Never saw a club that I liked

In my experience in doing finance in the period after the IT revolution, one thumb-rule that has reliably worked for me is this: anytime you see a small club that was created through government fiat, there's merit in asking first principles questions about why that club exists.

An example is the `primary dealer' institution as it existed in the US. When California was very far away, it made sense for the treasury to sell bonds to primary dealers on East Coast, who would then farm them out to customers all over the country. But in this electronic age, we only introduce frictions by introducing one more layer of intermediaries. A better market design would involve direct auctions open to the world at large.

On 12th December, the US Fed announced a new animal called the Term Auction Facility (TAF). Stephen Cecchetti has an excellent summary of the efforts that are presently underway, in resolving the difficulties of monetary plumbing.

The quick summary is this. Temporary liquidity injections by the US Fed were done through repos against the 20-odd primary dealers. This broke down because these 20 banks are in the eye of the storm themselves. In response, as Cecchetti says: the Fed announced that they are going to auction off reserves for terms of up to 35 days, allowing all banks to participate and accept the same collateral that is accepted in discount lending. This is different from open market operations because it involves all 7000+ banks, not just the 20 primary dealers.

Now, in this computer age, an auction with 7000 or 7 million players is not hard to organise. What I found really funny is footnote 9 of the article, which points out that the US Fed will not use computer systems for any of this! The 7000+ banks are going to bid by phone!

Well before this crisis erupted, my policy instincts would have been to break open clubs. The right way to sell securities is through the massive distribution networks of the securities industry, where auctions can reach millions of screens worldwide. There is no need to have select clubs like primary dealers or investment bankers in this modern IT-enabled world. At best, enshrining a club introduces frictions. At worst, it could lead to serious policy difficulties when the select club is in trouble, as has happened in the US.

As an aside, India was a pioneer in using NSE/BSE screens to sell IPOs. This was done well before google made it famous. See World's biggest democracy can show Google how to conduct an online IPO by Francesco Guerrera in Financial Times, 31 Jul 2004. However, the present state of the IPO process in India is highly unsatisfactory; it is far, far from a state where securities are auctioned off, with bids emanating from every NSE/BSE screen, at a market-determined price, without an investment banker. The SMILE report had walked in the right direction, but after that there was no follow through. The full transformation of the primary market should be on the agenda for the next SEBI chairman, and when it's done, this would be the vehicle of choice for the Debt Management Office in selling securities, and the central bank for conducting monetary policy.