Chapter 5. Market Structure and Development

Marco Arnone, and Piero Ugolini
Published Date:
February 2005
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In analyzing the issue of primary dealers, it is important to include considerations of securities market structure and development, and coordination of the various players involved. A decision whether to set up a primary dealer system, and the associated design, can be considered from both a developmental point of view and, in more advanced economies, a market structure point of view. In this context, design of the mix of obligations and privileges must be an integral part of the strategy for developing and improving a government securities market, and the design itself can target market development (create a market and accommodate public sector borrowing requirements) and/or market structure (competition, efficiency, and financial instruments).

A. Financial Development

From a developmental point of view, in the early stages of development the authorities might view the existence of a group of specialized institutions as instrumental in supporting their efforts to develop a market for government securities. These institutions would concentrate limited know-how and scarce resources in a limited number of players, thereby facilitating coordination among players and supporting a smooth market process. For instance, in the absence of liquid funding markets, a broad and well-informed investor base, available and well-developed trading platforms, and a supporting infrastructure, a PD system can be a very useful platform upon which to develop the government securities market. In this context, the developmental role that a coordinated set of players can have in supporting government borrowing strategy, while at the same time creating some of the conditions for the use of indirect instruments of monetary policy, is clear.

The design of the primary dealer system for a developmental objective should aim at a mix of obligations, privileges, and supporting arrangements that helps the authorities to achieve their objectives. Equally important, other supporting markets or infrastructures are likely to be missing in this context, so there must be a commitment from the authorities to implement policies to put in place necessary infrastructure (e.g., book-entry system, delivery versus payment (DVP), and bidding technology) and to develop other markets (interbank market and local capital market, for instance). Given this background, the performance of primary dealers can be expected to be less than optimal, but mechanisms should be put in place to limit possible noncompetitive behavior and moral hazard.

B. Market Structure

In more advanced economies, where developmental issues become less pressing, a market structure approach is also useful. When a country has already developed market intermediaries and infrastructures, the reasons for having a PD system are different than the ones highlighted above. Arguments for specialization and economies of scale tend to prevail, and country experience in advanced economies (France and Italy) indicates that a PD system accomplishes several objectives: (1) decreases market and refinancing risk; (2) improves knowledge of the market; (3) strengthens product and process innovations; (4) provides better access to end investors; (5) improves promotion of debt; and (6) provides skillful advisory support in building and following the debt management policy. One could also argue that some potential threats to an efficient market functioning must be taken into account—for instance, by selecting a preferential group of intermediaries, the authorities might reduce competitive neutrality (New Zealand) and limit contestability. In addition, when the authorities have introduced on-line trading systems and financial markets and intermediaries are extremely sophisticated, as in the United States, which has had a system of primary dealers for a long time, the case for a primary dealer system becomes less clear. When there are substantial fiscal deficits and financing needs, however, primary dealers may continue to play a positive role in the primary market even in developed markets.

The practice of selecting a specialized group of intermediaries for government securities can be seen as similar to the practice of private commercial borrowers that implement their financing strategy via placements through a specific group of investment banks for the same reasons highlighted above (advisory, access investors, lower market, financing risk, and so forth). However, there are additional risks in taking this approach by a government with a specific group of primary dealers. One risk is increased moral hazard, or the possibility that designated primary dealers will engage in more risky behavior because they have been selected by the authorities. In addition, compared with the private market solution, selection by the authorities may risk reduced contestability and possible anticompetitive behavior.

Therefore, it is essential that in deciding to adopt a primary dealer system, the authorities design mechanisms to reduce these risks, while preserving as much of the benefits as possible. Contestability can be supported by rotating primary dealers based on performance (Mexico), while the risk of anticompetitive behavior must be addressed by strengthening supervision. The argument for moral hazard/implicit guarantees must also be addressed in the context of liquidity/crisis management policies by designing an appropriate structure of incentives and controls.

In deciding on the adoption of a PD system, the authorities should simultaneously address these issues so as to achieve their debt objectives while maximizing market efficiency. Countries that have fairly advanced markets and intermediaries, but that for some reason would not be able to address the negative effects induced by the introduction of a PD system, should strengthen their capacity of intervention in these areas before putting the system in place, or phase in supervisory and regulatory reforms at the same time. While in developing economies the developmental aspects can outweigh downsides related to market structure, in more advanced economies the authorities should clearly evaluate whether the market would be able to perform the same functions without introducing a selected subgroup of specialized intermediaries.

Another aspect of a primary dealer’s activity in the secondary market is to serve as an intermediary between the debt manager, often the central bank, and retail investors. In this regard, primary dealers are often expected to serve as partners with the debt manager and central bank in developing the institutional and retail markets. This function may include educating the public about investing in government securities.

In recent years, a number of debt managers in developed economies have been moving into direct sales of securities over the Internet. More generally, modernization of markets and automation are making some of the functions traditionally performed by primary dealers less important or redundant. For example, automation is a means to handle large numbers of participants in auctions, which was not previously possible. Electronic markets offer information on market conditions and prices that might have only been possible to have directly from dealers. Whether this recent trend in developed economies also applies to the needs of developing countries depends on country-specific situations, given the technological constraints that different countries face.

C. System Design in the Course of Financial Development

It may be useful to consider whether the trade-off between the advantages and the disadvantages of a primary dealer system changes during the course of economic development. In the early stages, for instance, not all of the key conditions may be present for an effective PD system. In particular, there may not be enough dealers that are active in the government securities market. Moreover, in those early stages, the commercial banks, which are some of the most likely candidates for primary dealership, may have a vested interest in not developing the government securities market, because they have competing products and may profit from the scarce opportunities of their depositors. In addition, the size of the financial system and of the government securities market, in particular, may play an important role, with smaller countries finding it more difficult to justify a PD system. In this context, the potential for specialization on the part of dealers in government securities is limited by the small size of the financial market. At the same time, the potential contributions of a primary dealer system—developing the primary and secondary markets and developing the retail base for government securities—are most relevant for developing and emerging market countries.

In the latter stages of financial development, especially in large diversified financial systems (Germany or Switzerland), the need for, or potential contributions from, a PD system may be less important. In many developed countries, there may be a relatively large number of active participants in the primary market; and there may be an active and highly competitive secondary market, while retail investors have a number of attractive alternatives. Thus, some industrial countries, such as Australia, Germany, Japan, New Zealand, and Switzerland, do not have PD systems, while the United States, with the largest and most diversified financial system in the world, does have such a system. The United States, however, has reduced the privileges of primary dealers over time, and opened the system to more competition. Now, aside from being recognized as a primary dealer, the main privilege is to be one of the counterparties to the Federal Reserve when it conducts its open market operations. More generally, the role and specific features of a primary dealer system may change during the course of economic development.

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