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Treasury-Federal Reserve Study of the
U . S . Government Securities Market
VIEWS OF THE U.S. GOVERNMENT SECURITIES DEALERS
Staff Study prepared by
Normand Bernard
Economist, Board of Governors
March 31, 1967
THE
FEDERAL
RESERVE
RANK of
SE LOUIS
Research Library
March 31, 1967
Treasury-Federal Reserve Study of the
U.S. Government Securities Market
VIEWS OF THE U.S. GOVERNMENT
SECURITIES DEALERS
CONTENTS
PAGE
Introduction Dealer Views Concerning the Performance of the U.S.
and Federal Agency Securities Markets in the 1960's
Major factors affecting the Treasury bond market
Other developments affecting the Treasury bond market
Structural and institutional changes in the market
Accommodation of investors in the Treasury bond market
Performance of the Treasury bill market
Performance of the market for Federal agency securities
III.
Performance of Individual Dealer Firms
Trading activity
Relationships to the Treasury and Federal Reserve
Profitability of dealer operations
Comments on Specific Policy Issues and Suggestions for Improving
the Market
Treasury debt management techniques
1.
2.
3.
4.
5.
Advance refundings
Treasury bill auctions - - - - - Tax-and-loan
account credit in cash financings
11
"Cash or "rights" exchanges - - - - - - - Competitive sale of long-term Treasury bonds
through underwriting syndicates - - - - - - -
Secondary market operations by official accounts
Federal Reserve transactions in U.S. Government
securities - - - - - - - - - - - - -
22
22
24
25
Treasury trust fund transactions in U.S. Government
securities
- - - - - - - - - - - - - - - - - - - - Official account operations in Federal agency
securities
- - - - - - - - - - - - - - - - - -
28
9Q
Techniques of the Trading Desk at the Federal
Reserve Bank of New York
3.
4.
5.
6.
7.
Identifying accounts and amounts involved in Desk
operations
- - - - - - - - - - - - - - - - - - - 11
Use of go-around" technique for executing Desk
transactions - - - - - - - - - - - - - - - - - Frequency of Desk operations
- - - - - - - - 11
Timing of Desk operations; cash" vs. "regular"
trading - - - - - - - - - - - - - - - - - - Repurchase agreements vs. outright transactions
Technical features of System repurchase agreements
Review of minimum dealer standards for trading
with the Desk - - - - - - - - - - - - - - - - -
Problem of dealer financing
32
33
33
34
35
36
36
The market for Federal agency securities
1.
2.
Methods of marketing new issues - - - - - Improving the marketability of Federal agency
issues
- - - - - - - - - - - - - - - - - - - -
Organization of the market, trading facilities, and
market practices
1.
2.
3.
4.
5.
6.
7.
Dealer association Brokers' market - Problem of odd lots - - - - - - Mechanism for clearing securities
Facilities for borrowing securities
Margin requirements on dealer loans - Settlement of transactions in "Federal" or
"CI earing-House" funds - - - - - - - - - The 4-1/4 per cent interest rate ceiling -
42
42
44
45
45
46
46
47
I.
Introduction
This paper summarizes the views of primary dealers in U . S .
Government securities concerning various aspects of the markets for
Treasury and Federal agency securities.
These views were solicited
in the spring and early summer of 1966.
All of the 20 dealer firms
that were authorized to transact business with the Trading Desk of the
Federal Reserve Bank of New York (as of the date of the study) submitted
written replies to a questionnaire and participated in individual meetings
with officials of the Treasury and the Federal Reserve.
The principal topics that were covered included the major
factors affecting the performance of the U . S . Government securities
market in recent years, major developments in the Federal agency
securities market, the extent of participation in both markets by
individual dealer firms, Treasury debt management techniques, Federal
Reserve and Treasury trust fund operations in the secondary market for
longer-term Treasury obligations, and operating techniques of the Trading Desk at the Federal Reserve Bank of New York.
Dealers were also
asked about their views concerning possible problem areas, specific
market practices, trading facilities, and market
organization.
The
dealers made numerous proposals for improving the functioning of the
markets for U . S . Government and Federal agency securities.
The dealer firms that replied to the questionnaire and that
also participated in individual consultations with Treasury and Federal
Reserve officials were the following:
-2Barik dealers
Bankers Trust Company, New York
Chemical Bank New York Trust Company
Continental Illinois National Bank and Trust Company
of Chicago
The First National Bank of Chicago
First National City Bank, New York
Harris Trust and Savings Bank, Chicago
Morgan Guaranty Trust Company of New York
United California Bank, Los Angeles
Nonbank dealers
Blyth & C o . , Inc.
Briggs, Schaedle 6c C o . , Inc.
Discount Corporation of New York
The First Boston Corporation
Aubrey G . Lanston 6c Co., Inc.
Merrill Lynch, Pierce, Fenner 6c Smith, Inc.
New York Hanseatic Corporation
W m . E . Pollock 6c C o . , Inc.,
Chas E . Quincey 6c C o .
D . W . Rich and Company, Incorporated
Salomon Brothers 6c Hutzler
Second District Securities C o . , Inc.
II.
A.
Dealer Views Concerning the Performance of the
U.S. Government and Federal Agency
Securities
f
Markets in the 1960 s
Major factors affecting the Treasury bond market
Most dealers believed that the secondary market for
intermediate- and long-term Treasury securities had deteriorated in
!
f
the 1960 s as compared with the 1 9 5 0 s .
The two reasons most often
cited for this worsening in market performance were (1) the abandonment of the Federal Reserve's "bills usually" policy in favor of transactions in all maturity areas of the market and (2) the Treasury's
introduction of the new debt management technique of advance refundings.
Many dealers suggested that Federal Reserve operations in
longer-term Treasury obligations were destabilizing and that these
operations led to the formation of "artificial" prices in the market.
-3Such operations were not compatible with the functioning of a "free"
market, because they inhibited or precluded dealer initiative in forming independent judgments about market trends based upon underlying
economic forces.
In particular, several dealers noted that Federal
Reserve transactions in Treasury bonds could have policy implications
and were of such potential size that even when actual operations
turned out to be small, they tended to dominate market psychology and
to create uncertainty in the minds of market participants.
Some
dealers made similar allegations with respect to Desk operations for
Treasury trust accounts, or at least did not distinguish between
transactions for the System and for the Treasury trust funds.
Advance refundings, dealers generally conceded, were an
excellent debt management device, but the Treasury's utilization of
this technique since 1960 had been too frequent and on too massive a
scale.
As a result many investors had been able to circumvent the
secondary market in achieving their portfolio objectives.
This had
proved detrimental to the functioning of the secondary market.
Many
dealers also indicated that trading had tended to be concentrated
during periods of financings and that between such periods market
activity in longer-term securities had been greatly reduced.
The dealers were especially critical of what became known
as "operation twist."
This policy sought to maintain upward pressure
on short-term interest rates for international balance of payments
reasons.
Many market participants felt that the policy also was
-4designed to put downward pressure on long-term interest rates or
at least to prevent such rates from rising.
twist
11
In practice, "operation
often meant that intermediate and long-term Treasury bonds
were purchased by the Desk instead of Treasury b i l l s — w h i c h have
maturities of 1 year or less--in order to avoid placing direct
downward pressure on bill rates when large purchases had to be
made in the market.
Other techniques, mainly in the area of
Treasury debt management, were also used to maintain upward pressure
on short-term rates.
While sympathetic to the objectives of this policy, many
dealers believed that implementation of the policy had involved
too much intervention in the U.S. Government securities market by
both monetary and debt management officials.
Several dealers said
that private investors had tended to withdraw from the market as
a result of this intervention.
Moreover, "operation twist" in
conjunction with Treasury advance refundings had contributed to a
dampening of fluctuations in bond prices, since purchases of
longer-term issues for official accounts tended to maintain a floor
under bond prices, while advance refundings imposed a ceiling on
prices through periodic additions to market supply.
In this respect
many dealers commented that, although the authorities had not actually
"pegged" bond prices, there often seemed to be an officially approved
range of price fluctuations.
Under these circumstances, dealers
felt that it had been very difficult to achieve profitable operations,
since the major source of dealer p r o f i t s — t h e correct anticipation
-5of fluctuations in market prices from which alert dealers could
benefit by timely additions to or liquidations of their inventorieshad been denied them.
A number of dealers conceded that the objectives of
Treasury and Federal Reserve officials were of overriding importance.
Nevertheless, most of these dealers also felt that the officials
needed to give more attention to the impact of official account
transactions and of debt management techniques on the functioning
of the secondary market for U.S. Government bonds.
Several dealers stressed the fact that the market's belief
in some officially approved range of market fluctuations had been
abruptly shattered during the late summer and fall of 1965 when
interest rates rose sharply.
in this period.
Many dealers suffered sizable losses
At the same time, the dealers spoke approvingly
of an apparent return to "freer" markets since the fall of 1965.
While the System and Treasury trust accounts had continued to
operate in the intermediate and long-term maturity sectors of the
Treasury bond market, such operations had been relatively small
and, most important, did not appear to have any interest rate
objectives.
Several dealers indicated that the performance of the
market was much improved as a consequence, although the rising
trend of interest rates continued to make the market a difficult
one in which to operate.
B.
Other developments affecting the Treasury bond market
Several other reasons were given to explain what many
dealers regarded as a deterioration in their ability to make
-6satisfactory secondary markets for longer-term Treasury
obligations during the 1961-65 period.
Prominent among these was
the over-all performance of the economy which in conjunction with
debt management and monetary policies had fostered relatively
narrow fluctuations in prices over most of the period and a
gradual uptrend in yields.
Indeed, some dealers gave more weight
to economic developments than to official policies for the general
market stability which made it difficult for dealers to stimulate
investor activity and to realize profits from swings in market prices.
Several dealers pointed out that the relative stability
of prices and yields during most of the 1961-65 period had been
accentuated by increased competition among the dealers.
This
competition had contributed to the narrowing of spreads between
dealers' bid and asked quotations to amounts that many dealers
felt were incompatible with the market risks they assumed.
A
related development had been the assumption of what many dealers
regarded as undue inventory risks.
With trading spreads narrow
and fears of sizable declines in bond prices stilled by official
policy actions, many dealers sought to maintain profits through
larger positions and a larger volume of trading.
As a consequence,
many dealer firms sustained substantial losses on their portfolios
when Treasury bond prices fell in the late summer and fall of 1965.
A number of dealers remarked that, as a result of this experience,
the dealer fraternity had become more realistic about assuming
market risks.
Moreover, some of the temptation to assume such risks
-7had been removed with the return of more freely fluctuating market
prices and a widening of quotation spreads.
Another development that had tended to damp market
fluctuations and to narrow spreads between dealer bid and asked
quotations in the 1961-65 period was the intensified competition
from many so-called
ff
quasi" dealers, mainly large commercial banks.
Dealer views differed widely as to the contribution that quasi
dealers made to the functioning of the market*
It was alleged
that quasi dealers were willing to trade actively in the market
and to take speculative positions during Treasury financings, but
only so long as market risks were deemed to be minimal.
When
market yields began to rise sharply after mid-1965, for example,
quasi dealers were said to have substantially reduced their trading
activities.
A few dealers complained that the number of true primary
dealers had declined in the period under review, especially since
mid-1965.
It was alleged that under difficult market circumstances
very few dealer firms stood ready to make realistic markets and to
assume significant risks in intermediate- and long-term bonds.
The
result was poorer over-all market performance than should be expected
of firms that advertised themselves as primary dealers.
one dealer firm questioned this view, however.
At least
It suggested that
historically very few firms had been willing to make active markets
in all maturity areas under all market circumstances; moreover, only
a few firms were needed to fulfill this function and investors or
-8or other dealers could secure realistic execution of their
transactions by addressing themselves to these primary dealers.
A number of dealers also thought that the market benefitted from
a larger number of dealers, even though many of them might specialize
only in certain maturity areas of the market; among the advantages
cited were the availability of an increased amount of capital to
the dealers as a group, a wider dispersion of market risks, and
a broader range of contacts with investors.
C. * Structural and institutional changes in the market
Several dealers suggested that with the growth in types
and amounts of competing market instruments and the broadening of
investment authorizations for many institutional investors, U.S.
Government securities had declined in relative importance in many
f
investment portfolios during the 1 9 6 0 s .
Some dealers concluded
that the broadening of market options had tended to impair the
performance of the Government securities market, but other dealers
were more neutral on this subject, and a few emphasized the greater
trading opportunities generated by more flexible management of
portfolios by institutional investors.
A related development that was more universally viewed
as detrimental to market performance was the reduction or immobilization of the Government securities holdings of some of the most
active participants in the market, especially commercial banks.
In recent years many commercial banks had drawn down their investments
in Government securities to minimal levels consistent with liquidity
-9and growing collateral requirements.
As a result, commercial
banks, who were considered to be the mainstay of the secondary
market, had tended to curtail their in-and-out trading activity
in the market.
Concomitantly, many traditionally less active
market participants --such as pension funds and official accounts""
had acquired large blocks of securities.
The resulting decline
in institutional trading activity was felt to have affected mainly
the intermediate- and long-term maturity areas of the U . S . Government
securities market where the problem was compounded by reduced trading
because of Treasury advance refundings, by lessened opportunities
for switching because of relative market stability, and by reluctance
to sell securities and realize book losses on issues acquired in
earlier years when interest rates were much lower.
Several dealers indicated that the reduction or
immobilization (for use as collateral) of Government securities in
commercial bank portfolios had also tended to make it more difficult
for dealers to borrow such securities for use in executing short sales.
It was noted that other types of institutional investors tended to
be less willing, or were not authorized, to lend securities for the
purpose of facilitating short sales.
With their operational
flexibility impaired by the growing difficulty of borrowing securities,
many dealers felt that the functioning of the market had been harmed.
Some dealers viewed the problem as having become quite serious and
only a few dealers said they had encountered little or no difficulty
in borrowing securities.
-10Another problem that drew considerable comment from
dealers was the extent to which funds were available to finance
positions.
Most dealers indicated that their sources of financing
had not changed significantly with respect to institutional
composition in recent years, although the number of individual
sources had tended to increase.
However, the cost of funds to
finance inventories had been a growing burden, especially in the
period of rapidly rising yields since mid-1965.
Dealers had
increasingly been faced with a negative carry on their inventories,
and on occasions when the money market had come under particularly
severe pressure some dealers had feared that necessary financing
might not be available even at penalty rates.
Large New York City
banks, it was said, had tended to shy away in periods of very tight
money from their traditional role as residual lenders to the dealers.
Financing difficulties, many dealers suggested, had contributed in
1965 and 1966 to a reduction in their willingness to take positions
and to make markets--thereby impairing market performance.
There were many comments about the changing composition
of the firms in the dealer industry.
Several dealers decried the
decline in the number of specialized, nonbank dealer firms and
saw a long-run threat to the market in the relatively fast growth
of bank dealers.
Since 1960 three major banks had initiated
operations as primary dealers and a fourth very large bank was
actively moving in that direction.
Three specialized, nonbank
dealer firms had disappeared from the ranks, including one that
-11was absorbed by a large and diversified nonbank securities firm.
Two other nonbank firms, which were already active in other sectors
of the securities business, had formed new dealer departments since
1960.
Over all, the number of primary dealers reporting to the
Federal Reserve Bank of New York and authorized to transact
business with the Trading Desk of that Bank had increased from
17 to 20 in this period.
While some dealers intimated that new firms were not
needed in an industry already characterized by a high degree of
competition for the available business, others welcomed the added
competition and indicated that it fostered better markets and
more service to customers.
Moreover, a larger and more heavily
capitalized dealer community was in a better position to underwrite
Treasury financings and to accommodate sizable secondary market
operations by the Federal Reserve and the Treasury trust funds.
With varying degrees of emphasis, several nonbank dealers
and two or three bank dealers expressed concern over the recent
growth, and the prospects for continued growth, in the number of
bank dealers.
The long-range danger seen for the market in this
development was not so much a matter of increased competition per se
but the potential displacement of nonbank dealers as a result of
uneven competition.
Concern was felt especially for the narrowly
specialized firms that did not have a broad securities business to
fall back upon.
Dealers expressing these fears thought that bank
dealers tended to avoid making good markets in periods of tight
-12money when bank management was tempted to force a retrenchment
in the amount of funds used by the dealer department.
As several
dealers saw the matter, optimal performance by dealers under
difficult market circumstances could be secured only from
dealers who looked primarily to the Treasury and other closely
related markets for their profits in bad years as well as good.
The competitive advantages that bank dealers were said
to enjoy over nonbank dealers included readier access to sources
of financing.
Most bank dealer departments received a large part
of their funds from the bank itself, which in turn could borrow
on relatively favorable terms from the day-to-day Federal funds
market or even perhaps from the discount window of the Federal
Reserve Bank.
Another reason for the uneven competition by bank
dealers stemmed from the alleged fact that large banks tended to
use the operations of their dealer departments as
11
loss leaders
11
designed to enhance the prestige of the bank and to secure a
variety of collateral advantages through enlarged market contacts
and services performed for customers.
It was also asserted that
bank dealers had a competitive edge in some Treasury cash financings,
because banks were allowed to pay for certain new issues through
credits to so-called Treasury tax-and-loan accounts at the banks.
This form of deferred payment used by the Treasury to help underwrite large new cash issues was available to other banks but not
to nonbank dealer firms.
Several bank dealers d i s p u t e d — s o m e hotly--the contention
that they enjoyed any, or any significant, competitive advantage
-13over other dealers.
In particular, they stressed the fact that
their dealer departments were expected to operate at a profit
and were not to be subsidized by the rest of the bank for any
lengthy period of time.
Moreover, bank dealers had to assume
the burden of a sizable and unprofitable odd-lot business which
they executed for correspondent banks and other bank customers.
This burden was shared by the large and diversified nonbank
dealer firms, especially those with a stock exchange business,
but the specialized Government securities dealers could avoid
it for the most part.
The bank dealers also pointed out that
any benefits deriving from tax-and-loan account privileges in
Treasury cash financings accrued to the investment department
of a bank rather than to the dealer department, which normally
was not allocated the new issues.
Finally, with respect to the
availability of funds to finance their positions, bank dealers
pointed out that they were not granted access to Federal Reserve
repurchase agreements,—^ which were of considerable benefit to
nonbank dealers, especially in periods of tight money.
D.
Accommodation of investors in the U.S. Treasury bond market
Even though a number of dealers felt the functioning
of the Treasury bond market had deteriorated in the 1 9 6 0 s , they
emphasized their belief that the market had performed quite well
1/ A repurchase agreement involves a sale of securities and a
simultaneous agreement to repurchase the same securities at a later
date. Differences in prices, or rates of discount in the case of
Treasury bills, provide a specific rate of return to the buyer for
the period of time between the sale and repurchase dates. Repurchase
agreements furnish dealers, in effect, with a means of financing
their inventories.
-14in view of the many obstacles it had to overcome.
It was even
suggested that dealer willingness to make highly competitive
markets and to accommodate customers had been "too good" in this
period, as evidenced by narrowed trading spreads, increased
volume, and greater position risks.
The Treasury bond market,
the dealers noted, was still in a class by itself when compared
with secondary markets for seasoned corporate and State and
local government bonds or for outstanding mortgages.
There had been times in recent years when the market
for U.S. Government bonds was very active, especially around
periods of Treasury financings, and in those circumstances
investors had been able to move sizable blocks of longer-term
securities.
Even under less propitious market circumstances,
the dealers observed, investors had been able to execute transactions of $1 million in bonds quite readily at prevailing market
prices; more sizable blocks of longer-term securities could also
be handled by the iflarket, but these larger transactions occasionally
required more time to be worked out.
Some dealers indicated that from an investor standpoint the
Treasury bond market became "thinner" after mid-1965 than it had
been earlier.
Investors found it more difficult to make sizable
portfolio adjustments.
However, this development was viewed as
normal in a period of rising yields, and most dealers still f e l t given prevailing market circumstances--that the functioning of the
market had tended to improve after mid-1965.
The reason offered
for this improvement, as noted earlier, was that the market
-15became freer to respond to basic supply and demand forces and
to changes in the outlook for over-all economic activity.
At
any given time, dealers believed, optimal performance of the
bond market was achieved when official controls or manipulations
were minimal.
E.
Performance of the Treasury bill market
Most of the dealers reported that the market for Treasury
bills had continued to function exceptionally well in recent years.
The market had been highly competitive, and investors were continuously
able to execute a large volume of business at, or very close to,
prevailing market quotations.
Dealer views differed concerning the impact of a general
broadening in investment authorizations and the growth in alternative
short-term investment media during the 1960's.
Some dealers believed
that these developments had had little effect on the performance of
the Treasury bill market as such, although the over-all increase
in short-term debt instruments had tended to raise the general
level of short-term interest rates.
A few dealers thought the
Treasury bill market had lost some of its relative attractiveness
for investors, although they also thought that the performance of
the bill market had been adversely affected only to a minor extent.
There was considerable emphasis, however, on the fact
that profitable dealer operations in bills had been most difficult
to achieve in recent years.
The difficulty was attributed mainly
to the general stability of bill rates over most of the 1961-65
-16period and
to the related development of very narrow trading
spreads stemming from intense competition among an increased
number of dealers and quasi dealers.
With differing degrees
of emphasis, dealers blamed part of the stability in bill rates
on direct policy actions of debt management and monetary officials.
In this connection, the dealers were not opposed to secondary
market operations in the bill market by the Federal Reserve.
Indeed, most of the dealers were in favor of having the System
confine its operations to the bill market under most circumstances.
The dealers objected, however, to market maneuvers or debt
management techniques whose aim might be to control the level
of, or fluctuations in, Treasury bill rates.
F.
Performance of the market for Federal agency securities
The dealers who commented on the market for Federal
agency securities were agreed that this market had grown
significantly during the 1960's.
This growth had been a concomitant
of the large increase in agency debt outstanding, which in turn
had stimulated increased dealer and investor participation in the
market.
The dealers noted that they and other securities firms
had done much to help broaden the market in recent years by educating
investors to the merits of investment in Federal agency obligations.
All of the primary dealers in U.S. Government securities now
operated in the secondary market for agency issues, whereas before
1960 very few dealer firms had regular traders assigned to these
securities.
-17A sharp distinction was drawn between the functioning
of the secondary market for the seasoned issues of the old-line
Federal agencies and the market for the less familiar securities
of agencies with little previous market exposure.
The better
known agency names included the issues of three farm agencies
(banks for cooperatives, Federal intermediate credit banks, and
Federal land banks) and seasoned obligations of two agencies in
the housing field (Federal home loan banks and Federal National
f!
Mortgage Association, the latter better known as "Fannie Mae ).
Issues of these agencies, some dealers felt, currently enjoyed a
better secondary market in the shorter maturities than did
Treasury coupon obligations of comparable maturity.
However, no
secondary market--that for Federal agency securities included-even approached the depth and breadth of the market for Treasury
bills.
The newer agency issues, the dealers added, did not
share in this active secondary market for the more familiar agency
obligations.
Notable among the newer types of Federal agency
obligations were the participation certificates (PC's) that were
marketed by (or through) the Federal National Mortgage Association
and the Export-Import Bank of Washington.
The secondary market
for PC's had been hampered not only by the relative newness of
the instruments but also by various technical considerations.
For example, their original availability only in registered form,
as opposed to bearer form, had inhibited their tradeability.
-18In addition, their sale in serial form, with relatively small
individual maturities, had also impaired their marketability,
as smaller individual issues were harder to trade than fewer but
more sizable "term
11
obligations.
In short, these drawbacks, as
well as others, had precluded the development of any real
secondary market for participation certificates.—^
Some dealers expressed objections to the basic idea
of issuing relatively expensive Federal agency debt in the place
of direct Treasury obligations.
A few dealers also asserted that
the proliferation of new types of agency securities represented
at least a long-run threat to the U.S. Government securities
market.
Several dealers thought that the record amount of new
issues sold by Federal agencies during the first half of 1966 had
contributed importantly to the upward escalation of interest rates
in that period.
It was strongly urged that in the future new
issues be better timed and coordinated, so as to avoid the disruptive
impact on markets that the "bunching"of new issues tended to produce.
III.
A.
Performance of Individual Dealer Firms
Trading activity
All of the dealers reported that they were active
participants in the markets for shorter-term Treasury and Federal
agency securities.
Many indicated their trading in such securities
had increased in recent years, especially in the case of Federal
f
1/ P C s were made available in bearer form and were sold as term
obligations beginning with a FNMA offering on January 5 , 1967.
-19agency obligations.
On the other hand, relatively few dealers
said they conducted any significant amount of business in
intermediate- and long-term Treasury bonds.
Some dealers
mentioned that they had curtailed their trading in longer-term
issues in the period of rising yields after mid-1965.
A number of dealers pointed out that from time to time
they shifted the emphasis of their operations to those sectors
of the market that appeared to promise the greatest potential
for profits under prevailing market circumstances.
The market
for Federal agency securities had been a case in point during
recent years and several dealers commented that they had looked
increasingly to this market for their profits.
Moreover, as it
became more difficult to make profits in the Government securities
market, the mors specialized dealer firms had shown a tendency
to diversify in recent years.
B.
Relationships to Treasury and Federal Reserve
The dealers generally felt that the nature of their
business obligated them to help underwrite Treasury financings,
and several dealers considered that the dealers as a group had
performed very well in this respect.
Some dealers believed that
they should not be expected to participate in Treasury financings
when they thought their capital would be unduly jeopardized.
In
particular, some dealer firms held that their underwriting
responsibilities were lessened when the Treasury offered new
issues on terms which differed significantly from those that the
-20dealer firm had recommended.
Some dealers made it a practice to
inform Treasury officials whenever they intended to reduce their
participation in a given Treasury refunding operation.
The dealers recognized a responsibility to make
competitive bids or offers when the Federal Reserve or the Treasury
trust funds wanted to buy or sell U.S. Government securities.
Some
dealers said they felt obligated to extend themselves at times to
accommodate official accounts under difficult market circumstances.
It was also their duty, the dealers said, to keep Treasury
and Federal Reserve officials fully informed of market developments
and to advise the Treasury concerning its financing operations.
Some
dealers suggested that the Treasury and the Federal Reserve should
make fuller use of the dealers
1
expertise and that contacts between
officials and the dealers should be improved.
Several dealers
complained that they received too little information from monetary
and debt management officials, although the dealers generally
recognized that the flow of information had to be a one-way affair
for the most part.
C.
Profitability of dealer operations
Most of the dealers indicated that their profit experience
had been poor in the 1961-65 period, particularly toward the end of
the period.
Several dealers reported losses in one or more of these
years and in some cases these losses had been substantial.
The
profitability of dealer operations had tended to improve for most
films in the first half of 1966, however.
Most of the firms that
had been in operation for a decade or more said they had realized
substantially better profits in 1955-60 than in 1961-65.
-21The dealers stressed that the general stability of interest
rates over most of the 1961-65 period had greatly limited the potential
for profits on dealer inventories.
Over time, position profits were
the major source of net dealer income.
Moreover, the narrow trading
spreads associated with generally stable market yields and the
intensified competition among dealers and quasi dealers in the
1961-65 period had further restricted dealer profits.
Many dealers also emphasized the rising cost of financing
their inventories in this period.
They drew attention to the "negative
carry" that they increasingly encountered in this period when interest
rates on dealer loans were higher than the interest return on the
securities being financed.
Finally, some dealers pointed up the
fact that a generally rising trend of interest rates in the 1961-65
period had further curtailed the potential for profitable operations,
especially since this trend was associated with relatively narrow
short-run market fluctuations.
Several dealers indicated that unprofitable operations
were compelling a reassessment of their continued functioning as
primary dealers.
Only a few firms had reduced their dealer
operations substantially as of mid-1966, but some others had
curtailed operations in the relatively risk-laden intermediate- and
long-term sectors of the market.
The necessity of profits for
continued operations over the longer run was highlighted, and even
those firms whose dealer operations were only a part of a diversified
securities business or a department of a large commercial bank
-22stressed that the firm or the bank could not be expected to
subsidize unprofitable dealer operations over long periods of time.
It must be observed that many dealer firms remained quite
optimistic about the long-run prospects for profitable operations
in the market for U.S. Government securities.
This was true
especially of the firms that had been in this market for a long
period of time.
IV.
Comments on Specific Policy Issues and Suggestions for
Improving the Market
A.
Treasury debt management techniques
Advance refundings.
Virtually without exception, the
dealers believed that advance refundings as conducted in the 1960-65
period had been too massive and too frequent and had proved detrimental
to the secondary market for intermediate- and long-term Treasury bonds.
The dealers conceded that advance refundings were an excellent debt
management technique, but they argued that more weight needed to be
given to secondary market performance.
Accordingly, future advance
refundings should be made smaller, less complicated, and less
frequent.
At least one dealer recommended that advance refundings
be abandoned altogether.
In the long run, the dealers intimated,
a strong secondary market would be of greater advantage to the Treasury
than an optimal debt structure.
Moreover, the Treasury could and
should offer more long-term bonds in regular Treasury refundings.
Treasury bill auctions.
A number of dealers suggested
that the issues of 1-year bills were too small in size (at the time
$1.0 billion) to be effectively traded in the secondary market.
-23Some dealers advised that the Treasury replace the current monthly
auctions of such bills with larger quarterly a u c t i o n s — r e v e r t i n g to
the practice it had followed until the summer of 1963.
Other
dealers suggested retaining the monthly auctions and either
enlarging them or reopening already outstanding issues of 1-year
bills to investors some time after their initial issue.—^
Several dealers recommended that, as a matter of general
debt management policy, the Treasury should aim to enclose all of the
debt within fewer but more tradeable issues.
This objective could
be implemented by reopening more outstanding issues at times of
Treasury financings instead of offering new issues.
A larger floating
supply of a given issue, dealers said, gave that issue a more
competitive trading market and in particular made dealers more
willing to assume a short position in the issue in order to execute
a sale.
Dealer views varied with respect to the Treasury policy of
limiting individual dealer allotments to roughly 25 per cent of any
single bill issue.
Some dealers saw no likelihood that individual
dealers, who received as much as one-fourth of a bill issue, might
exert an undue influence on the market, especially since new issues
had to compete with outstanding issues of comparable maturity.
Other
dealers thought that when two or three dealers got large awards in
the same auction, they tended to influence secondary market trading.
1/ In September 1966 the Treasury introduced a new cycle of
monthly auctions of 9-month bills involving additions to 1-year bills
that were already outstanding.
-24Thus, while no abuses might be found, the dealers recommended
that the Treasury review its policy on allotments to individual
dealers.
Some dealers believed the Treasury should abandon its
infrequent practice of auctioning so-called "bill strips."
These
auctions involved bidding for several bill issues of varying
maturities at a single price, with the successful bidders being
awarded the "strip" of bills rather than a single issue.
Some
dealers contended that such auctions were awkward and tended to
destabilize the entire bill market.
Tax-and-loan account credit in cash financings.
Several
dealers, especially the nonbank firms, commented that the privilege
of paying for certain new Treasury cash issues by crediting Treasury
tax-and-loan accounts--a privilege allowed only to b a n k s — r e s u l t e d
in an unfair advantage to bank dealers.
It was suggested that
nonbank dealers be accorded some comparable advantage in these
financings, possibly through some form of deferred payment for the
new issues.
Several dealers conceded that the tax-and-loan account
privilege was necessary to secure the underwriting support of banks
around the country in Treasury bill financings where a large amount
of new cash was being raised.
However, they saw no need to extend
this privilege to cash financings or refundings involving Treasury
notes and bonds ("coupon issues"), especially if the amount of new
money being raised, if any, was relatively small.
Alternatively,
-25a few dealers suggested that nonbank dealers be given some
equalizing advantage only in cash financings involving coupon issues.
11
Cash" or "rights
11
exchanges.
Dealer views differed on this
topic, but there was a tendency to favor rights exchanges.
Some
dealers thought that cash refundings were more difficult to underwrite
than refundings in which holders of the maturing issues ("rights")
were given the option to exchange these issues into one or more new
issues.
Cash refinancings always entailed more or less uncertainty
as to the percentage allotment that would be received on cash
subscriptions, and since 100 per cent allotments were rare, subscriptions
had to be "padded" in line with estimates of the allotment percentage.
A few dealers played down the difficulty of padding subscriptions,
however, and one argued that from a dealer's standpoint a cash
financing was preferable in periods of tight money when a "negative
carry
11
might be involved in financing positions in maturing rights.
Some dealers contended that the several cash refundings
undertaken by the Treasury in recent years had reduced the attractiveness
of short-term coupon issues.
Holders of these maturing obligations
could no longer be sure that they would be offered a chance to
exchange them at maturity.
At the same time, such h o l d e r s — p a r t i c u l a r l y
the smaller banks and other institutions that were the backbone of
this sector of the market--were often wary of padding their subscriptions
in cash financings.
Moreover, investors and dealers who wanted to
speculate on the potential appreciation of the value of rights, if
and when the Treasury offered attractive new issues in a rights
-26exchange, now tended to shy away from the short-term coupon
sector of the market.
From the Treasury's standpoint, a cash exchange might be
desirable, if it was deemed necessary to avoid attrition from
unexchanged holdings of maturing rights or if it was considered
expedient to raise net cash by making the new issue(s) larger than
the maturing obligations(s).
Dealers favoring rights exchanges
concluded that only if these considerations were overriding should
the Treasury use the cash refunding technique.
A few dealers commented on the practice of setting
subscription ceilings for individual dealer firms in Treasury
cash financings involving coupon issues.
Some of the smaller
dealers complained that the subscription limits tended to favor
the large, diversified dealer firms whose capital might be greater
but who were not necessarily more active in the market.
It was also
pointed out that there were no limits on subscriptions in Treasury
bill auctions apart from the limitation that only about one-fourth
of any issue might be awarded to a single dealer firm.
The dealers
argued that the amount of subscriptions and risk-taking in cash
financings should be left to the judgment of the individual dealer
firms.
Competitive sale of long-term Treasury bonds through underwriting syndicates.
The few dealers who commented on this Treasury
debt management technique urged that it be abandoned.
In their view
it was a cumbersome and costly device that had proved unprofitable
-27for the dealers.
Moreover, the amount of long-term debt that could
be marketed through this means was relatively small.
B.
Secondary market operations by official accounts
Federal Reserve transactions in U.S. Government securities.
Most dealers were opposed to Federal Reserve operations in coupon
issues if the objective was to control long-term yields.
They
objected, for example, to the policy that came to be known as
"operation twist."
At the extreme, some dealers argued that the
Federal Reserve should intervene in the coupon market only to avoid
or to correct a "disorderly
11
market situation.
A "disorderly
11
market
might follow a declaration of war or some other highly unsettling
event.
However, most of the dealers did not voice objections to
Federal Reserve operations in very short-term Treasury coupon issues.
A less extreme view, shared by many dealers, was that
relatively moderate operations in longer-term Treasury securities
were acceptable, so long as these operations did not have any
interest rate objectives.
Accordingly, many dealers had no real
quarrel with the type and scope of transactions in coupon issues that
the Federal Reserve had carried out between the fall of 1965 and
the summer of 1966.
A number of dealers went a step further and
actually recommended such operations with limited objectives.
On
the other hand, some dealers questioned the need for such marginal
operations.
If the Federal Reserve decided that it should operate in
all maturity areas of the market, then several dealers thought the
-28System should consider selling as well as buying longer-term
Treasury obligations.
This idea gave rise to several demurrers,
but those subscribing to it pointed to possible advantages of
System sales such as increased flexibility of Federal Reserve
operations and the provision of scarce issues to the market which
would enhance the tradeability of such issues.
In this connection,
some dealers also recommended that the official accounts engage in
"swap
11
transactions with the dealers.
The aim would be to provide
the market with relatively scarce issues whose prices were higher
and yields lower than other issues of comparable maturity.
In
return, the official accounts would enhance their earnings by
acquiring less scarce and higher yielding issues.
Some dealers
indicated objections to this proposal, partly on the grounds that
any sizable amount of swapping activity would prove unsettling to
the market.
Treasury trust fund transactions in U.S. Government securities.
Dealer views were divided concerning the proper role of Treasury
trust fund operations in the secondary market for coupon issues.
At one extreme, some dealers expressed a preference for having all
Treasury trust fund investments limited to nonmarketable "special"
issues and none in marketable Treasury obligations.
A more moderate
view held that investments in marketable issues were desirable when
the earnings of the trust funds could be enhanced thereby.
According
to this group, management of the trust funds on a "professional" basis
was the criterion that should be followed.
However, these dealers
-29did not approve of using the trust funds to "dress up the market
during periods of Treasury financings.
11
In particular, they believed
attempts at rate validation or the encouragement of close pricing
of new issues by the Treasury should be avoided.
At the other extreme, a few dealers believed that the
trust funds could properly be used to stabilize the market during
Treasury financings, although one dealer felt that such market
intervention should be undertaken only rarely.
In general, the
dealers deemed the avoidance or correction of disorderly market
conditions to be a function of the Federal Reserve rather than
of the Treasury trust funds.
It would be helpful, some dealers thought, if the Federal
Reserve were to issue some "ground rules" spelling out its philosophy
of operations in coupon issues and the conditions under which it
intended to enter the market.
The Treasury trust funds might also
issue "ground rules" governing their operations.
Another useful
procedure, one dealer suggested, would be for the official accounts
to give some notice to the market when operations in coupon issues
were contemplated.
This notification might indicate the general
purpose of the operations, but the official accounts would not be
expected to reveal their plans in any detail.
Official account operations in Federal agency securities.
The dealers were sharply divided on the issue of official account
operations in Federal agency issues.
Their views ranged from strong
support of such operations to equally ardent opposition.
There was
also a difference of views among senior spokesmen for several individual
-30dealer firms.
It might be added, however, that none of the dealers
expressed opposition to Federal Reserve repurchase agreements made
against Federal agency securities as distinguished from outright
purchases or sales of such securities.
A major argument used by dealers who advised against such
outright transactions was the probability of strong political
pressures on the Federal Reserve to support particular agency issues
or financings.
It was felt that if such support were given, Congress
might be encouraged to proliferate new agencies to finance pet projects
and might even require Federal Reserve support of issues by such
agencies.
Another major argument against official operations in agency
issues stressed the disturbing impact on the secondary market of
relatively large, and by nature discontinuous, Federal Reserve operations.
The result would tend to be a market dominated by official transactions
rather than one responsive to the basic forces of supply and demand.
In essence, this was the same argument used by dealers opposed to
Federal Reserve operations in longer-term Treasury obligations.
In
this instance, however, not all of the dealers who favored the "bills
usually
11
policy were opposed to Federal Reserve operations in agency
issues.
A majority of the dealers were convinced that the short-term
sector of the market for Federal agency securities was sufficiently
developed to accommodate more than token Federal Reserve transactions.
Even a few of the dealers who opposed such operations conceded this
point.
Several of the dealers thought the Federal Reserve could and
should conduct operations on both the buying and selling sides of the
-31market.
Such operations, some indicated, would enhance the
prestige of the Federal agency securities market, would tend to
bring rates on agency issues into closer alignment with yields on
direct U.S. Government debt, and would stimulate investor activity
in Federal agency obligations.
C.
Techniques of the Trading Desk at the Federal Reserve Bank of New York
Identifying accounts and amounts involved in Desk operations.
The dealers
1
most common and insistent recommendations concerning
Trading Desk techniques centered on a desire to obtain as much
information as possible about the nature and scope of the Desk's
operations.
Accordingly, a large majority of the dealers urged that
the Desk identify the account for which it was conducting a given
transaction.
This meant indicating whether the transaction was for
Federal Open Market Account, for Treasury trust funds, or for other
"customer
11
accounts such as foreign central banks and official
international institutions.
The dealers alleged that this identi-
fication was important to them because the psychological impact of
operations for the Federal Open Market Committee could differ
markedly from the market effects of similar transactions for
"customer" accounts.
The dealers were always interested, of course,
in trying to determine whether monetary policy was a consideration
when the Desk was conducting operations.
A small minority among
the dealers felt that the Desk could not properly undertake to
inform the dealers about the source of given market transactions,
but even these dealers conceded they would find such identification
useful.
-32A few dealers recommended that the Desk give some
indication of the total amount of each operation that was spread
among several dealers.
The Desk would not obligate itself for
the total specified if bids or offers to the Desk were not in
line with current market quotations.
It was argued that this
technique would assure better execution for the Desk and would
obviate a good deal of market uncertainty and dealer criticism.
One dealer recommended that the size of operations be indicated
only in the case of "customer
11
accounts; for operations for the
Federal Open Market Committee, he suggested that only the general
maturity area of the transactions be divulged.
Use of "go-around" technique for executing Desk transactions.
Some dealers thought the Desk should utilize the "go-around"
technique
in all of its transactions instead of limiting use of the technique
to operations for the System Open Market Account and occasional large
transactions for "customer
11
accounts.
A "go-around" involves the
soliciting of bids or offers from all of the dealers when a given
operation is conducted.
An alternative, often used when relatively
small transactions are being carried out, is to fill orders from
bids or offers that individual dealers have spontaneously made to
the Desk.
This method means rechecking the quotations of a small
number of dealers when the transaction is about to be executed and
completing the transaction on the basis of the best price.
This
"best price" has to be in line with general market quotations at
a given time.
-33A few dealers indicated that failure to use the
11
go-around
ff
technique in all operations subjected the Desk to allegations of
favoritism, especially from the smaller or less active dealers and
tended to create some confusion and ill-feeling among market participants.
said.
Poorer execution of orders could also result, these dealers
Other dealers argued that the Desk could secure optimal
execution of its orders, if it limited its contacts to those dealers
who were active in the sector of the market involved in the
transaction.
For example, only a relatively few dealers had made
active and competitive markets in intermediate- and long-term bonds
after mid-1965.
These were therefore the only dealers who would
be furnishing the Desk with competitive quotations on such issues
and who were in a position to execute Desk transactions on a
realistic basis in that sector of the market.
Frequency of Desk operations.
A small number of dealers
expressed a general preference for limiting the frequency of System
operations and allowing the market to make more of its own short-run
adjustments.
In this connection, one dealer suggested longer reserve
settlement periods for banks than the then current 1-week period
for reserve city banks and 2-week period for country banks.
A 4-week
reserve settlement period was recommended for all member banks with
actual settlement on a staggered basis among the banks.
Timing of Desk operations:
"cash" vs. "regular
11
trading.
Several dealers advised that Desk operations be undertaken as early
in the business day as possible, preferably well before noon.
Early
-34operations greatly facilitated the delivery of securities sold to
11
the Desk for cash
11
(same-day payment and delivery) and gave
dealers more flexibility in trading or financing securities
purchased from the Desk on a given day.
Moreover, when the Desk
was buying, there tended to be a better availability of securities
early in the day, that is, before the dealers had made commitments
to trade or to finance their holdings.
A number of dealers also urged that the Desk engage in
11
more trading for regular" delivery (next-business-day payment
and delivery) rather than for "cash" delivery.
As in the case made
for early operations during the day, the dealers felt that the
11
greater lead-time afforded by trades for regular
11
delivery gave
them more flexibility in their own trading, financing, and delivery
of securities.
Repurchase agreements vs. outright transactions.
A number
of dealers recommended that the Federal Reserve undertake relatively
more outright transactions in U.S. Government securities and rely
less on repurchase agreements.
This suggestion was in line with a
general preference on the part of most dealers to execute outright
sales rather than merely to enter into a form of financing arrangement.
However, a qualifying view was expressed in reference to periods of
tight money when dealer financing costs were high.
At such times,
repurchase agreements with the System helped the dealers to finance
their positions at something less than penalty rates, since the
Desk usually made repurchase agreements at the discount rate.
Another
-35advantage seen for repurchase agreements was the possible use
of such agreements to minimize the impact of Federal Reserve
operations under difficult market circumstances.
Technical features of System repurchase agreements.
A
number of dealers recommended the permanent removal of the maturity
restriction which made only securities due within 24 months eligible
for System repurchase agreements.
This restriction had already been
lifted during periods of Treasury financings.
During the summer
of 1966 the Federal Open Market Committee decided to remove all
maturity restrictions on U.S. Government securities eligible for
System repurchase agreements.
The dealers also recommended that they be allowed in
effect to substitute collateral on repurchase agreements made with
the Desk.
Under current regulations, dealers are permitted to
terminate a repurchase agreement before maturity, but if they do
so, they may not initiate a new repurchase agreement for the
unexpired term of the old contract.
Thus, when dealers sell
securities that have been placed with the System under repurchase
agreements and terminate the agreements by withdrawing the
securities, the latter m a y not be replaced with other collateral,
and unless the Desk decides to make an equal amount of new agreements
on the same day, total repurchase agreements are reduced.
Permission
to (in effect) substitute collateral, the dealers argued, would add
flexibility to their operations.
Moreover, System repurchase
agreements would become more attractive to dealers--thereby increasing
-36the potential amount of such contracts that the Desk would be
able to make at any given time.
Review of minimum dealer standards for trading with the Desk.
A few dealers intimated that not all of the firms allowed to conduct
transactions with the Desk functioned as true primary dealers in
U.S. Government securities.
It was alleged that a number of firms
that formerly were active participants in the market had tended to
reduce their activity in recent years.
And since trading access to
the Desk carried with it a number of privileges and advantages, the
assumption of certain responsibilities should be a quid pro quo.
It was therefore recommended that the Federal Reserve undertake
a review of standards for firms wishing to trade with the Desk.
D.
Problem of dealer financing
The problem of dealer financing elicited comments and
suggestions from virtually all of the dealers.
Several dealers,
especially among the nonbank firms, saw an urgent need for a
"lender of last resort
11
in periods of very tight money such as was
being experienced at the time of the dealer meetings (June and July
1966).
Several proposals were made to provide the desired lending
facilities.
A number of dealers recommended that banks making loans to
nonbank dealers or financing their own bank dealer departments be
granted freer access to the Federal Reserve discount window, especially
in periods of market stress.
Such access should be without prejudice
to the bank's over-all borrowing record from the Federal Reserve.
-37Another suggestion was to permit direct access to the discount
window by nonbank dealers under a "line of credit.
11
Other dealers
urged that repurchase agreements with the System be at dealer
initiative, also under a line of credit.
Some bank dealers felt
that they should be extended the privilege of entering into
repurchase agreements with the Federal Reserve, a facility that
only nonbank dealers currently enjoyed.
One dealer envisioned a more elaborate financing arrangement
and argued for the establishment of a bank-credit pool which would
have access in case of need to the discount window.
Participation
by individual dealers in this pool would be determined by formula.
A major problem seen in the extension of Federal Reserve
credit to dealers at their own initiative was the possible conflict
with prevailing System policy that such a release of reserves would
tend to create.
The problem would arise even if the Federal Reserve
retained control over the total line of credit being granted.
Moreover, if the System sold securities to offset an undesired
release of reserves to dealers exercising their option to borrow,
the ultimate financing needs of the dealers would not be changed,
because the dealers would then have to finance the securities newly
acquired from the System.
The distribution of this need among the
dealers might, of course, be altered somewhat.
To obviate this sort of difficulty, some nonbank dealers
recommended an extension of Federal Reserve c r e d i t — s a y , through
repurchase agreements--that would be fully used by the dealers for a
-38specified period.
Thus, a participating dealer withdrawing
securities from a System repurchase agreement would agree to
replace this security with other collateral to maintain his total,
commitment at a given level.
Under such an arrangement, the
Federal Reserve would retain control over the total amount and
timing of bank reserves being injected and absorbed.
Even this
approach was seen to incorporate a basic drawback for the dealers,
because a fully used line of credit, however welcome it might be
in periods of tight money, would still leave the dealers with the
necessity of having to finance peak needs.
While conceding that unresolved problems and new
precedents were involved, the dealers felt that the availability
of extra financing in tight money periods would encourage them to
position more securities, thereby significantly improving the
functioning of the market in such periods.
E.
The market for Federal agency securities
Methods of marketing new issues.
In the opinion of all the
dealers who commented on methods of marketing new issues, the fiscal
agents
1
method of marketing new Federal agency securities through
selling groups has proved very effective and economical.
This
marketing approach was utilized to sell the well-known securities
issued by three farm credit agencies (banks for cooperatives, Federal
intermediate credit banks, and Federal land banks) and two housing
credit agencies (Federal home loan banks and Federal National Mortgage
Association).
Three fiscal agents were involved, including one for
the three farm credit agencies and one each for the housing agencies.
-39The obligations of these agencies were well seasoned, and the securities
firms that constituted the selling groups had widespread contacts
around the country with a large number of institutional investors.
Virtually the only complaint expressed concerning this marketing technique was a conviction on the part of a number of dealers that
the selling groups were too large and included too many small securities
firms that did not have enough retail contacts to sell all of their
allotments.
Concomitantly, many larger members of the selling groups
felt that their allotments were too limited to meet the demands of
all of their own customers.
The consequence, it was alleged, was
that the smaller members of the selling groups tended to sell their
allotments to the larger firms who often lost the underwriting spread
in the process.
Thus, it was intimated, many of the smaller firms
were "free riders" who performed no true service of retail distribution.
Moreover, since the selling of allotments by these firms might tend to
be unsettling under some market circumstances and consequently might
inhibit the effective distribution of new issues, many dealers recommended that "free rider" members of the selling groups be weeded out.
Dealer views were less uniform, but on the whole commendatory,
concerning the method employed to sell the relatively unseasoned participation certificates issued by the Federal National Mortgage Association
and the Export-Import Bank of Washington.
These securities have been
marketed in negotiated sales through a group of underwriters.
the members of the fiscal agents
1
Unlike
selling groups, who are not compelled
to participate in every new offering, the members of the underwriter
group assume responsibility for selling an entire issue of P C ' s .
-40Among the reasons adduced in support of this selling
approach was the need for underwriting support in a sale where
a large amount of new money was being raised and where intermediateand long-term issues were involved.
It was also claimed that
much selling effort, necessitating the services of many salesmen,
was required to distribute successfully this relatively new market
instrument, especially in periods when capital markets were weak.
For these reasons, among others, possible alternative methods of
selling participation certificates were deemed inadequate, save
perhaps under very favorable capital market conditions.
For example, the fiscal agents
1
selling groups were
alleged to work best where relatively short-term issues and/or
little or no new money were involved.
Competitive underwriting
groups did not appear practicable, since two or more syndicates
probably could not be put together to bid on an offering as large
as $500 million or $750 million.
Finally, the direct sale to
investors method used by the Treasury did not appear feasible,
because of the continuing selling effort and the frequent underwriting support required to market new participation certificates.
Among the drawbacks seen by some dealers in the
negotiated syndicate underwriting method was the wider underwriting spread than the one paid by the fiscal agents to their
selling groups.
In addition, it was felt that negotiations prior
to each sale were too protracted and that intra-group trading rules
-41were too restrictive, since all such trading had to be channeled
through the group managers.
Improving the marketability of Federal agency issues.
Most
of the dealer comments on the question of improving the marketability
of Federal agency issues were addressed to participation certificates.
On the technical level, it was urged that these securities be made
available in bearer form as well as in registered form and that larger
and more tradeable "term
small serial issues.
11
issues be offered instead of relatively
Both of these features were incorporated in
the participation certificates sold in 1967.
The dealers also recommended that transfers of Federal
agency issues be permitted over Federal Reserve wires and that new
issues be delivered at all Federal Reserve Banks rather than at the
New York Bank only.
Since early 1967, wire transfers of participation
certificates have been authorized between the Federal Reserve Banks
of New York, Chicago, and San Francisco and new issues m a y be
delivered at any of these Banks.
Federal Reserve facilities outside
New York may not be used for other agency securities.
Another suggestion made by many dealers was for better
scheduling of new issues.
It was felt that new agency offerings
should avoid conflicts with each other and with offerings of direct
U.S. Government debt.
The "bunching^
1
of new issues in the spring
of 1966, it was believed, had contributed importantly to the
escalation of interest rates in that period.
In particular, it
was deemed desirable to accommodate the timing and amounts of new
-42participation certificates to market conditions rather than to
fiscal year constraints.
F.
Organization of the market» trading facilities» and market practices
Dealer association.
Dealer views on the question of a
dealer association varied from outright opposition to enthusiastic
endorsement.
Dealers expressing disapproval believed that an
association of dealers could lead to restrictive trading rules,
and one dealer suggested that it might tend to reduce competition
and limit the entry of new firms.
It was also stated that a
dealer association could not be made to function effectively.
Several dealers adopted an intermediate position on the
issue and indicated at least a qualified interest in an informal
association.
These dealers regarded self-regulation as preferable
to SEC control, and some suggested that a formal association was
not needed because of the small number of dealers.
The dealers who saw merit in the idea of a dealer
association, whether formal or informal, stressed that it might help
to resolve a variety of problems common to dealers.
Examples cited
were in the areas of trading hours, odd lot charges, clearing of
securities, trading spreads, brokers
recognition of dealers.
1
market, and definition and
It was noted that fear of possible anti-trust
prosecution had inhibited the development of a dealer association
and that sponsorship by the Treasury and the Federal Reserve might
be necessary to overcome this obstacle.
Brokers market.
concerning the brokers
1
As on many other questions, dealer views
market were sharply divided.
Perhaps the only
-43area of general agreement was that dealers used brokers mainly for
the purpose of trading relatively small amounts of Treasury coupon
issues.
The brokers, who were not themselves dealers and had no
positions, took a small "spread
11
for their services.
A number of dealers asserted that the brokers performed a
very helpful function.
Brokers provided a useful quotation service
for coupon issues, and they permitted dealers to execute small
transactions in these securities on an impersonal basis--that is,
without revealing the identity of the parties involved in the
transaction.
The brokers could also be used to sound out market
interest in particular issues.
Several other dealers were equally convinced that the
brokers
1
market was more disruptive than constructive.
Brokers
could be used by individual dealers to manipulate the market to
their advantage.
As a result, the use of brokers tended to conceal
the true condition of the market.
the brokers
1
In addition, it was alleged that
market injected much unnecessary activity into the
market and that brokers could not be used to execute sizable
transactions.
Some tempering assessments, used with varying degrees of
emphasis by both defenders and opponents of the brokers
1
market,
suggested that brokers could not be used to move the market in any
substantial way against the basic forces of supply and demand.
induced movement in quotations, therefore, tended to be of short
duration.
One dealer pointed out that other means of market
manipulation were available to a dealer, if he were inclined to
Any
-44attempt to influence the market.
Another dealer emphasized that
the onus of any dubious legerdemain in this market rested with the
dealers rather than with the brokers.
There were few specific recommendations for dealing with
the brokers
1
market beyond an implicit plea for continued exercise
of dealer responsibility.
One dealer suggested that the Federal
Reserve respond periodically to bids or offers in the brokers
market.
1
He suspected that such intervention would create uncertainty
but that it would also be a constructive influence on the market.
Problem of odd lots.
Most of the dealers, especially the
diversified firms and bank dealers, viewed odd lots as a costly and
growing problem.
Several of these dealers had instituted schedules
of odd-lot charges or had established price differentials that were
the equivalent of such charges.
However, it was felt that customer
relationships precluded setting odd-lot charges or their equivalents
sufficiently high to compensate for the expenses of handling small
transactions.
Dealers pointed out that it costs as much to handle
a small order as one running to several million dollars.
A number of proposals were advanced to help remedy this
problem.
Some dealers recommended higher minimum denominations for
marketable Treasury obligations.
It was suggested, for example,
that these be set at $10,000 or even $25,000 as compared with the
current $500 standard for most Treasury bonds and $1,000 for Treasury
bills, certificates, and notes.
Several dealers also regarded as
promising the idea of having a central odd-lot house for handling
-45U.S. Government securities, possibly under the auspices of the
U.S. Treasury.
However, a few dealers were not enthusiastic about
this proposal.
They indicated that the dealers would still need
to handle the initial odd-lot requests, and they were not certain
that any savings would be involved.
But regardless of the approach
eventually adopted, a number of dealers pointed up the need for
more effective handling of odd lots through such means as the
bunching of orders and the use of computers.
It was also recommended
that the Federal Reserve expedite its denominational exchanges of
U.S. Government securities.
Mechanism for clearing securities.
A number of dealers
urged that progress toward a fully automated system for clearing
securities be accelerated.
Some deklers also mentioned that faster
transfers of securities over Federal Reserve wires would be most
helpful.
Another suggestion was aimed at liberalizing Federal Reserve
and commercial bank time schedules for delivery of securities.
Facilities for borrowing securities.
Several dealers
mentioned that borrowing securities to execute short sales or to
avoid delivery failures had become an increasing problem in recent
years.
Some dealers described the problem as already serious.
Only a minority of the dealers indicated that their trading activity
had not been inhibited by difficulties in borrowing securities,
although they conceded that a few individual issues had posed problems
in this respect.
Many dealers recommended, some in quite urgent terms, that
a study of the feasibility of lending officially held securities be
-46undertaken.
Loans of securities might be made from the Federal
Reserve portfolio, from the holdings of the Treasury trust funds,
and perhaps also from other "customer
the Federal Reserve.
11
accounts in the custody of
Most of the dealers suggested that such loans
be made on standard commercial terms--including the provision of
satisfactory collateral, payment of interest on the securities
borrowed, and payment of a loan fee of 1/2 per cent per annum.
These loans might be made for the purposes of avoiding delivery
failures and to enable the dealers to sell securities "short" for
relatively limited periods of time.
The dealers concluded that
an increase in the volume of securities that could be borrowed
would considerably enhance the tradeability of many issues and
would augment the over-all flexibility of the market.
Margin requirements on dealer loans.
Very few dealers
commented on the subject of margin requirements on dealer loans,
and only one suggested that some loose practices had developed in
this area.
He recommended that standard margins be established on
repurchase agreements and on bank loans made
to
nonbank dealers.
A few dealers noted that dealers who are members of the New York
Stock Exchange are automatically subject to margin requirements on
borrowings to finance security holdings.
Settlement of transactions in "Federal" or "clearing-house"
funds.
The dealers indicated that the current practice was to settle
in Federal funds any transactions involving issues due within 1 year
and in clearing-house funds any transactions involving longer-term
-47obligations.
All transactions executed over Federal Reserve
wires were settled in Federal funds.
Several dealers recommended that all transactions be
settled in Federal funds.
They argued that in periods of tight
money, especially, too many purchases for settlement in Federal
funds (i.e. immediately available funds) and too many sales for
settlement in clearing-house funds (available the next business
day) could be very costly because the dealers had to finance the
securities in the interim at relatively high interest rates.
The 4-1/4 per cent interest rate ceiling.
Several dealers
believed that removal of the 4-1/4 per cent interest rate ceiling
would be desirable from the standpoint of the market as well as from
the standpoint of debt management.
They indicated that the absence
of the Treasury from the long-term market for considerable periods
of time when interest rates were high tended to decrease investor
interest in U.S. Government bonds.
strong preferences for "current
11
Moreover, many investors had
coupons and were reluctant to purchase
issues bearing lower coupon rates of return, even though yields on
such issues might be equally high due to their sizable discounts.
@FedFRASER