Full text of Government Securities Reform : Hearings Before the Subcommittee on Telecommunications and Finance of the Committee on Energy and Commerce, House of Representatives, One Hundred Third Congress, First Session, on H.R. 616 and H.R. 618, March 17 and 30, 1993

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GOVERNMENT SECURITIES REFORM
HEARINGS
BEFORE THE

SUBCOMMITTEE ON
TELECOMMUNICATIONS AND FINANCE
OF THE

COMMITTEE ON
ENERGY AND COMMERCE
HOUSE OF REPRESENTATIVES
ONE HUNDRED THIRD CONGRESS
FIRST SESSION
ON

H.R. 616 and H.R. 618
BILLS TO AMEND THE SECURITIES EXCHANGE ACT OF 1934 AND TO
EXTEND AND REVISE RULEMAKING AUTHORITY WITH RESPECT TO
GOVERNMENT SECURITIES UNDER THE FEDERAL SECURITIES LAWS
MARCH 17 AND 30, 1993

Serial No. 103-22
Printed for the use of the Committee on Energy and Commerce

U.S. GOVERNMENT PRINTING OFFICE
71-390CC

WASHINGTON : 1993
For sale by the U.S. Government Printing Office

Superintendent of Documents, Congressional Sales Office, Washington, DC 20402
ISBN

0-16-041376-1

COMMITTEE ON ENERGY AND

COMMERCE

JOHN D. DINGELL, Michigan, Chairman
CARLOS J. MOORHEAD, CaUfornia
HENRY A. WAXMAN, CaUfornia
THOMAS J. BLILEY, JR., Virginia
PHILIP R SHARP, Indiana
JACK FIELDS, Texas
EDWARD J. MARKEY, Massachusetts
MICHAEL G. OXLEY, Ohio
AL SWIFT, Washington
CARDISS COLLINS, IlUnois
MICHAEL BILIRAKIS, Florida
MIKE SYNAR, Oklahoma
DAN SCHAEFER, Colorado
W.J. "BILLY" TAUZIN, Louisiana
JOE BARTON, Texas
RON WYDEN, Oregon
ALEX MCMILLAN, North CaroUna
RALPH M. HALL, Texas
J. DENNIS HASTERT, IlUnois
BILL RICHARDSON, New Mexico
FRED UPTON, Michigan
JIM SLATTERY, Kansas
CLIFF STEARNS, Florida
JOHN BRYANT, Texas
BILL PAXON, New York
RICK BOUCHER, Virginia
PAUL E. GILLMOR, Ohio
JIM COOPER, Tennessee
SCOTT KLUG, Wisconsin
J. ROY ROWLAND, Georgia
GARY A FRANKS, Connecticut
THOMAS J. MANTON, New York
JAMES C. GREENWOOD, Pennsylvania
EDOLPHUS TOWNS, New York
MICHAEL D. CRAPO, Idaho
GERRY E. STUDDS, Massachusetts
RICHARD H. LEHMAN, CaUfornia
FRANK PALLONE, JR., New Jersey
CRAIG A WASHINGTON, Texas
LYNN SCHENK, California
SHERROD BROWN, Ohio
MIKE KREIDLER, Washington
MARJORIE MARGOLIES-MEZVINSKY,
Pennsylvania
BLANCHE M. LAMBERT, Arkansas
ALAN J. ROTH, Staff Director and Chief Counsel
DENNIS B. FITZGIBBONS, Deputy Staff Director
MARGARET A. DURBIN, Minority Chief Counsel and Staff Director

SUBCOMMITTEE ON TELECOMMUNICATIONS AND FINANCE

EDWARD J. MARKEY, Massachusetts, Chairman
JACK FIELDS, Texas
W.J. "BILLY" TAUZIN, Louisiana
THOMAS J. BLILEY, JR., Virginia
RICK BOUCHER, Virginia
MICHAEL G. OXLEY, Ohio
THOMAS J. MANTON, New York
DAN SCHAEFER, Colorado
RICHARD H. LEHMAN, CaUfornia
JOE BARTON, Texas
LYNN SCHENK, CaUfornia
ALEX MCMILLAN, North CaroUna
MARJORIE MARGOLIES-MEZVINSKY,
J. DENNIS HASTERT, IlUnois
Pennsylvania
PAUL E. GILLMOR, Ohio
MIKE SYNAR, Oklahoma
CARLOS J. MOORHEAD, California
RON WYDEN, Oregon
(Ex Officio)
RALPH M. HALL, Texas
BILL RICHARDSON, New Mexico
JIM SLATTERY, Kansas
JOHN BRYANT, Texas
JIM COOPER, Tennessee
JOHN D. DINGELL, Michigan
(Ex Officio)
DAVID H. MOULTON, Chief Counsel/Staff Director
JEFFREY DUNCAN, Policy Analyst
DOLORES DALY, Legislative Assistant
STEPHEN BLUMENTHAL, Minority Counsel
(II)

CONTENTS
Hearings held on:
March 17, 1993
March 30, 1993
Text of:
H.R. 616
H.R. 618
Testimony of:
Basham, Michael E., managing director, Smith Barney, Harris Upham
& Co
Breeden, Hon. Richard C., Chairman, Securities and Exchange Commission
Gottlieb, Paul, chairman, Investment Adviser Committee, Securities Industry Association
McDonough, William J., Executive Vice President, Federal Reserve Bank
of New York
McGuire, Catherine, Special Assistant, Securities and Exchange Commission
Mullins, David W., Jr., Vice Chairman, Board of Governors, Federal
Reserve System
Paret, Jonathan R., vice president, Securities Industry Association
Strausberg, Randy M., president, Top Gun Capital Management
Zicklin, Lawrence, managing partner, Neuberger & Berman, New York
City
Material submitted for the record by:
College Savings Bank, Princeton, NJ: Statement of Peter A. Roberts,
chairman
Federal Reserve Bank of New York: Letter from William J. McDonough
to Chairman Markey responding to subcommittee questions
Federal Reserve System:
Letter from Alan Greenspan, Chairman, Board of Governors, to

Chairman Markey, February 1, 1993
Letter from David W. Mullins, Jr., Vice Chairman, Board of Governors, to Chairman Markey, June 3, 1993
M.G. Tivon Group: Letter from Randy M. Strausberg to Chairman Markey, March 24, 1993
Securities and Exhange Commission: Letter from Richard C. Breeden,
Chairman, responding to subcommittee questions
Securities Industry Association: Letter from Paul Gottlieb to Chairman
Markey, May 3, 1993
Telerate Systems, Inc.: Letter from Carl M. Valenti, president, to Chairman Markey, April 5, 1993
(ill)

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184

GOVERNMENT SECURITIES REFORM
WEDNESDAY, MARCH 17, 1993
HOUSE OF REPRESENTATIVES,
COMMITTEE ON ENERGY AND COMMERCE,
SUBCOMMITTEE ON TELECOMMUNICATIONS AND FINANCE,

Washington, PC.
The subcommittee met, pursuant to notice, at 9:40 a.m., in room
2322, Rayburn House Office Building, Jon. Edward J. Marked
(chairman) presiding.
Mr. MARKEY. Good morning.
Today the subcommittee is holding its fifth hearing on the state
of the Government securities marketplace and the need for reforms
in the regulation of this market. Today's hearing will be focusing
on H.R. 618, the Government Securities Reform Act of 1993, which
I introduced earlier this year along with Representatives Fields,
Wyden, Sonar, and Cooper, and the chairman of the full committee,
Mr. Dingell.
All investors and taxpayers have a stake in the regulation of the
most important financial market we have, the $4 trillion market
for the U.S. Government debt. This market provides the fuel for
the Nation's fiscal engine, establishes a benchmark for interest
rates throughout the global economy, and is used by the Federal
Reserve to carry out monetary policy and represents the primary
investment held by many State and local governments.
Ironically, this most important financial market has traditionally
been largely exempt from the type of regulations we have relied on
to police the stock market or corporate bond market. Originally,
such exemptions may have been justified on the basis of the riskfree nature of Treasury securities.
During the 1980's, however, the Government securities market
was transformed from a sleepy arena for funding the public debt
to a fast-paced playground for Wall Street traders and speculators.
In addition to traditional Treasury notes, bills, and bonds, Wall
Street firms are now peddling a wide array of more risky financial
products such as interest-only or principal-only STRIPS of Treasury securities and a bewildering alphabet soup of ABA's, CMO's,
and REMIC's.
The Salomon Brothers auction bidding scandal dramatically underscored the consequences of relying continually on a chubby system of informal regulation based on the New York Fed's private
business relationship with a select group of privileged primary
dealers and periodic closed-door sessions between Treasury and an
industry trade association.
(l)

2
The apparent disregard of the Treasury auction rules by key
Salomon Brothers traders and the failure of Salomon's senior management to report evidence of wrongdoing to regulators provided
compelling evidence of the need to reform the system and to ensure
that informal regulation was a thing of the past.
Moreover, the Salomon regulations and revelations were followed
by subsequent disclosures that 98 firms engaged in improper activity in connection with the sales of Fannie Mae, Freddie Mac, and
other Government agency securities, reports of abuses of Treasury's
noncompetitive bidding rules, and pre-arranged trades aimed at
generating fictitious tax losses.
Let's face it. This is not your father's Government securities market any longer. Competitive pressures have built to a critical point,
and new checks on improper or manipulative activity are needed.
During the last Congress, this subcommittee struggled long and
hard to craft a bipartisan compromise that would assure that the
SEC can carry out its mission to police this market for fraud and
manipulation, correct other regulatory deficiencies, and not undermine the fundamental liquidity and efficiency of this market. Towards this end, the subcommittee worked closely with regulators
and industry to pare back early proposals for large trader reporting, audit trails, and broad price transparency authority in favor
of more tightly focused provisions authorizing large provision reporting, enhanced transaction record-keeping, and price transparency back-stop authority.
I believe that the resulting product struck the proper balance in
assigning rule-making or consultative roles to each of the respective agencies with interest and responsibilities related to the functioning of this market.
In my view, H.R. 618 represents the irreducible minimum of
what Congress must enact if it wants to be at all serious about reforming the market in the aftermath of the Salomon Brothers and
other scandals.
The time for boosterism has passed, yet some refuse to admit it.
To the boosters I can only say, boosterism leads to complacency and
complacency leads to disaster. We do not intend to ignore the lessons of the recent scandals, and we intend to move forward to
schedule a markup on this bill at an early date.
This morning, we will be examining some of the steps regulators
have taken to respond to the lessons of the Salomon Brothers scandal. We will also be considering what additional measures Congress should adopt to supplement these actions with legislative reforms.
We will be asking regulators just what they are doing to prevent
fraud and manipulation in this market and what tools they need
to detect and prosecute any future effort to con, squeeze, or otherwise manipulate any sector of this market. We will also be hearing
from two distinguished witnesses with extensive regulatory and
trading experience in the Government securities market who can
testify as to the continued need for vigilance in combatting manipulative and fraudulent activities in this market.

3
I look forward to the testimony of all of our witnesses which will
be helpful to us as we move forward in passing this important legislation.
That concludes the opening statement of the Chair.
[Testimony resumes on p. 40.]
[The text of H.R. 618 follows:]

4
I

103D C O N G R E S S
1ST SESSION

* *

/ »
Q

|
1

Q
0

To extend and revise rulemaking authority with respect to government
securities under the Federal securities laws, and for other purposes.

IN THE HOUSE OF REPRESENTATIVES
JANUARY 26, 1993

Mr.

MARKET (for himself, Mr. FIELDS of Texas, Mr. DINGELL, Mr. WYDEN,
Mr. SYNAR, and Mr. COOPER) introduced the following bill; which was

referred to the Committee on Energy and Commerce

A BILL
To extend and revise rulemaking authority with respect to
government securities under the Federal securities laws,
and for other purposes.
1

Be it enacted by the Senate and House of Representa-

2 tives of the United States of America in Congress assembled,
3

S E C T I O N 1. S H O R T T I T L E .

This Act may be cited as the "Government Securities

5 Reform Act of 1993".

5
2
1

SEC. 2. EXTENSION OF GOVERNMENT SECURITIES RULE-

MAKING AUTHORITY.

Section 150(g)(1) of the Securities Exchange Act of

4 1934 (15 U.S.C. 78o-5(g)(l)) is amended by striking
5 "October 1, 1991" and inserting "October 1, 1997".
6

SEC. 3. RECORDKEEPING.

Section 17 of the Securities Exchange Act of 1934

8 (15 U.S.C. 78q) is amended by adding at the end thereof
9 the following new subsection:
10
11

" ( i ) GOVERNMENT SECURITIES RECORDKEEPING.—
" ( 1 ) MAINTENANCE OF RECORDS.—The

Com-

mission may prescribe rules to require any govern-

ment securities broker or government securities deal-

er to make, keep, and maintain for prescribed peri-

ods, in a form and containing such information as

may be specified by the Commission, records of gov-

ernment securities transactions, including (but not

limited to) records of the date and time of execution

of trades.

" ( 2 ) EXAMINATION OF RECORDS.—Eveiy gov-

ernment securities broker and government securities

dealer shall make such records available for exam-

ination to representatives of the appropriate regu-

latory agency for such government securities broker

or government securities dealer and furnish copies

thereof to such representatives on request.
•HR 618 IH

6
3
1

" ( 3 ) FURNISHING RECORDS TO RECONSTRUCT

TRADING.—Every government securities broker and

government securities dealer shall furnish to the

Commission on request such of the information re-

quired to be made, kept, or maintained under this

subsection as the Commission may require to recon-

struct trading in furtherance of the purposes of this

title. In requiring information pursuant to this para-

graph, the Commission shall specify the information

required, the period for which it is required, the time

and date on which the information must be fur-

nished, and whether the information is to be fur-

nished directly to the Commission, to the Federal

Reserve Bank of New York, or to an appropriate

regulatory agency or self-regulatory organization

with responsibility for examining the government se-

curities broker or government securities dealer. The

Commission may require that such information be

furnished in machine readable form.

" ( 4 ) LIMITATION; CONSTRUCTION.—The

Com-

mission shall not utilize its authority under this sub-

section to develop regular reporting requirements for

information concerning a substantial segment of all

daily transactions in government securities; however,

the Commission may require information to be fur•HR 618 IH

7
4
1

nished under this subsection as frequently as nec-

essary for particular inquiries or investigations. The

Commission shall, where feasible, avoid requiring

any information to be furnished under this sub-

section that the Commission may obtain from the

Federal Reserve Bank of New York.

" ( 5 ) CONSULTATION REQUIREMENT.—In mak-

ing rules under this subsection applicable to govern-

ment securities brokers and government securities

dealers for which a Federal banking agency is the

appropriate regulatory agency, the Commission shall

consult with and consider the views of each such ap-

propriate regulatory agency. If a Federal banking

agency comments in writing on a proposed rule

under this subsection that has been published for

comment, the Commission shall respond in writing

to such written comment before adopting the pro-

posed rule. The Commission shall, at the request of

the Federal banking agency, publish such comment

and response in the Federal Register at the time of

publishing the adopted rule. For purposes of this

paragraph, the term 'Federal banking agency* has

the meaning provided in subsection (h)(3)(G).

" ( 6 ) AUTHORITY OP THE COMMISSION TO LIMIT

DISCLOSURE

•HR618 IH

INFORMATION.—Notwithstanding

8
5
1

any other provision of law, the Commission and the

appropriate regulatoiy agencies shall not be com-

pelled to disclose any information required under

this subsection. Nothing in this subsection shall au-

thorize the Commission or any appropriate regu-

latory agency to withhold information from Con-

gress, or prevent the Commission or any appropriate

regulatoiy agency from complying with a request for

information from any other Federal department or

agency requesting information for purposes within

the scope of its jurisdiction, or complying with an

order of a court of the United States in an action

brought by the United States, the Commission, or

the appropriate regulatoiy agency. For purposes of

section 552 of title 5, United States Code, this sub-

section shall be considered a statute described in

subsection (b)(3)(B) of such section 552."

18
19

SEC. 4. LARGE POSITION REPORTING.
( a ) AMENDMENT.—Section 1 5 C o f the Securities E x -

20 change Act of 1934 (15 U.S.C. 78o-5) is amended—
21
22
23

(1) by redesignating subsections (f) and (g) as
subsections (g) and (h); and
(2) by inserting after subsection (e) the follow-

ing new subsection:

" ( f ) LARGE POSITION REPORTING.—

•HR 618 IH

9
6
1

"(1)

REPORTING

REQUIREMENTS.—The

Sec-

retary may adopt rules to require specified persons

holding, maintaining, or controlling large positions

in to-be-issued or recently issued Treasury securities

to file such reports regarding such positions as the

Secretary determines to be necessary or appropriate

for the purpose of monitoring the impact in the

Treasury securities market of concentrations of posi-

tions in Treasury securities and for the purpose of

otherwise assisting the Commission in the enforce-

ment of this title. Reports required under this sub-

section shall be filed with the Federal Reserve Bank

of New York, acting as agent for the Secretary, and

shall be provided by that Federal Reserve Bank to

the Commission on a timely basis.

" ( 2 ) LIMITATION ON REQUIRING CERTAIN RE-

PORTS.—The Secretary may not require under this

subsection—

"(A) reports from persons that are not

government securities brokers or government

securities dealers, or

"(B) reports from government securities

brokers and government securities dealers that

identify particular customers and customer po-

sitions,
•hr sis m

10
7

except when the Secretary determines, after con-

sultation with the Commission and the Board of

Governors of the Federal Reserve System, that mar-

ket conditions exist that require such information be

obtained to carry out the purposes of this sub-

section.

" ( 3 ) ADDITIONAL CONSIDERATIONS.—In mak-

ing determinations under paragraphs (1) and (2),

the Secretary shall take into account any impact on

the efficiency and liquidity of the Treasury securities

market and on the cost to the taxpayers of funding

the Federal debt.

" ( 4 ) RECORDKEEPING REQUIREMENTS.—Rules

under this subsection may require persons holding,

maintaining, or controlling large positions in Treas-

uiy securities to make and keep for prescribed peri-

ods such records as the Secretary determines are

necessary or appropriate to ensure that such persons

can comply with reporting requirements under this

subsection.

21
22

"(5) AGGREGATION RULES.—Rules under this
subsection—

"(A) may prescribe the manner in which

positions and accounts shall be aggregated for

the purpose of this subsection, including aggre•HR 618 IH

11
8
1

gation on the basis of common ownership or

control; and

"(B) may define which persons (individ-

ually or as a group) hold, maintain, or control

large positions.

"(6)

DEFINITIONAL AUTHORITY;

DETERMINA-

TION OF REPORTING THRESHOLD.—

"(A) In prescribing rules under this sub-

section, the Secretary may, consistent with the

purpose of this subsection, define terms used in

this subsection that are not otherwise defined in

section 3 of this title.

13
14

"(B) Rules under this subsection shall
specify—

"(i) the minimum size of positions

subject to reporting under this subsection,

taking into account the purposes of this

subsection and the potential for price dis-

tortions or other anomalies resulting from

large positions;

"(ii) the types of positions (which may

include financing arrangements) to be re-

ported;

"(iii) the securities to be covered; and

•HR 616 IH

12
9

"(iv) the form and manner in which

reports shall be transmitted, which may in-

dude transmission in machine readable

form.

" ( 7 ) LIMITATION ON DISCLOSURE OF INFORMA-

TION.—Notwithstanding any other provision of law,

the Secretary and the Commission shall not be com-

pelled to disclose any information required to be

kept or reported under this subsection. Nothing in

this subsection shall authorize the Secretary or the

Commission to withhold information from Congress,

or prevent the Secretary or the Commission comply-

ing with a request for information from any other

Federal department or agency requesting informa-

tion for purposes within the scope of its jurisdiction,

or complying with an order of a court of the United

States in an action brought by the United States,

the Secretary, or the Commission. For purposes of

section 552 of title 5, United States Code, this sub-

section shall be considered a statute described in

subsection (b)(3)(B) of such section 552.".

(b) CONFORMING AMENDMENT.—Section 15C(d)(2)

23 of such Act is amended to read as follows:
24

"(2) Information received by an appropriate regu-

25 latory agency, the Secretary, or the Commission from or
HR 618 IH

13
10
1 with respect to any government securities broker, govern2 ment securities dealer, any person associated with a gov3 ernment securities broker or government securities dealer,
4 or any other person subject to this section or rules promul5 gated thereunder, may be made available by the Secretary
6 or the recipient agency to the Commission, the Secretary,
7 the Department of Justice, the Commodity Futures Trad8 ing Commission, any appropriate regulatory agency, any
9 self-regulatory organization, or any Federal Reserve
10 Bank.".
11

SEC. 5. AUTHORITY OF THE COMMISSION TO REGULATE

12
13
14

TRANSACTIONS IN EXEMPTED SECURITIES.
( a ) PREVENTION OF FRAUDULENT AND MANIPULATIVE ACTS AND PRACTICES.—Section

15(c)(2) of the Se-

15 curities Exchange Act of 1934 (15 U.S.C. 78o(c)(2)) is
16 amended—
17

(1) by inserting "(A)" after "(2)";

(2) by striking "fictitious quotation, and no

municipal securities dealer" and inserting the follow-

ing:

21 "fictitious quotation.
22
23
24

"(B) No municipal securities dealer";
(3) by striking "fictitious quotation. The Commission shall" and inserting the following:

25 "fictitious quotation.
•HR 618 IH

14
11
1

"(C) No government securities broker or government

2 securities dealer shall make use of the mails or any means
3 or instrumentality of interstate commerce to effect any
4 transaction in, or induce or attempt to induce the pur5 chase or sale of, any government security in connection
6 with which such government securities broker or govern7 ment securities dealer engages in anyfraudulent,decep8 tive, or manipulative act or practice, or makes any ficti9 tious quotation.
10

"(D) The Commission shall"; and

(4) by inserting at the end thereof the follow-

ing:

"(E) The Commission shall, prior to adopting rules

14 or regulations under subparagraph (C), consult with and
15 consider the views of the Secretary of the Treasury and
16 the Board of Governors of the Federal Reserve System.
17 If the Secretary of the Treasury or the Board of Gov18 ernors of the Federal Reserve System comments in writing
19 on a proposed rule or regulation of the Commission under
20 such subparagraph (C) that has been published for com21 ment, the Commission shall respond in writing to such
22 written comment before adopting the proposed rule.".
23

( b ) FRAUDULENT AND MANIPULATIVE DEVICES AND

24 CONTRIVANCES.—Section 15(c)(1) of the Securities Ex25 change Act of 1934 (15 U.S.C. 78o(c)(l)) is amended—
•HR 618 IH

15
12
1

(1) by inserting "(A)" after "(c)(1)";

(2) by striking "contrivance, and no municipal

securities dealer" and inserting the following:

4 "contrivance.
5

"(B) No municipal securities dealer";

6
7

(3) by striking "contrivance. The Commission
shall" and inserting the following:

8 "contrivance.
9

"(C) No government securities broker or government

10 securities dealer shall make use of the mails or any means
11 or instrumentality of interstate commerce to effect any
12 transaction in, or to induce or attempt to induce the pur13 chase or sale of, any government security by means of any
14 manipulative, deceptive, or other fraudulent device or eon15 trivance.
16

"(D) The Commission shall"; and

(4) by inserting at the end thereof the follow-

ing:

"(E) The Commission shall, prior to adopting rules

20 or regulations under subparagraph (C), consult with and
21 consider the views of the Secretary of the Treasury and
22 the Board of Governors of the Federal Reserve System.
23 If the Secretary of the Treasury or the Board of Gov24 ernors of the Federal Reserve System comments in writing
25 on a proposed rule or regulation of the Commission under
•HR 618 IH

16
13
1 such subparagraph (C) that has been published for com2 ment, the Commission shall respond in writing to such
3 written comment before adopting the proposed rule.".
4

SEC. 6. BROKER/DEALER SUPERVISION RESPONSIBILITIES.

Section 15 of the Securities Exchange Act of 1934

6 (15 U.S.C. 78o) is amended by adding at the end thereof
7 the following new subsection:
8
9

" ( h ) POLICIES AND PROCEDURES TO PREVENT AND
DETECT

VIOLATIONS.—Every

government

securities

10 broker and government securities dealer shall establish,
11 maintain, and enforce written policies and procedures rea12 sonably designed, taking into consideration the nature of
13 such person's business, to prevent and detect in connection
14 with the purchase or sale of government securities, insofar
15 as practicable, fraud and manipulation in violation of this
16 title and the rules and regulations thereunder and viola17 tions of such other provisions of this title and the rules
18 and regulations thereunder as the Commission shall des19 ignate by rule. The Commission, as it deems necessary or
20 appropriate in the public interest or for the protection of
21 investors, shall prescribe rules or regulations to require
22 specific policies or procedures reasonably designed to pre23 vent such violations.".

•HR 618 IH

17
14
1
2

SEC. 7. SALES PRACTICE RULEMAKING AUTHORITY.
(a) RULES FOR FINANCIAL INSTITUTIONS.—Section

3 15C(b) of the Securities Exchange Act of 1934 (15 U.S.C.
4 78o-5(b)) is amended—
5

(1) by redesignating paragraphs (3), (4), (5),

and (6) as paragraphs (4), (5), (6), and (7), respec-

tively; and

8
9
10

(2) by inserting after paragraph (2) the following new paragraph:
"(3)

SALES PRACTICE R U L E S . — ( A )

With respect to

11 any financial institution that has filed notice as a govern12 ment securities broker or government securities dealer or
13 that is required to file notice under subsection (a)(1)(B)
14 of this section, the appropriate regulatory agency for such
15 government securities broker or government securities
16 dealer may issue such rules with respect to transactions
17 in government securities as may be necessary to prevent
18 fraudulent and manipulative acts and practices and to pro19 mote just and equitable principles of trade.
20

"(B) Each appropriate regulatory agency shall con-

21 suit with the other appropriate regulatory agencies for the
22 purpose of ensuring the consistency of the rules prescribed
23 by such agencies under this paragraph. The appropriate
24 regulatory agencies shall consult with and consider the
25 views of the Secretary and the Commission with respect
26 to the impact of such rules on the operations of the market
•HR 618 IH

18
15
1 for government securities, consistency with analogous
2 rules of self-regulatory organizations, and the enforcement
3 and administration of such rules. The consultation re4 quired by this paragraph shall be conducted prior to the
5 appropriate regulatoiy agency adopting a rule under this
6 paragraph, unless the appropriate regulatoiy agency de7 termines that an emergency exists requiring expeditious
8 and summaiy action and publishes its reasons therefor.
9 If the Secretary or the Commission comments in writing
10 to the appropriate regulatory agency on a proposed rule
11 that has been published for comment, the appropriate reg12 ulatory agency shall respond in writing to such written
13 comment before adopting the rule.".
14
15
16

(b) RULES BY REGISTERED SECURITIES ASSOCIATIONS.—
(1)

REMOVAL

OF LIMITATIONS

ON AUTHOR-

ITY.—(A) Section 15A of the Securities Exchange

Act of 1934 (15 U.S.C. 78o-3) is amended—

19
20

(i) by striking subsections (f)(1) and
(f)(2); and

(ii) by redesignating subsection (f)(3) as

subsection (f).

(B) Section 15A(g) of such Act is amended—

•HR 618 IH

19
16
1

(i) by striking "exempted securities" in

paragraph (3)(D) and inserting "municipal se-

curities";

(ii) by striking paragraph (4); and

(iii) by redesignating paragraph (5) as

paragraph (4).

(2)

OVERSIGHT

OP REGISTERED

ASSOCIATIONS.—Section

change Act of 1934 (15 U.S.C. 78s) is amended—

(A) in subsection (b), by adding at the end

11
12

o f the

SECURITIES

Securities

Ex-

thereof the following new paragraph:
"(5) The Commission shall consult with and consider

13 the views of the Secretary of the Treasury prior to approv14 ing a proposed rule change filed by a registered securities
15 association that primarily concerns conduct related to
16 transactions in government securities, except where the
17 Commission determines that an emergency exists requir18 ing expeditious or summary action and publishes its rea19 sons therefor. If the Secretary comments in writing to the
20 Commission on such proposed rule change that has been
21 published for comment, the Commission shall respond in
22 writing to such written comment before approving the pro23 posed rule change.";
24
25

(B) in subsection (c), by adding at the end
thereof the following new paragraph:
•HR 618 IH

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17

"(5) Before adopting a rule to amend a rule of a reg-

2 istered securities association that primarily concerns con3 duct related to transactions in government securities, the
4 Commission shall consult with and consider the views of
5 the Secretary, except where the Commission determines
6 that an emergency exists requiring expeditious or sum7 mary action and publishes its reasons therefor. If the Sec8 retary comments in writing to the Commission on such
9 proposed rule change that has been published for com10 ment, the Commission shall respond in writing to such
11 written comment before approving the proposed rule
12 change.".
13

( 3 ) CONFORMING AMENDMENT.—

(A) Section 3(a)(12)(B)(ii) of such Act (15

U.S.C. 78b(a)(12)(B)(ii)) is amended by strik-

ing "15, 15A (other than subsection (g)(3)),

and 17A" and inserting "15 and 17A".

(B) Section 15(b)(7) of such Act (15

U.S.C. 78o(b)(7)) is amended by inserting "or

government securities broker or government se-

curities dealer registered (or required to reg-

ister) under section 15C(a)(l)(A)" after "No

registered broker or dealer".

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1

SEC. 8. MARKET INFORMATION.

(a) TRANSPARENCY.—The Securities Exchange Act

3 of 1934 is amended by adding at the end of section 11A
4 (15 U.S.C. 78k-l) the following:
5

"MARKET INFORMATION WITH RESPECT TO GOVERNMENT

SECURITIES

"SEC. 11B. (a) FINDINGS.—The Congress finds

8 that—
9

"(1) it is necessary and appropriate for the pro-

tection of investors to assure public dissemination of

information concerning government securities trans-

actions and quotations;

"(2) government securities brokers, government

securities dealers, and government securities infor-

mation systems have created substantial trans-

parency through the dissemination of information

concerning government securities transactions and

quotations and are expected to maintain and im-

prove such transparency through voluntary actions;

and

"(3) if such voluntary actions do not attain the

objectives stated in subsections (b) and (c), the

Commission should have the authority, in accord-

ance with the requirements of this section, to assure

the attainment of those objectives.

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2

" ( b ) GOVERNMENT SECURITIES INFORMATION SYSTEMS.—

"(1)

CONDITIONAL AUTHORITY.—Upon

a find-

ing by the Commission that information available to

investors generally through government securities in-

formation systems taken as a whole does not meet

the objectives set forth in paragraph (2) with respect

to a class or category of regularly traded govern-

ment securities, the Commission, having due regard

for the public interest, the protection of investors,

the maintenance of fair and orderly markets, the in-

tegrity, liquidity, and efficiency of the government

securities market, and the fostering of competition,

may prescribe rules applicable to government securi-

ties information systems to the extent necessary to

assure that government securities information sys-

tems meet the objectives set forth in paragraph (2)

with respect to such class or category of securities.

The Commission (A) shall not utilize its authority

under this paragraph to regulate the amount of fees

charged for information, and (B) shall not require

dissemination through government securities infor-

mation systems of information not transmitted by or

through government securities interdealer brokers

(or their functional equivalents).
•HR 618 IH

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1

"(2) OBJECTIVES.—The Commission may not

take action under paragraph (1) of this subsection

unless the Commission makes the finding required

by paragraph (1) and determines that such action is

necessary or appropriate—

"(A) to assure that information on trans-

actions in and quotations for a class or category

of regularly traded government securities being

reported through government securities infor-

mation systems taken as a whole is available to

investors generally and includes—

"(i) information concerning price and

volume with respect to a reasonably suffi-

cient number or proportion of transactions

in any security in such class or category to

permit the determination of the prevailing

market price for such security; and

"(ii) reports of the highest bids and

lowest offers for any security in such class

or category being reported through such

systems (including the size at which gov-

ernment securities brokers and dealers are

willing to trade with respect to such bids

and offers);

•HR618 IH

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21
1
2

"(B) to assure that such information is
timely reported;

"(C) to assure that such information is

made available to investors generally on a fair,

reasonable, and nondiscriminatory basis; and

"(D) to assure the ability of investors to

obtain and retain such information for analyt-

ical purposes.

9
10

11
12

" ( c ) STANDBY AUTHORITY W I T H RESPECT TO MARKET INFORMATION.—

"(1) AUTHORITY.—Subject to paragraph (2),
the Commission by rule—

"(A) may require any government securi-

ties broker or government securities dealer that

regularly trades a security as to which the Sec-

retaiy of the Treasury has made a determina-

tion under paragraph (2) to report any pur-

chase or sale of such a security to any securities

information processor that has the capability

and agrees to disseminate such reports or, if

there is no such processor, to a self-regulatoiy

organization designated by the Commission to

receive such reports, and may require such se-

curities information processor or self-regulatory

organization to make information with respect
•HR 618 IH

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22
1

to such purchase or sale publicly available on

fair, reasonable, and nondiscriminatory terms

and conditions; and

"(B) may require any self-regulatory orga-

nization, and any government securities broker

or government securities dealer that regularly

trades such securities, to act jointly in plan-

ning, developing, or operating facilities for the

dissemination of information with respect to

purchases or sales of government securities.

" ( 2 ) INADEQUATE PRICE INFORMATION FIND-

ING REQUIRED.—The Commission may not take an

action authorized by paragraph (1) of this sub-

section with respect to any class or category of regu-

larly traded government securities unless the Sec-

retary of the Treasury, after consultation with the

Commission, determines that information that is

available to investors generally with respect to such

class or category either—

"(A) does not permit investors in general

to determine readily the prevailing market price

of securities in such class or category of regu-

larly traded government securities; or

•HR 618 IH

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23

"(B) is no longer representative of the

market for such class or category of govern-

ment securities.

"(3)

RULE

CONSTRUCTION.—This

sub-

section is not intended to authorize the Commission

to require the establishment or use of a consolidated

trading system for government securities.

" ( d ) RULEMAKING.—

"(1) CONSULTATION.—In making rules under

this section, the Commission shall consult with and

consider the views of the Secretary of the Treasury

and the Board of Governors of the Federal Reserve

System. If the Secretary of the Treasury or the

Board of Governors of the Federal Reserve System

comments in writing on a proposed rule that has

been published for comment, the Commission shall

respond in writing to such written comment before

adopting the proposed rule. Prior to prescribing a

rule pursuant to subsection (c), the Commission

shall consult with representatives of the persons de-

scribed in subsection (a)(2).

"(2) STANDARDS.—In making rules under this

subsection, the Commission may designate classes or

categories of government securities, establish stand-

ards for determining whether they are regularly

•HR 818 IH

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24
1

traded, and establish standards for determining

whether a person regularly trades such government

securities or a class or category of such government

securities.

" ( e ) EXAMINATION ACCESS.—

" ( 1 ) AUTHORITY TO EXAMINE.—Systems and

operations of government securities information sys-

tems (and records relating thereto) are subject to

reasonable examination by representatives of the

Commission—

"(A) to assess whether the objectives set

forth in subsection (b)(2) of this section are

being met; and

"(B) to assess compliance with any rules

or regulations under this section.

"(2)

LIMITATIONS.—The

Commission shall

have no authority under this section—

"(A) to examine the financial, personnel,

marketing, sales, product, and service develop-

ment, or similar business records of such per-

son; or

"(B) to examine systems and operations

unrelated to dissemination of government secu-

rities information.

•HR 618 m

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25
1

The Commission may not examine contracts except

to the extent necessary to assess whether the objec-

tives set forth in subsections (b)(2)(C) and (b)(2)(D)

of this section are being met, and to determine com-

pliance with rules prescribed for purposes of such

subsections.

" ( 3 ) PROTECTION OF INFORMATION.—Notwith-

standing any other provision of law, the Commission

(and any Federal agency or department to which

such information is disclosed) shall not be compelled

to disclose any information obtained by the Commis-

sion in an examination under this subsection. Fur-

thermore, the Commission (and any Federal agency

or department to which such information is dis-

closed) shall not publicly disclose information ob-

tained by the Commission in such an examination,

except that this sentence shall not prohibit the dis-

closure of such information in a proceeding brought

by the Commission. Nothing in this section shall au-

thorize the Commission to withhold information

from Congress, or prevent the Commission or any

appropriate regulatory agency from complying with

a request for information from any other Federal de-

partment or agency requesting information for pur-

poses within the scope of its jurisdiction, or comply-

•HR 618 IH

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1

ing with an order of a court of the United States in

an action brought by the United States, the Com-

mission, or the appropriate regulatory agency. For

purposes of section 552 of title 5, United States

Code, this subsection shall be considered a statute

described in subsection (b)(3)(B) of such section

552.

" ( f ) VIOLATIONS OP RULES PROHIBITED.—No gov-

9 ernment securities broker, government securities dealer,
10 securities information processor, or government securities
11 information system shall make use of the mails or any
12 means or instrumentality of interstate commerce to effect
13 any transaction in, to induce the purchase or sale of, or
14 to distribute or disseminate any quotation or transaction
15 report for, any government security in contravention of
16 any rule adopted pursuant to this section.
17

" ( g ) EFFECTIVE DATE OF RULEMAKING AUTHOR-

18 ITY.—The authority of the Commission to prescribe rules
19 under subsections (b) and (c) is effective on October 1,
20 1993.
21

"(h) DEFINITION.—For purposes of this section, the

22 term 'government securities' does not include a security
23 secured by an interest in pools of mortgages representing
24 liens on residential real estate.".

•HR 618 IH

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O - 93 - 2

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27
1

(b)

CONFORMING

AMENDMENTS.—The

Securities

2 Exchange Act of 1934 is amended—
3
4
5
6

(1) by striking "(other than an exempted security)"

in section 3(a)(22)(A);
(2) by adding at the end of section 3(a) the fol-

lowing:

"(53) The term 'government securities informa-

tion system' means any person engaged in the busi-

ness of operating a system for the timely, automated

dissemination to more than 10 persons of (A) quota-

tions for government securities of or through govern-

ment securities interdealer brokers (or their func-

tional equivalents), or (B) reports of purchases or

sales of government securities by or through govern-

ment securities interdealer brokers (or their func-

tional equivalents)."; and

(3) by inserting at the end of section llA(b)(l)

the following: "The Commission shall not require

any securities information processor to register

under this section in connection with its activities

with respect to quotations for or transactions in ex-

empted securities.".

GOVERNMENT SECURITIES.—

•HR 618 IH

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1

( 1 ) STUDIES REQUIRED—With

respect to gov-

ernment securities (as defined in section 3(a)(42) of

the Securities Exchange Act of 1934) that are se-

cured by an interest in pools of mortgages represent-

ing liens on residential real estate (hereafter in this

subsection referred to as 'mortgage-backed govern-

ment securities'), the Secretary of the Treasury, the

Securities and Exchange Commission, and the

Board of Governors of the Federal Reserve System

shall monitor and evaluate the effectiveness of pri-

vate sector efforts to disseminate mortgage-backed

government securities price and volume information,

and determine whether such efforts—

(A) assure the prompt, accurate, reliable,

and fair reporting, collection, processing, dis-

tribution, and publication of information with

respect to quotations for and transactions in

mortgage-backed government securities and the

fairness and usefulness of the form and content

of such information;

(B) assure that all mortgage-backed gov-

ernment securities information processors may,

for the purpose of distribution and publication,

obtain on fair and reasonable terms such infor-

mation with respect to quotations for and
•HR 618 IH

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1

transactions in mortgage-backed government se-

curities, as reported, collected, processed, or

prepared for distribution or publication by any

processor of such information (including self-

regulatory organizations) acting in an exclusive

capacity; and

ernment securities brokers, mortgage-backed

government securities dealers, mortgage-backed

government securities information processors,

and other appropriate persons may obtain on

nondiscriminatory terms such information with

respect to quotations for and transactions in

mortgage-backed government securities as is

distributed or published.

(2) REPORTS.—The Secretary of the Treasury,

the Securities and Exchange Commission, and the

Board of Governors of the Federal Reserve System

shall each submit a report to the Congress describ-

ing its findings under this subsection and any rec-

ommendations for legislation not later than 18

months after the date of enactment of this Act.

•HR618 IH

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30
1

SEC. 9. STUDY OF REGULATORY SYSTEM FOR GOVERN-

2
3

MENT SECURITIES.

(a)

JOINT STUDY.—The

Secretary of the Treasury,

4 the Securities and Exchange Commission, and the Board
5 of Governors of the Federal Reserve System shall—
6

(1) evaluate the effectiveness of any rules pro-

mulgated or amended after October 1, 1991, pursu-

ant to section 15C of the Securities Exchange Act

of 1934 or any amendment made by this title, and

any national securities association rule changes ap-

plicable principally to government securities trans-

actions approved after October 1, 1991, in carrying

out the purposes of such Act;

(2) evaluate the effectiveness of surveillance

and enforcement with respect to government securi-

ties, and the impact on such surveillance and en-

forcement of defects in any available audit trails

with respect to transactions in such securities; and

(3) submit to the Congress, not later than

March 31, 1997, any recommendations they may

consider appropriate concerning—

22
23

(A) the regulation of government securities
brokers and government securities dealers,

(B) the dissemination of information con-

cerning quotations for and transactions in gov-

ernment securities,
•HR 618 IH

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1

in connection with transactions in government

securities, and

4
5

(D) such other matters as they consider
appropriate.

(b) GAO STUDY.—The Comptroller General shall—

(1) conduct a study of the effectiveness of regu-

lation of government securities brokers and govern-

ment securities dealers pursuant to section 15C of

the Securities Exchange Act of 1934 and the effec-

tiveness of the amendments made by this title; and

(2) submit to the Congress, not later than

March 31, 1996, the Comptroller General's rec-

ommendations for change, if any, or such other rec-

ommendations as the Comptroller General considers

appropriate.

SEC. 10. TECHNICAL AMENDMENTS.

(a) AMENDMENTS TO DEFINITIONS.—Section 3(a) of

19 the Securities Exchange Act of 1934 (15 U.S.C. 78c(a))
20 is amended—
21

(1) in paragraph (34)(G) (relating to the defini-

tion of appropriate regulatory agency), by amending

clauses (ii), (iii), and (iv) to read as follows:

"(ii) the Board of Governors of the

Federal Reserve System, in the case of a
•HR 618 IH

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1

State member bank of the Federal Reserve

System, a foreign bank, an uninsured

State branch or State agency of a foreign

bank,

owned or controlled by a foreign bank (as

such terms are used in the International

Banking Act of 1978), or a corporation or-

ganized or having an agreement with the

Board of Governors of the Federal Reserve

System pursuant to section 25 or section

25A of the Federal Reserve Act;

a commercial

lending company

"(iii) the Federal Deposit Insurance

Corporation, in the case of a bank insured

by the Federal Deposit Insurance Corpora-

tion (other than a member of the Federal

Reserve System or a Federal savings bank)

or an insured State branch of a foreign

bank (as such terms are used in the Inter-

national Banking Act of 1978);

"(iv) the Director of the Office of

Thrift Supervision, in the case of a savings

association (as defined in section 3(b) of

the Federal Deposit Insurance Act) the de-

posits of which are insured by the Federal

Deposit Insurance Corporation;";
•HR 618 IH

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1

(2) by amending paragraph (46) (relating to

the definition of financial institution) to read as fol-

lows:

"(46) The term 'financial institution' means—

"(A) a bank (as defined in paragraph (6)

of this subsection);

"(B) a foreign bank (as such term is used

in the International Banking Act of 1978); and

"(C) a savings association (as defined in

section 3(b) of the Federal Deposit Insurance

Act) the deposits of which are insured by the

Federal Deposit Insurance Corporation."; and

(3) by redesignating paragraph (51) (as added

by section 204 of the International Securities En-

forcement Cooperation Act) as paragraph (52).

(b)

17
18

EFFECTIVE

DATE

OF BROKER/DEALER

REG-

ISTRATION.—
(1)

GOVERNMENT

SECURITIES BROKERS AND

DEALERS.—Section 15C(a)(2)(ii) of the Securities

Exchange Act of 1934 (15 U.S.C. 78o-5(a)(2)(ii)) is

amended by inserting before "At the conclusion" the

following: "The order granting registration shall not

be effective until such government securities broker

or government securities dealer has become a mem-

ber of a national securities exchange registered
•HR 618 IH

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1

under section 6 of this title, or a securities associa-

tion registered under section 15A of this title, unless

the Commission has exempted such government se-

curities broker or government securities dealer, by

rule or order, from such membership.".

( 2 ) OTHER BROKERS AND DEALERS.—Section

15(b)(1)(B) of such Act (15 U.S.C. 78o(b)(l)(B)) is

amended by inserting before uAt the conclusion" the

following: "The order granting registration shall not

be effective until such broker or dealer has become

a member of a registered securities association, or

until such broker or dealer has become a member of

a national securities exchange if such broker or deal-

er effects transactions solely on that exchange, un-

less the Commission has exempted such broker or

dealer, by rule or order, from such membership.".

SEC. 11. OFFERINGS OF CERTAIN GOVERNMENT SECURI-

TIES.

Section 15 of the Securities Exchange Act of 1934

20 (15 U.S.C. 78o) is amended by inserting after paragraph
21 (6) of subsection (c) the following new paragraph:
22

"(7) In connection with any bid for or purchase

of a government security related to an offering of

government securities by or on behalf of an issuer,

no government securities broker, government securi-

•HR 618 IH

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1

ties dealer, or bidder for or purchaser of securities

in such offering shall knowingly or willfully make

any false or misleading written statement or omit

any fact necessary to make any written statement

made not misleading. For purposes of the preceding

sentence, the term 'government security' shall not

include any obligation subject to the public debt

limit established in section 3101 of title 31, United

States Code.".

SEC. 12. RULE OF CONSTRUCTION.

(a) IN GENERAL.—No provision of, or amendment

12 made by, this title may be construed—
13
14
15

(1) to apply to the initial issuance of any public
debt obligation, or
(2) to grant any authority to (or extend any au-

thority

Commission—

18
19

of)

the

Securities

and

Exchange

(A) to prescribe any procedure, term, or
condition governing such initial issuance,

(B) to require any recordkeeping, or the

furnishing of any information, with respect to

such initial issuance, or

23
24

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(b) PUBLIC DEBT OBLIGATION.—For purposes of

2 this section, the term "public debt obligation" means an
3 obligation subject to the public debt limit established in
4 section 3101 of title 31, United States Code.
O

•HR 618

40
Mr. MARKEY. The Chair turns to recognize the gentleman from
Louisiana, Mr. Tauzin, if he has an opening statement.
Mr. TAUZIN. Mr. Chairman, in recognition of the Chair's earlier
motion to monopolize opening statements—I'm teasing you—so the
witnesses could have more time to tell us their story, I do not have
an opening statement.
Mr. MARKEY. The Chair respects the gentleman's deference to
the Chair, and he notes that most other members are now still in
traffic most likely, and we will, as a result, turn to our opening set
of witnesses, which I think will help to lay out the basic problems
in this area.
We will begin with the Honorable Richard Breeden, who is the
Chairman of the Securities and Exchange Commission. No. Let's
start with Mr. Mullins. I think it might make sense to start with
Mr. Mullins instead, who is from the Board of Governors of the
Federal Reserve System.
Other members have arrived.
Do any of the arriving members have an opening statement they
would like to make?
Ms. SCHENK. Just that the metro was late.
Mr. MARKEY. Without objection, all of the opening statements in
written form of all of the members will be included in the record.
[The prepared statement of Hon. Michael G. Oxley follows:]
STATEMENT OF HON. MICHAEL G. OXLEY

Thank you, Mr. Chairman. I want to commend you for holding these hearings on
H.R. 618, The Government Securities Reform Act of 1993.
The purpose of the Government securities market is to finance the national debt
at the lowest possible cost. Public confidence in the integrity of the market is essential. It was to help preserve that confidence that Congress enacted the Government
Securities Act of 1986.
The GSA established a Federal system for regulating the Government securities
market, including previously unregulated brokers and dealers, in order to protect
investors and to ensure the maintenance of a fair, honest and liquid markets.
At that time,, the Department of the Treasury was instructed to adopt rules to
prevent fraudulent and manipulative acts and practices. Their efforts have been successful. The rules they adopted have improved and strengthened investor safety in
the market. Treasurys rulemaking authority, however, sunset on October 1, 1991.
I believe it is incumbent upon Congress to remedy the situation in which the
Treasury Department is without authority to regulate its own marketplace as quickly as possible. Our legislation does this by reauthorizing the Treasury Department
to adopt rules as necessary.
In 1987 Treasury, the Federal Reserve and the GAO agreed that Government securities brokers should make more quotation information available. Increasing the
amount of information available to the public makes financial markets more efficient without any risk to their safety.
In testimony at our hearings in the 102nd Congress, many witnesses agreed that
additional disclosure would help but they urged caution. Specifically, they asked us
to allow private industry to lead the development of market information systems.
I agreed with them then and I agree now. I do not see the Government replacing
private companies as the manager of the evolution of vendor services. Private sector
initiatives have significantly enhanced transparency in the Government securities
market.
I do believe that the Government has a role to play in insuring that this critically
important marketplace is not disrupted by fraud and scandal. It is appropriate for
the Government safety valve" to guard against market information streams misleading investors. To the extent that disclosure of quotation information could result
in misinformed investors, it is appropriate for the Government to continue to monitor developments in this area, and to retain "back-up" authority to step in to prevent fraud or manipulation.

41
If industry systems deteriorate to the point where the information they publish
no longer represents the true market, then the SEC must be authorized to take action. Tne legislation before us today, however, recognizes the Treasury Department's
special interest in the operation of this market. Consequently, it is up to the Treasury to make the determination that the information systems have become dysfunctional. This is a good solution to a potential problem.
Personally, I believe industry initiatives show that this legislative authority will
most likely never be used, and in time will be viewed as an overabundance of caution on the part of Congress.
The 1986 Act did not give Treasury authority to enact sales practice rules, and
it restricted the NASD from applying its already existing sales practice rules to its
member Government securities dealers. The securities exchanges and bank regulators do regulate the sales practices of their Government securities dealers. Critics
maintain that the NASD's inability to enforce sales practice rules on over 1,300
dealers creates a major gap in investor protection. I agree, and support the sales
practice provisions of this legislation.
In H.R. 618, I believe we nave fashioned responsible legislation. During the hearings held before this subcommittee during the 102nd Congress, many witnesses
urged caution and we have responded appropriately.
I reject the suggestion offered by another committee of the House that wholesale
restructuring of the Government securities markets is necessary or desirable. The
Energy and Commerce Committee should push forward with this careftdly crafted
legislation and bring it to the house floor as soon as is possible.
I look forward to the testimony of our witnesses on these and the other issues
before us today and yield back the balance of my time.

Mr. MARKEY. SO we will turn then and recognize you, Mr.
Mullins. Whenever you feel comfortable, please begin.
STATEMENTS OF DAVID W. MULLINS, JR., VICE CHAIRMAN,
BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM; WILLIAM J. MCDONOUGH, EXECUTIVE VICE PRESIDENT, FEDERAL RESERVE BANK OF NEW YORK; AND HON. RICHARD C.
BREEDEN, CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION, ACCOMPANIED BY CATHERINE McGUIRE, SPECIAL
ASSISTANT

Mr. MULLINS. Thank you, Mr. Chairman. We are happy to go
first.
Mr. Chairman, members of the committee, I appreciate the opportunity to present the views of the Board of Governors of the
Federal Reserve System on H.R. 618, the Government Securities
Reform Act of 1993.
This committee is to be commended for working long, hard, and
conscientiously on issues pertaining to the Government securities
market, matters that are of crucial importance to our Federal finances. The Board has reviewed H.R. 618 carefully. However, I
must report that we remain unconvinced of the wisdom and necessity of adopting many of the measures called for under this legislation.
Let me summarize briefly our views. As my colleague, Mr.
McDonough, has outlined in his written testimony, the Government
securities market has already undergone a substantial amount of
change, including redesigned auction procedures and techniques,
substantially intensified surveillance and enforcement mechanisms,
changes to the primary dealer system to open it up, and supply
management through Treasury reopenings. All of this should help
eliminate the possibility of a recurrence of the abuses committed in
the Salomon Brothers episode and should serve to deter and detect
any future episodes of abuse.

42
In weighing the need for additional legislation, we should recognize that the U.S. Government securities market shows few signs
of a need for sweeping regulatory redesign. It is the broadest, deepest, and most liquid of all securities markets, offering widespread
economic benefits by permitting transactions of enormous size at
razor-thin bid-ask spreads and allowing the Federal debt to be financed at minimum cost to the taxpayer.
Under the current regulatory structure, the smooth functioning
of the overall market betrays no indication of any loss of confidence
or fear of fraud on the part of market participants. Nonetheless, in
the Board's view, the Nation's interest would be served by the
timely enactment of the legislative agenda outlined in last year's
joint report and included in H.R. 618. This agenda, reestablishing
Treasury's rule-making authority for the Government securities
market and perhaps eliminating the prohibition on NASD to specify sales practice rules, would complement the administrative actions that are already well advanced.
Unfortunately, H.R. 618 goes far beyond this legislative agenda.
It would introduce confusing and overlapping lines of authority
among agencies, it would erect a regulatory apparatus that is more
appropriate for the equity markets, and it would create the potential for bureaucratic edict to substitute for market determination of
the flow of pricing information. These actions would raise the cost
of participating in the Government securities market precisely
when our Federal finances are critically reliant on world-wide market acceptance for Treasury's massive debt issuance.
The Board of Governors supports Congress's wisdom in 1986 in
designating the Treasury Department as the primary regulator and
rule-writer in the Government securities market. Treasury is in the
best position to weigh the impact of regulation on taxpayers and
market participants, and Treasury has every incentive to protect
the integrity of the market.
In the Board's view, there is no compelling need to grant new
record-keeping authority to the SEC, especially when existing
Treasury authority can be used more effectively if necessary, nor
is there any need for large position reporting given the substantial
improvement of the Agency's market surveillance efforts. In our
view, there is no demonstrated need to thrust the SEC into the
business of mandating what trading screens should look like, especially in view of the risk of impeding rapidly advancing industry
initiatives.
The Board acknowledges that the broad-based apparatus of reporting requirements that could be erected under H.R. 618 might
facilitate and reduce the cost of investigating relatively infrequent
episodes of abuse. On the other side of the ledger, such changes
would boost the cost of every trade, all $200 billion a day in trades,
and potentially reduce the ranks of market participants, thereby
raising the cost of financing the Federal debt.
In considering broad-based regulatory change for a market this
important, the burden should rest with the proponents for establishing a convincing case that benefits outweigh associated costs. In
view of the scale of Federal borrowing, we should be wary of imposing costs or discouraging participation without the strong presump-

43
tion of offsetting benefits. In our estimation, many of the proposals
in H.R. 618 do not pass this test.
In conclusion, Mr. Chairman, the current effort of the administration and Congress to reduce the Federal budget deficit is a most
encouraging development. However, with interest expense fast becoming the single largest item on the expenditure side of the Federal accounts, it would take a sustained rise of less than a quarter
of a percentage point in the average Treasury issuing rate over the
next 4 years to offset $30 billion of spending cuts proposed by the
President. The stakes are indeed high in considering regulatory redesign of a market that reaches directly into the taxpayer's pocketbook.
Instead of considering a risky overhaul of a market that works
so well, Congress can chart a safer and sounder course: Restore the
Treasury' rulemaking authority, perhaps allow NASD to set sales
practice standards, and support the Agencys' substantial ongoing
efforts to improve surveillance and enforcement. The Board of Governors feels that such a course would be certain to reinforce and
enhance the efficiency and integrity of this very important market.
We look forward to continuing to work with the committee on these
issues.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Mullins follows:]
STATEMENT OF DAVID W . MULLINS, JR.

I welcome this opportunity to discuss legislative initiatives concerning the Government securities market. By my count, this marks the ninth time since Salomon
Brothers' admission of wrongdoing that I have delivered testimony on this subject
before a Congressional panel. In my view, there is enough at stake, particularly in
terms of financing the Federal deficit, to warrant this close scrutiny. The interest
cost of the Federal debt depends on the rates when securities are first auctioned,
while this committee's mandate concerns secondary market trading in Government
securities. But that is not a realistic distinction in practice, since the Treasury's
ability to tap funding sources in the primary market depends critically on the assurance of smooth trading in the secondary market.
Over the past IY2 years, the Board of Governors, the Federal Reserve Bank of
New York (FRBNY), the Treasury, and the Securities and Exchange Commission
(SEC), among others, have devoted considerable attention to the Government securities market. An important initial product of that work was the Joint Report on the
Government securities market, which contained a comprehensive survey of the market and a detailed plan for correcting the problems that had been identified. Much
of the plan delineated in the report has been put in place. After consulting with the
other agencies, Treasury implemented redesigned auction procedures and rules to
eliminate the possibility of a recurrence of tne abuses committed in the Salomon
Brothers episode. With the help of staff at the New York Fed and the Commodity
Futures Trading Commission (CFTC), the Board, Treasury, and SEC formed an
Interagency Working Group on Market Surveillance. As a result, enforcement responsibilities and procedures have been clarified and intensified. After careful study,
the Treasury commenced a year-long experiment with auction technique, and the
FRBNY has made considerable progress in automating the auction process. In addition, the New York Fed has adopted changes in the administration of its relationdealers and is in the process of revising the information that it
Meanwhile, staff at the various agencies, as well as academic researchers, have
studied the relationship between prices in the cash andfinancingmarkets. This research has produced techniques to identify rate anomalies that could be associated
with squeezes. And the Treasury has shown a willingness to act through supply
management when market prices suggest a serious shortage. Last year, one issue,
a 10-year note, was reopened under the policy articulated in the Joint Report for
addressing an "acute, protracted" shortage. Under the threat of Treasury
reopenings, no market participant can be confident of profiting by cornering the

44
market in a Treasury issue. Thus, the Government securities market has already
been subject to substantial change and to intensified scrutiny on an ongoing basis.
This extensive, in-depth analysis has increased my respect and appreciation for
this financial marketplace. In this regard, the U.S. Government securities market
has no rival. This market is the deepest and broadest of all securities markets, offering widespread economic benefits by permitting transactions of enormous size to be
conducted at razor-thin bid-ask spreaas. In general, the governmental initiatives undertaken to date with respect to this market have not oeen intrusive or especially
costly, and thus have been consistent with its continued efficiency.
In weighing the need for additional legislation, the Board of Governors believes
that the best, most efficient, and equitable laws and regulations are drawn up to
address specific problems. This is why, in the Board's view, the timely enactment
of the legislative agenda outlined in the Joint Report would serve the Nation's interest. This agenda—reestablishing the Treasury's rulemaking authority for the Government securities market and perhaps eliminating the prohibition on the National
Association of Securities Dealers (NASD) to specify sales practice rules for members
participating in this market—would complement the administrative actions that
have already been put into motion. Unfortunately, H.R. 618 goes far beyond this
recommendation by introducing potentially confusing and possibly overlapping lines
of authority amongst the agencies, by erecting a regulatory apparatus that is more
appropriate for equity markets, and by creating the potential for bureaucratic judgment to substitute for the market determination of the flow of pricing information.
These actions would raise the cost of participating in the Government securities
market precisely when our Federalfinancesare critically reliant on worldwide market acceptance for the Treasury's massive debt issuance.
The Board of Governors does not believe that the evidence supports the case for
the sweeping changes in regulatory practices envisioned in this proposed legislation.
In our view, the record over the last IV2 years and a careful weighing of the costs
versus benefits would not warrant such steps. The incidents that have come to light
are apparently related to individual ethical lapses that are unfortunately all too
common when money changes hands. From what is known thus far, it appears that
the existing body of laws and regulations has proved sufficient to mete out punishment to the guilty. While there are reports that criminal investigations may have
been made more difficult by shoddy bookkeeping practices at some Government securities brokers and dealers, recordkeeping at most of those entities is already covered under the existing regulatory umbrella. The measures already implemented,
including stricter enforcement ana more uniformity in interpretation of the existing
rules by self-regulatory organizations and regulatory authorities that administer the
rules, should smooth the way in investigating potential abuses. Of course, such improvements within the current regulatory framework would be made easier if Congress acted to restore the Treasury's rulemaking authority for Government securities brokers and dealers, which lapsed in 1991.
The Board of Governors believes that a decisive case has not yet been presented
for adding statutory requirements on sales practice rules. If Congress deems that
a provision for sales practice rules is necessary, this could be obtained by simply
removing the prohibition on the NASD from applying its sale practice rules to Government securities transactions. This would bring NASD firms into line with procedures at New York Stock Exchange member firms, extending sales practice rules to
all nonbank brokers and dealers.
Compared with H.R. 618, the legislative agenda outlined above is narrower and,
in our view, better targeted. It appropriately recognizes the substantial administrative changes already set in motion as well as the unique nature of the Government
securities market. In the view of the Board of Governors, more sweeping and intrusive action does not stand the scrutiny of rigorous cost-benefit analysis. This was
our judgment at the time of the writing of the Joint Report, and events since have
only strengthened this conclusion.
There is no evidence of market failure that would warrant the significant overhaul envisioned in H.R. 618. In a market where so much money changes hands so
quickly, even the whiff of illicit activity would inspire a chorus of complaints and
withdrawals from trading. In fact, bid-ask spreads remain narrow, volume remains
heavy, and there have been no notable changes in the ranks of participation. Even
without evidence of spotty trading, thin markets, or trading failures, if there was
a convincing logical cnain to suggest that the Government securities market was
now susceptible to wrongdoing, then prophylactic action could well be justified. On
this score, though, the structure of the Government securities market would appear
to offer little scope for large-scale mischief.
First, prices in the Government securities market appear mostly driven by macroeconomic fundamentals. Government securities are homogeneous, with few of the id-

45
iosyncratic factors that push and pull the prices of private debt or equity instruments relative to market averages.
Second, in a homogeneous, highly visible market such as this one, the force of
competition remains the best protection from manipulation. With narrow bid-ask
spreads and the quick dissemination of information, there is little room to hide collusive activity. Such a market is inherently transparent.
Third, a trader who attempted to gain from market manipulation now faces the
prospect of aggressive Treasury debt management that would reopen an issue to
shave any illicit gain. Against this backdrop, many of the potentially costly provisions of H.R. 618 guard against an enemy that will never take the field.
In the Board's view, there is no compelling need to grant new recordkeeping authority to the SEC, especially when existing authority can be used more effectively.
Nor is there a need for large-position reporting, given the substantial improvement
in the agencies' market surveillance efforts. The FRBNYs discussions with market
participants provide a wealth of detail to inform the Treasury reopening decision
and to alert enforcement agencies of potential problems. These sources are augmented by dealer report forms that soon will routinely extract information on specific securities. But at a more fundamental level, currently available data on market
prices provide a continuing stream of data to mine for evidence of manipulative intent.
In our view, there is no demonstrated need to put the SEC into the business of
mandating what trading screens look like and who gets the information feeds, and
such initiatives could impose significant costs on the market. Transparency, or the
ability to get timely and reliable price quotes in the Government securities market,
has improved markedly of late. GOVPX, for example, has enhanced the information
that it provides to the market. If private sector initiatives are allowed to run their
course, this access should be further widened. The threat of governmental interference may only prove counterproductive, as private firms delay additional improvements for fear that another format might be thrust upon them.
The Board accepts that the broad-based apparatus of reporting requirements in
this market that could be implemented under H.R. 618 might reduce the cost of investigating abuses and facilitate enforcement. On the other side of the ledger, such
changes would boost the cost of every trade and potentially reduce the ranks of market participants. The Treasury's appetite for financing is too large to make purchasing its securities more expensive or to discourage willing buyers with administrative
burdens motivated by the vague fear that someone, somewhere out there, may be
inclined to cheat.
It is true that H.R. 618 does not mandate these increased reporting requirements
but rather gives various agencies the authority to enact these changes should they
deem them fit. However, even backup authority may send a chilling message about
the U.S. market to all participants choosing where to trade in the global marketplace. Rather than risk slipping into a fundamental change through backup authority, the Board of Governors feels it would be a wiser course of action to return to
Congress for enabling legislation in the future should such authority appear necessary.
Mr. MARKEY. Thank you very much, Mr. Mullins.

Our next witness, Mr. William McDonough, is the executive vice
president of the Financial Market Group from the Federal Reserve
Bank in New York, and is continuing our Hibernian trend here in
the witnesses. He represents the New York Fed which conducts the
auctions, carries out the open market operations to conduct monetary policies, and runs the market surveillance program that collects data on market activity.
We welcome you, Mr. McDonough. Whenever you feel comfortable, please begin.
STATEMENT OF WILLIAM J. McDONOUGH

Mr. MCDONOUGH. Thank you, Mr. Chairman and members of the
subcommittee.
I will concentrate this morning on the progress that has been
made during the last year regarding official oversight and regulation of the Government securities market. This review should help
the subcommittee address the question of how the legislative proc-

46
ess can best support efforts to ensure that the Government securities market retain its status as the most efficient market in the
world.
Following the Salomon Brothers events, the Treasury, the SEC,
and the Federal Reserve moved quickly to address the various concerns. The Agency set up a working group on market surveillance
with the New York Fed accepting primary responsibility for collecting and disseminating information. The Treasury clarified and restated auction rules and, with the Fed, strengthened procedures for
enforcement of those rules.
What we seek is balance between the efficiency of the market
and adequate regulatory oversight. It is simply not possible to design a system at any price which would provide absolutely fail-safe
protection against all problems or potential problems. Overloading
the regulatory system increases cost and discourages innovation
without materially improving the likelihood of detecting and remedying any wrongdoing or possible wrongdoing.
Remember that in the face of apparent irregularities in the marketplace, securities and bank regulators already have access to individual dealer firms' books, records, and trading systems.
There has been great progress made in improving communications among the agencies involved in the surveillance effort, the
New York Fed, the Federal Reserve Board, the Treasury, the SEC,
and the CFTC. The entire working group holds biweekly conference
calls, and senior officials of the working group meet quarterly.
There has been no facet of the work of the Interagency Group to
date that has witnessed material differences of opinion or judgment
among the various agencies.
The New York Fed surveillance group looks at both the overall
market and specific cases that look unusual and might be a cause
of official concern. We look at price movements, yield spreads, and
trading volume in the cash market as well as market quotes and
trades for overnight contracts and term maturities in the financing
markets. We collect aggregate data from individual primary dealers
on positions, transactions, financing, trade settlement, and whenissued activity. We also receive information on individual securities
when we undertake a formal survey of primary dealers activity as
part of our analysis of unusual situations.
Based on our ongoing surveillance of the overall Treasury market
and related markets, we can evaluate the current behavior of specific securities of interest against a comprehensive market view.
Then we share our conclusions with the Interagency Working
Group.
In the situations we have analyzed, we found that the apparent
shortages of specific Treasury issues represented the natural consequences of legitimate uses of the Treasury market, especially in
connection with risk management strategies to facilitate underwriting, issuance, and distribution of the full range of fixed-income securities, those sold by corporations, State and local governments,
and others.
We are mindful that we must pursue each incident of unusual
market activity rigorously, and we are increasing our capabilities
and resources to do just that. Congress can support these efforts
by reauthorizing the Treasury's rule-making authority under the

47
GSA of 1986 and explicitly incorporate the making of misleading
statements to an issuer of Government securities as a violation of
the Securities Exchange Act of 1934.
The New York Federal Reserve Bank is sympathetic to legislation giving the Treasury back-up authority to require holders of
large positions in Treasury securities to report that information.
With those steps and our continued and improving surveillance efforts, I believe we best strike that balance between providing effective oversight by the agencies and avoiding the cost of excessive
regulation. That cost will, without the slightest doubt, be borne by
the American taxpayer.
The progress we have made so far and the outlook for ongoing
improvement make any additional measures clearly premature.
The agencies already have the ability to review, analyze, and act
appropriately and promptly when market developments raise issues of public concern.
Thank you, Mr. Chairman.
[The prepared statement of Mr. McDonough follows:]
STATEMENT OF WILLIAM J. MCDONOUGH

Mr. Chairman and members of the subcommittee, I am pleased to have the opportunity to appear before you in my capacity as Executive Vice President of the Federal Reserve Bank of New York responsible for the Financial Markets Group. As
such I have responsibility for Domestic and Foreign Operations of the System Open
Market Account and for the recently formed Market Surveillance Function. My
statement this morning will discuss the market surveillance activities of the Federal
Reserve Bank of New York, and the overall subject of the official oversight and regulation of the Government securities market.
We all share a common goal regarding the Government securities market. That
is, we all want to ensure that the integrity, health and efficiency of the world's largest and most liquid securities market is preserved. Quite clearly, the American public and the world at large share an enormous interest in the continued vitality of
the market for U.S. Treasury securities and its ability to meet both public and private needs.
Against this background, the immediate question before the subcommittee centers
on how the legislative process can best support efforts to ensure that this vital market retains its status as the most efficient market in the world. As the subcommittee
deliberates this important topic, I think it necessary to consider the strides taken
over the last year to improve the monitoring of this market.
Salomon Brothers' admissions of deliberate and repeated violations of Treasury
auction rules could well have damaged the public's confidence in the overall soundness of the Government securities market. Fortunately, this did not happen, as evidenced by the efficiency with which the market has continued to perform. Nonetheless, some important questions were raised about the workings of that market and
the official oversight of the market.
Following the events of August, 1991, the Treasury, the SEC and the Federal Reserve moved quickly to address the various concerns that arose from the Salomon
revelations. The agencies have set up a working group on market surveillance with
the Federal Reserve Bank of New York accepting primary responsibility for collecting and disseminating information. The Treasury facilitated broader auction participation, clarified and restated auction rules and, with the Federal Reserve, strengthened the procedures for enforcement of those rules. Changes were made to the administration of the primary dealer system to provide greater access to participants
who wished to service the central bank.
Ongoing automation initiatives will lend further support to ensuring that the primary ana secondary markets are, open and accessible. Our new system for automated Treasury auctions is in the final stages of testing and its implementation is
scheduled for next month. This effort will speed and further systematize the auction
review process and further allow for broader bidder access. In addition, we have finalized many of the business requirements for the automation of our open market
operations and have taken some initial steps in development, with a view toward
implementing a number of capabilities next year. This effort will provide an efficient

48
way of accommodating an expansion in the number of our trading counterparties—
should such occur.
Market participants themselves have reviewed and improved internal compliance
procedures and audits following the revelations of wrongdoing in 1991. Finally, it
is important to restate that, in the face of apparent irregularities in the marketplace, securities and bank regulators already have access to individual dealer firms'
oooks, records and trading systems. Having said that, it should also be stressed that
it is neither possible nor desirable to have absolutely failsafe management and control systems or regulatory schemes that can prevent or detect every problem or potential problem. Nor is it desirable to discourage innovation with overly restrictive
and duplicative rules. What is needed is an approach which strikes an appropriate
balance between the efficiency of the market ana adequate regulatory oversight.
Of the efforts taken to date, I should comment on the significant progress made
in improving communications among the agencies involved in the surveillance effort—the Bank, the Treasury, the SEC, the Federal Reserve Board, and the CFTC.
The entire working group holds a bi-weekly conference call and senior officials of
the working group meet quarterly. I can assure you that the progress made in cooperation ana information sharing will certainly continue. And, I can also assure
you that there has been no facet of the work of the Interagency Group to date that
has witnessed material differences of opinion or judgment among the various agencies.
In its effort to satisfy the needs of the working group, the New York Fed's surveillance work has focused on activity surrounding a number of specific Treasury securities, as well as a variety of overall market conditions. Additional attention was devoted to those incidents that, based on comparisons to either historical experience
or then-existing market conditions, were a potential source of concern. Needless to
say, our methods are being refined as we gain more experience and receive input
from the other agencies.
In the interest of time, I will not cover the full scope of our efforts. However, allow
me to mention briefly a few of the specifics of market surveillance. We look at price
movements, yield spreads and trading volume in the cash market. In the financing
market, we review market quotes and trades for overnight contracts and term maturities. From individual primary dealers, we collect aggregate data on positions,
transactions,financing,trade settlement and when-issued activity in specific securities. We also receive information on individual securities when we undertake a formal survey of primary dealers' activity.
More broadly, we have access to market opinion, analytics, general economic data,
and specific information on other, related markets. Finally, our daily conversations
with the market participants themselves provide invaluable information on market
developments and their own trading activity. This wealth of information allows us
to evaluate the current behavior of specific securities of interest from the vantage
point of a comprehensive view of the market. We share with the members of the
Interagency Working Group all significant market information that we collect.
Our surveillance efforts over this past year focused on apparent shortages of specific Treasury securities. Time and again, we found that individual episodes of "specials" trading represented the natural consequence of legitimate uses of the Treasury market, especially in connection with risk-management strategies to facilitate
the orderly underwriting, issuance and distribution of the full range of fixed-income
securities sold by corporations, State and local governments and others. At times,
these activities can generate large amounts of short positions in Treasury securities
as underwriters hedge their exposures. As a consequence, temporary shortages of
certain issues can and will develop even though there is a large amount of securities
outstanding.
Despite the general thrust of ourfindingsto date, we recognize that we must continue to pursue each incident of unusual market activity rigorously. To meet this
responsibility, we intend to build upon the strong start we have made in tightening
surveillance. We will continue to improve our knowledge of market developments,
our methods of review and analysis, and the technical resources we need to operate
efficiently and effectively with a view to servicing the needs of the other members
of the Interagency Working Group.
At the same time, I believe Congress can provide some further support for our
efforts by reauthorizing the Treasury's rulemaking authority under the Government
Securities Act of 1986, and explicitly incorporating the making of misleading statements to an issuer of Government securities as a violation of the Securities Exchange Act of 1934. In addition, the Federal Reserve Bank of New York is sympathetic to legislation that would give the Treasury backup authority to require holders of large positions in Treasury securities to report this information. This measure
will further our efforts to develop a comprehensive view of the market.

49
With these steps—and our continued surveillance efforts—I think we come much
closer to striking that appropriate balance I spoke of earlier between providing effective oversight by the agencies and avoiding the burdens of excessive regulation that
can easily stifle the efficiency and liquidity of the market, a potentially significant
cost which ultimately will be borne by the American taxpayer. The progress we have
made so far and the outlook for our near-term initiatives make any additional measures seem clearly premature. The agencies have the ability to review, analyze and
act appropriately—and in a timely fashion—when market developments raise issues
of public concern.
Thank you, Mr. Chairman.

Mr. MARKEY. Thank you, Mr. McDonough, very much.
Now for the next in a series of Richard Breeden's final victory
tour around this subcommittee. This is his final appearance on
Government securities before the committee.
We welcome you back, Mr. Chairman, once again, and we appreciate your willingness to continue to aid the subcommittee in the
drafting of legislation. Whenever you feel comfortable, please begin.
STATEMENT OF HON. RICHARD C. BREEDEN

Mr. BREEDEN. Thank you, Mr. Chairman.
I am reminded of the Broadway show, "Promises, Promises."
I am also, on St. Patrick's Day, reminded of the fact that sometimes we are treated to a display of blarney, and some of the arguments on this overall issue, I think, display the finest of that tradition.
Mr. Chairman, you have often referred to the SEC as the cop on
the beat. You have never said so, but I have often assumed that
you had in mind an Irish cop. Thus, it is a pleasure on St. Patrick's
Day to discuss the need for some new law enforcement tools for the
cops on the Government securities beat.
Mr. MARKEY. Are you Irish, sir?
Mr. BREEDEN. Only partially.
Mr. MARKEY. Only partially. Well, we really hit the jackpot here
today, didn't we? We see all sides of the species sitting right here.
We have gathered them all together. We can see wny we have
never resolved the problem in Northern Ireland right here. We like
to argue just for the sake of arguing. Transubstantiation has nothing on the Government securities marketplace. We can't resolve either one of them.
Yes, please go ahead.
Mr. BREEDEN. As the Government's deficit spending has increased in recent years, the market for Government securities has
grown ever larger and more important. For a long period, there
was complacency about how this market operated and how it was
regulated. The New York Times captioned a long article about regulation in this area with the title, "When the regulators stood still."
Many people assumed that most market participants were sophisticated institutions that could fend for themselves; some people still
do assume that.
This complacency should have been shattered, in my opinion, by
the revelation that Salomon Brothers and others submitted false
bids involving billions of dollars in at least 10 separate Treasury
auctions. In some cases, Salomon Brothers and certain customers
acquired nearly 90 percent of the securities in specific Treasury
auctions. These securities subsequently traded at levels that were
not reflective of prices in the Treasury market generally. The

50
Salomon Brothers scandal underlined not only the extent to which
a few primary dealers have dominated some aspects of this market
but, to a degree, also dominated the oversight system of this market.
Among other things, the SEC's review in conjunction with the
Federal Reserve, the Treasury, the Federal Reserve Bank of New
York of these markets has revealed a number of serious problems,
many of which have been chronicled before this committee. The
auction technology used for auctions of Treasury securities still depends on slips of paper being dropped into wooden boxes. I think
the top hats and tails used by the people to collect them are gone,
but the system still does create delays of up to an hour or more
between the time an auction actually occurs and the time that results are announced. Thus, for an hour or so market participants
don't know whether they now own billions of dollars worth of
Treasury securities, forcing them to hedge in the marketplace what
they may not actually own.
This cost to hedge phantom positions is not necessary. The cost,
which over the years, has probably run into the hundreds of millions of dollars or more is, of course, ultimately passed on to the
Treasury in the form of higher borrowing costs; 1960*8, or at least
1970's, technology could have eliminated this problem. The absence
of automated auction systems also makes it impossible to verify the
identity of bidders electronically, verification that would have made
the Salomon Brothers' false bids much, much harder to submit.
Fortunately, the Treasury and Federal Reserve are said to be
about to implement a fully automated auction system to resolve
those problems. However, other problems shown by the Salomon
scandal still remain. For example, even though the transparency of
the Government securities market has improved substantially in
recent years due to private and voluntary actions, this system, the
entire system of transparency for the market, is today still completely voluntary.
No matter how the market changes or transparency diminishes,
there is no agency—not the Treasury, not the Federal Reserve, not
the SEC—that has statutory authority to require the public reporting of prices and transactions. That is a worrisome fact, given that
the interests of primary dealers and the interests of the public,
both as taxpayers and as investors, are not congruent.
Even witn the much-ballyhooed improvement in transparency to
date, the fact remains that any trade that big dealers or their customers want to hide from sight can be simply conducted in a manner that never shows up on today's screens. The total amount of
Government securities trading is said to be very, very high. But if,
in fact, you look at the number of transactions—they are a quite
small number compared to the vastly higher volume of trading in
corporate debt and equities. Yet the Government securities transparency systems still do not capture trades by certain dealers or of
certain securities. It would be easy to do this.
We hear a lot of rhetoric about cost and bureaucratic mandates
and how burdensome this would be. The fact of the matter is that
reporting these trades would be very easy to do with off-the-shelf
technology that exists today and is used in markets all over the
world. The fact of the matter is, it wouldn't be hard to do it. People

51
just don't want to do it because then the public would be able to
look into the clubhouse.
The sales practices used by brokers in Government securities
are, by statute, exempt from the sales practice rules that govern
their conduct in every other securities market. This means that if
the Treasury or GSE securities are involved, abuses such as churning accounts or making unsuitable recommendations must reach
the level of deliberate fraud before they become illegal. Sales practice rules relate to the conduct of brokers. They have nothing to do
with, and should not depend on, the identity of the issuer of the
securities.
Another very serious problem that exists today and has not been
solved to date is the issue of books and records concerning trades
in Government securities, particularly books and records by bank
dealers and certain other dealers that are not subject to current
SEC rule-making authority on the retention of books and records.
In other areas of securities law, a firm that has committed a
fraud has a Hobson's choice; they have to either keep incriminating
evidence which we can find when we go in to investigate a case,
or they have to alter or destroy books and records that are required
to be kept, in which case we can prosecute the failure to keep the
books and records as an independent offense.
Thus, books and record requirements are not simply a paperwork
requirement of some kind, but they are a key element of the law,
making it hard for people who have committed a crime in the marketplace to avoid detection for that conduct.
Now we have come a long way from the time when Irish monks
carefully and beautifully copied out religious records, but in some
senses nothing has changed, for some firms do still use scrolls. I
thought, since this is a debate the committee has been having for
a long time, that you might be interested, Mr. Chairman, in seeing
how some of the records in this market are kept (indicating scroll).
This is a scroll that one securities firm used to keep its trading
records. It is printed out like this. This is only 3 hours of trading
by one dealer in one day. As you can see, some of these transactions are typed, others are scratched out, others are handwritten,
and if you want to find out what happened in this market for these
3 hours from this trader, you can't get the information, put it in
the computer, and analyze it. You get the scroll—and this is literally how the firm keeps it—and you go through this scroll by
hand looking for evidence.
If the public would like to hire an extra 25,000 civil servants to
go through scrolls hunting for evidence, I suppose we could charge
them to do so, but with today's computer technology it would be
very easy to keep these records in a form that could be put on one
3.5-inch disc that could go in a computer and could rather easily
be analyzed.
That is what this debate about record-keeping is all about, the
simple fact that we would like the authority to say, "You can't keep
the records in a scroll; we would like it in a capacity that it can
be delivered to us so that we can analyze it." That is the law in
every other securities market, and it absolutely escapes me where
it is that all these enormous costs that are supposedly going to be
incurred are going to come from—from saying that you have to

52
keep your records in a format that a computer rather than a monk
can digest?
Now what H.R. 618 would provide is, in fact, the legal authority
to issue uniform rules for the Government securities market for
making, keeping, and providing records of trading. I might add
that those records are, in most cases, unless we get a witness who
wants to sing—those records are the only evidence of crime, and we
can't bring people to court because we have a suspicion. We have
to bring them to court only when we have evidence that will stand
up in front of a judge and a jury.
So if you don't let us keep the evidence, you are making a decision that you don't want any prosecutions, and, believe me, people
in the marketplace understand that very simple distinction.
In the current form in which some of the records are kept, it is,
I should hope, obvious that it is quite difficult for us to reconstruct
trading. If it is difficult or impossible to reconstruct trading, traders will be tempted to violate trading rules, and, as Oscar Fingal
O'Flaherty Wills Wilde said, "I can resist everything except temptation."
In these and other areas, there are serious weaknesses in the
current system. Even though almost 2 years have passed since the
May 1991 auction, after which the first reports of wrongdoing
emerged, the legal loopholes in this market have still not been
plugged.
One argument against this legislation is that it would increase
costs and that these costs would be passed along to the taxpayers.
I agree with the paramount importance of avoiding unnecessary
regulatory costs. I think that is important all across the economy
and certainly is a factor that we must bear in mind in securities
markets.
Unfortunately, the argument in this area is rather overdone. Neither transparency nor full audit trails, which this bill does not require, are unusual or abnormally burdensome. They are, in fact, requirements that are complied with by every bank or securities firm
that conducts business in securities markets anywhere in the world
every day. They are normal things; they are traditional.
Indeed, a high official of the Bank of England once told me that
they would find it inconceivable to operate the U.K. gilt market
without maintaining full audit trails so that they could later investigate if wrongdoing was to occur in that market. So even in Government securities markets in other parts of the world the concept
of record-keeping and audit trails is neither unknown nor thought
to be unduly burdensome. Most firms that are active in the U.S.
market because of other areas of their securities trading have those
requirements that they live with every day.
Now another argument, other than cost, is that we ought to trust
to evolution in the marketplace to solve this problem. Here I would
suggest that the appropriate answer would be gleaned from Mr.
Dooley, the legendary Irish barman and sage who once said, "Trust
everybody, but cut the cards."
Some who oppose these requirements simply do not want to see
a larger role for the SEC in these markets. However, I would point
out that the SEC, and only the SEC, has the authority to enforce
the anti-fraud provisions of the Federal securities laws against se-

53
curities firms, banks, insurance companies, industrial companies,
or anybody else who commits a fraud in the purchase or sale of securities. The Federal Reserve doesn't have the authority to bring
an action for violations of rule 10b-5, for example. They can conduct examinations, but they cannot enforce the anti-fraud rules.
That is something that only the SEC can do. So if you deny us the
access to the evidence to bring cases because no other agency can,
in fact, bring those cases, you are, in essence, mandating that no
cases will be brought.
Now events in many countries, as well as our own sometimes
painful history, show that when public confidence in a financial
market is lost it can take many years to restore. While I accept the
Vice Chairman's argument that there have been relatively infrequent problems, it only takes once, as events in the Indian securities market demonstrated, where the market collapsed and was
closed essentially for months. It can only take one problem, if it is
the wrong kind of problem, to shatter public confidence, and it
could take years to restore that public confidence. In the meantime,
the public could lose billions of dollars through lost participation in
the market.
In sum, the SEC strongly supports H.R. 618. What happened at
Salomon Brothers in its dealings with the Treasury and at many
other firms in their dealings with the GSE's was almost predictable
given the legal and practical structure of the market. The legal
loopholes should be plugged, and doing so will not result in any serious issue of cost or market efficiency.
The concepts and requirements at issue are perfectly standard in
U.S. and foreign securities markets. Hopefully, Congress will eliminate these unnecessary risks to public confidence in this vital market. If you don't choose to act, it cannot be said that it can't happen
here. It already did, and it is time that we learned from what happened.
Thank you.
[Testimony resumes on p. 80.]
[The prepared statement of Mr. Breeden follows:]

54
TESTIMONY OF
RICHARD C. BREEDEN, CHAIRMAN
U.S. SECURITIES AND EXCHANGE COMMISSION
CONCERNING H.R. 618,
THE GOVERNMENT SECURITIES REFORM ACT OF 1993
BEFORE THE SUBCOMMITTEE ON TELECOMMUNICATIONS AND FINANCE
OF THE COMMITTEE ON ENERGY AND COMMERCE
U.S. HOUSE OF REPRESENTATIVES
MARCH 17, 1993

Chairman Markey and Members of the Subcommittee:

I am pleased to appear before the Subcommittee, on behalf of the Securities and
Exchange Commission, to testify in support of H.R. 618, the Government Securities
Reform Act of 1993.

Throughout the past few decades, as the volume of deficit spending by the
government has risen dramatically, the market for government securities in the United
States has grown steadily larger and more important in providing financing to operate
the government. For a long period, there seemed to be a general complacency
concerning the overall operation and regulation of this marketplace.1 Known instances
of serious wrongdoing seemed to be minimal, though most traditional systems of

1 See, ejk, Louis Uchitelle & Stephen Labaton, When the Regulators Stood Still. N.Y.
Times, Sept. 22, 1991, § 3, at 1; Jonathan Fuerbringer, A Year Later. Bond Traders Are
a Humbler Lot. N.Y. Times, Aug. 7, 1992, at D l .

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2
oversight of securities markets were limited or nonexistent in these markets. In
addition, market participants were traditionally thought to be large and sophisticated
institutions that did not need all the protections of federal securities laws.

Previous assumptions about the government bond market were shattered with the
revelation that false bids involving billions of dollars had been submitted in at least ten
separate auctions of Treasury securities by officials of Salomon Brothers and others. In
some cases, Salomon Brothers and certain of its customers acquired as much as 86% of
the securities of a specific Treasury auction. Prices of those securities subsequently
traded at levels that were not reflective of prices in the Treasury market generally.
Widespread publicity of the existence of a possible "squeeze" in the Treasury market
raised the specter that public confidence in the Treasury market as a whole might be
seriously damaged.

The SEC has participated in several reviews of the market for "government
securities." That term includes not only securities issued by the Treasury, but also
securities issued by the various government-sponsored enterprises ("GSEs"), which are
in fact securities issued by private corporations. That long review has pointed up
numerous problems. These include:

Auction technology: While there are numerous electronic systems in use around
the world that permit the instantaneous transmission of orders into a central computer,
prior to the Salomon revelations the Treasury auction was run using slips of paper
dropped into wooden boxes. Among other defects, this system created a one-hour delay

56
3
following the time of an auction before participants were advised whether or not they
had been successful in the auction. Thus, participants would have to hedge billions of
dollars in purchases that might or might not have occurred, resulting in considerable
unnecessaiy costs that ultimately would be passed on to the Treasury. The absence of
automated auction systems also prevented the ability to verify the identity of bidders
electronically, which would have made it much more difficult to submit false bids.

Transparency: Traditionally the government market has operated in an
environment in which large "primary dealers" doing business with the Federal Reserve
had the most up-to-date information concerning prices in the market. Public customers,
and smaller firms that did not have "primary dealer" status, did not have access to the
most current prices and volume of transactions. By contrast, all market participants large and small - have access to virtually real time public reports of prices and volume
of trades in the U.S. equity securities market through the "consolidated tape." This lack
of transparency in trading government securities means that, relatively speaking, the
largest dealers had an enormous information advantage that virtually guaranteed the
ability to profit at the expense of their customers.

Over the past few years, Congress has been considering the lack of transparency
in the government securities market. As this debate has continued, the industry has
made considerable improvements in the information that is now disclosed through
various private reporting systems. This growth in transparency is extremely important
because it increases public confidence in the quality of executions, improves market
efficiency and makes it easier to detect suspicious transactions.

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4

Despite the paramount importance of transparency in protecting public interests
in an honest trading market, transparency today remains completely voluntary. In
addition, existing systems capture only certain transactions, such as interdealer
transactions. Other transactions, such as transactions between a dealer and a hedge
fund, for example, do not appear on today's screens.

Sales practices: What are supposed to be the safest securities today may be sold
using sales practices that would result in a dealer in other types of securities being
severely sanctioned. In order to prosecute traditional customer abuses such as churning
of accounts or the sale of unsuitable securities to customers, they would have to rise to
the level of fraud if such abuses involve Treasury or government-sponsored enterprise
securities rather than traditional corporate debt or equity securities. This anomaly
results from a statutory prohibition against the NASD applying its normal rules to its
members concerning sales practices in government securities.

Law Enforcement: Today books and records concerning trades in government
securities by bank dealers and certain other dealers are not subject to any SEC
rulemaking authority. In other areas of securities law, a firm that has committed a fraud
must either keep incriminating evidence, which the SEC can then discover, or alter or
destroy required books and records, which the SEC can prosecute as an independent
offense. Books and records requirements are thus not a mere "paperwork" requirement,
but a key element of the law that enables the SEC to build prosecutions in numerous
fraud cases. Books and records requirements also make it easier for outside auditors

58
5
and internal compliance staffs to monitor a firm's trading practices. Unfortunately,
brokers and dealers in government securities are today not required to keep records in a
prescribed fashion, thereby making it difficult to obtain useful information to track
suspected market manipulations, for example, or to bring a separate case for books and
records violations.

In these and other areas, serious weaknesses in the current system were
discovered, and have been chronicled in numerous reports and Congressional hearings.
Despite the seriousness of the past problems, the holes in our normal dike against
wrongdoing in securities markets have not been plugged nearly two years after the
problems with the May 1991 auction came to light.

Of course it is true that any additional regulatory costs in this market could be
passed along to taxpayers, and the SEC does not support creating unnecessary new
regulatory controls. However, the argument about regulatory costs in this area is often
blown out of proportion. In fact, neither transparency requirements nor full audit trails
(both well beyond the provisions of H.R. 618) are unusual or abnormally burdensome
requirements for securities markets. Indeed, audit trails are required by most significant
capital markets around the world, including other markets for sovereign debt such as the
U.K. "gilt" market. Most firms that are active in this market live with such
requirements in other markets every day.

Of course some who oppose such requirements simply do not wish to see a larger
role for the SEC in these markets. However, the SEC and only the SEC has the

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6
authority to enforce the antifraud provisions of the federal securities laws against
securities firms, banks, insurance companies, industrial companies or anyone else,
individual or corporate, who commits a fraud in the purchase or sale of securities.
Thus, it is not H.R. 618 that would create a larger role for the SEC, but rather the
temptation of market participants to engage in fraud in the belief that enforcement in
this area is not likely to be effective.

Events in many countries, as well as our own sometimes painful history, show that
when public confidence in a financial market is lost, it can take many years to restore.
Fraud or customer abuse can dramatically reduce public participation in a securities
market. Thus, the costs of modest oversight of potentially manipulative or abusive
practices must be compared against the incalculable costs for taxpayers that would result
if public confidence in the honesty and integrity of this market were to be seriously
eroded.

For these and other reasons, we believe that reforms to governing law in this area
are warranted. Fortunately, the Federal Reserve and the Treasury are working hard to
implement automated systems for auction bidding that will make a significant
improvement over the past. However, the well-known gaps in the law made it easier for
abuses to be attempted. Closing these gaps would strengthen the market without
resulting in any serious cost or market efficiency. Hopefully, Congress will move to
reduce the unnecessary risks to public confidence in this market that we cannot do
without.

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7
H.R. 618 represents a continuation of efforts by the Subcommittee over the last
two years to address, in narrowly prescribed ways, the regulatory gaps that have left the
government securities market without basic safeguards that apply to every other
securities market in this country. The bill carries over the provisions of H.R. 3927, as
reported last session by the full Energy and Commerce Committee.2 However, H.R. 618
has been significantly narrowed from earlier proposals, especially in the areas of
transparency and recordkeeping. I testified on behalf of the Commission in April of
1992 in support of an earlier and somewhat broader version of that bill,3 and before this
Subcommittee in October 1991 concerning related reform proposals.*

H.R. 618 adopts certain legislative proposals recommended in the January 1992
Joint Report on the Government Securities Market ("Joint Report") of the Department
of the Treasury, the SEC and the Board of Governors of the Federal Reserve System
and contains some additional provisions designed to deter fraud and manipulation.
Although the SEC has supported broader authority in certain respects than is contained
in H.R. 618, we support H.R. 618 as a means to address identified deficiencies in the
current regulatory structure for the government securities market in a responsible,
balanced manner. Most important, we believe that, in the absence of the recordkeeping

House Comm. on Energy and Commerce, Report to Accompany H.R. 3927. H.R.
Rep. No. 722, 102d Cong. 2d Sess. (July 24, 1992) ("House Report").

Testimony of Richard C. Breeden, Chairman, Securities and Exchange Commission,
Before the Subcommittee on Domestic Monetary Policy of the Committee on
Banking, Finance, and Urban Affairs (April 28, 1992) ("April 1992 Testimony").

Testimony of Richard C. Breeden, Chairman, Securities and Exchange Commission,
Before the Subcommittee on Telecommunications and Finance of the Committee on
Energy and Commerce (October 25, 1991) ("October 1991 Testimony").

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8
and reporting, sales practice, and transparency reforms contained in the legislation, the
Commission's ability to fulfill its mission to maintain public confidence and combat
fraud in the market will be seriously compromised.

Recordkeeping
The SEC's ability to discover wrongdoing is affected by its ability to obtain clear

and comprehensible transaction records. Section 3 of H.R. 618 authorizes the SEC to
prescribe consistent and uniform recordkeeping rules for completed transactions and to
require records to be provided for investigations in a useable format. Although the
authority is carefully limited, it would substantially increase the SEC's ability to
effectively investigate cases of suspected wrongdoing. It would also create a more
effective tool for sanctioning firms where records that would show improper activity are
altered or are not maintained for any reason.

Identified Deficiencies in Recordkeeping Practice

As has been noted in previous testimony by the SEC,5 the investigations into
wrongdoing by Salomon Brothers and GSEs revealed serious recordkeeping problems at
certain government securities brokers and dealers. Specifically, inadequate
recordkeeping practices among market participants impeded the staff's ability to
investigate instances of fraud and abuse through reconstruction of trading activity.

April 1992 Testimony at 12-13.

71-390

0 - 9 3 - 3

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9
Our manual reconstruction of trading activity was complicated by the absence of
any standardization in transaction records. The Commission's staff learned in the course
of its investigations that recordkeeping practices among government securities brokers
and dealers range from handwritten ledgers to sophisticated computerized systems. For
example, one firm maintained trading records on a continuous scroll of computer paper
containing handwritten notes, cross-outs, and markings over the computer text. These
scrolls stretched for literally hundreds of feet for each day's trading activity, requiring
extraordinary effort (and patience) by the staff to organize the information in a coherent
format. In other cases, records reflecting customer orders were maintained in
handwriting on scattered scraps of paper, or in spiral notebooks.

In the bidding context, the handwritten records used in connection with Treasury
or GSE auctions were not maintained after the auction, even though such records could
have evidentiary value. Moreover, the staff discovered a lack of records adequately
explaining the allocation of Treasury securities obtained in auctions between certain
firms' proprietary and customer accounts, making it difficult to monitor whether a firm
submitted unauthorized bids.

The investigations further uncovered recordkeeping inadequacies relating to the
timing of orders and transactions. Where the required records were kept, they often
lacked consistent methods to record execution times or used unreliable timestamping
practices. Where computerized transaction records were kept, the accuracy of the
records varied, depending upon when the transactions were entered into the computer
system. For example, some government securities brokers or dealers time-stamped

63
10
required records at a single time in large batches, making it impossible to discern when
a transaction was executed, or when a customer order was placed. Of course, knowing
the sequence of transactions could be vital to our ability to prove a case of manipulation
or other violations in court.

The absence of a single set of rules applicable to all dealers that specifically
prescribes the information required and the form in which it is required to be kept also
may increase the likelihood that records will be altered after the fact. This concern is
underscored by the widespread existence of false books and records revealed by the
enforcement action involving the bidding practices of 98 broker-dealers and financial
institutions in the GSE securities market. Without any requirements as to the form of
records and other retention matters, internal and external auditors and compliance
personnel do not have a mandatory records baseline where missing records could serve
as a warning of possible wrongdoing.

Recordkeeping Authority

In order to address these identified deficiencies, Section 3 of the bill supplements
the SEC's existing recordkeeping authority applicable to dealers other than financial
institutions, with authority to adopt rules applicable to all dealers in government
securities. Section 3 clarifies that this authority includes the ability to prescribe
specifically the form and content of transaction records. This provision would not
impose any significant additional costs on dealers by requiring them to compile or
record information that is not already readily accessible. Indeed, the basic terms of any
trade ~ what was traded, at what price, and by whom ~ is in practice needed in order to

64
n
settle the trade.6 Instead, the bill would help to ensure that minimum standards of
professional practice are observed in maintaining records for reference in conducting
investigations.

The bill would extend this authority to all government securities firms, including
bank dealers, in a manner that is extremely narrow and generally consistent with the
existing regulatory structure. Though the SEC could require a bank dealer or any other
market participant to keep trading records for a specified time and in a specific format,
the SEC would not have the authority to conduct routine examinations of bank dealers
to determine if records were being maintained. Here, the existing examination and
enforcement authority of bank regulators is undisturbed. In addition, the consultation
provisions of Section 3 will ensure that the experience and expertise of bank regulators
will be utilized to avoid duplication and expense. Indeed, a standardized trading records
format and better capacity of firms' internal auditing and compliance staff to detect
potential problems should reduce, not increase, the time the SEC might need to spend
in a bank in connection with a fraud investigation.

Because the SEC is the only agency with responsibility for enforcing the general
antifraud provisions of the federal securities laws, and because of the critical role that
recordkeeping plays in allowing the SEC to fulfill that responsibility, the very limited
authority over the recordkeeping practices of bank dealers granted to the SEC by
Section 3 is fully justified. The SEC already has similar recordkeeping authority with

See House Report at 45.

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12
respect to the municipal securities activities of bank dealers,7 which generally has been
delegated to the Municipal Securities Rulemaking Board. This authority in the
municipal securities market has not impeded bank regulation or unduly burdened bank
dealers.8

Furnishing Records to the Commission

Section 3 also would grant to the SEC authority to require that prescribed
records be furnished to the SEC or other regulatory agencies as needed in order to
reconstruct trading activity. In order to avoid burdensome costs on dealers, this
authority is significantly limited. In making a request for information under this
subsection, the SEC must specify the information required, the period of time for which
information is sought, the time and date on which it must be furnished, and whether the
information is to be furnished to the SEC or to another appropriate regulatory agency.

The SEC may require that the information be furnished in machine readable
form. This provision responds directly to the difficulties discussed above in obtaining
transaction records in a format that is useful for investigatory purposes. However (as
described further below), the provision does not require the establishment of an audit
trail mechanism, and the means of transmission could be tailored to the technological
capabilities of different firms. Particularly in the case of smaller dealers, the SEC would

Section 17(a) of the Exchange Act provides recordkeeping authority over registered
municipal securities dealers, including bank dealers registered under Section 15B.

Further, the adoption of rules that are consistent across the spectrum of government
securities firms will also help avoid competitive inequalities.

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13
work to establish cost-efficient means of furnishing the information, which could include
providing software that could be used to "down-load" stored records onto standard
diskettes.9 The ability to require that records be furnished in this way would have
substantially assisted the staff in recent investigations of government securities dealers.

Section 3 is substantially narrower than earlier proposals, which would have
provided authority to the SEC to require audit trails, or daily time-sequenced trade
reports. Audit trail mechanisms are an everyday protection in the equity markets in the
United States, where information is furnished to SROs, and in some foreign markets for
sovereign debt. The SEC supported audit trail authority in the government securities
market in the Joint Report, 10 and we have supported the incorporation of such authority
in earlier versions of this legislation.11 The SEC continues to believe that audit trails
would provide a substantial deterrent to fraudulent or manipulative conduct, and that
requiring audit trails would eliminate a major gap in the oversight of these markets - or
any market. To would-be fraud artists, the absence of audit trails of any kind in a
trading market is a clear sign that law enforcement authorities would find it much more
difficult to turn suspicions into prosecutions. That is the wrong signal to send for a
market as important as this one.

See House Report at 45.

Joint Report at 24-25.

April 1992 Testimony at 11-14.

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Although the bill does not authorize the SEC to mandate audit trails, the SEC
supports the trade reporting authority contained in Section 3 as a significant
improvement over the status quo. In addition, a partial and voluntary audit trail could
be constructed by combining trade information reported on interdealer broker screens,
such as that made publicly available by GOVPX, with clearing data received by the
Government Securities Clearing Corporation ("GSCC"). The SEC agrees with the view
of the Committee that this step could be accomplished without additional authority,
although of course it would require the cooperation of, and investment of resources by,
G O V P X and GSCC. 12 However, it should be clearly understood that reliance on
existing systems would not serve as a complete substitute for full audit trail authority
because, among other reasons, GOVPX does not provide information on all interdealer
trades and does not provide any information on trades with customers.13 Finally, it
should be emphasized that without the assurance of adequate transparency provided by
Section 8 of the bill, the need for audit trail authority would be much greater.14

II.

Transparency
The term "transparency" refers to the degree to which real-time reports of trades

and quotes are publicly available. Section 8 of H.R. 618 provides limited authority to
assure that industry efforts to improve transparency in the government securities market
continue. Although the current provision is more limited than prior proposals, the

House Report at 25.

See October 1991 Testimony at 18.

See Joint Report at 24-25.

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15
Commission believes that it would provide an important safeguard against any future
efforts by primary dealers to limit the accessibility of other dealers and ordinary
investors to key categories of market information.

As a general matter, transparency promotes efficiency and fairness in every
securities market. Transparency limits the systematic disadvantage of public investors
compared to market "insiders," reduces price discrepancies, allows investors to
determine whether they are receiving a fair price, and increases the ability of regulators
to detect and deter manipulative trading.15 Public access to price and volume
information also increases the pricing efficiency of derivative instruments, such as the
many futures and options instruments that relate to government securities.

The SEC has long had authority to assure adequate transparency in equity
markets. Pursuant to Section 11A of the Exchange Act, the SEC oversees a wide variety
of SRO trade reporting systems, including the Consolidated Tape and Consolidated
Quotation Systems, NASDAQ, and the Options Price Reporting Authority. The
Consolidated Tape provides real-time trade and quote reports for listed stocks regardless
of whether trading occurs on the New York and American Stock Exchanges, on regional
exchanges, or on NASDAQ. The NASDAQ National Market System provides
immediate trade reports for about 2,700 securities, and real-time reporting recently has
been extended to about 4,700 other NASDAQ securities.16 The Options Price Reporting

See October 1991 Testimony at 8-13; April 1992 Testimony at 3-8.

Securities Exchange Act Release No. 30569 (April 10, 1992).

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16
Authority provides for the consolidated reporting of last sale reports and quotation
information in eligible option contracts listed and traded on national securities
exchanges. The number of trades in the government securities market is actually much
lower than the number of trades in these equity markets. Presently, the trade reporting
systems overseen by the SEC process many times more trades each day than the trades
reported through GOVPX.

In addition, the SEC oversees trade reports processed through a range of
proprietary systems. Finally, the SEC has had transparency authority in the corporate
and municipal debt markets, although it has not found it necessary to exercise that
authority. Recently, the NASD has proposed creating a new Fixed Income Pricing
System providing for real-time trade reporting for certain high-yield debt securities.

The existing transparency in the government securities market results from the
public dissemination of quotation and last sale information by certain interdealer screen
brokers. Information is disseminated by GOVPX, which is a joint effort of four
interdealer brokers and the 38 primary dealers, and Telerate, which has an exclusive
arrangement to disseminate information from Cantor Fitzgerald, another interdealer
broker. G O V P X screens represent approximately 75% of the brokered interdealer
trades in Treasury securities. Recently, GOVPX began providing information on the
size associated with quotes and we understand it will soon permit data to be used in
conjunction with analytical systems. GOVPX also recently announced that it would
begin to provide price information for additional categories of securities; G O V P X does
not now cover GSE or zero-coupon Treasuries.

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While these recent steps and announcement are welcome, it should be recognized
that the transparency improvements of the last several years have occurred against the
backdrop of continuing Congressional consideration of proposals to mandate greater
transparency and only following substantial earlier resistance on the part of primary
dealers to increased information dissemination. In contrast to concerns previously
voiced by some of those dealers, there is no indication that the liquidity of the market
has been impaired by increased dissemination of information. It has been the
Commission's consistent experience in other markets that expanded public disclosure of
trading data actually increases liquidity, sometimes dramatically. This occurs because as
customers are better able to determine for themselves if they are being gouged by
dealers, spreads tend to narrow and customer participation rises.

The bill would address transparency concerns through the most limited possible
means. Section 8 clearly states that Congress prefers to see the continuation of private
sector efforts to improve transparency without federal intervention. However, it also
provides two tiers of backstop authority to assure that adequate transparency in the
market for government securities, other than mortgage-backed securities, could be
maintained or achieved if private sector efforts fail.

The first tier concerns the dissemination of information from broker screens.
Under this authority, the SEC could act if it determined that trade reports and price
quotations (including size) for regularly traded government securities that are available
through brokers' screens were not made available to the public in a timely manner and

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on a fair, reasonable, and nondiscriminatory basis. The provision would not require any
action even if such a determination were made, and it would require the SEC to
consider the effects of any proposed regulation on the liquidity, efficiency, and
competitiveness of the market.

The second tier of authority would apply only if the Secretary of the Treasury
found that investors were unable, through existing government securities information
systems, readily to determine the prevailing market price of a class of securities or to
analyze the comparative value of securities within a group of similar securities. If
Treasury made such a finding, the SEC would be authorized to require government
securities brokers and dealers that regularly trade the identified securities to report the
information to a securities information processor or SRO (if no securities information
processor could carry out this function). The SEC could require these firms and SROs
to act jointly in developing facilities for information dissemination, but the SEC could
not require anything unless the Secretary of the Treasury acted first to make the
necessary findings.

This authority would be much more limited than the transparency authority the
SEC has with respect to equity markets under Section 11 A. The bill does not authorize
the establishment of a consolidated quotation or transaction reporting system for
government securities.17 Moreover, the bill's prohibition on the regulation of fees of
government securities information systems ensures that this authority, if used, would not

See House Report at 52.

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reduce the financial incentive to invest in reporting systems. The limitations built into
the bill are all appropriate. Further, the SEC believes that this authority should never
be used unless all other reasonable avenues are exhausted. Indeed, the SEC has
possessed authority to mandate transparency in some other bond markets that has not
ever been exercised, demonstrating that our preference for privately-designed systems
has a long history and commitment.

Although limited, the transparency authority in H.R. 618 would be important.
The financial interest of primary dealers and other dealers may not in all circumstances
coincide with the maintenance of an open and transparent market. For example, dealers
who are inclined to collude in attempting to create an artificial "squeeze" for a
particular security in the secondary market may be inclined not to trade through an
interdealer broker. In other circumstances not involving manipulative intent, if one or
more major dealers in a given class of securities ceased to trade through interdealer
brokers, the ability of investors to determine the true market price of the security
necessarily would be impaired. The government securities market is simply too
important to the Nation's economy, and the investor protection implications are too
great, to leave the preservation of the gains in transparency of the last several years to
chance.

Ensuring adequate trade and quote reporting in the government securities market
would not in fact cause any significant cost, and it can be done with existing standard
technology. The only real issue is whether Congress wishes to promote a dealer's club
or a truly efficient market. If the latter, transparency is a fundamental requirement.

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III.

Antifraud Measures
H.R. 618 contains several provisions prohibiting fraudulent and manipulative

conduct or providing additional authority to the SEC and the NASD to adopt or apply
rules designed to deter fraud and manipulation and promote just and equitable
principles of trade.

False or Misleading Statements

Section 11 amends Section 15(c) of the Exchange Act to make it an explicit
violation of the Exchange Act for a broker, dealer, or bidder to make false or
misleading written statements in connection with the primary offering of government
securities other than Treasury securities. Such a provision was recommended by all
three agencies in the Joint Report. If applied to Treasury securities it would respond
directly to the false bids made by Salomon Brothers and as applied in H.R. 618 it
directly addresses the false representations made by selling dealers in bidding for GSE
securities. The SEC continues to endorse this measure.18

See April 1992 Testimony at 17-19. The definition of government security does not
include public debt obligations for purposes of this provision, and Section 12 states
that the bill does not grant authority to the SEC to regulate in any manner the initial
issuance of any public debt obligation. The general antifraud authority of Section
10(b) applies to all transactions in all securities. While a distinction between
Treasury auction transactions and secondary market (including when-issued)
transactions may be appropriate in the context of other provisions of the bill, the
Commission believes that the antifraud provisions of the bill, including the express
authority of Section 11, should apply equally to both types of transactions.

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B.

Sales Practice Rules

Section 7 of H.R. 618 eliminates the current prohibition on the application of
NASD sales practice rules to government securities transactions. NASD sales practice
rules supplement the antifraud provisions of the federal securities laws by applying just
and equitable principles of trade, the violation of which, unlike the antifraud provisions,
generally does not require a showing of specific intent. Section 15A(f) of the Exchange
Act effectively prevents the application of NASD sales practice rules to the government
securities market by providing that, with limited exceptions, "nothing in this section shall
be construed to apply with respect to any transaction by a registered broker or dealer in
any government security."

This regulatory gap is anomalous. The NASD's sales practice rules governing
mark-ups, churning, suitability, and unauthorized trading apply to transactions in all
equity and corporate debt transactions. In addition, the sales practice rules of the New
York Stock Exchange and the other exchanges apply to the government securities
activities of their members.

In addition to the application of the sales practice rules themselves, the removal
of the limitation in Section 15A(f) would allow the NASD to adopt rules such as fidelity
bonding requirements and qualification and testing requirements in order to assure that
sales personnel have the requisite knowledge to comply with sales practice and other
rules. A sensible and functional approach to regulation requires that government
securities transactions not be exempt from the basic customer protection rules that apply

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22
in every other market. Sales practice rules inherently relate to conduct, not to the
identity of the issuer or security.

T o the extent that this unequal treatment reflects a traditional attitude that
government securities are risk-free and therefore that transactions in those securities are
not readily susceptible to abuse, that rationale clearly no longer applies in the modern
marketplace. First, new derivative government securities that have proliferated in recent
years, including STRIPS, mortgage-backed securities and real estate mortgage
investment conduits issued or guaranteed by GSEs (which do not themselves carry a
government guarantee), zero-coupon securities, and other instruments carry a substantial
risk of diminution in value resulting from fluctuation in interest rates. In addition,
complicated trading strategies and increased leverage that often accompany these new
instruments increase the potential for loss.

The increase in range of available instruments has been accompanied by
increased secondary market activity by individuals and smaller corporations and
institutions who are attracted by the desire for safe investments. Municipalities,
including small towns and villages, have become major holders by investing free cash
balances in government securities. Indeed, the presumed safety of government securities
may itself increase the potential for sales fraud by lulling more unsophisticated investors
into a false sense of comfort. 19

In the last five years, the NASD has brought 26 disciplinary actions against 29 firms
or individuals associated with those firms for sales practice abuses involving
government securities or options on government securities that are exempted under
Exchange Act Rule 3al2-7. The abuses included churning, adjusted trading,

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23

The expansion of the NASD's authority in this area is consistent with the
traditional Congressional preference for self-regulation of the securities markets. In
addition, this approach will not involve significant additional costs because the NASD is
already familiar with the application of rules in other contexts and these rules are known
and understood by the sales forces of integrated firms.

Additional Antimanipulation Authority

Section 15(c)(2) of the Exchange Act presently authorizes the SEC to adopt rules
reasonably designed to prevent fraudulent and manipulative conduct by broker-dealers.
Transactions in government securities are explicitly exempted from this provision.
Accordingly, the SEC's ability to adopt antifraud rules relating to government securities
transactions depends on its general authority under Section 10(b) of the Exchange Act.
Because Section 15(c)(2) permits the SEC to adopt rules "reasonably designed to
prevent" fraud, it provides more flexible authority to prevent fraudulent or manipulative
activity.

Unquestionably, the government securities market, like other markets, is subject
to manipulation by broker-dealers who have a substantial financial stake in daily price
movements. Removing the exemption of government securities from rules designed to

excessive markups and markdowns and unsuitable recommendations. Although the
NASD does not have legal jurisdiction to take action against sales practice abuses
that cannot be proven fraudulent, four cases, three of which were related, were
settled solely on the basis of violations of NASD rules which are legally inapplicable
to exempted securities.

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24
prevent fraudulent conduct would not impair the interests of honest dealers, but it could
help make it tougher to attempt a manipulation. The goal here is to deter unlawful
conduct, making both market disruptions and enforcement actions less likely. This
current exemption is unwarranted for the same reasons that an exemption from NASD
rules is unjustified.

Internal Procedures

Section 6 would require government securities broker-dealers to adopt and
maintain written policies and procedures reasonably designed to prevent the violation of
antifraud provisions and such other rules as may be designated by the SEC in
connection with government securities transactions. The SEC also is granted authority
to prescribe such written policies and procedures by rule.

These provisions mirror existing requirements of the SROs. In addition, Section
15(b)(4)(E) of the Exchange Act provides an affirmative defense to an action by the
SEC based on a failure to supervise others who violate the securities laws. Accordingly,
the securities industry has long been familiar with the substance of the obligation to
supervise. The provision would not create any private right of action.20 While the SEC
did not suggest this provision, we do not believe that it would create significant new
costs or burdens.

House Report at 48.

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25
IV.

Treasury Rulemaking Authority
A.

Extension of Treasury Rulemaking Authority

H.R. 618 would reinstate and extend until October 1, 1997 the Treasury's
authority to issue rules regarding financial responsibility, recordkeeping, and reporting.
This authority was an important component of the GSA; the Treasury used it effectively,
and the SEC supports its reinstatement.

Large Position Reporting

H.R. 618 grants to the Treasury the authority to adopt rules to require holders of
large positions in Treasury securities to file reports and keep records concerning such
positions. This provision adopts a recommendation by all three agencies in the Joint
Report, and the SEC continues to support this provision.21 It should be noted that this
authority does not duplicate or serve as a substitute for the recordkeeping and reporting
authority of Section 3 because it is designed for a different purpose and is intended to
be invoked on a less frequent basis. It should also be noted that the recordkeeping and
transparency provisions of H.R. 618 would probably cost far less in practice than large
position reporting. If a choice must be made between them on the basis of cost, large
position reporting should be deleted.

Conclusion
H.R. 618 builds on the foundation established by the GSA to fill gaps in the

regulatory structure of the government securities market in highly specific ways. The

See April 1992 Testimony at 15.

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26
additional regulatory authority that would be granted to the SEC is modest, but we
believe it would be beneficial in helping to maintain the honesty and integrity of these
massive trading markets. The recordkeeping and transparency provisions of the bill are
especially important in creating more effective deterrence against repeated instances of
the violations of law that occurred in these markets. Where significant gaps in the
normal protections of law routinely applicable to other trading markets become avenues
for illegal activity that could, at its worst, prove seriously destabilizing, prudence dictates
closing these gaps in the law. That job should be done carefully, with as little effect and
cost as possible on honest market participants. However, given the events we have
witnessed, no one can say "it can't happen here."

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Mr. MARKEY. Thank you, Mr. Chairman, very much.
We will now turn to questions from subcommittee members, and
clearly there is a huge gap that exits between the world which, in
my opinion, the SEC observes and the world which Mr. McDonough
and Mr. Mullins presume to exist in this Government securities
marketplace.
What we have here is, in my opinion, damning evidence of the
lack of attention which has been paid by the Fed and the Treasury
to the change which has occurred in the marketplace, and it is
their right, I suppose, if it is going to be their watch, for President
Bush and Treasury Secretary Brady to want to keep this market
functioning the same way it was when their dads were investment
bankers in the 1930's; that is their privilege.
But, in the same way that President Bush, when he was putting
a loaf of bread across a bar scanner in a supermarket and lifted
it up in surprise with the same reaction that an ape had discovering fire for the first time, we, in fact, have moved far beyond this
point in time in terms of our ability to use modern technology in
order to solve problems.
Now, Mr. Mullins and Mr. McDonough are, in fact, raising issues
that appear to me to be nothing more than hyperbolic responses to
the very real world problems that have been identified, and, to be
honest with you—and we will go through this in the course of the
morning—we want to hear from Mr. Mullins as to how we are jeopardizing this huge marketplace by ensuring that there is integrity,
that there is proper record-keeping, and the issues, by the way, basically boil down to two of the seven provisions which were built
into the legislation, which the Chairman of the SEC properly focused his initial testimony on, and that is improved transaction
records for enforcement purposes and price transparency to require
public access to market price and quotation information, just those
two provisions alone.
Although the others are important, they are not clearly as contentious as these two provisions are because they strike at the secrecy, they strike at, if you want, the right of the bishops of the
Government securities marketplace to engage in indulgence selling,
and the reformation which we are talking about right here is allowing each and every participant in the Government securities marketplace to have their own direct relationship with the Lord without having to rely on the secret sessions of the College of Cardinals
meeting and passing on, in good faith although with their interests
completely protected, information on to the other souls which are
out there operating completely at the will and whim of those bishops and cardinals.
So, Vice Chairman Mullins, I personally find your statements—
and I quote—that "there is no evidence of market failure that
would warrant the significant overhaul envisioned in H.R. 618" and
that "the structure of the Government securities market would appear tp offer little scope for large-scale mischief' to be an absolutely
astounding statement, absolutely astounding.
That you continue to maintain that in the wake of the Salomon
Brothers scandal, of the 98 firms involved in the GSE scandal, the
noncompetitive bidding abuses, the fictitious tax trades, Steven
Wymer's multiple frauds—if that is not enough to convince you

81
that there is, in fact, massive fraud in this market that has transpired and continues to go on as we sit here right now, and that
there is need for change, I don't know what you are going to need,
Mr. Mullins, in order to finally deal with this not from the perspective of an economist but of those people who are out there wondering whether or not, in fact, this real world, with real corruption in
it, with people who have real incentives to corrupt this marketplace
for their own personal gain, needs changes that will build in more
integrity. What else do you need, Mr. Mullins?
Mr. MULLINS. Mr. Chairman, the Board of Governors has deliberated over these issues for more than a year, and when the bill
came up again this year, I made a special effort to visit with every
member of the Board of Governors on these issues, and I must report that the Board is unanimous in the view and, I think, more
concerned than last year in the view that this sort of legislation is
unwarranted and could cause problems.
In terms of why we feel that the market overall does not display
signs of loss of confidence or widespread fear of fraud, everyone
pretty well acknowledges this is the most efficient market observable on Earth with the lowest transaction costs observable on
Earth.
Mr. MARKEY. May I ask you something? Can something be efficient and still corrupt at the same time? Are they mutually inconsistent concepts to be operating simultaneously in the same market?
Mr. MULLINS. It is inconsistent to see bid-ask spreads at this
level if people are concerned about corruption in the overall market.
Mr. MARKEY. In the overall market, fine. But does that mean
that 5,000 or 10,000 people can't be ripped off in a market that is
otherwise efficient? And does that mean, as far as you are concerned, that it is not worth the cost to go in and to ensure that
those people are not, in fact, stripped of millions, tens of millions,
of dollars by those who just want their golden little crumbs that
they are going to be able to take on the side in an otherwise efficient market?
Mr. MULLINS. Let me respond to that. Again, our point on the
overall market is that we wouldn't see this evident. There are certainly evidences, as Chairman Breeden said, infrequent episodes of
abuse, and we think those should be pursued as aggressively as
possible. We also believe, though, that if we are going to impose restrictions which will save the cost
Mr. MARKEY. DO you consider that a restriction, to have that
modernized and turned into effective transaction record-keeping,
the system that is useful to law enforcement? Is that an unacceptable additional cost?
Mr. MULLINS. The way I would view that, Mr. Chairman, is,
record-keeping authority already exists in the Treasury, and if the
SEC and tne New York Fed need better records, I think they ought
to go to the Treasury. That is who Congress gave the authority to.
Mr. MARKEY. Mr. Mullins, don't you understand? It is 2 years
later. Denial is massive over at the agencies. You are an economist.
Mr. McDonough, I don't know what your background is; you are
a banker.

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But this is not your life's calling. You are not—as you wake up
as Irishmen, you are not saying, "I want to be a cop." This is what
Mr. Breeden always thought was going to be one of the highest
callings he could have. We give each of you your due. You know,
we need economists.
Mr. MCDONOUGH. He is only partially Irish.
Mr. BREEDEN. Today we are all Irish.
Mr. MARKEY. Or wish today we were Irish.
Anyone can demur from that if they want after they hear all the
testimony.
Mr. MULLINS. Again, we would trust the Treasury Department
and Secretary Bentsen and his staff if changes need to be made.
Mr. MARKEY. Are you going to recommend changes, Mr. Mullins?
Didn't you just say that the Board of Governors has said that everything was copasetic?
Mr. MULLINS. Well, no. Let me describe
Mr. MARKEY. Are you going to recommend changes, Mr. Mullins?
Mr. MULLINS. Well, the enforcement people—and this can be the
New York Fed or the SEC
Mr. MARKEY. HOW many enforcement people work for you, Mr.
Mullins? Do you have any enforcement people who work for you?
Mr. MULLINS. We have no regulatory jurisdiction.
Mr. MARKEY. YOU don't have any enforcement people.
Mr. McDonough, do you have any enforcement people working
for you?
Mr. MCDONOUGH. Mr. Chairman, we are not in the enforcement
business either.
Mr. MARKEY. YOU are not in the enforcement business, and you
are not in the enforcement business, so tell me again, Mr. Mullins,
how it works when there is enhanced enforcement with neither of
the agencies who are responsible for it ostensibly are in the enforcement business? How does this work?
Mr. MULLINS. Well, let me tell you what our perspective is here.
We are the Nation's central bank. This market is extraordinarily
important to us. We implement monetary policy through it. The entire credit structure of the economy is priced off this market—mortgage rates, corporate rates—and any disruptions in this market or
increases in overall rates are transmitted through the entire economy. This is why the Board of Governors thinks that we ought to
be very careful in instituting wholesale changes.
One of the reasons I think we are more sensitive this year is that
President Clinton at the White House last week proposed initiatives to roll back record-keeping and documentation requirements
in banking which had been put in statute in response to the S&L
crisis and which many people blame as affecting behavior, especially loan availability.
We are concerned that in response to Salomon Brothers
Mr. MARKEY. DO you agree with the assessment that Mr. Clinton
made?
Mr. MULLINS. Well, we worked with the administration
Mr. MARKEY. Did you agree with his assessment?
Mr. MULLINS. We worked with the administration and do agree
that the specific record-keeping and documentation charges adversely affected loan availability. We are concerned that in re-

83
sponse to Salomon Brothers in which the specific abuses have already been dealt with we might overreact and put in too heavy restrictions, and we simply think the stakes are high.
If it involves increasing the cost of Treasury finance one basis
point, that is $250 million a year every year, and you can transcribe a lot of scrolls for $250 million a year.
Mr. MARKEY. Mr. Mullins, there was a $ 1 billion profit made by
the 33 primary dealers last year. That is a lot of profit. Why can't
the dealers, out of profit, afford to keep a few more records, report
large positions, establish better internal controls? Is that too much
of a burden to place upon an industry which clearly is able to make
money just by waking up in the morning? This is not a high-risk
business.
Mr. MULLINS. I think we should go to Treasury and make those
recommendations. The notion of bringing another agency with duplicative responsibility will create
Mr. MARKEY. But it is not duplicative. As you have both testified
today, you are not in the enforcement business.
Mr. MULLINS. But the rule-writing and record-keeping authority
is currently at Treasury. Do we need another area of financial regulation with overlapping and balkanized responsibility?
Mr. MARKEY. Well, let me say this to you. We had Steven Wymer
here. Are you familiar Steven Wymer? Steven Wymer was before
our committee 2 weeks ago, and I asked Mr. Wymer how he felt
about the Government securities marketplace, and he told us, this
subcommittee, that the Government securities marketplace, in
terms of his ability, and every other person he knows who has like
minded's ability to corrupt a financial marketplace in America, that
this marketplace is like shooting fish in a barrel; and, in fact, he
told this committee that of all the marketplaces in America this
was the easiest and the most, on a daily basis, corrupted marketplace in the country.
Now this man is an expert, and he is doing it, and he gives us
his own opinion regarding to those who are like minded, who wish
to corrupt the market system in America; he gives his expert testimony to us with regard to the Government securities marketplace.
Now you can sit here and tell us that you place this incredibly high
value on efficiency, Mr. Mullins, but you have yet to tell us what
value you place on integrity.
Mr. MULLINS. We strongly support the integrity of this marketplace.
Mr. MARKEY. Then why, in the face of the testimony that we
have, the scandals which we have observed, are you not willing
then to give over to an agency whose task is to police the securities
marketplace the ability to get the information and to provide the
transparency to customers so that they can be protected and protect themselves?
Mr. MULLINS. If the SEC, for its enforcement objectives, needs
better records, I think they should talk to the Treasury. The Congress in 1986 gave Treasury authority here. We think they have
the right perspective. It is their market. We have full confidence
in the Secretary of the Treasury, and perhaps we need to go to the
Treasury and say we need better records. It is my understanding

84
that the Treasury pretty much copied the SEC recordkeeping requirements.
In Mr. Wymer's case, it is not clear how that relates to the legislation in terms of record keeping. Again, if we need better records,
let's get the Treasury to write the rules to do that.
Mr. MARKEY. Since you have such great respect for the 1986 Act
and we passed that out of this subcommittee, we may just utter the
four most difficult words to utter, and clearly it is not in your
power or capability to do this, but we can say the words, "We made
a mistake," in 1986, and now we might want to review whether or
not, in fact, we should give all of this exclusive power into hands
that clearly do not want to do anything with it.
Let me just ask Mr. Breeden; How do you respond to the argument that giving the SEC enhanced record-keeping authority is duplicative, as Mr. Mullins says?
Mr. BREEDEN. Mr. Chairman, I think the issue of new bureaucracies and duplicative regulation is very much overblown, although
I accept the importance of the principles that Mr. Mullins is talking about. I agree, for example, that there has been a serious problem in banking with too many rules and requirements, that documentation for a loan rather than for banks buying Government securities—which is what they have been doing instead of making
loans for the last 4 years—became overextensive. But I don't see
what in the world that has to do with the question of keeping a
simple record about whom you bought from, at what price, at what
time, or whom you sold to for a securities deal.
Now if you don't know whom you bought from, how are you going
to collect the money? How are you going to know if you didn't get
at settlement time what it was you were supposed to get? Every
firm already has to keep the information we are talking about. We
are not talking about something exotic, we are not talking about
appraisals, we are not talking about going out and hiring outside
evaluators the way they have to do in some of these lending documents. We are talking about keeping information on who the buyer
was, who the seller was, what the time of the transaction was, and
what the price of the transaction was, but to do so in a format that
isn't filled with white-outs and criss-crosses, and done in a manual
way, and dispersed in a way that you have to march up Fifth Avenue with a brass band issuing subpoenas in order to look at whether certain transactions were honest or manipulative.
So we are talking about a simple question of standardizing
records that already exist by people who keep it in a standardized
form in general in every other aspect of their business.
Mr. MARKEY. We have a roll call on the Floor right now, and we
have the opening Journal vote of the day. So I would like to proceed with consultation with the members. How would they like to
proceed?
Would the gentleman from Ohio like to be recognized now to ask
his questions?
Mr. OXLEY. Yes, Mr. Chairman.
Mr. MARKEY. The gentleman from Louisiana
Mr. TAUZIN. I'll run and vote and come right back.
Mr. MARKEY. He will be recognized as he returns.
So I will turn and recognize the gentleman from Ohio, Mr. Oxley.

85
Mr. OXLEY. Thank you, Mr. Chairman.
I ask unanimous consent that my opening statement be made
part of the record.
Mr. MARKEY. The gentleman's statement and all other opening
statements have already been approved for insertion in the record.
Mr. OXLEY. Thank you, Mr. Chairman.
Chairman Breeden, I have several questions about the SEC's
anti-fraud authority. The anti-fraud language of section 11 of the
bill is not the same as rule 10b-5. Is it your position that the provisions of section 11 of the bill change the standard of fraud currently applied to false statements as it relates to government or
other securities markets?
Mr. BREEDEN. The intent of section 11 was to make explicit for
this market area that which we believe is already the law in 10b5, not to change the law itself. It is, some would say, redundant.
But after our experience in the GSE case, where we found almost
100 securities firms and banks that were engaged in purchases
using false statements, all the agencies jointly thought it would be
a good idea to make what is essentially 10b-5 an explicit requirement for this market.
Mr. OXLEY. Thank you.
The testimony of Mr. Wymer a couple of weeks ago and the disclosure of Goldman Sachs that its employees engaged in cherry
picking—that is, the allocation of successful trades to favored accounts—raise serious questions. Does the SEC have rules against
cherry picking in the equity or debt markets?
Mr. BREEDEN. Well, the self-regulatory organizations have rules
against cherry picking; that is not allowable. The difficulty is knowing when it is going on because virtually every dealer that does
business in volume allocates trades at the end of a day, and so determining when those trades are being allocated fairly and equitably and the trader is being honest and equitable and when they
are cherry picking and segregating trades on the basis of the winners and losers is something that the SRO's and the firms' own
compliance staffs have to keep a close eye on. It is not always clear
on its face when that is happening.
Mr. OXLEY. Does the bill that we are talking about give you additional authority to deal with the cherry picking situation?
Mr. BREEDEN. I think the answer to that is no. We would not
read it as giving us authority specifically directed to cherry picking.
Mr. OXLEY. Would you support a modification in the legislation
to permit the SEC to expand its authority in that area?
Mr. BREEDEN. I don't think that is necessary, but certainly cherry picking, as far as we are concerned, is against existing rules
today and, if there is a need for any further rule writing in that
sense, I would not be opposed to any changes to reflect that. I
would be happy to look at and consult our Enforcement and General Counsel's divisions to see whether, in their view, a change in
the law is necessary or whether perhaps we ought to sharpen up
the rules in that area.
Mr. OXLEY. IS the SEC currently investigating Goldman Sachs
for violations of the anti-fraud jmles in connection with its cherry
picking violations?

86
Mr. BREEDEN. I would respectfully decline to answer that. It
would violate the rules of the Commission for me to answer as to
whether we are investigating anyone. I don't want that answer to
be read to suggest that we are or are not investigating Goldman
Sachs. I just simply cannot answer questions about whom we
might be investigating. That is nonpublic.
Mr. OXLEY. I understand that response.
Let me ask you in a more general way: Mr. Wymer testified a
couple of weeks ago that the SEC examined him on narrow
grounds, three different times, but never really saw his entire operation. They were somewhat like the blind man and the elephant;
they never really quite got the whole picture. My question is, in
that context, what is the ability of the SEC to undertake a full investigation into all of the potential violations.
Mr. BREEDEN. I would note, number one, that there is a considerable difference between the broker-dealer examination area, where
we have far greater resources, and the investment adviser area
that Mr. Wymer was involved in. Broker-dealers are subject to a
much more intensive oversight than we are currently able to give
investment advisers. That is number one.
Number two, you do have the SRO's—the New York Stock Exchange and the NASD—that have their own very large and very
active inspection programs that are applicable to all broker-dealers.
Number three, firm compliance staffs can be very, very active. In
this particular case there has been public disclosure, reported in
the media, that Goldman itself took action against the person on
the desk that was involved in this particular situation. So that was
a case in which the firm detected the activity and acted, unlike
Salomon where, after it was detected, nothing changed, the person
stayed on the desk, and then further events occurred. In this case,
the firm itself took very rapid action to remove the person from the
trading desk. So I think each of these situations needs to be looked
at on their merits.
If I might just very quickly say on the previous question of the
rules and cherry picking, I am reminded that the provision in the
bill that would remove the prohibition on the NASD's rule-writing
would allow the NASD's normal standards about ethical practices,
including cherry picking, to be applied to trading in governments.
They can't now be applied.
The NASD has rules for cherry picking in corporate debt, but because of the statutory bar on those rules being applied to trading
in Government securities, those rules don't apply. So the provision
already in the bill that would get rid of that prohibition would, in
extending the NASD's rules, also extend the cherry picking rules.
Mr. OXLEY. Mr. Mullins, in your testimony you say that the Fed
does not believe that a decisive case has been presented for adding
statutory requirements on sales practice rules. I am sure you will
grudgingly accept NASD authority over its members, but let me
ask you this: Just removing the NASD prohibition would still leave
banks out from underneath mandated sales practice rules currently; isn't that right?
Mr. MULLINS. Yes, although they would be regulated by the
banking regulators who look at these issues.

87
Mr. OXLEY. Do you think there would be some kind of a gap or
some kind of an anomaly from a regulatory standpoint?
Mr. MULLINS. We don't think there would be, and we haven't
seen a problem in this area, and indeed I think some of it must
be enforcement, because certainly the firms that you referred to in
the previous question, many of these firms, are New York Stock
Exchange members, including presumably many of the firms dealing with Mr. Wymer. So they had sales practice rules, and so it
may be an enforcement issue.
On the banking side, we haven't seen a problem, and we feel confident in our approach to examination so that we would prefer not
to have to explicitly adopt the sales practice rules, although the removal of the prohibition on the NASD I wouldn't go so far as to
say we accept that "grudgingly". We think there is a case for consistency, the case Chairman Breeden referred to.
Mr. OXLEY. Mr. McDonough, one of the other witnesses has
called for more attention to be paid to aggregation of orders by subsidiaries or otherwise related companies. Do existing Fed rules govern aggregation, and does the Fed monitor the Government securities dealings of entities under common control acting in concert?
Mr. MCDONOUGH. The reporting requirements under the Treasury auction rules do require that all of the entities under a corporate umbrella report jointly, and the agency involved in the supervision of each of the entities has the responsibility of checking
to make sure that that is done accurately.
Mr. OXLEY. Thank you.
Mr. Breeden, one last question, if I may. In your testimony you
say that 10b-5 is not enough, that the SEC needs authority over
Government securities under 15(c)(2) to adopt rules "reasonably designed to prevent fraud." Instead of enforcing anti-fraud regulations, you will be defining what is fraud and designing rules governing operation of the market to try to prevent fraud. Doesn't that
change the whole nature of the SEC's role in the regulation of the
Government securities market?
Mr. BREEDEN. I don't think so. It is really consistent with our approach to other markets across the board. There is a distinction between the existing anti-fraud standards that apply to everyone. We
already have jurisdiction over banks that violate rule 10b-5 in the
securities market; it exists today; it has existed for 60 years; it is
not some new regulatory empire that anybody is looking for, it is
something that we have had for a long, long time. To supplement
that in other markets, we have rules that, across the board, say
there are certain practices that could run the risk of being used in
connection with the manipulation of a market that you can't use.
And we have a series of rules, 10b-6 and others, that set out certain standards, and under section 15(c) we have some authority in
that area to pass rules.
Now those sections, the general rules, to avoid the necessity of
bringing repeated 10b-5 lawsuits, are not applicable in this market.
And we are simply saying that that exclusion—it is really the same
principle as the NASD loophole—that trading in Government bonds
and in Freddie Mac bonds and Fannie Mae bonds ought to be
under rules that are no better and no worse than trading in AT&T
bonds. We are not talking about something exotic or strange. The

88
dealers already understand these rules, they live under them every
day, whereas they trade large volumes of the other types of securities under these rules, and we are just saying you shouldn't have
a special little orchid hothouse for trading in Government bonds,
it is a big enough market, it can live under the normal rules; everybody already understands them.
Mr. OXLEY. Thank you, Mr. Chairman.
Mr. TAUZIN [presiding]. Thank you, Mike.
The Chair recognizes himself now for a few questions.
Let me first of all, Mr. Mullins, concede to you that I share some
of your concerns about over-regulation, and I think your analogy
about the banker's problems with making a lot more money not
making loans now than making loans is a real one we need to
avoid, and also let me tell you, I share with you some concerns
about giving two different agencies the power to require recordkeeping, because I have seen that happen in many other agencies
where two different agencies come out with different rules and two
sets of books, two sets of paper, have to be filed because of bureaucrats simply operating differently in each shop and without talking
to each other. That is a problem, and we ought to avoid it.
But let me, on the other hand, turn to a couple of issues in the
chairman's bill that I think deserve a bit more discussion.
On the transparency issue, Mr. Breeden has pointed out that in
large measure the existing systems that are now being disclosed
are being disclosed voluntarily, that certain trades, such as between the dealer and a hedge fund, cannot appear on the screens,
are demonstrated for some. I take it, Mr. Breeden, that is not customary, that is not the usual way in which firms keep records.
Mr. BREEDEN. This is the way in which one of the larger interdealer brokers does keep its records.
Mr. TAUZIN. But it is not the way that most of the dealers keep
records, I understand.
Mr. BREEDEN. Well, it is certainly not the way most dealers in
normal markets would do it.
Mr. TAUZIN. Right. And that is, I guess, where I want to focus,
and that is that those dealers that are operating voluntarily today
are certainly not the ones to be terribly concerned about until and
unless somebody in that dealership decides to do something dishonest.
Isn't it true that so long as you have voluntary systems, that it
is the player who doesn't comply with the voluntary system that
you have got to worry about, the one who wants to be dishonest,
and don't you have to have some regulations, some means of making sure that the player who doesn't want to voluntarily comply
somehow complies, and doesn't that speak to the need for some
Government requirement?
Mr. MULLINS. Yes, Congressman Tauzin, and we believe that
market surveillance is very important. I don't view the transparency approach as primarily a surveillance issue or approach. We
have greatly intensified the surveillance of the market and feel confident that that would be sufficient to turn up any problems. We
would hope that whatever needs to be done on record-keeping to
make prosecution and investigation cheaper could also be carried
out.

89
On transparency, I guess we feel that the industry is making
great strides.
Mr. TAUZIN. Well, it is. I think we have heard all of that; we all
agree with that; Mr. Breeden agrees with that. The concern is for
those that don't want to play by those rules. If one of the players
really wants to commit fraud, why would he voluntarily submit to
a transparency?
Mr. MULLINS. There is a question of whether it is feasible to get
every transaction, force it into this transparent mode.
Mr. TAUZIN. Well, let's talk about that for a second, Mr. Breeden.
The argument about who decides what records are kept, whether
it is the agency that normally worries about the economic health
of this area of Government financing or whether it should be the
policeman—and, by the way, us Cajun Irish are a little offended by
all this Irish talk this morning.
Mr. BREEDEN. I'm part Cajun too.
Mr. TAUZIN. Everybody is really.
Let me draw another analogy perhaps. The Justice Department
prosecutes violations of the IRS Code. The IRS requires us to keep
records, requires us to file. If we file incorrectly, they audit us. If
something is wrong, they turn it over to the Justice Department.
I take it Justice probably tells IRS on occasion if their record-keeping is inadequate for the purposes of a prosecution. I take it there
is communication going on. Why doesn't that system work well
with your Agency and Treasury? Why can't, for example, with the
current laws on the books that allow Treasury to require better
records than scrolls—why can't the SEC simply report, as you have
reported to us today on this practice, and indicate to Treasury that
you can't do your job to police this system if, in fact, it doesn't come
up with some better requirements on record-keeping itself?
Mr. BREEDEN. I am sure over the years on various occasions we
have tried to emphasize the importance of not just the aggregate
data, and from a monetary policy perspective what some agencies
want is the aggregate data, looking at the total volumes of purchases, what interest rates are like, and so on, the total flows of
funds.
From our approach, we are not focused on aggregate data, we
have to look at trade by trade; we have to look at specific individual trades in which a living human being in business as a broker,
whether he is employed by a bank or a securities firm, cheats his
customer, and so our interest is for micro-data, if you will, rather
than macro.
Mr. TAUZIN. Have you communicated that to Treasury?
Mr. BREEDEN. Oh, I'm sure that has been communicated numerous times.
Mr. TAUZIN. Have you personally communicated it?
Mr. BREEDEN. I haven't personally communicated that issue. But
our staff has, Congressman.
Mr. TAUZIN. Your staff has asked Treasury for better recordkeeping requirements on securities firms?
Mr. BREEDEN. Yes? No?
M s . MCGUIRE. NO.
Mr. TAUZIN. NO. My

point is made.

90
Mr. BREEDEN. Well, if I might just deal with another dimension
of it, while Mr. Mullins has made a great deal about Treasury's
being the rule writer, Treasury's rule making, in this area, is largely oriented and was created for the purpose largely of looking at
financial responsibility of the firms. The GSA Act in 1986 came
after the failure of Bevill Bresler and ESM, and you had some specialized Government securities firms that collapsed with horrendous losses; you had several New York State Government agencies
that went bankrupt because of it.
Mr. TAUZIN. Are you saying Treasury can't require the kinds of
records you would require to police it correctly?
Mr. BREEDEN. Theoretically, they probably can, but the whole
statute was passed and assigned them to do something different,
to pass rules for a different purpose.
Mr. TAUZIN. But that is not the point, Mr. Breeden. The point
is, if Treasury has the authority to require these kinds of records
and you have never even asked Treasury to make that requirement
for you to do a better job, why should Congress step in and micromanage and write into law new requirements that the current law
literally allows Treasury to implement? Why should we jump in
there?
Mr. BREEDEN. Well, it isn't micro-managing that anybody is asking you to do. This is a question in which these firms, whether they
are banks are broker-dealers, are in securities trading markets.
They trade on any given day. These desks are clustered very close
to one another. They will be trading Government bonds at one
phone, and the next phone over they are trading in municipals and
securities.
Mr. TAUZIN. We know all of that.
Mr. BREEDEN. SO the idea of having one set of rules that says,
"Here's how you keep your records," rather than having 16 different sets of record-keeping rules would be vastly simpler and
vastly less costly.
Mr. TAUZIN. I agree with you. So you think one set of rules about
record-keeping is a good idea, but you have never asked Treasury
to implement them.
Mr. BREEDEN. We have the other 15 sectors on which we pass
the rules, so Treasury cannot pass a common set of rules that
would apply to municipal securities, corporate securities, Government securities. The only Agency that can do that is the SEC.
Mr. TAUZIN. Mr. Mullins.
Mr. MULLINS. Why don't you ask Treasury simply to take over
your rules in these areas and put those in?
Mr. TAUZIN. Well, I'm not sure we want to do that either.
Mr. McDonough.
Mr. MCDONOUGH. Mr. Tauzin, I think it might be useful to say
how we make sure or seek to make sure that nothing is going on
in the market and what we do at the New York Fed in the market
surveillance business if we are suspicious that something is going
on. One of the great advantages in watching a market which has,
as David Mullins describes it, razor-thin spreads, is, as soon as you
see in the cash market or the financing market, the repo markets,
that those spreads are widening, you sniff and you say, "Something
may be going on here that we ought to know more about." So Mary

91
Clarkin, the blond lady behind me who is in charge of market surveillance, goes after it fast and moves in and inquires. We start
getting daily information if we need it; we are using our gossip network, everything that we can to discover what is going on. If we
come to the conclusion that there is something that is really suspicious, we turn immediately the firm in question over—we would,
because we haven't had to do this yet—over to the appropriate regulatory authority, which in most cases actually is the SEC.
It is our belief that in this most important of all markets to the
U.S. taxpayer the present system makes it possible within that balance between cost and assurance of success that we can see if anything bad is happening, investigate it fully, and the present structure makes it possible for the regulatory authority involved to get
in there and do its job. That is why we have the view that, with
the progress we have made over the last year and the progress that
we assure you we will continue to have, that the present system
is one that we should continue to work with, watching it evolve in
a very positive manner to give the kind of protection that is needed.
Mr. TAUZIN. Let me make a couple of points in connection with
that. There are some of us on this committee and in Congress who
tend to be very concerned about over-regulation and duplicative authorities and all that sort of thing, but we are equally concerned
about the fact that, as Mr. Breeden reports, in some cases records
reflecting consumer orders were maintained in handwriting on
scattered scraps of paper, spiral notebooks. In the GSE auctions,
the records were not maintained after the auctions even though the
records could have created evidentiary value in that case.
I mean obviously there are some very bad practices in recordkeeping that ought to be immediately resolved, and the present
system is not going to satisfy those of us on this panel who believe
in a heck of a lot more Government regulation and those of us who
believe in less.
I guess what I am saying is that if the policing authority in this
area is telling us that the records are not adequate for them to do
a good job in policing, I would hope that the authority that does
have the right to clear that up would do so, and I would hope Mr.
Breeden would make those claims and those requests of Treasury
before we have to jump into the act.
Mr. BREEDEN. If I could just supplement one key factual
point
Mr. TAUZIN. Yes, please.
Mr. BREEDEN. One of the reasons we haven't asked them to do
that is that the rule-making authority of the Treasury expired 2
years ago, and one of the reasons we are engaged in this debate
is because that authority is sunsetted.
Mr. TAUZIN. It needs to be extended; we understand.
Mr. BREEDEN. SO it would be a waste of time to go over and ask
them to write rules when their authority no longer exists. So if
Congress, in reauthorizing that authority, chooses to put all the
rule-writing authority at the Treasury, of course we will work with
the Treasury.
Mr. TAUZIN. Mr. McDonough.

92
Mr. MCDONOUGH. Mr. Tauzin, we, as you know, at the Federal
Reserve, both at the Board and at the New York bank, believe that
the Treasury rule-making authority should be renewed and should
be permanent.
On July 23, 1987, the U.S. Treasury issued the final regulations
under the Government Securities Act. Regarding record-keeping
and reporting, it says, "Newly registered Government securities
brokers and dealers will be required to follow SEC record-keeping
and audit rules."
Mr. TAUZIN. Staff is indicating to me that Mr. Breeden, of course,
is right, that authority expired, that it was, in fact, as Mr. Breeden
pointed out, for the purposes of financial adequacy. Would you have
any objections if in legislation Treasury's authority was made more
explicit and would be very clearly required to extend to the kind
of record keeping that would give SEC all of the information it
needed to properly police?
Mr. MCDONOUGH. Since we believe that the Treasury should
have that responsibility and the Treasury is not here today, I am
reluctant to speak on behalf of the Treasury.
Mr. TAUZIN. I understand.
Mr. MULLINS. We do believe they have broad responsibility, and
it is our understanding, as Mr. McDonough pointed out, that they
had simply adopted the SEC's record-keeping requirements. So
maybe there is an enforcement problem.
Mr. TAUZIN. Well, let's examine that quickly.
Mr. Breeden, is that correct? Did Treasury adopt the SEC's report requirements?
Mr. BREEDEN. They did in some areas, and in some areas they
did not.
Mr. TAUZIN. HOW about in this area, this scroll area?
Mr. BREEDEN. Not in this particular area.
But if I can try and bring us back to
Mr. TAUZIN. Well, no. Let me, please, not leave it. Are you saying
that the SEC requirements in regard to this kind of record keeping
have not been adopted by Treasury?
Mr. BREEDEN. There are no rules whatsoever in this area requiring standardized record keeping. The normal rules have not been
extended to this area.
Indeed, Congress has followed a pervasive pattern of, in this
market, providing exemptions from every particular rule. You have
been urged to do it by other agencies that say, "Well, don't subject
this market to sales practice rules, don't subject it to record keeping, don't subject it to transparency"—in each case because it might
involve these mysterious enormous phantom costs that are going to
occur. Except that these rules that they keep getting exempted
from are normal everyday practice that the firms that we are talking about, that are trading an AT&T bond on one desk and a Government bond on the next, are subject to. The rules apply on one
desk and not on the other, and the only way to have consistency
and simplicity and low cost is to say that the rules they already
live with, the computers they have already bought and already programmed to keep reports in the normal manner under the SEC
rules ought to be used for Government bonds. This is not a suggestion that we get another bureaucracy over in some other agency

93
and start writing different rules. But it is just a question of whether you want to have a simple system or whether you want to create
a byzantine and complex system.
Mr. TAUZIN. Would it be your recommendation—I draw the analogy again—that Justice should keep all IRS records and make all
the rules of reporting?
Mr. BREEDEN. I have no opinion about that. It would be my recommendation that H.R. 618 be passed, because in this area it
would, with very little cost, little burden, and little difference to the
regulated firms, plug a legal gap that now exists and makes it difficult to bring cases.
Mr. TAUZIN. I think my time has expired, and the chairman has
returned. I just want to make one final point, and that is, I tend
to agree with you, Mr. Breeden, that if firms are already voluntarily providing transparency, that requiring that they provide it
certainly is not going to cost them any more, provided the requirements aren't byzantine and bizarre themselves.
Second, I don't know how one can escape the logic of your argument that record keeping needs to be improved. Obviously, you
can't make a case if scraps of paper are kept in an area where
clearly technology allows a lot better record keeping than scrolls
and bits of paper, and that is certainly true.
But in regard to Mr. Mullins' point that the entire mortgage interest, commercial, and business and personal loans across this
country are dramatically affected by the sale of Government securities and that the fluctuations, as people have been reading in the
last few days, in the success or failure of the Clinton administration in reducing the deficit have dramatically changed those markets and resulted in extraordinary differences in interest rates to
consumers all over the country, not just to the Government—recognizing all of that, there appears to be some need for us to proceed
carefully and without disrupting a marketplace that apparently is
working fairly well and at the same time do as the chairman suggests and install procedures and record keeping requirements that
will put a little more integrity into this system for those players
who don't want to voluntarily submit transparencies and decent
record keeping.
Mr. BREEDEN. Mr. Tauzin, I would agree that we should certainly proceed cautiously and carefully, and I think that is what
the committee has sought to do, and I know all the agencies have
worked closely with the different committees. We have written joint
reports, and we have expressed separate views.
I might take one common example, because I think the fact you
cite and Mr. Mullins cites, about the tie between mortgage markets
and treasuries, cuts the other way.
Right now, as we speak, there is a 5-year Treasury issue that is
what in the lingo of the trade is called "on special." It means that
its interest rates aren't behaving like they ought to behave in accordance with the normal yield curves. Something special is going
on with that security. Now it may be a squeeze in that market; it
may not; it may be perfectly natural market forces that account for
that. If that rate is at an abnormally high interest rate because of
manipulative activity rather than because of market forces, every

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94
homeowner in the country with a 5-year adjustable rate mortgage
will pay a higher interest rate on their mortgage.
So this is not a market where, in my view, the public ought to
be told, "Well, look, you just have to rely on a gossip network," as
the Federal Reserve of New York has suggested, "as the enforcement mechanism." We can do better than that, I'm sorry. We just
can, and we ought to.
Mr. TAUZIN. I am going to let each respond, and Fm going to get
out of the chair.
Mr. MCDONOUGH. The 5-year security which Chairman Breeden
mentioned is on special in the repo market, not in the cash market,
and it is the cash market which affects this mortgage seeker that
has been brought to our attention.
Mr. TAUZIN. Thank you.
Mr. Mullins.
Mr. MULLINS. And I would say that I suppose it reflects—well,
Mr. McDonough Fm sure is looking at it—the increased issuance
of private debt as rates have started to move up, and so people
short this one.
The only thing that your line of questioning, Mr. Tauzin, brings
to mind is the importance of having people from the Treasury here
to comment on these issues.
Mr. TAUZIN. Thank you, Mr. Mullins.
I will recognize Ms. Schenk for questions, and I yield back the
Chair.
Ms. SCHENK. Thank you.
I think the Irish glass ceiling is one barrier I will never be able
to overcome here.
I would like to return for a moment to the issue of the multipleagency jurisdiction. Chairman Breeden, as you know—and I am
learning and reviewing the history of this bill—last year the House
Banking Committee sought to amend the anti-fraud and the
record-keeping and internal control and price transparency provisions of the bill. That would have given the SEC and four separate
bank regulatory agencies rule-making authority. Perhaps we may
be confronted with that again this year with a similar proposal.
I would just like your views, Chairman Breeden, on what you
think it is going to be like having potentially five different sets of
rules in this area.
Mr. BREEDEN. Five times more costly than it needs to be. To say
that we are going to repeat a given function, if we need a rule on
something, we will do it five separate times, rather than doing it
only once, is wasteful and duplicative. I think all the studies, going
back to the Hoover Commission in the 1940,s and the Bush task
force in the mid-eighties, have recommended better use of what we
call functional regulation. Have set one set of rules and apply it
across the board. You have both more costly rule-writing and less
effective enforcement when you have little nuances of difference between the five different sets of rules.
Ms. SCHENK. In your prepared testimony, you noted that the
SEC's existing 10b-5 and anti-fraud authority already applies to
banks and that the SEC already has record-keeping authority over
banks in the municipal securities area particularly. So the ones

95
who say that only the bank regulators write and enforce rules for
the banks in the securities area, do you see them
Mr. BREEDEN. That is totally wrong.
Ms. SCHENK. That is wrong?
Mr. BREEDEN. It is just a

misstatement of history and a
misstatement of the law.
Ms. SCHENK. Just following up on that, if bank regulators began
writing anti-fraud rules for bank dealers, do you see that there
might be a danger that this might create sort of safe harbors from
the anti-fraud provisions of the securities laws?
Mr. BREEDEN. It would be an extremely damaging and dangerous
path to go down. First of all, you are talking about agencies whose
expertise in the case of the FDIC, for example, is deposit insurance,
not securities fraud. So why would you turn over the job of writing
rules about securities fraud to an agency that has no experience
with it?
Ms. SCHENK. They want it.
Mr. BREEDEN. Well, I don't know that they want it. At the time
of the Bush task force, all of the banking agencies recommended
transferring the securities activities over to the SEC, centralizing
it and not having it balkanized the way it is today. So I don't know
whether the FDIC wants it.
The Banking Committee may or may not have its own jurisdictional reasons why they are interested in such approaches. I am
not competent to opine on those kinds of motivations. But from the
standpoint of what the public ought to care about, the question is
do you have a system that is effective in preventing fraud in markets?
If I am a customer and the bank wants to compete with Merrill
Lynch, and if I am going to think about either buying a security
through a bank or through Merrill Lynch, am I equally protected?
The answer ought to be yes, your protection doesn't vary on whether you happen to go to a State member bank, a State nonmember
bank, a national bank, a federally-charted thrift association, or a
broker-dealer. You ought to get the same protection against fraud
wherever you go, with a common set of rules.
Ms. SCHENK. Thank you, Mr. Chairman.
Mr. Mullins, I just have one quick question for you. It is sort of
a bottom line question. If a bank commits securities fraud, isn't it
the SEC, not bank regulators, that should bring an action against
them?
Mr. MULLINS. Correct.
Ms. SCHENK. Good.
Thank you, Mr. Chairman. I yield back the balance of my time.
Mr. MARKEY [presiding]. Thank you.
The gentleman from California, Mr. Moorhead.
Mr. MOORHEAD. Mr. Chairman, I have no questions this morning, but I do want to commend you for this legislation on which I
have become a co-sponsor. I believe that you have refined this legislation since its original introduction as a result of input from Federal regulators and others. It is an entirely important piece of legislation.
I ask that my whole statement be put in the record, and I yield
back the balance of my time.

96
[The prepared statement of Mr. Moorhead follows:]
STATEMENT OF HON. CARLOS J. MOORHEAD

Mr. Chairman I want to commend you for calling this hearing on reauthorizing
the Government Securities Act.
In response to the failure of a number of unregulated Government securities dealers between 1975 and 1985, Congress passed the Government Securities Act of
1986. For more than the last 2 years this subcommittee has been working on legislation that will update the 1986 Act to close gaps in its web of regulation, and to create authority to address problems that have become apparent in the markets since
the 1986 Act was passed.
Currently the Treasury Department is the principal regulator of this market.
They work hand in glove with the Federal Reserve overseeing every aspect of it. The
Treasury raises money to pay the interest and principal of the national debt by selling Treasury securities. As a regulator it wants an honest market. As the administration it wants an efficient market so that the cost to the Government of raising
money is as low as possible. The fact that Treasury has two roles does not mean
they conflict.
Treasury's regulation has worked very well but there have been some problems.
The first was The Salomon Brothers matter and Paul Mozer. The second matter involved abuses by the selling group of dealers in Freddie Mac and Fannie Mae securities. They puffed up their statements to the agencies concerning buying interest.
By saying they had more buyers than they did, they got a greater share of securities
to sell. There is a lot of evidence the agencies knew about this and never tried to
stop it until it became public. The entire matter was handled with fines and
warnings.
I wish I could say these were the only problems in the market, but it seems that
every few months there is another disclosure of scandal or possible scandal. Now
it appears there may have been manipulation in the noncompetitive bidding process.
Most recently, the testimony of Steven Wymer, the investment advisor who testified
before this subcommittee on his way to prison, highlighted problems with our regulatory oversight of sales practices and the manipulation known as "cherry picking."
For these reasons I have joined as a co-sponsor of this legislation. I believe it has
been refined since its original introduction as the result of input from Federal regulators and the effected industries. This is timely legislation that must be passed to
insure the highest levels of public confidence in this most important of securities
markets. I yield back the balance of my time.

Mr. MARKEY. Thank you. The gentleman's time has expired, and
we appreciate his support.
Let me ask a few more questions if I could. Again, this just gets
back to a philosophical discussion which economists are prone to
raise as they testify before our committee which has jurisdiction
over the enforcement of laws in the country.
What we always have a hard time understanding, Mr.
McDonough, is why an incremental addition to the cost of recordkeeping, to ensure that all of the bad actors in that particular financial marketplace are put on notice that it would be much more
easily discoverable that they were engaging in nefarious activity
doesn't, in fact, make the markets more efficient because you have
weeded out or reduced the likelihood that those bad actors will, in
fact, move into and serve as a corrosive influence on a particular
financial marketplace. How do you weigh that in your mind, Mr.
McDonough, as you are opposing these record-keeping and transparency changes? How do you view the improvements in efficiency
as you go through and create an equation in your mind?
Mr. MCDONOUGH. Mr. Chairman, as was mentioned earlier, it is
in abatement at the moment because the Treasury's rule-making
authority under the GSA has expired and you wish to renew it. As
you know, the Federal Reserve believes that that should be done
and there not be a time limit placed on it.

97
The Treasury in 1987 said that Government securities brokers
and dealers are required to follow SEC record-keeping and audit
rules. I am surprised that in the course of time whoever has jurisdictional responsibility over the keeper of that particular scroll did
not require that some more modern approach be taken. I don't
know enough of the details to be able to take it beyond that.
I think what one is talking about is not whether good record
keeping is a good idea or not—clearly it is—but rather whether the
present system in which the Treasury has the ultimate or should
be restored to having the ultimate jurisdiction in this area is good
or not, we believe that it is.
As regards transparency, there has been a tremendous amount
of private sector improvement in transparency. It is certainly not
perfect, but it is a great deal better than it was, and I think one
of the marvelous things that one has seen in the recent past is that
when one of the most important brokers which happened to be in
the World Trade Center had to go out of business for a short period
of time, and is not fully restored to business, virtually its entire
market share shifted literally from one day to the next to other
brokers who are involved in GOVPX, and so at a time when I think
even I when I started hearing about the World Trade Center
thought we were going to have a loss of transparency, I was delighted by what happened. The private sector solution, which has
improved a transparency a good deal, responded to the occasion.
So I think, again, we are not talking about, is one opposed to
transparency—we, of course, are not—but rather whether the very
significant progress that is made by the private sector should be
encouraged; we believe that it should be.
Mr. MARKEY. OK. So, Mr. McDonough, if the New York Fed's
market surveillance system relies on information available on the
inter-dealer-broker screens to track what is going on in the market,
if the information available on the dealer screens was no longer
representative of the market for a given class or category of Government securities or was no longer sufficient to allow you to determine the prevailing market price of a security, wouldn't that complicate your market surveillance capability for that marketplace?
Mr. MCDONOUGH. There is no question that we, because of our
market surveillance responsibilities, think that the ongoing improvement in transparency is good. However, we do not now and
never will depend completely on what we see on screens. We are
constantly looking at the market, observing the market. As you
know, we are a participant in it because of our repo activities and
occasionally, as we did yesterday, when we buy securities outright.
So we know what is going on in the market.
When we see anything from any source that makes us believe
that something needs additional research, we get at it very quickly
and very thoroughly, and when we reach a point where we think
something is truly demanding the attention of the cops, we call
them. We have not since we created market surveillance reached
the conclusion that that was necessary, but I can assure you that
that is what the rules are, and there is a very strong bias on my
part and on the part of all of us involved in market surveillance
at the Federal Reserve Bank of New York that we are not going

98
to hesitate for a nanosecond in calling the regulatory authorities
when we should.
Mr. MARKEY. Well, I am afraid that is not the history, Mr.
McDonough. That is, the nanosecond is more like a nanodecade or
a nano-era in terms of how quickly the New York Fed and the Fed
and the Treasury Department over the years have dealt with these
issues. This is common knowledge on the street.
A congressional expert is an oxymoron, we are only experts compared to other congressmen, but we have experts that come here
on all sides of the issue and testify not only in public but in private
with regard to the ability to corrupt any of these marketplaces, and
the experts who are interested in corrupting this marketplace tell
us that it is the easiest of all the marketplaces to corrupt.
So our concern is that we have found a remarkable coincidence
between improvements in the surveillance in this marketplace and
hearings that are scheduled before this subcommittee. We can almost track how the hearings or the meetings are being called at
the agencies based upon the need to deal with some public relations problem, and that is our real concern, that it is seen as a public relations problem: If only we can get by that hearing; if only it
doesn't get that much attention; if only the word doesn't get out
that this is the most corrupt marketplace in the country; if only we
can lull them into believing that, in fact, the efficiency which we
provide there does, unfortunately, under our present rules, have to
accommodate a substantial amount of corruption; then we will survive for another day, and we will make whatever other incremental
changes we have to make.
I think that our history with this whole issue, going back now
2V2 years, has turned us so cynical in terms of how we view the
regulators, the present-day regulators, in this marketplace that it
would almost be difficult for me to fully express to you how concerned I am about the level of corruption which does exist in this
marketplace today and that the Salomon Brothers scandal was, in
fact, just the canary in the mine shaft, it was nothing more than
the warning that there is more down there, and that thus far all
I have seen is incremental change in trying to deal with a fundamental problem.
Mr. Corrigan, in testifying here more than 2 years ago, made it
quite clear that he didn't see himself as an enforcement officer,
which is fair. Mr. Mullin, or his predecessor who was here—I think
J. Powell was here a couple of years ago; he said the same thing;
nothing has changed. And I appreciate that. You don't spend any
significant part of any day on this issue—that is, enforcement. It
is not really the primary part of how you see yourself. I respect
that.
All I wish you would do is just respect our views and the public's
views, but other participants, other than those with whom you
speak on an ongoing basis, Mr. McDonough. I am just afraid that
on issues like this it has turned too much into a jurisdictional,
inter-agency dispute, which then manifests itself in public here,
using veiled references to efficiency in the market or to changes
which are made voluntarily, to mask the fact that you are more
concerned about the prerogatives of your historic agencies than you
really are about the integrity of the marketplace.

99
That is of most concern to me, because I don't think this is a very
difficult issue, to be quite frank with you. It should not have
consumed
years of the subcommittee's time, I will tell you, regarding an issue which, in my opinion, would not have any significant impact on the market whatsoever, notwithstanding Mr.
Mullins' testimony. I just cannot, for the life of me, understand how
you can elevate something which is so obviously needed to this
level of dispute.
I would like, Mr. Breeden, if you could, to give us some sense
about what is gained by giving you this price transparency backstop authority supplementing what Mr. Mullins or Mr. McDonough
or their agencies might want to put on the books.
Mr. BREEDEN. Mr. Chairman, I concur that there is an element
of bureaucracy and agency interest in some of these debates. The
Fed's testimony, in its written form, suggests there shouldn't be
any record-keeping authority, and the argument today has become
that the Treasury ought to do the record keeping, not the SEC.
Those are somewhat different arguments.
I don't want to over-regulate the market. I don't think we are
talking about anything unusual or unique or costly. I think I have
a pretty good track record of trying to make sure that the SEC's
regulations are cost effective and not burdensome. We wouldn't be
proposing it otherwise.
But every one of these firms has to know who they bought from
or whom they sold to and at what price and at what time. They
can't do business without knowing that. It is a simple little question of whether we can mandate that they give us that information
in a form that will make it easy for us to piece together what happened in a marketplace and find out whether there was unlawful
activity or not.
Now there are people who do not want to see us have an easier
job of it. Gilbert in "The Pirates of Penzance," said, "When constabulary duty is to be done, the policeman's lot is not a happy
one." People like to make it as hard as possible for people to oversee what is going on. I understand that is a concern that people
in the market might have, but what we are really talking about in
this legislation is something, I think, as you mentioned, that is
pretty simple; it is keeping records that are already kept in a form
that is accessible and usable to have cases that can be presented
to a judge and a jury.
If nobody wants us to be able to do that, fine; I'd rather be told
that we are going to repeal 10b-5 as to the banks' securities business and just have them have the honor system. But if people want
us to try to enforce the law, then we have got to be able to get evidence to bring the cases, and the current system can be improved.
Mr. MARKEY. This raises the question then of why the SEC, who
is, after all, is the Agency which is going to use these records,
shouldn't have the primary role in drafting the rules to ensure that
the information is usable to the enforcement agency.
After all, Mr. McDonough and Mr. Mullins, you both agree that
you are not in the enforcement business. So wouldn't it make
sense, at least in the delegation of authorities in a complex government, to give the responsibilities to the Agency that ultimately is
going to have responsibility for the use of that information?

100
Mr. MULLINS. I think Congressman Tauzin used the analogy of
the IRS and the Justice Department. We do think the Treasury is
in the best position to weigh the impact of regulation on market
participants and taxpayers. They have a strong incentive to protect
this market.
Now I do think that the SEC and others should communicate
with Treasury if they think there is a problem here, but we would
oppose creating overlapping authority here in yet another area of
balkanized
Mr. MARKEY. But is this balkanized, Mr. Mullins?
I mean if there is a murder in the bank, Mr. McDonough, you
don't investigate, the local police or the State or Federal police
would investigate. If you as a banker have, unfortunately now, participated in a deal that has hazardous waste materials on some
construction site, it is the EPA or the State environmental agency
that comes in and deals with the issue and has responsibility for
oversight. If there is a minority or an affirmative action hiring
problem in an institution, it is the relevant agency that comes in,
it is not the banks, and that is balkanization, I guess, if you want
to use it in its pejorative sense. But, in its most positive light it
is used in a way to ensure that those who are given primary responsibility for advancing agreed upon societal goals are given
their opportunity to come in and to use their expertise, and I don't
understand what is wrong with that, Mr. Mullins.
Mr. MULLINS. We don't disagree with that. The S E C is the person to do the enforcement, and what we disagree with is also giving
them duplicative rule-writing authority as well. It is the overlapping rule-writing authority we object to.

Mr. MARKEY. It is not duplicative. W e will give to them the ability to be able to put together the rules, and you say you are not
an enforcement agency, so how can it be duplicative if the agency
which is an enforcement agency is going to ensure that the rules
are constructed in a way that gives them their enforcement information?

You clearly admit, both of you, that you do not have the expertise
at your relevant agencies to be able to do this.
Mr. MULLINS. Nor do we seek it.
Mr. MARKEY. I know that.
Mr. MULLINS. Again, my suggestion is that this is an issue in
which it would be very useful to get the perspective of Treasury,
who does have the primary regulator role here.
In terms of the turf issues, we have no regulatory jurisdiction at
issue at all in this debate, and our only concern is what is best for
the market and the country.
Mr. MARKEY. YOU have a philosophical difference of opinion with
us, which I think is probably unbridgeable, and that is valid, and
we can accept that as a perspective—you know, efficiency over
other values.
Mr. MULLINS. We have seven members of the Board.
Mr. MARKEY. I appreciate that, and I am sure that they are selected from a broad cross-section of America, meeting all the Clinton diversity elements.
Mr. MULLINS. We have members from Arkansas.
Mr. MARKEY. Bankers from Arkansas, bankers from California.

101
The problem that we have here is that, amongst other things,
Treasury is the issuer as well, and you get into a conflict. It is the
same conflict that we have in other areas where agencies are set
up. The Nuclear Regulatory Commission is set up to regulate nuclear power; the Atomic Energy Commission is set up to promote
nuclear power.
Now you are promoters, and that is fine. You have a good rule.
You are basically the fiscal chamber of commerce in terms of your
attempts to convince this country and the rest of the world this is
a great place to invest and we are very efficient and we will try
to work with you to make it more of a comfortable environment for
you. That is a very important role, and we don't mean to demean
it in any manner, shape, or form. What we have a problem with
is when you demean the other part of the system that also has a
role.
We set up Glass-Steagall, and we know that it has now basically
been back-doored through every possible way imaginable to seek its
undermining, but essentially the philosophical insight that was inherent in the construction of Glass-Steagall is still valid, which is
that you need to have different agencies responsible for different
roles. The SEC is the cop, and the bankers are the promoters. That
is fine as long as we can continue to accept the legitimate conceptual distinction which is made between the roles.
As we hear you today, we still don't, I think, elicit the proper respectful tones in terms of the functional regulation responsibilities
which the SEC was tasked with, the expertise which that agency
has developed, and the absolute consistency which our committee
has with the Banking Committee and others with the efficient, orderly transfer of capital from investors into the hands of CEO's in
this country. We have the same goal. But you are not willing, unfortunately, to give enough attention to or respect for the other side
of the coin, and that is fine. The Atomic Energy Commission has
it.
You can go down agency after agency that we have to split off
in terms of its promotional and regulatory functions because of that
psychic barrier which is created in people's minds as they determine at age 15 or 16 where they want to work for the rest of their
life, and it makes a lot of sense while you can't deal with this, and
that people who want to work for the SEC take another view of the
world as well, each of them legitimate if they could be harmonized.
The balkanization which you speak about is not that in fact but,
in fact, delegation of authority to various parts of the Government
that have primary responsibility for, expertise in, and interest in
it.
I hate to break off here, but I would ask each of you to give us
a 1-minute summation of what you want the committee to remember as we are going along, because I will have to call the second
panel to give them a chance to testify, and I would ask if we could
go in the same order—if you, Mr. Mullins, could give us your summation to the committee.
Mr. MULLINS. I would just say we view this as central bankers
and, I would agree, not as enforcement agents, even though at age
15 I doubt that I knew what a central banker was. We view this
as a very important market, as everyone does, and believe that it

102
is quite important that we be very careful in assessing the potential impact on this market of making major shifts in regulatory authority. Our judgment is—which is a unanimous judgment from the
Chairman and the entire Board of Governors—that indeed there
may be significant risks involved to the smooth functioning of this
market and to taxpayers from engaging in a dramatic change in
regulatory authority.
Thank you, Mr. Chairman.
Mr. MARKEY. Mr. McDonough.
Mr. MCDONOUGH. Mr. Chairman, I became a central banker only
at the age of 57.
Mr. MARKEY. YOU became a banker at which age?
Mr. MCDONOUGH. Actually, at age 33, after being in the U.S.
Navy and the State Department.
I think I could perhaps help best by saying what has changed
since the Salomon Brothers scandal at the Federal Reserve Bank
of New York. As you know, at that time we were in what we called
the dealer surveillance business, which was to make sure that we
had creditworthy counter parties. We have had a massive change
to the market surveillance area, which is to look at the market in
its entirety and its actions.
We believe that our capability, working with the other agencies—
the SEC, the CFTC, the Board—has made a tremendous amount
of progress in making it less likely, a good deal less likely, that the
kinds of things that we saw in the Salomon Brothers case will happen again. Nobody under any system, including the proposed legislation, can give you assurance that it will never happen again. But
we believe that the Federal Reserve Bank of New York, with tremendous cooperation from all of the agencies involved, has done a
great deal to make this market safer, more efficient, and better supervised for the benefit of the taxpayer.
Thank you.
Mr. MARKEY. Thank you.
Mr. Breeden.
Mr. BREEDEN. Mr. Chairman, I, too, agree that this is a vital
market and that there is a paramount public interest in keeping
the cost of financing as low as possible. To the degree that the market becomes seen as one where it is easy to commit fraud, there
will be fewer participants in the market, it will be less liquid and
less efficient, and the cost over time of financing the Government
will go up, not down. That is what brings us all here in good faith,
to try and figure out what is the best way to assure that we have
an efficient and an honest market. Those goals should not be inconsistent; they can be consistent.
Just as people have been talking about the IRS here, the IRS,
in fact, has authority very much like the SEC. They bring civil enforcement actions. They are the ones who enforce their own recordkeeping requirements. The Justice Department brings criminal actions in the IRS area, the same way the Justice Department brings
the criminal actions for securities fraud. But the IRS sets the
record-keeping requirements, and it then enforces them. It is the
enforcement agency. Here, we are the enforcement agency, and we
ought to be able to set the record-keeping requirements.

103
What is at issue here, I think, is a fairly simple question of
whether we want to balkanize an efficient trading system. I have
been in the trading room of most major firms in this area, and
when you walk into a trading room, you walk into an array of people at phones and looking at screens, and they are trading fixed income, or they are trading equities. The fixed income will include
RTC securities, Treasury securities, Freddie and Fannie securities,
it will include AT&T—corporates. What is being suggested here is
that, although every single security being traded in that entire
trading room is under the record-keeping requirements of the SEC,
one little sliver of that market ought to have a different agency
that needs to start writing the rules about what needs to be kept,
and the computer systems of all these firms need to be able to
track and record records on fixed income except for Government
fixed income. Now that is balkanization.
What we are arguing for is consistency, functional regulation,
simplicity, and if we want to trade securities, then there should be
a set of rules that you have to follow; if you don't want to be in
that business, that is fine, nobody makes you go into it. But what
we are trying to promote here is the idea of consistent enforcement
and simple enforcement of the law, and I regret that sometimes the
issue of agency interest gets in the way of what needs to be our
paramount focus, which ought to be making sure that, for the people who don't happen to be honest, we make the system difficult
for them to abuse, and we can do better than the system that exists today.
Thank you.
Mr. MARKEY. Thank you, Mr. Breeden, very much.
We do want to resolve this issue soon, and to the extent to which
it is necessary for us to make clear the extent of the corruption in
this marketplace and the extent to which there is a complete mismatch between the existing regulation and the corruption which is
out there, then this committee will do so.
We would hope that we would be able to negotiate out something, but, if necessary, we will resort to increasing the numbers
of hearings and new witnesses that we will bring in here to demonstrate clearly the inadequacy of the existing system. It just
would be our hope that we could work something out on a rational
basis rather than forcing the subcommittee to take more dramatic
testimony from witnesses before this committee that would be
much more palpably obvious to the ordinary investor as to what is
going on.
Thank you all very, very much.
Mr. MULLINS. We would be happy to work with you.
Mr. MARKEY. Our second set of witnesses: Mr. Michael Basham
is the managing director of Smith Barney; and Mr. Randy
Strausberg is the president of Top Gun Capital Management, Inc.
Ladies and gentlemen, if we could please begin. I would ask everyone to please sit down and for the witnesses to be seated.
We will begin with Mr. Basham, who is managing director of
Smith Barney, or, for the purposes of today's hearings, "Smith
Blarney." That is hopefully not in his testimony however.
So whenever you are comfortable, Mr. Basham, please begin.

104
STATEMENTS OF MICHAEL E. BASHAM, MANAGING DIRECTOR,
SMITH BARNEY, HARRIS UPHAM & CO.; AND RANDY M.
STRAUSBERG, PRESIDENT, TOP GUN CAPITAL MANAGEMENT

Mr. BASHAM. Thank you, Mr. Chairman.
Mr. Chairman and members of the subcommittee, it is a pleasure
for me to respond to your request to appear before you to discuss
H.R. 618, the Government Securities Reform Act of 1993.
At the outset, I would like to make it clear that my testimony
and my responses to your questions represent my own views and
are not intended to represent those of my employer, Smith Barney,
Harris Upham, soon to be Smith Barney Shearson.
Your invitation asked me to respond to a series of questions as
well as to provide the subcommittee with my views on the major
provisions of H.R. 618, and I am happy to comply. I would first like
to address H.R. 618, the Government Securities Reform Act of
1993.
With respect to section 2, the extension of the Government securities rule-making authority, the subcommittee should permanently
extend the Treasury's rule-making authority under the Government Securities Act of 1986. Congress made the correct judgment
in 1986 concerning the basic regulatory structure of the market for
Government securities. The various regulatory agencies, the GAO,
market participants, and industry representatives all agree that
the Treasury has done a good job as the rule-maker.
Because the regulatory objectives established by Congress when
it enacted the GSA have been successfully met, another sunset provision designed to review the efficacy of the regulatory structure is
not necessary.
With respect to section 3 on record keeping, under the Government Securities Act of 1986 Treasury was granted the authority to
promulgate rules concerning record-keeping requirements for all
participants in the Government securities market. Under H.R. 618,
the Treasury's authority would be renewed and the SEC would also
be granted authority to adopt rules on record keeping. There is no
identifiable need for duplicative or overlapping layers of regulatoiy
rule-making authority. To the extent the subcommittee believes enhanced record-keeping rules for enforcement purposes are necessary, Treasury should be required to develop these rules in consultation with the SEC.
With respect to section 4, large position reporting, the most important provision of H.R. 618 would grant Treasury the authority
to adopt rules requiring large position reporting for all market participants. I would recommend to the subcommittee that the legislation require the Secretary of the Treasury to adopt large position
reporting rules.
Disclosure of a large controlling interest would make it more difficult for market participants to manipulate the secondary market
without the knowledge of regulatory agencies. Requiring large position disclosure will also act as a deterrent to manipulative practices. In terms of enhancing regulatory oversight of the Government securities market, eliminating manipulative, and collusive
practices and protecting market integrity, this is the most important step this subcommittee could take.

105
With respect to section 5, prevention of fraudulent manipulative
acts and practices, extending the SEC's existing anti-fraud and manipulation authority over regulated brokers and dealers to the Government securities market is a positive step that will further enhance. market integrity.
Section 6, broker-dealer supervision responsibilities: The New
York Stock Exchange and the National Association of Securities
Dealers currently have rules requiring their member firms to establish procedures to ensure compliance with applicable securities
laws and regulations. Additionally, all financial institution regulators have similar authority. As a result, the provision requiring
brokers and dealers to establish separate compliance and control
procedures for Government securities would appear to be redundant and unnecessary.
Section 7, sales practice rule-making authority: The proliferation
of financial instruments that are Government securities and that
pose greater risk than traditional Treasury or agency securities necessitates uniform sales practice rules in order to protect less sophisticated investors who have historically been attracted to the
Government securities markets because they seek safe investments.
While protecting investors is vitally important to the integrity of
the marketplace, inconsistent or heavy-handed rule-making can
have the unintended result of negatively impacting market liquidity and efficiency. The inevitable consequence of this would be increased cost to the taxpayer for financing the deficit.
Of all the agencies, only Treasury has a vested interest in minimizing the cost of financing the public debt by maintaining both
the efficiency as well as the integrity of the Government securities
market. Treasury, with its superior understanding of the market
for its own securities, is also best positioned to determine the consistency and the market liquidity impact of proposed sales practice
rules.
With respect to section 8 and market information, the threat of
a Government-mandated effort was the catalyst for voluntary industry price dissemination efforts, and, as a result, Government securities price and volume information dissemination has become a
reality. Street efforts to be responsive to customer demands for new
services should increase and enhance the information available to
market participants.
However, dealers did not willingly give up the competitive edge
that nontransparency of prices provided them, and in the short run
there may be some slight chance that price dissemination efforts
may stall or may not respond to customer demands for more and
better information. As a result, some appropriate stand-by mechanism to ensure that private market efforts continue to be successful
is warranted. H.R. 618 would appear to go far beyond what is necessary to ensure the success of the private sector initiatives. I believe it is important to note that a lot has already been accomplished in the price dissemination area without Congress passing
legislation.
I would like now to respond to the written questions that were
included in your invitation to testify.

106
Is it possible, without breaking Treasury auction rules, to create
artificial shortages in the Government securities market in order to
control or manipulate market prices?
Yes. For example, three bidders acting in concert could tender for
the 35 percent maximum amount Treasury will allow any bidder
to purchase, with each bidder being awarded one-third of the issue
auctioned. While Treasury auction rules have not been violated,
this concentration of ownership could result in market manipulation of the new issue if the owners manipulate the supply they
make available to the secondary market.
How could a deliberate manipulation of the market occur? What
trading strategies might be employed? How would a manipulator
profit, and how would other market participants be affected?
Most deliberate market manipulations involve some attempt to
restrict the supply of a security in the markets. To accomplish this,
the manipulator would need to obtain control of a substantial portion of the available supply of a security. Control can be established by outright ownership or by collusion among several owners.
The manipulator profits when the price of the security goes up as
a result of market demand substantially exceeding the available
supply. Obviously, market participants who need to purchase the
security pay a higher price than they would in the absence of the
manipulation. Additionally, market manipulation hurts issuers of
securities by driving away market participants who fear losses,
thereby reducing market liquidity.
What can regulators do to better detect and combat the risk of
fraud and manipulation in the Government securities market?
With respect to the current regulatory structure, I think it is important to understand that it was the existing surveillance and enforcement mechanisms that ultimately forced Salomon Brothers admissions of wrongdoing in August 1991. My own involvement in
those events suggests to me that for the most part the process
worked. With a multitude of appropriate laws and regs available
to various enforcement agencies, what seems to be needed is more
effective surveillance and enforcement, not broad sweeping changes
in the regulatory environment.
More effective surveillance will be the result of a requirement for
all market participants to report their control of large positions in
a security to the appropriate regulatory authority. The natural end
result of enhanced market surveillance will be effective enforcement of current laws dealing with manipulative practices and collusion.
What should regulators look for when trying to distinguish a manipulative market squeeze from one resulting from natural market
forces?
The most significant feature that distinguishes a manipulative
squeeze from a natural squeeze is concentration of ownership. By
way of example, in May 1986 the 9Y4 percent Treasury bond maturing February 15, 2016, suffered a severe secondary market
squeeze resulting in significant losses to those who had shorted it
as part of their secondary market trading activities.
At the time, ownership of the
percent Treasury bond was
spread across a large diverse group of buyers with no one owner
having a large enough position that would allow manipulation of

107
the price. This was a squeeze that resulted from the independent
decision making of multiple owners and sellers, or natural market
forces. In contrast, the 2-year note squeeze in May 1991 came
about as a result of 2 or 3 market participants controlling the outstanding supply of the entire issue. This concentration of ownership is suggestive of a manipulative squeeze.
What steps can regulators take to respond to an artificial
squeeze?
The proper response to a manipulative squeeze in the market is
aggressive prosecution of the perpetrators of the squeeze. Aggressive enforcement should be the most effective deterrent. There are
only a small number of market participants who have the capital
and the sophistication to perpetrate a manipulative squeeze on the
Government securities market. As a result, the universe of potential transgressors is very small, which suggests that sweeping regulatory reform designed to deal with a broad, pervasive threat is unnecessary. Again, enhanced surveillance as a result of large position reporting should result in more effective enforcement of existing laws against collusion and market manipulation.
The general reexamination of the Government securities market
over the last 18 months has been a worthwhile exercise for all market participants. A fair and open market is vitally important to the
Federal Government's efforts to fund the deficit. However, I would
encourage the subcommittee to focus on the fact that, as with the
loss of investor confidence, poorly designed regulation can have an
equally disastrous impact on the cost of borrowing by driving away
those who provide the Federal Government with the funds it needs.
Mr. Chairman, that concludes my statement. Thank you.
Mr. MARKEY. Thank you, Mr. Basham, very much.
Mr. Strausberg.
STATEMENT OF RANDY M. STRAUSBERG

Mr. STRAUSBERG. Mr. Chairman, I want to thank you for the opportunity to testify on the issue of Government securities regulation. I have spent my entire career involved with the market first
at the New York Fed and later at a number of primary dealers. I
was a trader, salesman, I managed the Government Securities Department at Nikko Securities, a very large Japanese firm, and, consequently, I feel a personal involvement in maintaining the integrity of the market even at the cost of greater regulation. We would
fool ourselves to imagine that dishonesty and covetousness could be
restrained by written laws which would catch the weak and the
poor but easily be broken by the mighty and the rich. The proper
goal of regulation is to assure that the Treasury obtains the lowest
long-run cost of financing. Such a goal requires the market to attract the widest variety of buyers and sellers, allow for efficient
risk management, result in the narrowest bid-to-offer spread, offer
the greatest liquidity, and generate the most derivative uses. It
also reminds the regulator that morality is not in conflict with efficient markets.
The Treasury must avoid a severe reduction in the size of individual long-term bond issues. Skimpy issues invite abuse and will
require frequent unscheduled reopenings till these issues remain
liquid and trade in line with similar securities.

108
Restrictions on the size of bids at auctions will not prevent artificial shortages. Such limits do not restrict ownership, and I do not
recommend any. We shall have to monitor other methods of accumulating and controlling securities. There are futures markets,
swaps, options, STRIP'S traded by nonregulated dealers, banks, foreign monetary authorities, and hedge funds in all time zones.
In particular, we need to address the issue of common control
and foreign unregulated subsidiaries. This does not imply that any
abuses have occurred, but it is the nature of regulation that creative players will find a way to defeat it. Vigilance requires information.
Manipulation requires the creation of an illusion in order to encourage other participants to pay an inflated price. Market and financing prices may indicate a shortage. Players attempt to tighten
an issue in the financing market by taking them "off the street" to
a lender that will not recycle the securities.
With the advent of screen-based trading, the illusion can be assisted by commentary on information systems and dissemination of
quotes instantly. The use of misinformation can be just as manipulative as no information.
The greatest cost to the Treasury results from the loss of hedging
vehicles. A hedge, by definition, must have a definable relationship
to that being hedged. When hedging securities are hard to borrow,
when yield spreads to surrounding issues change unpredictably,
when traders lose money simply by servicing their clients, the market will become less efficient; traders will bid lower and widen
their bid-to-offer spread; other things being equal, yields will be
higher than they ought to be. It is irrelevant whether the price
anomaly results from manipulation or natural forces, a trader's reaction is the same. As a result, the Treasury should adopt a clear
cut policy for reopening tight issues regardless of the cause. A statistical measure of the market's difficulty with an issue should be
developed.
In regard to H.R. 618, I think it necessary to exempt small dealers from burdensome record-keeping requirements. Any information obtained from dealers or other market participants should be
held in confidence and used only by agencies directly involved in
securities regulation. Information systems sponsored by dealers or
inter-dealer brokers should report trades in real time with the size
of bids and offers displayed. The date and time of last trade should
also be displayed.
Price manipulation can occur regardless of Treasury bidding
rules. Provided information is confidential, position reporting
worldwide would assist in developing measures of tightness and
clear-cut parameters for response.
[The prepared statement of Mr. Strausberg follows:]

109

r I 1

m. m •
M.G. Tivon Group

Written Comments Regarding H.R. 618 - Randy M. Strausberg
Mr. Chairman, members of the Telecommunications and Finance Subcommittee,
I want to thank you for the opportunity to testify on the issue of Government
securities market regulation to preventfraudand manipulation. I have spent my
career in the Government securities market,firstat the New York Fed and later at
a number of Primary dealers. The market can serve the needs of the Treasury, the
Fed, investors, borrowers, foreign monetary authorities and speculators if integrity
can be maintained. But, we would be foolish to " imagine that dishonesty and
covetousness could be restrained by written laws which would catch the weak and
poor, but easily be broken by the mighty and rich."*
Prior to addressing this issue, however, I think it necessary to define the goal of
any regulation. Is it to provide a level playingfieldso thatfreemarket players can
maximize their profit? Is it to provide a deep and broad market so the Fed can
carry out its monetary policy responsibilities? Is it to allow the Treasury to issue
its debt at the lowest possible price over the long term? These goals are not always
consistent. While I strongly believe infreemarkets, I do not believe that free
markets are automatically efficient and honest. Sometimes the Invisible Hand does
notfindthe optimal allocation of resources at the best price; it simplyfindsits way
into your pocket.
Government securities regulation has lagged behind other markets because we
were never concerned with "insider information" about the issuer. Also, the buyers
220 Archers Point
Longwood, Fla. 32779
(407) 333-9500 Fax (407) 333-9506

110
had traditionally been sophisticated institutions that did not need protection. A
small community of dealers, in a close relationship with the Fed, earned a
comfortable living distributing Government securities. Activities which in other
markets are clearly prohibited as price manipulation are routine in Governments.
This is especially so with the advent of screen based trading and significant trading
away from the home market, either overseas or through derivatives.
I was particularly struck by this phenomenon when I ran the Government
department at Nikko Securities, a Japanese owned Primary dealer. At the time,
Japanese investors were the single largest player in the long-term bond auctions
and often ten year note auctions as well. Quite often, during refundings, I would
be asked for a comment by a news service on expected Japanese interest in
auctions. I began to notice that sometimes when my remarks hit the tape, the
market would have a price reaction. I am not in favor of restricting such comments
since the alternative is to restrict the information to a handful of inside players. I
simply point out that the question of manipulation goes far beyond an artificial
squeeze or shortage; with instant dissemination of news to a great many market
participants, misinformation has as great a potential for manipulation as no
information.
In answering your specific questions, I assume the goal of regulation to be the
broadest need - to permit the Treasury to borrow at the lowest possible cost over
the long run. A market with unquestioned integrity based on the highest credit
available will attract the most buyers and sellers, allow for efficient risk
management, result in the narrowest bid to offer spread, offer the greatest liquidity
and generate the most derivative uses, all of which will lead to the lowest possible
cost to the Treasury.
2

Ill
This assumes that the Treasury will itself avoid policies that lend themselves to
shortages and squeezes. If the Treasury continues to reduce the issuance of longer
securities, it may have to go to a regular cycle offrequentre-openings, so these
issues remain liquid and trade in line with other similar issues. As the benchmark
for all long term securities, we can ill afford a stray bellwether.
As to the question posed by your letter, yes, it is possible to create artificial
shortages without breaking Treasury auction rules. Such restrictions impose no
limits on ownership and I do not propose any. We should not in any way prevent
legitimate buyersfromaccumulating Government securities. In being more vigilant
about administering our regulations, we can prevent the temptation to challenge
them.**
In particular, we need to address the issue of common control of buyers and
foreign subsidiaries. Common control might mean that a single large bank buys an
issue for its trading department, portfolio, trust department, swap group and other
derivative uses. For a dealer, it might mean purchases by managed funds as well as
the trading department. In Japan, it might mean purchases by group related
companies also. With 24 hour trading, we must address subsidiaries around th?
world. This does not imply that any abuses have occurred but it is the nature of
regulation that creative players will find a way to defeat it. Vigilance requires
information. Required filings should not be made public.
Manipulators can profit if they can lay off a sufficient amount of "overpriced"
securities at a greater than normal price. This requires the creation of an illusion.
Since disgorging a large amount of the squeezed securities would cause a price
3

112
decline as soon as the shorts have covered, it is possible for the balance of the
issue to sell at a "discounted" price. This requires keeping the issue tight in the
financing market so it is difficult to borrow and forces the shorts to cover - in other
words, you may borrow in the repurchase agreement market, while selling your
actual position at inflated prices.
Other uses involve related markets. Since the Treasury market is the benchmark
for other markets, even short term squeezes can have benefits if it permits the sale
of other securities at inflated prices.
The major cost of shortages and squeezes is the loss of a useful hedging vehicle.
When traders are afraid to use the current or "on the run" securities to hedge, their
ability to manageriskis diminished. In such circumstance, bids will weaken and
bid to offer spreads will widen. A hedging vehicle must necessarily have a
predictable relationship to the security being hedged. When a hedging security is
difficult or expensive to borrow, when yield spreads to surrounding issues change
from the norm significantly, when traders lose money simply by servicing their
customers because spreads go "out of whack", the market will become less
efficient. The Treasury's cost will go up. In that regard, it is irrelevant whether a
long lasting or pronounced price anomaly is artificial or resultsfromnatural
market forces. From a market standpoint, they should both be treated the same
way. The legal issue is for others to address.
The best known example of a natural forces squeeze is the 9-1/4% T-Bond due
Feb. 2016. At the time, bond yields were about 7.4%, resulting in a market price
for this issue of about 123. Japanese insurance companies owned a significant
share of the issue. Because they were only permitted to pay dividendsfromincome
4

113
and notfromcapital gains, they desired to keep these high yielding bonds. Dealers
had gotten short in the normal process of preparing for the auction of a new issue.
Unfortunately, when the Japanese did not sell their bonds in exchange for the new
issue, dealers had no way to cover. When they purchased other bonds or futures to
temporarily hedge, the spread between the 9-1/4's and other bonds changed
dramatically, especially since the rest of the bond market began a 12 point decline.
These bonds moved "out of line" by about 6 points (6% in price) to futures and
other bonds. On a $9 billion issue, that is about a S500 million mispricing from
natural forces. Does it really matter if it was deliberate? The following nine
months were extremely volatile. Long term rates moved up and down about 1 full
percent twice during that period. I believe the losses suffered by dealers, because
their hedging vehicles failed, contributed to the subsequent volatility.
If damage to the market can be caused by both deliberate and natural shortages, the
Treasury must adopt a clear cut policy with regard to re-opening of tight issues. I
see no reason for a bias to bailing out the shorts, if there are no fraudulent
practicesfrombuyers. If hedging is becoming difficult, there must be a statistical
way to measure that difficulty. Such a method will establish an objective standard
for re-opening. The buyers of an issue should certainly know what standards the
Treasury will use simply because the absence of a standard leads to uncertainty
and uncertainty leads to instability. Speculators should not be punished because
they identify a shortage and move to take advantage of it. Being a speculator is a
normal market function. Without them, price signals cease to exist.
In regards to H.R. 618, the Government Securities Reform Act of 1993,1 believe
the committee has identified the key need for information. I believe that certain

114
points need to be emphasized to prevent the regulatory functionfromclashing with
the efficiency of the market.
A. Smaller broker-dealers should be exemptfromreporting and record keeping
requirements beyond routine NASD requirements. These dealers are not the source
of squeezes and manipulation. Burdensome record keeping can only cause
inefficiency and raise the cost to the dealer and the investor for no useful purpose.
These dealers are an important part of the distribution network for individuals and
small institutions. An annual volume in Government securities exceeding some
high level - at least $10 billion - would trigger additional requirements.
B. All information on positions and strategies must be considered proprietary.
Before releasing information to any agency not directly related to securities
regulation, contributors should be notified and given an opportunity to challenge
the release. This is especially true for information receivedfromnon-dealers and
foreign entities. Without a guaranty of privacy, participation in the market may be
inhibited.
C. Every entity whose positions exceed certain percentages of an issue, both in
outright positions and financing positions, should report.
D. Information systems sponsored by dealers or inter-dealer brokers should report
trades in real time with the size of bids and offerings displayed. For "off-the-run"
securities, the date and time of last trade should be displayed. The public should
have all of the trade information available on dealer screens.
Manipulations can occur regardless of Treasury bidding rules. Such practices
require control over both the ownership of the security as well as the market for
borrowing the security. Regulators need to monitor the activities of major players
worldwide but with a guarantee that information gathered will remain confidential.
6

115
Additionally, the Treasury must develop a clearly defined rule for re-opening a
tight issue, based possibly on time duration, price or yield spread to some standard
and volatility compared to surrounding issues, regardless of the cause of tightness.

* Anacharsis, quoted in Plutarch
** Diodotus, quoted in Thucydides

Outline of Maior Points regarding H.R. 618 -

Randy M. Strausberg

1. The best goal of regulation to prevent market abuses is the lowest borrowing
cost to the Treasury, which requires efficient markets with broad participation.
2. The expansion of a cozy community of dealers and professional investors to
worldwide participation has left regulators far behind in uncovering potential
abuses in Government securities.
3. Withoutfrequentre-openings, reducing the size of bellwether issues will lead to
shortages and squeezes.
4. Common control of buyers around the world requires more extensive data
collectionfromdealers and market participants.
5. From a practical view, the loss of hedging vehicles will reduce liquidity and
cause inefficiency. Whether this resultsfrommanipulation or natural shortage, a
clear cut policy for relieving squeezes must be developed.

116
Mr. MARKEY. Thank you, Mr. Strausberg, very much.
Mr. Strausberg, why are you here? What is your concern?
Mr. STRAUSBERG. Well, essentially, I would like to give a trader's
perspective. I am not a lawyer; I can't comment on individual aspects of who has what regulatory authority. But essentially, as
someone who has always been involved in the market, I see always
the possibility of manipulation, the possibility of abuse. Having
traded for 20-odd years in Government securities, I think it is just
a different perspective that I would like to share with you.
In my written comments I added a section about the 9Vi of 2016.
It is a very famous issue from the spring of 1986. There was essentially an accumulation of securities by Japanese insurance companies at that time, and so I am using this example to show you why
I think I want to give you a trader's perspective.
At that time, the Japanese insurance companies owned about
two-thirds of that issue, and essentially that issue came out in February. There was a new issue coming out in the May refunding.
Dealers took their normal positions, getting short, selling the new
securities in anticipation that the owners of the previous securities
would let them out and buy the new securities in its place.
Unfortunately, they weren't aware that the Japanese insurance
companies had a restriction and could only pay dividends to their
clients based on interest earned and they couldn't at that time use
the capital gains. At that time, interest rates were rather low. A
new issue came out finally with a 7 Vi coupon, and so the 9V4 were
trading at a price of something like 123.
Essentially, two-thirds of that issue stayed in Japan. It wasn't
deliberate, it wasn't illegal, they didn't collude to the best of my
knowledge, but essentially that issue traded six full dollar points
out of line with the rest of the market. Essentially, the bond market began to decline after the May refunding. The bond market declined about 12 or 13 points; that issue declined 6 points.
People who had shorted that issue ended up buying Treasury futures and other bonds against it and essentially had their issues,
their hedging vehicles, go down 12 or 13 points while their shorts,
of course, only went down about 6 or 7 points.
I believe as a result of that disaster for the dealer community—
and just to give you a measure of what it means to be out of line
by 6 percent, that is a $9 billion issue, so 6 percent amounts to
something like $450 or $500 million of difference in value from
what that issue ought to have been. Essentially, the market then
dropped 13 points, rallied 12, dropped 15, and rallied 10. That kind
of volatility cannot be helpful to the Treasury or to investors.
Mr. MARKEY. SO the Treasury needs large reporting authority.
Mr. STRAUSBERG. Well, whoever needs large reporting authority.
I think you need to track who owns large positions in Government
securities in individual issues.
Mr. MARKEY. Thank you.
Just so I can help to get your philosophical perspective for coming in here, you are a participant in this marketplace, Mr.
Strausberg?
Mr. STRAUSBERG. Well, right now I am starting a small dealership. But yes, for 20 years I was at primary dealers, I was at the
New York Fed, I managed a large Government securities depart-

117
ment, and obviously observed that particular instance from the perspective of a Japanese dealership.
Mr. MARKEY. But just broadly though, in terms of the need for
price transparency, the need for better record keeping, so that
there is more information out there, if you are not the biggest player in the biggest firm, how necessary is this in order to make the
market more honest?
Mr. STRAUSBERG. I think for the regulator, I cannot see how today's derivative instruments, world-wide trading, hedge funds all
around the world trading Government securities, unless you can
somehow gather information on who the players are and what the
positions are and what they own on a world-wide basis, I cannot
possibly see how you could identify any potential for abuse.
Mr. MARKEY. SO do you think there is a substantial winking that
goes on in firms across the whole scene? You know what I am saying—winking about what they are able to do because they know
there is absolutely no chance of detection.
Mr. STRAUSBERG. Oh, of course.
Mr. MARKEY. There is?
Mr. STRAUSBERG. Of course. I am not going to sit here and tell
tales, but the fact is that people understand that they can do
things and get away with it, and they do.
Mr. MARKEY. Right now? Every day?
Mr. STRAUSBERG. Yes, absolutely.
Mr. MARKEY. And they would be illegal if we passed this Act.
They would not be engaging in those activities
Mr. STRAUSBERG. Well, I don't want to comment specifically. You
know, I am not a lawyer enough to answer that question, but the
answer is certainly N A S D sales practices—I don't see any problem
with that whatsoever applying to every kind of security, and I do
think regulatory agencies should have this position-gathering information from again—and I want to say around the world.
I will give you one example. There is a new hedge fund—new,
let's say, the last 6 months—from Bermuda of all places. The question is, where did they get money from? I have heard it was
through an Austrian bank, I have heard it was through the Channel Islands from Middle Eastern interests. But the point is, this is
a new player with over $10 billion of positions and no one even
knows who they are or what they have, and they are in Bermuda.
Mr. MARKEY. All right.
Let me go to Mr. Basham.
Mr. Basham, you heard this problem. How can it be rectified?—
if you think it is a problem. Is it a problem?
Mr. BASHAM. Well, the identity of the offshore hedge fund based
in Bermuda—I am not necessary sure the identity of the financial
backers is such a problem in terms of market integrity.
Mr. MARKEY. Mr. Strausberg?
Mr. STRAUSBERG. I am not saying we need to know the name of
the guy who has the money, but we need to know that this hedge
fund has large positions if, in fact, they have large positions.
Mr. MARKEY. DO you agree with that, Mr. Basham?
Mr. BASHAM. Absolutely.

118
Mr. MARKEY. YOU do. Then do you support that provision in the
legislation that would have that large position authority given to
the Treasury and mandate that they develop it?
Mr. BASHAM. Yes, sir, I would.
Mr. MARKEY. YOU would. O K , fine. So we can solve that problem
as far as you are concerned.
What else have you got, Mr. Strausberg? Any other problems
that you can think of?
Mr. STRAUSBERG. Well, as a person who is not sitting at a primary dealership right now, I get to look at GOVPX an awful lot,
and, having been at a large dealership where there is a constant
flow of information and customer business going through, where
you can have a day-to-day pulse on the repo market and so forth,
so you can find out what is going on, it is a lot different when you
are sitting out in the hinterlands and all you have to depend on
is GOVPX, and you begin to see some of the faults in GOVPX.
For example, the information doesn't come across real time, so,
for example, if trades are working up—let's say two dealers are
having a trade and one guy hits a bid and says sell 5 million, 10
million, 50 million, and so forth, and works up the trade, you don't
really get to see that until the trade is over; you don't see it as it
is happening. So, suddenly flashing across the screen might be, 100
million was done with some time delay.
In addition, there are any number of off-the-run issues that appear on GOVPX and may not trade every day or every 5 minutes.
I believe you should have the date and the time of the last trade.
I mean that is important information for especially small dealers
around the country.
Mr. MARKEY. Let's go to Mr. Basham.
What do you think?
Mr. BASHAM. With respect to GOVPX, Mr. Chairman, clearly you
want as much price transparency as you can technologically provide in the marketplace.
To the extent that the current technology probably would not
allow every single piece of information that someone might like to
see to be transmitted, obviously that is going to take time and new
technology or an investment of capital to make that happen.
But in terms of the issue of transparency itself, obviously it is
a good thing; the more information the better.
Mr. MARKEY. Then why is there a technological obstacle to getting—the information is now with the dealers, right?
Mr. BASHAM. Correct.
Mr. MARKEY. What is the technological obstacle to getting it to
the public? Why can't the public get it? We are the telecommunications subcommittee here as well, and so we have both
Mr. BASHAM. Correct. Mr. Chairman, I am not an expert. All I
will do is relay to you, this is an issue that I pushed quite actively
when I was at the Treasury Department, and in terms of the PSA
GOVPX effort we were constantly being told that there was literally a limit to the number of lines of information that could be
provided on the current computer technology they were employing
for GOVPX. To the extent that—to provide more information literally would require more blocks, more lines on the screen, would

119
require an investment of additional money, and providing new
hardware.
Mr. MARKEY. Well, again, we don't think we are really recommending anything that is too revolutionary here. It is just that
there should a telescoping of the time frame it takes for the modernization of this communications system. You know, we have to
battle with the Merc all the time; they like this open outcry system; and maybe—you know, just maybe, if we really work hard, we
will be able to figure out, you know, if they are telling us 6 or 7
years ago how to put this up there so everyone can see what is
going on in these markets. We appreciate the difficulty there. You
could have maybe a year, but it takes decades sometimes to get
people to move, which makes sense; the people who already have
a stake in the existing market don't want to get out any additional
information.
Mr. Basham, Mr. Strausberg, I would also like to ask your comment on proposals to split rule-making—anti-fraud, record keeping,
internal controls, price transparency provisions of our bill—between the SEC and four separate bank regulatory agencies. Does
it make any sense to have five potentially different sets of rules in
this area, Mr. Strausberg?
Mr. STRAUSBERG. Well, again, you are getting into legal questions, but the Municipal Securities Rule-Making Board, as you
know, regulates municipal bond dealers, and as far as I understand
those laws, the enforcement belongs to the agency that happens to
regulate that particular entity, so if you are a securities dealer it
is the NASD, if you are a bank it is a bank regulator. So there is
an example where we do have split enforcement. Whether or not
that works, I can't answer that.
M r . MARKEY. O K .

Mr. Basham.
Mr. BASHAM. Where there are different securities, there are different markets. I will say, Mr. Chairman, that the Government securities market is somewhat unique in terms of who it benefits. Obviously, to the extent that the SEC historically has had its role of
protecting the purchaser or the end user
Mr. MARKEY. It is not unique in terms of who it victimizes.
Mr. BASHAM. NO, sir, not at all. To the extent that you have individual investors who could be victimized by unscrupulous practices
or practitioners, certainly, that is always a possibility.
But, you know, the SEC has got one primary focus, and that is
essentially to protect investors, to make sure they get all the information they need to have to make investments and to protect them
against unscrupulous practices.
To the extent that the Treasury market is not the penny stock
market, you know, it is the other side of the equation, the issuer,
the American taxpayer, as got a vested interest in that market as
well, you know, that suggests to me that you do need potentially
a different perspective on that market than you might on the
penny stock market or the over-the-counter market or listed stocks.
M r . MARKEY. O K .

Mr. Basham, you were responsible for putting in that 35 percent
role that Mr. Mozer and others—were you not the primary Govern-

120
ment official tasked with the responsibility for putting that on the
books?
M r . BASHAM. Y e s , sir.
Mr. MARKEY. SO I appreciate

your concern about this marketplace. But I wonder whether or not you accept the view of the administration that you served in, their view with regard to functional regulation—that is, that the agency that is the agency of expertise should continue to move wherever those types of responsibilities trail them as the marketplace changes.
Mr. BASHAM. We had a somewhat unique perspective. Again, it
was a different market. We thought we were the only agency that
really had both perspectives in the forefront of our minds, not only
investor protection, which gets to the heart of protecting the integrity of the market—obviously, if the integrity of the market comes
into question, that will impact the cost of financing the deficit. By
the same token, regulations, and not heavy handed, per se, but
even at the margin, incremental regulatory authority that could
chip away at the efficiency and liquidity of the market we had to
be concerned about too. So we thought we were a unique agency
in that respect.
Mr. MARKEY. OK. I apologize, we are going to have to wrap it
up, and I would ask that each of you give us a 1-minute concluding
statement, if you would. We will begin with you, Mr. Basham, and
then we will ask you, Mr. Strausberg, what it is you want us to
remember as we are going through our proceedings here.
Mr. Basham.
Mr. BASHAM. Mr. Chairman, I think essentially as an individual—and I will try not to let my former organizational bias enter
into this, but as an individual, with the Treasury Department, I obviously had the responsibility for assisting the Secretary in his role
as the rule-maker for the market under the Government Securities
Act of 1986. I was a champion of price transparency, of sales practice rules, and of large position reporting. I can't say that I find
much about the legislation, other than the jurisdictional issues,
that I would find fault with.
My only caution would be that this is a market that, again, is
not just one where the primary focus should be on protecting the
end user of the product that is being created but also the issue of
the product; the American taxpayer is not IBM or Exxon Corporation.
Mr. MARKEY. Thank you.
Mr. Strausberg.
Mr. STRAUSBERG. Thank you.
I think the essence is, when you say that the Treasury should
be able to borrow at the lowest cost, that requires a lot. It requires
efficient markets, it requires information, requires integrity, it requires an ability to prevent abuse, and it also requires an ability
to deal with natural shortages.
I know everyone has made a distinction between a natural shortage as opposed to an abusive shortage. As a trader, I don't make
that distinction. The fact is, the Treasury needs the information
about who owns Government securities—or someone needs the information about who owns large positions, whether outright or in
the financing market, and, in essence, needs to be able to deal with

121
the problems of reopening issues to straighten out anomalies in the
pricing structure, because it is essentially those anomalies which
make traders afraid to deal in the marketplace, and being afraid
means high volatility, and high volatility means higher cost.
Mr. MARKEY. Thank you, Mr. Strausberg. We thank both of you.
As you can see and the other witnesses to this proceeding this
morning can obviously see, this is going to build to a boiling point
before the end of this year, and we would hate to take Mr.
Strausberg's insight
Mr. STRAUSBERG. IS that the Irish pronunciation of my name?
Mr. MARKEY. It is the Boston pronunciation, actually imitating
the British accent. It kind of goes from the Kennedys imitating the
Cabots and the Lodges and then the Markeys imitating the Kennedys imitating—and so it goes on.
In fact, this accent—they did a PBS special about 5 years ago on
the etymology of the English language, and they took one person
speaking in downtown Boston, and they tracked it all the way
back—this Irish guy in Boston—they tracked it all the way back
to the Irish imitating the British to this town about 80 miles north
of London, and they put a microphone on a guy of the exact same
age in that town, and he sounded just like someone from Boston
who had carried on this accent. So we are all products of where we
come from; whether it be the banking industry, securities industry,
or our ethnic origin, it is hard for us to break that track.
Nonetheless, I think that Mr. Strausberg's concern, as reflected
by others who have given us their insights on this subject, is that
in the real world there are big problems, and the ability to scam
this market is substantial. They can do it almost without regard
to any real likelihood of apprehension.
This wink-winking that goes on in this market, and has always
gone on in this market, is going to end, and we will do whatever
it takes in this committee in order to make this much more public
and to make firms who are engaging in it much more public in
terms of who they are and what we already know about these firms
who are allowing it to be tolerated inside of their firms. If necessary, we will begin naming names, we will begin bringing much
more public light on to this subject across the whole public securities arena. We don't want to do it, we want to negotiate it out, but
we are not going to do it unless and until we get a positive resolution to this issue.
We don't think we are asking for a lot here, just that the information be made more public. Those who are going to block us will
run the risk, as a result, of forcing us to raise the visibility of the
firms and others who are engaging in and tolerating this activity.
We would hate to do that, but we feel it necessary to do so in order
to get a positive resolution of the issue. We just say to all out there,
beware, it is on the horizon unless we get a quick and reasonable,
respectful resolution of this issue.
We are not going to stop until we get this question answered,
and I just want everyone in this audience who may represent whatever interest to understand what is being invoked in terms of this
subcommittee's need to raise the visibility of the firms who have
inside of their activities right now concerns which Mr. Strausberg
and many others have talked to us about privately that must be

122
altered and can only be altered if this information is put into the
hands of the proper regulators.
With that, we thank all of you, and this hearing is adjourned.
[Whereupon, at 12:13 p.m., the subcommittee was adjourned, to
reconvene at the call of the Chair.]
[The following material was received:]

123
BOARD

OF
GOVERNORS
OF THE

F E D E R A L R E 5 E R V E SYSTEM
WASHINGTON, D. C. 2 0 5 5 1
ALAN

G R E E N S P A N
CHAIRMAN

February 1, 1993

The Honorable Edward J. Markey
Chairman
Subcommittee on Telecommunications
and Finance
Committee on Energy and Commerce
House of Representatives
Washington, D.C.
20515
Dear Nr. Chairman:
Thank you for your letter of December 17, 1992, which
requested information about the Federal Reserve's operations in
the market for U.S. Treasury securities. The Federal Reserve
operates in this market primarily to implement monetary policy,
with the size and timing of the operations determined by the
reserve needs of the banking system and the stance of policy.
These transactions generally represent only a small share of
total market activity and go smoothly because of the breadth and
depth of the market.
We also execute transactions for correspondents,
primarily foreign official institutions. In such cases, we
basically fill the investment orders of our official
correspondents who hold a share of their dollar assets in U.S.
Treasury instruments. These institutions are attracted to
Treasury securities in large part because of the presence of an
active and liquid secondary market.
I hope that you find these comments and the enclosed
specific responses to you
?ful.

Enclosure

124
A.

The Federal Reserve's Portfolio
(Questions

3 and

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in:

Treasury

maturities

remaining
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with

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used

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for

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Treasury

years;

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determining

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125

In Treasury auctions, the Federal Reserve is awarded new
securities in exchange for maturing issues on a noncompetitive basis,
accepting the price established by competitive bidders.

In the case

of Treasury coupon offerings, the amount sold to the Federal Reserve
augments the total sold to the public.

Since the Federal Reserve's

rollover operations do not impact the amount sold to the public, there
is no market effect from these exchanges.

In the case of Treasury

bills, where our award is made from the publicly available amount, we
seek to keep our distribution across issues relatively uniform to
minimize any potential market effect.
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Having

our

decided

71-390 0 - 9 3 - 5

mutually

on t h e

policy

our

issues.
and

needs

seasonality.

to
the

be
last
when

sales

have

should

note

foreign

five
there

that

official

compatible.
consider

bills

the

coupon
or

supply

instrument,

type

issues

coupons

assessment

relative

type

Such

tend

also

or Treasury

our

decisions

market

we f i r s t

purchase

and t h e

occasionally

with

portfolio

size

a year

but

a year.)

bills

our

outstanding

market

executed

portfolio,

situation,

the

reserves,

the
of

element

6 times

purchase,

and c u r r e n c y .

a heavy

4 to

once

are

a market

market

from monetary

from d e a l e r s

when o u r n e e d s

and b o n d s ) .

each market.

increase

c a n b e made d i r e c t l y

planning

current

year,

abundance

securities

reserves

occurring

sales

prospective

any

arise
for

a r r a n g e d more t h a n

correspondents

security

rollovers,

purchases

the

seasonal

been

specific

such

(Outright

purchases

the

from purchases

infrequent,

a large

come

outright

years.

bulk

through

unevenly

relatively

the

rests

cr.

the

conditions
the

selection

126

specific

across

the

issues
full

attractively
curve.

The

best-price
our

fairly

maturity

priced

vis-a-vis

operations
basis.

existing
As

are

know,

for

liquidity,

and t h e i r

vehicles.

lower

yield,

securities
price

approach.

purchases

from about

coupon

percent

over

the

4.3

the

issues

tended
of

heavy

reflected

shown

these

relatively

issues

takings

these

our

modest,

best-

coupon
ranging

coupon

no m a r k e t

purchases

the

averaged

three

years.
was

had caused

thereby,

premium

(There were

percent

and.

command a

them under

operations,

auction

account

concentration.

years.

last

the

take

we w o u l d b e

purchase

our market

the

preventing

that

yield

made on a

circumscribed
are

most

For b i l l

two

1990.)

Fed

(This

on t h e

bills

figure

run.

increasing

The

a market purchase a

few

leaves

mature a day

from r e c e i v i n g

On t h a t

out

before

the amount

available

portion

one

occasion,
they

any twelve-month

Desk consequently acquired SQS^

public.
in

likely

which

limitation

may b e

we w o u l d

are

undue

often

offerings

are

on t h e

we a l s o

avoid

securities

proportion

percent

last

less

has

for

that

issues

characteristics

replaced,
the

offered,

market

issues,

availability
These

We a s k
those

and p u r c h a s e s

issue

over

purchase
ceiling

Thus,

the

0.4

operations
of

that,

select

surrounding

among

a given

w h i c h makes

the

"on-the-run"

use

hedging

and

competitive

choosing

holdings
you

straightforward:

spectrum

its

debt

were

bills

the
typical

days later.)

Custody Holdings for foreign and International Accounts

What percentage of the Federal Reserve's $300 billion customer

(Questions 2. 5 and 6)

safekeeping portfolio is in: A) Treasury bills; B) Treasury securities
vith remaining maturities up to two years: C) Treasury securities with

127
-4-

remaining maturities from two to five years; D) Treasury securities
with remaining maturities from five up to ten years; and. E) Treasury
bonds with remaining maturities of ten years or longer?
5.

When p u r c h a s i n g

what

discretion

making
6.

decisions

What h a s

issues

the

been

purchased

securities
Federal

the
for

for

which

a customer

Reserve

Bank o f

particular

mix between
customer

safekeeping
New Y o r k

securities

"on-the-run"

accounts

for

are

versus

each

account,

allowed

purchased?
"off-the-run"

the

past

three

years?
At

year-end

custody

for

Bank o f

New Y o r k

that

you

foreign

Foreign

the

The

Federal
of

Reserve

the

correspondent
or

Bank o f

New Y o r k

instructions
either

are

standing
under
into

required

by t h e

type

range

organizations

Treasury

their

own

that
custody

discretion.

securities

own and c a n b e

by t h e

Federal

based

the

purchase
Bank.

among

executed

Reserve

(such

Bank

These

up t o

instructions

(bill,
three

purchases

by t h e

Reserve

specific

are

receipt

instructions

purchased
as.

Federal

securities

Most

triggered

Standing
be

the

upon t h e

authority.

and a r e

account.

security

maturity

order

on f i l e

Reserve

distribution

investments

correspondents,

foreign

the

Federal

participants.

securities

instructions

a correspondent's

the

issues

offered

foreign

with

and

securities,

market

instructions

the

New Y o r k

for

provided

Treasury

The m a t u r i t y

international

dollars,

purchases

accounts

Table

and

services

its

marketable

dollar-denominated

private

received

standing

specify
its

agent

Bank o f

investing

dollar-denominated

billion.

banks

their

other

New Y o r k

$281

attached

using
of

holdings

international
at

central

a portion

choice

and

stood

requested

may h o l d

1992,

made

funds

typically

note,

months

bond)
or

and

up t o

six

128
-4-

months).

The B a n k ' s

required
at

the

maturity

price

toward

range

most

Less

typically

favorable

the

frequently,

security

choosing

issues

opts

the

for

COL r e s p o n d e n t .

within

security

with

some

the
offered

view

well.

we r e c e i v e

a security

an e x a m p l e ,

a specific

permit

Bank d i s c r e t i o n

this

involves

and

distribution

designated

discretion

order

to
of

specific

purchase
1 to

orders

a designated

a five-year

3 months

purchase

maturity

on e i t h e r

range.

side

might

years.
During
foreign
about
the

the

last

correspondents

percent

considerably

about

percent

bonds

were

the

our

Securities Lending

have

volume
foreign

on-the-run

years,

securities

smaller

was

issues

the

bills

we p u r c h a s e d

been o f f - t h e - r u n
were

on t h e

run.

transactions

correspondents'
in

1990

and

With

regard

coupon

securities,

purchases

1992;

for

securities--only

1991.

notes

that

and

figure

percent.

(Questions

three

largely

9 and

10)

What is the Federal Reserve's policy regarding lending securities

from its own portfolio to primary dealer firms when such securities
are trading "on special" in the repo market?
10.

What is the Federal Reserve's policy regarding lending customer

securities to primary dealer firms when such securities are trading
"on special*1 in the repo market?
The F e d e r a l
order

smooth
it.

help

avert

functioning

The t e r m s

and

Reserve
market

the

established

delivery
market

conditions

failures

and.

under

a lending

hence,

which

which
our

facility
could

ability

securities

are

impair
to

1969
the

operate

made

129
-6-

available

from the

being

special"

"on

lending

takes

actively

the

traded

System's
in

the

form of

issues

portfolio

are

repo market.
items

are

that

most

not

are

likely

conditional

practice,

on s p e c i a l

on an

much o f
because

experience

issue

our
those

delivery

failures.
I
we l i m i t
our

should

the

holdings

cases
loan

add.

amount
of

heavy

some

however,

a security

issues

demand.

primary

dealers

hundred

million

dollars.

are

on a n y

small

generally

specials,

not

factor.

determine

terms

lend

securities

and i n t e r n a t i o n a l
needs
engage

under

which

accounts,

and u s e s .

they

in
do

repos,
so.

as
is

only

noted
their

not

on
a

Thus,

program

as w e l l
We do

out

few

reverse

day.
the

and

rationing

we h a v e
totals

each

sales,,

any t i m e ,

borrow or

we c h a r a c t e r i z e

securities

on t h e i r

for

the

above,
decision
setting

operate

the

such

behalf.

8 and

11)

When conducting open market repurchase agreement (adding

reserves)

transactions with primary dealers, what is the Federal Reserve's
policy regarding accepting collateral that is trading "on special" in
the repo market?
8.

Open Market Repurchase Agreements
(Questions

own p o r t f o l i o

and c o n d i t i o n s

facility

their

dollars

dealers

short

require

day

repo market

whether

given

By c o n t r a s t ,

billions

a major

enough

for
at

securities

foreign

a dealer

the

Our

lend

purposes

but

we do n o t

lent

The v a l u e

hundreds

useful,

that

Since January 1. 1991. how many times has acceptance of "on

special" collateral happened when conducting repurchase agreement
transactions with primary dealers?

130
11.

What

mitigate
dealers

specific
the

might

Treasury

steps,

potential

exacerbate

Treasury

issues

the

manner,

any.
its

the

does

the

Federal

open market

potential

for

Reserve

operations
short

take

with

squeezes

primary

the

market?
When we p r o v i d e

inject

that

are

acceptable

appropriate

and we h a v e

purpose.

Thus,

reserves

volume

we do

need
not

through

as
of

repurchase

collateral.
reserves

acquire

pre-screen

Our
the

specific

agreements,

objective

most

when

efficient

issues

collateral

all

for

this

accepting

propositions.
In t h e
with
for

great
several

securities

issues
are

are

not

off

special

far

securities

Market
is

not

our

shown

that

a r e more

these

area.

the

shown t h e s e

"on
it

next,

days.

special

rates

and

Many o f

because

and b e c a u s e

no d i f f i c u l t y

advise

deeply

the

We p r e f e r
repo

and,
that

information

securities
the

that

general

not

market,

issues.

on s p e c i a l

Open M a r k e t

If
as

special"
is

they

common

these

their

taking

take

we d o

gee

rates

are

1991,
to

not

items

for

your

rate--only

the

same

concept

occasions
place

that

significant

when we w e r e

this

two-year

While the data "series"

context

period

received.

shown

special
such

by n o t i n g

question

came

the

kind

maintain

question,

special--that

is.

times.

collateral

that

not identical, we

described

the

above.
in

total

amid t h o u s a n d s

that
of
of

there
are

submitting

shown t h i s

three

our

which

we r e v i e w

when we b e g a n t o
address

matter,

s u c h demand,

contact

on s i g n i f i c a n t

collateral

another

to rsspond to your request, v« reconstructed data for the first
months of 1991.

and

these

D e s k and i n

them,

appropriate,

needed
were

are

Trading

and g i v e n

we p r e f e r

Since mid-September

and d i s a p p e a r
the

operations.

circumstances

the

on most

lightly

collateral

demand

percent

We h a v e

collateral.

appear
hour

be on s p e c i a l

quickly.

firm to

database

issues

from one

Surveillance

surrounding

been

We t r a c k

usually

even

from g e n e r a l

great

dealer

market,

considered

Issues
however.

repo

frequency,

There
period.

collateral

a
have
about
order
nine

used

were

8 occasions

the

5
should

over
items

the

131

Table

Federal Reserve System P o r t f o l i o
of U.S. Treasury S e c u r i t i e s
(December

31.

1992;

Commitment

Millions

Percent

of Dollars
Treasury

bills

Treasury

coupons

within
2 to

2 years*

5 years*

basis)

of total

150,219

49.5

70,184

23.1

36,324

12.0

5 to

10 y e a r s *

18,903

6.2

over

10 y e a r s *

27,805

9.2

Total

303,435

remaining

maturities

Table

Marketable U . S . Treasury S e c u r i t i e s Held in Custody f o r
F o r e i g n and I n t e r n a t i o n a l C o r r e s p o n d e n t s a t F . R . B . N . Y .
(December
Millions
of Dollars
Treasury
Treasury

bills

31.

1992)
Percent
of t o t a l

89,778

32.0

94,179

33.6

65,767

23.3

21.756

7.8
3.3

coupons

within

years*

2 to

5 to

years*

over

years*

9,144

Total

280.624

remaining

maturities

132
TESTIMONY OF PETER A. ROBERTS
CHAIRMAN, COLLEGE SAVINGS BANK
PRINCETON, N.J.
before the
SUBCOMMITTEE ON TELECOMMUNICATIONS A N D FINANCE
COMMITTEE O N ENERGY A N D COMMERCE
U.S. HOUSE OF REPRESENTATIVES
March 17, 1993

Mr. Chairman and Members of the Subcommittee, I am Peter A.
Roberts, Chairman of College Savings Bank, a savings institution
formed for the primary purpose of originating and marketing
certificates of deposit designed to assure funding for college
costs.
Prior to forming College Savings Bank in 1987, I was a
general partner of Lazard Freres in charge of its Government
securities trading desk.
While H.R. 618, the "Government Securities Reform Act of
1993," provides welcome improvements to the market for Government
securities,
one aspect of the system which has not been
adequately addressed by H.R. 618 nor in the numerous committee
hearings on the subject is the Government's own activities
relating to the marketing of its securities. Specifically, there
is little if any mechanism for ensuring the relevant agencies are
completely forthright when selling Government securities to the
general public.
For the past several years, the Department of Treasury has
been engaging in deceptive advertising on behalf of its U.S.
Series EE (Education) Savings Bonds. While undertaking a massive
and tremendously successful campaign to tout these securities as
"tax free for college", Treasury has regularly failed to note
that significant restrictions apply which reduce or completely
eliminate the favorable tax treatment of these instruments for
many American families.
The result is that many parents will
find out too late that they have insufficient savings to provide
education
due
to
undisclosed
tax
for
their
children's
consequences or eligibility rules.
After much effort on my part to encourage Treasury to
disclose this information to potential buyers, as well as a great
deal of press coverage concerning the deceptive nature of the
Savings Bond advertising campaign, the Department in 1991
announced that it would begin disclosing the limitations in
future advertising. I have attached a letter from the Executive
Director of the Savings Bond Division explaining this new policy,
which I would like to be included in this record.

133
Although I am pleased that Treasury has announced its
intentions to inform consumers of this critical information, I
remain concerned about their refusal to take any steps to inform
past purchasers of Savings Bonds who otherwise may remain unaware
of these limitations until they seek to redeem the bonds for
their children's education.
Furthermore, I am concerned that
Treasury has not engaged in a bona fide recall of the deceptive
advertisements.
Attached for the record please find an example
of the aforementioned advertisement appearing in the March 1993
issue of the 900, 000-circulation Working Mother magazine. Consumers
continue to be misled.
Despite Treasury's claimed acquiescence in changing its
advertising policy, there remains no real oversight concerning
the manner in which many Government securities are marketed to
the public.
The Government Securities Act of 1986 gives the
Secretary of the Treasury the power to promulgate regulations
with respect to transactions in Government securities by dealers
and brokers which are "designed to prevent fraudulent and
manipulative acts and practices and to protect the integrity,
liquidity,
and
efficiency
of
the
market
for
government
securities..." P.L. 99-571, Sec. 101. While this language gives
Treasury the authority to regulate the advertising practices of
private dealers
and brokers
of Government
securities,
no
independent review exists for Treasury's own conduct in marketing
Government securities to the public. In this regard, it must be
remembered that the success and integrity of the Government
securities markets ultimately depend on the reputation of the
Federal government.
Deceptive advertising such as that by the
Savings Bonds Division can only harm the market in the long run.
I appreciate you allowing me the opportunity to address the
Subcommittee on this important issue.

134

DEPARTMENT O F T H E
U.S. S A V I N G S B O N O S
WASHINGTON. D C
December 2 4 ,

TREASURY
DIVISION
20226
1991

Mr. Garret G. Rasmussen
Patton, Boggs 6 Blow
2550 M Street, NW
Washington, DC 20037-1350
Dear Mr. Rasmussen:
This is in response to your letter of October 18, 1991,
concerning our new policy with respect to Savings Bonds
advertising. After review by the Department and informal
consultation with the Federal Trade Commission, the Savings Bonds
Division has undertaken the following actions to clarify some of
its advertising of the tax-exclusion for education feature of
Series EE Savings Bonds.
The Division has ceased publishing small space print
advertisements containing unqualified statements that the Bonds
are tax free for education. The Division has asked the public
service directors of broadcast stations to cease airing certain
public service announcements which do not clearly state that
limitations apply. All future print and broadcast advertising
addressing the education feature will, at a minimum, clearly
indicate that maximum income and other limitations apply. As much
of our advertising has provided in the past, future advertisements
will encourage the public to seek additional information from the
Savings Bonds Division and financial institutions. Finally, the
message on our 800 information line (l-SOO-US-BONDS) has been
revised to contain information on the limitations on the
availability of the tax-exclusion for education feature.
The Division does not intend to undertake a mass mailing to
individuals who purchased Savings Bonds after December 31, 1989.
We believe that, taken as a whole, the public information on the
tax exclusion for education feature which the Department has
distributed in the past, coupled with actions described above,
adequately address the concerns you and Mr. Roberts have
expressed in your communications with us.
Sincerely

Thomas E. Antinson
Executive Director

Now
I n Free
For
College
U.S. Savings
Bonds
A public service of this publication.

page 86

136

VJt. ftou*e of SUpretfentattbe*
j

C«nrittte OR Cacti? ml C m m t

SUBCOMMITTEE ON TELECOMMUNICATIONS AND FINANCE

flUftltnffton. BC 20513-6119
March 19, 1993

The Honorable Richard C. Breeden
Chairman
Securities and Exchange Commission
450 5th Street, N.W.
Washington, O.C. 20549
Dear Mr. Chairman:
As you know, the Subcommittee on Telecommunications and
Finance has been investigating the nature and adequacy of current
regulation of the government securities market, and abusive or
illegal trading practices affecting the fairness and integrity of
this market.
This morning's Washington Post reports that a 35-year-old
college dropout with a bogus financial statement duped several
government securities dealers into carrying out approximately $1
billion in trades in government securities resulting in losses
totaling $550,000 (See "Wall Street Firms Duped by 'Trader,' SEC
Alleges," Washington Post, March 19, 1993, p. Al).
This report is deeply troubling to the Subcommittee, and I
request that the SEC staff provide the Subcommittee staff with an
immediate briefing on the facts and circumstances surrounding the
events described in the £fift£ article. In addition, I request
your assistance and cooperation in responding to the following
questions:
1. Hov do government securities brokers and dealer verify
the identity and creditworthiness of the counterparties they
trade with?
2. Are the policies and procedures employed by government
securities brokers and dealers adequate to prevent or minimize
the potential for con artists, unregistered broker-dealers or
uncreditvorthy broker-dealers from being allowed to trade?
3. Does the Commission see any need for improvement in the
policies and procedures employed by government securities firms
to prevent or minimize the potential for government securities
firms from being victimized by a recurrence of the types of
abuses described in the Post article?
Thank you for your assistance and cooperation in responding
to the Subcommittee's request. I request that your response to
these questions be forwarded to the Subcommittee by April 9,
1993. Should you have any questions regarding this request,
please have your staff contact Jeffrey S. Duncan of the
Subcommittee staff at 226-2424.
Sincerely,

Edward J. Markey
Chairman

137
•OOM

FOUO HOUSC Of'Kl (UN.OIMG

l>ou*e of l&epretfentattoea

0»VI0 « *KJUV.TO»
CHI« COUNSEL *N0 STIFF 0'«ICTO«

Committee on Cnergp anb Commrce
SUBCOMMITTEE ON TELECOMMUNICATIONS AND FINANCE

•aiJjmgton, B C 20515-6119
March 29, 1993
The Honorable Richard C. Breeden
Chairman
Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549
Dear Mr. Chairman:
Thank you once again for your testimony at the
Subcommittee's March 17, 1993 hearing on H.R. 618, the Government
Securities Reform Act of 1993. Your appearance before the
Subcommittee was extremely useful in informing our deliberations
on this important legislation.
In order to address certain issues raised in connection with
the Subcommittee's March 17, 1993 hearing, I would greatly
appreciate your assistance and cooperation in responding to the
attached follow-up questions.
Again, thank you for your assistance and cooperation in
responding to the Subcommittee's request. It is requested that a
response be provided within 10 working days, or no later than
close of business on April 12, 1993. Should you have any
questions regarding the Subcommittee's request, please have your
staff contact Mr. Jeffrey S. Duncan of the Subcommittee staff at
226-2424.
Sincerely

Chairman
Enclosures

138
POST-HEARING QUESTIONS FOR CHAIRMAN BREEDEN
IN CONNECTION WITH
MARCH 17, 1993 SUBCOMMITTEE HEARING ON H.R. 618
1. The Public Securities Association recently submitted a
statement for the record of the Subcommittee's hearing on H.R.
618 which asserts that Section 11 of the bill is "overly broad
and may go beyond the stated objective" of making the use of
false or misleading statements in connection with any bid or
purchase of government securities an explicit violation of the
federal securities laws. In your oral testimony, you indicated
that you saw Section 11 as making explicit for this market area
"that which we believe is already the law in lOb-5, [but] not to
change the law itself." Please provide the Subcommittee with
your analysis of and response to the assertions made in the PSA
statement regarding Section 11.
2. During your oral testimony, you mentioned that "there is
a five-year Treasury issue that is on what in the lingo of the
trade is called on special" and that it was possible for the
existence of such specials could have an adverse impact on
interest rates affecting seekers of home mortgages. Mr.
McDonough stated that the issue in question "is on special in the
repo market, not in the cash market, and it is the cash market
which affects this mortgage seeker that has been brought to our
attention." The attached letter from Mr. Randy Strausberg
suggests that tightness in the repo market also affects interest
rates. Do you agree with Mr. Strausberg's or Mr. McDonough's
analysis? Why?
3. In your response to a question from Representative Oxley
regarding the need to modify the federal securities laws in order
to address so-called "cherry picking" abuses in the government
securities markets, you stated that "I would be happy to look at
and consult our enforcement and general counsel's divisions to
see whether, in their view, a change in the law is necessary or
whether perhaps we ought to sharpen up the rules in that area."
Please inform the Subcommittee whether you Relieve there are any
legislative changes affecting either the Government Securities
Act of 1986 or the Investment Advisers Act OF 1940 which would be
advisable to respond to the problem of cherry picking abuses. In
addition, please inform the Subcommittee of any SEC rule changes
being contemplated for this area.
4. The Subcommittee recently received a letter from New
York Fed President Corrigan which attributed several recent short
squeezes in the market for Treasury securities to "natural market
forces." In general, how does the SEC determine whether a short
squeeze in the Treasury market results from natural market forces
or fraudulent and manipulative activity?
5. Press reports have referred to the short squeeze that
occurred in the April 1991 2-year Treasury notes as the

139
"forgotten squeeze." New York Fed President Corrigan recently
wrote the Subcommittee that for a time, the April 2-year traded
at "an even greater cash market premium than the May 2-year note"
that resulted in Salomon Brothers' troubles. Is there any
information you provide the Subcommittee for the record at this
time regarding the SEC's inquiries into the causes of this
particular squeeze and whether any manipulative activity may have
occurred?
6. Last year's Joint Report highlighted abuses associated
with noncompetitive bidding for Treasury securities and indicated
that the Commission was pursuing investigations in this area.
Last year, Cantor-Fitzgerald publicly confirmed the existence of
an SEC's investigations into their noncompetitive bidding
practices to the press, but vigorously denied any wrongdoing.
More recently, press reports have indicated that the Discount
Corporation disclosed to its shareholders that n the staff of the
Securities and Exchange Commission ("SEC") has advised the
registrant that they contemplate bringing an administrative
proceeding against the registration" alleging violations of the
federal securities laws in connection with submission of
noncompetitive bids. Is there any information you can provide
the Subcommittee for the record at this time regarding the SEC's
findings and conclusions regarding potential wrongdoing in the
noncompetitive bidding area?

140

M.G, Tivon Group

Congressman Edward J. Markey
Chairman, House Subcommittee on
Telecommunications & Finance
Ford House Office Bldg., Rm. 316
Washington, D.C. 20515-6119

March 24, 1993

Dear Mr. Chairman,
As further evidence of my view that squeezes and shortages lead to losses in hedging
vehicles and higher costs to the economy, I have collected some statistics which follow.
My view is that traders cannot properly hedge their risk when current issues are severely
squeezed out of line with other surrounding issues. As a result, they will bid lower than
the market price and, thereby, receive higher yields on securities purchased so they can, in
turn, re-offer to customers at higher yields.
Once a sale is completed, dealers, unable to efficiently hedge, will attempt to maintain
lower inventories, ao that when customers wish to buy. dealers will offer at higher than the
market price, to assure they can buy back the issue sold. Common sense tells you that this
process results in higher than normal volatility. Higher volatility affects the decision
making process of every participant in the credit market negatively,fromthe home buyer
to the home builder who cannot forecast a mortgage rate three months down the road at
closing time; to the business person planning a new factory with long term borrowed
money.
The 9 1/4 of February 2016 and the 7 1/4 of May 2016, issued in February and May of
1986, respectively, will illustrate the problem. (The 7 1/4 were so out of line that they
were reopenedforadditional issuance in August of 1986.) The 9 1/4 issue was owned for
the most part by Japanese holders. By May, the 9 1/4 was trading at about 20 basis points
lower than the yield curve. The new 7 1/4 issue was also bought heavily by the Japanese
and it too traded at lower than normal yields; by August, as much as 30 basis points lower
than the 91/4.

220 Archen Point
Logwood, Fta. J2779
(4Q7) 333-9500 Fax (407) 333-9506

141
In perspective, a trader who had sold short the 9 1/4 bond and hedged with futures would
have lost almost four points in price andfinancingin one month,fromMay 8 to June 2,
1986. That is a loss of $40,000 per million; or a total of $360 million on the entire issue,
In one month. This issue remained out of line for several months more, as did the 7 1/4
issue until August 1986, when it was reopened by the Treasury. In total, losses from
misalignment in both the actual cash market and the repurchase agreement market easily
totaled over $500 million over several months.
How did this affect the economy and the Treasury? Enclosed is a chart showing bond
futures prices in 1986 and 1987. Each line represents the range of prices for one month.
As you can see, these ranges were larger than at any time in the years before. As prices
rise interest rates decline; as prices fall, interest rates rise.
If you were a home buyer, business person, the Treasury or anyone involved in borrowing
or lending, consider this:
In April of 1986, when the tightness in 91/4 bonds began, bond yields were 7.20%.
By June, 1986
By August 1986
By September 1986-By January 1987

8.2%,
7.3%
8.1%
7.25%

By May 1987, bond yields rose to 8 3/4% and by October 1987 were almost 10 1/2%.
Loss of hedging vehicles exaggerates the swings in prices and yields. Business and buying
decisions are impeded when rates are so volatile On an average home mortgage of about
$80,000, that 1% swing m rates is about $70 per month in a mortgage payment. That
happened four times in eight months, before rates rose dramatically in 1987.
Reno Finance Distortion is Costly Too
Tightness in the repo market also affects interest rates. Much has been made in testimony
of the supposed difference between a squeeze in cash market prices that forces issues out
of line and a squeeze in repo rates that "only" affects financing. This contention is
misleading.
When repo rates on a particular issue decline because the issue is on "special", an
arbitrageur may purchase the security and sell in the forward or futures market at a lower
price than otherwise. For example if a ten year issue has a 6% coupon and the repo rate is
3%, the owner earns about $85 per day per million in positive interest cany, since the
interest earned is greater than the interest on the money borrowed tofinancethe security
If the repo rate is one percent, then positive interest carry is $140 per day per million, a
difference of $55 per day. Over three months, that is about $5000 of difference per

142
million of securities. An arbitrageur may sell at lower and lower prices (higher yields)
before hitting break even, just because of the tower repo rate. In yield, that is a difference
of eight basis points higher in interest rates on ten year notes three months forward. How
does that affect the real world?
Every forward commitmentformortgages will be at higher interest rates affected by the
ten year repo rate because forward prices used to hedge commitments will be lower.
Every option used to hedgeriskor forward swaps used tofixrates for business borrowers
will result in higher interest rates if the repo rates on two tofiveyear notes are lower. Just
as a measure, if the $300 billion of mortgage securities sold in 1992 had a higher yield by 8
basis points, that would be a cost to mortgage borrowers of $240 million.
I agree with those who say the Treasury market is the basis for credit pricing for all other
debt markets. Because of this, I believe we should follow the principle that "there is no
free lunch". When hedging costs are affected in the cash or repo market, the cost will
show up in the forward rates, mortgages, portfolio hedging, options and other places. I
believe some regulatory agency must be empowered to gather datafromlarge market
participants on squeezes, large positions, and abusive practices; and make appropriate data
available to the Treasury or take legal action when needed.
Sincerely yours,

Randy M. Strausberg

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144

U N I T E D STATES

SECURITIES AND EXCHANGE COMMISSION
W A S H I N G T O N . D C.
THE

20549

CHAIRMAN

April 23, 1993

The Honorable Edward J. Markey
Chairman
Subcommittee on Telecommunications and Finance
Committee on Energy and Commerce
U.S. House of Representatives
Washington, D.C. 20515
Dear Chairman Markey:
Thank you for your recent letters about the government
securities market and the pending reform legislation.
In response to your letter of March 29, 1993, with followup questions from the Subcommittee's March 17, 1993 hearing on
H.R. 618, a set of responses is enclosed. Also enclosed is a
memorandum prepared by the staff in response to the questions
raised in your letter of March 19, 1993, concerning the
government securities trading activities of JFM Securities, Inc.
With respect to your letter of December 17, 1992, concerning
the profitability of various activities of primary dealers of
government securities, I understand that the Commission staff met
with your staff on February 10, 1993 to discuss the information
that is available from reports filed with the Commission and
subsequently provided certain profitability data filed with the
Federal Reserve Bank of New York.
Please do not hesitate to contact us if you have any
additional questions.
Sincerely

Chairman
Enclosures

145
MEMORANDUM
April 26, 1993
TO:

Chairman Breeden

FROM:

Brandon Becker, Deputy Directory 7
Division of Market Regulation

RE:

Account and Credit Approval Procedures of Government
Securities Brokers and Dealers

v<x

In connection with Chairman Markey 1 s letter to you of March
19, 1993 (attached), you have asked the staff to review existing
rules and procedures relating to the approval of new accounts and
credit approval procedures employed by government securities
brokers and dealers. Chairman Markey's inquiry arises from
reports of the government securities trading activities of Daniel
0. Teyibo ("Teyibo") and JFM Government Securities, Inc. ("JFM").
Facts
A brief recitation of the facts concerning JFM may be
helpful. Based on information received from dealers who had
traded with JFM and the Commission's investigation to date, it
appears that, beginning in approximately March 1991, and
continuing up to the present, Teyibo and JFM (operating under
various aliases) engaged in a "free riding" scheme whereby JFM
accepted profits from government securities transactions
conducted with government securities dealers and refused to pay
for losses on settlement. In other cases, JFM attempted to
effect such transactions but was unsuccessful. Overall, it
appears that Teyibo and JFM accepted profits of approximately
$165,000 and reneged on losses of approximately $550,000 in
connection with trades involving a total of approximately $1
billion of Treasury securities and approximately 25 dealers.
In furtherance of this scheme, Teyibo consistently
misrepresented his status to the dealers with whom he traded or
attempted to trade and provided false or fabricated financial
statements and other documentation in support of these
misrepresentations. In connection with these trading activities,
he variously represented himself as a government securities
dealer, an institutional money manager, or even an account
executive in one of the firm's associated branch offices. He
placed numerous calls to different traders within each firm, and
if he was unsuccessful in effecting a trade in one office, called
traders at other, including overseas, offices of the same firm.
The Commission filed a complaint against Teyibo and JFM for
a permanent injunction and other relief on December 23, 1993.
After receiving evidence that Teyibo had continued to engage in
illicit trading activity under new aliases after the filing of

146
2
the complaint, the Commission sought and obtained a temporary
restraining order and asset freeze on February 23, 1993, and on
March 12, 1993, obtained a preliminary injunction enjoining
Teyibo and JFM from violating the general antifraud provisions
and the government securities dealer registration provisions of
the Securities Exchange Act of 1934 ("Exchange Act"). Discovery
in this matter is continuing.
In responding to the questions raised by Chairman Markey, we
reviewed applicable regulatory requirements and also questioned
four large, integrated broker-dealers that had effected
government securities transactions with Teyibo or JFM with
respect to internal procedures. The following responds directly
to the specific questions raised by Chairman Markey in his
letter.
Question 1. How do government securities brokers and dealers
verify the identity and creditworthiness of the counterparties
they trade with?

ftegppnse
Rules of the Commission and self-regulatory organizations
("SROs"), as well as internal firm guidelines, affect the process
by which government securities brokers and dealers approve
accounts with new customers. It appears that most of the firms
that effected trades with Teyibo were members of the New York
Stock Exchange ("NYSE"). NYSE Rule 405 requires that every
member "specifically approve the opening of an account prior to
or promptly after the completion of any transaction for the
account of or with a customer..." Accordingly, the rule permits
documentation necessary to approve the account to be obtained
after an initial trade is executed but before settlement. In
addition, the rule requires each member to "use due diligence to
learn the essential facts relative to every customer, every
order, every cash or margin account accepted or carried by such
organization and every person holding power of attorney over the
account..."
In addition, Rule 17a-3(a)(9) under the Exchange Act
requires broker-dealers registered under Section 15 of the
Exchange Act to maintain a record for each cash and margin
account showing, among other things, "the name and address of the
beneficial owner of such account."
These rules are designed primarily to require that firms
obtain and maintain adequate documentation in order to ensure
that trades are legally authorized by the account holder and that
the party or parties who are charged with liabilities and
entitled to assets in the account are adequately identified.
Concerns relating to customer creditworthiness are addressed

147
3

primarily by internal firm guidelines, including credit approval
procedures.
In general, government securities and other broker-dealers
have fairly specific internal procedures for accepting new
customer accounts. The type of information required for
institutional accounts varies among firms and includes financial
information, investment experience, and corporate resolutions.
Financial statements may or may not be required to be audited.
Typically, firms provide the name of the customer to a compliance
reporting service that maintains credit information derived from
FOCUS and other reports in order the examine the credit history
of the counterparty. In certain cases, a deposit may be
required, and a personal meeting with the customer may be
requested.
Generally, new accounts are approved in advance of a trade
by a branch or sales manager, although this does not appear to be
an absolute or consistent policy. One dealer indicated to us
that requiring in all circumstances that all account information
be verified prior to conducting an initial trade could pose an
undue burden, although the circumstances in which such trades
should be permitted would be rare. In addition, the manager may
authorize a trade in advance of all new account information being
provided and verified in some circumstances, depending on the
circumstances and the size of the cash trade. This decision is
seen primarily as a "judgment call" by the local manager.
The firms with whom we spoke indicated that, if or when a
new customer names another trader or salesperson as his or her
primary contact at the firm, the individual identified should be
contacted before effecting the trade. One firm indicated that it
had recently reiterated and strengthened its policy in this
regard.
When trading for the first time with a party that identifies
itself as another dealer or an investment adviser, the firm can
identify the counterparty as a registered entity by consulting
one of various lists of registered broker-dealers or advisers
published by private corporations. The firms contacted indicated
that their policy was to confirm that the counterparty was in
fact registered.
The rules and procedures described are intended both to
protect dealers from uncreditworthy or untrustworthy customers
and to protect customers from misunderstandings or unauthorized
trades. The risk to firm capital from free riding schemes or the
poor credit of counterparties is more significantly limited by
margin rules and internal credit approval procedures.
In general, credit approval is not required for cash
transactions, although transactions of large size may involve

148
4
review by the credit department. In general, cash transactions
are considered to consist of those with a settlement period of
five days of less. Settlement of U.S. Treasuries occurs by next
day payment versus delivery. The only credit exposure resulting
from these trades, therefore, is the risk of an adverse one-day
rate movement prior to settlement.
Accounts effecting "credit" transactions, including options,
forwards, repurchase agreements, and derivatives, generally
require approval by a credit department or committee within the
firm in advance of any credit trade. The level of credit review
depends on the type of customer and investment objectives, but
generally will include a financial analysis based on a review of
the financial statements and other information submitted,
assurance that the preliminary credit checks described above have
been conducted, contacting references, discussions with other
firms with whom the customer has traded, and, in some cases, onsite interviews and other due diligence. Once this review has
been completed, the firm assigns an internal credit rating and
limit on aggregate exposure, as well as sublimits in terms of
exposures to different categories of instruments. Depending on
the size of the account and frequency of trading, the credit
rating and limits will be reviewed periodically, e.g.. annually
or monthly. Although the procedures employed appear to be
generally consistent among the firms we contacted, the size of
and resources devoted the credit department vary.
Each of the dealers we contacted maintain a "credit watch"
or "no business" list of customers experiencing financial
difficulty or with whom they have experienced credit problems,
and this list is distributed to the various branch offices
throughout the firm. One of the firms indicated that it had
adopted this procedure recently in response to its experience
with JFM.
Question 2. Are the policies and procedures employed by
government securities brokers and dealers adequate to prevent or
minimize the potential for con artists, unregistered brokerdealers or uncreditworthy broker-dealers from being allowed to
trade?

Respgnss
In general, we believe that the policies and procedures
described are adequate to prevent a material risk to firm capital
from trading with uncreditworthy parties or unregistered brokerdealers. Indeed, it appears that many of the trades effected by
Teyibo and JFM succeeded not because of the inadequacy of
procedures but because of the breach of established procedures by
a few persons. In the great majority of cases, these were cash
transactions that did not involve the potential for significant
loss to the firm. The procedures certainly are not foolproof,

149
5

but we believe that the cost of constructing compliance systems
that would avoid circumvention in all cases by the most skillful
manipulators would outweigh the prospective benefits.
Question 3. Does the Commission see any need for improvement in
the policies and procedures employed by government securities
firms to prevent or minimize the potential for government
securities firms from being victimized by a recurrence of the
types of abuses described in the Post article?
Response
The most prudent compliance systems will not in all cases
detect or prevent fraudulent practices, including free riding
schemes, which derive from an intent not to pay for unprofitable
trades rather than inadequate credit or account approval
procedures. We believe that mandating by regulation the specific
terms of account or credit approval procedures would be of
doubtful utility. In terms of the risk to broker-dealer capital
from the failure to pay for trades ordered by the customer, the
primary regulatory safeguards are the Commission and SRO rules
relating to net capital requirements, early warning procedures,
and similar rules. Apart from these protections, broker-dealers
have a strong incentive, from the standpoint of "business risk,"
to ensure that their counterparties are creditworthy.
Accordingly, we do not at this time see a need for increased
regulatory requirements in this area.

150
Responses to Chairmen Markey*s Post-Hearing Questions on H.R. 618
Question 1. The Public Securities Association recently submitted
a statement for the record of the Subcommittee's hearing on H.R.
618 which asserts that Section 11 of the bill is M overly broad
and may go beyond the stated objective" of making the use of
false or misleading statements in connection with any bid or
purchase of government securities an explicit violation of the
federal securities laws. In your oral testimony, you indicated
that you saw Section 11 as making explicit for this market area
"that which we believe is already the law in 10b-5, [but] not to
change the law itself." Please provide the Subcommittee with
your analysis of and response to the assertions made in the PSA
statement regarding Section 11.

Response
Section 11, which would add to the Exchange Act subsection
15(c)(7), would not alter the Commission's existing authority
under Section 10(b) of the Exchange Act and Rule 10b-5 to
prosecute fraud in government and other securities transactions.
Instead, subsection 15(c)(7) provides strengthened antifraud
protection with respect to the very narrow area that was the
direct focus of the Commission's investigation of Salomon
Brothers and the distributing dealers of government-sponsored
enterprises. Accordingly, we believe that the PSA's concern that
the legislation could "establish a new standard for securities
fraud" is not justified outside the limited context to which the
provision is addressed, and within that context, is overstated.
Subsection 15(c)(7) is distinguishable from the Commission's
authority under section 10(b) and Rule 10b-5 in the following
specific ways.
Scope
Rule 10b-5 applies to false or misleading statements made by
any person in connection with any securities transaction.
Subsection 15(c)(7) would apply only to false or misleading
statements by government securities broker-dealers, bidders, and
purchasers in connection with a new offering of government
securities by an issuer.

Frivati hotlong
An implied private right of action under section 10(b) and
Rule 10b-5 has long been recognized. Because subsection 15(c)(7)
is intended to guard specifically against false statements to the
issuers of government securities, not to other purchasers or
sellers, a private right of action is unnecessary and should not
be inferred.

151
2
Written Statements
Section 10(b) and Rule 10b-5 apply to oral as well as
written statements. Subsection 15(c)(7) would apply only to
written statements, which are specifically required of bidders in
Treasury auctions and distributions of GSE securities.

Rulemaking
Section 10(b) provides authority to the Commission to define
by rule acts and practices that are fraudulent. Subsection
15(c)(7) would not grant any additional rulemaking authority to
the Commission.

Materiality
Rule l0b-5 expressly applies to false or misleading
statements or omissions of material fact. Although we believe
that the abuses uncovered in the Salomon and GSE cases were
violative of Rule 10b-5, subsection 15(c)(7) does not contain an
express materiality standard. Because of the narrow range of
misstatements that would be covered, we believe that a
materiality requirement is not necessary in this context. Minor
violations are unlikely to be prosecuted, and bidders and dealers
can easily avoid liability by ensuring the accuracy of written
statements addressed to the Treasury or another issuer.
Knowledge Standard
Section 10(b) and Rule 10b-5 apply to statements made with
scienter, which the Supreme Court has defined as "a mental state
embracing an intent to deceive, manipulate, or defraud." 1/
Subsection 15(c)(7) would apply to written statements made
"knowingly or willfully." 2/ Thus, although subsection 15(c)(7)
would require proof that a person knowingly submitted a bid that
was false, it does not require an intent to defraud as under
Section 10(b).
Question 2. During your oral testimony, you mentioned that
"there is a five-year Treasury issue that is on what in the lingo
of the trade is called on special" and that it was possible for
the existence of such specials could have an adverse impact on
interest rates affecting seekers of home mortgages. Mr.
McDonough stated that the issue in question "is on special in the
repo market, not in the cash market, and it is the cash market
1/

Ernst * Ernst v. Hochfelder. 425 U.S. 185, 193-194 n.12
(1976).

See generally 137 Cong. Rec. 13733, 13734 (statement of Sen.
Dodd in support of S. 1699).

152
3
which affects this mortgage seeker that has been brought to our
attention." The attached letter from Mr. Randy Strausberg
suggests that tightness in the repo market also affects interest
rates. Do you agree with Mr. Strausberg 1 s or Mr. McDonough*s
analysis? Why?

The Commission recognizes that the regular-way secondary
market in Treasury securities ("Cash market") and the Repurchase
Agreement market in Treasury securities ("Repo market") are
separate markets, each with its own dynamics, but it does not
appear that these two markets are totally unconnected. It is
possible that price distortions due to a supply shortage or
"squeeze" may develop independently in the Repo market. We
believe, however, that it is an overstatement to say that
squeezes that originate in the Repo market cannot have spillover
effects on rates in the Cash market. Because Treasury securities
act as benchmarks for a wide range of other rates in the national
economy (including mortgage rates), any spillover that might
occur in the Cash market can have widespread ramifications.
Accordingly, in order to maintain a comprehensive overview of the
Treasury securities markets, the surveillance staffs of the
Commission and the Federal Reserve Bank of New York ("FRBNY")
routinely review rates in both the Cash market and the Repo
market.
The complex relationships between the Cash and Repo markets
are illustrated by the rates evidenced in mid-March 1993 for the
February 1998, 5 1/8 coupon five-year Treasury notes. During
this period, our systems indicated that the five-year notes were
trading in a range of 250-300 basis points below general
collateral in the Repo market, a deviation that the staffs of the
Commission and the FRBNY viewed as significant. In other words,
the low rates in the five year notes were indicative of strong
demand, constrictions of supply or some combination thereof in
the Repo market.
During the same period, a yield curve regression analysis
routinely conducted by the FRBNY staff indicated that the yield
in the five year notes was running a few basis points lover in
the Cash market than what was "predicted" by the yield curve. In
other words, the lower rates indicated higher prices in the Cash
market than might be indicated by a comparison with rates in
Treasury securities with similar durations. In discussions among
the agency staffs participating in the Working Group for Treasury
Securities, however, there was a consensus that a deviation of
only a few basis points in the Cash market did not appear, in
itself, to be significant in the prevailing market environment.
At that time, the FRBNY regression analyses were indicating that
all of the current or "on-the-run" Treasury notes were trading at

153
4
rates that were a few basis points lower than predicted by the
yield curve.
Question 3. In your response to a question from Representative
Oxley regarding the need to modify the federal securities laws in
order to address so-called "cherry-picking" abuses in the
government securities markets, you stated that N I would be happy
to look at and consult our enforcement and general counsel's
divisions to see whether, in their view, a change in the law is
necessary to whether perhaps we ought to sharpen up the rules in
that area." Please inform the Subcommittee whether you believe
there are any legislative changes affecting either the Government
Securities Act of 1986 or the Investment Advisers Act of 1940
which would be advisable to respond to the problem of cherry
picking abuses. In addition, please inform the Subcommittee of
any SEC rule changes being contemplated for this area.

Response
"Cherry picking" by an investment adviser occurs when the
adviser places an order for securities for a group of clients
and, after prices have changed, allocates them among clients in a
way that advantages certain clients at the expense of others.
That practice violates the fiduciary duties of the adviser and is
a violation of Section 206, the anti-fraud provision of the
Advisers Act. The Commission currently has sufficient
legislative authority to address these practices. Section 206(4)
authorizes the Commission to adopt rules reasonably designed to
prevent fraudulent acts and practices.
In addition, Section 204 permits the Commission to require
advisers to keep records of all brokerage transactions, which
permits Commission staff to identify such abusive practices.
Under this authority, the Commission has adopted Rule 2042(a)(3), which requires registered advisers to create and
maintain a memorandum of each brokerage order and of any
modification or cancellation of the order. The memorandum must
identify the account for which the order is entered. This
recordkeeping requirement is designed to create a paper trail to
inform Commission examiners of abusive practices such as cherrypicking. Because, as a practice, investment advisers complete
these memoranda contemporaneously with the order, cherry-picking
can be discovered.
Because these rules appear adequate to deal with this
relatively rare practice, no new rules are currently contemplated
in this area.
Question 4. The Subcommittee recently received a letter from New
York Fed President Corrigan which attributed several recent short
squeezes in the market for Treasury securities to "natural market

154
5
M

forces.
In general, how does the SEC determine whether a short
squeeze in the Treasury market results from natural market forces
or fraudulent and manipulative activity?

Response
Under the framework of the Working Group for Treasury Market
Surveillance, the Federal Reserve Bank of New York gathers
information with respect to Treasury securities markets
(including the Cash and Repo markets). While there are no audit
trails or other SEC surveillance systems in the government
securities market, the SEC monitors, to the extent practicable,
suspicious price/yield and volume movements and overall market
conditions using our own automated systems.
Reports concerning dealer practices and market activity are
analyzed to determine if there appear to be significant
concentrations of positions at particular firms or by particular
customers. If such concentrations are indicated, the parties are
contacted by the FRBNY staff in order to obtain their
explanations of trading strategies or other rationales for
acquiring and maintaining such large positions. The explanations
offered by these parties are scrutinized in order to determine if
they are credible and consistent with market perspectives
obtained from other market participants. At that point, if
necessary, further inquiries are made to determine if one party
has attempted to control or influence prices/yields artificially
or if several parties may have colluded to accomplish the same
results. In such cases, the SEC, as part of its responsibility
as the primary enforcement agency for this market, would
investigate and if appropriate prosecute for violations of the
securities laws.
This framework was followed in each of the Treasury note
"squeezes" mentioned in the letter from FRBNY President Corrigan.
These situations and the preliminary findings of the FRBNY were
discussed among the agency staffs participating in the Working
Group. In each instance, the FRBNY believed that there appeared
to be legitimate explanations, based upon prevailing market
dynamics, to indicate that position concentrations were not
sufficiently suspicious to warrant further investigation. While
we have no reason to disagree with the FRBNY findings, the SEC is
not, of course, bound by any such determination by the FRBNY, and
the final decision concerning whether the SEC will seek to
investigate possible violations of the federal securities laws
remains that of the SEC alone.
Question 5. Press reports have referred to the short squeeze
that occurred in the April 1991 2-year Treasury notes as the
"forgotten squeeze." New York Fed President Corrigan recently
wrote the Subcommittee that for a time, the April 2-year traded
at "an even greater cash market premium than the Nay 2-year note"

155
6
that resulted in Salomon Brothers' troubles. Is there any
information you can provide the Subcommittee for the record at
this time regarding the SEC's inquiries into the causes of this
particular squeeze and whether any manipulative activity may have
occurred?
Response
At this time, we cannot provide any information for the
record in response to the foregoing question concerning the April
2-year notes.
Question 6. Last year's Joint Report highlighted abuses
associated with noncompetitive bidding for Treasury securities
and indicated that the Commission was pursuing investigations in
this area. Last year, Cantor-Fitzgerald publicly confirmed the
existence of an SEC investigation into their noncompetitive
bidding practices to the press, but vigorously denied any
wrongdoing. More recently, press reports have indicated that the
Discount Corporation disclosed to its shareholders that "the
staff of the [SEC] has advised the registrant that they
contemplate bringing an administrative proceeding against the
registration** alleging violations of the federal securities laws
in connection with submission of noncompetitive bids. Is there
any information you can provide the Subcommittee for the record
at this time regarding the SEC*s findings and conclusions
regarding potential wrongdoing in the noncompetitive bidding
area?

RgffP9ngg
At this time, we cannot provide any information for the
record in response to the foregoing question concerning
noncompetitive bidding.

156
B HOUST 0»'<CI (UIUMMG

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SUBCOMMITTEE ON TELECOMMUNICATIONS AND FINANCE

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JIM COOFFR TTNNCSMZ
JOHN 0 OINGCU. MICHIGAN

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March 29, 1993

The Honorable David W. Mullins
Board of Governors of the
Federal Reserve System
20th and C Streets, N.W.
Washington, D.C. 20551
Dear Mr. Mullins:
Thank you once again for your testimony at the
Subcommittee's March 17, 1993 hearing on H.R. 618, the Government
Securities Reform Act of 1993. Your appearance before the
Subcommittee was extremely useful in informing our deliberations
on this important legislation.
In order to address certain issues raised in connection with
the Subcommittee's March 17, 1993 hearing, I would greatly
appreciate your assistance and cooperation in responding to the
attached follow-up questions.
Again, thank you for your assistance and cooperation in
responding to the Subcommittee's request. It is requested that a
response be provided within 10 working days, or no later than
April 12, 1993. Should you have any questions regarding the
Subcommittee's request, please have your staff contact Mr.
Jeffrey S. Duncan of the Subcommittee staff at 226-2424.
Sincerely,

Chairman
Enclosure

157
P08T-HEARING QUESTIONS FOR MR. MULLINS
IN CONNECTION WITH
M U C H 17, 1993 SUBCOMMITTEE HEARING ON H.R. €18
1. In a recent letter to the Subcommittee, Federal Reserve
Board Chairman Greenspan stated that the Fed does "not lend for
short sales," that it "limit[s] the amount of a security lent to
a dealer at any time," and that when its holdings are small it
sometimes rations in cases of heavy demand. Please provide the
Subcommittee with responses to the following questions:
A.) What is the rationale for not lending for short
sales, given the fact that counterparties who are not
short would presumably be free to relend the securities
to those who are?
B.) What limits does the Fed place on the amount of a
security it lends to a dealer at any time, and what is
the justification for these limits?
C.) How does the Fed go about rationing supply of a
issue in cases of heavy demand?
2. In the aforementioned letter, Chairman Greenspan also
indicated that the Fed does not offer a lending facility for its
foreign and international accounts. Why is this? Are you at all
concerned that the failure to provide such a lending facility may
reduce market liquidity or efficiency?
3. The Greenspan letter also stated that the Fed does not
"pre-screen collateral when accepting propositions" when it
provides reserves through repurchase agreements, and that "many
of these securities are considered to be 'lightly special'
because their rates are not far from general collateral rates and
because they are on and off special so quickly." Please provide
responses to the following questions:
A.) Why doesn't the Fed pre-screen collateral when
providing reserves through repurchase agreements?
B.) What criteria does the Fed use to define when a
security is "lightly special"?
C.) What criteria does the Fed employ to determine
when an issue is "on significant special"?
D.)

When and how were these criteria adopted?

E.) If an issue were 25 basis points or more from
general collateral, why wouldn't the Fed want to adopt
a policy of generally not accepting such collateral in
order to reduce the potential for a squeeze in the
issue?

71-390 0 - 9 3

158
4. Chairman Greenspan's letter also indicated that since
January 1, 1991 the Fed had accepted collateral that was on
Significant special** — which he defined as 50 percent of the
general collateral rate — a total of 8 times. Please provide a
chart indicating how many times between January 1, 1991 and
December 31, 1993 the Fed accepted collateral that was on
special. In this chart, please provide a breakdown of how many
times the security accepted was: 1) less than 25 basis points of
general collateral; 2) between 25-50 basis points of general
collateral; 3) between 50-75 basis points of general collateral;
75-100 basis points of general collateral; and, over 100 basis
points of general collateral.
5. Chairman Greenspan's letter also indicated that the Fed
preferred **not to take items for which there is a great demand in
the repo market,** and that "if we do get them, we review the
surrounding circumstances and, as appropriate, contact the
submitting dealer firm to advise it that we prefer not to be
shown this type of collateral." From January 1, 1991 to December
31, 1993, how many times has the Fed rejected collateral on this
basis? In each case, how many basis points from general
collateral was the issue?
6. During the Subcommittee's hearing, Mr. Randy Strausberg,
a former New York Fed official, testified that to effectuate a
manipulative strategy "players attempt to tighten an issue in the
financing market by talcing them 'off the street' to a lender that
will not recycle the securities." Does the Fed monitor all of
the collateral it accepts when it provides reserves through
repurchase agreements to assure that it is not being utilized by
market participants seeking to take an issue off the street and
put it on special?
7. Of the collateral the Fed accepted between January 1,
1991 and December 31, 1992, how many instances did the issue
subsequently trade 25 basis points or more from general
collateral?

159

BOARD

QF
GOVERNORS
• F THE

F E D E R A L R E S E R V E SYSTEM
W A S H I N G T O N , • . C. 2 0 5 5 1
• AVID

VICE

M U L L I N S ,

JR.

CHAIRMAN

June 3, 1993

I hope that you find my specific responses to your

questions, which are enclosed, helpful.
Sincerely

Enclosure

160
Q.l.

Chairman
sales,"
any
in

recent

Greenspan
that

time."
cases

and

responses

given

the

free

Q.l.A.

established
that

could

its

demand.
following
is

that

Fed

amount

provide

rationale

for

help

avert

market.

The

program

securities

lending

program

market.

about

each

day

$13

averaged

contrast,
in

dealers

securities

security

What

lends

$10

The

million

million
chosen

of
to

size

$236

for

the

with

million

facility

the

The

loan

was

size

minimize

the
size

relative

the

past

two

years

securities

out

$180

the

any

by t h e

small

problems

smooth

constrained

and

presumably

strategies

therefore

1991

reverse

would

structured

amount

short-sales,

settlement

trading

average

for

short

and

short.

total

limits
to

does

dealer

those

the
at

million

hundreds

loan

1992.

billions

dollars

securities
the

Fed
any

place
time,

on t h e

amount

and what

the

limits?

limits

are

$50 m i l l i o n

any one T r e a s u r y

reflect

rations

day.

lending
for

and

and t h e

borrow or

each

justification
A.l.B.

The

million,

a dealer

are?

lending

necessarily

holdings

not
who

negative--on
securities

overall

Subcommittee

lending

clearance

selling

was

Board

short

sometimes

disruptions

Reserve's

for

lent

not

securities

such

Federal

lend

security

the

those

practices,

the

"not

Reserve

small

who a r e

unnecessary

positive

are

Federal

questions:

securities

does

holdings

Reserve's

the

effect--either

the

counterparties

Federal
solely

Subcommittee.

Please

the

result

functioning

the

when

the
What

the

that

"limit(s)

relend

The

stated

that

fact

heavy

to
A.

letter

lent

typical

any

note
one

market

for

any

one T r e a s u r y

bond,

and

a total

dealer.

These

transaction

size

limits
and.

bill.

$150

were
with

our

161
-6-

holdings

some

accommodate
in

all

an e q u i t a b l e

designed

supplement
clearing

cases

manner.

them

the

private
sake

Hov d o e s

heavy

requests,

dealers

generally

the

day

Reserve's

the

Fed

the

are

set

volume

holdings

amounts

letter.

that

the

Fed

does

international
failure

liquidity

provide

the

organizations

that

Federal

assets.

hold

based

morning

on o u r
The

issue

holdings,

amounts

and may b e

requests

Chairman

the

rationed

increased

and t h e

Greenspan

facility

this?

Are

lending

retain

T h e y may l e n d

own i n i t i a t i v e
The G r e e n s p a n

and

later

Federal

for

you a t

facility

its
all

also

indicated

foreign

and

concerned

may r e d u c e

that

market

through

accepting

considered

full

those

also

repurchase

from general

banks

and

their

international

dollar

control

denominated

over

the

other

securities

assets

disposition
parties

discretion.

letter

collateral.when

are

central

a portion

Reserve

Q.3.

far

lending

Why i s
such

foreign

their

securities

supply

efficiency?
The

not

offer

accounts.

not

A.2.

are

not
only

permit.

aforementioned

screen

but

functioning

requested.

the

reserves

relationship

p r o g r a m was

rationing

subsequent

those

ability

arrangements,

efficient

issue

Q.2.

the

our

a trading

lending

market

go a b o u t

specific

and t h e

with

assure

demand?

Rationing

the

w h i c h we h a v e

Moreover,

with

for

limited,

with

mechanism.

number

quite

dealers

compete

A.l.C.

issues
the

stated

that

propositions"

agreements,
be

the

when

and t h a t

'lightly

collateral

Fed

rates

special'

does
it

"many

not

provides
of

because

and b e c a u s e

"pre-

they

these
their
are

rates
on

and

162
-4-

off special so quickly."

Please provide responses to the following

questions:
A.

Why doesn't the Fed pre-screen collateral when providing

reserves through repurchase agreements?
A.3.A.

The

operations

primary
is

institutions.
Reserve

arrange
system
a.m.

review

need

repo

which
the

Reserve

reserve

objectives.

our

operation
period

need

for

process

is
of

specific
was

issue

issues

and

propositions
with

in
to

noon

use

thus

then

the

a position
until

system's
decisions
do

repo.

issues

dealers
Since
the

takes

know

after

our

minimizing

our

the

with

securities,

Hence,

contingent

market

afternoon
for

and

complete

banking

different

accepted.
not

amount

consistent

the

11:30
we

changing

around

delivered

about

later,

we t r y

banking

advantageous

possible,

pricing
in

whether

market

the

dollar

amount

possible

depository

Federal

collateral.

Only

and
not

most

the

intend

were

a dealer

terms

dealers

the
to

dealers

possibly

a number

we a r e
is

they

recording,

that

offers.

provide

Thus,

collateral

the

enter

a premium,

quickly

determine

15 m i n u t e s

those

promptly

their

or
to

time.

transaction

and

up t o

exposed

We n o t i f y

assembling,

announced

do t h e

are
as

reject

likely

considerable

rate,

the

specific

reserves

10 t o

stated
the

market

available,

picture

we d e c i d e

About

open

available

become

we c o n t a c t

time

efficiently
dealers

reserves

additional

are

Reserve

reserve

and

Since

new d a t a

indicate

and m e e t i n g

which

a dealer

which

terms

reserves.

tell

that

conditions

made.

propositions

the

current

basis),

not

Federal

supply

provides

propositions,

but

propositions.

Federal

(which

request

evaluate

the

on a t e m p o r a r y

receive
rate

manage

Each morning

staff

adjustments

objective

the

our

the

on t h e

operation

agreement
specific

163
-4-

security

used

below,

we h a v e

deeply

the

criteria

What

criteria

participants

Greenspan's

letter

special"

was

rate"

order

Fed

and

detailed

securities

that

effectively

define

employ t o

criteria

are

making

when a

security

determine

when

"lightly

special",

the

1993,
50

this

the

basis

Fed w a n t

collateral

order

adopt

the

Federal
In

"on

the

market

Reserve

significant

your

more f r o m

the

Chairman

general
to

a policy

reduce

significant
used

area.

answer

points

"on

terms

phrase

percent

a quantitative
25

are

Certainly,

taxonomy

"about

were

adopted?

"specialness"

sense.

February

issue

collateral
question.
general

generally

potential

for

issue?

Federal

Reserve

on s p e c i a l
to

such

formulate

such

the

deeply

these

formal

why w o u l d n ' t

accepting

The

collateral,

any

specified

Public

the

a qualitative

established

squeeze

and

special"?

special",

are

does

significant

Phrases

We i n t e n d

Fed u s e

When a n d how w e r e

A.3.E.

receive

the

"on

"deeply

not

community,

does

a n d D)

not

dealer

matter

collateral.

special",

not

a practical

preference
to

A.3.(B.C.

has

special"?

C.
is

our

plain

pre-screen

What

"lightly

issue

made

special

unnecessary

collateral.

remind

Securities

that

has

a policy

should

them o f

our

Association

not

familiar

policy

which

taking

the

all

securities

primary

that

dealers.

upcoming

meeting

will

all

the

primary

dealers

that

the

rate

which

the
be

represented.
With
security
of

the

early

trades

day.
in

that

the

or
a

said,
is

would

quoted

result,

morning might

note

updated

a security
not

continuously

that

considered

over

deemed t o
to

given

the

course

"on

special"

"special"

later

the

164
-6-

same m o r n i n g
securities
rate

without

Q.4.

the

times

breakdown
basis

100

basis

The d a t a

would

caution

unusual

for

day.

pertain
the

rates

repo

rates

morning

repo

New Y o r k R e s e r v e
issues

conclude

the

that

Federal

Reserve

1991
as

1991.

had t o

As
be

reliable;

collateral

indicating

1992

the

please
was:

25-50

points

general

January

"significant

accepted

Fed

accepted
a

than

less

basis

how many

provide

points

general

collateral;

data

the

dealers

and.

over

data

the

formal
repo

from
for

although

over

the

course

the

attached

the

securities

by which t i m e
one

table

contributed

use
to

database

data

the

sources

remainder

as
a

repo

the

rates

below

the

collateral

shortage.
rates

first

that

table

necessarily

were t r a d i n g

their

for

repo

cannot

I
not

that

other

the

below,

from them.

transfer

Hence,

may h a v e

a consequence,

table

considerably

therefore,

maintain

the

conclusions

afternoon,

reflected
and.

repo

collateral

since

general

chart
31,

basis

changed.

reconstructed
the

between

derive

but

the

operations

Bank b e g a o

September

not

Reserve

fluctuate

may h a v e

rate

for

general

that

the

chart,

security

strong

used

issues

collateral

was
of

December

50-75

rates,

Bank

that

presented

draw

common

collateral.

are

indicated

provide

points

squeeze.

In t h i s

the

from the

percent

and

between
basis

not

also

collateral;

general

on p a r t i c u l a r

general

1991

requested
you

special.

75-100

repo

The
to

general

points

A.4.

the

Please

away

collateral

times.

was

letter

collateral;

threat

how many t i m e s

points

general

Further,

points

defined

January

that
of

accepted
he

between

collateral

basis

Greenspan's

Fed h a s

total

afternoon.

concern

special"--which
rate--a

the

trade

Chairman

1991

are

nine

The

mid-

months

probably

period

you

Securities Accepted as Repo Collateral
That Were Quoted at Rates below the General Collateral Rate
Basis points below the general collateral rate
Less

than 25

1991

Total Desk
Repo Collateral
($ mil.)
Within each
category ($ mil.)

25 to 5Q

51 to 75

76 to 100

Greater t
than 1003

508,650

24,369

406

6,811

7 ,508

2,286

7,358

•

Percent of total

4.8

0.1

1.3

1.5

0.4

1.4

•

Number of items

151

1992

Total Desk
Repo Collateral
($ mil.)
•

Within each
category ($ mil.)

•

Percent of total

•

Number of items

9*
C71

533.378

7 .854
1.5
42

3,417

1,503

659

2,225

0.0

0.6

0.3

0.1

0.4

1. The repo rates used are taken from morning indications, while the collateral is submitted to the
Federal Reserve in the afternoon.
2.

Estimated from two different data sources on repo rates.

3. These include the 8 occasions cited in Chairman Greenspan's February letter in which the
securities were quoted at less than one-half the general collateral rate.

166
- 6 -

requested are given to us by dealers as indications of where rates
were over the course of the morning.
To put the figures in the table in some perspective, the
Federal Reserve accepted collateral in the form of approximately
20,000 items totalling over a trillion dollars in 1991 and 1992.

The

average dollar amount of each item in the categories you requested was
only $167 million.

Given the enormous volume of trading in the

Treasury market, it is hard to envision how the acceptance of these
securities could have had a discernible impact on their financing
rates.
5.

Chairman

"not

Greenspan's

take

market,"

items

and t h a t

circumstances
to

advise

From J a n u a r y
rejected
points
A.5.
the

from

that
1,

collateral

to
in

might

have

operation

we
item

the

are

after

was

such

a handful

amounts
of

that

we d o

want

days,

shown

instances
to

31,

that

and t h e
warranted

receive

this

preferred

the

repo

the

surrounding

submitting
type

case,

dealer

firm

collateral."
has

how many

3 , we d o n o t

course,

rate

either
the

we d o

Because

demand

we h a v e

review

Fed

the

Fed

basis

issue?

fact.

great

the

how many t i m e s

each

question

special

the

1992,
In

the

that
demand

shown t h i s

collateral

significantly

great

we r e v i e w

was t h e

answer

general

prior

presented.

that

contact

basis?

When we f i n d

Only

not

collateral

indicated

them,

December

receive

day.

been
or

the

that

the

get

on t h i s

that

later

1991

also

there

appropriate,

we p r e f e r

general

fluid,

letter

which
we d o

discussed

securities

closer

"if

and.

collateral

very

for

early
when

evaluate
the

in
is

received
on t h e

shown t o

intraday

the

trading.

dealer

security.

tha~

circumstances -

a security

a call
of

d a y may

day o f

surrounding

the

repo market

the

pattern

type

pre-screen

advising

167
Q.6.

During

former

the

New Y o r k

manipulative
financing
not

Subcommittee's
Fed

strategy

market

recycle

official,

the

collateral

accepts

assure

when
that

seeking

attempt

them

securities."

agreements

participants

"players

taking

hearing,

testified

'off

Does

Mr.

the

not

take

issue

Strausberg.

effectuate

tighten
street'

an
to

Fed m o n i t o r

provides

Randy

that

reserves

being

the

a lender
of

through

utilized

off

issue

all

street

a
the
that

will

the

repurchase

market
and

put

special?
A.6.

Yes,

described

above,

we r e v i e w

all

the

securities

we t a k e

January

1991

repo.
Q.7.

the

collateral

December

31.

1992.

points

basis

A.7.

Most

manner

that

specialness
its

life

reflects

cycle,

from

well

hedging

strategies

may b e

basis

particularly
points

reviewed

away

small

500

one-tenth

collateral

from general

these,

market

period

approximately

general

have

However,
repo

a two-month

about

below

not

a handful
amounts).

More
useful

general
the

late

1992.

sets

the

held

hedging

market
degree

15 t o

its

trade

of
issue

usefulness
and n o t

basis

issues,

risk,

often

answer

some
of

heavily

points

issues

trade

sample,

100

quotes,
within

Fed

point
as

basis

than

during

the

collateral

matter,

traded

consists

indicates
25

question

on t h e

issues

which

repo

moved

your

light

active

were

some

the

shed

sample
The

morning

traded

necessary

that

and

collateral.

intraday

issues

collateral
were

special

The

including

only

an o n - t h e - r u n

actively

trade

an a t t e m p t
for

the

less

actively

data

quotes

on w h e r e

factors

are

might

collateral.

We do
directly.

other

that

subsequently

extent,

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168

VJt.fcoufieof &epre*entattoe*
ClKff ««fe CtMMICI
SUBCOMMITTEE ON TELECOMMUNICATIONS AND FINANCE

OUffrngton. M 20515-6110
March 29, 1993
Mr. William J. McDonough
Executive Vice President
Federal Reserve Bank
of New York
33 Liberty Street
New York, NY 10045
Dear Mr. McDonough:
Thank you once again for your testimony at the
Subcommittee's March 17, 1993 hearing on H.R. 618, the Government
Securities Reform Act of 1993. Your appearance before the
Subcommittee was extremely useful in informing our deliberations
on this important legislation.
In order to address certain issues raised in connection with
the Subcommittee's March 17, 1993 hearing, I request your
assistance and cooperation in responding to the attached followup questions.
Again, thank you for your assistance and cooperation in
responding to the Subcommittee's request. It is requested that a
response be provided within 10 working days, or no later than
April 12, 1993. Should you have any questions regarding the
Subcommittee's request, please have your staff contact Mr.
Jeffrey S. Duncan of the Subcommittee staff at 226-2424.
Sincerely

]

Chairman
Enclosures

169
P08T-HEARING QUESTIONS FOR MR. MCDONOUGH
ZN CONNECTION WITH
MARCH 17/ 1993 HEARING ON H.R. 618
1. During the hearing, SEC Chairman Breeden mentioned that
"there is a five-year Treasury issue that is on what in the lingo
of the trade is called on special" and that it was possible for
such specials to have an adverse impact on interest rates
affecting seekers of home mortgages. You stated that the issue
in question "is on special in the repo market, not in the cash
market, and it is the cash market which affects this mortgage
seeker that has been brought to our attention." The attached
letter suggests that tightness in the repo market also affects
interest rates. Do you agree or disagree with this analysis, and
if so, why?
2. In a recent letter to the Subcommittee, President
Corrigan said that "a market participant alone or acting in
concert with others, could attempt to corner or manipulate the
market for a particular security with the intention of generating
an artificial shortage." At the same time, both his letter and
your testimony attribute recent episodes of Treasury securities
trading "on special" to natural market forces. How do you
distinguish a "natural squeeze" from a "manipulative squeeze"?
3. President Corrigan also stated in his letter to the
Subcommittee that the New York Fed "remain[s] mindful that the
manner in which...market participants pursue profit opportunities
can raise concerns of whether some participants exert any undue
influence on market prices and financing rates." At what point
do you become concerned that a market participant was exerting
"undue influence" on market prices or financing rates?
4. President Corrigan's letter also noted that a single,
large non-dealer firm acquired a sizable position in the December
1991 5-year Treasury note in when-issued trading and the auction,
and then "executed repurchase agreements with dealers when it was
possible to ensure a sufficient profit after expenses." Aside
from the issue of auction rule violations, how does this type of
activity differ from what Mr. Mozer reportedly was trying to do
in the financing market following the May auction?
5. President Corrigan's letter also said that following the
auction of the August 1992 10-year note "a number of market
participants attempted to profit from their perception of an
imbalance between the level of — short positions and the
availability of the 10-year note from holders willing to lend
their securities. While this activity helped redistribute the
note to market participants seeking to satisfy their delivery
obligations, at times it also may have enhanced the temporary
scarcity value of the 10-year note and contributed to maintaining
large rate concessions in the financing market." Aside from the
issue of auction rule violations, how does this behavior differ
from what Mr. Mozer and others reportedly were doing with the

170
April and May 1991 2-year notes?
6. During the Subcommittee's hearing, one of the witnesses
testified that when Treasury issues go on special, "the greatest
cost to the Treasury results from the loss of hedging vehicles,"
because "when hedging securities are hard to borrow, when yield
spreads to surrounding issues change unpredictably, when traders
lose money simply by servicing their clients, the market will
become less efficient; traders will bid lower and widen their
bid-to-offer spread — other things being equal, yields will be
higher than they ought to be." Do you agree that these adverse
consequences can result from a squeeze caused by "natural market
forces." If so, shouldn't one objective of reopening policy be
to minimize the potential for such inefficiencies?
7. President Corrigan's letter to the Subcommittee argued
that "there is not, and perhaps will never be, a neat and precise
definition of 'acute and protracted'" short squeezes. Corrigan
also cautioned "against relying solely on simple statistical
criteria, especially to the exclusion of judgment regarding the
ability of the market's normal adjustment mechanism to work
through temporary conditions." In contrast, one of the witnesses
at the Subcommittee's hearing argued that frequent short squeezes
result in losses in hedging vehicles and higher costs. To
respond to this situation, the witness suggested that "the
Treasury should adopt a clear cut policy for reopening tight
issues regardless of the cause" and develop "a statistical
measure of the market's difficulty with an issue." What is the
Hew York Fed's justification for not relying primarily on
statistical measures, appropriately supplemented with judgments
about the state of the market, in order to determine when an
issue trading on special should be reopened?

171
F E D E R A L R E S E R V E BANK OF N E W YORK
N E W Y O R K , N.Y.
A R E A

C O D E

FACSIMILE

WILLIAM J.

10045-0001

212
212

7 2 0 - 6 I S 0
7 2 0 - 8 6 S I

MCDONOUGH

Executive Vice

Prcsiocnt

April 13, 1993

The Honorable Edward J. Markey
Chairman
Subcommittee on Telecommunications
and Finance
Committee on Energy and Commerce
House of Representatives
Washington, D.C. 20515
Dear Mr. Chairman:
Your letter of March 29, 1993 contained some follow-up
questions arising from the March 17 hearing before the
Subcommittee and from Mr. Corrigan's January 25, 1993 responses
to your December 17, 1992 letter.
My responses to your recent questions are enclosed.
I can be of further assistance, please let me know.
Sincerely

Enclosure

172
FEDERAL RESERVE BANK OF NEW YORK
QggSTIQN 1
During the hearing, SEC Chairman Breeden mentioned that
"there is a five-year Treasury issue that is on what in the lingo
of the trade is called on special11 and that it was possible for
such specials to have an adverse impact on interest rates
affecting seekers of home mortgages. You stated that the issue
in question "is on special in the repo market, not in the cash
market, and it is the cash market which affects this mortgage
seeker that has been brought to our attention.1' The attached
letter suggests that tightness in the repo market also affects
interest rates. Do you agree or disagree with this analysis, and
if so, why?
The point of my remark was that the yield on this issue
in the cash market, while possibly a bit lower than other
surrounding issues, was about normal.
In my view, in a broad context, a mortgage seeker
ultimately feels only very small—essentially

negligible—effects

from activity in the financing market for Treasury securities.
Because homeowners repay their loan principal gradually
throughout the life of their mortgage, these loans produce cash
flows that differ fundamentally from their Treasury market
counterparts.

As a result, the Treasury market provides an

imperfect hedge for the mortgage market.

While this hedge is

clearly valuable, it has its limits and, importantly, market
participants have increasingly come to recognize and compensate
for these limits.
In determining their benchmark lending rate, mortgage
lenders sample rates for a number of different Treasury
maturities over a few months* time.

Thus, mortgage pricing

relies on general stability in the overall yield curve and not at
any one individual point in time.

Our work over the past year

has shown that the impact of "natural•• shortages on yield-curve

173
- 2 -

relationships appears only small and temporary, thereby leaving
critical relationships unaffected over a somewhat longer
timeframe.

After the mortgage lenders determine the appropriate

benchmark rate, the actual rate they offer to the homeowner will
also reflect the outlook for the broader conditions in the
overall mortgage market, further weakening the linkage between
mortgage loan rates and activity in the Treasury market.
A change in cash Treasury yields could affect certain
adjustable-rate mortgages if they are tied to a particular
Treasury security.

Strong demand for Treasury issues and the

resultant scarcities that may develop in particular issues act to
push yields down, thereby perhaps generating a beneficial effect
to borrowers in the mortgage market.

QUESTION 2
In a recent letter to the Subcommittee, President
Corrigan said that N a market participant alone or acting in
concert with others, could attempt to corner or manipulate the
market for a particular security with the intention of generating
an artificial shortage. M At the same time, both his letter and
your testimony attribute recent episodes of Treasury securities
trading '*on special1* to natural market forces. How do you
distinguish a "natural squeeze" from a "manipulative squeeze11?
In a broad sense, a natural shortage or so-called
"squeeze" can occur when market participants make independent
assessments of market factors with the result that demand for a
security sharply escalates relative to its available supply.
A manipulative squeeze might occur as the result of a
combination of factors that would not have developed naturally.
The shortage could be by design and would be motivated by a
desire to significantly influence the price of the security.

174
-3-

The resulting shortage would not have occurred if ordinary
economic and market forces were at play.

The shortage could

develop because one participant had a decidedly controlling
position - or if two or more market participants worked in
concert to create a severe shortage.
Having said that, it is important to note there will
always be elements of judgement necessary when attempting to
answer the question of whether the anomalies that develop in the
market-place are an outgrowth of natural market forces or of
manipulative efforts.

The Federal Reserve Bank of New York's

efforts over the last year have been geared to developing and
gathering the type of information necessary to provide the
appropriate regulatory and/or legal authorities with an
understanding of developments in the market.

These efforts

should assist them in making informed judgements and fulfilling
their responsibilities.

As we gather and review the considerable

amount of information available to us, we are in constant contact
with members of the inter-agency working g r o u p — t h e Treasury, the
Federal Reserve Board, the SEC and the CFTC.

Each and every

inquiry into market behavior is discussed by the group and any
questionable activity would be referred on to the appropriate
regulatory or legal authority for further inquiry should we or
any member of the group deem it necessary.

I can assure you

there would be no hesitation on our part, or the working group's,
to make this referral—which in itself is a matter of judgement.

175
-4-

QUE8TI0N 3
President Corrigan also stated in his letter to the
Subcommittee that the Mew York Fed "remain[s] mindful that the
manner in which.•.market participants pursue profit opportunities
can raise concerns of whether some participants exert any undue
influence on market prices and financing rates •** At what point
do you become concerned that a market participant was exerting
••undue influence1* on market prices or financing rates?
Our efforts are geared toward detecting incidents in
which a participant or participants gain effective control over
the availability of a specific Treasury issue, in either the cash
market or the financing market.

We have established procedures

to identify conditions under which the market's normal adjustment
mechanism breaks d o w n — s o that the market can no longer provide
reasonable alternatives for investments, risk management or
speculation.

Aside from the clear need to distinguish between

temporary and persistent conditions, the market's difficulties
must also appear directly and largely attributable to the actions
of an individual market participant or to a group acting in
concert.

QTOGTIQW 4

President Corrigan's letter also noted that a single,
large non-dealer firm acquired a sisable position in the December
1991 5-year Treasury note in when-issued trading and the auction,
and then ""executed repurchase agreements with dealers when it was
possible to ensure a sufficient profit after expenses ."• Aside
from the issue of auction rule violations, how does this type of
activity differ from what Mr. Moser reportedly was trying to do
in the financing market following the May auction?
The non-dealer firm that was noted is an investor in
Treasury securities.

Investors in Treasury securities have no

obligation to lend their securities.

Indeed, an investor that

provides securities to the market incurs certain risks that some

176
-5-

investors may want to avoid, particularly credit risk.
Nevertheless, other investors choose to lend securities because
they can enhance their investment return by providing their
securities to dealers and others.

However, an investor is

unlikely to provide securities unless the incentive overcomes the
risk and costs.
For example, investors typically provide Treasury
securities to financing market participants through repurchase
agreements.

By executing a repurchase agreement an investor

receives cash in return for the securities and pays a rate of
interest.

The provision of securities would create an economic

loss for the investor unless the cash could be invested at a rate
higher than the rate the investor is paying for the repurchase
agreement.

Under current rate relationships, if the investor

executes the repurchase agreement at the general collateral rate
and invests the cash at the Federal funds rate there is likely to
be little if any profit since the rates are often very close and
any spread that may be earned may not compensate for the
administrative costs of employing traders, clerks, credit
analysts and accountants.

If the repurchase agreement can be

arranged at a rate lower than the general collateral rate there
may be sufficient incentive to entice the securities away from
the investor.

To be sure, a bank investor, other financial

institutions, or institutional investors may have a particular
need for cash or may be able to employ funds raised through
repurchase agreements at rates higher than the Federal funds

177
- 6 -

rate, but there are not many overnight or very short-term
investments that offer a rate much higher than the overnight
repurchase rate for general Treasury collateral.
Because of continuing inquiries and legal proceedings
regarding the events of the spring of 1991 it would be
inappropriate to comment about what Mr. Mozer was trying to do.

QVHWloy ?
President Corrigan 1 s letter also said that following
the auction of the August 1992 10-year note "a number of market
participants attempted to profit from their perception of an
imbalance between the level of...short positions and the
availability of the 10-year note from holders willing to lend
their securities. While this activity helped redistribute the
note to market participants seeking to satisfy their delivery
obligations, at times it also may have enhanced the temporary
scarcity value of the 10-year note and contributed to maintaining
large rate concessions in the financing market.1* Aside from the
issue of auction rule violations, how does this behavior differ
from what Mr. Moier and others reportedly were doing with the
April and May 1991 2-year notes?
It is important to keep in mind the market conditions
that surrounded the August 10-year note throughout the third and
fourth quarters of 1992.

The corporate bond market underwent a

dramatic period of increased underwriting activity during the
third quarter in response to steadily declining interest rates.
Underwriters were able to sell the new issues as long as
investors remained interested in buying them; however, when
investor interest began to decline in September, underwriters
were left with a need to hedge large volumes of unsold corporate
issues.

Many of them chose to hedge their inventories by selling

short the August 10-year note, which market participants widely
acknowledged as the most popular hedging instrument for the new
corporate issues.

178
-7-

When called upon to discuss the August 10-year note,
market participants attributed the issue*s scarcity value almost
exclusively to the considerable level of demand created by
hedge-related short selling.

The comments made by market

participants were consistent with position data gathered by the
Market Surveillance unit, which indicated that the primary
dealers maintained sizeable cash market short positions in this
issue throughout the September - November period.

Given the cash

market conditions prevalent at that time, the issue almost
certainly would have traded with a significant rate concession
regardless of the strategies pursued by matched book traders.
Those who established matched book positions in the
August 10-year note did so by executing repurchase and reverse
repurchase agreements in the open market in anticipation that
repo rates would either rise or fall, with no assurance that
rates subsequently would move in their favor.

Furthermore, the

agreements they used to establish their positions were available
to other market participants, including those who maintained cash
market short positions in the issue despite the large and
persistent rate concession with which it traded.

Thus, it would

appear that the profits, if any, made by these traders would have
been available to other market participants who shared their
convictions concerning the probable course of future financing
rates.
In addition, not all of the firms that established
matched-book positions in the August 10-year issue were poised to
profit from an increase in the issue's scarcity value.

In fact,

the most active matched book traders of the August 10-year note

179
- 8 -

were firms with sizeable cash market short positions.

These

firms stood to lose money if the repo rate concession increased
the cash market value of the 10-year note relative to other
securities.
Another point worth noting is that those who traded
specials positions in the 10-year issue had an incentive to
locate and to draw into the market collateral that otherwise
might not have been available to short sellers attempting to meet
their delivery obligations.

While their activities occasionally

might have enhanced the scarcity value of the issue, the
intermediary function performed by these traders on balance
likely added to the liquidity with which the issue traded in the
repo market during the September - November period.
In light of these considerations, it is evident that
the factors at work in determining how the August 10-year note
traded in the financing market differed greatly from those that
had influenced the trading of the 2-year notes issued in April
and Nay of 1991.

QUESTION 6
During the Subcommittee^ hearing, one of the witnesses
testified that when Treasury issues go on special, "the greatest
cost to the Treasury results from the loss of hedging vehicles,"
because "when hedging securities are hard to borrow, when yield
spreads to surrounding issues change unpredictably, when traders
lose money simply by servicing their clients, the market will
become less efficient; traders will bid lower and widen their
bid-to-offer spread — other things being equal, yields will be
higher than they ought to be." Do you agree that these adverse
consequences can result from a squeeze caused by "natural market
forces." If so, shouldn't one objective of reopening policy be
to minimise the potential for such inefficiencies?
Let me begin by addressing several of the points made
in the statement above.

First, when an issue becomes difficult

180
-9-

to borrow in the financing market, it does not necessarily mean
that a hedger will move his hedge into a less efficient, more
costly off-the-run issue, or that he would look to another
financial market for a replacement hedging vehicle.

We have

observed that hedgers prefer to use on-the-run securities for
their hedging activity and are not likely to move their hedges
into an off-the-run security, even if the on-the-run issue is
trading significantly on special in the financing market.

This

is true because the cost of an issue trading significantly on
special in the financing market can be much less than the cost of
the wide transaction spreads incurred by moving the hedge into a
less liquid, off-the-run issue, where bid-to-offer spreads tend
to be somewhat wider.
Second, there is always the possibility in the Treasury
market that yield spreads to surrounding issues will change
unpredictably —
financial market.

this is part of the risk inherent in any
Before entering the market, participants

assess the factors that are likely to affect price/yield
relationships over the course of their exposure to the market.
Clearly, these participants benefit to the degree that these
relationships remain stable over time.

During the past year of

our enhanced surveillance activities, we have found that,
overall, the U.S. Treasury market has provided hedgers with an
environment of stable yield relationships.

Third, there has been

no indication that traders have widened their bid-to-offer
spreads in the cash market for actively traded issues.

181
-10-

The U.S. Treasury market continues to offer a level of
efficiency and liquidity that is unmatched by any other financial
market in the world.

The high degree of competition and activity

in the Treasury market, and the large number of outstanding
issues, make Treasury securities a prime hedging tool.

The

activity of hedgers undoubtedly provides an even greater degree
of efficiency to the U.S. Treasury market.
Based on the above discussion, we have found no
evidence that hedging activity in the Treasury market has
significantly decreased; therefore, there has been no indication
that the Treasury's borrowing costs have increased as a result.
We will continue to monitor the important role hedgers play in
the Treasury market over time.
With respect to the second part of your question, I
will restate that policies regarding the reopening of issues are
left to the discretion of Treasury.

However, we continue to feel

that orderly Treasury debt management practices are essential to
the continued efficient operation of the Treasury market.
QUESTION 7
President Corrigan's letter to the Subcommittee argued
that "there is not, and perhaps will never be, a neat and precise
definition of "acute and protracted 111 short squeezes. Corrigan
also cautioned "against relying solely on simple statistical
criteria, especially to the exclusion of judgment regarding the
ability of the market's normal adjustment mechanism to work
through temporary conditions." In contrast, one of the witnesses
at the Subcommittee's hearing argued that frequent short squeeses
result in losses in hedging vehicles and higher costs. To
respond to this situation, the witness suggested that "the
Treasury should adopt a clear cut policy for reopening tight
issues regardless of the cause" and develop "a statistical
measure of the market's difficulty with an issue.'• What is the
New York red's justification for not relying primarily on
statistical measures, appropriately supplemented with judgements
about the state of the market, in order to determine when an
issue trading on special should be reopened?

182

The decision to reopen a Treasury security rests with
the Treasury Department, not the Federal Reserve.

The Federal

Reserve Bank of New York, through its market monitoring
activities, provides the Treasury with information relevant to
making that decision and acts in an advisory capacity.
The Market Surveillance function of this Bank collects
data on both the cash and financing markets, such as yield curve
spreads, financing rates and transactions volume.

These data

form the foundation of our analyses and recommendations to the
Treasury.

However, no one statistic or combination of statistics

is a perfect measure of the severity of a shortage.

Market

conditions are constantly changing, and there can be no
substitute for flexibility and sound judgement.

All of the data

must be considered in the context of current and anticipated
market conditions.
A single statistical rule might force the Treasury to
reopen an issue when it is anticipated that natural market forces
are likely to ease the shortage soon.

A reopening, in this

instance, may disrupt the market further and could impact future
liquidity.

Given the implications of a reopening to the

marketplace and to its debt operations, the Treasury has
determined that it should only issue additional securities when
it is necessary to ensure the market's efficiency.
In addition, it is not clear that the number or
severity of shortages would be reduced by establishing a
mechanical measure.

The relevant factor is how aggressively the

Treasury implements its reopening policy, regardless of whether
statistical or subjective criteria are used.

In fact, by being

183
-12-

somewhat vague about if and when a security will be reopened, the
Treasury may actually deter participants from creating an
•artificial1 shortage, in that potential manipulators are
uncertain about how much influence they can exert before
triggering a reopening.
Incorporating a subjective understanding of market
conditions into the reopening decision should not be confused,
however, with giving consideration to the cause of a shortage.
The Treasury stated in the Joint Report that it "will provide
additional quantities of a security to the marketplace when an
acute, protracted shortage develops, regardless of the reasons
for the shortage."

Indeed, when the Treasury reopened the ten-

year note (6 3/8 % TN 8/15/02) in November of last year, it was
made clear that there was no evidence of wrongdoing or
manipulative behavior, but rather that the severity of the
shortage warranted a reopening.

184
Carl M. Valenti
Presaerr

^ E L E R A T E
Dow Jones Glodal Information

Telerate Systems Incorporated

One World F'nanc:a! Center
200 Lioerty Street
New v 0 rk. NY 10281

April 5, 1993

The Honorable Edward J. Markey
Chairman, Subcommittee on
Telecommunications and Finance
Committee on Energy and Commerce
United States House of Representatives
Washington, D.C. 20515
Dear Mr. Chairman:
On behalf of Telerate Systems, Inc. ("Telerate"), a
wholly owned subsidiary of Dow Jones & Company, Inc., I appreciate
the opportunity to submit this letter for the record of the
hearing before the Telecommunications and Finance Subcommittee on
March 17, 1993. As you know, we have previously communicated to
you our concerns about the so-called transparency provisions of
government securities reform legislation. We would like to
reaffirm our position that standby authority to regulate
transparency could adversely affect the secondary market for
government securities, and assure you that the private sector,
through new initiatives, continues to improve transparency.
Creating transparency in markets is Telerate 7 s core
business. We specialize in the delivery of financial data,
decision support products and transaction services to financial
markets where decision-making requires time-critical data.
Telerate operates in 70 countries with a staff of 2,400
professionals worldwide. In 1969, Telerate pioneered the field of
electronic financial information services with the delivery of
real-time market rates for commercial paper. Telerate thereby
transformed a fragmented market involving thousands of traders
into a centralized source of information which can be accessed by
market participants.
Today, our strength still lies in the collection and
distribution of rates and quotes on financial instruments. The
Telerate service provides real-time information covering foreign
exchange, fixed income securities (including government
securities), equities, energy, mortgage markets, metals,
commentary and news — including Dow Jones' newswires and Capital

185
The Honorable Edward J. Markey
April 5, 1993
Page 2

Markets Report S M — displayed on 60,000 pages. The cost of
subscribing to Telerate is as little as $600 per month.
Providing transparency in the secondary market for
government securities is one of our principal services. Using
data obtained from Cantor Fitzgerald (and its related companies),
we provide best bids and best offers for U.S. government
securities, the size associated with the best bids and best
offers, and the volume and price of executed transactions. Our
system includes trading for every government security issue in
which Cantor Fitzgerald displays a market, including every issue
of U.S. Government Treasury securities, U.S. Treasury S.T.R.I.P.S.
(zero-coupon securities) and non-guaranteed publicly traded
government-sponsored enterprise issues (such as Federal National
Mortgage Association debentures). This data can be manipulated in
numerous ways with the use of value-added products offered by us.
In addition, that segment of Telerate's customer base that has the
means and desire to receive government securities market
information through a digital feed is able to store, analyze and
process the data supplied through the Telerate information
service.
Although it is not uncommon for traders to subscribe to
several financial information services, Telerate's information is
available to, and relied on by, virtually every significant
participant in the fixed income and foreign exchange markets
worldwide. Our subscribers include brokers, dealers, the Federal
Reserve System, foreign central banks, mutual funds, insurance
companies, federal, state and local governmental units, pension
funds and other sophisticated institutional and individual
investors.
In June of 1991 Telerate significantly broadened the
distribution of government securities information by the
introduction of its Treasury 500 product. Treasury 500 provides
live broker quotes (bids and offers and transaction sizes) and
includes — for the first time — "off-the-run" Treasury
securities (securities issues that have already been fully
distributed), agency securities, zero coupon Treasuries and
sophisticated cross-market derivative products. Users can store
and organize this data to meet their own analytical needs.
Telerate also has created a more transparent market by
providing trading information on U.S. Government Sponsored
Enterprises (GSEs) in response to requests from its customers.
While this innovation, like other improvements in transparency
during recent years, is costly to develop and maintain, Telerate
still has an economic incentive to develop such new products.

186
The Honorable Edward J. Markey
April 5, 1993
Page
2

Moreover, because of the limited brokerage commission revenue
available in the GSE market, the broker providing Telerate the GSE
information could become active in GSEs only because it could sell
such information to Telerate. The enactment of Section 8 would
change this analysis significantly. Indeed, Telerate might not
have invested in the GSE product if Section 8 had been in effect
when the product was being considered. Putting it another way:
If this information were to become commoditized — so to speak —
there might not be enough of an economic incentive to attract
distributors for it.
Most recently, on February 1, 1993, Telerate began to
provide trading information on "odd lots1' of Treasury securities,
which are amounts of less than $1 million. Prior to the
introduction of Telerate's new service, investors trading odd-lots
frequently had to pay higher prices because dealers do not like to
handle small denominations. In addition, many institutional
investors who wanted to buy or sell odd lots had to solicit bid
and offer prices on the telephone from multiple dealers and
compare the quotes to find the best price. Telerate's new service
offers a fundamental change in the way odd lots are traded,
allowing customers instantaneous, real-time access to a market
previously lacking transparency.
Telerate'a competitors in the information industry
continue to enhance transparency through improvements in their
products. Last year, the Joint Report on the Government
Securities Market ("Joint Report") acknowledged that GovPX was
playing a role in its system improving transparency. We
understand that GovPX, through its principal product PROPHESY, now
provides information on the size associated with quotes and a
digital feed which allows the use of analytical software.
Furthermore, GovPX announced that it will offer trading data for
GSE, federal agency and zero-coupon securities by mid-year.
However, even before GovPX made these improvements, the secondary
market for government securities was transparent because of
Telerate and other information processors.
Last September, two of Telerate's market data vendor
competitors, Bloomberg and Knight-Ridder, began to distribute
"executable" odd lot prices on a range of U.S. government
securities originating from a service operated by First Boston
called GovTrade. The GovTrade service, which reportedly is
targeted to small investors, allows qualified Bloomberg customers
to route their orders from their terminals directly to First
Boston's trading desk. Online order routing is not yet available
to users of Knight-Ridder's information services? instead, the
subscribers communicate by telephone with First Boston's traders.

187
The Honorable Edward J. Markey
April 5, 1993
Page
2

Industry publications report that a number of other
primary dealers, including Kidder Peabody, Morgan Stanley and Fuji
Securities, and the aspiring primary dealer Spear Leads Government
Securities, all have plans to publish their own "live" prices over
market data vendor networks. According to trade journals, a major
equity quote vendor, ADP, is planning to join in the near future
its principal rival, Quotron, in disseminating delayed U.S.
Treasury prices from interdealer broker Garban Ltd.
This activity in the private sector demonstrates that
the information services market is vibrant and increasingly
competitive. Information processors continue to enhance the
quality of products and services that, in turn, increase
transparency. Moreover, more interdealer brokers are entering the
information services market and are distributing their trading
data to a wide range of customers.
With respect to Section 8 of H.R. 618, we are concerned
that although it is well-intended and has facial appeal, the
legislation could impair the gains in transparency that are
already evident in the private sector and the continued increases
in transparency in the future. For the reasons outlined below, we
respectfully suggest that the Subcommittee delete Section 8 and
agree to the language of S. 422, which provides for a
comprehensive study of transparency in the government securities
market.
The regulatory approach of Section 8 is not necessary.
The Joint Report was prepared in response to allegations of
improprieties in the primary market and should not be used to
justify regulation in the secondary market. There is no evidence
that even suggests that the secondary market for government
securities is distorted because of a lack of information needed to
participate fully in the market.
We think it is noteworthy that only one of the
regulatory agencies contributing to the Joint Report — the SEC —
supports a grant of additional regulatory authority over
transparency. The Treasury Department has not revised its stance
since the Joint Report. Moreover, the Federal Reserve System
Board of Governors, in testimony before this Subcommittee on
March 17, 1993, noted that private sector initiatives have
enhanced transparency and, if allowed to continue unencumbered,
will develop further gains for investors in this market.
More importantly, SEC Chairman Breeden has not disavowed
his statement before the Senate Securities Subcommittee on January
23, 1992, in which he conceded that "immediate regulatory steps to

188
The Honorable Edward J. Markey
April 5, 1993
Page
2

mandate transparency in the government securities market at this
time are not necessary."
Because Section 8 seeks to solve a problem that has not
yet been identified, the language is inherently broad and is
likely to result in unintended consequences. David W. Mullins,
Jr., Vice Chairman of the Board of Governors of the Federal
Reserve System, in testimony on March 17, 1993, emphasized that
every single member of the Board of Governors was opposed to the
regulatory approach of H.R. 618. Moreover, a major peril of
excessively broad regulation of the secondary market for
government securities is that it could increase the Federal
government's cost of borrowing money in the primary market.
According to the Joint Report, "An increase of financing costs of
only one basis point — one hundredth of one percentage point —
would cost taxpayers over $300 million each year."
The private sector will necessarily perceive Section 8's
grant of standby authority to be a grant of actual authority to
regulate the price and content of trading data. Standby authority
will have a chilling effect on the capital-intensive financial
information service business. Telerate alone has spent hundreds
of millions of dollars during the past several years to develop
the state-of-the-art system that provides transparency in the
government securities market (and other markets) today. We would
be reluctant to continue to make such significant, long-term
capital investments if the SEC were vested with regulatory
authority that could completely change the nature of and demand
for Telerate's services.
In summary, we at Telerate take great pride in our role
as one of the pioneers in bringing real-time prices to the
secondary market for government securities. We are confident that
we and other information providers will continue to deliver the
leading-edge technology that further enhances the level of
transparency. We must continue to do so if we expect to survive
in this highly competitive market place. We would welcome the
opportunity to work with the regulators who may be responsible for
assessing the private sector's efforts to increase transparency in
the secondary market for government securities.
Very truly yours,

GOVERNMENT SECURITIES REFORM
TUESDAY, MARCH 30, 1993
HOUSE OF REPRESENTATIVES,
COMMITTEE ON ENERGY AND COMMERCE,
SUBCOMMITTEE ON TELECOMMUNICATIONS AND FINANCE,

Washington, DC.
The subcommittee met, pursuant to notice, at 2:15 p.m., in room
2322, Rayburn House Office Building, Hon. Edward J. Markey
(chairman) presiding.
Mr. MARKEY. SO sorry to keep all of you waiting. Well, we have
a very curious interaction of the procedural posture on the floor
being such that the Republicans are using roll calls in order to
make particular points with the Democrats, which is fine and all
within their Constitutional and procedural rights, combined with
other business which is pending before the House and unfortunately this issue has been caught in the middle of this scheduling
confluence and we very much apologize to you for that.
Today the subcommittee is holding a hearing on H.R. 616, a bill
to repeal section 11(a) of the Securities Exchange Act of 1934 in
order to permit members of national securities exchanges to effect
transactions for accounts for which they have investment discretion.
I have joined with Representatives Fields and Moorhead in sponsoring this legislation in order to eliminate an anachronistic provision of the law which prevents money managers who are members
of the New York Stock Exchange and other national exchanges
from using an affiliated broker to buy or sell stock for certain client
accounts.
This restriction was adopted in the mid-1970's in response to
concerns over institutional access to exchanges and the potential
conflicts of interests resulting from allowing combinations of money
management and brokerage functions.
As implemented by the SEC, the 11(a) managed accounts provision allow money managers to use affiliated brokers to do everything other than actually executing a buy and sell order on the exchange floor for their managed accounts. Instead, the current rules
require money managers to use independent floor brokers known
on Wall Street as "two dollar brokers" to execute trades for their
managed accounts.
H.R. 616, in contrast, would allow money managers to use an affiliated broker to actually execute the buy or sell order provided
that full disclosure of compensation arrangements is provided in
order to alert investors to any potential conflicts of interest.
(189)

71-390 0 - 9 3 - 7

190
In the last Congress this subcommittee heard testimony indicating that elimination of the 11(a) managed account provisions would
reduce unnecessary costs associated with the use of independent
floor brokers, enhance the ability of money managers to assure
quality of execution of trades for their managed accounts, reduce
certain administrative and compliance burdens and eliminate incentives for transactions to be executed on foreign exchanges or in
the over-the-counter market merely to avoid incurring the costs associated with the provision.
The witnesses before us today are testifying in support of the
pending legislation and the SEC has also indicated its support. We
look forward to receiving their testimony and would hope that they
will work with us as we move this legislation forward through the
process to the House floor and hopefully into law.
That concludes the opening statement of the Chair.
[The text of H.R. 616 follows:]

191
I

103D C O N G R E S S
1ST SESSION

T
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To amend the Securities Exchange Act of 1934 to permit members of national
securities exchanges to effect certain transactions with respect to accounts for which such members exercise investment discretion.

IN THE HOUSE OF REPRESENTATIVES
JANUARY 26, 1993

Mr. MARKEY (for himself and Mr. FIELDS of Texas) introduced the following
bill; which was referred to the Committee on Energy and Commerce

A BILL
To amend the Securities Exchange Act of 1934 to permit
members of national securities exchanges to effect certain
transactions with respect to accounts for which such
members exercise investment discretion.
1

Be it enacted by the Senate and House of Representa-

2 tives of the United States ofAmerica in Congress assembled,
3

SECTION 1. PROHIBITED TRANSACTIONS.

Section 11(a)(1) of the Securities Exchange Act of

5 1934 (15 U.S.C. 78k(a)(l)) is amended—
6
7

(1) in subparagraph (E), by striking "(other
than an investment company)";

192
2
1
2
3
4
5
6

(2) by striking "and" at the end of subparagraph (G);
(3) by redesignating subparagraph (H) as subparagraph (I); and
(4) by inserting after subparagraph (G) the following new paragraph:

"(H) any transaction for an account with re-

spect to which such member or an associated person

thereof exercises investment discretion if such

member—

"(i) has obtained, from the person or per-

sons authorized to transact business for the ac-

count, express authorization for such member

or associated person to effect such transactions

prior to engaging in the practice of effecting

such transactions;

"(ii) furnishes the person or persons au-

thorized to transact business for the account

with a statement at least annually disclosing

the aggregate compensation received by the ex-

change member in effecting such transactions;

and

"(iii) complies with any rules the Commis-

sion has prescribed with respect to the require-

ments of clauses (i) and (ii); and".
O

•HR 616 IH

193
Mr. MARKEY. We now turn to recognize the ranking Republican
member on the full Committee of Energy and Commerce, the gentleman from California, Mr. Moorhead.
Mr. MOORHEAD. Thank you, Mr. Chairman.
I want to commend you for calling this hearing on H.R. 616, a
proposal to amend section 11(a) of the Securities and Exchange Act
of 1934.
The prohibition against an exchange member firm effecting orders for managed accounts over which it has investment discretion
is a holdover from the days of fixed commission rates. Since May
1st, 1975, the markets have changed dramatically and experience
has shown that the restrictions of 11(a) are unnecessary, although
this section of the law does not appear to increase investor protection. It does impose unnecessary administrative costs and market
inefficiencies on money managers.
In considering amendments to the Securities Law of 1975, Congress was apprehensive about the possibility that broker dealers
might churn managed accounts to generate commissions. It was
also concerned that a firm might pressure managers of advised accounts to purchase a particular security to complete a block transaction or to close an underwriting of a new issue. Finally, there
was also concern that brokers might give preference to managed
accounts in the execution of their orders.
To resolve these problems section 11(a) was adopted as a part of
the Securities Act Amendments of 1975. The practical effect of section 11(a) is to require institutions to channel their exchange business through unaffiliated broker dealers. It also forces exchange
members to execute trades for their managed accounts through an
unrelated firm. In the absence of demonstrated conflicts of interest
occurring, the section introduced unnecessary inefficiency in the
order execution process.
Mr. Chairman, I agree with the conclusion of the SEC that the
elimination of the managed account provision of section 11(a)
would reduce costs for affiliated brokers executing orders for managed accounts.
I know however that the testimony today of the Securities Industry Associations says that between $200 and $250 million a year
of costs have been borne indirectly by holders of mutual funds and
pension plan participants. That would seem to me to be an argument in favor of some portion of the savings to be realized by this
legislation being passed back to the customers.
I look forward to hearing the testimony on this point and expect
to be fully supportive of this legislation.
I yield back the balance of my time.
Mr. MARKEY. Great. The gentleman's time has expired and all
other time has expired for opening statements from members.
Without objection, the record will remain open for any other opening statements which members wish to insert in the record.
I'll turn to our panel, which consists of Paul Gottlieb, who is Associate General Counsel of Paine-Webber, and Lawrence Zicklin,
Managing Partner of Neuberger & Berman.
We thank both of you for your willingness to participate here
today and we apologize again for the delay. We don't anticipate a
lengthy hearing but we must for each session assure that there is

194
a record that justifies the passage of the legislation, which is our
full intention on an expeditious basis, so Mr. Gottlieb, whenever
you feel comfortable, please begin—pull over the microphone.
STATEMENT OF PAUL GOTTLIEB, CHAIRMAN, INVESTMENT
ADVISER COMMITTEE, SECURITIES INDUSTRY ASSOCIATION, ACCOMPANIED BY JONATHAN R. PARET, VICE PRESIDENT; AND LAWRENCE ZICKLEN, MANAGING PARTNER,
NEUBERGER & BERMAN, NEW YORK CITY

Mr. GOTTLIEB. Thank you, Chairman Markey.
Gentlemen, my name is Paul Gottlieb. I am the Chairman of the
Securities Industry Association's Investment Adviser Committee. I
am here to testify on behalf of the SIA in support of the repeal of
the managed account prohibition in section 11(a) of the Securities
Exchange Act of 1934. I appreciate the opportunity that you have
accorded me and I ask that the SIA's written statement be included
in the record.
Mr. MARKEY. Without objection, it will be included in the record.
Mr. GOTTLIEB. As you know, the managed account provisions in
section 11(a) prohibit an exchange member from executing certain
securities trades on the floor of any national securities exchange to
which it belongs. These prohibitions cover transactions for the accounts of the brokerage firm itself, the accounts of its associated
persons, any accounts over which member firms or its employees
have investment discretion—the latter called "managed accounts."
The SIA strongly supports the legislative efforts to repeal the
managed account prohibitions. Congress adopted these provisions
in 1975 to address perceived problems then thought to be inherent
in the combination of brokerage and money management functions.
We believe it is clear that section 11(a) no longer serves the purpose for which it was adopted and unnecessarily costs the securities industry millions of dollars each year. Beyond that, it has
spawned an unnecessary layer of regulation and it has lessened the
accountability of firms in their execution of transactions for managed accounts.
For all these reasons, we believe that the repeal of the prohibition is both in the interest of the securities industry as a whole and
the investing public.
The managed account prohibitions are no longer relevant to the
current structure of the securities markets because of the dramatic
changes which have occurred in those markets since the mid1970,s. Fully negotiated commissions have replaced fixed fees. Exchanges are now open to all qualified persons and access to exchange floors has been expanded via various electronic means.
These changes in the structure of the market obviate the need for
the 11(a) prohibitions for managed accounts.
Moreover, it should be remembered that the managed account
prohibitions only apply to a limited portion of securities transactions. Trades executed for institutional managed accounts on the
over-the-counter markets or off exchange floors are not affected.
Thus the prohibitions tend to distort order flow by artificially driving transactions to other markets.
The absence of the prohibitions for OTC securities has not led to
abuses in that marketplace. At least in part we believe that is be-

195
cause the brokerage and money management firms are regulated
and subject to the provisions of the '34 Act, the Company Act, the
Investment Advisers Act, and ERISA. Whatever the reason, however, our experience suggests that the 11(a) prohibitions have outlived whatever usefulness they may have had.
In fact, the SEC as you know adopted Temporary Rule ll(a)22T to temper the consequences of 11(a) by permitting member
firms to provide all securities services for a managed account except on the floor executions. This is a so-called effect versus execute
rule and as you know it is still in force today.
As a result of the above, an exchange member must use independent floor brokers, the so-called two-dollar brokers, to execute
trades for managed accounts.
One of the main reasons for the SIA's support for repeal is the
cost to the industry of compliance with 11(a). Based on a survey
conducted by the SLA in the late 1980,s, the managed account prohibitions cost the industry annually between $200 and $250 million.
In addition to the substantial cost savings to the industry, SIA's
survey found substantial administrative burdens associated with
11(a) compliance. These include within often a very tight time
frame the need to determine the status of managed accounts, to indicate to trading desks whether a particular order or percentage of
an order was for an account subject to 11(a) and to respond to floor
broker questions regarding the status of orders.
In today's fast-paced marketplace, any delay in executing a particular trade may very well have significant consequences with regard to that transaction.
In addition to the costs and burdens which I have previously
mentioned, the prohibitions in 11(a) can have a negative effect on
the way brokered services are rendered to managed accounts—
11(a) compels exchange members to delegate responsibility of their
professional judgment as to how and when to achieve executions to
independent floor brokers. Thus, 11(a) diminishes the ability of
member firms to use their expertise in executing trades and it further reduces the ability of institutional clients to hold exchange
members accountable for the quality of executions rendered.
In sum, SLA strongly supports the repeal of the managed account
prohibition. The prohibition is no longer needed to enhance fair
competition and compliance with the prohibition creates unnecessary costs to brokerage firms and inefficiencies in the order process. It diminishes the ability of members firms to use their expertise while reducing ultimate client accountability.
The demise of this provision will create a substantial benefit.
I thank you for inviting me to testify today and I would be
pleased to answer any questions that you may have.
[Testimony resumes on p. 210.]
[The prepared statement of the Securities Industry Association
follows:]

196
STATEMENT OF
SECURITIES INDUSTRY ASSOCIATION

Chairman Markey, my name is Paul Gottlieb and I am an
Associate General Counsel with PaineWebber Incorporated.

I am

here to testify today on behalf of the Securities Industry
Association ("SIA") in my capacity as Chairman of SIA*s
Investment Adviser Committee.

I would like to thank the

Telecommunications and Finance Subcommittee ("Subcommittee")
for the opportunity to participate in this hearing and provide
the Subcommittee with SIA's views on the proposed repeal of the
managed account prohibitions in Section 11(a) of the Securities
Exchange Act of 1934 ("1934 Act").

SIA is the trade association representing over 700
securities firms headquartered throughout the United States and
Canada.

Its members ere securities organizations of virtually

all types —

including investment banks, brokers, dealers and

mutual fund companies.

SIA members are active in all exchange

markets, in the over-the-counter ("OTC") market and in all
phases of corporate and public finance.

Collectively, they

provide investors with a full spectrum of securities and
investment services and account for approximately 90% of the
securities business being done in North America.

Description of the Managed Account Prohibitions in

Section 11(a)

197
Section 11(a), adopted as part of the Securities Acts
Amendments of 1975 ("1975 Amendments"), bars a national
securities exchange member from executing certain securities
trades on the floor of the exchange(s) to which it belongs.

discussed below, Section 11(a) was designed to address Congress'
concerns about the conflict of interest then thought to be
inherent with the combination of money management and brokerage.

Section 11(a)*s managed account prohibitions apply to
exchange member firms' own accounts, their associated persons'
accounts and institutional accounts over which the member or its
associated persons have investment discretion ("managed
accounts").

Section 11(a) does not prohibit investment managers

from executing trades for managed accounts in the OTC market or
on foreign securities exchanges.

Pursuant to a rule promulgated under Section 11(a) by the
Securities and Exchange Commission ("SEC") in 1978 —
ll(a)2-2T —

Rule

exchange member firms engaged in investment

management, directly or through affiliates, are permitted to
perform some brokerage functions with respect to managed
accounts' trades.

They must retain independent floor brokers,

however, in order to execute those trades on behalf of their
institutional managed accounts.
2

198
II.

General Discussion of the Reasons Why The Managed Account
Prohibitions in Section 11(a) Should Be Repealed

SIA strongly supports legislative efforts to repeal the
managed account prohibitions in Section 11(a).

While the

prohibitions were thought necessary when implemented, SIA
believes they are no longer appropriate or necessary.

The 1975 Amendments were the most comprehensive changes to
federal securities regulation in over forty years.

The

legislation addressed perceived problems with institutional
exchange membership and related issues through measures
including the following:

1) the elimination of fixed commission rates (resulting in
sharply reduced institutional rates);

2) the modification of exchange rules so that all qualified
broker-dealers could join an exchange on a nondiscriminatory basis; and

3) the creation of a national market system under the SEC's
authority, resulting in expanded electronic access to
exchange floors.

199
The changes in the 1934 Act resulting from the SEC's broad
rulemaking authority it was granted in the 1975 Amendments led
to major economic and structural changes in the markets in the
mid- to late-1970's and after, largely reducing the potential
for conflict between brokerage and money management functions
and thus greatly diminishing the need for Section ll(a)'s
trading restrictions.

Some of these changes are discussed in

the following paragraphs.

First, non-exchange members are no longer at a competitive
disadvantage compared to exchange members with respect to
management of institutional accounts because membership on all
exchanges is now available to any qualified broker-dealer,
including affiliates and subsidiaries of any institutional
investor.

Also, general availability of current last sale and

quotation information, access to automated execution systems
for small orders and electronic linkages between and among
markets eliminated whatever unfairness existed for non-exchange
members prior to the 1975 Amendments.

Second, because commission rates are relatively low in all
markets for institutional investors, firms executing trades for
institutional clients can seek the best execution of those
trades within the national market system and no longer need to
direct these transactions to alternate markets in order to
recapture commissions.
4

200
Third, the ability to negotiate commission rates and the
close monitoring of institutional trades has significantly
reduced any potential conflicts of interest resulting from the
combination of money management and exchange membership.

seen in the OTC market, broker-dealers cannot successfully
charge high commission rates for trades for institutional
accounts managed by them or their affiliates.

Finally, Section 11(a) does not restrict the execution of
OTC trades by broker-dealers for their own or their affiliates'
accounts or for advisory clients.

Yet the absence of the

managed account prohibitions has not led to abuses in the OTC
market, as both broker-dealers and their affiliated investment
managers are subject to a broad array of other fiduciary
obligations.

These fiduciary obligations also would apply to

broker-dealers and their affiliated investment managers with
respect to transactions in exchange-listed securities.

i n . History of Section 11(a)

Market Operation Before 1975

The "institutionalization" of the securities markets had
begun in the late 1960's.

Prior to 1975, exchange memberships

and access to the exchange floor had been limited strictly in
5

201
order to prevent institutional investors from avoiding

fixed

commission rates by executing their own trades on exchanges.
Congress and the SEC determined that, absent Section

ll(a)'s

restrictions, investment managers might have an incentive to
manage accounts in order to generate brokerage commissions for
their affiliates, given the structural climate at the time.

Both fixed commission rates and exchange membership
restrictions created a distinct competitive edge to exchange
members.

Further, the NYSE and possibly other national

exchanges permitted their existing members to engage in money
management, creating even more of a competitive disadvantage
for non-exchange-member money managers.

An exchange member

could increase the performance of its managed accounts by
reducing its management fees, while continuing to profit from
the fixed commissions charged for executing transactions for
those accounts.

Before the 1975 Amendments, in order to carry out their
fiduciary responsibilities as money managers —

including

obtaining best execution on client transactions —
the comparatively high fixed-commission cost,

and to avoid

institutional

money managers resorted to a number of practices to attempt to
recapture a portion of the high fixed-rates,

including:

Executing transactions in the OTC market
commission rates were negotiable);
6

(where

202
o

Attempting to join regional exchanges;

Attempting to obtain rebates on orders executed by
other firms on the exchanges; and

Buying exchange-listed securities from non-member
broker-dealers on a net price basis to avoid exchanges'
fixed rate commissions (i.e.. the "third market").

Adoption and Repeal of Rule 19b-2 Under the 1934 Act

The SEC tried to respond to the market distortions caused
by limited access to some exchange memberships by restricting
membership on all exchanges to those broker-dealers which
conducted a principally public business.

The SEC adopted Rule

19b-2 under the 1934 Act in 1973, which required each member of
an exchange "to have as the principal purpose of its membership
the conduct of a public securities business."

A member was

said to fulfill the "public purpose" requirement if at least
80% of its transactions were effected for persons other than
"affiliated persons", or consisted of specified transactions.

Effectively, Rule 19b-2 allowed existing exchange members
to continue conducting business for their managed accounts.
7

203
However, broker-dealer affiliates of institutions that had
succeeded in joining certain regional exchanges, the principal
exchange business of which consisted of transactions for
affiliated institutions, were severely disadvantaged.

Rule

19b-2 was criticized highly by both the House and Senate, which
concluded that Section 11(a) should be amended.

Rule 19b-2 was

rescinded 18 months after the adoption of the 1975 Amendments.

Adoption of Section 11(a)

Congress adopted the managed account prohibitions in
Section 11(a) in 1975 as part of a comprehensive package
designed to ease the industry's transition away from fixed
commissions and limited access to exchange membership.
According to Senate Report 94-75 (April 14, 1975) and House
Report 93-1476 (November 19, 1974), the Committees adopted the
approach taken in the 11(a) amendment for the following reasons:

The Senate Banking Committee determined that competition
between money managers had been harmed because the
membership rules of the various stock exchanges were
discriminating between firms in very similar businesses,
and gave exchange members who wanted to enter the money
management business a distinct advantage over managers
unable to join exchanges;
8

204
o

The same Committee also regarded the practice of directing
order flow to regional exchanges for the purpose of
recapturing commission dollars inconsistent with the
development of a national market system, as called for in
the 1975 Amendments;

A House Committee decided that institutions had become the
dominant investor force in the marketplace and that, by
virtue of their size and ability to obtain services and
preference to others, institutions were able to gain unfair
advantages in the marketplace; and

Both House and Senate Committees decided that fixedcommission rates had created or aggravated conflict of
interest problems stemming from the combination of money
management and brokerage in entities under common control.

Adoption of

Rule 1192-2(T)

In 1977, the Commission adopted "temporary" Rule Ila2-2(T)
under the 1934 Act ("Rule").

The Rule, still in effect today,

permits exchange members to "effect" transactions otherwise
prohibited by Section 11(a) if the trades are "executed" on an
exchange floor through a member which is not an associated
person of the initiating member, under certain conditions,
including disclosure to clients regarding execution practices.
9

205
The SEC adopted the Rule because it was concerned that the
1975 Amendments were having and would have unintended and
undesirable effects in light of the changes in the markets since
their enactment.

One of the Rule's main goals was to egualize

the competition between exchange-member and non-exchange-member
money managers.

The SEC also was concerned that Section 11(a)

might result in inefficiencies in the order process.

Under the Rule, the SEC construes the term "effect" to
include all transaction services except on-the-floor execution.
Exchange members are permitted to perform all brokerage
functions in connection with exchange trades for institutional
managed accounts other than the trades' execution.

As a result,

to comply with Section 11(a)'s managed account prohibitions,
exchange members need to have an independent broker —
"two-dollar broker" —

termed a

to execute transactions for such accounts

on exchange floors.

IV.

Discussion of Compliance and Quality of Trade Execution
Problems

and

unnecessary Costs Results from the Managed

Account Prohibitions' of Section 11(a)
10

206
A.

Unnecessary Expenses

In 1987, SIA conducted a survey to determine the costs of
the managed account prohibitions in Section 11(a) to the
securities industry.

To estimate these costs, SIA surveyed ten

NYSE members engaged in the investment management business,
either directly or through affiliates.

Of the ten firms,

diverse in size, several are large broker-dealers, while others
rank among the top 100 managers of tax-exempt assets or offer a
complex of mutual funds.

The survey results showed that the managed account
prohibitions in Section 11(a) cost the industry between $200
and $250 million in 1986 and 1987.

The costs are primarily

associated with the required use of independent brokers on
exchange floors.

These funds are paid directly by exchange

members or their affiliates which provide investment management
services.

Indirectly, of course, the costs are borne by

institutional managed accounts and, inevitably, the pension
holders and mutual fund investors whose funds are being managed
by investment management firms.

If Section 11(a)*s managed account prohibitions are
eliminated, and exchange members are permitted to execute
trades themselves for their own and their affiliates'
11

207
institutional managed accounts, there would be certain new
additional expenses that these firms may incur, including the
costs of additional floor brokers and/or leasing exchange
seats.

Nevertheless, SIA's study concluded that net savings in

floor brokerage resulting from the repeal of the Section
ll(a)'s managed accounts prohibitions would be substantial.

Additional Compliance Requirements

Exchange-member money managers incur administrative and
compliance burdens resulting from Section ll(a)'s trading
restrictions.

Among other things, firms must determine, on an

extremely short timeframe, the Section 11(a) status of their
various managed accounts to indicate to their trading desks
whether a particular order or percentage of an order is on
behalf of an account subject to Section 11(a)'s prohibitions
(and thus must be executed by an independent floor broker) and
must respond minute-to-minute to their floo.r brokers' questions
regarding the status of these orders.

In today's fast-paced

marketplace, any amount of time which unnecessarily delays a
particular trade may very well negate the benefit of that trade
for the particular

investor.

Negative Results on Quality of Trade Executions

In addition to the monetary costs and administrative and
compliance burdens resulting from Section 11(a), the managed
12

208
account prohibitions also have a negative effect on the waybrokerage services are rendered to institutional

accounts

managed by exchange members or their affiliates.

Section

prevents exchange members from exercising their

11(a)

independent

professional judgment as to how and when to achieve executions
of exchange transactions for their managed accounts or those of
affiliates.

Instead, such exchange members are forced to give

that responsibility to independent floor brokers.

Thus,

Section 11(a) diminishes the ability of institutional
to hold exchange members and their advisory

clients

affiliates

accountable for the quality of the execution services provided
to such clients.

Indeed, the required use of independent floor brokers for
the trades of institutional managed accounts compels exchange
members to take special steps to avoid competing with their own
managed accounts for trade executions.

This problem occurs

because these investment managers are forced to execute trades
through unrelated exchange members for institutional managed
accounts, while the investment manager is free to execute
trades through an affiliated exchange member for
advisory accounts
account

individual

[not covered by the Section 11(a) managed

prohibition].

Conclusion

SIA believes Section 11(a) is no longer necessary to

209
enhance fair competition and that compliance with Section 11(a)
creates unnecessary costs and inefficiencies in the order
process.

Further, Section 11(a) creates an incentive to trade

off the exchanges because the provision does not apply to trades
on the OTC market.

We urge the Subcommittee to take a very

important step toward market efficiency and repeal the managed
account prohibitions in Section 11(a).

Again, I would like to thank you, Chairman Markey, for
giving us the opportunity to share our views on this issue that
is so important to our industry.

210
Mr. MARKEY. Thank you, sir, very much. Our second witness,
Mr. Zicklin, Managing Partner from Neuberger & Berman. When
you are ready, please begin.
STATEMENT OF LAWRENCE ZICKLIN

Mr. ZICKLIN. Thank you, Mr. Chairman. My name is Lawrence
Zicklin and I am the Managing Partner of Neuberger & Berman in
New York.
We have been making investment decisions for institutional accounts for more than 40 years and for individual accounts for over
50 years. Neuberger & Berman currently has under management
investments valued in excess of $25 billion.
I am pleased to be able to testify today in strong support of H.R.
616, a bill to repeal the managed account restrictions of section
11(a) of the Securities Exchange Act of 1934. The concerns for
which 11(a) was originally enacted are now either obsolete or addressed by other statutory protections. Indeed, the managed account provisions of section 11(a) have become a significant and
costly burden on the investment management industry without any
compensating investor benefits.
Section 11(a) prohibits exchange members from effecting transactions for their managed institutional accounts on a national securities exchange. Effectively this prohibition requires us to channel
our exchange business through unaffiliated broker dealers and to
execute trades for our managed accounts through unrelated firms.
These section 11(a) constraints were enacted in 1975 primarily to
prevent money managers from reaping the benefits of becoming exchange members, and secondarily to reduce potential conflicts of interest resulting from the combination of money management and
brokerage functions. However, these section 11(a) constraints have
been rendered obsolete by the regulatory market and statutory developments since 1975.
These statutory, regulatory, and market developments include:
In January, 1975, before enactment of the 1975 Amendments the
Securities and Exchange Commission eliminated fixed commission
rates, resulting in dramatically lower negotiated rates. Therefore
there was no longer a need to direct orders to inferior markets in
order to lower commission costs.
Shortly after enactment of the 1975 Amendments, the Commission opened exchange membership to all qualified broker dealers,
thereby permitting membership by the affiliated broker dealers of
institutional investors and eliminating their potential competitive
disadvantage.
In March, 1978, Rule ll(a)2-2T permitted exchange members to
effect transactions from managed accounts as long as independent
brokers executed the trades on the exchange floor. By requiring the
affiliated brokers to obtain written authorization for managed accounts and to disclose transaction related compensation, the rule
addressed conflict of interest concerns behind section 11(a).
The Investment Company Act of 1940, the Employee Retirement
Income Security Act—the ERISA Act—of 1975, and Federal and
State banking and insurance laws and regulations all imposed fiduciary obligations on money management and brokerage professionals.

211
Technological advances including general availability of current,
last sale, and quotation information, access to automated execution
systems for small orders, and electronic linkages between and
among markets have eliminated inequities that put non-exchange
members at a disadvantage before 1975.
Unfortunately, section 11(a) managed account restrictions are
not simply unnecessary. They are inefficient and costly to an industry whose hallmark is efficiency and for whom profits are often calculated in basis points.
Surveys conducted by the Securities Industry Association reveal
that section 11(a) prohibitions cost the industry between $200 million and $250 million in 1986 and 1987. New York Stock Exchange
figures for 1989 and 1990 put the section 11(a) costs at between
$335 million and $409 million in 1989 and between $233 million
and $285 million in 1990. Such costs can conceivably be justified
if there was some benefit to the managed account constraints of
section 11(a). There are none.
Indeed, the restrictions are anachronistic and costly. Fair competition among money managers and efficient execution of transactions for institutional accounts have been achieved by other statutory, regulatory, and market developments.
The restrictions of section 11(a) that target transactions executed
for institutional accounts on national exchanges also result in market inefficiencies because these constraints do not apply to the
over-the-counter markets or foreign securities exchanges or to the
execution awarded for individual accounts.
Because of the section 11(a) restrictions for institutional accounts, many individual orders in the same security must be executed by third party independent brokers both for efficiency's sake
and for fiduciary reasons. The regulatory treatment of all institutional transactions should be comparable, thereby avoiding distortions and inefficiencies.
We support provisions in the legislation that would require prior
authorization for engaging in the practice of using an affiliated
broker and that require disclosure of compensation provided to
such affiliated brokers. This disclosure coupled with the sophistication of institutional clients and their consultants should provide
adequate protections against potential conflicts of interest and
should enable institutional investors to hold their investment managers accountable for the quality of their total performance, which
includes execution services.
Finally, I would like to assure the members of the subcommittee
of the breadth of support for this legislation. There are hundreds
of investment management professionals and dozens of investment
management firms that will experience regulatory relief when this
measure is enacted. These fiduciaries operate out of all major
American cities on behalf of thousands of institutional clients.
Thank you, Chairman Markey, for giving me the opportunity to
express these opinions.
Mr. MARKEY. Thank you, sir, very much.
That concludes the opening statements of the witnesses.
Let me recognize the gentleman from California for any questions which he may have.
Mr. MOORHEAD. Thank you, Mr. Chairman.

212
Mr. Gottlieb, your testimony says the fees are currently being
paid directly by the investment managers and then indirectly they
are being paid by the public.
I support the elimination of unnecessary costs on business but I
would like to see some of the savings your firms will realize passed
on to the customers.
Do you think that is possible? How would you suggest that Congress express this particular desire that investors share the benefits of cost savings?
Mr. GOTTLIEB. I appreciate your concern, Congressman.
Let me respond in a couple of ways.
First, I think there is an inherent argument being that this regulation is unnecessary and superfluous. Our goal should be to maximize efficiency and I think even for no other reason other than that
I would urge that the provision be repealed, but I think, more to
the point of your question, history has demonstrated that given the
competition in our industry, and I point to the dropping of fixed
commissions in 1975, that competition has demonstrated the historical result that fees have dropped, that commissions have
dropped, and it's my belief that with the repeal of this provision
and the cost savings to the industry competition will naturally result in a lowering of fees to customers and will also provide a benefit for participants in pension plans as well as mutual funds that
currently have to pay the load in connection with these provisions.
Mr. MOORHEAD. A lot of the reduction fees have been because of
these folks that advertise that they will, their prices are 'way below
everyone else, they can handle your stock transaction probably
without advisory services that so many of the larger firms have but
they can do it, if you know what you want to buy, for a much lower
price. Don't you think that's basically it?
Mr. GOTTLIEB. Well, the wonderful thing about competition is
that it has the effect in all services being provided given the number of firms that are offering advisory products at this point, and
that number still continues to grow, I'm confident that the competitive urges will cover the full gamut of services being offered to the
public.
Mr. MOORHEAD. If this legislation is passed, will investment
managers still use floor brokers? Under what circumstances?
Mr. ZLCKLLN. I can take that, if you like.
M r . MOORHEAD. Y e s .
Mr. ZICKLIN. The extent

that the floor remains the marketplace,
I don't know how long that is going to last. There will be floor brokers used. The question is whose floor broker will be used. It will
either be the firm's or the traditional two-dollar broker.
I suspect in many cases the two-dollar broker will continue to be
used or the two-dollar broker will be retained by the investment
manager to act on behalf of the investment manager.
Mr. MOORHEAD. What's a $ 2 broker?
Mr. ZICKLIN. It's a misnomer. A $ 2 broker is a independent person who executes orders on the floor. Historically it was done for
two dollars a hundred. It is far less than that now as the intense
competition has brought it down to 60 or 70 cents a hundred or
sometimes below that.

213
Mr. MOORHEAD. I'm sure that people are the most competent
people in the world but if you just watch the action down there,
it looks like a zoo. You wonder how they ever keep it up hour after
hour. Tough job.
Mr. ZICKLIN. You have to watch them one at a time, rather than
the mass.
Mr. MOORHEAD. HOW could a fiduciary justify paying additional
fees to an outsider once he is permitted to do the trade with an affiliate?
Mr. ZLCKLIN. This is a very competitive industry. The fiduciary
will act in a manner that is both competitive in order to earn his
fee and in a manner to justify the total return that he's promised
the client.
Remember, every fiduciary that is acting as a money manager is
judged ultimately by the results he secures for that client. If he secures the proper result, he is re-hired. If he doesn't, he's gone, and
therefore you find the proper people to act in your behalf, whether
they be your own executor's orders or independent executor's.
Mr. MOORHEAD. You know, I have no further questions but I
want to say I really appreciate your both coming in today. It's obvious that there is no great disagreement about the need for this legislation, but as the chairman has said, it's very important that we
do have a record that is established and other than just our own
feeling that it is in the best interest of everyone involved. We get
people like you that know the industry and know what is going on
to come and help us fill the record. Thank you.
Mr. GOTTLIEB. Well, I thank you, and just let me add that it is
an honor for me, Fm sure for both of us, to be here.
This is a crucial process. It's important to all of us and the honor
is ours to be here and we thank you for listening.
Mr. MARKEY. The gentleman's time has expired.
I assure you that each and every one of us feels as though it is
an honor to work on the Robert Pozen Memorial Securities Act of
1993, and if none of us ever see it again or hear of it again, it will
be an honor we can all look at in the rear view mirror, you know—
never to be reflected upon again.
Let me ask this, Mr. Zicklin, in your written testimony you note
that section 11(a), managed account restrictions result in market
inefficiencies because, quote, "these restrictions don't apply to overthe-counter markets to foreign securities exchanges."
Could you explain the market inefficiencies
Mr. ZICKLIN. Sure.
Mr. MARKEY.—which are created and how the national market is
hurt by it.
Mr. ZICKLIN. Let me give you just one example.
A money manager manages an institutional type account and
what we call a "natural account." Let's assume he wanted to buy
$100,000 XYZ shares. He's first got to investigate how many shares
are 11(a) and how many are non-11(a).
He then theoretically could enter the non-11(a) through our own
Erocess while the 11(a) would have to go through an independent
roker. Well, you are not going to do that because you are not
going to have two orders competing on the floor on the same side
thereby creating more demand than ordinarily would be and com-

215
Again, thank you very much for enabling me to be a part of this effort. If you
have any further questions, please do not hesitate to contact me.
Sincerely,
PAUL GOTTLIEB, Chair, Investment Adviser Committee.

Mr. MARKEY. Mr. Zicklin, as you note in your written testimony,
the original rationale for 11(a) managed account provisions was
Congressional concerns of breaches of fiduciary duties by money
managers such as churning of their managed accounts for commission income.
How large a role has the demise of fixed commission rates played
in eliminating the competitive distortions? Has it eliminated the
distortions between exchange member and non-member money
managers that gave rise to the managed account restrictions in the
first place?
Mr. ZICKLIN. I think since any competitor has the ability to join
a national securities exchange, I think you now really have an
equal playing field. To the extent people don't want to join, it's because they have no economic reason to join and find no economic
reason to do so. Otherwise, I think the playing field has been levelled.
Mr. MARKEY. DO you agree with that, Mr. Gottlieb? There's no
real difference?
Mr. GOTTLIEB. I would basically concur.
Mr. ZICKLIN. I think the evidence is Fidelity. Years ago when
this was first enacted by recollection is Fidelity was not a member.
Fidelity deemed membership advisable and therefore joined.
Mr. MARKEY. HOW important was unfixing the rate?
Mr. ZICKLIN. I think it was critical. I think once commissions
were "unfixed," to use your terminology and membership were permitted, everything else was superfluous. The game was over.
I think for 18 years we have had this anachronism going on artificiality. I think it's time it ended.
Mr. MARKEY. OK, and let me ask this finally to both of you.
Some academic experts have suggested that the existence of
minimums of one-eighth of a dollar introduces inefficiencies that
make possible certain controversial trading practices such as payments for order flow.
Does the same logic that made the managed account restrictions
unnecessary also apply to that situation? In other words, if the
fixed rate of one-eighth of a dollar were replaced with a decimal
system, would that reduce the potential for conflicts of interest that
money managers today may confront in accepting payments for
order flow?
Mr. ZICKLIN. I don't know if it would reduce that conflict but I
think that anything that makes the markets more efficient we
would vote for and if we could get 12.5 cents down to 6.25 cents
from the point of view of our clients, it would be a much more efficient system.
I think that's where you have seen the electronic systems handled now.
Mr. MARKEY. Mr. Gottlieb.
Mr. GOTTLIEB. I agree
Mr. MARKEY. "I concur
"
Mr. GOTTLIEB. "Completely." My very words.

216
Mr. MARKEY. It takes all the fun out of it, know what I mean?
There should be somebody completely disagreeing saying—we can't
find anyone.
Mr. ZLCKLLN. We could suggest other legislation if you like.
Mr. MARKEY. Well, I think that we might have a couple of other
questions that we would submit to you for the record, if we could
and would ask for there to be a rapid written response to the questions but I don't think there is any controversy between the majority and minority on the subcommittee on the subject, and I think
as a result we can process this legislation very quickly, which is
our intention.
We would like to work with you as we are moving along to flesh
out the legislative record and ensure in fact that we are giving
proper instructions to the SEC and to the marketplace.
With that, we thank you very much for your participation. We
thank you for coming down to help us today.
Mr. GOTTLIEB. Thank you very much.
Mr. ZICKLIN. Thank you for having us.
Mr. MARKEY. The hearing is adjourned. Thank you.
[Whereupon, at 2:45 p.m., the hearing was adjourned.]

ISBN

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Full text of Government Securities Reform : Hearings Before the Subcommittee on Telecommunications and Finance of the Committee on Energy and Commerce, House of Representatives, One Hundred Third Congress, First Session, on H.R. 616 and H.R. 618, March 17 and 30, 1993

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