Chapter 6. Key Prerequisites for a Primary Dealer System

Marco Arnone, and Piero Ugolini
Published Date:
February 2005
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In paving the way for the establishment of a primary dealer system, the authorities might want to create an environment conducive to its most effective functioning. Important prerequisites for establishing a PD system include at least eight listed below. Ideally, they should be in place at the time of the establishment of a PD system. However, that may not always be feasible for all prerequisites; in this case, they should be phased in over a short time span to sustain the development of the system and the markets:

Interest rates should be liberalized. It is essential that interest rates on government securities reflect actual demand and supply, in both the primary and secondary markets, so as to guarantee efficient price discovery.

Arrangements between primary dealers and debt managers in support of the auction system should be carefully arranged. This is an important prerequisite because the auction is the central mechanism for securities allocation in the primary market. The auction design must allow an efficient price discovery. Problems in auction design are bound to have a strong negative effect on subsequent segments of the market because inefficient price discovery or inefficient allocation will affect the secondary market at both the wholesale and retail levels.

A government must have a strategy for issuing government securities. A government must accurately plan its debt issuance strategy so as to provide a medium-term horizon for the investment strategy of primary and secondary market agents.

A minimum set of attractively designed securities should be available. In deciding its debt strategy, the government should plan for a certain number of different types of securities, taking into account different maturities and trying to establish benchmarks. Also, other instruments could include index-linked securities and inflation-linked securities, to mention just some simple examples that can help investors diversify their portfolios of instruments and provide instruments for risk management.

An adequate number of end investors is necessary. This means that the government should try to estimate potential demand among individuals and the financial sector and be able to fine-tune its own supply, arising from its financing needs, to be able to meet potential demand. Preliminary discussions with banks will help the government gauge this potential absorption capacity.

The government must also be committed to market-determined outcomes. The authorities should make efforts to stimulate a setup of the primary and secondary market so as to allow competitive forces to play a dominant role. In this context, primary dealers should not be seen as a captive group whose portfolio can be burdened with government securities, but rather as the initiators of a market or a group providing additional liquidity and transparency to the market for the purpose of better price discovery and resource allocation.

Sufficient debt and a potential volume of secondary market trade should be available to support a profitable group of competing dealers without subsidies for the operations. With respect to the size of the market, it is important to have an adequate number of active participants in the market, and enough volume in government securities issued to justify a primary dealer system. In addition to authorities’ commitment to market-determined prices and attainment of a minimum size of the market for government securities, there are other highly desirable conditions for establishing a PD system, including a legal framework for government securities, a regulatory/supervisory system for government securities dealers, and an adequate payment and settlement system. However, primary dealers can be used as a platform and an integral part of the building of such systems. In many developing and emerging market countries, for instance, primary dealers have been used as custody agents as part of the book entry system. They have been given accounts with central banks to clear and settle on a DVP basis. Also, in some countries, the setting up of primary dealers has been the cornerstone of developing efficient primary markets.

The government must be committed to secondary market development. This condition is important because it guarantees that the primary dealers and other market participants will not compete directly with the government in the placement of securities in the retail market. The authorities should refrain from intervening directly in the market—for instance, limiting or avoiding direct sale of securities.

In the early stages of development and also for many small developing countries, there may not be enough participants in the government securities auctions to reduce the number further by establishing a PD system. Having an adequate number of participants in the auction may be a particular problem if the authorities are trying to limit participants to commercial banks for clearing and settlement purposes. If the main objective is to be as inclusive as possible for bidding at the auctions, then limiting the numbers further to start a PD system may be inappropriate. Thus, one of the respondents to the questionnaire from countries without PD systems said the reason the country had not set up a PD system was the small size of the market (Latvia), and another (Chile) said there were too few participants for establishing a PD system.

What is the minimum number of primary dealers to ensure an acceptable degree of competition? While there are no absolutes on this issue, five to seven seemed to be among the minimum number of primary dealers cited by respondents in the IMF’s Monetary and Financial Systems Department’s survey (e.g., Mexico, Norway, Armenia, Morocco, and Sweden), although Iceland, which recently established a PD system, has only three primary dealers. Chile, in particular, indicated that four to seven primary dealers were not enough—a key reason why Chile did not adopt a PD system.

Based on the MFD survey, the typical number of primary dealers for a country with a successful PD system seemed to be approximately 15, and 20 to 26 primary dealers was toward the high end of the range.3 Several respondents indicated that the number of primary dealers had increased as the volume of dealing had grown over time (e.g., Brazil and India), while several others indicated that the number had fallen as the volume of securities issued had declined (e.g., Canada and Sweden). There were also other reasons for a trend toward declining numbers of primary dealers, including, in particular, consolidation of the financial services industry. In the case of the United States, the number of primary dealers peaked in 1988 at 46 and has since declined to 25, owing largely to consolidation within the industry.


Among the countries with PD systems, the average number of primary dealers was 14.5, and the median number was 13. Countries in the lowest quartile (in terms of number of primary dealers) had 8 primary dealers. Austria, Czech Republic, Ghana, and the Republic of Korea had the largest number of primary dealers—each with 26, and the United States was next with 25.

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