The Primary Dealer (PD) system of Sri Lanka has evolved over 20 years undergoing several improvements in terms of issuance processes, instruments, investor base, and trading and settlement infrastructure to its current level.
The PD System was first introduced in 1992 as an Accredited Primary Dealer (APD) System. As APD system was not restricted to government securities transactions and there found to be a conflict of interest, the Dedicated Primary Dealers (DPDs) in government securities were appointed in 2000, with a view to infuse greater competition, liquidity and depth into the government securities market. By the introduction of the DPDs, the borrowing cost of the government was expected to be reduced, through effective participation of PDs in both primary and secondary markets. In 2002, Licensed Commercial Banks (LCBs) were allowed to become PDs with a view to increase the intermediation abilities of the system and to infuse more competition and liquidity into the government securities market. However, PD System is still burdened with certain systemic limitations.
(a) Asymmetry in market information due to non-availability of a dynamic benchmark yield curve A significant proportion of the secondary market transactions in government securities take place in
the Over-the-Counter (OTC) market. The underlying prices and yields of these transactions are not reflected in the current yield curve, thereby creating an asymmetry in market information. This leads to low volume of transactions and low level of market liquidity in the secondary market.
(b) Lack of secondary market liquidity in terms of rupee leg and the security leg
As per the current settlement system, delivery versus payment-1 (DVP-I), each secondary market transaction in government securities is required to be settled on one-to-one gross basis where market participants are expected to maintain substantial amounts of liquidity in both security and money terms. As a result, the secondary market transaction volume in government securities has stagnated at a considerably low level for several years.
(c) Limited participation at primary and secondary market activities
DPDs are expected to act as the intermediaries and market makers for government securities. However, due to the shallow and illiquid secondary market for government securities, PDs tend to buy and hold securities rather than exploring yield enhancement through secondary market trading thereby distorting the price discovery mechanism. In a rising interest rate regime, PDs tend to incur large marked-to-market losses leading them to refrain from actively trading in government securities. The illiquid nature of the market has created a substantial spread between the buying and selling prices
of government securities by making such instruments comparatively less attractive for secondary market investors, including retail investors.
Apart from the above systemic limitations, PDs have experienced certain inherent operational inefficiencies as well such as:
(a) Lack of an institutional arrangement for the management of risks
Certain standalone PDs continue to operate with lack of board approved policies, procedures and a clear institutional arrangement for the management of risks inherent to the activities that they have been engaged with.
(b) Inherent liquidity risk
Standalone PDs are faced with an inherent liquidity risk due to the large overnight maturity mismatch they carry in the assets and liability maturity profile. Their activities are funded mainly through short- term repo borrowings from the market. Also, some PDs do not have satisfactory stand-by liquidity arrangement/s to bridge unforeseen liquidity shortfalls in time to come.
(c) Non-availability of a Business Plan
Most PDs do not have a business plan clearly articulating its strategies on business expansion, enhancement of market share and strategies to improve the PD operations in the medium-term.
Suggestions for improving the efficiency and effectiveness of Primary Dealer System
In order to address the above issues, the present PD system requires certain improvements that will facilitate PDs to operate efficiently in volatile market conditions and to energize the government securities markets, which will ultimately help to reduce the cost of borrowing to the government. Efficiency and effectiveness of PDs can be improved by the following strategies:
(a) Implementation of an E-trading and reporting platform for Government securities
An Electronic Trading (E-trading) platform for Government securities together with mandatory reporting of all secondary market transactions, including those contracted through OTC market would help eliminating the current information asymmetry while helping the price discovery in the secondary market yields. Also, the dynamic yield curve based on trades executed on the platform for government securities, can be used as a benchmark yield curve for trading government securities, thus promoting volume of transactions and liquidity in the secondary market for government securities.
(b) Central Clearing Arrangement
A central clearing arrangement on net settlement of rupee leg and security leg (DVP III) would help to enhance the efficiency in intra-day liquidity management of participants and thereby increase the secondary market trading volumes substantially.
(c) Liquidity Support
In order to overcome the liquidity constraints faced by PDs due to lack of secondary market demand for government securities, a mechanism of liquidity support for standalone PDs can enhance the liquidity position in the government securities market and activate secondary market transactions. In developed government securities markets, standalone PDs are provided with liquidity support, based on their performance in the primary and secondary markets.
(d) Diversification
Diversification of PD activities by permitting PDs to act as corporate debt dealers, will facilitate PDs to reduce the vulnerability to market risk in a rising interest rate scenario as PDs have the flexibility to diversify their activities in line with the changes in the market, instead of operating in a single product market. Also, the appointment of PDs as corporate debt dealers would improve the activities in the domestic debt market and lower the borrowing cost of the government through greater competition. (e) Customer Charter
For the purpose of safeguarding the interests of both PDs and customers and to strengthen their relationships, it is required to introduce a customer charter that includes certain rights, obligations, ethical standards and norms which will be applicable to PDs and their customers.
(f) Fitness and Propriety Assessment
In view of the need for development of the government securities market, PD system and customer protection, it is also necessary to put a system in place to assess the fitness and propriety (honesty, integrity and reputation, competence and capability, and financial soundness) of directors and officers performing executive functions of PD institutions. This will protect the interests of investors in government securities.
(g) Short Selling
As a measure of enhancing the secondary market liquidity, it is suggested to allow PDs to undertake short selling which would facilitate PDs to sell government securities without actually holding the relevant securities in their portfolio. This will also enable firm two-way quotes for benchmark government securities.
Above improvements would provide significant contributions towards expanding and strengthening the PD system and ensuring an improved and efficient primary and secondary market for government securities.