Statements to the Congress.
ROLE OF PRIMARY DEALERS
A key component of the government securities market is the group of so-called primary reporting dealers. These dealers are the firms with which the Federal Reserve's trading desk conducts its open market operations. They are major participants in the market, maintaining active markets to customers across a broad spectrum of issues. They are also active in the distribution of Treasury debt, buying large portions of the Treasury auctions and placing the securities with a wide variety of investors here and abroad. At present there are thirty-nine primary dealers, of which about half are banks or the securities affiliates of banks and half are diversified-or in a few cases specialized-securities firms. Last year, the total volume of activity conducted by the Federal Reserve with primary dealers to carry out open market operations was about $460 billion. Our trading desk also operates in this market to effect investment orders for foreign central banks and monetary authorities-another $65 billion of volume last year.
As a major market participant and public entity, the Federal Reserve naturally has sought private-sector counter-parties that can meet the standards for handling our large orders efficiently and safely from the standpoint of credit, delivery, and settlement risk. We have developed standards for selecting those firms with which the Federal Reserve does business, described in an attachment to this statement.1 Central banks in several other countries with well-developed financial markets have developed broadly similar arrangements to designate a group of firms with which to conduct money market operations.
The number of primary dealers has grown in the last few decades, although there has been some shrinkage in the last couple of years. From eighteen in the early 1960s, the number increased to thirty-six in 1981 and to a peak of forty-six in 1988, growing as the market expanded, and-as this committee well knows-the debt expanded. Since late 1988, there has been a shrinkage in the number of dealers, to thirty-nine today. The decline largely reflects a reaction to the exuberant increase in numbers of participants in the 1980s and some years of poor profitability in the industry. In 1989, four firms withdrew while two were added. In 1990 five firms withdrew while two were added, and so far in 1991 another two firms have withdrawn.
Besides having strong financial credentials, the primary dealers are expected to facilitate the Federal Reserve's open market operations, to make markets to a wide variety of customers in the full range of government securities in good times and bad, and to be consistent and meaningful participants in the Treasury auctions for 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 firms with which it will transact business. We feel somewhat between a rock and a hard place on this question. We need financially sound private-sector counterparties, and the size and speed requirements for our operations mean that the number must be limited in some fashion. Thus, our criteria result in some firms being chosen and some not, and the Federal Reserve will have a trading relationship with a selected group of firms whether or not we call them primary dealers. Inevitably, recent events bring this matter under examination again, but whether another approach would better serve our business needs and public policy needs remains a difficult question.
It is worth noting that the business relationship of the Federal Reserve Bank of New York with the primary dealers exists in a framework in which the Federal Reserve Board has only limited statutory authority to regulate or supervise primary dealers or, for that matter, other participants in the government securities market. 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 rule-maker and the Securities and Exchange Commission and banking supervisors responsible for enforcement.
Although our relationship with the primary dealers is rooted in a "business counterparties" connection, our interests in the health and well-being of the market extend well beyond that 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. Thus, we recognize fully that as the central bank and fiscal agent for the Treasury, we have a natural interest in the efficient working of the market and hence in the integrity of the market and its major participants. At the same time, we recognize that the extent and nature of our own participation in the market, for ourselves and for the Treasury, make it difficult to ignore the reality that we are regarded as one of its "regulators."
For example, the 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 help create that impression. In reality, the primary dealer monitoring program is relatively narrow in its purpose and scope and is not comparable, say, to the bank examination program. One basic aim of the monitoring program is to satisfy ourselves that the Federal Reserve, in its transactions with dealers, is not incurring substantial operational risk or 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. The statistical reports also help monitor whether the dealers are meeting our standards for breadth of market-making activity. These information-gathering efforts have not been structured with a view toward enforcement or regulatory compliance, although we recognize that there will always be some overlap between such activities and our broad market monitoring. Except for the so-called when-issued reports, the statistical data collected from dealers on positions and transactions are not specific as to a particular security. Rather, we get weekly data grouped by broad maturity ranges. These reports have virtually no application in detecting the kind of problem that arose in the Salomon case. Even the when-issued report, which is daily for a limited period, would have only limited value in this regard.
However, we are taking a fresh look at the statistics that we gather to see whether they can better serve the coordinated needs of the Treasury, the SEC, and ourselves in either their existing or potentially revised formats.
Before leaving the subject of primary dealers, it is worth asking why firms seek to be primary dealers in the first place. A starting point is that many firms evidently regard this function as an economically effective way to deploy their capital. In fact, however, positive returns do not come easily. As noted earlier, profits were particularly spotty in the last few years, with a significant fraction of individual firms incurring losses-a circumstance that no doubt contributed to attrition in the ranks since 1988.
For some firms, however, low returns and even periodic losses apparently are tolerable because the firm may judge that having a major presence in this market provides advantages related to other aspects of the firm's business. Or it might be that a long-term view is taken, in which prospects for the government securities area are viewed over a timeframe of more than just a few years. Another factor that should be mentioned explicitly as an attraction of the primary dealer designation is that of prestige-although one could think of it, long run, as related to profitability, too. The fact is that, whether we like it or not, there is an element of prestige associated with primary dealer status-and in times of stress that factor can loom very large indeed.
In sum, the primary dealer system has worked well over the years, serving the Federal Reserve, the Treasury, and the nation effectively. It also has its problems, including the elevated importance that can attach, in the public view, to this designation. As we consider possible changes in these arrangements, we need to keep in mind that, 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 counterparties with whom the Federal Reserve will do business. One way or another, the identity of these firms is likely to be known in the marketplace. Further, the sheer size of the federal government's financing needs is such that, 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. If the returns are not there to attract private capital to that business-perhaps because the burdens of excessive regulation stifle the efficiency and liquidity of that market-the cost to the taxpayer could be enormous.
THE FEDERAL RESERVE'S ROLE IN THE AUCTION PROCESS
The basic rules governing the auctions of Treasury securities-including the 35 percent rule-are set by the Treasury. Responsibility for ultimate compliance with, and enforcement of, these rules also rests with the Treasury. However, just as most central banks throughout the world act as fiscal agents for their treasuries or finance ministries, the Federal Reserve is the U.S. Treasury's point of contact with the market. It is the Federal Reserve's responsibility to call to the Treasury's attention events or circumstances that, in its judgment, suggest that the Treasury's rules or intentions may have been breached. By the same token, it is the Federal Reserve's responsibility to alert the Treasury or other regulatory or enforcement authorities to situations in which it finds evidence of improper secondary market activity in government securities.
For many years, the process by which Treasury securities are auctioned or otherwise placed in the market has worked very well. Until the Salomon events, we had no knowledge of circumstances that would constitute a significant breakdown in the workings of the auction process. Granting that the recent events do constitute a significant exception that must be dealt with and are being dealt with, I would still say that the auction process continues to work well on the whole.
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 buyers of government securities in the auctions. This situation is natural, given the capital that they have devoted to this business as well as their distribution network and role as market-makers.
The mechanics of the auction process are straightforward. Competitive bids must be submitted to a Federal Reserve Bank or to the Treasury by 1:00 p.m. eastern time on the auction day. 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 after the bid deadline.
Within that single hour between 1:00 and 2:00 p.m., the initial responsibility for tabulating and checking the bulk of bids-including their compliance with the 35 percent rule-falls to the staff of the Federal Reserve Bank of New York. In fact, we have only about one-half hour because we must get our results to the Treasury to be combined with reports from elsewhere around the country.
It was this initial check of bids submitted for the February 1991 five-year auction that we now know began the unraveling of Salomon's improper bidding activities. At the time, however, there was no reason to suspect any illegal activity in the form of trumped-up customer bids. Rather, we were simply checking for compliance with the Treasury's rule limiting any single entity to 35 percent of the issue. As it happens, the bids submitted in that auction included a small bid for S.G. Warburg and Co., itself a primary dealer, as well as a bid submitted at the 35 percent limit by Salomon for a customer listed as Warburg Asset Management. If the two bids were awarded in full, and if under Treasury rules these two entities were considered a single entity, the combined bid would have slightly exceeded the 35 percent limit. One of our staff members promptly called Salomon-at around 1:20 p.m. on the auction day-and was told that the customer name should have read Mercury Asset Management, an affiliate of S.G. Warburg. Immediately afterward we called the Treasury to alert them to a possible 35 percent problem. As this action was occurring, it became evident that the bids in question would be at the so-called stop-out rate and get only a partial award, so that the 35 percent award limit would not be exceeded even if the two entities were combined. In those circumstances the Treasury indicated that it would accept both bids. It was understood that there would be a subsequent inquiry about the relationship of the Warburg entities with reference to future auctions, an inquiry free of the extreme time pressure of the immediate auction deadline.
In the following weeks, Treasury and Federal Reserve staff members reviewed that relationship, leading finally to the Treasury's April 17 letter to Mercury informing it that in the future the affiliated Warburg entities in question would be considered a single entity for purposes of the 35 percent rule. A copy of that letter was sent to Salomon.
As is well known now, of course, the so-called "Mercury" bid was not a customer bid at all but apparently a scheme designed by Mr. Mozer at Salomon to obtain more than 35 percent of the issue for Salomon's own account. (Salomon was also bidding for 35 percent in its own name and, as emerged later, for yet another 35 percent under still another fabricated customer name.)
Receipt of a copy of the Treasury's letter to Mercury apparently prompted Mr. Mozer to go to considerable lengths in requesting Mercury and Warburg officials not to embarrass Salomon by responding to the Treasury in a manner that revealed that Mercury was not in fact a Salomon customer in the auction. At the same time, receipt of the letter caused Mr. Mozer to disclose his wrongful "Mercury" bid to his superior at Salomon, who then went on to inform top management at the firm.
Inexplicably, top Salomon management did not come forward to reveal this wrongdoing until August. We surmise that the reason they came forward then was that the Salomon firm had in the meantime become aware of official investigations into still another matter involving government securities-the alleged squeeze on the supply of two-year notes auctioned on May 22. As that two-year note investigation became more intense, Salomon engaged an outside law firm to do an internal investigation at the firm, and apparently that investigation uncovered the earlier bidding irregularities.
I might add that the official investigation of the May two-year note situation followed a period of informal inquiry into market developments by the Federal Reserve Bank of New York and the Treasury immediately after the May 22 auction of those notes. Just a week later, on May 29, the Treasury alerted the SEC to the situation, and the Justice Department also was brought into the picture shortly afterward.
Turning back to the February auction, it is fair to ask whether a more rigorous investigation into the authenticity of bids at that time might have made a difference in regard to subsequent events. It probably would have made a difference. However, given the previous history of the auction process-which did not arouse suspicions about the basic authenticity of bids-it still seems reasonable, looking back, to say that the steps then taken by the Federal Reserve and the Treasury were appropriate and responsible. With the benefit of hindsight, we could have done more. Looking back, another thing that surely would have made a difference would have been the timely disclosure of those earlier events by the top management of Salomon when they learned about at least some of them in late April. And in terms of internal management, for the firm to have allowed an individual who had acknowledged such wrongdoing to remain in charge of a key area is questionable, to say the least.
At this time, as investigations of the past continue, our focus also has to be on the future, making sure that the integrity of the auction process and of the secondary market trading process are maintained at the highest levels. For the past month we have been undertaking spot checks of customer bids submitted through primary dealers, verifying the authenticity of those bids directly with the indicated customer. In addition, a more formal verification process for the very largest bids, with written confirmation, is being developed. We also are seeking to accelerate plans for automation of the Treasury auctions-but there should be no illusion that automation can solve all problems. An automated system would not, of itself, have been able to uncover fake bids. At best, it might help speed the review process to identify situations for follow-up inquiries, and it could speed the review process for compliance with rules such as the 35 percent rule. Automated bidder access might also make it more feasible for some larger investors to submit bids directly rather than enter the auctions as customers of dealers. Automation could also cut somewhat further the time required to process tenders before the announcement of results. Meantime, we understand that the Treasury is reviewing its auction rules.
As for the secondary market, we are moving ahead with plans for closer monitoring of day-to-day market developments and closer coordination of the results of such monitoring with other supervisory and regulatory agencies. We will also be reviewing, within ninety days after the last round of testimony, the possible need for additional legislative authority. Certainly, the problems that have come to light need to be addressed systematically and forcefully. At the same time, a high priority is to avoid a heavy panoply of regulation that could impair market efficiency and liquidity.
I think that with the cooperation of supervisory and regulatory agencies and with responsible private-sector leadership, a proper balance can be struck that permits a flourishing, liquid, and efficient market free of the taints that have been uncovered of late.
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|Title Annotation:||statement by Peter D. Sternlight|
|Publication:||Federal Reserve Bulletin|
|Date:||Nov 1, 1991|
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