In the autumn of 2004, officials at the Department of Finance and the Bank of Canada launched a review of the debt distribution framework to assess the framework's effectiveness in ensuring that the government has continued access to stable, low-cost funding sources over a medium-term horizon and that the Government of Canada securities market continues to function well. The framework, which includes the rules governing access to sales of new issues of government securities and surveillance of participants, was last reviewed in 1998. At that time, measures were put in place to enhance the reliability of access to funding for the government and to ensure that the auction process would not result in undue concentration of securities or unfair competitive advantage for any particular market participants.
Since changing the framework in 1998, the government has conducted auctions that are consistently covered and well bid. At the same time, participation at auctions has become increasingly concentrated, with the government relying on fewer dealers to cover the sale of securities. The secondary market for government securities, along with other sectors of the domestic fixed-income market (e.g., provincial and corporate securities), has also become increasingly concentrated, consisting of a small handful of large dealers and a few medium-sized firms. Other trends that have developed since the last review include interest in direct participation at auctions by investors; greater price transparency; the advent of electronic trading systems (ETSs); and changes in the practices of sovereign-debt managers.
The views of securities distributors and institutional investors were sought through consultation meetings held in October and November, to help ascertain the current effectiveness of the framework and to determine whether changes to the present framework are warranted.
To date, the general finding conveyed from the consultations is that the government's present debt distribution framework is working well in the context of the current market structure, and that major changes are not needed at this time.
Consulted parties expressed general concerns about liquidity in an environment where the supply of securities continues to decline and where there is uncertainty about how the market would adapt in the event of further concentration among dealers and investors. However, the government's debt distribution framework was seen as balancing the differing interests of market participants and helping to promote a well-functioning government securities market and the broader fixed-income market by extension.
Distribution of Securities
Consulted parties were generally of the view that there is an adequate number of dealers to sustain competitiveness. Many believed that the market would adjust naturally in the event of further dealer concentration. But it was unclear how this might happen.
Some investors believed that they would be negatively affected, at least for a time, if further concentration removed from the market a dealer on whom they rely for securities trading, particularly with respect to corporate securities. Other investors expressed concerns about the limited number of dealers currently in the market but had no specific suggestions for how to increase the number.
Some domestic dealers indicated that market making in government securities is a low-margin business in its own right but that it is a foundation business that supports other profitable business lines, such as activity in corporate securities and derivatives markets. Smaller Canadian primary dealers (PDs) indicated that their businesses could grow if trading were reallocated by investors in the event of further dealer concentration.
U.S. dealers, who used to have a presence in Canada, now trade Government of Canada securities as customers of Canadian dealers. These U.S. dealers indicated that the allocation of scarce global capital is increasingly being centralized in financial capitals (e.g., London and New York). This centralization poses a challenge for smaller capital markets around the world to maintain a competitive domestic dealer system.
Access to Auctions
All the larger dealers were in favour of maintaining the current system of tiered access to bond auctions, which they viewed as fair, given their larger shares of the market and larger capital commitments. The larger dealers expressed their concern that changes to the framework that favoured smaller dealers could reduce the incentives for larger dealers to commit risk capital to the distribution of the government's debt and to their market-making activities. To encourage auction participation and facilitate the interests of ever-larger investor flows, some suggested that the ceilings on auction bidding, for themselves and/or for investors, could be raised slightly.
Smaller PDs were also, on balance, comfortable with the status quo, seeing bidding limits as 'fair', and not restrictive. They did, however, support changes to the framework to facilitate business growth (e.g., changing the bidding-limit formula to incorporate buybacks, or rewarding secondary-market trading by allowing their bidding limits to rise more quickly when their market share is growing).
Officials from ETSs had mixed interest in direct participation at auctions, viewing it either as inconsistent with best practices from a regulatory perspective (e.g., know-your-client rules) or as an opportunity to grow their business. Some dealers were opposed to granting ETSs access to auctions because in their view ETSs do not provide market-making services as dealers do, resulting in lower capital requirements.
A couple of dealers favoured the use of single-price (Dutch) auctions to encourage greater participation at auction by reducing the bidding risk of those bidders who are not aware of market flows. Most of the largest PDs were strongly opposed to Dutch auctions, seeing them as reducing their informational advantages and ultimately their incentive to bid. Many larger dealers also did not support an increase in non-competitive bidding limits to facilitate the participation of less-well-informed participants.
Investors' views on participation at tenders varied. For the most part, investors did not express a strong interest in direct participation at auctions. They generally look to dealers for liquidity in the secondary market. Several investors expressed an interest in direct access, primarily as a way to shield their bids and investment strategy from dealers. They admitted, however, that this would be inconsistent with their greater preference that the framework support the provision of liquidity by dealers and the general practice of buying bonds from dealers pre- or post-tender.
There was little comment from retail investors. Dealers did not oppose changes to the distribution framework aimed at augmenting the access of retail investors to securities, such as raising the non-competitive bidding limit. Dealers wondered, however, about the degree of interest on the part of retail investors in bidding directly at Government of Canada auctions. The large PDs believed that retail investors had access to fairly priced Government of Canada securities through their proprietary retail networks.
Transparency of Trade Information and Market Integrity
All parties expressed the view that the standard of price transparency in the institutional marketplace in Canada is high, although lower than in the United States. Conversely, many agreed that transparency for retail investors, and with respect to corporate bonds, could be improved. A number of dealers questioned the merits of full transparency regarding trade volumes. They stated that liquidity and bid/offer spreads could be negatively affected if full and immediate transparency of trade volumes were implemented.
With respect to market integrity, the auction rules and Investment Dealers Association of Canada Policy 5 (the code of conduct in the domestic debt market) are seen as supporting the well-functioning operation of the market and reducing the risk of market manipulation.