Statements to the Congress.

I am pleased to have this opportunity to appear before you this morning to share with you my observations on the Joint Report on the Government Securities Market, with particular emphasis on those aspects of the report that relate directly to the activities or responsibilities of the Federal Reserve Bank of New York.

Let me say at the outset that I strongly support the overall thrust of the joint report. Taken as a whole, the changes and legislative recommendations outlined in the report represent a comprehensive yet well-balanced approach to the problems that surfaced in the government securities market last year. Let me quickly add that the changes are at or near the outer threshold of what I believe the market can reasonably absorb in the near term without running undue risks to market efficiency, Treasury debt management practices, or the flexibility of Federal Reserve open market operations.

With those general observations in mind, let me turn to the specific aspects of the report that relate directly to the responsibilities of the Federal Reserve Bank of New York. There are three such major areas: first, the changes in the Bank's administration of relationships with primary dealers; second, the Bank's role in the development, testing, and implementation of new automated systems for Treasury auctions and Federal Reserve open market operations; and third, the Bank's expanded role with regard to day-to-day surveillance of the government securities market. The statement concludes with a brief status report from the Federal Reserve's standpoint on the Salomon Brothers situation, as requested by the committee.

ADMINISTRATION OF RELATIONSHIPS WITH

PRIMARY DEALERS

Attached to this statement is a paper issued late last month by the Federal Reserve Bank of New York outlining revised procedures for the administration of the Bank's relationships with primary dealers. (1) Although that document itself represents a careful balancing of many considerations and viewpoints, it is based on the following key and interrelated considerations:

First, although change was needed, the complete dismantling of the primary-dealer system--including the responsibility of dealers to make markets for Federal Reserve open market operations and to participate meaningfully in Treasury auctions--would not have been a prudent step.

Second, it was important to provide for a more "open" system of primary dealers, in part because the existing approach has been viewed as conferring on dealer firms special status that carries with it elements of "franchise" value, and in part because of fairness and equity considerations. This provision has been accomplished by the elimination of the so-called 1 percent market share requirement and the use of straighforward and objective capital standards for eligibility as a primary dealer. Taken together, these changes will substantially increase the potential number of firms that can become primary dealers.

Third, it was important that the Federal Reserve Bank of New York make absolutely clear to the marketplace that the Bank does not regulate the primary-dealer firms, in part because of "moral hazard" considerations and in part because of legal and regulatory realities. For this reason we are disbanding the Bank's dealer surveillance unit.

Fourth, for obvious reasons, it was necessary to clarify the reasons and the conditions under which the Federal Reserve Bank of New York would alter its relationship with a primary-dealer firm. Under the new administrative procedures, the three independent sets of circumstances under which that might occur, are the following:

* A dealer firm's status will be altered if the firm fails to meet its responsibilities to make reasonable markets for Federal Reserve open market operations or if it fails to participate meaningfully in Treasury auctions or if it fails to meet its responsibilities to provide the Federal Reserve with meaningful market intelligence over time. To the extent that a firm's dealer status is altered for any or all of the above reasons, that action by the Federal Reserve will reflect considerations relation to the business relationship alone and will carry no implication about the creditworthiness, financial strength, or managerial competence of the firm.

* A dealer firm's status will be altered if its capital falls below the relevant capital standards and it does not, in the eyes of its primary federal regulator, have a credible plan to restore such capital in a reasonable period of time.

* A dealer firm's status will be altered if the firm is convicted of a felony under U.S. law or pleads guilty or nolo contendere to a felony under U.S. law for activities directly or indirectly related to its business relationship with the Federal Reserve. This provision should create powerful incentives for a firm--when faced with wrongdoing by individual employees--to take immediate and strong actions to root out the source of the problem to minimize the risk to that firm.

Although major elements of the changes in the administration of the relationships with primary dealers will begin to take place immediately, the full benefits of these changes will occur only as the automation of Treasury auctions and Federal Reserve open market operations take place and as the other changes contemplated by the Joint Report take hold. Over time, however, the automation efforts may prove particularly important. These initiatives are described below.

AUTOMATION EFFORTS OF THE FEDERAL

RESERVE BANK OF NEW YORK

The design work for the automation of the competitive bidding portion of Treasury auctions based on existing auction techniques has been under way for some time and should be completed late this year. The software for the automation of the auctions is not particularly difficult to develop. The difficult aspects of this task relate more to its communications system--particularly as the number and nature of prospective direct participants in the auctions change. But what makes this automation effort especially difficult is the need to build into the computer systems and the communications systems a very high level of operation integrity as well as multiple levels of backup for various contingencies.

If the Treasury were to decide to move to a different auction technique, the strategy would be to enhance the system now being developed to accommodate both types of auctions. Although important elements of the work being done for the current auction procedures can be used with a new auction technique, the enhancement of the system being developed to accommodate the new procedures will take some time after the requirements have been defined. This enhancement will not, however, delay the planned implementation of automated procedures for the current auction by the end of this year.

The committee might gain a more useful insight into exactly how the automated Treasury auction system will work in practice if the major characteristics of the system are thought of, at the risk of a great oversimplification, in the following terms:

First, each institution that is "eligible" to submit competitive bids in Treasury auctions would have a terminal-based telecommunications link to the Federal Reserve Bank of New York, either directly or through another Federal Reserve Bank. The basic "hardware" used for this purpose will be the FedLine terminal that is currently used in more than 9,000 depository institutions nationwide. The communications network will be the proven and highly reliable Fedwire telecommunications system. Finally, the new auction system will utilize the same security and encryption devices that are currently used for Fedwire operations.

Second, for each such "eligible" bidder, certain data--including any affiliations with other "eligible" bidders--would have to be housed in our database, as would acceptable methods for making payment for securities and for receiving delivery of securities awarded in the auctions. Because payment and delivery must be made in electronic form, nonbanks would have to have suitable "auto-charge" agreements in place with banks for this purpose.

Third, after electronic announcements of notices of auctions, bidders would be able to submit bids electronically until the auction cutoff time, which currently is 1:00 p.m. Eastern time. To provide adequate backup for contingencies, however, the system must be designed so that all bids can be routed to both the Federal Reserve Bank of New York's main data processing center in lower Manhattan and its remote backup processing center.

Fourth, the computers would then sort through the bids on the basis of the highest prices (lowest yields) received, in much the same fashion as in today's manual procedures. As a part of this process, several internal audit and control procedures are planned to ensure compliance with Treasury auction rules and to "flag" outlier bids, including those resulting from clerical errors in message preparation.

Fifth, once the proper audits have been performed, the information has been sent to the Treasury, and the "awards" have been made, the payment for and delivery of the securities must be initiated and completed. This process will be carried out through the Federal Reserve's money and securities transfer systems (Fedwire).

Finally, and in the normal course, after the initial delivery and payment for the securities in question is completed, end-of-day verifications and reconcilements must be made as a part of the overall controls on operating systems that often handle more than $1 trillion of transaction per day.

The full automation of Federal Reserve open market operations is even a more complex and time-consuming task, especially because it is impossible to prejudge with any precision the number, location, and other characteristics of potential counterparties for such operations. Moreover, the operating systems and communications systems associated with this effort must be integrated with several other highly complex automated systems, including the Federal Reserve's existing money and securities transfer systems. Because of this complexity, an extraordinarily high level of reliability and integrity will be needed. To illustrate the concerns I have in mind, just imagine for a moment what might have occurred on the morning of October 20, 1987, if the Federal Reserve had been unable--because of technical problems with such a system--to furnish substantial liquidity through open market operations as a part of the effort to stabilize financial markets in the wake of the stock market crash.

THE ROLE OF THE FEDERAL RESERVE

BANK OF NEW YORK IN THE MARKET

SURVEILLANCE PROCESS

Little needs to be added to what is contained in the joint report as it pertains to the expanded role of the Federal Reserve Bank of New York--in cooperation with the other agencies--with regard to day-to-day surveillance of the government securities market except to emphasize that (1) market surveillance is quite distinct from dealer surveillance, which we are discontinuing and (2) it will take some time to put in place the new or altered statistical reporting arrangements that might be agreed upon by the interagency surveillance working group over the period immediately ahead.

As a first step, the Federal Reserve Bank of New York expects to have the initial redeployment of key personnel necessary for this effort in place later this month. Final decisions about the number and mix of personnel needed for this effort will have to await agreement among the agencies about the precise scope and nature of the statistical reporting and other aspects of the market surveillance effort, which should be essentially completed in a month or two.

THE SALOMON BROTHERS SITUATION

Because the official investigation into the Salomon Brothers wrongdoings is still under way, very little can be said at this time regarding the particulars of that situation. The firm, in response to inquiries by the Federal Reserve Bank of New York, has provided the Bank with several reports over the period of September through December 1991. In general, these reports cover (1) the sweeping changes in management and management structure that were put in place after the disclosures made by the firm last August, (2) the major changes in internal control procedures and compliance systems that have been put in place over the period in question, (3) various estimates of the profits associated with the auctions in which irregularities have been acknowledged by the firm, and (4) further details regarding the firm's financing activities in certain of the Treasury issues. All relevant materials have been made available to the Securities and Exchange Commission (SEC) and the U.S. Attorney.

It is contemplated that any decision by the Federal Reserve Bank of New York regarding the status of Salomon Brothers as a primary dealer will be made in the context of the findings reached by the SEC as a result of its ongoing investigation of the matter. This approach, which has the support of the other agencies, is being followed in deference to fairness and due process considerations and to minimize uncertainties that might follow from multiple and uncoordinated announcements of this nature. The timing of the Salomon Brothers episode is such that certain sanctions by the Federal Reserve Bank of New York might apply even if the firm is not convicted of, or if it pleads guilty or nolo contendere to, a felony under U.S. law.

(1) The attachment to this statement is available on request from Publications Services, Board of Governors of the Federal Reserve System, Washington, DC 20551.