22 February 2013

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.