February 17, 2009
The Federal Reserve is reportedly in negotiations to expand its shrunken list of Primary Dealers. Who are these firms? What do they do? Why are they important?
Each day the Federal Reserve enters financial markets to adjust the amount of Federal Funds (deposit balances of banks with the Federal Reserve) outstanding to keep the rate on overnight Federal Funds close to the target rate set by the Federal Open Market Committee. It does so by either buying or selling short-term US Treasury bills or by engaging in repurchase agreements or reverse repurchase agreements in which the Fed agrees to sell and then buy back, or buy and then sell back, Treasury securities to counterparties at a specified time in the future (eg. overnight, three days, twenty eight days, etc.).
These transactions are conducted by the Open Market Desk, which executes transactions on behalf of the FOMC through the SOMA or System Open Market Account. The Desk and SOMA are housed at the Federal Reserve Bank of New York, although technically they are not part of the bank. In fact, two of the past three presidents of the NY Fed were managers of the Open Market Desk – Bill McDunough and Bill Dudley (though you don’t have to be named Bill to hold that position).
Every business day morning, the Desk staff first prepares an estimate of the amount of reserves the banking system will need that day, in conjunction and in consultation with the Treasury and Federal Reserve Board staff in Washington, DC. That proposed program is shared on a phone call at about 9:10 AM with the Board staff, the Desk staff, and one of the voting Federal Reserve Bank presidents on the FOMC. A number of factors affect the size of the program for the day. This includes (a) estimates of float for the day (checks and electronic payments in process of collection but not yet cleared through the system), (b) Treasury disbursements of funds for the day, (c) transfers out of Treasury Tax and Loan Accounts (which are accounts at commercial banks into which tax receipts are aggregated), (d) the need to replace maturing transactions from previous days, and (f) additions or reductions in the SOMA to accommodate increased demands for currency. As it turns out, weather, especially in the winter, can cause significant unanticipated fluctuations in float, because planes carrying checks can be delayed. Once the needs have been determined, the Desk sends out a notice to the Primary Dealers and calls for bids to participate in that day’s program. This is where the so-called Primary Dealers come into the picture: they stand ready to buy or sell according to that day’s program.
The Primary Dealers are specially designated banks and investment banks who agree to submit bids and participate in the daily auctions that constitute the SOMA’s program. These are supposed to be large, well-capitalized, sound institutions. There are presently 16 such institutions, but that number has been much larger in the past. Who are these firms? The NY Fed provides the list, and it is attached at the end of this commentary. Interestingly, over half are either foreign institutions or US-chartered subsidiaries or affiliates of foreign parents. For example, Merrill-Lynch and Bear Stearns were Primary Dealers, as were Lehman Brothers and Countrywide, all of whom have disappeared.
Why would a firm want to become a Primary Dealer? Treasury securities can be bought and sold and used as collateral for interbank borrowings and for investments by both foreign and US citizens and companies. These securities trade at bid-ask spreads, and participants can engage in transactions with the Fed that are free of credit risk and make the bid-ask spread by redistributing securities and funds to other counterparties throughout the banking system. Put simply, the Primary Dealers are directly involved on a day-to-day basis with the major determinant of interest rates in the Federal Funds market and therefore have inside knowledge of trade volumes, etc. This access was especially important when the Fed didn’t publicly announce changes in monetary policy, and bid-ask spreads were wider. It is likely becoming more important again today because of the widening bid-ask spreads, the increase in outstanding Treasury borrowings due to the stimulus programs, and the Fed engaging in quantitative easing, with the Federal Funds rate allowed to float between 0 and 25 basis points.
Why only 16 firms? First, the current system structure is really an anachronism. It is rooted in the days before electronics, when bids were submitted on paper by runners and US government securities were all paper instruments that had to be shuffled between buyer and seller. That meant that bidders had to be in close proximity to the NY Fed, and this implied that they had to be major banks or investment banks. Keep in mind that in the early history of the NY money market, investment banks were major traders and distributors of US government obligations. Now, of course, bids are submitted electronically.
The NY Fed is now seeking to expand the number of primary dealers, for two principal reasons. The first is to make up for the shrinkage in the number of dealers, and the second is to increase liquidity in the market in anticipation of the flood of new Treasury obligations that will be coming onto the market.
Why so few? Interestingly, the ECB uses a different system and deals with over 500 counterparties located throughout Europe. It is possible that the strong linkage between the Primary Dealers and the Fed and the extreme financial difficulties that many of these key institutions experienced this past year and a half explain the special efforts made by both the Fed and Treasury to ensure the dealers’ continued existence, irrespective of the costs.
This is one area where the Fed should consider being more innovative.
There is no reason, for example, that any healthy Federal Reserve member bank in the US shouldn’t be able to participate in the auctions if it chose to do so. The bids are accepted electronically, and the securities are electronic book entries (not paper) and can be transferred daily over the Federal Reserve’s wire system. There is no need for those institutions to deal though a Prime Dealer intermediary and pay the bid-ask spread. Broadening the participation would make the market to be more liquid and deeper. Increasing the number of counterparties and would also lessen the Desk’s dependence upon the Primary Dealers, most of whom now aren’t the pillars of strength they once were. Finally, it would diversify operational risk both in terms of numbers and geographically, by lessening the dependence on NY-based institutions; a risk that the 9/11 experience suggests is very real. .
BNP Paribas Securities Corp.
Banc of America Securities LLC
Barclays Capital Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Credit Suisse Securities (USA) LLC
Daiwa Securities America Inc.
Deutsche Bank Securities Inc.
Dresdner Kleinwort Securities LLC
Goldman, Sachs & Co.
Greenwich Capital Markets, Inc.
HSBC Securities (USA) Inc.
J. P. Morgan Securities Inc.
Mizuho Securities USA Inc.
Morgan Stanley & Co. Incorporated
UBS Securities LLC
Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at www.cumber.com. He may be reached at Bob.Eisenbeis -at- cumber.com.