You all must remember Shaukat Tarin’s koonda episode, when the ex-finance minister during a live program with Dunya TV’s anchor Kamran Khan, threatened Primary Dealers (PDs) [banks] regarding their high bids in the government bond auctions, by saying that if PDs [banks] do not start behaving, he will deploy tools that will ruin them (in ka koonda ho jaye ga). Guess what, PDs didn’t budge.
Why didn’t they budge? Are they so protected under the SBP umbrella that a sitting Finance Minister cannot mend their ways? It all boils down to the lack of players in the government securities market trading arena. And who do you think is responsible for bringing new players to the arena? Primary Dealers, duh. This brings the efficiency and efficacy of the market-making function of PDs into question. Clearly, the current market-making arrangements and regulations carved by the SBP have not yielded the desired results. But why?
Profit explains.
How do government securities operate?
State Bank of Pakistan (SBP) acts as an agent of the Government of Pakistan for managing domestic public debt. SBP is responsible for distribution of marketable government securities (Market Treasury Bills, Public Investment Bonds & Government Ijarah Sukuk) through a network of ten primary dealers (all of which are commercial banks – except one DFI) and two Special Purpose Primary Dealers (National Clearing Company of Pakistan Limited (NCCPL) & Central Depository Company of Pakistan (CDC)). Primary dealers are selected from among financial institutions including Banks, DFIs, Investment Banks, Listed Brokerage Houses as per the criteria laid out by the SBP based on minimum capital requirements, secondary market participation, technical requirements, fulfillment of market making obligations, among others.
The PDs enjoy significant perks and privileges after attaining their PD status such as exclusive participation in the Government Securities auctions, claim to underwriting commission, entertaining pass-through bids, among others. In exchange for this, there are some obligations on the PDs which should be fulfilled in order to compensate for the perks and privileges they enjoy. These obligations include the essential market making function which include quoting two-way prices of government securities, increasing participation of non-PDs & retail segment, and displaying Prices of Government Securities across multiple platforms. Performance assessment of PDs is based on compliance with the secondary market turnover, market-making responsibilities, use of Electronic Bond Trading system, among other criterions.
If all these mechanisms are in place, one might think that there should be a thriving government securities market in the country. However, the devil is in the details. So, what are the pertinent issues in the PD system that are hampering market making?
Skewed towards commercial banks
Ideally, the PD network should raise its inventory through participation in Government Securities auction and then it should be offloaded to other retail and non-PD financial institutions. However, the commercial banks are busy hoarding the government securities for their own inventories. So much so that more than 90 percent of the total investments of banks were made in Federal Government Securities during CY21. However, other participants like Investment Banks, and Brokerage Houses that are better suited to the role of primary dealers are not included in the PD network. These entities usually do not have a strong capital base and cannot afford to buy the Refinitiv/Bloomberg Dealing Terminal, which is a must to have to join the PD club. Therefore, banks have essentially monopolized the government securities trading arena.
In contrast, the Reserve Bank of India uses an extensive network of PDs including 7 standalone PDs which are mostly fixed income brokerage houses in addition to the 14 bank PDs. But the inclusion of standalone PDs in Pakistan will create a regulatory overlap between SECP and SBP, which is the last thing the SBP wants to deal with. Not to mention that the SBP has kept the depository and settlement of government securities under its ambit rather than devolving it to the CDC and NCCPL.
Pass through bids
SBP has allowed non-PD financial institutions and secondary market participants to directly participate in the primary auction process through pass through bids. This provision has significantly hampered the development of the secondary government securities market. As the non-PDs and secondary market participants who want to participate in the secondary market trade can directly get their securities from PDs rather than getting it through our non-existent secondary market. Why does this matter? There is something called an illiquidity premium, which the government has to pay to the bondholders as they require an incremental return that compensates them for owning an asset that is not highly liquid (easily convertible into money). Therefore, the government pays the bondholders (mostly PDs) extra for each security in the form of a higher interest rate due to the illiquidity of government securities.
Conflict of Interest of Commercial Banks
Well, this is a no-brainer that commercial banks have competing banking products against the government securities, which are much more profitable to the bank. For example, bancassurance products pay the banks a handsome amount of commission. Therefore, the value of the total securities held in the Individual Portfolio Securities (IPS) account of the top PD – Bank Alfalah (as per SBP ranking) is almost half the commission earned by the bank through bancassurance. For those of you who don’t know, IPS accounts are those accounts in which the PDs hold government securities on behalf of their non-PD and retail customers.
This can also be attributed to the lenient market making obligations bestowed upon the PDs that evaluate the performance of PDs based on an annual incremental increase in IPS accounts of 500 only. And there is more to this, if the PDs exceed this target they get bonus points for this. You won’t be amazed to observe that the total number of IPS accounts in the top 3 PDs does not exceed 5,000 for any of the PDs (FY 2021-2022).
One more thing that makes the IPS accounts less attractive is that the charges imposed on the applicant of IPS account should be reasonable and in line with SBP’s objective to broaden the investor base of Government securities (as per SBP circular). However, for other banking products the room for earning profits is much more than IPS accounts.
Over-lenient obligations & Performance Assessment of PDs
SBP has taken a very hands-off approach towards the PDs for acting as a market maker on the PSX trading platform. Resultantly, trading activity on the Bond Automated Trading System (BATS) remains negligible due to a dearth of PDs willing to serve as market makers. PSX cannot assign this market making obligation on any PD too. However, the SBP can assign this responsibility to PDs through laying it out in the eligibility criteria or performance assessment criteria of PDs. Essentially, the issue at hand is that when a customer makes a quote on BATS the system lacks the ability to respond to that quote since the PDs are not bound to quote two-way prices of government securities on the PSX platform. The relevant obligation of the SBP in this regard is as follows:
“PDs and PPDs shall be responsible for displaying the prices of Government securities on Refinitiv/Bloomberg, websites, branches and PSX (if the PD/PPD is a market maker on PSX).”
You can see how the SBP has conveniently left the market making responsibility to those PDs who want to act as market makers on PSX. Hence, PDs are not required to perform this function but if they opt to act as market maker then and only then they are required to quote on the PSX trading platform (BATS). Why did SBP leave this at the discretion of the profit-hungry banks? It should be compulsory for every PD to quote two-way prices for government securities on the system for effective market making. Just like in South Korea, where the government has made it compulsory for PDs to conduct 40% of all Government Securities (secondary) trading on the Korea Stock Exchange. It has resultantly risen to become the most dynamic, liquid and well-functioning government securities market in Asia, after Japan.
Expensive Bloomberg Bond Trade System/Terminals
Small & medium-scale financial institutions have another barrier in the way of becoming PDs. The SBP has directed the PD applicants to equip themselves with “modern” treasury infrastructure, including:
- a) Dealing Terminals including Refinitiv/Bloomberg.
- b) Phone Recording Systems (with records retained for a period of 90 days).
- c) Telex/Swift.
- d) Fax machines.
- e) High speed internet
- f) Any other equipment necessary for conduct of treasury operations.
Nothing in the list above is modern except the Refinitiv/Bloomberg dealing terminal. The Refinitiv/Bloomberg dealing terminals are pretty expensive (almost $24,000 per annum) and mostly bank treasuries can only afford them. Hence, this barrier keeps the competition away just like the SBP and commercial banks like it. Indigenous dealing terminals and trading systems can be used for improving the accessibility of government securities to local capital market participants.
Looking at the list, one can also conclude that most of the deals in the secondary market in Pakistan are voice-brokered. Nothing wrong with this, there are many developing countries where the voice-brokered deals take place but in parallel they also have a vibrant government securities market on the stock exchange. However, the integration with the PSX trading platform is not something the SBP looks for while selecting its PDs.
Although enough time has passed since the koonda episode occurred, the status quo remains intact (just like all other things in this country). However, there is still hope that SBP realizes that it has to play its part in creating a vibrant government securities market. All this can be fixed with just a new circular issued by the SBP. But who will bell the cat? That remains to be seen.
