The New York Fed's Primary Dealers, Liquidity, Monetary Policy, Excess Reserves and Financial Dreadnoughts in Times of Currency War

Someone asked me about Primary Dealers today.   I think it was in regard to liquidity concerns.

Cutting to the punchline, however one wishes to characterize and attribute it, the financial system is once again over-leveraged, over-concentrated, fraught with interconnected with counterparty risk, and fragile.

This is because of the policy failure of the Treasury and the Fed which could be characterized as extend and pretend without engaging in significant reforms and law enforcement in the aftermath of what might be best described as a control fraud. 

I also postulated years ago that when push came to shove, the Fed would gather around itself a few 'friendly banks' which would act on its behalf in private to enforce certain policy decisions in markets in which the Fed and Treasury do not wish to openly operate.  

It is hard to think of any other somewhat moral reason for the government to babysit and subsidize these very expensive and dangerous TBTF monstrosities, except as instruments of policy to provide some degree of freedom to shape events and responses. 

If you want to wage a currency war, you need to have some dreadnoughts packing serious financial throw-weight, and economic muscle.  Think of economic hitmen on steroids.   It may be Machiavellian,  counter-democratic, and expensive, but that is the dictate of strategy if you want to control things and wield power to do what you will, both at home and abroad. 

Is a corollary to the currency war a financial arms race and the construction of institutional behemoths?  I think it might be.  Or it could just be widespread ignorance and corruption amongst the ruling class which certainly is conceivable.  Or some of both.  Why do governments sometimes engage in corporatism?  Take your pick.

So putting that bit of editorial fuss and postulating out of the way, let's talk about some loosely related details of what Primary Dealers are all about.

The Fed uses Primary Dealers to manage monetary policy and its market in Treasury transactions,  first and foremost.   

These operations are both 'temporary' and 'permanent' transactions involving Treasuries, involving repos/reverse repos and purchases/sales respectively. 

I cannot stress enough that in a period of ZIRP, some things are not quite the same and do not carry the same significance as they might imply in 'normal times.'   I think the last chart show the Fed's Adjusted Monetary Base and Excess Reserves helps to illustrate this.

Although the analogy is a bit strained and far from perfect, I think what Bernanke has been doing with the Fed's monetary base and the excess reserves is roughly comparable to what had been done in 1933 with the removal from gold from private hands, and it revaluation afterwards in order to re-capitalize the banks with what was essentially seignorage.

They used gold instead of a platinum coin.  There is no need to confiscate gold when you are not on an external standard, the only constraint being the Fed's willingness to expand its balance sheet, and of course, the value at market of the bond and the dollar, which some conveniently forget when it suits them.

And the 'platinum coin' was a political rather than a monetary play. It is important to keep the two separate, although both are dysfunctional these days. Corruption ranges far and wide.

Certainly Bernanke and Paulsen/Geithner have been much less selective in spreading the wealth to banks, and never engaged in the sort of reforms and bank holiday that the FDR Administration had done.

The management of liquidity in the banking system with particular member banks, non-banks, and foreign entities is not relevant to the Primary Dealers list per se.

I am not sure why they wanted to know this, but since it has been some time I have written about them,  here is a current list of the Primary Dealers from the NY Fed.

"Primary dealers serve as trading counterparties of the New York Fed in its implementation of monetary policy.

This role includes the obligations to:

(i) participate consistently in open market operations to carry out U.S. monetary policy pursuant to the direction of the Federal Open Market Committee (FOMC); and

(ii) provide the New York Fed's trading desk with market information and analysis helpful in the formulation and implementation of monetary policy.

Primary dealers are also required to participate in all auctions of U.S. government debt and to make reasonable markets for the New York Fed when it transacts on behalf of its foreign official account holders."

Here is some additional information about the nature of the Primary Dealer relationship with the NY Fed.

As one can easily see not all banks, including member banks of the Federal Reserve, and not only banks, are primary dealers.  For example, MF Global was removed from this list in October, 2011.

An institution is not required to be a Primary Dealer to borrow funds from the Fed's various lending facilities including the Discount Window. 

And being a Primary Dealer, or a member bank of the Federal Reserve for that matter, does not oblige a Bank to engage in money laundering or rigging LIBOR, or any other markets. That sort of activity is largely engaged at the discretion of the Bank.

There is a distinction therefore, between the management of monetary policy and the Treasury sales, and the Fed's other operations with banks including reserves, excess reserves, and discount lending among other things.  So one has to have some care about drawing broader conclusion from their activities.

With the advent of ZIRP, the role of excess reserves held at the Fed, and the payment of interest by the Fed to the banks on those reserves, has taken on an added importance in the management of monetary policy and system liquidity. 

In regard to foreign dollar transactions, the Fed typically arranges swap lines with foreign central banks,  as they did in the case of the dollar short squeeze we had seen in Europe for example.

At one time I kept detailed spreadsheets of most of the Fed's weekly operations.  I gave that up around the time of the financial crisis, when the Fed's activities became much more convoluted and even less transparent than they already had been.


Current List of Primary Dealers

Bank of Nova Scotia, New York Agency
BMO Capital Markets Corp.
BNP Paribas Securities Corp.
Barclays Capital Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Credit Suisse Securities (USA) LLC
Daiwa Capital Markets America Inc.
Deutsche Bank Securities Inc.
Goldman, Sachs & Co.
HSBC Securities (USA) Inc.
Jefferies & Company, Inc.
J.P. Morgan Securities LLC
Merrill Lynch, Pierce, Fenner & Smith Incorporated
Mizuho Securities USA Inc.
Morgan Stanley & Co. LLC
Nomura Securities International, Inc.
RBC Capital Markets, LLC
RBS Securities Inc.
SG Americas Securities, LLC
UBS Securities LLC.

Primary Dealer Banks Want Their Treasury Sales Franchise Protected

Direct bidding means bypassing the 'percentage' that the dealer banks take. The banks hate it. It not only dents their vigorish, but it makes it more competitive in pricing the auction, which cuts into profits as well.

Today's Ten Year Auction was a bit weak, with Direct Bidders down as a percentage.

I have heard that more firms that are not PIMCO class in size are seeking to become Direct Bidders because of the price gaming that is going on with the Primary Dealer Banks serving as intermediaries.

By way of information, 'indirect bidders' are often considered a proxy for foreign purchasers from the official sector.

The Treasury auctioned $25 billion 10-year notes on 10 February 2010.

The high yield was 3.692%, which was 3+ basis points lower than the 1pm "When Issued" yield.

The bid to cover ratio, a measure of auction demand, was 2.67 bids submitted for every one accepted by the Treasury. This compared to a 3.0 BTC in the last 10yr auction

Dealers took 53.3% vs. 53.2% last time

Direct Bidders took 12.9% of the issuance. Previously 17.2%

Indirect Bidders were awarded 51.2% of the auction, vs 52.9% last time.

For some interesting background reading on some relatively recent changes in the bidding process and the definition of indirect bidding made by Treasury, read Smoke, mirrors and Treasury sales by Izabella Kaminska.

ForexPros
Angry US bankers seek curbs on direct bidders
By Emily Flitter
2010-02-09 17:18:22 GMT

NEW YORK, Feb 9 (Reuters) - Two minutes after the U.S. Treasury Department closed a multi-billion dollar debt auction last month, one banker was angrily punching in numbers of a hotline he'd found on the Treasury's Web site.

Primary dealers, including his bank, had just been blindsided by a large order from a group of so-called direct bidding firms whose presence is growing.

Financial firms acting as direct bidders are sapping profits for the big banks that have long seen themselves as the main intermediaries in the sale of government debt.

Primary dealers say direct bidders need tighter control given risks they could make auctions more volatile and expensive for the U.S. government at a time when it is borrowing record amounts to fund its programs.

The U.S. Treasury, however, says it supports broader access to auctions on grounds it raises competition and cuts costs.

The banker, who did not want to be named for this story, said he called Treasury to find out more about the firms in this group: He wanted to know how many had bid that day and what the standards were for allowing them to participate.

Primary dealers say a large direct bid in an auction makes it harder for them to properly price their own bids for Treasuries ahead of time. If primary dealers guess direct bidders will turn out in force for an auction, they could choose to pull back from a portion of their bids. They say Treasury auctions could begin to show less stable results. This would likely raise borrowing costs for the U.S. government.

"Because of the direct bid, determining the accurate price in the auction becomes more problematic. If it becomes more problematic fewer people will be willing to put capital at risk for size in the auctions," said Ian Lyngen, senior government bond strategist at CRT Capital Group in Stamford Connecticut.

Some primary dealers are asking the Treasury for limits on the percentage of direct bids that can be placed in a given auction. This, they say, would cut down on the level of uncertainty that has taken hold ahead of auctions recently.

WHY SO ANGRY?

On the day the angry banker made his phone call, direct bidders took down more than 17 percent of a $21 billion auction of 10-year notes, a far higher portion than normal. Direct bidders took 8.9 percent of the December 10-year note auction, and in November their bids made up 4.5 percent of the total. Similarly, January's three-year note auction saw direct bidders take 23 percent, while they accounted for only 2.9 percent of the December three-year auction.

"More and more buy-side accounts are so starved for yield that they're trying to go around the dealers," said Chris Whalen, co-founder of Institutional Risk Analytics. "Why should PIMCO go through a primary dealer?"

But despite the constant communication between these big banks and the government, they can't hope for much change.

"We support broad access to the auction process and we think that this is a good thing from the standpoint that it breeds competition and helps us achieve our goal of financing the government at the lowest cost over time," said Matthew Rutherford, the deputy assistant Treasury secretary for federal finance, speaking to reporters at last week's quarterly refunding announcement.

The direct bidder issue is one on which the primary dealers have little leverage in persuading Treasury. Despite the record size of recent Treasury issuance, investors are still snapping up U.S. government debt, creating healthy demand that has led to smoothly executed auctions.

This means the Treasury Department has little incentive to do more than listen to primary dealers' complaints about direct bidders.

"I think they like having a larger number of people with access to their auctions," said Rick Klingman, managing director of Treasury trading at BNP Paribas in New York. He explained that in the event of a disaster such as the 9/11 attacks, which knocked out New York firms' systems, a broader network of direct bidders could step in and make sure an auction went smoothly.

There are few details on the makeup of the group of direct bidders available to the public. Treasury does not disclose the number of firms authorized to participate as direct bidders, and there's little information available to indicate the potential size of firms that have direct bidding terminals.

Primary dealers aren't afraid to speculate on who the mystery bidders might be. Some posit they are smaller securities firms that are preparing to apply to become primary dealers, while others say those firms aren't well-capitalized enough to make much of a dent in a single auction.

Current List of Primary Dealers with the New York Fed

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.
Goldman, Sachs & Co.
HSBC Securities (USA) Inc.
Jefferies & Company, Inc.
J. P. Morgan Securities Inc.
Mizuho Securities USA Inc.
Morgan Stanley & Co. Incorporated
Nomura Securities International, Inc.
RBC Capital Markets Corporation
RBS Securities Inc.
UBS Securities LLC.