) serving as a market maker in the secondary market by providing two-way quotes for specified groups of securities, either indicative or firm; and

  • (3) providing market-related information to the debt manager.

Privileges, or supporting arrangements, which vary widely among countries, generally involve the granting of some aspect of exclusivity—for example, the exclusive right to participate in the auction for treasury bills, and/or the right to serve as a counterparty to the central bank when it conducts open market operations, and/or access to a line of credit or to borrow particular issues from the central bank.

Among the respondent countries in the survey, there was broad agreement that primary dealers are recommendable—that is, they make a positive contribution to the development and liquidity of government securities markets. Of those countries that did not have primary dealer systems (10 countries), several respondents indicated that their markets were not large enough to support a sufficient number of primary dealers to ensure competitive behavior, while some of the more advanced countries indicated that their markets were functioning well without primary dealer systems (e.g., Germany and New Zealand).

On the issue of whether the stage of development at which a primary dealer system should be introduced is relevant, more than half indicated that it was either always desirable or desirable to do so in the early stages of development. With respect to later introduction, however, some of the detailed comments pointed toward necessary conditions that should be present before development of a PD system, such as the existence of a legal and supervisory system, and an adequate payment system.

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