Issuance of and Trading in Danish Government Securities

Danish government securities are issued to primary dealers in, respectively, Treasury bills and government bonds. The primary dealers have an ongoing obligation to be market makers in Danish government securities, i.e. to quote current bid and ask prices within fixed maximum spreads and for minimum amounts. Market making helps to ensure a transparent and well-functioning market for Danish government securities.

Government Debt Management at Danmarks Nationalbank has agreed with the primary dealers that MTSDenmark is the market place for issuance of and market making in Danish government securities.

Government bonds are primarily issued by tap sale in the secondary market. In 2005, six of the primary dealers in government bonds took up 70 per cent of the bonds sold. The average daily turnover in Danish government securities on MTSDenmark was almost DKK 2 billion in 2005, of which around 60 per cent pertained to benchmark securities.

The market structure for Treasury bills was modernised in 2005. In the primary market, a new and improved MTS auction system has been implemented. This has reduced the response time from approximately 30 minutes to a maximum of 15 minutes. In addition, a primary dealer system has been introduced for Treasury bills, with 12 Danish and international banks as participants.

5.1 PRIMARY DEALER SYSTEMS FOR DANISH GOVERNMENT SECURITIES

Danish government securities are issued to and bought back from banks that have concluded primary dealer contracts. Primary dealer status is awarded on the expectation that the banks in question will enter into long-term partnership with the issuer on trading and distributing Danish government securities to a broad range of investors. The most important right of primary dealers is to buy government securities on issue and to be counterparties in buy-back transactions. The main obligation of primary dealers is market making in government securities. Thus, the primary dealers must quote current bid and ask prices within fixed maximum spreads and for minimum amounts, cf. Box 5.1.

Government Debt Management has concluded primary dealer contracts for, respectively, government bonds and Treasury bills. The primary dealer contract for government bonds was concluded in connection with the introduction of MTS in the Danish bond market in 2003. As of 1 January 2006, the system comprises 13 Danish and international banks, cf. Table 5.1.1.

In 2005, a primary dealer system was also established for Treasury bills, with 12 Danish and international participants, cf. Table 5.1.1. The system was set up in connection with the introduction of a new auction facility for issuance of Danish Treasury bills on MTSDenmark, and the introduction of market making on MTSDenmark.

In addition, some primary dealers have entered into voluntary agreements relating to market making in the central government's euro loans.

MTSDenmark
According to the primary dealer contract, and after consultation with the primary dealers, it has been agreed that issuance and electronic market making takes place in a dedicated market segment – MTSDenmark. Besides the primary dealers, market takers can also be connected to MTSDenmark. A market taker can trade at prices quoted by primary dealers, but cannot itself quote prices. As of 1 January 2006, five banks were connected to MTSDenmark as market takers, cf. Table 5.1.1.

MTSDenmark is a market segment on MTSAM, a company registered in Belgium. MTSAM also has Belgian and Finnish market segments. Administration of MTSDenmark takes place independently of MTSAM, and governance is undertaken by the primary dealer committee comprising Government Debt Management, the primary dealers and MTS S.p.A., cf. Box 5.2.

In July 2005, the controlling interest in MTS S.p.A. was sold to a consortium comprising EuroNext and Borsa Italiana, which hereby have increased their European bond trading activities. The change of ownership of MTS S.p.A. may lead to adjustments of the ownership structure of the local MTS markets, but is not expected to have any impact on the market participants' activities on MTSDenmark.

A key element of the MTSDenmark infrastructure is clearing and settlement. In 2005, the settlement facilities were enhanced, when the market participants were given the choice of VP Securities Services (VP), Euroclear and Clearstream as their preferred clearing house for straight-through processing of transactions concluded on MTSDenmark. The new set-up reduces the entry barriers to MTSDenmark since new market participants can join MTSDenmark without having to adjust their internal settlement processes.

Securities lending facility
Primary dealers have access to the securities lending facilities of the central government and the Social Pension Fund (SPF). The former comprises benchmark securities and key on-the-run issues. Securities lending in other government securities that are bullet loans is part of SPF's securities lending facility. The securities lending facilities support secondary trading in government securities and thereby liquidity in government securities. This makes it easier for primary dealers to conduct market marking, while also reducing the risk of distorting price formation.

As from 1 January 2006, the fees for using the government and SPF securities lending facilities have been lowered. The fee for borrowing in the government bonds comprised by the facilities is now 0.2 per cent p.a., while the fee for borrowing in Treasury bills remains unchanged at 0.15 per cent p.a. If price changes lead to significant changes in the use of the securities lending facilities, Government Debt Management can adjust the fees. The terms and conditions for use of the facilities remain unchanged and are presented in the Appendices.

In 2005, the lending volume under the central government's securities lending facility was DKK 16.2 billion, cf. Table 5.1.2. Lending under SPF's securities lending facility amounted to DKK 21.2 billion. Lending mainly took place in January, when there was a shortage in the private market for securities lending.

5.2 GOVERNMENT BONDS

Issuance and buy-backs
Danish government bonds are issued on MTSDenmark, primarily by tap sale, to primary dealers in Danish government bonds. Tap sale means that issuances are distributed over the year. Sale takes place directly in the secondary market at market prices that are quoted by the primary dealers. In connection with the issuance, Government Debt Management has a market-taker status, i.e. sales are effected at the best bid price.

All primary dealers have equal opportunities to buy newly issued government bonds from the issuer. To avoid influencing the market, sale generally only takes place when there is considerable underlying interest, i.e. a small bid/ask spread, substantial depth and a narrow yield spread to the euro benchmark curve. In 2005, three banks accounted for around 50 per cent of total sales, while the six largest participants acquired approximately 70 per cent of the issues, cf. Chart 5.2.1. This is by and large equivalent to the level in the preceding year.

Buy-backs also take place on MTSDenmark with the primary dealers as counterparties. Buy-backs in securities with a remaining term to maturity of more than 13 months take place on the MTSDKL segment, cf. Box 5.1, where government securities are purchased at the current market price (best ask price) on an ongoing basis. For government securities maturing in less than 13 months, buy-backs are transacted in a specific buy-back segment since these securities are not subject to market making. As the Chart shows, buy-backs are concentrated on fewer primary dealers than issuance as six primary dealers are counterparties to around 90 per cent of the buy-backs.

Additional measures are planned in 2006 with a view to increasing the number of instruments available for issuance and buy-back. For example, it is the intention to introduce an MTS buy-back facility, and increasingly to conduct simultaneous issuance and buy-back via an exchange facility. The latter facility is initially considered for exchanging government bonds with a remaining term to maturity of less than 12 months for Treasury bills.

Electronic trading and market making on MTSDenmark
A key element of the primary dealer contract is the ongoing market-making obligation for government bonds. Market making by primary dealers gives market participants access to current prices, so that they can see the price at which the market is willing to buy or sell a given government bond before making a transaction. This transparency is important in a well-functioning market and helps to improve liquidity in the market.

Table 5.2.1 presents key figures for liquidity and transparency in the benchmark government securities. It is seen that the average order coverage, defined as the part of the trading day when bid and ask prices are available, is almost 100 per cent. Market participants omit to quote prices for brief periods only, e.g. in connection with the announcement of key ratios, publications, etc.

The average spreads between bid and ask prices in the 2-, 5- and 10-year securities are, respectively, 2, 3 and 4 ticks^[1], cf. Table 5.2.1. The difference between the best bid and ask prices is the cost of buying a government bond and selling it at the same time. The narrower the spread, the more efficient the market. Among other factors, the price difference is determined by competition intensity and trading costs. The difference between the bid and ask prices is comparable with similar wholesale markets for government bonds in the EU.

The market depth reflects the volume that can be traded at the best price, and thereby the volume of Danish government securities that can be traded without affecting the price. Each primary dealer has an obligation to quote bid and ask prices for benchmark securities in volumes of at least DKK 80 million, DKK 40 million and DKK 40 million in, respectively, the 2-, 5- and 10-year maturity segments.

The average daily turnover on MTSDenmark was close to DKK 2 billion in 2005. Trading was concentrated in the benchmark securities since around 60 per cent of the turnover related to the 2-, 5- and 10-year benchmark securities, cf. Chart 5.2.2. Trading was more or less equally distributed among primary dealers in Danish government securities. Six of the primary dealers in Danish government bonds accounted for around 60 per cent of all trading, while in 2004, six primary dealers accounted for 65 per cent of the traded volume.

5.3 Treasury bills

A primary dealer system for Treasury bills was established in 2005. Under the contract, primary dealers have a market-making obligation in relation to Danish Treasury bills. Moreover, a new auction system developed on MTSDenmark was introduced in the primary market. At the same time, the duration of the auctions was reduced from approximately 30 minutes to a maximum of 15 minutes, which lowered the participants' market risk. These measures were aimed at improving the market structure for issuance of and trading in Treasury bills.

Issuance of Treasury bills
Treasury bills are sold at monthly auctions. In the 1st half of 2005, Treasury bills were issued via the existing auction facility with the existing counterparties, in practice eight active banks. In connection with the Treasury bill auction in July, a new MTS auction facility was introduced, and the group of counterparties was expanded to 12 primary dealers.

The bid volume in the auctions was greatest at the beginning of the year, cf. Chart 5.3.1. The acceptance rate was around 30 per cent in the 12 auctions in 2005. The acceptance rate was generally higher in the four auctions in which new Treasury bills were opened. The average acceptance rate was slightly lower than in 2004, when the level was around 40 per cent.

The distribution of the total issues by auction on market participants is more concentrated than for government bond auctions. The three largest market participants have a market share of around 70 per cent of the total volume issued. However, smaller bidders have acquired a larger share than previously. In 2003, an analysis showed that the allocation to small bidders was around 15-20 per cent.^[2] The change is attributable to the increase in the number of participants in connection with the introduction of the primary dealer system.

Secondary trading and market making on MTSDenmark
The introduction of the primary dealer system has increased transparency in the market for Treasury bills. Participants have current access to pre-trade data, which improves their opportunities to monitor price developments. The order coverage shows that bid and ask prices are displayed in the system throughout most of the trading day. In this connection, it should be noted that during a transitional phase, market making was only available for the Treasury bill with the longest maturity. Since 1 November, all Treasury bills have been subject to market making.

At the same time, the market-making obligation within a maximum spread of 4 basis points and for a minimum amount of DKK 100 million has made it possible to trade intraday within a narrow spread and in a certain volume without affecting the price. In practice, primary dealers quote sharper prices. Combined with competition between primary dealers, this entails that the spread between the best bid and ask prices is typically less than the maximum spread, cf. Chart 5.3.2.

It is seen that the spread in the interdealer market after the introduction of the primary dealer system has become both narrower and more stable^[3]. Prior to the introduction, the average spread in the four Treasury bills was around 5 basis points; this has narrowed to around 2.5 basis points.

Modernisation of the Treasury bill market and introduction of electronic trading and market making on MTSDenmark have made the market for Treasury bills more transparent, making it easier for investors to trade.

Notwithstanding the new measures, trading in Treasury bills on MTSDenmark was not expected to be substantial, since Treasury bills are generally buy-and-hold instruments, i.e. they are typically bought when issued and held by the final investors until maturity. In the first few months of trading on MTSDenmark, the average daily turnover was slightly above DKK 100 million.

5.4 Turnover in Danish government securities

Besides electronic trading in the wholesale market on MTSDenmark, Danish government securities are traded on a number of other electronic platforms such as TradeWeb, BondVision and BloombergBondtrader. These platforms tend to focus on resale in the segment between banks and their customers and are therefore typically referred to as dealer-to-customer systems. In addition, Government Debt Management has established a price-quoting system on the Copenhagen Stock Exchange. Finally, considerable volumes of Danish government securities are traded on electronic single-dealer platforms and in the OTC market.^[4]

Electronic trading in Danish government securities
Most of the electronic trading in Danish government securities in the interdealer market takes place via MTSDenmark. In 2005, the average turnover on MTSDenmark was almost DKK 2 billion, cf. Chart 5.4.1. The turnover on MTSDenmark fell compared to 2004. This has been the general tendency in several MTS markets.

Besides the interdealer market, trading in Danish government securities takes place on electronic trading platforms in dealer-to-customer systems. These systems typically operate with quote-on-request agreements, i.e. the market dealers quote a price on the basis of a specific inquiry from a customer wishing to buy or sell government securities. Since several dealers operate on these platforms, price formation is usually efficient because the dealers compete for customers. The turnover on the electronic dealer-to-customer platforms was on the level of MTSDenmark in 2005.

Since the introduction of electronic platforms in the Danish market towards the end of 2003, electronic trading has grown considerably. Previously, by far the greater share of trading in both the interdealer and dealer-to-customer markets took place OTC, which generally entails less transparency because market participants have less access to pre-trade information.

According to two reports, the electronic share of aggregate European government-bond trading is assessed to constitute more than half of the total turnover^[5]. In a Danish context, it is difficult to assess the percentage of trading that takes place electronically since Danish government securities are traded via many different channels and by participants that have no obligation to report and publish transactions. However, electronic trading is not assumed to account for a smaller share of total trading in government bonds in Denmark than in other EU member states. This is also indicated by the fact that trading on MTSDenmark and electronic dealer-to-customer platforms accounts for approximately 50 per cent of the turnover in Danish government securities reported to the Copenhagen Stock Exchange, cf. Chart 5.4.1.

Price-quoting system on the Copenhagen Stock Exchange
Parallel with the introduction of the wholesale market MTSDenmark, Government Debt Management also introduced a price-quoting system on the Copenhagen Stock Exchange. Six banks (Danske Bank, Fionia Bank, Jyske Bank, Nordea, Nykredit and Sydbank) have an obligation to quote current prices in Danish government bonds on the Copenhagen Stock Exchange. The aim is to ensure that small investors have access to a transparent and efficient market for trading in government bonds.

The six banks are obliged to quote prices for all government bonds that are bullet loans with a remaining term to maturity of more than 13 months. Current price quotation implies that participants must quote bid and ask prices within fixed spreads and for fixed amounts during 95 per cent of the interval from 9.00 a.m. to 4.30 p.m.

Members of the Copenhagen Stock Exchange bond sub-segment can trade at the quoted prices. They can also place their own orders in the system. Finally, other investors can place trading orders via their bankers. The trading rules are designed for any order exceeding DKK 1,000 to influence prices in the trading system.

The price-quoting system means that investors have current access to prices in the system. The average daily order coverage, i.e. the part of the day with access to pre-trade information, has been around 95 per cent since the system was introduced in December 2003, cf. Chart 5.4.2. Combined with the option to place their own orders via a banker, this gives small investors good opportunities to trade in an efficient market.