Context and Considerations

Funding Requirements Lower and Change in Target for the Debt Structure

The most notable change in the government securities environment is the fact that the government's fiscal performance since the mid-1990s has resulted in the reduction in the outstanding stock of government securities. With the debt on a downward track, the trading activity of bonds and treasury bills among securities dealers and investors remains lower than when the debt was at its peak (Figures 1 and 2). The declining size of the government debt compared to the stock of other types of fixed-income securities is expected to affect trading activity for intermediaries in government securities.

Through its annual debt strategy plans, the government has continued to introduce adjustments to its borrowing programs to promote participation and liquidity in its securities. These include focusing on regular issuance in key bond and treasury bill maturity sectors, building benchmarks to target sizes that are established in consultation with market participants, and introducing the bond buyback programs on a cash and switch basis.

The near-term outlook for funding requirements remains relatively unchanged, with some year-to-year variation, given the government's desire to achieve balanced budgets or better. The issuance of bonds is expected to remain fairly stable, with relatively modest adjustments to reduce the fixed-rate target debt structure from two-thirds to 60% by 2007-08 (see Debt Management Strategy 2003-04). Gross bond issuance may need to be adjusted downward depending on the availability of outstanding bonds for repurchase from the market through the buyback programs. The size of the treasury bill program is expected to increase slightly to achieve the target debt structure.

Auction Participation

Primary market concentration has increased, as a result of the greater share of auction participation by fewer, larger intermediaries. For example, the top 10 market participants at treasury bill and bond auctions obtained roughly 94 per cent of issuance in 2003/04 compared to 88 per cent of issuance in 1999/00 (Table 1).

Following consolidation in the Canadian securities dealer market since the late 1980s, the Canadian fixed-income dealer market may be characterized as having several large firms, few medium-sized firms and, a number of small firms. This consolidation trend is also evident internationally, particularly in the Unites States where several firms are becoming increasingly dominant in the primary fixed-income market. The implication of this trend in Canada is that auction participation of smaller domestic PDs and GSDs has generally continued to decline compared with that of large PDs.

Consequently, the government has relied on fewer PDs to cover the sale of securities at auctions. Auction participation of foreign dealers has also declined recently compared with that of the large PDs, particularly since the departure of three large U.S. primary dealers from the Canadian fixed-income market in 2001. By way of comparison, there were 30 dealers distributing Government of Canada securities in 1997 and 20 today.

With the exception of Real Return Bond (RRB) auctions, customer participation at treasury bill and bond auctions has been low compared with the participation of market intermediaries. Real Return Bond auctions are buy-and-hold securities and are not traded as actively as other Government of Canada securities. Customers' participation at RRB auctions is higher because they are more likely to obtain large amounts of securities at auctions.

Secondary-Market Trading

Another important trend is the change in the mix of the fixed-income trading activity of dealers. The share of secondary-market trading of foreign firms peaked in the late 1990s but has declined over the past five years with the departure of a number of foreign primary dealers. The trading activity of small primary dealers and Government Securities Distributors has declined somewhat over the past decade (Figures 3 and 4).

Trading shares of the largest primary dealers have increased significantly since 1998, helped by the departures of foreign dealers and the purchase of several independent domestic dealers by the large domestic banks that took place in the late 1980s and to a lesser degree in the mid-1990s.

Standard measures of market concentration suggest that the secondary market for government securities, along with other sectors of the domestic fixed-income market, is highly concentrated. From the perspective of competition theory, a further increase in concentration may reduce market competitiveness, particularly to the extent there are barriers to entry.

Transparency

Transparency pertains to the availability of reliable trading-related information to market participants. Markets that are more transparent can enhance the integrity and attractiveness of the Government of Canada securities market for a wide array of investors. The government has long had a strong interest in enhancing the transparency of the Government of Canada securities market.

For over a decade, the government has supported the development of CanPX, an industry-led initiative of the Investment Dealers Association, Canadian dealers, and inter dealer brokers. CanPX provides ongoing bid-and-offer, price/yield, and trading volume information on government bonds and treasury bills, provincial securities, and selected corporate bonds traded by participating inter dealer brokers. The system is broadly available to clients for a small subscription fee.

In recent years, discussions have taken place with Canadian securities regulators and market participants on the regulatory framework for electronic trading systems since 1999, when the Canadian Securities Administrators first proposed rules for these systems. The government has advocated mandatory reporting of secondary market-trading in Government of Canada securities. Due to a lack of consensus among market participants on the appropriate standard for transparency, regulators opted in 2003 to maintain the exemption on reporting trade-related information for Government of Canada securities until the start of 2007 (see http://www.osc.gov.on.ca/MarketRegulation/mr_index.jsp).

The central concern of market participants is the likely trade-off between greater transparency and market liquidity. Given the relatively limited number of active dealers in the trading of fixed-income securities, the real-time posting of large-volume trades could potentially affect the ability of dealers to make active markets. Comments provided by market participants during the last two rounds of debt strategy consultations highlighted the fact that the introduction of electronic trading systems and CanPX, as an information consolidator, had improved price transparency.

Electronic Trading

Electronic trading systems (ETSs) designed for posting securities quotes and matching buy-and-sell orders are developing in Canada, although they remain relatively small compared with those in other countries. To date, there are two broad types of electronic trading systems in Canada: a dealer-client quote-based system and an order-driven trading system. Both types facilitate trading of Government of Canada securities. A dealer-client system provides real-time consolidated inventory price feeds from participating dealers, who provide on-line quotes to clients when requested. This system allows investors to execute against the best of the dealers' bids or offers and automates the settlement process. An order-driven trading system provides a real-time marketplace that automatically and anonymously matches bids and offers by dealers, and institutional and retail investors. Interest has recently been expressed in using electronic trading technology to access Government securities auctions.

Debt Distribution Frameworks of Other Sovereign Borrowers

Most industrialized countries use a PD distribution framework to market government securities. Compared with Canada, primary dealer models in other developed countries tend to require fewer obligations for dealers at auctions but more obligations in secondary markets such as continuous market making and minimum trading volumes during a given period of time.

Over the past several years, sovereign issuers have adapted their debt distribution frameworks in response to evolving market trends. For example, the advent of the euro and the resulting ability to reach a wider audience of investors prompted some European issuers to revert to syndicated offerings for openings of new conventional and inflation-linked bonds, with re-openings issued through auctions. A significant trend is the general increase in consolidation in the financial sector of many countries, resulting in more concentrated participation at government auctions.

Some sovereign borrowers now provide electronic access to their marketable securities for retail investors. For example, retail investors of U.S. Treasuries can use the TreasuryDirect system or acquire the securities from a dealer. Similarly, Sweden provides retail investors access to government securities over the Internet. France designates a percentage of 10-year conventional and inflation-linked bonds for direct sales in the retail sector.

1. What are your views of the identified trends in the government securities market? Are there other trends that are relevant?


2. What are the likely impacts of these trends on the government securities market and on the broader fixed-income market in Canada?