CHAPTER 12

New Market-Making Obligations for Primary Dealers

The financial crisis has reduced liquidity and price transparency in the mar kets for government securities. The spread between bid and ask prices on elec tronic trading platforms has increased, and it has become more dif ficult to make large transactions without affecting the price in the mar ket.

In order to improve liquidity conditions and price transparency in the secondary market, most government debt management offices, DMOs, in clud ing the Danish DMO, gradually tightened the primary dealers' mar ket-making obligations in 2009. This was done by narrowing the max imum bid-ask spreads and increasing the depth requirements as market conditions improved.

The stricter requirements have had limited impact on liquidity. Against this background, a number of countries have introduced new require ments based on market making by primary dealers relative to each other. Requirements of this type are well suited for adjustment of market-making obligations to changing market conditions.

A system to calculate maximum bid-ask spreads was introduced in the Danish market for government bonds in January 2010. Depending on ex peri ence, further elements may be added to increase competition among the primary dealers.

International Trends 12.1

Issuers, banks and investors all have a shared interest in the markets for government securities being liquid and well-functioning. Effective and transparent price formation in the secondary market is a precondition if investors are to buy and sell government bonds without affecting the market price. Investors are typically willing to pay a premium for liquid bonds, and turnover in the secondary market is typically higher in liquid securities. This helps to ensure lower financing costs and easier access to the financial markets for the central government than would otherwise be the case. It is therefore in the interest of DMOs to ensure a framework that supports a well-functioning secondary market.

In periods when the markets are unstable, failure to adjust the bid-ask spread requirements may lead to artificially high activity on electronic platforms. This is because the primary dealers' quoting of prices will often lead to mutual trading among primary dealers as a result of more signific ant movements in bond prices. Failure to adjust requirements to more volatile market conditions may therefore lead to primary dealers being forced to take unwanted positions. Ultimately, the banks may choose not to be primary dealers.

In a system with fixed market-making obligations, adjustments to re quire ments are typically made in consultation between the DMOs and the group of primary dealers. Individual primary dealers often have different inter ests. Wide bid-ask spreads give rise to large profits on individual transactions, while activity is typically low. Conversely, narrow bid-ask spreads typically give rise to higher trading activity, while profit per trans ac tion is lower. As a group, primary dealers are typically diversified. Thus the individual primary dealers' definitions of optimal market-making re quire ments may vary significantly. Consequently, fixed bid-ask spread re quire ments have proved to involve sluggish adjustment to changing mar ket conditions.

Lower liquidity in the secondary market
The financial crisis caused considerable uncertainty and volatility in the mar kets for government securities. In that context, DMOs eased the re quire ments relating to the primary dealers' market-making ob li ga tions. Unlike in several other financial markets, however, market mak ing func tioned in most markets for government securities during the crisis.

Liquidity conditions and price transparency declined as a result of the less stringent market-making requirements. At the same time, the banks needed to reduce the risk on their balance sheets due to the financial crisis. The primary dealers were consequently unable to stock large portfolios of government bonds to the same extent as before. This reduced their capacity to trade and resell bonds in the secondary market, thereby weakening liquidity and price transparency even further.

Adjustment of market-making obligations in 2009
In the spring of 2009, volatility in the financial markets declined. In that con nection, several DMOs launched initiatives to increase liquidity in the markets for government securities by gradually tightening market-making require ments. In general, it has only to some extent been possible to recreate the level of market-making requirements that existed before the financial crisis. At the same time, the markets are still characterised by pri mary dealers making smaller balance sheets available, which has affected liquidity. Finally, the markets are characterised by reduced resiliency, i.e. re duced ability to regain equilibrium following changes in supply or de mand that are not based on new information, cf. Box 12.1.

Liquidity	Box 12.1
The term liquidity cannot be defined unequivocally. The term is generally used about the option to buy and sell a security without affecting its price. The degree of liquidity of a security involves four parameters: The depth indicates the amounts that can be traded without affecting the price. The width indicates the difference between the bid and ask price. The immediacy indicates how fast a counterparty can be found that meets an investor's requirements. The resiliency indicates how fast the market regains equilibrium following changes in supply or demand that are not based on new information. A liquid market is associated with substantial depth, insubstantial width and high levels of immediacy and resiliency.
Source: Harris, L., 1990, Liquidity, trading rules and electronic trading systems. Monograph Series in Finance and Economics 1990-4, Salmon Centre, New York University.

Relative market-making obligations
Acknowledging that fixed bid-ask spread requirements are difficult to ad just and thus to adapt to changing market conditions, a number of coun tries have introduced a new type of market-making requirements. This type of requirements is based on the primary dealers' quoting of prices relative to each other, cf. Box 12.2. As a result, the bid-ask spread require ments are automatically adapted to changes in market conditions. There are still fixed requirements in terms of amounts.

Examples of relative market making

Box 12.2

Belgium introduced a new system on 1 October 2009 under which primary dealers quote prices for minimum amounts and within a calculated competitive bid-ask spread that varies between securities and between days. When the system was introduced, the competitive spread was calculated as the average bid-ask spread plus one standard deviation.

Based on experience with very low standard deviations, the calculation of the competitive spread was subsequently changed to a fixed factor of 1.25 multiplied by the average spread. At the same time, a lower market-making limit was set under which primary dealers are compliant.

Primary dealers are ranked on the basis of an evaluation of their market making. The evaluation comprises several parameters, including the price-quoting quality (the bid-ask spread level), the number of price-quoting hours and trading activity. On the basis of the evaluation, non-competitive allocations are made through auctions. The allocations are made to the five best primary dealers in the secondary market over a specified prior period. On the settlement date (three trading days after the auction), each of the five dealers is allowed to buy an additional amount at the average price that applied at the auction.

The Netherlands uses a dual system for market-making requirements. Under normal conditions, the requirements in terms of bid-ask spreads and amounts are fixed. If more than half of the primary dealers indicate that they are unable to quote prices within the specified bid-ask spreads in a given security, special conditions are applied in that security. Under special conditions, the primary dealers comply with the market-making requirements if prices are quoted for minimum five hours within the average bid-ask spread plus one standard deviation. When more than half of the primary dealers are able to quote prices within the fixed bid-ask spreads again, the market-making requirements revert to normal conditions.

The primary dealers who comply with the market-making obligations for minimum 90 per cent of the time during a specified period prior to an auction are allowed to make non-competitive bids for up to three days after an auction. Settlement will take place at the average auction price.

In order to give the primary dealers an incentive to undertake market mak ing at competitive bid-ask spreads, a number of countries have intro duced non-competitive allocations in connection with the introduction of relative market-making obligations, cf. Box 12.3. The allocations are con di tional on good results in the secondary market, among other factors. This increases the primary dealers' incentive to create a well-functioning secondary market.

Non-competitive allocations

Box 12.3

Non-competitive allocations is the general term used about bidding rights where no bid price is required. Such allocations are made as options where the buyer at an auction is entitled to buy an additional amount for a period of time after the auction and at a price fixed at the auction. The value for the buyer depends on the price development after the auction. If the price goes up, the buyer will typically choose to exercise the right to buy additional securities.

New Danish Market-Making System From January 2010 12.2

Liquidity in the Danish market for government securities has mirrored the international development during the financial crisis. Stricter market-making requirements were gradually imposed throughout 2009 as market conditions allowed. However, it has not been possible to recreate the level of liquidity from before the financial turmoil.

In the autumn of 2009, Government Debt Management analysed inter national experience with improving liquidity in the markets for gov ern ment securities. Based on good experience from other countries and positive announcements from primary dealers in government bonds, the market-making obligations in Danish government bonds were changed. In the preparation of the new market-making requirements for Danish primary dealers, the following was emphasised:

flexible adjustment to market conditions

some international harmonisation

independence of choice of electronic platforms.

In connection with the re-opening of the T-bill programme, special market-making requirements will be introduced. The market for T-bills is characterised by a smaller group of participants and a wide range of price bench marks in the money market. For T-bills fixed requirements in re la tion to bid-ask spreads and amounts are consequently introduced.

Compliance with market-making obligations in the new system
In the new market-making system, quoting of prices for government bench mark bonds is mandatory as such bonds are references in the Danish mar ket. In order to support liquidity and price transparency for all govern ment bonds, quoting of prices in the other government bonds is included with a certain weight in overall market making.

Government Debt Management, in cooperation with the primary dealers, determines a fixed minimum amount for the bond series, cf. Table 12.2.1.

Market making obligations, January 2010		Table 12.2.1
DKK million	Mandatory amount	Mandatory period
Benchmarks
2-year segment	100	5 hours
5-year segment	80	5 hours
10-year segment	50	5 hours
30-year segment	25	5 hours
Liquids	25	5 hours

The mandatory amount is the required market making by a primary dealer if the price-quoting is to be included in the calculation of compli ance with market-making obligations. In addition, a mandatory period is determined, during which a primary dealer must quote prices within the average spread multiplied by a fixed factor (the competitive spread).

While explicit requirements apply to the price-quoting amount and period, the competitive spread for each security will vary from day to day.

For each security, individual primary dealers' time-weighted bid-ask spread will be compared with the calculated competitive spread and included in the calculation of the daily and monthly compliance with market-making obligations, respectively, cf. Box 12.4. The evaluation of primary dealers is based on compliance with obligations on a monthly basis.

compliance with market-making obligations

Box 12.4

The competitive spread in security s (CompSp_s) is calculated as a scaling of the average of each primary dealer p's time-weighted bid-ask spread during the best five hours (5HrSp_p,s). If a primary dealer quotes prices for less than five hours, the simple time-weight ed spread will be applied. Market making is only included where prices are quoted for the mandatory amount or more. The competitive spread is calculated as follows:

,
where #PD_s is the number of primary dealers quoting prices in security s. In benchmark series, #PD_s is the total number of primary dealers. For liquid series, the variable indicates the number of primary dealers who have quoted prices for the mandatory amount. k is fixed at 1.5, but it will be evaluated on an ongoing basis.

For each security, compliance (Compliance_p,s) will be in the 0-1 interval, depending on the number of hours (Hours_p,s) during which primary dealer p quotes prices in security s within the competitive spread and for the mandatory amount. If Hours_p,s is minimum five, there is full compliance with the obligations in security s, i.e.:

.

Daily compliance: Based on compliance in each security, s, daily compliance (DC_p,d) is calculated for each primary dealer p and for each working day d. In such calculations, the weighting of benchmark securities differs from the weighting of liquid series:

.

If market making is restricted to benchmark series alone, daily compliance cannot exceed α. α is fixed at 0.8 and like k it will be evaluated on an ongoing basis in cooperation with the primary dealers.

Monthly compliance: Monthly compliance (MC_p) is calculated as the average daily compliance for primary dealer p, i.e.:

,

where the number of working days may vary from one primary dealer to the next depending on public holidays. Primary dealer p is compliant during a month if MC_p is at least 85 per cent.

Opportunities of adjustments and extensions in Denmark
The new market-making requirements in relation to Danish government bonds are not restricted to market making being conducted on specific trading platforms. Market-making obligations will always be based on the quoting of prices on the trading platform where the primary dealer has the lowest time-weighted bid-ask spread.

In connection with the implementation of the new Danish system, the competitive spread in each security is calculated as 1.5 multiplied by the average spread. Some DMOs apply a lower factor. The relatively high factor has been selected based on the assessment that it is important to ensure that the system introduced is not too restrictive from the outset.

Depending on the experience gained with the new system, the market-making obligations may be adjusted.

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