The third webinar of the PDM Webinar Series entitled Primary Dealer Systems: Models and Experiences Across Countries, successfully concluded on March 5, 2024. The event featured as speakers Giovana Leivas Craveiro, Head of Local Trading Desk, National Treasury, Brazil, Luis Alexander Lopez Ruiz, Deputy Director of Domestic Financing, Ministry of Finance, Colombia, Fabrizio Tesseri, Head of Medium-Long term Funding, Ministry of Finance, Italy, with Zsolt Bango, Senior Financial Sector Specialist, FCI, World Bank, moderating the event.

A well-functioning Primary Dealer (PD) system can be an important catalyst and contribute significantly to government bond market development. However, designing a PD system is a complex and continuous process. It can be organized in many ways, depending on the status of market development, general market conditions, expected benefits, and the risks associated with its establishment.

The objective of the webinar has been to discuss the main characteristics and key issues and challenges of establishing a well-functioning PD system, recent changes, and dynamics in PD systems in both advanced and developing markets through three country cases: Brazil, Colombia, and Italy.

Main topics discussed related to preconditions for a well-functioning PD system, PDs’ eligibility criteria, rights and obligations, evaluation, and remuneration.

Zsolt Bango introduced the topic, highlighting the crucial role of preconditions for a well-functioning PD system. If preconditions are met, a PD system can be an important catalyst and contribute significantly to government bond market development, by enhancing price discovery, providing greater secondary market liquidity and investor diversification, making demand more stable and proving advisory services.

Zsolt illustrated the main preconditions for a PD system to work, based on the World Bank’s experience in the field, namely i) stable macroeconomic conditions, ii) the existence of a legal and supervisory system, iii) solid and robust financial market infrastructures, iv) a sizeable market, v) a stable, predictable and transparent issuance policy, vi) benchmark bonds, vii) the ability to maintain trading books, viii) existing money markets, ix) a diversified investor base, x) a sufficient number of PDs, and xi) an existing secondary market. Without such preconditions in place, a PD system can limit competition and might be even more harmful than beneficial for market development.

According to Zsolt, once such preconditions are in place, three main considerations need to be assessed when designing a PD system: i) eligibility criteria for financial institutions to be appointed as PDs, ii) well-balanced PDs rights and obligations, and iii) a framework for regular performance evaluation. The specific blend of obligations and rights varies from country to country, and each country may vary over time as the market deepens. In the early stage of 

market development, the contribution to the price discovery and the secondary market liquidity provision takes center stage. In more mature markets, PDs advisory Services become more important.

As Zsolt emphasized, the advantages and disadvantages of a PD system need to be assessed on a case-by-case basis. Furthermore, conditions for a well-functioning PD system – including global regulatory frameworks, market development agenda progress, changing banks’ business models - may change over time.

The moderator left then the floor to the panel members.

Giovana Leivas Craveiro made a brief introduction on the Brazilian PDs’ system, which was created in 1992 at the Central Bank of Brazil (BCB) and then, in 2015, split into two (one at BCB and one at the National Treasury). Giovana described next the eligibility and evaluation criteria in Brazil. The main benefits of being PDs include participating at exclusive meetings with the National Treasury, higher number of bids in auctions, and eligibility for special operations (such as exchanges auctions). In her concluding remarks, Giovana highlighted that, notwithstanding the clear benefits of having a PDs’ system (increased market liquidity, promoting electronic trading and helping to achieve a desired debt profile), shortcomings are: a constant evaluation and monitoring of the system, and difficulty to change market practices and to measure the achievement of goals.  

Luis Alexander Lopez Ruiz talked about the Spanish origins of the PDs’ system in Colombia, which was launched in 1997, and its main features. He focused then on the eligibility criteria and requirements in terms of capital, rating, and memberships. Luis addressed the issue of the delicate and continuous balance between costs and benefits. On the one hand, PDs enjoy exclusive access to the securities lending facility, to the non-competitive auctions and to the repo market. On the other hand, PDs are forced to double quoting in the secondary market with maximum spread and shall obtain at least 3.85% of the amount placed through auctions. Luis briefly mentioned performance metrics, which consist of participation in long term auctions in primary markets, traded volume in secondary markets, quote presence, and volume traded between PDs in repo operations. Lessons learned included: a fine tuning between privileges and obligations is needed, important to settle an efficient institutional arrangement, and communication with the market is paramount. 

Finally, Fabrizio Tesseri looked at the PDs’ performance evaluation and remuneration practice in Italy. The evaluation framework is based on both primary and secondary market indicators. Fabrizio focused on the most representative of them, namely - among primary market indicators - the Auction Aggressivity Index (whose main objectives are to reward the auction participation strategies which contribute to determine an auction price not significantly above the market and ensuring continuity of participation to the auctions) and – among secondary market indicators – the Quotation Quality Index (based on high frequency snapshots on the bond’s order book for each PD) and the number of bonds traded as filler. As it concerns PDs’ remuneration, the Italian DMO has the most unique incentives’ scheme for PDs, as it pays fees to PDs for participation in bond auctions. The fee is proportional to the allotment and duration of the bond and, since 2023, is also slightly dependent on PDs performance in the secondary market. This remuneration approach, which includes the payment of commissions, is still rather exceptional in global practices.

The Q&A session discussed DMOs benefits in having a PD system, the role of hedge funds, conditions of securities lending offered to PDs, and the correlation between PDs’ balance sheet constraints and market liquidity.

Key takeaways:

• • DMOs will have to be cautious between looking for ways to improve the sustainability of primary dealerships and the liquidity of their bonds, while ensuring they do not dilute the advantages and incentives for PDs to remain committed to this market.
• • The role of hedge funds as liquidity providers has been increasing in recent years. However, there is still reluctancy in allowing them to participate as PDs, at least in the countries examined. Hedge funds are not subject to the same heavy regulatory requirements as banks and there is skepticism on whether they can meet such obligations soon, so that DMOs could rely on them.
• • While the provision by a DMO of a securities lending facility (SLF) to its PDs is not a requirement for a well-functioning secondary market, well-structured SLFs can be particularly useful for PDs that must comply with quoting obligations and often engage in short positions as part of their daily market-making activity. They can be then a powerful instrument to enhance secondary market liquidity.