What is Primary Dealer System all about? In market operations, open market operations,

a nutshell it is an arrangement between two underwriting commission, etc. PDs can play

major stake holders in the Government a vital role in the development of the

Securities market the debt manager and a secondary market as a market maker by

group of dealers to pursue a common providing two way quotes, either indicative

strategy in support of functioning and or firm for specified group of securities. By

development of primary and secondary being in the market, their prices discount all

markets for government securities. Setting available information; they take up trading

up of primary dealer system helps in positions, and also render valuable

achieving certain goals such as lowering cost assistance to the central bank by providing it

associated with the servicing public debt with latest market information, designing

and also encouraging saving by providing an new instruments, etc. Selection criteria for

appropriate environment facilitating primary dealers typically include financial

investment and trading in government strength as indicated by adequate

securities. It even acts as an indirect capitalization; an active role in government

instrument of monetary policy in the hands securities market and financial expertise,

of the central bank. such as skilled management and staff with

access to appropriate technology. Many countries have established a system of

Primary Dealers (PDs) as important Why a primary dealer system is set up in a

intermediaries to promote activity in country will depend on the needs of the

Government Securities market. Such PDs are country which inturn depends on the state of

assigned specific responsibilities like the economy. Like in advanced economies

participating in the primary market in a where developmental issues become less

substantial and consistent manner, pressing, it has its own advantages such as

minimum bidding requirements, giving two- improving knowledge of the market,

way quotes, providing market information decreasing market refinancing risk,

to the central bank, etc. In some cases, PDs providing better access to investors and

have been given exclusive right to primary providing skilful advisory support in

auctions, or some special facilities in money bui ld ing and fo l lowing the debt

PRIMARY DEALER SYSTEM: A COMPARATIVE STUDY

Research Department, CCIL*

*Research Department, The Clearing Corporation of India Limited.

Countries India

(Emerging) Chile

(Emerging) Germany

(Developed) Saudi Arabia (Developing)

Korea (Emerging)

United States (Developed)

Morocco (Developing)

No of Dealers in Gsec

18 PDs apart from banks

Participants in the Gsec market include banks, pension funds, insurance companies and mutual funds

No PDs. No PD system 102 (26 PDs) 25 PDs

Central bank, 18 credit institutions, one broker dealer, 103 mutual funds (9 PDs)

System Established

1996 no PD system N.A N.A Jul-97 1960 Aug-95

PDs obligations

obligation to bid in auctions, fulfil minimum bidding commitment, offer two way quotes, achieve a minimum success ratio for dated securities and treasury bills, achieve minimum turnover in government securities.

N.A N.A N.A

Bid in the auctions, quote two ways, and to trade a minimum of 2 percent of total secondary market volume

to bid in auctions but not necessarily all, participate in OMO's and provide the Fed with information on market

Obligations to bid in the auctions and to quote firm and two ways.

Privileges

Banking and borrowing facilities with the central bank. Access to call money market and receipt of underwriting commission

N.A N.A N.A

Exclusive access to primary auctions and non competitive bidding

Privilege to borrow securities from the central bank's portfolio during its daily securities lending operation

Possibility to have non competitive bids upto 20 percent of the weighted average with holdingvolume.

management policy. disadvantages such as risk of promoting a

less than efficient market structure. A second While designing a primary dealer system the

drawback stems from the fact that it limits authorities have to be very careful as there are

competition and can contribute to risks involved. A PD system can have its own

oligopolistic behaviour.

The annexure summarises the experience and expectations of PD system in different countries

with different levels of development and compares with that of the Indian experience.

Evaluation of PD system in India: an volume of both long term and short term

extension.* debt expanded considerably due to

automatic accommodation through the In the pre 1991 period the government

mechanism of adhoc treasury bills. securities market was underdeveloped

because of illiquid and narrow based market Considering the significance of a vibrant

with limited institutional infrastructure. In government securities market for activating

order to keep cost of government borrowings indirect tools of debt management policy

low the coupon rates offered on government and for more effective conduct of monetary

securities remained negative in real terms. policy few reforms were introduced. Initially

The borrowing requirements of the Central in 1984 RBI set up DFHI allowing it to

Government were mainly through pre- participate in the call money market and to

emption of resources for maintaining high handle treasury Bills. Further reforms were

SLR (Statutory Liquidity Ratio). During introduced in the early 1990's to improve the

such a period the major players in the depth of markets. The 364, 91 as well as the

government securities market were Banks 14 day Treasury bill were introduced as a part

and Insurance Companies. Banks were of these reforms along with the auction

actively involved only because of SLR system for the sale of Government securities.

requirements. During the eighties the In 1994 Securities Trading Corporation of

Advantages

under writing and market making, improved liquidity for govt securities market, helps Open Market operations

*Having a PD system would help in better information and development of secondary markets.

*There already exists a very successful auction system and active trading in stock exchange.

*To enhance market efficiency and liquidity along with creating active secondary market.

Reduces cost of govt bond issue, lowers underwriting fees, increases demand and stabilizes bond market

Facilitates the implementation of monetary policy

Organization of the bond market, promotion of treasury bills, exchange of information on available bids as well as the price levels at which the investors are ready to subscribe.

Dis-advantages

High dependence on short term funding and call money market.

*A PD system would leave out pension funds and insurance companies who are major players in the Gsec market creating a dependence on small number of institutions.

N.A N.A Nothing particular

Designation of Primary Dealer is often viewed as giving the institutions a special status or guaranteeing their creditworthiness

N.A.

(* Felt advantages / disadvantages of a PD system) Source: IMF Working Paper

India (STCI) came in to the picture at the RBI takes into account both the bidding

initiative of RBI for developing an commitment and the performance of PDs

institutional infrastructure for an active in the primary and secondary markets for

secondary market in Government determining the quantum of liquidity

securities. A large participant base reduces support and hence offers some privileges

the borrowing cost for the government, to fulfil their obligations effectively. PDs

market volatility and imparts competition have an access to banking facilities with the

in the market. In accordance with the central bank, exclusive borrowing

announcement in the Monetary and privileges with the central bank,

Credit Policy in May 1994, the institution permission to borrow and lend including

of PDs has been adopted in India in 1996, Call Money and to trade in all money

for developing both primary and market instruments, favoured access to

secondary markets in Government open market operations and are allowed to

Securities by accrediting Primary underwrite for a commission for dated

Dealership to DFHI and STCI. The main government securities. PDs now even have

objectives of promoting the institutional the flexibility of hedging their interest rate

mechanism of PDs are to strengthen risks in the swap markets. In contrast to the

institutional infrastructure in the Indian scenario in the United States PDs

Government Securities market in order to do not have privilege to borrow fund from

make it vibrant, liquid and broad based the central bank but they can borrow

and t o en su re d e v e l opmen t o f securities form the central bank's

underwriting and market making portfolio.

capabilities for Government Securities Incidentally, RBI experimented with a

outside the RBI so that the latter could system of Satellite Dealers (SDs) from 1996

gradually shed these functions. PDs to serve as a second tier to PDs in the

obligations include giving annual bidding Government Securities market with the

commitment, underwriting the primary particular objective of promoting retail issuance and offering two-way quotes, segment. However, on a review it was found achieve required success ratio for dated to be not as useful as was expected and was securities and treasury bills and to achieve given up. However, since 2001-02, retail a minimum turnover in government investors are allowed to participate in securities. The RBI guidelines specify that government securities primary auction PD should have sufficient and continuos through bank or a Primary Dealer. This presence in the government securities move was to encourage retail participation market and a minimum net owned fund of

in the primary market. RBI is allocating Rs. 50 crore. PDs are obligated to bid in

maximum 5 per cent of the notified auctions in order to fulfil minimum

amount in auction of select dated bidding commitment.

securities for allotment to retail investors on Primary Dealers will need to decide whether

a “non competitive” basis at the weighted in the long run they should diversify into

average rate. Retail investors are allowed to other related fixed income business such as

send only one bid per auction up to Rs. 1 corporate bonds and commercial paper.

crore through the intermediaries to RBI.An issue which has been raised by PDs relates

In most of the countries PD's are expected to to their exclusive access in primary auctions

bid in primary auction but they may not be of T-Bills and in open market operations

under any contractual obligation as in USA. with regard to Government dated securities.

However other market participants are International experience with the Primary

expected to participate through the primary Dealers System shows that few developed

dealer. In UK which is supposed to be the countries have introduced exclusive access to

model for the Indian system, there is no PDs in OMO (USA and UK). On the other

bidding obligation on part of PDs. However hand, many countries, both developed and

offering two way quotes is a mandatory emerging, have given exclusive access to PDs

requirement in UK and in Spain but not in in the primary auction process. Since 2000

USA. on few occasions RBI came out with OMO

in Treasury Bills exclusively for PDs to Though the PD system has been beneficial

overcome short term liquidity problems. In which is evident from the growing turnover

add i t ion , RBI conduc ted " sw i t ch of the government securities market they

operations" for the first time in August 2000 have their share of disadvantages such as

that was restricted only to PDs. It is argued high dependence on the short term funding

that giving exclusive access might create and call money market. Secondly as most of

private monopolies, which may go against the PDs are offshoots of banks their

the creation of a deep and liquid market. involvement as market maker has taken a

There is another view that exclusive access to back seat. This is primarily because of the

PDs may raise the cost of financial risks which they face given the volatility in

intermediation, which may not be desirable the gilts market. A concern which the

from the viewpoint of efficiency of financial Primary Dealers have for the future is of

markets. In sum it may be stated that giving maintaining profitability given that they are

exclusive rights to PDs in primary auctions slowly going to be phased out of the call

will essentially depend on the state of money market. Therefore they will have to

development of the market, the size of the look at every opportunity of lowering

primary issue and financial strength of the funding costs and enhancing trading profits

PDs.by pushing up turnover. Shri D. Basu

Chairperson of STCI in his recent address at * Source RBI.

the Annual General Meeting indicated that