To be an intermediary is to have conflicts of interest built in — and periodically, the investment banks that make a living sitting between sellers and buyers are hauled over the regulatory coals for mismanaging their duties to one side or another. Maybe they acted a principal when they should have acted as agent, maybe the other way around. Maybe big investors got a better deal in allocations than they should have, or maybe they got screwed because pricing screamed in too quickly. Sitting in the middle means taking shots from both sides.
Primary dealerships for government bonds, though, are among the most refined of balancing acts aimed at controlling intermediation — and the system is designed to tip the scales. Governments want market access, in size, at all times and at a price that gives tax payers the best value. They control the supply of bonds, and they can shape demand, too, through regulation the institutions that buy their debt and trade it.
They also control the shape of intermediation. Step back a little, and a primary dealership is explicitly an insiders’ club. Governments want to bring the largest traders of their debt inside the tent, and give them a special round of privileges, in return for a special round of obligations.
Dealers outside the system may, indeed, find themselves run over by the activities of the primary dealers. Knowledge of the thinking of a certain debt manager, and the ability to give formal market feedback about the desired timing and structure of new supply, can be a huge advantage, as can access to preferential repo facilities. It is rare to find an investment bank prominently placed in trading a given government’s securities without a primary dealership to go with it.
But dealers outside the system are also free of obligations. They are not obliged to bid in auctions to maintain their standing; they are free to make markets to their clients without a country's debt management office looking over their shoulder. There’s a natural balance, and institutions can choose where they want to play.
One indication of a crooked system should be outsize profits made by the players on the inside. By this metric, primary dealerships are as clean as they come.
Primary dealerships are notorious loss leaders. So much so that in recent years there have been high profile departures from a number of sovereign dealing programmes across the Street.
Banks reliably lose money up front running their dealerships, and behind closed doors many bankers fume about having to keep them going. Sometimes the demand to stay top of a certain sovereign’s dealership may come from on high — but the P&L pain is taken in the trenches.
If we’re evaluating who is rigging the system, and for what reason, look at who the beneficiaries are. It’s not the investment banks, nor is it obviously the end investors, who see bonds bid up by the incentive structures in auctions (although probably see greater liquidity in the secondary market). In primary dealership systems, it’s pretty clearly it is the sovereign that benefits. When the system works well, a government can issue in enormous size, at a time of its choice, with minimal market disturbance and at a tiny cost to tax payers.
That’s as it should be — government debt management offices created these systems for precisely that purpose, and to load the dice, intentionally, in favour of the public purse. It’s a rigged system, but that’s a feature, not a bug.
That doesn’t mean that no bad behaviour ever goes on, or that every bank has quite the same approach to compliance. The FMSB’s reminder to cross the t’s and dot the i’s is probably worthwhile. Sometimes, too, it’s worth stepping back and considering not just whether something is wrong by the current standards of a market, but whether it would look wrong on the front of a mainstream newspaper, or when explained to a parliamentary scrutiny committee.
The biggest factor in keeping the primary dealership system honest — and many other markets — is real competition and a lack of concentration. In smaller, less liquid markets, major concentrations can easily coalesce, and with it, opportunities for outsize profits using that market power. Even in large markets, certain products, such as inflation-linked issues, can be controlled by just a handful of players, and the competitive tension that keeps players honest can be eroded.
There’s nothing wrong with the FMSB guidance, but the long term interests of government auctions are best served by making sure there’s a wide participation from plenty of strong banks, who can take a little economic pain for the right to play.