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Practices and procedures that support auctions of government debt fall into three broad categories: pre-auction, the auction itself, and post-auction.
i. Communication between Bank of Canada and Department of Finance
Pre-auction communications and coordination between the Bank of Canada and the Department of Finance are generally effective. Although our study focused on the period prior to the crisis, the effectiveness of the current process is evidenced by the success of the debt program and operations throughout the crisis in 2008 and 2009. During the period of our study and during the crisis, auctions were characterized by proper authorities, timely decision making, and high quality strategic and policy advice to the Minister. We believe that the process for gathering pre-auction information and summarizing the results is efficient and effective. The Bank of Canada is well positioned to gather detailed market information which serves as key input to the final decision regarding calls for tender since the Department of Finance does not gather information independently.
Transparency of the terms of the annual bond program contributes to the effectiveness and efficiency of the auctions. However, like many other sovereigns, in order to maintain some flexibility to adapt to market conditions Canada does not pre-announce specific auction securities or sizes.
A call for tender is prepared and released every time the Bank of Canada issues bonds for the Government of Canada, whether it is a new issue or a re-opening of a current issue. Although the call for tender release date is officially the Thursday before the auction date, preparation and verification of the call for tender begins a week before its release date. There is a special release time for holidays.
The approach to seeking the market’s view on the terms that will be posted on calls for tender for upcoming debt operations is similar to other sovereigns in that it involves consultation with dealers and customers. However, the process used for Canadian bonds is unusual compared to other sovereigns in that the pre-approval of the terms of each call for tender by the Department of Finance is required (the Bank of Canada has been delegated authority for treasury bills and the cash management bond buyback). For the other sovereigns in our study, the authority to determine bond auction terms is delegated completely to the issuing authority within the parameters of the plan that is agreed to in advance, usually on an annual basis.
In normal market conditions, the current timing and process is effective and efficient. The Department of Finance usually accepts the recommendations from Bank of Canada. However, under unusual or distressed market conditions, the process has little time or leeway for dialogue between the Department of Finance and the Bank of Canada or for escalation to senior officials in the case of disagreement.
We question the rationale for the Department of Finance to approve the call for tender for each bond auction. The interests of the Bank of Canada and Department of Finance are aligned to achieve the objectives of the annual bond program. For each auction, the Bank of Canada conducts both formal and informal consultation with market participants and has up-to-date information that informs the decision to balance the desired funding amount with market conditions to determine the details of each auction.
The Department of Finance relies on the market related information provided by the Bank of Canada and does not conduct independent market research. If the Department of Finance disagrees with the recommendation of the Bank of Canada, it is unlikely to be because Finance has superior market information. It may be that the Department of Finance has a different view on how to interpret the market information in light of the trade-offs of size vs. cost and cover, or that it brings a broader perspective with respect to how each individual decision fits within the overall strategy for the issuance program. However, in our opinion, the Bank of Canada is well positioned to analyze market conditions and to assess these trade-offs, especially if there is ongoing communication at the policy level with the Department of Finance.
For potential improvements in efficiency, consider changing the interaction between the Department of Finance and the Bank of Canada occurring ahead of bond auctions to a reporting function rather than an approval process.
This recommendation is consistent with the process in all the other sovereigns we studied, where the issuing authority has full control over the auction details once the overall borrowing program has been determined, addresses some process related concerns raised during interviews with the Department of Finance and the Bank of Canada, and does not introduce any issues that would likely be of concern to market participants. Input from the Department of Finance can continue to be conveyed to the Bank of Canada through the development of the annual Debt Management Strategy and the determination of the QBS where the timing and term type of auctions is announced.
An alternative solution might be to bring in the Department of Finance earlier into the formulation of recommendations for calls for tender for bond auctions. For example, a Bank of Canada staff member could be present at the Bank of Canada’s internal debriefing regarding the market consultations that occur prior to the call for tender recommendation to the Department of Finance.
ii. Authorization letter for debt auction operations
We recommend that the Authorization Letter for debt auction operations be replaced with more informative, timely reporting and accountability to senior management.
The bond auction process currently requires a letter from the Department of Finance to authorize the Bank of Canada to conduct the auction for both treasury bills and bonds. However, in practice the letters are sent after the fact. This process should be replaced with timelier and improved pre- and post-auction reporting from the Bank of Canada to the Department of Finance.
Fungibility, i.e. securities that share the same maturity date, can serve the same purpose as policies on bidding limits and participation at auctions to limit the possibility of market manipulation by participants. It is broadly agreed by all Canadian interview participants and other sovereigns that fungibility helps liquidity overall, which in turn enhances price discovery and auction effectiveness. However, note that in theory, fungibility can have two opposing effects on the price of the security. On the one hand, a concentration of liquidity can improve prices, but on the other hand, an increase in supply can depress prices. Fungibility should continue to be assessed as part of the ongoing annual debt program, and through formal and informal consultation with market participants.
iv. Terms of Bond Buybacks
Buybacks for bonds have been implemented by some sovereigns during times of reduced financing needs primarily as a mechanism to improve the liquidity of government markets. When this has occurred, the general approach has been to buy back older and smaller issues to enhance the size of new benchmark issues. Buybacks for bonds are currently small or irrelevant in every country we surveyed, with the exception of Canada where the buyback program is relevant only for nominal bonds, not treasury bills or RRBs.
Regular buyback operations occur on a cash basis (on auction dates) as well as on a switch basis (on dates not coinciding with bond auction dates). To assess the impact of buybacks on auction effectiveness, we analyzed the relationship between buyback amounts and auction bid-cover and tail. For buybacks on a switch basis, the data suggest that the buyback program does not impact auction effectiveness for 2- and 5-year auctions. For 10-year auctions, larger buybacks are associated with wider tails for switch buybacks, but there is no other evidence of an impact on effectiveness for 10-year auctions.
Interviews with dealers resulted in suggestions that secondary market efficiency may improve if the Bank of Canada retains the option to conduct switch buybacks, with one day notice to the market, when market opportunities are available, not just on a set schedule.
v. Call for Tenders
The timing of the call for tender relative to auctions in Canada is typical of other sovereigns. Most sovereigns continue to value transparency and predictability over flexibility, with the US being the most predictable and rigid in its schedule. Most Canadian dealers and investors were pleased with timing of the call for tenders for nominal bonds and treasury bills, both in terms of timing relative to auctions, and timing of auctions on the calendar for the period we studied.
Some Canadian market participants emphasized the natural source of demand for new issues that arises from coupon payments from existing nominal bonds and RRBs on June 1 and December 1. The coupon payments and resulting cash available for reinvestment may increase customer demand and enable dealers to bid more aggressively and improve auction effectiveness. The auction process currently accommodates this well while staggering operations throughout the quarter.
In general, information transparency is key to process and effectiveness, both pre- and post-auction. This has driven Canada and all the sovereigns we evaluated to provide a great deal of detail well in advance as a matter of policy. However, in light of recent increases in funding needs and volatile market conditions, some sovereigns are reconsidering the trade-off between transparency and flexibility. In some markets transparency may be purposely reduced or securities may be issued through a process other than auctions (syndication or taps) in order to issue debt quickly in an opportunistic way or to increase the likelihood of full placement of the desired amount of debt. Market participants prefer transparency but based on our interviews, they understand the need for flexibility in unusual circumstances, and the effectiveness of auctions and debt distribution has generally been maintained.
Some interviewees suggested the use of headline announcements or standby for new issue alerts for calls for tenders on Bloomberg and other news services, and through bond trading platforms such as CanDeal and CanPx.
vi. Formal and informal consultations
For all securities, a mix of communication formats should be considered by the Bank of Canada, including more frequent telephone conference calls and multi-lateral discussions in addition to the traditional bi-lateral visits with individual dealers. Encourage all market participants to play a more active role in the design of the debt strategy, such as through an annual workshop in addition to the standard consultation process. Consult with a larger sample of current and potential customers more frequently. Include them in annual formal consultations individually and in group formats. For less liquid securities (long-term bonds and RRBs), we recommend more detailed and consistent feedback from a larger number of market participants, including large and small customers, prior to and following each auction.
All sovereigns have regular informal consultation between the auction authority and market participants, and varying levels and frequency of formal consultation. Canada has an annual formal consultation process, with other communication occurring prior to each auction with every Primary Dealer. Compared to other sovereigns we studied, the consultation and communication are in the middle of the pack in terms of formality and frequency. This process is well received by the market and is generally perceived to be transparent, timely, effective and efficient, but a few market participants would prefer more communication. However, it is not clear that under normal market conditions more communication would improve effectiveness or efficiency, particularly for the most liquid securities (treasury bills and nominal bonds under 10 years to maturity). The importance of consultations is greater in the presence of changing issuance amounts (either significantly higher or lower than recent experience) or during volatile or distressed market conditions.
vii. When-Issued (WI) market
The role and importance of a when-issued (WI) market is closely related to the fungibility of auction securities and the prevalence of new issues vs. re-openings. The WI market can facilitate price discovery and hedging or setting up for the auction by auction participants. It is also related to the depth and liquidity of the secondary market, futures markets, or markets for similar securities. The deeper and more liquid these markets, the less important the WI market for price discovery. However, the WI market will tend not to exist or will have limited activity or liquidity for securities that themselves have limited secondary market liquidity, such as inflation-linked bonds in markets other than the US.
For all sovereign nominal bond and treasury bill markets, interviews suggested that where there is limited trading in WI markets, it is because price discovery is effective in other markets for similar securities. According to the interviews, the importance of WI markets for auction effectiveness is limited for shorter-term securities, and secondary or related markets are viewed as effective substitutes. For longer-term securities, there are fewer effective substitutes, and auctions for new issues may benefit from a WI market.
Based on the Canadian market participant interviews, two dealers said that in treasury bills, WI market activity is mainly aimed at maintaining duration in the treasury bill book, not price discovery because customers and hedgers (rather than speculators) dominate the market, and customers are all buyers, with no sellers. One dealer pointed out that for bonds, the WI market plays no role in setting up for the auction – it is only for price discovery.
viii. Impact of market conditions
Higher market volatility and general illiquidity in 2008 and 2009 presented some challenges for dealers and customers around auctions, but auctions were nonetheless effective. As a result, dealers found it harder to bid aggressively. Market participants acknowledge that in extreme and rare events there could be good reasons to delay an auction, but that predictability is normally preferred. The data analysis examined the impact of three factors on bid-to-cover and tail: bond yield volatility, credit conditions (Baa spread), and liquidity (monthly trading volume for the auctioned security or similar securities). The evidence supports the conclusion that higher volatility, wider credit spreads, and lower liquidity are related to wider auction tails (i.e. less effective auctions) for nominal maturities up to 10 years, and for treasury bills, but not for longer term nominal bonds or RRBs. Although the auctions in 2008 and 2009 were effective, if the data period had included the remainder of 2008 and 2009, this conclusion may have had even stronger support.
ix. Selection criteria for participants
Selection criteria for auction participation vary across sovereigns. Only Canada has a significant minimum participation requirement that must be fulfilled in each individual auction. In Canada, there are two types of bidders: Government Securities Distributors and Customers. See Appendix D for a description of the role of primary dealers. A recent OECD study notes that existing primary dealer arrangements have not been working as efficiently as before the crisis, and raises the question whether requirements need to be revised. The study also suggests that the broader business model of cooperation between Debt Management Offices and primary dealers may need to be re-examined, with possible changes to the market-making obligations and market infrastructure in order to support the debt issuance process in times of market stress. The Canadian model worked well during the crisis, as the Canadian banking system remained relatively stable. Auctions continued to be effective, which may be due to the specific structure of the bidding rules that ensure that every auction is covered provided primary dealers wish to maintain their status. Developments in other market should be monitored and evaluated.
x. Dealers pre-auction risk management and willingness to bid
The depth and liquidity of the secondary market are important for the price discovery process. In addition to liquidity, transparency and volatility, factors that affect willingness to bid that were noted in the sovereign and Canadian market participant interviews include: the dealer’s pre-auction holdings (short position increases willingness to bid), their ability to hedge, coupon payments on similar bonds (especially inflation-linked bonds), the extent of bond index tracking in the market and its implications for demand for the security, the number of traders on holiday, and announcements of potentially market-moving information, repo market conditions, nearness to fiscal year-end for banks, balance sheet constraints, and frequency and size of auctions (concern about “auction fatigue”). There were no concerns expressed by Canadian market participants regarding auction size for any of the bond types. However, there were comments about 10-year new issues sitting in inventory and some dealers have concerns about their ability to meet their obligation to participate at auctions consistently.
We measured dealer Willingness to Bid as the percentage (of total auction size) of dealer bid amounts with bid yield less than the auction average yield, and we examined the relationship between this measure and measures of market volatility, credit conditions, and auction size. In the data analysis, we found no significant relationships between this Willingness to Bid, and Yield Volatility, Baa credit spread and Auction Size for any securities.
xi. Impact of non-competitive bids
Non-competitive bidding varies across sovereigns. In Canada, the US and France, non-competitive bids are intended to permit small bidders to achieve allocation at auction and are restricted to small quantities. However, in the UK, the role of non-competitive bids is to allow dealers a guaranteed supply, and they are permitted to buy up to 10 per cent of the auction non-competitively.
In Canada, non-competitive bids are less than 2 per cent for nominal bond auctions, and less than 1 per cent for treasury bill auctions. They are more substantial for RRB auctions, representing between 3 and 5 per cent of total bids submitted. Non-competitive bids have a dollar maximum which partly explains the differences in their proportions for each type of auction since treasury bill auctions are the largest in size and RRB auctions are the smallest. There has been a steady increase in the proportion of non-competitive bids for 30-year bond auctions over the evaluation period. Also, while still small, non-competitive bids in treasury bill auctions have seen a marked decline since 2006, and no structural change in the auction process or rules appears to explain this. Interviews with market participants suggested that the small size of non-competitive bids means that they do not play an important role at auctions.
b. Day of Auction
i. System for accepting bids
We recommend encouraging greater participation of customers already holding a bidder identification number, and identifying and actively soliciting potential new customers. Large customers should be offered direct access to the Communication, Auction and Reporting system (CARS).
The Communication, Auction and Reporting System (CARS) system used in Canada has been highly reliable. Rules programmed into the system that prevents most possible types of human input error, and incidences of errors are very rare. Interviews with all existing types of users led to no recommendations regarding improvements to the system. However, several large customers expressed interest in having direct access to the CARS system to simplify their participation in auctions and to allow them to report their holdings directly to the Bank of Canada in an automated fashion. They expressed a preference to not share their holdings with dealers, and were either not aware of the option to bypass dealers for this purpose by conveying holdings directly via phone or fax, or they had a preference for an automated platform. Offering CARS access to large customers has the potential to improve auction effectiveness if some large investors will bid more aggressively.
ii. Bank of Canada participation, right to reject bids, and right to reduce quantity offered
Canada is unique among the sovereigns investigated in that the Central Bank can participate at auction without restriction and not as an add-on. The Government of Canada also can, at its discretion, re-open and issue outside the timetable provided by the QBS and the usual cycle for treasury bill issuance.
The Bank of Canada participated up to 15 per cent in nominal bond auctions and up to 25 per cent for treasury bill auctions. During the evaluation period, the Bank of Canada participated at a constant 10 per cent of all 2-year auctions and 15 per cent of all 5-year auctions. The minimum purchase by the Bank of Canada changed in the 10-year and 30-year sectors from 10 to 15 per cent in January 2008. Dealers are most concerned about the net size of auction plus buyback. No one commented directly on the recent change in bidding amounts, with the implication that the change has not been a concern.
iii. Timing of buybacks relative to auction
Participants were generally pleased with the timing of buyback operations relative to auctions. However, two dealers expressed a strong preference that buybacks be at least 5 minutes earlier relative to auctions to reduce dealer risk exposure. They suggested that this may lead to more aggressive bidding at auctions and therefore increase auction effectiveness. It is not clear whether this change would make a meaningful difference in auction effectiveness, but this may be worth considering in light of higher issuance volumes and increased desire to ensure maximum auction participation. Interviews with the Bank of Canada and Department of Finance suggested that this timing is achievable with minor operational concerns.
iv. Reporting holdings
In Canada, there are minimum and maximum bidding requirements for Primary Dealers and maximum holdings acquired through the primary market for all auction participants. Canada requires reporting of net positions (including derivatives exposures) prior to the auction for dealers as well as customers who have a bidder identification number. In order to ensure that limits are not exceeded, position reporting is required since the maximum permitted bidding levels are based on the auctioned amount but could be limited by the net position amount.
In Canada, bidders are required to report their net holdings of the auction security prior to the auction. For customers, this may be done through dealers who have access to the CARS system for automated entry, or directly by phone and fax to the Bank of Canada.
Position reporting requirements vary substantially for other sovereigns and are related to the existence or absence of maximum bidding limits. The pre-auction reporting requirements are varied, but each sovereign’s own rules appear to work well for its auction process. In Canada, pre-auction net position reporting is required and compliance certificates and post-auction verification of net positions are the enforcement mechanisms. It is possible that a more systematic checking of pre-auction reporting limits is desirable, rather than random spot checks, but it would be labour intensive and it is not clear that the current almost self-monitoring system is subject to violations. The threat of penalty appears to suffice.
v. Bidding requirements
When it is desirable to encourage more participation due to higher debt issuance, Canada could relax the upper limit on bids and counteract the potential impact on short squeezes by reserving the right to re-open issues at any time through something like the United Kingdom mini-tender facility, or similar to the Australian approach of re-opening at its discretion. Given the stringent participation rules in Canada, we recommend a carefully chosen reservation price for some auctions since it may contribute to lower cost funding, although at the risk of less than desired funding amount at any given auction. In periods where the need to raise funds is relatively great, a reservation price is not likely to improve effectiveness and is not recommended. If Canadian bond and treasury bill issuance volume grows substantially, we recommend a post-auction option to increase the offering size. This provides greater predictability of raising the desired amount of funds without unduly disrupting the market.
Countries with strict selection criteria tend to have fewer bidding restrictions or obligations. Canada lies in the middle of the range of countries we examined in terms of strictness of selection criteria and obligations. All bidders must certify that they will not bid in concert with any other bidder. A government securities distributor who reaches a threshold level of primary and secondary market activity could become a primary dealer, with the commensurate responsibilities. The obligations of a primary dealer include meaningful minimum bidding requirements at each auction, in addition to an average over time. The Bank of Canada requires regular reporting of distributor activities related to Government of Canada debt, including firm-wide positions. Dealers are required to make available real-time information on fixed-income prices and yields. They may be required to (i) report secondary market trading; and (ii) report detailed issue-specific trading to the Bank of Canada. The purpose of such reports is typically to clarify why specific securities trade in the cash and repo markets at prices divergent from issues of similar maturity. In every country we surveyed there is a perceived value in the status associated with being a primary dealer.
One unique characteristic of the rules of the Canadian auction is the minimum bid required of all Primary Dealers (50 per cent of the auction limit or calculated value whichever is less, with a maximum of 12.5 per cent of the auctioned amount). While other sovereigns have guidelines for bidding requirements, none has a similar minimum for each auction. Given the number of Primary Dealers in Canada, this assures that in the absence of a disaster scenario, all auctions will be covered. Since all sovereigns are particularly concerned with execution risk (that an auction will be uncovered), Canada is in the unique position that it does not currently face this risk. Of course, in the longer run, such a rule cannot guarantee auction success. If Primary Dealers find this requirement to be too burdensome, some could choose to withdraw from being Primary Dealers.
With a fixed number of bidders, according to the literature, a higher price can be achieved with a well chosen reservation price, but an alternative distribution channel, such as a re-opening, may be necessary. However, in a model with endogenous entry, which may be relevant in auctions which are open to a broad range of bidders and do not have minimum participation rules, there is no advantage to having a reservation price. Canada has endogenous entry, but does have minimum participation rates, which does not quite fit the assumptions in the literature.
Based on volatile market conditions and the desire to increase funding amounts, some countries have introduced a post-auction option that allows winning bidders to purchase additional amounts of auctioned securities. This gives more flexibility regarding the issue size compared to fixed announcement of issuance amounts in advance. This option may encourage bidding at auction and raise more funds.
vi. Number of participants and participation rates – government securities distributors vs. customers
There is substantial variation in permitted bidders at auctions across sovereigns. Countries with strict selection criteria tend to have fewer bidding restrictions or obligations. Canada lies in the middle of the range of countries we examined in terms of strictness of selection criteria and obligations. As described in the previous section, in Canada, there are two types of bidders: Government Securities Distributors and Customers.
The number of Primary Dealers is 10 (treasury bills) or 12 (bonds) in Canada, compared to up to 18 in France and the US. In Canada there are 5 other government securities distributors (smaller institutions) and customers bid through government securities distributors. In France there are other dealers and customers occasionally participate through dealers. The US has the broadest participation, with many other dealers and customers participating directly. There are no other participants permitted in Australia or the UK, but customers can ask dealers to bid on their behalf. In Canada, Primary Dealers dominate nominal bond and treasury bill auctions, and Customer participation is greatest for RRB auctions. The number of total bidders in individual auctions including customers is not generally reported publicly.
For nominal bonds, customer participation is low (0 to 8 per cent) and does not appear to contribute to auction effectiveness or transparency. Customers participate more in RRB auctions (up to 40 per cent), where bid-to-cover and tail are both favourably affected by increased customer participation. For treasury bill auctions, customers participate up to 25 per cent, and higher customer participation tends to be associated with a greater bid-to-cover ratio, but tail is not impacted.
Each sovereign interviewed feels the number of bidders is roughly optimal in its own situation. Some bidders may have better information about market conditions and may be able to make more informed bids than others. Therefore, there may be a trade-off between quantity and quality of bidders.
Based on the analysis of the auction data, for a given security, greater dealer participation compared to customer bids is associated with a lower bid-to-cover ratio for 5-year bonds, RRBs and 6-month and 1-year treasury bills, but not for other bond maturities. Tail is unrelated to relative dealer participation except for 5-year bonds. We also examined whether the number of bidders is related to market conditions.
Aspects of the auction process differ across the sovereigns, contributing to the overall efficiency of the process. Modifying one or more aspects of the process is unlikely to lead to greater efficiency on the whole since the various pieces work together as part of the broad process.
With regard to pre-auction rules vs. flexibility, Canada has strict limits on maximum award, but Australian model has no limits and maintains the option to re-open to prevent short squeeze.
Based on volatile market conditions and the desire to increase funding amounts, some countries have introduced a post-auction option that allows winning bidders to purchase additional amounts of auctioned securities. For example, in June 2009, the UK, announced a post-auction option facility open from 12 to 2pm (starts an hour after the auction closes) where dealers can take down an additional 10 per cent of the auction amount at the auction price i.e. they make a profit if the secondary market price rises. The option does not apply if the auction was not covered. This gives more flexibility regarding the issue size compared to fixed announcement of issuance amounts in advance. The post-auction option facility was the result of a 2008/2009 UK consultation on supplementary issuance methods, which looked at a variety of alternative issuance methods. This option may encourage bidding at auction and raise more funds. In some sovereign markets, particularly the US, encouraging broad distribution at auctions is a policy priority. Greater customer participation may contribute to greater auction success, lower the likelihood of a failed auction, and lower and broader distribution.
We recommend motivating Government Securities Distributors to strive to become primary dealers (who are subject to more stringent minimum bidding requirements) by attaching more visibility and prestige to the primary dealer status (e.g. as in France). For example, a multilateral forum for primary dealers once a year where they are invited to discuss key issues with senior policy makers.
vii. Compliance with Terms of Participation – Surveillance Framework
There are two potential irregular practices of key interest: a short squeeze and collusive behaviour regarding pricing, such as bidding up yields in the WI or secondary market prior to the auction, or at the auction. Greater concentration of ownership and a smaller number of bidders increase the risk of both short squeezes and collusive behaviour. For sovereigns that take a rules-based approach to prevent irregular practices, there are multiple features of the auction process that play a role: who participates (broader is better), requirements of participants (maximum and minimum bids), pre-auction position reporting, and the possibility of re-opening. Preventing excessive concentration of ownership of a single security is a common goal. Sovereigns take very different approaches to achieving this.
All sovereign interviewees concluded that their auction process is not subject to concerns about irregular practices. The experience of the US in the 1990s is well known and each sovereign is vigilant and subjectively concludes that its own process is effective in preventing irregular practices. However, each sovereign takes a slightly different approach.
The potential for collusion may be related to the auction format. The theoretical literature suggests that single price auctions can, under some circumstances, be more subject to collusion but this is not supported by the empirical literature. Market manipulation and irregular practices are more likely when there are fewer participants and when securities are less liquid. Net positions and bidding limits are the most important factors for curtailing potential manipulation. However, there is little concern that irregular practices occur.
i. Release of results – timing and transparency
Generally, market participants said that the transparency of information released with the results is sufficient to support efficiency. Canada releases information comparable to the other sovereigns in a timely way. The literature is clear that the release of individual bid information should be avoided since it facilitates collusion, which lowers revenue.
All the sovereigns in our study release the results within ten minutes of the deadline for bid submission, usually faster. Some interviewees commented that the dissemination of results could be improved. Some noted that the website is unreliable, and that they would prefer that the information be pushed out more directly. Many customers wait to hear about the results through dealers rather than searching the headlines at major newswires such as Reuters and Bloomberg.
We noted that the Bank of Canada website maintains an email distribution list where market participants can sign up for notice of call for tender and auction results. Website improvements facilitate comparison of auction effectiveness over time by maintaining results for 10 recent auctions on the main page and providing a list of auction results for the past five years.
We recommend additional simultaneous release of results to the Bank of Canada pages on Reuters and Bloomberg and through CanDeal and other relevant trading systems used by Canadian market participants.
ii. Settlement timing and procedure
In the sovereigns we evaluated, the most common settlement timing for bonds, notes, and inflation-linked bonds is T+3, which is the same for Canada. Exceptions are Canadian 2-year bonds which are T+2, UK Gilts that are T+1, and re-openings of French BTAN’s (2 to 5-year bonds) which are T+1. Settlement varies in the US. For treasury bills, Canada settles T+2, Australia and the UK are T+1, France T+3 for auctions but T+1 in the secondary market, and the US is T+2 or T+3. There were some mixed comments regarding settlement timing, with some market participants expressing a preference for shorter settlement times for some securities, and others preferring the status quo. Careful consideration is given to settlement dates around holidays.
Adoption of best practices and standards for trade settlement by industry participants is key. This maintains the competitiveness of Canadian capital markets while working to reduce operational costs and risks while improving customer service. National Instrument 24-101 (Institutional Trade Matching and Settlement targets T+1 matching of at least 90 per cent of trades by June 30, 2010. Meeting these targets for secondary market trading will help maintain Canada’s capital market competitiveness, reducing credit risk, lowering operational risk and increasing productivity. However, while the Bank of Canada’s systems have the ability to move to shorter trade matching timelines, given the settlement practices for other sovereigns in the primary market, there does not appear to be an urgent incentive to settle trades in the primary market earlier than current practice.
Settlement procedures in each sovereign are through standardized third-party systems. None of the sovereigns surveyed expressed any concern regarding settlement risk, and no concerns were expressed by any Canadian market participant or by the Bank of Canada. Both dealers and customers consider settlement procedures to be good overall.
In normal market conditions, due to the stringent minimum bidding requirements for Canadian primary dealers, execution risk is low, but in the unlikely event that the auction fails to raise the desired funds, the impact is high, so execution risk is still the most important risk regardless of market conditions. The probability of an adverse event that is classified as operational risk is higher, but the impact is lower than for execution risk. Execution risk increases in volatile and illiquid market conditions, and during periods of heavy issuance. Operational and settlement risks are largely independent of market conditions.
a. Execution Risk
Execution risk is measured as the likelihood of a Bid Cover ratio less than one, i.e. a failed auction. This has never occurred during the evaluation period. Most of the sovereign interviewees stated that the main risk is execution risk. In our sample of five sovereigns, only the UK had experienced a failed auction. This occurred three times, most recently in March 2009. This experience led the UK to formally review its auction process.
In the event of a failed auction, treasury bills can be issued as backup funding provided that the cause of the failed auction does not also disable the treasury bill market. For example, if a financial institution fails and does not purchase bonds as expected, this amount could be raised through a same day settlement cash management auction. Execution risk also depends on the ability of dealers to maintain their operational platforms in the event of disaster. It is not possible to hold an effective auction if large bidders are not functional. Dealers have disaster plans and backup operational facilities which reduces execution risk (but we did not evaluate these), and some dealers have operations in different cities.
b. Operational Risk (including bidders compliance with bidding rules)
Operational risk includes the risk of errors in the auction process, such as data entry errors, errors in calculating auction pricing, as well as risks of system failure, human error, or communication error. Also included in this category are risks that bidders do not comply with selection criteria, bidding rules, or position reporting requirements.
The CARS system has built-in rules that prevent most potential human error. In particular, there is a plausibility range within which all bids must fall to be considered valid. This plausibility range provides a high and low that prevent potential “handle” errors where yields could be materially mis-typed. Bids are monitored by trained staff. Market participants and Bank of Canada staff are confident in the system, which has significantly reduced operational risk. The rules are audited by Risk Management.
Bidder compliance with net position reporting is monitored through annual compliance process that begins on November 1st. The process is led by the Bank of Canada in coordination with the Department of Finance. For the semi-annual post-auction verification, an auction is selected, and all participants who submitted competitive bids are contacted and asked to verify the positions reported in CARS. Throughout the year, dealers are expected to notify the Bank of Canada if they have misreported positions. This happens occasionally and they have been communicated quickly. However, the Bank of Canada cannot independently check an error in position reporting and relies on compliance certificates from dealers and customers. A concentrated net position in the primary market is of greatest concern to the Bank of Canada.
c. Settlement Risk
Settlement risk is very low and is difficult to measure. However, third party settlement systems reduce this risk to a negligible level. No incidents in our evaluation period, and no market participants or sovereigns expressed any concern about settlement risk in the Canadian or other markets.
d. Staffing Risk
We recommend that detailed guidelines and process documentation be reviewed and updated annually at the senior management level at both the Bank of Canada and Department to Finance.
Maintaining a sufficient qualified staff is essential since there is a high dependence on corporate knowledge held by specific experienced individuals related to the determination of the borrowing program, the QBS, and call for tender.
e. Systems Risk (including Disaster Recovery)
Systems backup is a key priority. If, prior to or during an auction, the auction computer site (which has a back-up computer in place on-site) is dysfunctional, business continuity and disaster recovery policies come into play. The Bank of Canada has an off-site facility that reduces operational risk and would likely provide support execution of the auction, but with some delay. These issues are addressed by the Continuity of Operations Group, distinct from Risk Management. A disaster recovery process and business continuity plan is maintained within the context of the overall Bank of Canada operations.
f. Risk Governance and Reporting
The Funds Management Committee (FMC) oversees all activities covering domestic debt, cash management, reserves and risk management. The FMC’s mandate is to advise the Minister, through the Deputy Minister or his/her delegate, on policy and strategy for funds and risk management, direct the implementation of approved policy and plans, and review performance outcome reports. The FMC oversees risk management practices and provides direction on establishing guidelines for risk identification, measurement, monitoring and mitigation. The FMC is provided with regular reports from the Financial Risk Office summarizing financial and operational risk exposures and key audit findings. The FMC meets semi-annually, in late spring/early summer and late fall/early winter, and on an ad hoc basis as required. The two meetings are used to discuss work plan priorities at the Department of Finance and the Bank of Canada, and address key policy issues related to funds management activities.
The Risk Committee (RC) is an advisory body to the FMC that reviews and provides opinions on the risk implications of market and operational developments, and policy proposals and recommendations put forward by the Funds Management Coordinating Committee, Asset Liability Management Committee and Retail Debt Coordinating Committee. The RC is supported by the Financial Risk Office (FRO), which provides advice to the RC on risk issues associated with policy proposals and recommendations.
The Financial Risk Office (FRO) monitors and reports on risk exposures, including market, credit and operational risks, related to financing and investment activities based on best practices of sovereign government funds operations and knowledge of private sector financial institution practices. FRO also provides advice in respect of the development of financial asset and liability management policy, particularly related to market, credit and operational risks. The Adviser, Strategic Planning and Risk Management, and the Director of the Financial Risk Office (FRO), Bank of Canada, are responsible for oversight of FRO.
Risk is also governed by the Memorandum of Understanding on Treasury Risk Management between the Bank of Canada and the Department of Finance.
We found that the current structure of the debt auction process works well and supports the transparency, efficiency and effectiveness of Canadian auctions as well as the ultimate goals of raising necessary funding at a low cost. Moreover, the auction process has helped sustain a liquid and efficient secondary market for Government of Canada debt.
While we suggest making several marginal changes to the auction process, we expect that the process will continue to achieve its objectives in the longer term in its current form or with the suggested changes in process that we cite. We make 8 recommendations primarily focused on internal and external process and risk management.
Is there still a need for an auction process or is there an alternative method for raising funds?
Both the academic literature and practice across other sovereigns suggest that an auction process should be the main process of issuing government debt. Auctions have been proven to be an effective way of selling securities, especially for selling liquid government debt for which there is little price uncertainty. Not only does the auction effectively raise funds, it also contributes to a liquid secondary market.
When there is more price uncertainty, for example for certain very long dated debt or inflation-linked debt, other sovereigns have sometimes preferred to use non-auction methods, such as syndication. As long as there are government funding needs, there will be a continued need for an auction process to raise funds.
Alignment with Government Priorities: Is the auction program relevant? What are the linkages between program objectives and federal government priorities and departmental strategic outcomes?
In our context, the government’s goal is to raise funds to finance its debt and expenditures. Further goals are to raise these funds at the lowest cost, and to contribute to an efficient secondary market. These goals are the same as the objectives of the auction process – to successfully raise funds at low cost by issuing liquid securities.
Consistency with Federal Roles and Responsibilities: Is there a need for the government to deliver this program? Why should this program be delivered by the federal government as opposed to other orders of government or the private sector?
Government debt auctions are conducted by central governments (or central banks) for all sovereigns that we are aware of. Unlike corporations that use intermediaries to underwrite and distribute their debt, an intermediary is generally not necessary for government debt, since such debt has little (if any) credit risk and has liquid secondary markets, and thus very little uncertainty about pricing. Since the purpose of auctions is to fund the federal government, and since the specific funding needs can only be determined at the federal level, it is appropriate for the auction to be conducted by the federal government. Of the sovereigns we investigated, Canada is the only one that uses the central bank to conduct auctions. Others generally use a different government entity, usually an issuing authority that may be independent or part of the treasury function, with the specific mandate of raising funds for the government (see Appendix A). A different model could be considered for Canada, but we found that the current structure works well, and found no evidence to suggest that the efficiency or effectiveness of Canadian auctions would be improved as a result.
Achievement of Expected Outcomes (Immediate, Intermediate and Ultimate): To what extent has the auction process been able to achieve its objectives and expected outcomes in the immediate, intermediate and ultimate long term?
Overall, the auction process has been successful in its immediate, intermediate, and ultimate goals of raising necessary funding at a low cost. Moreover, the auction process has helped sustain a liquid and efficient secondary market for Government of Canada debt. Above, we discuss a number of possible marginal changes to the auction process, but we expect that the process will continue to achieve its objectives in the longer term in its current form or with the suggested changes in place.