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Statements to the Congress.

Statement by E. Gerald Corrigan, President, Federal Reserve Bank of New York, before the Subcommittee on Securities of the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, September 11, 1991

I am pleased to appear before you this morning to shed further light on the Salomon Brothers incident and to share with you my views on the workings of the government securities market. I also want to provide some general thoughts as to how we can best ensure that this vital market remains the most efficient, liquid, and trusted market in the world.


Among the private participants in the market for government securities are the so-called primary dealers in U.S. government securities with whom the Federal Reserve Bank of New York conducts its open market operations. The primary dealers are the main market makers for government debt. They maintain two-way markets for government securities and participate directly and actively in the Treasury's auctions. Today, there are thirty-nine primary dealers-about half are banks or securities affiliates of banks, and half are diversified or specialized securities firms. All Federal Reserve transactions in the market, whether for its own account or for the accounts of other official institutions, are conducted with primary dealers. During 1990, the aggregate volume of such transactions conducted by the Federal Reserve with primary dealers was close to $525 billion.

The mere fact that the Federal Reserve Bank of New York must conduct transactions with private-sector counterparties implies, of necessity, that the Bank incurs the same elements of counterparty credit, delivery, and settlement risk that any private-sector participant in the market also incurs. For this reason, the Bank has established criteria for selecting those firms with whom the Bank does business. (The criteria for primary dealers are described in attachment A.1) It should also be noted that in several other major industrial countries there are broadly similar arrangements between central banks and a designated group of firms with whom those central banks conduct their business.

It is important to note that the role of the Federal Reserve Bank of New York in its business relationship with the primary dealers takes place in a framework in which the Federal Reserve has limited statutory authority to regulate or supervise primary dealers. Indeed, the Government Securities Act of 1986 established a formal supervisory and regulatory framework for the government securities market for the first time, with the Treasury as rulemaker and the Securities and Exchange Commission (SEC) and banking supervisors responsible for enforcement.

The number of primary dealers has varied over the years as the U.S. Treasury market has grown. From eighteen in the early 1960s, the number increased to twenty-three in 1971 and to thirty-six in 1981. Today there are thirty-nine primary dealers, after peaking at forty-six in 1988. As profitability ebbs and flows, firms come and go as primary dealers. For example, during 1990, two firms were added while five firms withdrew. Thus far in 1991, two more have left. These firms are expected to facilitate the Federal Reserve's open market operations, to make markets in the full range of U.S. government securities for customers in good times and bad, and to be consistent and meaningful participants in Treasury auctions of new securities.

From time to time, the Federal Reserve Bank of New York has carefully considered possible changes in its approach to the selection of those entities with whom it will do business. Those deliberations always collide head-on with two realities that seem to limit practical alternatives to current arrangements. First, the fact that we must deal with private-sector counterparties necessarily implies that some will be chosen and some will not. Second, the fact that some will be chosen and others not necessarily implies that whether they are called primary dealers or not, the unique relationship between the Federal Reserve Bank of New York and those entities with whom the Bank does business will remain. Recent events obviously have called into even sharper focus these difficult questions.

While the primary dealer system is, in the first instance, based on business counterparty relationships, our interests in the health and well-being of the market extend beyond that narrow framework. The breadth, depth, and liquidity of this market are essential characteristics that the Federal Reserve relies on for the implementation of monetary policy, the Treasury relies on for financing the federal government, and investors rely on in committing their funds.

In summary, the primary dealer arrangement fundamentally grows out of the fact that the Federal Reserve, like other central banks, must-as a wholly practical matter-conduct market operations with private-sector counterparties. It is therefore, in the first instance, a business relationship. Having said that, we recognize fully that as the central bank and fiscal agent for the Treasury we have a natural interest in the smooth workings of the market. We also recognize that our public nature and our participation in the market make it impossible to fully or even materially ignore the reality that our relationship with the market surely carries with it the implication that we are one of its "regulators."

For example, the mere presence of our limited program for the periodic monitoring of primary dealers and the fact that we regularly collect certain statistical information from the dealers create that impression. However, I should stress that the primary dealer monitoring program is quite narrow in its purpose and its scope and is not remotely similar to the bank examination program. The basic purpose of the monitoring program is to satisfy ourselves that the Federal Reserve-by virtue of its transactions with dealers-is not incurring unacceptable risk of financial loss in a context in which the nature of our transactions with dealers is relatively low in risk to begin with.

The data and information that we collect from primary dealers are aimed at providing broad insights into the workings of the market. These information-gathering activities have never been structured with a view toward enforcement or compliance activities, even though we fully recognize that there will always be a degree of overlap between these functions and our broad market-monitoring activities. For example, with the one exception of the so-called when-issued statistical report, none of the data we collect from the dealers on positions and turnover are specific as to any one security. We receive weekly data, grouped by broad maturity ranges. As such, these reports have virtually no utility in detecting the kind of problem that arose in the Salomon case because they were not designed for that purpose. Even the when-issued report, which is daily, has very limited utility in this regard.

In these circumstances, it follows quite naturally that as a part of our overall review of the lessons to be learned from the Salomon case, we will take a fresh look at these programs to see what changes may be needed and how those changes can best be coordinated with the needs of the Department of the Treasury and the Securities and Exchange Commission (SEC).

There is one last point regarding the system of primary dealers that should be discussed to fully grasp the dynamics of these arrangements. Namely, why do firms-domestic and foreign-want to be primary dealers in the first place? In part, the answer to that question is straightforward because some firms must judge that this particular function is an economically effective way to deploy their capital. In point of fact, however, returns on capital for primary dealers do not come easily. Indeed, it is not at all unusual for individual primary dealers to lose money. In fact, we have had any number of years in which a significant fraction of individual dealers has incurred losses in their operations in government securities.

For some, however, low returns and even periodic losses are tolerable because the firm may judge that having a major presence in this market is important because of the synergies that arise with other aspects of the firm's business here and abroad. In other words, the unique character and importance of the market for U.S. government securities may be such that some firms view a major presence in that market as so important to their overall business strategy that even subpar returns on capital deployed to this specific activity are acceptable.

There is another factor that may also be relevant in this regard-although its importance is diminishing. Historically, interdealer brokers in government securities made the wholly private business decision to provide access to the so-called brokers wires on a "no-name give-up" basis only to primary dealers. The Federal Reserve played no role in that decision and has sought to distance itself from it. With changing technology and more widespread price dissemination, that practice is now breaking down. The Federal Reserve wholeheartedly supports initiatives that move in that direction so long, of course, as these initiatives are consistent with the dictates of efficiency, reliability, stability, and soundness of the marketplace as a whole.

There is one last factor that must be cited as one of the key factors that attracts firms to the fold of primary dealers and that factor is prestige. Whether we like it or not, the fact remains that there is an element of prestige associated with primary dealer status. It is also true that in times of stress that prestige factor can loom very large indeed. In that regard, it is clear to me that the letter the Federal Reserve Bank of New York sent to Salomon Brothers on Tuesday, August 13, which discussed our review of the firm's status as a primary dealer, played a major role in the changes in top management at the firm announced on Friday, August 16. 1 might also add that then, and now, I regarded those changes in top management as an absolutely essential first step in the healing process for the market. The primary dealer system has worked well over the years. It has served the Federal Reserve, the Treasury, the nation, and the world effectively. Yet, the system is not without its drawbacks. However, as we consider whether basic changes in these arrangements are needed, it seems to me that we must keep two basic propositions in mind. First, regardless of what they are called and how they are selected, for at least the foreseeable future, there will be a finite group of private-sector counter-parties with whom the Federal Reserve will have to do business. One way or another, the identity of these firms will be known in the marketplace. Second, the sheer size of the financing and refinancing requirements of the federal government are such that, one way or another, for the foreseeable future there will have to be some relatively large firms that play a central role in the underwriting and distribution of that debt and in making secondary markets in the government's debt instruments. If the returns are not there to attract private capital to that business or if the burdens of excessive regulation so stifle the efficiency and liquidity of that market, the cost to the taxpayers and to the prestige of the United States can be enormous.


The basic rules governing the auctions of Treasury securities-including the 35 percent rule - are established by the Treasury. Compliance and enforcement responsibility for these rules rests with the Treasury. However, as the Treasury's fiscal agent, the Federal Reserve-as with most central banks throughout the world-is the Treasury's point of contact with the marketplace. As such, the Federal Reserve has a natural responsibility to call to the Treasury's attention events or circumstances, which, in its judgment, suggest that the Treasury's rules or intentions may have been breached in the auction process.

Over a very long period of time, the process by which Treasury securities are auctioned or otherwise placed in the market has worked exceedingly well. Indeed, until the Salomon event, we had no knowledge of any event or events that would constitute a significant breakdown in the workings of the auction process.

Although the auction process is open to all qualified bidders, the fact remains that over the long haul the primary dealers-and in recent years their large customers-are, by far, the major takers of government securities in the auction process. This development is natural given the capital that they have devoted to this business as well as their distribution network, their expertise, and their role as market makers in government securities. Having said that, it is also true that in recent years the auction awards have tended to become more concentrated, especially if one takes account of the large institutional clients of the primary dealers that choose to bid in the auctions through the primary dealers.

The mechanics of the auction process are, in one sense, quite simple. Those submitting competitive bids must present those bids on a prescribed tender form at a Federal Reserve Bank by 1:00 p.m. eastern time on the day of the auction. As a practical matter, the overwhelming share of such bids (often in the range of 80 percent to 90 percent) is received by the Federal Reserve Bank of New York. To minimize market uncertainties, the results of the auction are announced about one hour later, or around 2:00 p.m. eastern time.

Within that single hour, between 1:00 p.m. and 2:00 p.m., the initial responsibility for tabulating and checking the bids-including checking for compliance with the 35 percent rule- falls to the staff of the Federal Reserve Bank of New York. It was this initial check of the bids submitted for the February 1991 five-year note auction that we now know began the unraveling of Salomon's illegal activities. At the time, however, there was absolutely no reason to suspect any illegal activity. Nevertheless, since the circumstances surrounding that auction have received so much attention, allow me to recount what happened and how it was to shape subsequent events.

Included in the bids received at 1:00 p.m. for the February 21 auction in question was a small bid, for its own account, for S.G. Warburg & Co., itself a primary dealer, and a bid at the 35 percent limit submitted by Salomon for a customer described on the tender form as Warburg Asset Management. It should be noted that there was nothing unusual about an affiliate of one primary dealer submitting a bid through another primary dealer. What was unusual was the fact that if, under Treasury rules, the two Warburg entities were considered a single entity and if both bids were awarded in full, the result would have slightly exceeded the 35 percent limit. The Federal Reserve promptly called both Salomon and the Treasury. Salomon indicated that the client name was in error and that the bid had been received from their London office for Mercury Asset Management-an affiliate of Warburg. As this was occurring, it became evident that the actual awards in the auction would be such that the 35 percent limit would not be breached even if the entities in question were a single entity for purposes of the auction rules. In those circumstances, and in a setting in which there was, at the time, no reason whatsoever to suspect wrongdoing, the Treasury indicated to the Federal Reserve that it would accept both bids. It was understood at that time that the Treasury would subsequently investigate the legal relationships between the various Warburg entities.

Over the ensuing two or three weeks the Bank shared with the Treasury information it had regarding the bids, and on March 14, the Treasury, in response to an inquiry by the Federal Reserve, indicated that it was continuing its review of the corporate relationship between the entities in question. That review culminated with the Treasury's letter of April 17 to Warburg informing the firm that in the future the entities in question would be considered a single entity for purposes of the auction rule. A copy of that letter was sent to Salomon.

When Salomon finally disclosed its wrongdoings in August, and when the top management acknowledged to me that they knew of the unauthorized customer bid in the February auction, I surmised that it was the pressure of the inquiries about the "Mercury" bid submitted by Salomon in February that spooked Mr. Mozer into disclosing his wrongdoing to his superiors.

It is now quite clear that my suspicion was correct. What I did not know, however, until I read the statement submitted to the Congress by Salomon last week was that in the face of those developments Mr. Mozer apparently went to rather considerable lengths in requesting an official of Warburg not to respond to the Treasury's letter. This raises another question about possible wrongdoing. The SEC and the Justice Department are aware of these developments, and the Treasury and the Federal Reserve have arranged a meeting with Warburg for this week to learn its side of this story.

In all of these circumstances, it is only fair to ask whether a more rigorous investigation into the February auction might have made a difference in terms of the course of subsequent events. Given (1) the history of the auction process; (2) that there was not then a shred of evidence to suggest illegal activity; and (3) what now seems to have transpired between officials at Salomon and Warburg in April, it does not seem unreasonable to conclude that the steps followed by the Federal Reserve and the Treasury in that setting were appropriate. The one thing that surely would have made a difference would have been the timely disclosure of these events by the top management of Salomon when they learned of them in late April.

Having said that, three things are now clear in retrospect. The first is that despite the fact that the auction had worked so well for so long, we must be more rigorous in our review of the bids when received. Steps already have been taken to move in that direction. Second, programs currently under way to provide a higher degree of automation in the auction process should be accelerated to the extent possible-keeping in mind that even a fully automated auction system brings with it its own risks. Third, some further changes in the auction rules may be needed.


Within the context of the Salomon affair the great bulk of attention has, understandably, focused on the 35 percent rule and the firm's systematic violation of that rule. There is, however, another aspect of this situation that may warrant careful consideration. For example, operating wholly within the spirit and the letter of the auction rules, it is possible for a single dealer firm and one or two of its clients to win a very large share of any auction. If, in those circumstances, there are large short positions in the market, it is likely that one or both of the following will occur: First, the price of the securities in question will rise relative to close substitute securities, or, second, the financing cost of the securities in the repurchase agreement (RP) market will drop, thereby providing the owners of those securities with a very favorable cost of carry. When this latter condition occurs, the particular security is said to be "on special" in the RP market.

Either or both of these phenomena occur with some regularity in the market. Moreover, these phenomena tend to be self-correcting because the relative rise in the price of the specific security in question should provide clear incentives for the holders of such securities to sell, reap the arbitrage profit, and in the process add to the supply of the security in the market as a whole.

Over the past couple of years, however, the frequency with which particular issues are "on special" in the RP market has increased. It is also true that the emergence in the market of a handful of very large "hedge funds" that acquire large amounts of securities and may finance those positions through primary dealers may be contributing to this phenomenon. This development need not be a worry unless one were to conclude that highly concentrated holdings and financings of positions in a single issue create a condition in which the dangers of market manipulation are unacceptably large. At this point, I do not have a view on this question, but I do think that it is one of the issues we must look at over the period ahead.


The events surrounding the Salomon episode are shocking, but what makes them even more worrisome in terms of public confidence in financial markets and institutions is that they come on the heels of several other cases involving highly questionable, if not outright illegal, activities. Moreover, while we are naturally sensitive to these problems in this country, the phenomenon is global in nature. That, of course, raises the very important question of whether the incidence and nature of these unhappy events are worse than they have been in the past or whether it just seems that way. For example, there surely are some economic historians who might suggest that these problems are not all that unusual after a long boom, especially in the financial sector. However, others might suggest that the problems are different in nature and frequency, even allowing for the cyclical factor and that the cause lies with "deregulation." That, however, is a little hard to accept, in part, because we have seen at least some of these problems in segments of markets, or in institutions or even in countries where deregulation has not been a particularly important factor in influencing behavior.

Perhaps we will not fully understand what is happening, why it is happening, and whether it is truly out of line with historical experience until we are able to look back on these developments with the benefit of hindsight. On the other hand, confidence in our financial markets and institutions is simply too important to push these questions aside and leave them to the historians.

Having said that, I do not want to leave the impression that I have anything even resembling an answer to these questions at this time. But, there are two things that keep coming back to my mind as I ponder this situation. One is that "high-tech" financial practices are a two-edged sword. To be sure, this technology is doing many wonderful things for us all, but it also creates nightmares for control systems, for top managers, and, yes, for regulators. Indeed, the combination of high technology and financial innovation may even help to create the impression among some practitioners that sheer complexity makes it too easy and too inviting to cut corners and to play close to the edge. Finally, and more important, high technology and financial innovation are probably a major reason why profit margins are so thin, with the resulting need to push that much harder to earn that extra dollar of profit. Even if all of that is correct, however, the problem remains since we cannot and certainly should not seek to hold back technology and innovation. That being the case, the burdens on managers and regulators loom even larger. I might add that the burdens on legislators are also great in these circumstances. For example, some might look at the Salomon episode as a reason to further delay much needed progressive banking legislation. That, in my view, would be a mistake that I hope we can avoid.

The second thing that keeps haunting me when I ponder these issues is bound to be highly controversial. It is compensation practices in the financial sector. Maybe I am too old-fashioned, but I cannot see the merit of compensation practices that yield millions of dollars per year, for example, for individual securities or foreign exchange traders. Maybe it is asking too much, but somewhere I would like to think that there must be a chief executive officer or a board of directors that will have the courage and the conviction to begin the process of reversing these excesses. I cannot help but think that once that process gets started, others would quickly follow. In saying that, I am under no illusions that more conservative compensation practices will solve all or even many of these problems. On the other hand, human nature being what it is, compensation practices that hold out the potential for millions of dollars of annual income seem to me to entail the clear danger that reasonable standards of prudence and ethics can, all too easily, be cast aside for the sake of writing that next ticket.

I thank you, for your patience in allowing me to drift so far from the direct subject matter of this hearing, but I do think that as we search for remedies to the problems immediately at hand, we should also keep an eye on the larger picture.
COPYRIGHT 1991 Board of Governors of the Federal Reserve System
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Title Annotation:statement by E. Gerald Corrigan to the U.S. Senate
Publication:Federal Reserve Bulletin
Article Type:Transcript
Date:Nov 1, 1991
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