GLOBAL FINANCE & MARKETS | GOVERNMENT BOND MARKETS ADVISORY SERVICES DOMESTIC SYNDICATIONS Background Note May 2015 Background Note1 This note on domestic syndications is part of a series of background notes produced under the World Bank Group Government Bond Markets Advisory Services Program as a by-product of its strategy to support the development of liquid local currency bond markets. Topics selected have been a key focus in Advisory Services’ work area because of their catalytic impact on debt market development. Six notes have been produced so far: Domestic Syndications, Bond Buybacks and Exchanges, Securities Lending and Related Standing Facilities, Primary Dealer Systems, Electronic Trading Platforms, and Repo Markets. Domestic syndications can be a powerful tool in development of government bond markets by providing access to immediate liquidity for new benchmark bonds and diversifying an investor base. Additionally, domestic syndications serve well to bring and launch innovative instruments in the domestic securities markets. The objective of this background note is to illustrate the various aspects of syndications to be considered by a debt manager in deciding whether a domestic syndication is an appropriate placement mechanism in certain cases. The note reviews goals, prerequisites, limitations, and drawbacks of syndications and provides real-life examples in the case studies. Production of this background note was led by Olga Akcadag. Baudouin Richard was the primary author, working in collaboration with Anderson Caputo Silva, Olga Akcadag, and Indhu Raghavan, all of the World Bank Group Government Bond Markets Advisory Services Program Team. The authors wish to thank Anne Leclercq, Director of the Front Office at the Belgian Debt Agency, and Mike Williams, Senior Consultant, World Bank Group, for reviewing the paper, as well as Juan Manuel Govea Soria, Director of Institutional Investors Relations at the Mexican Treasury, for his contribution to the Mexico case study. A special thank you to David Anderson, who edited this background note, and Aichin Lim Jones, who provided the design and layout. 1 This background note has been prepared to support World Bank Group technical assistance programs for the development of local capital markets. This note is a work in progress because data intended to show practical examples of country practices are still being collected. Comments to baudouin.richard@live.be, asilva3@worldbank.org, oakcadag@ifc.org, and iraghavan@worldbank.org are welcome. Contents i Contents Abbreviations and Acronyms...................................................................................III 1.Introduction...........................................................................................................1 2. Syndications..........................................................................................................3 2.1. Standard Features of Syndications......................................................................... 3 2.2. External versus Domestic Syndications................................................................. 4 3. External Syndications............................................................................................7 3.1. Rationale for External Syndications...................................................................... 7 3.2. External Syndication Procedures........................................................................... 7 4. Domestic Syndications........................................................................................11 4.1. Rationale for Domestic Syndications.................................................................. 11 4.2. Using Syndications to Launch a New Financial Instrument................................ 13 4.3. Market Survey.................................................................................................... 14 4.4. Procedures Specific to Domestic Syndications..................................................... 14 4.5. Syndication Fees................................................................................................. 17 4.6. Case Study 1: Belgium........................................................................................ 17 4.7. Case Study 2: Dutch Direct Auction system (DDA)........................................... 19 4.8. Case Study 3: Mexico......................................................................................... 20 4.9. Choosing the Most Efficient Domestic Syndication Structure............................. 22 4.10. Factors Contributing to the Success of Domestic Syndications......................... 23 4.11. Syndications in the Absence of a PD System..................................................... 24 5. Conclusion..........................................................................................................25 References................................................................................................................27 ii DOMESTIC SYnDICATIONS Appendix 1............................................................................................................................................................. 29 Appendix 2............................................................................................................................................................. 31 Appendix 3............................................................................................................................................................. 33 Appendix 4............................................................................................................................................................. 35 Appendix 5............................................................................................................................................................. 37 Abbreviations and Acronyms iii Abbreviations and Acronyms AS Auctioned Syndication BBS Book-Building Syndication BDA Belgian Debt Agency DDA Dutch Direct Auction DMO Debt Management Office DSTA Dutch State Treasury Agency EMU European Monetary Union FRN Floating-Rate Note MoF Ministry of Finance OECD Organisation for Economic Co-operation and Development PD Primary Dealer 1. Introduction 1 1. Introduction This background note is intended to assist debt management offices (DMOs) in assessing whether a bond placement scheme combining auctions and syndications is an appropriate strategy in their markets and, if so, to assist them in designing the corresponding procedures. Syndications are currently best known in connection with the placement of external debt abroad. By contrast, a “domestic syndication” has three specific features: (1) a bond is placed in the domestic market denominated in a local currency,2 (2) a bond is generally placed with both domestic and foreign investors, and (3) the outstanding amount of a bond is intended to be subsequently increased through a calendar of auctions. In practice, domestic syndications are invariably linked to the launch of a benchmark bond.3 Domestic syndications were first used in the European Monetary Union (EMU) in 1999. Their usage is now expanding in Organisation for Economic Co-operation and Development (OECD) countries. At first glance, this seems to be an evolution backwards. The end of bank financing extended under the form of “club deals,”4 and their replacement by competitive auctions in the domestic government securities market has been a standing feature of the reforms initiated across the globe over the last 50 years to increase the efficiency of public debt management. Domestic syndications have three justifications. First, they can score better than auctions on four points: (1) they provide immediate liquidity, (2) they diversify the investor base by attracting new investors, (3) they are an efficient tool to ensure firm prices in the secondary market, and (4) they offer timing flexibility: by contrast with auctions, syndications do not need to be subject to an issuance calendar. Second, the issuer can play an active role in structuring the transaction and in overseeing its implementation. This was not the case for the “club deals” done in the past. Third, domestic syndications are also an efficient tool to 2 Thus, in local format as opposed to a euro or global bond format. 3 That is, placing the first issuance of a security. Domestic syndications are normally not intended to tap an existing bond. 4 In this context, a “Club deal,” alternatively called a “bank consortium,” means a financing extended jointly by a group of banks that effectively dictate their terms and conditions to the borrower. 2 DOMESTIC SYnDICATIONS launch new financial instruments,5 because they enhance This background note is organized in three parts. First, price discovery. As a result of the above features, domestic syndications in general: A general description of syndications syndications lower funding costs for an issuer. is followed by a review of the distinctive features of external and domestic syndications. Second, external syndications: Another valuable feature of domestic syndications is that The analysis of the rationale for external syndications is some of their specific procedures can be used in external followed by a description of the procedures generally syndications. This applies, in particular, to the selection of implemented. Third, domestic syndications: This section banks managing a transaction. covers their rationale, a survey of the markets using them Domestic syndications have prerequisites, limitations, and and an analysis of the features specific to this placement drawbacks. In particular, DMOs need to be clear on the procedure. Some case studies follow with a more detailed objective pursued, because a domestic syndication may not analysis of the objectives pursued and of the procedures be the most effective way of achieving it in their specific implemented in three representative countries: Belgium, market. the Netherlands, and Mexico. Finally, specific topics are briefly reviewed before concluding.This section describes the standard features of syndications in general, followed by an analysis of the specific objectives and distinctive features of external and domestic syndications. 5 Referring to financial instruments that represent an innovation in the domestic market. 2. Syndications 3 2. Syndications 2.1. Standard Features of Syndications Syndication is the process of putting together a group of banks that jointly underwrite and distribute a new security offering. The members of a syndicate commit to buy a certain amount of securities at a certain price. They are expected to place the securities with their customer base. In the event of a lack of demand by customers, however, the banks will keep the securities on their balance sheets. The members of a syndicate earn two commissions: an underwriting commission for committing to provide funding and a selling commission for placing the securities. Syndication is akin to a private placement where the issuer is ensured of having a certain amount of funding at a predetermined price. The specificity of a private placement is that the issuer negotiates with a smaller number of banks (typically from one to three institutions). The size of the funding is also smaller than in syndication. In general, the banks know beforehand where they will place the securities. The main advantage of a private placement is that it can be completed fast and with no publicity. See appendix 1 for further comparison. Banks consider syndications to be very attractive business. This applies particularly when a bank is mandated to be the arranger of the transaction (“lead or joint lead manager”). In addition to the commission earned, a lead or joint lead mandate raises the ranking of a bank in the league tables published to show the most active syndication managers. This enhances the business reputation of the bank, thereby attracting other mandates. The banks participating in a syndication are also given an opportunity to strengthen their relationship with their customers by being first to offer them new securities. As a result, syndication is a very competitive business. Syndicated transactions receive considerable coverage in the financial press. Syndications are a highly specialized business. The major players are a small number of large international banks. Most transactions are reviewed in great detail. The competitors of the appointed joint leads do not miss the opportunity to highlight any shortcoming in the “market comments” section of press reviews, expecting to increase their own chances of becoming lead managers next time. 4 DOMESTIC SYnDICATIONS This public scrutiny contributes to ensuring that the level An additional (or alternative) objective of a domestic of the selling price agreed between the DMO and the syndication can be to support the launch of a financial joint leads is a fair deal for both issuer and investors. This instrument that represents an innovation in the domestic applies especially when joint leads are important players market. Syndications facilitate price discovery (section in the business. The best known players are those most 4.1.2). The banks leading the syndicate can also help the sensitive to the detrimental impact on their syndicate desk issuer and/or the market in mastering the technicalities of of unfavorable comments published in the press. the new instrument. 2.2. External versus Domestic 2.2.2. Distinctive Features Syndications In an external syndication, the issued security is an External and domestic syndications share numerous international bond, and the transaction is subject to procedures. Yet they pursue different objectives, and each foreign law.8 The bond is denominated in foreign currency. has some specific features. It is usually placed primarily—if not exclusively—abroad and is rarely intended to be tapped again in the future. 2.2.1. Specific Objectives Pursued The funding need being met is usually not recurrent. The External syndications pursue primarily two objectives: syndication itself is a placement procedure that is for the (1) to fund the foreign currency requirements of the most part seldom used. government and/or meet funding needs that are beyond In domestic syndication, the issued security is a standard the absorption capacity of the domestic market and (2) to domestic benchmark bond of which the outstanding part diversify the investors’ base by familiarizing international will be subsequently tapped by auctions following the investors with the issuer’s credit. External syndications raise standard auction procedures applicable in the domestic an issuer’s market profile and visibility. market. The transaction is governed by domestic law. Alternative or additional objectives can be (1) to obtain The syndication itself is a securities placement procedure a lower cost funding than on the domestic market, if that tends to be used recurrently. Many DMOs have achievable by doing a currency swap,6 and (2) to provide made domestic syndications an integral part of their debt a pricing reference for bonds issued in the international issuance policy for issuing new benchmark maturities. market by domestic agencies or corporations. Well-managed domestic syndications reduce the issuer’s Domestic syndications pursue three objectives: (1) to funding cost. The higher liquidity of the security and provide immediate liquidity to a new domestic benchmark the larger number of investors potentially allow bonds to bond by issuing a large amount, (2) to widen the investor be sold at a higher price than in an auction, particularly base, and (3) to enhance the good functioning of the for the size issued. A domestic syndication also provides secondary market by creating the right mix between additional benefits that jointly further decrease the net real money investors and trading accounts among the cost of the funding (see section 4.1.2 and table 2.1). These bondholders. advantages generally outweigh the commissions paid. The widening of the investor base generally includes an expectation to attract foreign investors to the domestic market. Syndication is a tool that is more efficient than an auction because it minimizes the investor’s risk (section 4.1.2). Successful domestic syndications attract a significant amount of foreign buying. Yet the latter is not necessarily a prerequisite for a domestic syndication to be justified.7 6 This assumes that an arbitrage possibility exists between the two markets (“swap window”) and that investors can take advantage of it. 7 As an illustration, Mexico has not mentioned foreign investors as a specific objective nor has it set any target market share for placement abroad. 8 Generally, U.K. or New York (state) law. 2. Syndications 5 Table 2.1. Aspects of External and Domestic Syndications External Syndication Domestic Syndication Objectives Objectives • To meet foreign currency needs and/or financing • To increase size of issuance (immediate liquidity) needs beyond the absorption capacity of the domestic • To attract foreign investors to the domestic market market • To facilitate the issuance of new instruments (price • To diversify the investor base discovery) • To lower funding cost (if possibility of swap arbitrage) Distinctive features Distinctive features • Bonds denominated in foreign currency • Domestic benchmark tapped by auctions thereafter • Transaction subject to foreign law • Transaction subject to domestic law • Placement abroad • Placement both domestic and abroad • No (or little) recurrent placement procedure • Recurrently used placement procedure Additional benefits Additional benefits • Raises issuer’s profile and visibility • Decreases funding cost • Provides a pricing reference for other borrowers • Ensures firm prices in the secondary market • Supports primary dealers’ motivation to perform • Strengthens investor relationships • Can support liability management operations 3. External Syndications 7 3. External Syndications This section reviews the rationale for external syndications, followed by a description of the procedures usually implemented. 3.1. Rationale for External Syndications The reason for using syndications to place external debt is clear. The investor base is little known to the issuer and requires a special marketing effort to be tapped. Nonresident investors lack sufficient familiarity with the issuer to submit large and/or aggressive bids. Auctions are seldom used—if at all—for nondomestic issuance by sovereigns. In most cases they would not produce the best prices outside domestic markets. 3.2. External Syndication Procedures Syndications are usually preceded by a marketing campaign. The issuer updates investors on the country credit and government securities market, and the rationale and the main features of the transaction are described. This is typically done in the framework of conference calls and/or road shows organized abroad. Thereafter, the syndication of a bond issuance usually covers six steps: 1. Appointment of a syndicate group 2. Pricing guidance 3. Official announcement of the transaction/book building 4. Closing of the books 5. Allocation of orders 6. Management of the market postsyndication 8 DOMESTIC SYnDICATIONS 3.2.1. Appointment of a Syndicate Group of representative investors in their respective customer base A syndicate usually comprises a small number (two to four) for the price range would attract buying orders and for of joint leads and up to a dozen of co-managers. The joint what amounts. The corresponding price range is expressed leads9 assume responsibility for arranging the transaction, as a “spread range” over a reference rate.13 and the co-managers are working in the framework set by the joint leads. 3.2.3. Official Announcement of the Transaction and Book Building The selection of joint leads is a critical decision: The success The announcement of the transaction indicates the target of a transaction and the joint leads’ ability and experience amount to be issued14 and a spread range for the pricing. The are closely linked. order book lists the orders by price levels and by amounts, The joint leads can be selected on a competitive or in the same way as for bids submitted at an auction. The on a judgmental basis. In the first case, the banks that market is kept informed of the size of the book and of the have offered the lowest funding cost are appointed.10 In spread range, which is narrowed as the order book grows. the second case, some form of competitive process (an Some investors adjust their bids accordingly. interview or “beauty parade” based on formal submissions) may still be used, but the appointed banks are the ones 3.2.4. Closing of the Books that the issuer deems to be best equipped to achieve the When enough orders have been collected, a cutoff price is assigned objectives; that is, the qualities considered are set at the level that provides the desired amount of funding. the ability and experience of the bank for the transaction, The cutoff price is proposed by the joint leads and approved the strength of the bank’s relationship with the targeted by the issuer. As in an auction, the bonds will be allocated investor base, and the capacity and resources of the bank to investors who have submitted orders at the cutoff price to support the syndicated bond in the secondary market. or higher. As in a uniform price auction, all investors who are allocated bonds pay the same price (the cutoff price). The syndication corresponding to the first type of appointment is called a “bought deal.” Competitive 3.2.5. Allocation of Orders bidding creates a risk that the bond will perform poorly, Successful syndications are typically oversubscribed, that particularly in the secondary market, when the fee is is, the amount of orders submitted at the cutoff price or too low. Experience suggests that exercising judgment higher is larger than the amount of funding required. The in appointing joint leads is generally a more efficient orders then need to be allocated for a certain percentage procedure (section 4.9), at least for larger transactions. of their amount. This can be done in different ways: (1) allocation of the same percentage either across all investors 3.2.2. Pricing Guidance or by type of investors, (2) individual allocation on a case- The strategy is to determine the selling price of the bond by-case basis as a function of the type of investor and/or its based on investor demand. This procedure applies when geographical location and/or the quality of its relationship joint leads are selected on the basis of their placement with, for example, the DMO,15 or (3) a combination of capabilities and expertise in managing the market after (1) and (2). launch.11 The joint leads informally check12 with a sample 9 Also called “book runners.” 10 That is, the highest bond price and the lowest commissions. 11 Instead, in a “bought deal,” the price is set at the level at which joint leads have committed to underwrite the transaction. 12 The transaction is not yet announced officially. 13 For example, U.S. Treasuries + 100 to 120 bp or German Bunds + 20 to 25 bp; the level of the spread is a function of several variables, such as the credit rating of the issuer, the maturity of the deal, or the condition of the market. 14 For example, “benchmark size.” 15 For example, participation of the investor in bond buyback and exchanges or information given by the investor to the DMO on its portfolio management strategy. 3. External Syndications 9 The main objective pursued in allocating orders is to 3.2.6. Management of the Market Postsyndication ensure firm prices in the secondary market by enhancing The joint leads are assigned responsibility for ensuring the the stability of the placement and the liquidity of the liquidity of the secondary market. They also commit to bond. The stability of the placement can be increased by ensure that the price of the bond will remain firm during a giving allocations to final investors who are likely to keep period of a few weeks after launch. the bonds in their portfolio for some time.16 The liquidity of the secondary market can be enhanced by granting a This section covers the rationale for domestic syndications. certain percentage of allocations to actively trading market It includes a survey of the markets using them and analyzes participants.17 The combination of stability and liquidity the features specific to domestic syndications. Some creates the optimal conditions for firm prices in the case studies follow with a more detailed analysis of the secondary market. An additional objective often pursued is objectives pursued and procedures implemented in three to strengthen investor relationships. This can be achieved representative countries: Belgium, the Netherlands, and by granting larger allocations to, for example, investors who Mexico. Finally, three specific topics are briefly reviewed: are recurrent buyers, active participants in bond exchanges syndication fees, the factors contributing to the success of or buybacks,18 or providers of useful market feedback. domestic auctions, and the issues that would be raised by a domestic syndication done without being supported by a primary dealer (PD) system. 16 For example, central banks, insurance companies, and pension funds. 17 For example, hedge funds. 18 Syndications can indirectly support liability management when this allocation strategy is made explicit. 4. Domestic Syndications 11 4. Domestic Syndications 4.1. Rationale for Domestic Syndications At first glance, domestic syndications are a paradox. Auctions are the standard issuance procedure in modern government securities markets. Auctions are a competitive and generally commission-free process.19 They represent an improvement on the noncompetitive placement systems that used to prevail in most government securities markets. In principle, auctions should yield the lowest financing cost. The rationale for domestic syndications is that they can produce better results than actions in some specific circumstances. Yet domestic syndications have limitations and their own drawbacks. 4.1.1. The Drawbacks of Auctions Auctions do not always produce the best results in four respects: timing, size, price, and investor base. 1. Timing: Auctions are subject to timing constraints. Auctions are held in the framework of a calendar. This is sound market practice. In the long run, predictability reduces the financing cost. In the short run, however, the corresponding lack of flexibility can raise risk (issuance in unfavorable market conditions) or represent a missed opportunity. 2. Size: Auctions allow only relatively small amounts to be raised. Auctions are subscribed primarily by dealers who carry the securities until such time as they can on-sell them to customers. End investors generally participate little in auctions for three reasons: (a) the auctions may not take place at the right time (because of the calendar), (b) the investor is not certain to acquire the amount of securities wanted (its bid may not be successful), and (c) if the bid is successful and if the auction is multiple price, the price may be too high (“winner’s curse”). By contrast, in a liquid secondary market, an investor can buy the amount it wants at a price it knows and at the moment that suits it. Many end investors therefore tend to bid at auctions only when the secondary market is illiquid and/or the amount to buy in the secondary market is so large that it could move the market. As a result, 19 With exception of DMOs paying a commission on customers’ orders submitted by PDs. 12 DOMESTIC SYnDICATIONS auctions can require time for a bond to reach benchmark 3. Price: The book-building process gives the issuer some size. In the meantime, the issuer pays a liquidity premium. degree of control over the issuance price. The issuer can adapt the spread range (price guidance) as a function of the 3. Price: The issuer has little control over the price, and quality of the order book. In addition, expert syndication the flexibility to adjust the size of the issued amount is managers are able to create some momentum (“hype”) limited. A target issuance amount has been announced and in the investor community by delivering the appropriate a funding need has to be met. The auctioned price can be a market commentary. surprise for both issuer and investors. In any case, the selling price of a syndicated security is 4. Investor base: The issuer has no control of the investor generally higher than the price at which it would have been base, and bidding is often anonymous. In any case, the auctioned, particularly for the size involved, because of the issuer cannot choose the investor to whom the securities direct participation of a larger number of investors and the will be allocated or subsequently sold. ensured liquidity of the bond.21 4.1.2. The Advantages of Domestic Syndications 4. Investor base: The issuer can control where the bonds A domestic syndication allows correcting each of the are placed and with what type of investors when it allocates aforementioned drawbacks of auctions: the bonds. 1. Timing: Syndication takes place out of calendar. Two additional advantages of syndications over auctions Syndications can be done only when market conditions are the following: are right. This is a standard and a well-accepted market First, price discovery: Syndications help in achieving a practice. Syndications, therefore, decrease the execution correct price formation in markets where secondary market risk. prices are not reliable references. Placing the first tranche 2. Size: Syndication enables the issue of an amount through syndication gives market participants a clearer significantly larger than an auction, thereby providing idea of how to price the issue in subsequent auctions. In immediate liquidity. Final investors are attracted by particular, syndications enable DMOs to assess the correct syndications because their investment risk is then price for issuing a new financial instrument more accurately minimized: (a) investors know ahead of time the amount than do auctions (section 4.2). of buying orders and a range for the selling price; (b) Second, firm prices in the secondary market: The bond investors have a greater certainty of being allocated allocation process enables the issuer to achieve the optimal bonds: during the book-building process, they can adapt mix between buy and hold accounts and trading accounts their bid as they get more information on the degree of among the investors holding the bonds. In addition, the success of the placement; (c) investors are protected market-making obligation of PDs can be focused on the against the winner’s curse (the settlement price is the same joint lead managers who are made specifically accountable because all successful bidders buy the bond at the same for price stability. Issuers who have built a reputation of price); (d) investors have the assurance that the secondary expert syndication managers benefit from the investors’ bond will be liquid because of the large size issued, tight corresponding expectation of firm prices in the secondary quoting obligations, and balanced investor base; (e) when market with the possibility of issuing at a lower yield. syndication is well managed,20 investors have a reasonable expectation of getting a small capital gain. Last, issuers can turn a syndication into a marketing event more easily than for an auction. 20 Well-advised issuers usually tend to deliberately set their cutoff price a little below the intrinsic value of the bond, thereby offering investors on the primary market the likelihood of a small capital gain. The cost to the issuer is usually insignificant because a larger number of investors bid more aggressively as a result. 21 This does not mean that syndication will always be successful irrespective of market conditions (e.g., highly volatile market). 4. Domestic Syndications 13 The following list compares features of syndications and auctions: Size Price Investor Base Timing • Larger participation of • Issuer has better control • Wider investor base • Flexible (no calendar) end investors • Price discovery • Optimal composition • Decreased investment (allocation of orders) risk: price range • Attracts foreign • Book building investors (better • No winner’s curse information, lower • More attractive security risks) liquidity • Firm secondary market prices 4.1.3. The Limitations of Domestic Syndications They should not be used too often: Syndications are not Domestic syndications can show their specific usefulness a level playing field for banks. Large international banks only in some specific circumstances. To reap the benefits are privileged in the granting of joint lead mandates. of size, price guidance and discovery, and diversification of The recourse to syndications could therefore become investor base, a new bond has to be issued, and generally22 detrimental to the well-functioning of a PD group if the intention has to be to place it both in the domestic syndications were used too often. Also, syndications are market and abroad. best done seldom enough to remain a marketing event. In any case, domestic syndications are complement to, and The fact that syndications entail the payment of a are not a substitute for, auctions. commission to the syndication managers or selling agents is not listed as a drawback of domestic syndications because 4.1.4. The Drawbacks of Syndications the cost of the commission is normally offset by other Syndications have three drawbacks: benefits, in particular a higher selling price and a stronger motivation of PDs to perform. They are time consuming: Syndications are administratively much heavier to put in place than auctions. Completing a syndication is a full-time job lasting two or three weeks 4.2. Using Syndications to Launch a New (section 4.4.3). Financial Instrument Auctioning a new instrument is a risky process. An auction They have risks: The determination of the selling price is a one-time process that the issuer cannot influence, and is not as straightforward as it is in an auction. Yet the the result of an auction is particularly unpredictable when securities are unlikely to be sold at a lower price to the a new instrument is involved. An additional risk is that a detriment of the issuer as a result. The issuer is protected wrong start could be hard to correct when the instrument against this risk both by the competition between joint comes to be reissued. leads and by the scrutiny of the financial press. Admittedly, this protection is not as strong as that secured by the Syndications enable DMOs to assess the correct price of a competitive pressure in an auction. To eliminate the risk new type of bond more accurately than do auctions. This altogether, the DMO needs some technical expertise in reflects both the book-building process in syndications and handling syndications. On a comparative basis, a domestic the participation of a wider investor base. Both the DMO syndication, in countries where there is a PD system and and the market also benefit from the experience of the lead the stable relationship that it offers, is less risky than an managers in structuring the transaction. external syndication. 22 Not necessarily. 14 DOMESTIC SYnDICATIONS The use of syndications to launch a new financial From 2000 onward, domestic syndications have been instrument has become a widespread practice. In 2005, the increasingly used in the European Union for launching United Kingdom syndicated its first long dated (50-year) new benchmarks. Today all the small issuers in the euro inflation-linked bond; in 2006 Germany syndicated its first zone invariably follow this strategy. In 2005 large issuers inflation-linked bond; in 2006 France syndicated its first started using domestic syndications as well but with the inflation-indexed bond; and in 2008 Italy syndicated its objective of enhancing price discovery (see section 4.2). All first inflation-linked floating-rate note (FRN). In 2005 the EU issuers basically follow the same placement procedures, Agence France Trésor said that syndications are an efficient with the exception of the Netherlands. way to “launch a new instrument that requires a learning process for the market.”23 In 2006 the Deutsche Finanz In June 2003, the Dutch State Treasury Agency (DSTA) Agentur stated that “it would use the syndication route innovated a specific domestic syndication procedure again if it was issuing a new type of instrument or entering (the “Dutch Direct Auction” [DDA]). This placement a new market to have the assistance and experience of the technique reinforces the auction component in the standard banks.”24 domestic auction structure. The DDA is a hybrid between a syndication and an auction. In view of its specificity, the DDA is described in detail in section 4.7. 4.3. Market Survey The launch of new benchmarks with a “domestic In 2009, 16 OECD countries were reported to be using syndication” was initiated in the EMU by the Belgian Debt syndications followed later by auctions to increase the size Agency (BDA). The first Belgian domestic syndication took of the initial issuance as an additional way to issue domestic place in January 1999, a few days after the introduction of currency–denominated debt (Blommestein 2009). the euro. Belgium was then confronted with two challenges, Practices range from occasional use25 to systematic use compounding the problems created by an excessively large when launching a new benchmark.26 Some countries use public debt. First, more than 90 percent of the public debt domestic syndications only when issuing a new financial was held by resident investors. In the pre-euro days, these instrument in the domestic market.27 Mexico provides investors were somehow captive. They could not invest an instructive illustration of some innovative uses of this abroad without incurring a foreign exchange risk. With placement procedure (section 4.8). Poland reports that a the euro, domestic investors were expected to diversify domestic syndication is a means of placement that it might their holdings. The BDA therefore had an urgent need to consider in an emergency situation. develop a nonresident investor base. The second problem of the BDA was that the introduction of the euro raised 4.4. Procedures Specific to Domestic the size of the critical mass required to attract liquidity. Syndications A minimum amount outstanding of €5 billion is a prerequisite for bonds to be quoted on the pan-European 4.4.1. General electronic trading platform “Euro-MTS.” By contrast, the The specific features mentioned in this section are amount that the BDA could auction without disrupting basically common to all the slightly different procedures the market was estimated to be a maximum of €3 billion. implemented by various DMOs, with a few exceptions for The BDA inaugurated the domestic syndication technique Mexico and the Netherlands. The syndication steps are to overcome these two constraints. Since 1999 the BDA reviewed below in a similar sequence as in section 3.2. has launched all its new benchmarks with a domestic syndication: A total of 35 issues for a global amount of €105.5 billion had been issued as of June 30, 2011. 23 France: Travaux Parlementaires, “Pour une gestion consolidée des dettes de l’Etat,” July 12, 2005. 24 Euroweek, June 26, 2006. 25 Austria, Slovakia, Sweden. 26 Belgium, Finland, Greece, Ireland, Portugal, Spain. 27 France, Germany, Italy, Republic of Korea, the United Kingdom. 4. Domestic Syndications 15 4.4.1.1. Composition of a Syndicate Group 3. The motivation of PDs to do the best possible job in Two policies apply in virtually all countries with a PD carrying out their duties can be strongly supported by system: (1) the syndicate group comprises only PDs and allocating rewards as a function of the quality of their (2) subject to all other things being equal,28 the joint lead performance: This practice has been widespread in the mandates are awarded to the best PDs. The best PDs are European Union since the early 1990s. It has yielded considered the ones that rank the highest in the appraisal significant benefits to issuers, including more aggressive of their performance as a PD. The first policy enhances the biddings by PDs at auctions.32 attractiveness of the PD status in the banking community. The second policy provides the DMO with a powerful tool The policy of establishing a connection between the quality to motivate PDs to do better than just complying with the of performance as a PD and the granting of a joint lead commitments attached to their status. PDs acquire a vested mandate33 has a wide range of possible implementations: interest in competing against other PDs to be ranked (1) This policy can be applied to external syndications.34 It among the best performers. In this way, they get on the is a missed opportunity not to do so. Domestic and external short list for being appointed as a joint lead.29 debt should be managed in tandem, not in silos. (2) This policy can be applied in emerging markets where no The above policies rest on three observations: international bank with a strong franchise in syndications is active yet. It suffices that at least one such bank has a 1. PDs assume many duties: To bid at the auctions, to local office or a participation in a subsidiary that has been place the issued securities with final investors, to enhance appointed as a PD. Issuing a lead manager mandate to a the liquidity of the secondary market with a continuous head office is likely to have a favorable impact on the future quoting of prices, and to advise the issuer on its debt performance of the relevant PD. (3) This policy can be management policy and on the organization of its market. even applied in countries with no PDs. Some banks might These efforts deserve compensation. be more helpful to the DMO (or to the central bank) than 2. Issuers can compensate their PDs in various ways for others. It can be mutually beneficial that, all other things the cost and the effort involved: One way is to select PDs being equal, these banks are considered first when rewards as counterparts in DMOs’ debt management operations, are offered. which thereby offers a profit opportunity to the banks 4.4.1.2. Pricing Guidance involved.30 In mature markets, the PDs’ agreement almost The joint leads have a particularly strong vested interest invariably includes a provision stating that “PDs are the in ensuring that the suggested pricing is fair for both privileged counterpart of the DMO in its debt management issuer and investors. Domestic syndications are a recurrent operations.” procedure, and so joint leads are therefore especially careful The appointment as a joint lead manager in a syndication not to disappoint. is a reward particularly appreciated by banks. As mentioned earlier, it offers them three benefits: a commission, a closer relationship with customers, and a higher ranking in the syndications league tables.31 28 That is, assuming equal degree of expertise in arranging a successful syndication. The degree of expertise can differ as a function of the business specialization of the bank, its type of customer base, the geographical coverage of its placement, etc. Where a number of competent banks are part of a PD group, the lead might be deliberately rotated to maintain motivation. In case expertise in syndication and quality performance as a PD receive contradictory evaluations, expertise in syndication is the criterion that should prevail. 29 Poland reports that the announcement the DMO may consider syndications as a possible placement mechanism in itself led to improved competition among PDs. 30 For example, transactions in the currency or derivatives markets. 31 The latter is a particularly valued reward to the banks because of its snowball effect. Issuers (both public and corporate) tend to appoint as lead managers the banks with high rankings in the league tables, on the assumption that they are the most experienced ones in the field. 32 This process went too far in some EU countries during the mid-2000 as PDs started buying market share to be on the issuer’s short list of joint lead candidates. As a result, some securities started being auctioned at prices above the level of the prices in the secondary market, thereby forcing issuers to penalize excessively aggressive bids to avoid market distortions. 33 Assuming an equal degree of expertise as a lead manager in syndicated deals between the respective PDs. 16 DOMESTIC SYnDICATIONS 4.4.1.3. Book Building taxation regime, the procedures for subscription and sale of It is a frequent practice for DMOs to set a global ceiling the bonds, selling restrictions (if any), and the composition for the placement with domestic investors and to give some of the syndicate. fairly detailed instructions to joint leads with respect to the amount placed abroad (which joint leads place in which 2. Subscription and selling group agreement: This countries and to what type of investors). document specifies the commitments assumed by the members of the syndicate (underwriting and selling) and 4.4.1.4. Allocation of Orders by the issuer (bond issuance and payment of commissions), DMOs typically become more closely involved in the order respectively. allocation procedure in domestic syndications than in external syndications. Ultimately the allocation decisions 3. Confirmation of the invitation to participate: When should rest with the joint leads. They are responsible for the books are closed and the pricing done, the DMO ensuring the liquidity of the secondary market. Yet domestic confirms to each member of the syndicate its underwriting syndications are a procedure often used recurrently. DMOs commitment and the amount of its final allocation. The develop an increasingly expert knowledge of their investor document includes a power of attorney to one joint lead to base in the process. sign the corresponding subscription agreement on behalf of the whole syndicate. 4.4.1.5. Postsyndication Market It is standard practice to make a distinction between two 4. Signing and closing agreement: All parties sign the final secondary market functions: to support the price of the documents before the settlement of the transaction. bonds, and to ensure the liquidity of the issue. The former 4.4.2.2. Market Announcements applies specifically to the joint leads of the syndication Four announcements are made to the market during the because they assume the role of “stabilization managers.” syndication process: (1) intention to issue a syndicated The latter applies also to the co-leads. bond (description included) during the course of (period In countries with a PD system, the subscription agreement mentioned), (2) opening of books and a price range, (3) mentions only the function of stabilization manager. The closing of books and imminent pricing, and (4) pricing PDs’ obligations with respect to supporting the liquidity of and issuance of the bond. the market are set in the PDs’ Code of Duties.35 4.4.3. Time Investment Required for Syndication 4.4.2. Documentation The syndication process usually takes between two and Two types of documentation are drafted in the framework three weeks to complete. A first syndication requires close of syndication: legal and market announcements. to a full-time job for at least two persons in the DMO over this period. The time investment shortens as experience is 4.4.2.1. Legal Documentation gained. Four types of legal documentation are usually found: The syndication process is marked by four “landmarks”: 1. Information memorandum: The Information (1) start of the process (initial meeting with the joint leads), memorandum is meant to inform investors about the (2) start of book building, (3) pricing of the bond, and terms of the syndicated bond. It provides background (4) settlement of the transaction. The DMO and the joint information on the domestic government securities leads monitor the whole process through daily conference market, the clearing and settlement procedures, the calls. 34 One side benefit of this close involvement by a debt manager is to avoid potentially awkward situations such as meeting investors sometime before a syndication (e.g., in the framework of a non-deal-roadshow) to entice them to buy bonds and thereafter allocating only a very small percentage of the submitted order. 35 In practice, DMOs typically inform joint leads that their compliance with the obligation to make bid and offer prices to support liquidity of the government securities market will be monitored particularly closely in the framework of syndication. DMOs typically further inform joint leads that the sanction for their noncompliance with this obligation will be to significantly decrease their chance of being appointed a joint lead again in the future. Both policies are best kept pragmatic, however, and not mentioned in a specific agreement. 36 Through Reuters, Bloomberg, etc. 4. Domestic Syndications 17 The calendar is the following: An example of commission levels is shown in appendix 3. In Europe the fees paid to the BDA have followed a • Day minus …: Deal preparation period. The DMO downward trend since 2003, although a small increase has submits for the minister’s approval the contemplated been seen since 2008. bond issue (size and a maturity) and joint leads selection. • Day 0: The DMO and the joint leads meet to agree upon 4.6. Case Study 1: Belgium the terms and conditions of the syndication. At the end The case study outlines the provisions designed by the of this meeting, the minister makes the announcement BDA to govern the composition of the syndicate group, that a transaction is being contemplated and releases the the structure of the syndication, the collection of orders, names of the joint leads. and the allocation of securities. • Day 0 + approximately two weeks: The DMO sends to the co-leads an invitation to participate. The minister 4.6.1. Composition of the Syndication Group or DMO announces that book building begins. The All PDs and recognized dealers are invited to participate.37 co-leads and selling group members send in their order The syndication group is split into three segments. books using an Excel spreadsheet. The joint leads 4.6.1.1. Joint Leads: Three or Four PDs Selected among gradually build their book. They input their orders in the Best Performing Ones an online electronic book-building system that ranks The joint leads assume the following: the orders by price, type (firm, soft, reoffer) and type of investor (central banks, insurance companies, pension 1. Overall responsibility for the success of the funds, hedge funds, etc.). In the euro zone, the book- placement: They are the BDA’s advisors for the structure building process takes between one and three days. of the syndication, timing of the launch, pricing guidance, allocation decisions, etc. (see appendix 2). When the books are closed (i.e., the end of the book- building period), the minister announces the formal 2. Primary responsibility for the good performance launch of the issue and that the bond will be priced. From of the bonds in the secondary market: The joint leads that point in time, the DMO is legally bound to issue the have a vested interest in building a well-balanced and a bond. The bonds are allocated. On the next business day, diversified order book. the bond is priced. 3. Specific responsibility for some operational duties (for example, legal documentation, contacts with the press, 4.5. Syndication Fees launch and pricing announcements, online book building, Fees are normally quoted as a flat percentage of the nominal and clearing and settlement instructions): These duties are amount issued, and they are paid in advance. The level allocated between the joint leads (see appendix 4). of the commission is a function of several variables. The main ones are the credit rating of the issuer, the maturity The joint leads are responsible for the largest share of of the issue, the condition of the market, and the power of the placement. The size of their share increases when the negotiation of the issuer to lower the fee where it wishes placement is expected to be difficult. The objective then is to do so. to give joint leads better control over the global order book. For external syndications, each market has generally 4.6.1.2. Co-leads: The Remaining PDs accepted levels of commissions for underwriting and Co-leads are given only a small share in the placement. selling fees. Fees tend to be the same across markets for They are expected to concentrate on bringing small orders comparable borrowers and structures. Fees for domestic from attractive accounts, that is, primarily investors new or syndications tend to align on the levels applying to external thus far seldom seen or ones located in a target geographical syndications. area. The objective is to avoid competing with the joint leads, who concentrate on large accounts. 37 Recognized dealers are financial intermediaries that have an official status as dealers in government securities. They have fewer commitments than PDs and lower rewards. 18 DOMESTIC SYnDICATIONS 4.6.1.3. Selling Group Members: The Recognized 4.6.3. Pricing Guidance, Collection of Orders, and Dealers Book Building Selling group members have the same mission as the co- A spread range is announced initially and is narrowed as leads, but their share in the placement is smaller and they the order book grows. One joint lead is responsible for are paid only a selling commission (no underwriting). centralizing the orders collected by the joint leads group. The BDA collects itself the orders gathered by the co-leads Note that, in theory, the joint leads and co-leads assume and selling group members. The book-building period an underwriting risk. In normal market conditions, this typically takes between one and three days. risk hardly exists in practice in view of the book-building procedure and the issuer’s flexibility in setting the date of 4.6.4. Names Transparency and Allocation the launch. Yet the underwriting risk cannot be totally Decisions excluded (e.g., if the market becomes difficult during the 1. Joint leads: Full transparency is required between joint launch process). leads. In principle, joint leads disclose all investor names to one another as well as to the BDA. In practice, joint leads 4.6.2. Syndication Structure are allowed to disclose a few names only to the BDA when The amount to be issued is usually split into three pools: they deem that transparency would be a leakage of market 1. “Pot” for the joint leads: All joint leads pool their orders. intelligence. The names in question are then reported as Every joint lead is paid the same commission irrespective of “X” accounts to the other joint leads. the amount of orders it has actually collected. The size of The allocation of orders is discussed between the joint leads the pot is usually between 65 and 80 percent of the amount and the BDA. In cases of disagreement, the final decision to be issued. is made by the BDA. 2. “Retention” for the co-leads (usually 1 percent for 2. Co-leads and selling group members: Partial each): The retention is a guaranteed allocation in the transparency is required. They disclose names only to the placement. BDA, which does the allocation. This procedure applies 3. “Strategic reserve” for the co-leads and selling group to both the retention and the strategic reserve.38 When members (usually around 15 percent): The strategic allocating the strategic reserve, the BDA checks that there reserve is an amount set aside that the BDA uses to give at is no duplication with orders in the books of the joint its discretion an additional allocation to the co-leads and leads and co-leads or selling group members respectively. selling group members who have collected orders that the If duplication is found, the order submitted by the co- BDA deems to be particularly attractive. leads and/or selling group members does not qualify for an allocation in the strategic reserve.39 In a few cases, the retention has been eliminated from the structure and incorporated into the strategic reserve, 4.6.5. Securities Allocation Rules thereby suppressing the guaranteed allocations. This The allocation rules are discussed by the BDA with the procedure has been applied when the placement was joint leads. The rules are flexible and informal and are expected to be difficult (e.g., volatile market conditions) not disclosed officially. The co-leads and selling group and/or requiring a special expertise (e.g., placement of a members are told only that “the BDA will give priority to very long maturity bond). small size quality orders which ideally should be first time purchasers of Belgian government securities.” Some target geographical areas are sometimes also indicated. 38 Therefore referred to as “blind retention” to indicate that the names of investors are seen only by the DMO. 39 Co-leads and selling group members are expected to concentrate on small orders from accounts that are not in the joint leads’ customer base. 4. Domestic Syndications 19 The allocation rules are set in two stages. First, before the Then, second, a correct fee ensures that the banks will start of the book-building process, the BDA conveys some support the deal in the secondary market. A firm price in general guidelines to the joint leads, usually the following: the secondary market gives a positive image of the issuer in the investor community. This facilitates the placement of • 80 percent, real money; 20 percent, trading accounts. the next syndication. The preferred real money accounts are central banks and stable long-term investors such as insurance companies and pension funds. Trading accounts include leveraged 4.7. Case Study 2: The Dutch Direct money, proprietary trading accounts, and traders’ long Auction (DDA) positions.40 In June 2003 the Dutch State Treasury Agency (DSTA) inaugurated a new issuance technique, the objective of • Guidance on target geographical areas, for example, which was to increase the participation of end investors in maximum 20 percent to resident investors or the primary market by offering all investors a level playing preference for Asian accounts. field with a transparent and objective allocation process.36 • No protected orders; that is, syndication members are By contrast with the standard domestic syndication, which forbidden to guarantee an allocation to any of their is an adaptation of the external syndications procedure, the customers. DDA is a hybrid between an auction and syndication. Then, second, upon the closing of the books, the percentage actually allocated to each category of investors is a function 4.7.1. Differences with the Traditional Domestic of the size and quality of the order book, that is, the extent Syndication Method of the oversubscription and the relative importance of the As in a standard domestic syndication, the appointed real money and trading accounts. For example, a significant managers in the auction are the PDs of the DSTA. share might have to be allocated to hedge funds if the book However, the DDA includes five innovations: is small and with a large component of trading accounts.41 First, the DSTA acts as the lead manager. It runs the order Central banks and small orders (less than €25 million) are book. The order book is seen only by the DSTA, which typically allocated 100 percent in any case. itself allocates the orders. The information on the orders and on their allocation is confidential. They are disclosed 4.6.6. Postsyndication Market only as an aggregate. To be supported in this role, the DSTA The responsibility for quoting prices for the syndicated appoints three PDs as its advisors in (1) determining the benchmark rests on the joint leads and all co-leads. They timing and the organization of the auction and (2) setting are all PDs, and the bond is a benchmark subject to a PD’s the range of the spread guidance. quoting obligation in any case. The BDA informally advises the joint leads that their compliance with the obligation to Second, the PDs do not underwrite the issue. They only make bid and offer prices to support the liquidity of the collect orders from their customers. As in a standard bond will be monitored particularly closely. syndication, customers can at their discretion choose one single PD for the whole amount of their order or they can split their order between several PDs. 4.6.7. Syndication Fees The policy of the BDA is to pay whatever the prevailing Third, the allocation rules are preannounced and firm. market rate for the commission is. The BDA never Overall, the allocation process is the same as in a uniform negotiates to lower a commission below that level. This price auction. All bids submitted at a level higher than policy rests on the observation that, first, the degree of the cutoff price are allocated in full. Investors bidding expertise and commitment of the staff assigned by banks at tighter levels are thus given priority. Bids at the cutoff to the deal is a direct function of the level of the fee paid price are allocated proportionately. At equal bid level, early by the issuer. Low commissions impair the quality of the bidders are allocated ahead of those coming later, and real service provided and thereby the success of the transaction. money accounts are allocated ahead of trading accounts. 40 In principle, joint leads should have no long trading positions. On the other hand, joint leads are expected to keep short positions to support the secondary market. 41 An alternative is to downsize the deal to preserve the quality of secondary market performance. 20 DOMESTIC SYnDICATIONS However, the DSTA reserves the right to allocate in any 3. The responsibility for ensuring a good performance event a certain percentage to trading accounts with a view of the bonds on the secondary market is diluted: In a to enhancing the liquidity of the secondary market. traditional syndication, this responsibility rests primarily on the joint leads. The DDA uses no joint leads. Fourth, the DSTA is in direct contact with the customers as it sends to the successful bidders a “thank you” note 4. An advisor’s mandate in the DDA does not count for their order. In this way, the DSTA can check whether in the calculation of rankings in the league tables: the banks have effectively allocated to their customers the As a result, the DDA is a lost opportunity for the issuer amounts that the DSTA has instructed them to do. to reward its best performing PDs. The banks are less motivated for the deal and also possibly less committed to Fifth, the commissions paid by the DSTA are lower than the issuer overall. in a standard syndication (management and underwriting commission). The DSTA pays an advisory commission to 4.7.3. Conclusion its advisors and only a selling commission to the other PDs. Currently consensus among DMOs in the European Union is that issuers are better off maintaining flexibility 4.7.2. Analysis in deciding allocations, provided the allocation criteria are The DDA claims to have two advantages: for the PDs, clear. No conclusive evidence is found that investors are the creation of a level playing field, and for investors, the bidding at better prices in a DDA than in a traditional implementation of objective allocation criteria. domestic syndication. The DDA has also four drawbacks, at least in the context of So far, the DSTA is the only DMO using the DDA mature markets, by comparison with a more conventional procedure. However, Mexico adjusted its domestic syndication: syndication procedure in July 2011 to switch from a book- 1. A mechanical allocation may not always be optimal: building system to an auctioned syndication system, which For instance, in relation to the priority given to time of is comparable in many ways to the DDA. orders. Some Asian investors are typically slow to move, yet they may be a target. Likewise, in relation to priority 4.8. Case Study 2: Mexico for the tightest spreads: a trading account can then be given Mexico made its first domestic syndication in February precedence over a target real money account. Issuers may 2010 with the launch of a 10-year benchmark bond.42 The therefore prefer to make tailored allocations as a function government then reported that the launching of benchmarks of what they deem to be best in the circumstances. with domestic syndication will be a standing policy. There is also a lack of clarity in some of the counterparts’ classification. As an example, the difference between banks, 4.8.1. Innovative Objective Pursued asset managers, and fund managers may not always be clear. The Ministry of Finance (MoF) pursued four objectives when doing its first domestic syndication. Three objectives 2. The procedure can be too transparent for the are common practice, and one is an innovation. market: As an example, in a traditional syndication, the price guidance is discussed by the issuer only with the As reported by the MoF, the “common practice” objectives joint leads. Admittedly, the latter have market sensitive pursued by the syndication were “(1) to reach an adequate information ahead of the co-leads. However, it offers them outstanding amount at the inaugural issuance; (2) to place the possibility of managing the communication process to the security amongst a broader investor base in order to the market. In a DDA, there is no external lead manager. ensure the liquidity of the benchmark in the secondary Thus, all announcements (book size, changes in the price market; and (3) to strengthen the issuance process given guidance, etc.) are published on the screens. This is not the certainty of price, amount and broad investor distribution.” most efficient procedure when the placement begins with a slow momentum. 42 The information below has been sourced primarily from Secretaria de Hacienda y Crédito Público (2010). 4. Domestic Syndications 21 The innovative objective was to have the benchmark become Book-building syndications (BBSs) and ASs pursue immediately eligible for inclusion in the global fixed rate the same objectives. The first objective is to increase the income indices43 used by local and international investors amount issued upfront so as to have a liquid issue and a to monitor markets’ performance. In most global indices, bond eligible from the start for inclusion in global bond a minimum amount outstanding per bond is required to indices. Both types of syndications achieve this objective be included in standalone indices. Consequently inclusion because of a bond in an index represents a potential tool to attract foreign investment. • Investors are attracted by the prospect of buying a very liquid bond In Mexico, the track record of auctions in 2009 showed • PDs are motivated to place the bond for a commission two problems: (1) it took about 10.5 months for the and outstanding amount of a 10-year benchmark to reach the • The launch of a benchmark can be made a marketing size of Mex$25 billion, which is required for inclusion event. in most bond indices, and (2) the bond tended to be of uneven liquidity during the interim period and vulnerable The second objective is to widen the investor base. The to market squeezes at the point when it integrated the share of foreign investors is close to 20 percent in both indices. BBSs and ASs. The specific features of BBSs and ASs are summarized in 4.8.2. The Results Achieved table 4.1. At the inaugural transaction, the syndicated mechanism allowed debt of Mex$25 billion44 to be issued. This allowed In practice: the bond to be included in the global fixed rate income • The Treasury has organized a conference call with indices from the start. The book-building process also investors for all BBSs. For ASs, a conference call was diversified the investor base, including 20 percent placed arranged only for the first two issues (when the Treasury with nonresident investors.45 Moroever, the trading of the switched from BBSs to ASs for the second transaction). new 10-year bond has been greater than the previous 10- year references. • The amount issued has been identical for both types of syndications (Mex$25 billion for M bonds with the 4.8.3. The Two Different Procedures Implemented aforementioned exception in July 2012 for the five-year by Mexico maturity of Mex$30 billion). Mexico initially implemented a book-building process, • The range of maturities issued has likewise been the similar to that in EU countries (with the exception of same for both types of syndications (5, 10, 20, and 30 the Netherlands). For its inaugural syndicate transaction, years). the MoF appointed as joint leads the four PDs ranked as best market makers46 and the next three best ones as co- • The yield of ASs has been on average 7 bps below the managers. As of June 2011, five benchmarks had been maximum yield limit announced upfront by the MoF.48 syndicated. In July 2011 Mexico adjusted its domestic syndication procedures by switching to an auctioned • The bid/cover ratio of ASs has been a little lower than syndication (AS) system. The latter has some similarities for BBSs. However, this can be explained by the limit set with the DDA system (see section 4.7). Five ASs had been in ASs on the maximum amount accepted per investor. completed as of September 2012.47 In BBSs investors tend to “balloon” the amount of their bids in successful syndications with a view to offset the impact of the pro rata allocation. 43 For example, GEMX, GBI-EM (Morgan), and WGBI (Citi). 44 In fact, the book was almost three times oversubscribed with more than Mex$73 billion in 135 orders. 45 Ten percent in Europe and 10 percent in the United States. 46 Santander, JP Morgan, Bank of America, and BBVA Bancomer. 47 Two in 2011 (July and September) and three in 2012 (February, March, September). Maturities range across 5, 10, 20, and 30 years. Amounts are constant for M bonds: Mex$25 billion (except in July 2012 when a five-year maturity was syndicated for Mex$30 billion). 48 The yield of each issue depends on different variables such as market conditions, type of benchmark, or type of instrument. 22 DOMESTIC SYnDICATIONS Table 4.1 Specific Features of Book-Building Syndications (BBS) and Auctioned Syndications (AS) BBS AS Traditional syndication Similar to Dutch DDA • Small number of lead managers and • All PDs acting as market makers at the time the auction is taking place co-lead managers are joint leads (no co-leads) • Issue is underwritten • Two limits are announced upfront: • A book-building period is useda • (1) maximum yield accepted • Selective allocation to investors • (2) Maximum amount accepted from any single investor expressed as a percentage of the amount issued • Firm allocation rules (by price up to the maximum authorized amount: same allocation procedure as in a uniform price auction)b • One-hour bidding period Advantages Advantages • Selectively chosen investor base • More competition in setting the issue price (e.g., to privilege foreigners or • More level playing field for PDs stable investors or to enhance • Lower commissions secondary market liquidity) • Confidentiality for customer ordersc • Commitment of joint leads to ensure price stability and secondary market liquidity Drawbacks Drawbacks • Less competition in setting the issue • Potentially suboptimal investor base price • Potentially less commitment of the banks to look after the secondary • Higher commissions market (liquidity and price stability: see note below). Note: A joint lead mandate in an AS does not count in the calculation of rankings in league tables. This is considered to be a drawback in the DDA procedure. It is less of a drawback in Mexico because of the comparatively smaller involvement of international banks in the market. However, the MoF states that, in practice, the switch from BBSs to ASs has not affected the liquidity of the secondary market. a. The average book-building period has been two days. b. The price of the bid therefore has an impact only on the allocation. c. In a BBS, the allocation is transparent for all joint leads (“pot”) • The share of foreign investors has been marginally higher has evolved along the way, starting with a book-building for ASs. However, this can be explained by the fact that process and moving toward an AS system close—but not the AS procedure by then had become better known identical—to the DDA. abroad. A link can be seen between the optimal structure of a domestic syndication and the degree of development of the 4.9. Choosing the Most Efficient Domestic government securities market. Mature markets prefer the Syndication Structure syndication-type book-building procedure. Book building The case studies show that domestic syndications can be helps in maximizing the size of the order book. DMOs also structured in different ways. The structure originated by value the flexibility of the discretionary allocation of orders the BDA has many features in common with external because it enables them to optimize the composition of the syndications. It is the procedure currently prevailing in the investor base. Finally, the procedure provides the strongest European Union. The structure pioneered by the DSTA motivation to the banks because a joint lead mandate raises is a hybrid between a syndication and an auction. The rankings in league tables. Mexican system stands between these two procedures. It 4. Domestic Syndications 23 A domestic syndication with some auction features could The DMO has to be perceived as a credible and skillful be more efficient in emerging markets. Four reasons can issuer. The DMO’s reputation and credibility can play an be given. First, this procedure strengthens competition important role in attracting investors to participate in a in setting the issuance price. In mature markets, the syndication. scrutiny by the financial press and the attention paid to peers’ comments provide safeguards ensuring that the When the DMO has a PD system, a sufficient number price is technically correct. These safeguards would not be of PDs have to master the required technical expertise. A as effective in an emerging market. Second, it guarantees syndication done with banks that are not PDs loses some complete confidentiality for all orders in the book. This of its benefits, such as increased competition among PDs can be valuable for a placement focused on a small local to perform better in the primary and secondary markets. market. Third, the complete transparency in the criteria Particularly for BBSs, four additional factors play a major for allocating orders can help the issuer in building trust role: and credibility. The potential for a discretionary allocation of orders is probably limited in any case. The prerequisite 1. Selection of joint lead managers: Joint lead managers for a syndication—a significant oversubscription—could should have complementary strengths. They should not be be met only rarely in a developing market. Last, a domestic too numerous to preserve their motivation and facilitate syndication with some auction features creates a more level their coordination by the DMO. The optimal number playing field for PDs. This could support the development is a function of the amount and of the difficulty of the of the PD system. placement. Some syndications have been done with up to five or six joint leads. Three joint leads often seems to be Irrespective of the selected structure, the government the best number. securities market should have a certain minimum degree of development for a domestic syndication to be efficient. 2. Commissions: DMOs are advised to pay the market Domestic syndications are intended to help in building rate as opposed to selecting the banks that charge the lowest large lines of which the outstanding will be further commissions (section 4.10). Syndication fees are generally increased by auctions. A prerequisite is an already active a worthwhile investment.49 benchmark issuance policy using reopening of lines as a 3. Structure of a syndication: The structures combining standard procedure. Domestic syndications are intended a “pot system” for joint leads and a strategic reserve for co- also to create a liquid market from day one. There is no leads seem to be particularly efficient. The equal sharing of point in pursuing this objective if little or no activity takes commissions enhances the cooperation between joint leads. place in the secondary market even for seasoned issues. The possibility of receiving an additional allocation for attractive orders while preserving confidentiality enhances 4.10. Factors Contributing to the Success the motivation of the co-leads.50 of a Domestic Syndication It is important that the DMO clearly communicates to the 4. Investor base: The DMO should be actively involved market the reason why it is planning to do a syndication, in directing joint leads where to look for orders and in that is, the benefits it is seeking to achieve. This should allocating the orders brought by the syndicate group. be done after conducting thorough market research in consultation with PDs and final investors. Syndication may be needed to achieve certain objectives (e.g., size, market liquidity, investor diversification, and/or price discovery). Syndication would not be beneficial if these objectives have been achieved already. As an illustration, Brazil is said not to have not sought to do syndications for this reason. 49 However, some countries face a problem that the fees are treated above the line in government accounts, not netted off against debt interest. 50 The order book of the co-leads is open only to the DMO. 24 DOMESTIC SYnDICATIONS 4.11. Syndications in the Absence of a PD Over time, however, the number of qualified syndication System participants can be expected to grow. At this stage, one No precedent is seen so far of a domestic syndication done would recommend not to increase further the number of by an issuer with no appointed PDs. joint leads beyond three or four but to appoint co-leads instead. The number of joint leads is best kept small to In the absence of a PD system, the appointment of only ensure good coordination and no dilution of responsibility. three or four banks may be enough. Ideally the MoF should However, the appointment of co-leads helps the investors’ appoint as joint leads and co-leads only banks that are base to diversify further as a result of instructing the co- perceived to have a potential interest in, and the capacity leads to concentrate on small “quality accounts”51 (a policy for, playing an active role in the government securities that they should naturally be inclined to follow in any case market. If, in practice, the MoF can realistically count on in view of their small share in the placement). The fact that a very limited number of financial institutions to become the identity of the co-leads’ accounts is not disclosed to the active participants in the primary and secondary markets, joint leads (blind retention) is a further incentive for the co- the appointment of only three or four joint leads to manage leads to offer good quality names. Last, the appointment of the syndication appears to be the correct strategy. co-leads is also a good way to test the placement capabilities of the banks in question. In this way, syndication can pave the way for the future implementation of a PD system. 51 A quality account is usually defined as a stable real money investor who will hold on to the bond for some time and who has the potential to buy more bonds later if it is pleased with the investment. Central banks typically belong to this category. A real money investor, who has the reputation of taking its profit or its loss fast, without being a market maker and doing nothing to enhance the liquidity of the secondary market, is not a quality account. 5. Conclusion 25 5. Conclusion Historically, syndications have been used only in issuances of foreign currency–denominated bonds in external markets. This has changed since 1999. Many DMOs view domestic syndications as an efficient tool for both small and large issuers whenever the target investor base includes entities located beyond the national borders of the relevant issuer. Small issuers have been attracted by the possibility of issuing larger amounts. Larger issuers have been attracted by a better quality of price discovery. In both cases, syndicated bond issues are more liquid. Prices in the secondary market are usually firmer for syndicated issues. Syndications can enhance the motivation of PDs to deliver a good performance in the execution of their duties. In view of the aforementioned benefits, any reasonable syndication commission is a worthwhile investment. Domestic syndication has prerequisites, limitations, and drawbacks. In particular, the DMO has to be clear on the objectives to be achieved. These objectives should be communicated to the market. Domestic syndications are a complement to, not a substitute for, auctions. They are a time-consuming procedure, and they are not as straightforward a competitive process as an auction. On balance, however, domestic syndication is an efficient securities placement procedure, the use of which is expected to spread further across government securities markets. 52 52 In case a by-law or a decree is needed to allow this new bond placement procedure, a summary of provisions that could be incorporated in the relevant document is given in appendix 5. References 27 References Blommestein, Hans J. 2009. “New Challenges in the Use of Government Debt Issuance Procedures, Techniques and Policies in OECD Markets.” Financial Market Trends, OECD. Gemloc Peer Group Dialogue meetings of September 23 and 29, 2010: “Syndications as an Alternative Placement Mechanism for Domestic Government Debt Issues.” www.gemloc. org. Twelve countries participated: on September 23, Brazil, Hungary, Mexico, Poland, South Africa, and Turkey; on September 29, Costa Rica, Egypt, Morocco, Pakistan, Romania, Uruguay. Secretaria de Hacienda y Crédito Público. 2010. “10-Year M Bond Syndicated Issuance. A Successful Placement of Government Debt through a New Mechanism in the Primary Domestic Market.” www.shcp.gob.mx. Appendix 1: Comparison: Syndication versus Private Placement 29 Appendix 1: Comparison: Syndication versus Private Placement Private Placement Syndication Counterparty One or two financial A syndicate group institutions Investors One or two targeted A wide range of investors investors Timing Bilateral consensus Market driven Size Relatively small; Total size Larger; Gradual build-up pre-underwritten through book building Maturity Bilateral consensus Standard Commitment None: both parties can Joint leads commit to subscribe; call the deal off up to last Issuer commits to issue once the minute deal is launched Pricing Pre-negotiated Preset range; Refined on basis of investor interest Documentation Issue driven; Often International Security prepared by counterparty Management Association Trading Inactive; Buy and hold Active trading Listing No Yes Rated No Generally yes Source: BDA presentation “Syndicated OLO Issuance, Overview.” Appendix 2: First Meeting of DMO with Joint Leads, Usual Agenda 31 Appendix 2: First Meeting of DMO with Joint Leads, Usual Agenda • Rationale for the transaction • Syndication commissions • Terms of the new bond (maturity, coupon, settlement) • Structure of the syndication • Time table • Marketing and targeted investor base • Pricing process (reference rate, pricing methodology, first suggested pricing range) • Duration manager • Book-building process • Legal documentation • Clearing and settlement procedure • Communication to syndicate members • Wording of minister’s announcements • Press • Listing • Working party list (who does what) • Timing of first conference call Appendix 3: Syndication Commissions (Basis Points, Flat) 33 Appendix 3: Syndication Commissions (Basis Points, Flat) Europe BDA 1999 2002 2004 2008 2010 2011 5 years 15 10 12.5 12.5 10 years 22.5 15 17.5 17.5 15 years 17.5 17.5 20 25 years 25 30 years 27.5 DSTA Advisor, 8 bp (as of 2008); others, 5 bp Latin America Brazil: Usually pays between 25 and 30 bp for any tenor Chile: Paid 15 bp for four-year FRN in 2004 Colombia: Usually pays between 30 and 40 bp Mexico: Paid 25 bp for 30-year bond in 2008 Source: Informal sources; indicative figures. Appendix 4: Allocation of Duties between Joint Leads at the BDA 35 Appendix 4: Allocation of Duties between Joint Leads at the BDA The usual duties assigned by the BDA are the following: Communication manager: Responsible for delivering all the information intended for a syndicate group. The objective is that all members of the syndicate are informed at the same time. Press manager: Responsible for organizing contacts in the BDA with the press. Execution manager: The execution manager is in charge of the book-building process. It provides the BDA with a written summary of the strategy suggested by joint leads. It collects and summarizes the information provided by joint leads regarding their target investor list and their qualitative feedback during the book-building process. It updates the outstanding order book submitted to the BDA twice a day. After order allocation has been discussed jointly by the BDA and all joint leads, the execution manager submits to the BDA’s approval the final allocations, and it is responsible for dispatching the approved allocations to the members of the syndicate. Duration manager: The duration manager is a joint lead designated by the BDA to be a counterparty of the other members of the syndicate for the execution of their customers’ switch orders.53 53 Customers can submit their orders to the syndicate group either for cash or on a switch basis, in which case, as in a bond exchange auction, they state their willingness to exchange a certain old bond at a yield of “x” bp over the yield of the syndicated benchmark. Appendix 5: Input to Assist in Drafting of a By-law on the Recommended Bond Placement Scheme 37 Appendix 5: Input to Assist in Drafting of a By-law on the Recommended Bond Placement Scheme The objective of the government is to reduce or eliminate the liquidity premium currently paid on the bonds issued in the domestic market until they reach benchmark size. To meet this objective, the MoF has to create a competitive security issuance procedure based on a market mechanism that increases the number of participants to allow for a wider distribution of holdings, decreases the amount of time needed for a bond to reach benchmark size, and increases the liquidity of the secondary market. The syndicated issuance of new benchmark bonds allows for issuing larger amounts than in the framework of auctions by attracting a wider number of end investors to the primary market, including nonresident investors. As a result, this issuance method also fosters the development of the secondary market. The subsequent tapping of bonds in the framework of an auction calendar facilitates further increasing the outstanding amount issued while firmly anchoring benchmark bonds to the domestic market. This issuance procedure is widely implemented by public debt managers abroad. Therefore, 1. The MoF is empowered to syndicate the issuance of new benchmark bonds in the local market.54 2. The target issuance amount and composition of the syndicate group proposed by the DMO must be approved by the MoF. 3. The syndicated benchmark can be subsequently tapped in the framework of the auction calendar published by the MoF. 4. The bond auction scheduled to take place on the month during which the syndication is carried out can be canceled.55 54 Only as an example, the Belgian legislation does not refer specifically to the issuance of new benchmark bonds by syndications. Instead, it refers in general terms to “the first tranche(s) of a bond issue” and to “any form of underwriting conforming to market practices.” This allows for more flexibility in adapting to new market developments, if any. 55 The use of “can be” instead of “is” reflects only the writers’ personal view that the best regulations are the ones that leave the maximum flexibility to a public debt manager to do what he or she believes to be the best in the circumstances without needlessly being constrained by too precise instructions, sometimes written a long time before! Who knows what the market could be like tomorrow?