PRIMARY DEALER SYSTEM:
A COMPARATIVE STUDY
Research Department, CCIL*
What is Primary Dealer System all about? In
a nutshell it is an arrangement between two
major stake holders in the Government
Securities market the debt manager and a
group of dealers to pursue a common
strategy in support of functioning and
development of primary and secondary
markets for government securities. Setting
up of primary dealer system helps in
achieving certain goals such as lowering cost
associated with the servicing public debt
and also encouraging saving by providing an
appropriate environment facilitating
investment and trading in government
securities. It even acts as an indirect
instrument of monetary policy in the hands
of the central bank.
Many countries have established a system of
Primary Dealers (PDs) as important
intermediaries to promote activity in
Government Securities market. Such PDs are
assigned specific responsibilities like
participating in the primary market in a
substantial and consistent manner,
minimum bidding requirements, giving two-
way quotes, providing market information
to the central bank, etc. In some cases, PDs
have been given exclusive right to primary
auctions, or some special facilities in money
*Research Department, The Clearing Corporation of India Limited.
market operations, open market operations,
underwriting commission, etc. PDs can play
a vital role in the development of the
secondary market as a market maker by
providing two way quotes, either indicative
or firm for specified group of securities. By
being in the market, their prices discount all
available information; they take up trading
positions, and also render valuable
assistance to the central bank by providing it
with latest market information, designing
new instruments, etc. Selection criteria for
primary dealers typically include financial
strength as indicated by adequate
capitalization; an active role in government
securities market and financial expertise,
such as skilled management and staff with
access to appropriate technology.
Why a primary dealer system is set up in a
country will depend on the needs of the
country which inturn depends on the state of
the economy. Like in advanced economies
where developmental issues become less
pressing, it has its own advantages such as
improving knowledge of the market,
decreasing market refinancing risk,
providing better access to investors and
providing skilful advisory support in
building and following the debt
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.

India Chile Germany Saudi Arabia Korea United States Morocco

Countries
(Emerging) (Emerging) (Developed) (Developing) (Emerging) (Developed) (Developing)

Participants
in the Gsec
market
include Central bank, 18
No of banks, credit institutions,
18 PDs apart
Dealers in pension No PDs. No PD system 102 (26 PDs) 25 PDs one broker dealer,
from banks
Gsec funds, 103 mutual funds (9
insurance PDs)
companies
and mutual
funds
System
1996 no PD system N.A N.A Jul-97 1960 Aug-95
Established

obligation to
bid in
auctions,
fulfil
minimum
bidding
to bid in
commitment,
Bid in the auctions but
offer two way
auctions, quote not necessarily
quotes, Obligations to bid
two ways, and to all, participate
PDs achieve a in the auctions and
N.A N.A N.A trade a minimum in OMO's and
obligations minimum to quote firm and
of 2 percent of provide the
success ratio two ways.
total secondary Fed with
for dated
market volume information
securities and
on market
treasury bills,
achieve
minimum
turnover in
government
securities.

Banking and Privilege to

borrowing borrow
facilities with securities from
Exclusive access to Possibility to have
the central the central
primary auctions non competitive
bank. Access bank's
Privileges N.A N.A N.A and non bids upto 20 percent
to call money portfolio
competitive of the weighted
market and during its
bidding average with holding
receipt of daily securities
volume.
underwriting lending
commission operation
 Organization of the
under writing
*Having a bond market,
and market
PD system Reduces cost of promotion of
making, *There already
would help *To enhance market govt bond issue, treasury bills,
improved exists a very Facilitates the
in better efficiency and lowers exchange of
liquidity for successful auction implementatio
Advantages information liquidity along with underwriting fees, information on
govt system and active n of monetary
and creating active increases demand available bids as well
securities trading in stock policy
development secondary market. and stabilizes as the price levels at
market, helps exchange.
of secondary bond market which the investors
Open Market
markets. are ready to
operations
subscribe.

*A PD system
would leave
Designation of
out pension
Primary
funds and
Dealer is often
High insurance
viewed as
dependence companies
giving the
on short who are
Dis- institutions a
term funding major players N.A N.A Nothing particular N.A.
advantages special status
and call in the Gsec
or
money market
guaranteeing
market. creating a
their
dependence
creditworthine
on small
ss
number of
institutions.

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

Evaluation of PD system in India: an
extension.*
In the pre 1991 period the government
securities market was underdeveloped
because of illiquid and narrow based market
with limited institutional infrastructure. In
order to keep cost of government borrowings
low the coupon rates offered on government
securities remained negative in real terms.
The borrowing requirements of the Central
Government were mainly through pre-
emption of resources for maintaining high
SLR (Statutory Liquidity Ratio). During
such a period the major players in the
government securities market were Banks
and Insurance Companies. Banks were
actively involved only because of SLR
requirements. During the eighties the
volume of both long term and short term
debt expanded considerably due to
automatic accommodation through the
mechanism of adhoc treasury bills.
Considering the significance of a vibrant
government securities market for activating
indirect tools of debt management policy
and for more effective conduct of monetary
policy few reforms were introduced. Initially
in 1984 RBI set up DFHI allowing it to
participate in the call money market and to
handle treasury Bills. Further reforms were
introduced in the early 1990's to improve the
depth of markets. The 364, 91 as well as the
14 day Treasury bill were introduced as a part
of these reforms along with the auction
system for the sale of Government securities.
In 1994 Securities Trading Corporation of
India (STCI) came in to the picture at the
initiative of RBI for developing an
institutional infrastructure for an active
secondary market in Government
securities. A large participant base reduces
the borrowing cost for the government,
market volatility and imparts competition
in the market. In accordance with the
announcement in the Monetary and
Credit Policy in May 1994, the institution
of PDs has been adopted in India in 1996,
for developing both primary and
secondary markets in Government
Securities by accrediting Primary
Dealership to DFHI and STCI. The main
objectives of promoting the institutional
mechanism of PDs are to strengthen
institutional infrastructure in the
Government Securities market in order to
make it vibrant, liquid and broad based
and to ensure development of
underwriting and market making
capabilities for Government Securities
outside the RBI so that the latter could
gradually shed these functions. PDs
obligations include giving annual bidding
commitment, underwriting the primary
issuance and offering two-way quotes,
achieve required success ratio for dated
securities and treasury bills and to achieve
a minimum turnover in government
securities. The RBI guidelines specify that
PD should have sufficient and continuos
presence in the government securities
market and a minimum net owned fund of
Rs. 50 crore. PDs are obligated to bid in
auctions in order to fulfil minimum
bidding commitment.
RBI takes into account both the bidding
commitment and the performance of PDs
in the primary and secondary markets for
determining the quantum of liquidity
support and hence offers some privileges
to fulfil their obligations effectively. PDs
have an access to banking facilities with the
central bank, exclusive borrowing
privileges with the central bank,
permission to borrow and lend including
Call Money and to trade in all money
market instruments, favoured access to
open market operations and are allowed to
underwrite for a commission for dated
government securities. PDs now even have
the flexibility of hedging their interest rate
risks in the swap markets. In contrast to the
Indian scenario in the United States PDs
do not have privilege to borrow fund from
the central bank but they can borrow
securities form the central bank's
portfolio.
Incidentally, RBI experimented with a
system of Satellite Dealers (SDs) from 1996
to serve as a second tier to PDs in the
Government Securities market with the
particular objective of promoting retail
segment. However, on a review it was found
to be not as useful as was expected and was
given up. However, since 2001-02, retail
investors are allowed to participate in
government securities primary auction
through bank or a Primary Dealer. This
move was to encourage retail participation
in the primary market. RBI is allocating
maximum 5 per cent of the notified
amount in auction of select dated
securities for allotment to retail investors on
a “non competitive” basis at the weighted
average rate. Retail investors are allowed to
send only one bid per auction up to Rs. 1
crore through the intermediaries to RBI.
In most of the countries PD's are expected to
bid in primary auction but they may not be
under any contractual obligation as in USA.
However other market participants are
expected to participate through the primary
dealer. In UK which is supposed to be the
model for the Indian system, there is no
bidding obligation on part of PDs. However
offering two way quotes is a mandatory
requirement in UK and in Spain but not in
USA.
Though the PD system has been beneficial
which is evident from the growing turnover
of the government securities market they
have their share of disadvantages such as
high dependence on the short term funding
and call money market. Secondly as most of
the PDs are offshoots of banks their
involvement as market maker has taken a
back seat. This is primarily because of the
risks which they face given the volatility in
the gilts market. A concern which the
Primary Dealers have for the future is of
maintaining profitability given that they are
slowly going to be phased out of the call
money market. Therefore they will have to
look at every opportunity of lowering
funding costs and enhancing trading profits
by pushing up turnover. Shri D. Basu
Chairperson of STCI in his recent address at
the Annual General Meeting indicated that
Primary Dealers will need to decide whether
in the long run they should diversify into
other related fixed income business such as
corporate bonds and commercial paper.
An issue which has been raised by PDs relates
to their exclusive access in primary auctions
of T-Bills and in open market operations
with regard to Government dated securities.
International experience with the Primary
Dealers System shows that few developed
countries have introduced exclusive access to
PDs in OMO (USA and UK). On the other
hand, many countries, both developed and
emerging, have given exclusive access to PDs
in the primary auction process. Since 2000
on few occasions RBI came out with OMO
in Treasury Bills exclusively for PDs to
overcome short term liquidity problems. In
addition, RBI conducted "switch
operations" for the first time in August 2000
that was restricted only to PDs. It is argued
that giving exclusive access might create
private monopolies, which may go against
the creation of a deep and liquid market.
There is another view that exclusive access to
PDs may raise the cost of financial
intermediation, which may not be desirable
from the viewpoint of efficiency of financial
markets. In sum it may be stated that giving
exclusive rights to PDs in primary auctions
will essentially depend on the state of
development of the market, the size of the
primary issue and financial strength of the
PDs.
* Source RBI.