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Do primary dealer funding constraints impact sovereign bond liquidity and yields: evidence for nine Euro area countries

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Abstract

For a sample of nine euro area countries and a period running from 2004 to 2012, we empirically assess the effect of primary dealers’ financial constraints on the liquidity and pricing of the sovereign bonds in which these primary dealers make the market. We find that dealers’ financial constraints generally led to less liquid sovereign bond markets, with the effect depending on the subperiod under study, the issuer and the dealers’ origin. In addition, dealers’ financial constraints generally contributed to higher yield spreads, both directly and indirectly through their impact on liquidity.

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Notes

  1. The December 2013 SESFOD survey finds that the most important factors are “general market liquidity and functioning”.

  2. An early contribution to this debate is Keynes (1930) who defines an asset as more liquid than another if it is “more certainly realisable at short notice without loss”.

  3. Although direct depth measures of liquidity are typically computed using high frequency data, the Amihud ratio is considered a low frequency measure.

  4. We use daily spreads of single name 5-year senior CDS contracts where the underlying entity was a primary dealer active in the sovereign bond market of country c. For each underlying entity, we choose the CDS contract in the currency with the potentially highest liquidity.

  5. See http://www.ft.com/intl/cms/s/0/9a4cabc4-464d-11dc-a3be-0000779fd2ac.html#axzz2g5RQ7MXH$. In addition, this date is also used as on this day central banks intervened for the first time on a large scale. For the official statement, see http://www.federalreserve.gov/newsevents/press/monetary/20070810a.htm.

  6. To recall, in contrast to EuroMTS, bonds covering the entire spectrum of the yield curve are traded on the MTS domestic platforms.

  7. When this price is not available, the flat price quote based on the average of best bid/offer prices is considered.

  8. Using sovereign CDS with maturities 3, 7 and 10 year would oblige us to resort interpolation techniques to obtain a set of daily estimates of credit quality for all country, as these maturities are less liquid than the 5 year CDS while bringing essentially the same information.

  9. For instance, Munter and van Duyn in an article published by the Financial Times on 09/10/2004 document how, in August 2004, Citigroup netted a profit of about €15m at the expense of the other market makers by flooding MTS with sales and buying back government bonds at a lower price. See http://www.ft.com/intl/cms/s/1/35b8b6d4-0290-11d9-a968-00000e2511c8.html

  10. The finding that liquidity decreases in crisis times has also been demonstrated for other markets (e.g. Chordia et al. (2005) for US stock and government bond markets).

  11. The Amihud and the Hasbrouck ratios cannot assume negative values, so they are truncated or limited dependent variables. To address this issue, we have first run the analysis using the semi-parametric estimator for truncated regression models with fixed effects presented by Honoré (1992). As a further robustness check, we have also run the analysis taking the natural logs of the truncated illiquidity measures, as suggested by Brennan et al. (2013). In both cases, to deal with the potential endogeneity, we use lagged values of the explanatory variables. Finally, we have also run the estimation on the log-transformed Amihud (2002) and Hasbrouck measures using instruments like in Reed (2015). All the results are very similar and confirm our findings.

  12. The results for crisis countries is largely driven by Italy which presents around 85% of all observations.

  13. The bond-specific volatility as specified in Eq. 2 is included in all regression but not shown due to space constraints. The variable is statistically significant in all specifications.

  14. In 1960, 18 primary dealers were selected to trade directly with the Federal Reserve System. During the subsequent years, the number of PDs increased gradually until reaching 46 in 1988 and declined to 21 in 2013.

  15. However, many developed countries, like Australia and Switzerland, have no PD system. In Germany, a quasi-PD system is in place. Under the German system, no primary dealers are appointed, but a group of 33 international banks, known as the Auction Group Bund Issue, whose sole obligation it is to submits bids equal to 0.05% of the total annual auction volume.

  16. Please see Table 9 for the sources of information on PD systems.

  17. For instance, in Austria, the highest minimum percentage technically possible is 100 divided by the number of PDs. However, the minimum percentage generally required is much lower to allow for the differences in the PDs’ buying capacity.

  18. For example, in Greece the Committee of Primary Dealers’ Supervision and Control can change the minimum quantity per quote of lots (from 5 to 1 where 1 lot corresponds to EUR 1,000,000) of securities for which PDs (continuously) provide binding bid and ask price quotes.

  19. Some debt management agencies publish rankings of their primary dealers to reflect their performance.

  20. In terms of number of mandates, the shares of European and non-European dealers has remained largely unchanged. This implies that fewer European banks have more primary dealer mandates.

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Correspondence to Massimo Ferrari.

Additional information

M. Ferrari works for the European Securities and Markets Authority and University of Tor Vergata. Stéphanie Stolz works for the European Systemic Risk Board. Michael Wedow works for the European Central Bank. The views expressed in this paper are those of the authors only and do not necessarily reflect the views of the European Securities and Markets Authority, the European Systemic Risk Board or the European Central Bank. We are grateful to Wolfgang Lemke, Daniel Streitz, Peter Hoffmann and the participants of a seminar at the European Central Bank for their helpful comments and suggestion.

Appendix

Appendix

Table 8 Sources of information on PD systems
Table 9 Summary statistics of bond liquidity and primary dealer constraint
Table 10 Correlation table for liquidity measures and primary dealer constraint
Table 11 List of primary dealers which are/were active in the 9 countries, 2004–2012
Table 12 Number of primary dealers by country and year
Table 13 Number of primary dealers by country of origin and year
Table 14 Rules of conduct for primary dealers

Primary Dealers in European sovereign bond markets Primary dealers (PDs) are highly qualified financial intermediaries that enter into an agreement with national debt management offices and/or central banks to promote the primary placement and secondary trading of government securities. They typically agree to assist and to provide services to support the funding of the government in exchange for specific privileges. The PDs are appointed by national authorities to pursue a common strategy to stimulate the activity and development of the government debt securities market (McConnachie 1996; Arnone and Iden 2003). With this objective, PDs are expected first and foremost to build and sustain the demand for government securities by submitting bids at auctions given that they are the primary source of liquidity. In addition, primary dealers are typically mandated to perform all operations deemed as necessary to reduce the market and refinancing risks as well as to broaden the final investors’ base. To achieve these goals, the primary dealers’ task in the secondary market is to improve the market liquidity through a system of market-making. A well-functioning secondary market ensures the participation in the primary market and should ultimately lower the funding costs of the issuer (Tables 8, 9, 10, 11, 12, 13 and 14).

Against this background, a system of primary dealers is the underlying institutional arrangement between these financial intermediaries and the sovereign issuers. The first primary dealer system was introduced and implemented by the Federal Reserve System in 1960.Footnote 14 Starting in the 80s, many European countries adopted primary dealer systems (see Arnone and Iden 2003).Footnote 15

The economic rationale for the adoption of a system of primary dealers can be seen as a government’s response to market failure. In the absence of a primary dealer system, incentives are deemed insufficient for potential dealers to ensure effective functioning of the market. Government intervention in the form of granting some market makers preferential access helps to align the objectives of the government with the incentives of primary dealers. Moreover, appointing and entering into an agreement with a selected group of qualified institutions can be seen as a reliable signal of a sustainable public debt strategy and increasing investors’ confidence in government securities. On the downside, national authorities may inadvertently encourage risk taking and possible anti-competitive behaviour. In this respect, the combination of obligations and privileges, i.e. the structure of incentives and controls, can have a direct effect on the efficiency of the government securities market and the market’s ability to accommodate public sector borrowing needs.

As there are some differences between PD systems across countries with regard to the duties and rights, we briefly describe the systems of European countries in the next subsection.

PDs systems in European countries: general duties and privileges In designing their system of primary dealers, European countries define with different degree of detail the auction procedures and the general rules of conduct for market makers.Footnote 16 Typically, the obligations and rights are supervised by the Central Bank, the Ministry of Finance or the Debt Management Agency. Among the common duties, PDs have to bid at auctions on the primary market, generally by submitting a minimum amount of bids and/or successful bids. The total amount auctioned is defined by the national treasury agency and, in almost all EU countries, the minimum bidding commitment is a percentage of that amount.Footnote 17 PDs are also required to place government securities with end investors, which obliged them to act as a government securities depositary and to strengthen product innovation. Moreover, PDs are typically responsible to enhance the liquidity in the secondary market. This is achieved by requiring PDs to continuously quote two-way prices for a minimum size, with a certain spread and for a number of hours per day. Price-quoting obligations apply to prices quoted to customers and final investors as well as to other dealers. In fact, the ultimate aim of these price-quoting obligations is to avoid arbitrage opportunities and to increase and ensure the effectiveness of price transparency. For this purpose, in periods of market stress, many EU countries have lengthened the time window during which PDs can submit their non-competitive subscriptions or modify the maximum bidding amount, as a sort of compensation for their services and status.Footnote 18 Acting as counterparts of national treasury agency in both profitable and non-profitable debt management operations is a privilege and a duty for PDs. They are obliged to trade directly with national debt authorities and to provide these with advisory support on the debt management strategy as well as information on market developments. Another typical obligation for PDs is to regularly report to the national debt management office on their activity in the secondary market. This information in turn is used to appraise the PDs and evaluate their performance as market makers.Footnote 19

As already mentioned, to ensure the efficient performance of PDs, national debt authorities acknowledge and grant different rights and privileges which widely vary across countries. The most common conceded privilege derives from the title of PD itself and thus from their exclusive relationship with the debt management office. This inter alia includes the access to any relevant information and consulting. The recognised privileges of PDs can pertain to both the primary and the secondary market. Regarding the primary market, the special rights are: the exclusive right to be bidders at auctions; the provision of extra time to submit their bids if other market participants are allowed to take part at auctions, giving PDs an advantage over competitors; granting preference in profitable debt management operations and the right to participate as lead managers in syndicated debt issuances and buyback programs. PDs also benefit from the right to submit a pre-specified amount of non-competitive subscriptions during or after the auction, allocated to each PD as a fixed percentage of the successful bids at the relevant auction or, alternatively, as a percentage of the average amount of a PD’s bids over the last auctions.

In the secondary market, as a way to support their market making activity, the most important recognised special right is the exclusive access to securities lending facilities. Indeed, while acting as market makers in secondary markets, PDs can assume short positions for a security that they are not holding in their inventory. Moreover, PDs can have the exclusive right to create and reconstitute strip bond packages. In addition, the publication of rankings and lists of the best performing PDs both in the primary and in the secondary markets can be seen as a privilege given that it can lend attractiveness and increase the marketing value of the PD status with respect to final investors.

Table 1 in the annex summarises the rules of conduct currently in force in the nine European countries considered in our analysis (Austria, Belgium, Finland, France, Greece, Italy, the Netherlands, Portugal, and Spain). Clearly, duties and privileges are largely similar across the nine countries with some country-specific deviations as for example the minimum secondary market share and minimum participation on primary auctions.

Tables 2 and 3 report, respectively, the number of PDs active in the sovereign bond markets over time and the number of PDs by country of origin. The number of active PDs in Table 2 that are active in the different markets varies marginally across time and somewhat more across countries. At the same time, the variation across countries does not appear to be linked to the size of outstanding sovereign debt given that smaller and larger countries employ a similar number of PDs. With regard to the origin of PDs in Table 3, the majority of PDs are domiciled in Europe, but the number of non-European dealers has increased since 2004, while the number of European dealers has declined. Overall, the total number of PDs has declined from 62 in 2004 to 51 in 2012, revealing a consolidation process in this market.Footnote 20 The importance of foreign dealers stems from the potential wider investor base that can be reached through the participation of foreign banks and the potentially larger amount of capital that particularly large dealer banks can commit to market making Dunne et al. (2006). All primary dealers that were active in the nine countries during the period 2004–2012 are listed in Table 11 in the Annex.

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Ferrari, M., Stolz, S. & Wedow, M. Do primary dealer funding constraints impact sovereign bond liquidity and yields: evidence for nine Euro area countries. Empir Econ 56, 1855–1891 (2019). https://doi.org/10.1007/s00181-018-1451-6

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