Chapter

Chapter 4. Implications of Establishing a Primary Dealer System

Author(s):
Marco Arnone, and Piero Ugolini
Published Date:
February 2005
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By selecting certain firms as primary dealers and not others, authorities concentrate market activity in a smaller number of firms, which has both positive and negative implications. On the positive side, especially in the early phases of market development, there can be important efficiencies associated with larger volumes of financial transactions, including automation and more advanced technology, and the use of specialized, highly skilled personnel. Acquiring these resources has substantial fixed costs, and spreading these costs over a larger volume makes them more economical. Competition and efficiency can also increase if foreign firms are allowed to become primary dealers, if as seems likely those firms are advanced and have an international clientele. In addition, there are advantages to the debt manager (if it is the central bank) in limiting the number of institutions with which it has to deal in conducting auctions of government securities and in its open market operations.

The most significant possible problem in setting up a primary dealer system is the risk of promoting a less than efficient market structure. A primary dealer system is a dealer market structure; developing one involves choosing (by the issuer) this particular market structure for the trading and issuance of debt. If alternative market structures are more efficient or appropriate, then a PD system is best avoided and a different and more appropriate country-specific strategy developed.2

A second drawback of a PD system is that it can potentially limit competition and contribute to oligopolistic behavior. Since selection is fundamental to a PD system, it can in some respects run counter to the principle of establishing a level playing field. To a considerable extent, however, these potential “negatives” can be avoided by careful design of the system—for example, by not unduly limiting the number of market participants.

In addition, by selecting a group of financial firms to serve as primary dealers, there is a risk that the public may view them as possessing an implicit guarantee by the government. There may also be moral hazard in that guarantee, in that once selected as a primary dealer, the primary dealer may engage in more risky behavior, believing that the government would not stand by and let it fail. In this regard, the primary dealer might be induced to take on more risks than it otherwise would. Authorities should try to reduce this moral hazard by supervision and by allowing contestability. For example, authorities may periodically reassess and reselect the group of primary dealers.

Since establishing a system of primary dealers has its pros and cons, an important question concerns whether, or under what conditions, it is helpful to have such a system. In general, the answer depends on the authorities’ overall strategy for developing the government securities market and the appropriate size and microstructure for the market. In particular, if authorities envision a secondary market structure in which there are competing dealers and market makers, then a PD system may be an appropriate choice. However, authorities may opt for an auction system with direct buy and sell orders to a single location or an electronic matching system, in which case a PD system might not be appropriate. Or, alternatively, the secondary market may be too small to support an effective number of primary dealers, in which case the authorities may decide as a transitional measure to open a secondary window at the central bank.

The justification for establishing a system of primary dealers is that the system satisfies public goals that might otherwise not be met. One of the main goals in this regard is to maintain or enhance the liquidity of secondary markets. A liquid market may involve external benefits that accrue to other parties that are not directly involved in the government securities market.

For a more detailed discussion of the choice of market structure and the role of primary dealers, see Dattels (1997), pp. 209–82.

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