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Exchange Act of 1934, to bring entities
that deal exclusively in government
securities under regulatory control for
the first time. The bill, entitled the
"Government
Securities Act of 1985,"
would require all government
securities
dealers to register with the SEC,
although the Federal Reserve and the
SEC would have authority to exempt
certain dealers." Congress apparently
believes that registration
ultimately
would provide a device for enforcement
of the bill and would provide tools for
keeping government
securities dealers
from trading if they previously were
involved in fraud, or if they violated
any other provisions of the bill.
The bill would establish a selfregulatory organization
called the Government Securities Rulemaking Board
(GSRB), which would fall under Federal
Reserve oversight. The GSRB would
have only rule-making authority and
would have no enforcement
powers. Under the bill, the GSRB would have five
months to adopt rules in specific areas
involved in the recent failures of government securities dealers. The GSRB
would adopt rules for capital requirements and repo transactions,
and would
improve the transfer and control of
securities under RP agreements.
However, the GSRB would consider the possible impact that any of its rules might
have on the liquidity of the RP market.

In addition, the GSRB would adopt
rules for reporting and recordkeeping,
including requirements
for filing financial statements
and for maintaining
appropriate accounting standards.
No
other rules could be submitted until the
mandatory rules, mentioned above,
were adopted and until there was sufficient experience with the new rules. In
addition to the GSRB's rules, the Federal Reserve would have authority to
set rules for margin requirements
and
for when-issued trading."
The bill was designed to use existing
agencies for inspections and enforcement of the GSRB's rules to minimize
the cost of regulation. Primary
enforcement
authority would be given
to the SEC because it already has
primary responsibility
to enforce the
1934 Act. The bank regulatory agencies
would be given primary inspection and
enforcement
authority over government securities dealers that are banks.
Compliance by nonbank brokers and
dealers would be enforced by the selfregulatory organizations
(the NASD
and the exchanges). Thus, under the
bill, all government
securities brokers
and nonbank dealers would be required
to be members of organizations
such as
NASD or the exchanges.
In addition to the House-passed bill,
Senator Alfonse D'Amato (R-NY) intro-

to cover shorts is referred to as the specific issues
market because the dealer must find an investor
holding a specific issue (security).

duced a bill in 1985 that is similar to
the House version. The only substantive difference is the bill would not
establish a self-regulatory
organization,
but would give the Federal Reserve
new rule-making authority. Also, the
Treasury Department
has submitted a
proposal to Congress, yet to be introduced, that would give the Treasury
rule-making authority without establishing a self-regulatory
agency.

9. When-issued trading is the secondary market
trading of new Treasury securities between the
time of announcement of the new securities by
the Treasury and the subsequent day the securities actually are issued.

8. For a detailed summary of the bill, see
Government Securities Act of 1985, Federal
Banking Law Reports No. 1095.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Material may be reprinted provided that the
source is credited. Please send copies of reprinted
materials to the editor.

April 1, 1986

Federal Reserve Bank of Cleveland

ISSN O<l2R- 1276

ECONOMIC
COMMENTARY

The Government
Securities Market
and Proposed
Regulation
by James]. Balazsy, Jr.

Conclusions
Recent proposals to regulate the
government
securities market seek to
prevent some of the problems that led
to the failures of secondary government
securities dealers. However, such regulation would only provide additional
safeguards that prudent investors
already can use. No amount of regulation can prevent fraud completely.
Many of the losses that resulted from
unregulated,
undercapitalized
dealers
were due to investors' carelessness
and
to misplaced trust.
Thus, investors must complement
any legislation that might be passed
with their own common sense, and
should closely scrutinize the brokers
and dealers they trade with in order to
make sure their interests are adequately protected.

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Address Correction Requested: Please send
corrected mailing label to the Federal Reserve
Bank of Cleveland, Research Department,
P.O. Box 6387. Cleveland, OH 44101.

The failure of several unregulated
government
securities dealers since
1982 has led to pressure for at least
minimum regulation of this market.
According to some estimates, the
failures in 1985 of just two government
securities firms, E.S.M. Government
Securities Inc. (ESM) and Bevill,
Bresler and Schulman Asset Management Corp., caused losses of over $500
million to those who dealt directly with
them. Losses also were sustained indirectly by individuals who never transacted business with ESM, including
taxpayers of municipalities
such as
Toledo, Ohio. The failure of ESM also
produced a temporary decline in the
foreign exchange value of the dollar, led
to the temporary closing of 70 privately
insured savings and loan associations
in Ohio, and contributed
to a subsequent loss of confidence in private deposit insurance systems in other states.
The problems and issues raised by
calls for new laws to regulate the
market are worth examining because
the government
securities market,
where an estimated $225 billion worth
of transactions
occur per day, plays a
key role in our economy. The market,
for example, provides liquidity to our
domestic banking system. Government
securities-that
is, the bills, notes, and
bonds that are IOUs of the Treasury or
of other government
agencies-can
be
sold by banks to raise cash. The market is also important to fiscal policy
because the federal government
uses
the sale of securities to finance budget
deficits and to meet seasonal shortfalls
between receipts and expenditures.
Finally, the market also is used by the

James}. Balazsy, Jr. is a research assistant at the
Federal Reserve Bank of Cleveland. The author
would like to thank Walker Todd, Mark
Sniderman, Owen Humpage, Sarah Jaquay, and
James Hoehn for their helpful comments.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

Federal Reserve Bank of New York
(FRBNY) to implement the Federal Reserve's monetary policy. The New York
bank, through its trading desk, influences the nation's supply of bank
reserves by buying or selling large
amounts of government
securities.
Proposed legislation would bring the
market under closer regulation in an
effort to prevent future failures of
government
securities firms that could
have repercussions
throughout
the
financial system and that could inhibit
the conduct of domestic monetary and
fiscal policies.
This Economic Commentary examines the participants
in the government
securities market, and discusses the
desirability of minimum regulation, the
importance of avoiding excessive regulation, and recent proposals to regulate
the market.

Participants
Besides investors, participants
in the
government
securities market include
the Treasury Department,
the Federal
Reserve System, and primary and
secondary dealers.
The Treasury Department,
through
its fiscal agent, the Federal Reserve
Bank of New York, sells government
securities at competitive auctions. Most
of the trading in government
securities
is done by government
securities dealers who are individuals or corporations
who trade government
securities for
their own account.

Primary dealers are those with whom
the FRBNY is willing to deal when conducting the Federal Reserve's monetary
policy. Currently, there are 36 primary
dealers who are so designated if they
meet certain criteria outlined by the
Federal Reserve Bank of New York.'
Despite the lack of express statutory
authority, the FRBNY oversees the
primary dealers, who must submit
daily, monthly, and annual reports
showing their transactions,
positions
and capital.
In addition to the primary dealers, it
is estimated that there are 400 to 500 secondary dealers in the market. The exact number is unknown because there
is no strict definition of a government
securities dealer, and no requirements
for federal registration.
However, secondary dealers are important to the
market's liquidity - that is, they increase the ability of investors to buy
and sell government
securities because they act as a sales force and as
financial agents for the primary dealers. Secondary dealers also trade with
investors who don't buy large enough
quantities of securities to deal with the
primary dealers.
Secondary dealers contact municipal
treasurers
and other institutions
with
readily available cash in order to borrow to finance their positions (inventories of securities), and they may act as
intermediaries
in arranging financing
for the primary dealers. Many secondary dealers obtain financing for primary dealers through repurchase agreements (repos or RPs), but never hold

1. For a complete description of the criteria used
by the Federal Reserve in designating primary
dealers, see Statement of E. Gerald Corrigan,
President, Federal Reserve Bank of New York,
before the Subcommittee on Commerce, Consumer, and Monetary Affairs of the House Committee on Government Operations, May 15, 1985.

inventories in the securities covered by
the repos." Without the secondary dealers, primary dealers and, hence, the
Federal Reserve and the Treasury,
would not be able to dispose of large
amounts of new securities without disrupting the market.
Despite the importance of the government securities market, it has been one
of the least-regulated markets. Brokers
and dealers (except for banks) who
trade nonexempt securities, which now
include principally corporate securities
and municipal revenue bonds, fall
under a system of regulation enforced
by the Securities and Exchange Commission (SEC) as provided by the
Securities Exchange Act of 1934.3
Brokers and dealers registered with
the SEC must follow requirements
concerning capital, margin, professional qualifications, record keeping,
reporting, surveillance, and financial
responsibility that are designed to safeguard customer funds and securities.
The following securities are currently exempted from the 1934 Act:
government and agency securities,
bankers' acceptances, commercial
paper, and certificates of deposit. Thus,
whether or not a government securities
dealer is regulated by the SEC depends
on how the firm is organized. If it
trades exempt and nonexempt securities within the same entity, the whole
firm, including the government securities operations, is subject to SEC rules.
However, if the firm trades nonexempt and exempt securities via separate subsidiaries or affiliates, then the
subsidiary escapes SEC oversight.
Thus, brokers and dealers who separate their operations by type of securities dealings have greater flexibility,
especially since they are not subject to
the SEC's net capital or margin
requirements. To illustrate the impact
of the margin requirements on the
financing of the firm, a dealer who
buys corporate securities must deposit
at least 50 percent on margin (in cash)
when making a purchase because these
securities are nonexempt. However, it
is not unusual for firms trading exclusively in government securities to
finance their positions using only 1
percent cash.

2. A repo is a transaction in which an agent holding securities can temporarily acquire funds by
giving the other agent the securities, while
simultaneously agreeing to repurchase them at a
later date. In a reverse repo, the roles of the
agents are reversed, with the first agent providing funds (buying securities), while the second
agent sells securities, simultaneously agreeing to
repurchase them.

A majority of the estimated 400 to 500
secondary dealers already are subject to
some level of regulation by the federal
government because their government
securities operations are included
within otherwise regulated banking
organizations, or within SEC-registered
dealers. Dealers affiliated with banks,
for example, are supervised by one of
the three federal commercial banking
regulators (the Federal Reserve, the
Federal Deposit Insurance Corporation,
and the Office of the Comptroller of the
Currency). While most government
securities dealers are regulated through
one of these channels, at least 100
avoid any type of federal regulation.
The Case for Regulation
Critics contend that a system of overall
federal regulation would have prevented many of the problems associated
with the recent failures of secondary
government securities dealers.
One point made by critics is that
there is a lack of registration requirements that essentially allows anyone to
trade securities, even those who have
previously committed fraud. The
absence of formal reporting requirements and on-site examinations also
has been criticized. Since dealers who
specialize in government securities
aren't required to file reports with a
regulator and, if not publicly owned,
don't have to submit to audits and
inspections, it has been easy for a few
of them to conceal fraud. While no
degree of regulation can completely
eliminate fraud, on-site examination
could make it more difficult to conceal.
Many have argued, however, that
additional regulation is not needed,
since all securities dealers may be subject to Rule lOb-5 of the SEC, which
prohibits fraud in any type of securities
activity. However, under penal statutes
and regulations, an offending dealer
can be brought to justice only after
fraud has occurred. Proposed legislation that would provide for reporting
requirements and for on-site examinations seeks to reduce both the risk of
fraud and the loss of confidence that
failures of government securities dealers can cause.

3. The SEC delegates some of its supervisory
responsibilities to the various stock exchanges
and the National Association of Securities Dealers (NASD). Dealers that trade only municipal
securities are regulated by the Municipal Securities Rule-Making Board.

The absence of capital or margin
requirements for dealers who trade
only government securities eliminates
one of the safeguards against excessive
risk in the capital markets. For example, when Drysdale Government Securities Inc. failed in 1982, it had borrowed
$6.5 billion of government securities
with a capital base of only $20 million,
which was very small compared with
the $270 million in interest payments
owed on the borrowed securities.'
The absence of margin requirements
permits the firm to build up significant
inventories of government securities
with very little cash down, using
mostly borrowed funds. This practice
may encourage the dealer to take
excessive risks because, if losses are
sustained, the dealer's creditors have
proportionately more to lose than the
dealer. Dealers may increase their
inventories when they expect interest
rates to fall and security prices to rise.
However, if they guess wrong, sizable
losses can be sustained by the dealers
and their creditors. The proposed
establishment of minimum capital and
margin requirements supposedly would
diminish such risks by providing a
cushion against unfavorable movements in interest rates.
One of the most common problems in
the recent government securities firm
bankruptcies was the failure of market
participants to adequately secure the
government securities used as collateral in a repurchase or reverse repurchase transaction. The absence of a requirement for actual delivery of securities in a repo transaction makes it easy
for a dishonest dealer to pledge the
same securities as collateral for multiple transactions. While this increases
the leverage of the dealer and the potential profits, it also increases the risk
and the amount of loss that can be suffered when movements in interest rates
don't meet the dealer's expectations.
Despite the possibilities of such
abuses, requiring the actual transfer of
government securities in a repo transaction would diminish the profitability
of arranging some repos in small volume
because custodians' fees, reflecting actual delivery of collateral, would increase. Thus, a requirement for actual
delivery of collateral ultimately could
harm the market by impairing some of

its liquidity. In addition, such a requirement might be impractical in many circumstances and always would be timeconsuming. Those parts of the government or government agency mortgagebacked securities market that do not
yet have access to generally accepted
book-entry delivery systems also would
be impeded by such requirements.
To avoid impairment of market liquidity, many have advocated requirements for segregating and designating'
the government securities for specific
investors on the books of Federal
Reserve Banks. Unfortunately, such
activity by the Federal Reserve Banks
would compete directly with services
already offered by the private sector
and would conceivably require completely new and greatly expanded computer capacities and telecommunications networks at Federal Reserve
Banks, especially at the New York Federal Reserve Bank.
Recent developments have further increased pressures for regulation of the
government securities market. The
growth of government debt, and advances in communications and technology, have made it possible for hundreds
of new government securities brokers
and dealers to operate nationwide. The
large federal budget deficits have made
it necessary to market great amounts
of new government debt. Currently
about $1.4 trillion of marketable
government debt is outstanding, and
the Treasury has had to issue almost
$200 billion of new marketable issues
in the past two years to finance the
deficit (see figure 1).
The volume of government securities
trading will have to become even larger
to accommodate expected future budget
deficits. The Congressional Budget
Office estimates the cumulative debt
will reach $2.5 trillion by 1989.5
Another recent phenomenon, the
increased variability of interest rates,
has increased the market risk government securities dealers face. The risk
to the creditors of government securities dealers in particular has increased
because dealers can build up sizable
inventories of securities without margin requirements, capital requirements,
and the actual delivery of collateral in
repo transactions.

4. See Government Securities Act of 1985, Federal
Banking Law Reports No. 1095, Commerce Clearing House, Inc., September 27, 1985, p. 16.

5. See Statement of Richard M. Kelly, Chairman
of the Primary Dealers Committee of the Public
Securities Association, before the Committee on
Energy and Commerce, Subcommittee on Telecommunications, Consumer Protection and
Finance of the U.S. House of Representatives,
June 11, 1985, p. 5.

Figure 1 Total Marketable Treasury
Debt Outstanding and Transactions
of Government Securities Dealers
Billions of dollars
150

Transactions
100

125
75

50

25

o
a. Averages of daily figures.
SOURCE: Board of Governors of the Federal
Reserve System.

Importance of Avoiding Excessive
Regulation
Although the lack of regulation of the
government securities market has allowed problems to go undetected for a
long time, the ease with which new
dealers can enter the market adds to
the market's efficiency and liquidity.
The large number of government securities brokers/dealers has permitted intense competition, allowing customers
to trade at the best possible prices. The
large amount of competition allows the
spread between the price at which a
dealer buys securities from a customer
(bid) and the price at which the dealer
is willing to sell (ask) to remain small.
The typical bid-ask spread for a 3month Treasury bill ranges from 2 to 4
basis points. (1 basis point is one-one
hundredth of one percent.) For example,
on December 31, 1985 the bid on the
three-month Treasury bill was 7.03 percent, while the ask was 7.01 percent.
The market's competitiveness also
reduces the Treasury Department's
costs of issuing new debt, which ultimately benefits taxpayers. In addition,
the large number of firms in the

6. See Statement of Richard M. Kelly, p. 15.

market allows both the Treasury to
issue large amounts of securities and
the Federal Reserve Bank of New York
to conduct large monetary policy operations without significantly disrupting
the market.
Care must be taken so that new regulation does not unduly restrict entry
or cause firms to reduce their market
activity. If overly burdensome regulation reduced market participation, it
could increase the Treasury's costs of
financing the budget deficit. It has been
estimated that, if the Treasury's cost of
borrowing increased by as few as 10
basis points as a result of regulation,
the cost to the Treasury could be $2.2
billion over the life of the securities
issued during the first year of such
increased costs."
Proponents of regulation, however,
use a similar argument to support their
cause. They argue that if activity in the
government securities market is
reduced, and if interest costs rise
because of the lost confidence generated by failures of government securities firms, then there is a cost of not
regulating the market. Thus, any regulation must maintain a delicate balance, ensuring that confidence will not
be lost, while avoiding overly burdensome requirements.
The absence of formal regulation also
permits unimpeded innovation in the
government securities market. Market
participants have developed many new
trading techniques unheard of several
years ago, such as development of the
reverse market and the specific issues
market that have made shorting easier
and cheaper." Also, the opening of
futures and options trading has created
many new strategies for investing and
speculating in government securities
(including increased arbitrage) that has
attracted many new participants into
the market. Any regulatory structure
that is developed for the government
securities market must take care not to
inhibit useful market innovation.
Regulatory Proposals
On September 17, 1985, the U.S. House
of Representatives passed a bill that
would amend the Securities and

7. When a dealer shorts the market, he makes a
con tract to sell a securi ty he does not own for a
certain price on some future date. To cover the
short position when the contract expires, the
dealer must either borrow the security or
"reverse them in." In a reverse, the dealer
obtains the shorted securities by purchasing
them from an investor with an agreement by the
investor to repurchase. The market for reverses

inventories in the securities covered by
the repos." Without the secondary dealers, primary dealers and, hence, the
Federal Reserve and the Treasury,
would not be able to dispose of large
amounts of new securities without disrupting the market.
Despite the importance of the government securities market, it has been one
of the least-regulated markets. Brokers
and dealers (except for banks) who
trade nonexempt securities, which now
include principally corporate securities
and municipal revenue bonds, fall
under a system of regulation enforced
by the Securities and Exchange Commission (SEC) as provided by the
Securities Exchange Act of 1934.3
Brokers and dealers registered with
the SEC must follow requirements
concerning capital, margin, professional qualifications, record keeping,
reporting, surveillance, and financial
responsibility that are designed to safeguard customer funds and securities.
The following securities are currently exempted from the 1934 Act:
government and agency securities,
bankers' acceptances, commercial
paper, and certificates of deposit. Thus,
whether or not a government securities
dealer is regulated by the SEC depends
on how the firm is organized. If it
trades exempt and nonexempt securities within the same entity, the whole
firm, including the government securities operations, is subject to SEC rules.
However, if the firm trades nonexempt and exempt securities via separate subsidiaries or affiliates, then the
subsidiary escapes SEC oversight.
Thus, brokers and dealers who separate their operations by type of securities dealings have greater flexibility,
especially since they are not subject to
the SEC's net capital or margin
requirements. To illustrate the impact
of the margin requirements on the
financing of the firm, a dealer who
buys corporate securities must deposit
at least 50 percent on margin (in cash)
when making a purchase because these
securities are nonexempt. However, it
is not unusual for firms trading exclusively in government securities to
finance their positions using only 1
percent cash.

2. A repo is a transaction in which an agent holding securities can temporarily acquire funds by
giving the other agent the securities, while
simultaneously agreeing to repurchase them at a
later date. In a reverse repo, the roles of the
agents are reversed, with the first agent providing funds (buying securities), while the second
agent sells securities, simultaneously agreeing to
repurchase them.

A majority of the estimated 400 to 500
secondary dealers already are subject to
some level of regulation by the federal
government because their government
securities operations are included
within otherwise regulated banking
organizations, or within SEC-registered
dealers. Dealers affiliated with banks,
for example, are supervised by one of
the three federal commercial banking
regulators (the Federal Reserve, the
Federal Deposit Insurance Corporation,
and the Office of the Comptroller of the
Currency). While most government
securities dealers are regulated through
one of these channels, at least 100
avoid any type of federal regulation.
The Case for Regulation
Critics contend that a system of overall
federal regulation would have prevented many of the problems associated
with the recent failures of secondary
government securities dealers.
One point made by critics is that
there is a lack of registration requirements that essentially allows anyone to
trade securities, even those who have
previously committed fraud. The
absence of formal reporting requirements and on-site examinations also
has been criticized. Since dealers who
specialize in government securities
aren't required to file reports with a
regulator and, if not publicly owned,
don't have to submit to audits and
inspections, it has been easy for a few
of them to conceal fraud. While no
degree of regulation can completely
eliminate fraud, on-site examination
could make it more difficult to conceal.
Many have argued, however, that
additional regulation is not needed,
since all securities dealers may be subject to Rule lOb-5 of the SEC, which
prohibits fraud in any type of securities
activity. However, under penal statutes
and regulations, an offending dealer
can be brought to justice only after
fraud has occurred. Proposed legislation that would provide for reporting
requirements and for on-site examinations seeks to reduce both the risk of
fraud and the loss of confidence that
failures of government securities dealers can cause.

3. The SEC delegates some of its supervisory
responsibilities to the various stock exchanges
and the National Association of Securities Dealers (NASD). Dealers that trade only municipal
securities are regulated by the Municipal Securities Rule-Making Board.

The absence of capital or margin
requirements for dealers who trade
only government securities eliminates
one of the safeguards against excessive
risk in the capital markets. For example, when Drysdale Government Securities Inc. failed in 1982, it had borrowed
$6.5 billion of government securities
with a capital base of only $20 million,
which was very small compared with
the $270 million in interest payments
owed on the borrowed securities.'
The absence of margin requirements
permits the firm to build up significant
inventories of government securities
with very little cash down, using
mostly borrowed funds. This practice
may encourage the dealer to take
excessive risks because, if losses are
sustained, the dealer's creditors have
proportionately more to lose than the
dealer. Dealers may increase their
inventories when they expect interest
rates to fall and security prices to rise.
However, if they guess wrong, sizable
losses can be sustained by the dealers
and their creditors. The proposed
establishment of minimum capital and
margin requirements supposedly would
diminish such risks by providing a
cushion against unfavorable movements in interest rates.
One of the most common problems in
the recent government securities firm
bankruptcies was the failure of market
participants to adequately secure the
government securities used as collateral in a repurchase or reverse repurchase transaction. The absence of a requirement for actual delivery of securities in a repo transaction makes it easy
for a dishonest dealer to pledge the
same securities as collateral for multiple transactions. While this increases
the leverage of the dealer and the potential profits, it also increases the risk
and the amount of loss that can be suffered when movements in interest rates
don't meet the dealer's expectations.
Despite the possibilities of such
abuses, requiring the actual transfer of
government securities in a repo transaction would diminish the profitability
of arranging some repos in small volume
because custodians' fees, reflecting actual delivery of collateral, would increase. Thus, a requirement for actual
delivery of collateral ultimately could
harm the market by impairing some of

its liquidity. In addition, such a requirement might be impractical in many circumstances and always would be timeconsuming. Those parts of the government or government agency mortgagebacked securities market that do not
yet have access to generally accepted
book-entry delivery systems also would
be impeded by such requirements.
To avoid impairment of market liquidity, many have advocated requirements for segregating and designating'
the government securities for specific
investors on the books of Federal
Reserve Banks. Unfortunately, such
activity by the Federal Reserve Banks
would compete directly with services
already offered by the private sector
and would conceivably require completely new and greatly expanded computer capacities and telecommunications networks at Federal Reserve
Banks, especially at the New York Federal Reserve Bank.
Recent developments have further increased pressures for regulation of the
government securities market. The
growth of government debt, and advances in communications and technology, have made it possible for hundreds
of new government securities brokers
and dealers to operate nationwide. The
large federal budget deficits have made
it necessary to market great amounts
of new government debt. Currently
about $1.4 trillion of marketable
government debt is outstanding, and
the Treasury has had to issue almost
$200 billion of new marketable issues
in the past two years to finance the
deficit (see figure 1).
The volume of government securities
trading will have to become even larger
to accommodate expected future budget
deficits. The Congressional Budget
Office estimates the cumulative debt
will reach $2.5 trillion by 1989.5
Another recent phenomenon, the
increased variability of interest rates,
has increased the market risk government securities dealers face. The risk
to the creditors of government securities dealers in particular has increased
because dealers can build up sizable
inventories of securities without margin requirements, capital requirements,
and the actual delivery of collateral in
repo transactions.

4. See Government Securities Act of 1985, Federal
Banking Law Reports No. 1095, Commerce Clearing House, Inc., September 27, 1985, p. 16.

5. See Statement of Richard M. Kelly, Chairman
of the Primary Dealers Committee of the Public
Securities Association, before the Committee on
Energy and Commerce, Subcommittee on Telecommunications, Consumer Protection and
Finance of the U.S. House of Representatives,
June 11, 1985, p. 5.

Figure 1 Total Marketable Treasury
Debt Outstanding and Transactions
of Government Securities Dealers
Billions of dollars
150

Transactions
100

125
75

50

25

o
a. Averages of daily figures.
SOURCE: Board of Governors of the Federal
Reserve System.

Importance of Avoiding Excessive
Regulation
Although the lack of regulation of the
government securities market has allowed problems to go undetected for a
long time, the ease with which new
dealers can enter the market adds to
the market's efficiency and liquidity.
The large number of government securities brokers/dealers has permitted intense competition, allowing customers
to trade at the best possible prices. The
large amount of competition allows the
spread between the price at which a
dealer buys securities from a customer
(bid) and the price at which the dealer
is willing to sell (ask) to remain small.
The typical bid-ask spread for a 3month Treasury bill ranges from 2 to 4
basis points. (1 basis point is one-one
hundredth of one percent.) For example,
on December 31, 1985 the bid on the
three-month Treasury bill was 7.03 percent, while the ask was 7.01 percent.
The market's competitiveness also
reduces the Treasury Department's
costs of issuing new debt, which ultimately benefits taxpayers. In addition,
the large number of firms in the

6. See Statement of Richard M. Kelly, p. 15.

market allows both the Treasury to
issue large amounts of securities and
the Federal Reserve Bank of New York
to conduct large monetary policy operations without significantly disrupting
the market.
Care must be taken so that new regulation does not unduly restrict entry
or cause firms to reduce their market
activity. If overly burdensome regulation reduced market participation, it
could increase the Treasury's costs of
financing the budget deficit. It has been
estimated that, if the Treasury's cost of
borrowing increased by as few as 10
basis points as a result of regulation,
the cost to the Treasury could be $2.2
billion over the life of the securities
issued during the first year of such
increased costs."
Proponents of regulation, however,
use a similar argument to support their
cause. They argue that if activity in the
government securities market is
reduced, and if interest costs rise
because of the lost confidence generated by failures of government securities firms, then there is a cost of not
regulating the market. Thus, any regulation must maintain a delicate balance, ensuring that confidence will not
be lost, while avoiding overly burdensome requirements.
The absence of formal regulation also
permits unimpeded innovation in the
government securities market. Market
participants have developed many new
trading techniques unheard of several
years ago, such as development of the
reverse market and the specific issues
market that have made shorting easier
and cheaper." Also, the opening of
futures and options trading has created
many new strategies for investing and
speculating in government securities
(including increased arbitrage) that has
attracted many new participants into
the market. Any regulatory structure
that is developed for the government
securities market must take care not to
inhibit useful market innovation.
Regulatory Proposals
On September 17, 1985, the U.S. House
of Representatives passed a bill that
would amend the Securities and

7. When a dealer shorts the market, he makes a
con tract to sell a securi ty he does not own for a
certain price on some future date. To cover the
short position when the contract expires, the
dealer must either borrow the security or
"reverse them in." In a reverse, the dealer
obtains the shorted securities by purchasing
them from an investor with an agreement by the
investor to repurchase. The market for reverses

Exchange Act of 1934, to bring entities
that deal exclusively in government
securities under regulatory control for
the first time. The bill, entitled the
"Government
Securities Act of 1985,"
would require all government
securities
dealers to register with the SEC,
although the Federal Reserve and the
SEC would have authority to exempt
certain dealers." Congress apparently
believes that registration
ultimately
would provide a device for enforcement
of the bill and would provide tools for
keeping government
securities dealers
from trading if they previously were
involved in fraud, or if they violated
any other provisions of the bill.
The bill would establish a selfregulatory organization
called the Government Securities Rulemaking Board
(GSRB), which would fall under Federal
Reserve oversight. The GSRB would
have only rule-making authority and
would have no enforcement
powers. Under the bill, the GSRB would have five
months to adopt rules in specific areas
involved in the recent failures of government securities dealers. The GSRB
would adopt rules for capital requirements and repo transactions,
and would
improve the transfer and control of
securities under RP agreements.
However, the GSRB would consider the possible impact that any of its rules might
have on the liquidity of the RP market.

In addition, the GSRB would adopt
rules for reporting and recordkeeping,
including requirements
for filing financial statements
and for maintaining
appropriate accounting standards.
No
other rules could be submitted until the
mandatory rules, mentioned above,
were adopted and until there was sufficient experience with the new rules. In
addition to the GSRB's rules, the Federal Reserve would have authority to
set rules for margin requirements
and
for when-issued trading."
The bill was designed to use existing
agencies for inspections and enforcement of the GSRB's rules to minimize
the cost of regulation. Primary
enforcement
authority would be given
to the SEC because it already has
primary responsibility
to enforce the
1934 Act. The bank regulatory agencies
would be given primary inspection and
enforcement
authority over government securities dealers that are banks.
Compliance by nonbank brokers and
dealers would be enforced by the selfregulatory organizations
(the NASD
and the exchanges). Thus, under the
bill, all government
securities brokers
and nonbank dealers would be required
to be members of organizations
such as
NASD or the exchanges.
In addition to the House-passed bill,
Senator Alfonse D'Amato (R-NY) intro-

to cover shorts is referred to as the specific issues
market because the dealer must find an investor
holding a specific issue (security).

duced a bill in 1985 that is similar to
the House version. The only substantive difference is the bill would not
establish a self-regulatory
organization,
but would give the Federal Reserve
new rule-making authority. Also, the
Treasury Department
has submitted a
proposal to Congress, yet to be introduced, that would give the Treasury
rule-making authority without establishing a self-regulatory
agency.

9. When-issued trading is the secondary market
trading of new Treasury securities between the
time of announcement of the new securities by
the Treasury and the subsequent day the securities actually are issued.

8. For a detailed summary of the bill, see
Government Securities Act of 1985, Federal
Banking Law Reports No. 1095.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Material may be reprinted provided that the
source is credited. Please send copies of reprinted
materials to the editor.

April 1, 1986

Federal Reserve Bank of Cleveland

ISSN O<l2R- 1276

ECONOMIC
COMMENTARY

The Government
Securities Market
and Proposed
Regulation
by James]. Balazsy, Jr.

Conclusions
Recent proposals to regulate the
government
securities market seek to
prevent some of the problems that led
to the failures of secondary government
securities dealers. However, such regulation would only provide additional
safeguards that prudent investors
already can use. No amount of regulation can prevent fraud completely.
Many of the losses that resulted from
unregulated,
undercapitalized
dealers
were due to investors' carelessness
and
to misplaced trust.
Thus, investors must complement
any legislation that might be passed
with their own common sense, and
should closely scrutinize the brokers
and dealers they trade with in order to
make sure their interests are adequately protected.

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The failure of several unregulated
government
securities dealers since
1982 has led to pressure for at least
minimum regulation of this market.
According to some estimates, the
failures in 1985 of just two government
securities firms, E.S.M. Government
Securities Inc. (ESM) and Bevill,
Bresler and Schulman Asset Management Corp., caused losses of over $500
million to those who dealt directly with
them. Losses also were sustained indirectly by individuals who never transacted business with ESM, including
taxpayers of municipalities
such as
Toledo, Ohio. The failure of ESM also
produced a temporary decline in the
foreign exchange value of the dollar, led
to the temporary closing of 70 privately
insured savings and loan associations
in Ohio, and contributed
to a subsequent loss of confidence in private deposit insurance systems in other states.
The problems and issues raised by
calls for new laws to regulate the
market are worth examining because
the government
securities market,
where an estimated $225 billion worth
of transactions
occur per day, plays a
key role in our economy. The market,
for example, provides liquidity to our
domestic banking system. Government
securities-that
is, the bills, notes, and
bonds that are IOUs of the Treasury or
of other government
agencies-can
be
sold by banks to raise cash. The market is also important to fiscal policy
because the federal government
uses
the sale of securities to finance budget
deficits and to meet seasonal shortfalls
between receipts and expenditures.
Finally, the market also is used by the

James}. Balazsy, Jr. is a research assistant at the
Federal Reserve Bank of Cleveland. The author
would like to thank Walker Todd, Mark
Sniderman, Owen Humpage, Sarah Jaquay, and
James Hoehn for their helpful comments.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

Federal Reserve Bank of New York
(FRBNY) to implement the Federal Reserve's monetary policy. The New York
bank, through its trading desk, influences the nation's supply of bank
reserves by buying or selling large
amounts of government
securities.
Proposed legislation would bring the
market under closer regulation in an
effort to prevent future failures of
government
securities firms that could
have repercussions
throughout
the
financial system and that could inhibit
the conduct of domestic monetary and
fiscal policies.
This Economic Commentary examines the participants
in the government
securities market, and discusses the
desirability of minimum regulation, the
importance of avoiding excessive regulation, and recent proposals to regulate
the market.

Participants
Besides investors, participants
in the
government
securities market include
the Treasury Department,
the Federal
Reserve System, and primary and
secondary dealers.
The Treasury Department,
through
its fiscal agent, the Federal Reserve
Bank of New York, sells government
securities at competitive auctions. Most
of the trading in government
securities
is done by government
securities dealers who are individuals or corporations
who trade government
securities for
their own account.

Primary dealers are those with whom
the FRBNY is willing to deal when conducting the Federal Reserve's monetary
policy. Currently, there are 36 primary
dealers who are so designated if they
meet certain criteria outlined by the
Federal Reserve Bank of New York.'
Despite the lack of express statutory
authority, the FRBNY oversees the
primary dealers, who must submit
daily, monthly, and annual reports
showing their transactions,
positions
and capital.
In addition to the primary dealers, it
is estimated that there are 400 to 500 secondary dealers in the market. The exact number is unknown because there
is no strict definition of a government
securities dealer, and no requirements
for federal registration.
However, secondary dealers are important to the
market's liquidity - that is, they increase the ability of investors to buy
and sell government
securities because they act as a sales force and as
financial agents for the primary dealers. Secondary dealers also trade with
investors who don't buy large enough
quantities of securities to deal with the
primary dealers.
Secondary dealers contact municipal
treasurers
and other institutions
with
readily available cash in order to borrow to finance their positions (inventories of securities), and they may act as
intermediaries
in arranging financing
for the primary dealers. Many secondary dealers obtain financing for primary dealers through repurchase agreements (repos or RPs), but never hold

1. For a complete description of the criteria used
by the Federal Reserve in designating primary
dealers, see Statement of E. Gerald Corrigan,
President, Federal Reserve Bank of New York,
before the Subcommittee on Commerce, Consumer, and Monetary Affairs of the House Committee on Government Operations, May 15, 1985.