# Primary dealers in treasury auctions

When the treasury or equivalent institution of a country auctions of government bonds there is frequently (i.e. in most countries) some sort of restriction on who can participate. The term primary dealers refers to agents who participate in this primary auction with the intent of reselling the acquired bonds on the secondary market. Usually there is a gap between the bond price (or implied interest rate) of the primary and the secondary market so this is profitable.

Some papers on the phenomenon:

What benefit if any does the treasury derive from this setup, i.e. restricting auction access?

• If the primary dealers have a privileged position, then there is value in being registered as a primary dealer, and so the Treasury or Central Bank can impose standards of behaviour (e.g. an expectation of reasonable participation in all bond auctions or open market operations) as a condition of maintaining that registration – Henry Sep 17 '16 at 11:57
• @Henry How would this 'expectation' manifest itself and what benefit is it to the treasury? I am happy to participate in any auction as long as I can bid 0. There is definitely value to being registered as a primary dealer. This is the basis of my question. – Giskard Sep 17 '16 at 12:02
• If you bid $0$, I would probably not regard that as "reasonable participation". So you would not stay on my list. Since it is my list, I apply my discretion, and you could lose your privilege. – Henry Sep 17 '16 at 12:25
• @Henry Okay. So is there a manifestation of these rules for staying on the list, are the rules written down somewhere? Unfortunately otherwise this seems very vague. (Not to mention speculative.) – Giskard Sep 17 '16 at 12:41
• There are rules such as newyorkfed.org/markets/pridealers_policies.html though you will find words like "reasonable" in them. In effect primary dealers provide liquidity and information and markets even at times of crisis, which comes at a cost, one which countries such as the USA think is worth paying to get the increased financial stability it brings. – Henry Sep 17 '16 at 15:22

Primary dealers have a privileged position, so there is value in being registered as a primary dealer.

The Treasury or Central Bank can impose standards of behaviour (e.g. an expectation of reasonable participation in all bond auctions or open market operations) as a condition of maintaining that registration. There are rules such as https://www.newyorkfed.org/markets/pridealers_policies.html and you will find sections such as

The New York Fed expects a primary dealer to:

• participate consistently as counterparty to the New York Fed in its execution of open market operations to carry out U.S. monetary policy pursuant to the direction of the FOMC;

• provide the New York Fed’s trading desk with market commentary and market information and analysis helpful in the formulation and implementation of monetary policy;

• participate in all auctions of U.S. government debt; and

• make reasonable markets for the New York Fed when it transacts on behalf of its foreign official account holders.

In the selection process, the New York Fed will evaluate a prospective primary dealer with these expectations in mind.

In effect primary dealers provide liquidity and information and markets even at times of crisis, which comes at a cost, one which countries such as the USA think is worth paying to get the increased financial stability it brings.

The difference in prices is compensation for market making activities in the secondary market. The market maker is the intermediary that connects buyers and sellers. You could compare the market maker to a store, the intermediary that connects the producer to the consumer. And like operating a store, market making is both costly and risky, and so it is fair that market makers are compensated for their troubles. Whether the amount of compensation is fair is an entirely different issue, and one for which I do not have a ready answer.

But this answer is unlikely to be in opening up primary markets. If primary markets were open, issuers of financial securities would have to carry the risk and costs of market making themselves. And why would they do that? There are no economies of scale for them: it's not practical to hold auctions that are open to thousands of bidders, particularly if all participants' details and credit scores need to be checked. Conversely, what's the benefit of having more bidders? Maximizing the return is all that matters to the issuer, and it is not at all obvious that the difference in price would outweigh the additional costs.

• How is making the primary market, were prices are determined through auctions, any less difficult than making the secondary market? That is if the treasury can cope with the first, why can it not cope with the latter? – Giskard Sep 20 '16 at 15:40
• @denesp You misunderstand, it's not about difficulty but about cost and risk. Is the comparison with a store unclear? – user7935 Sep 20 '16 at 16:07
• I understand the comparison but doubt is accuracy. The Treasury has an online auction interface. As such it has a direct link to buyers. Why is there need for an intermediary? (Here I thought you would argue proper prices, but I argue those are set by the auction algorithms.) – Giskard Sep 20 '16 at 19:12
• It seems as though you are looking for an argument as to why the Treasury couldn't possibly integrate the markets. This is the wrong way to look at it, because they can. The question is why they would want to. By employing private (and more efficient) market makers, they avoid a bunch of unnecessary costs and risks. Don't you think that if the Treasury yield would be higher if they would function as their own market maker, they would do so? – user7935 Sep 21 '16 at 15:40
• I think there a lot of occasions when the optimal solution is not reached simply because of institutional inertia. I think in this case the Treasury could reach a higher yield by integrating the markets. As Henry pointed out in his answer there could be considerations other than yield, such as liquidity, but I am not sure the market integration would not solve this problem as well. – Giskard Sep 21 '16 at 20:05