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IMPACT ON MONEY AND CREDIT POLICY OF
FEDERAL DEBT MANAGEMENT
HEARING
BEFORE THE
SUBCOMMITTEE ON
DOMESTIC MONETARY POLICY
OF THE
COMMITTEE ON
BANKING, FINANCE AND URBAN AFFAIRS
HOUSE OF REPRESENTATIVES
NINETY-EIGHTH CONGRESS
FIRST SESSION
APRIL 25, 1983
Serial No. 98-11
Printed for the use of the Committee on Banking, Finance and Urban Affairs
U.S. GOVERNMENT PRINTING OFFICE
20-953 O
WASHINGTON : 1983
HOUSE
COMMITTEE ON
BANKING,
FINANCE AND URBAN
AFFAIRS
FERNAND J. ST GERMAIN, Rhode Island, Chairman
CHALMERS P. WYLIE, Ohio
HENRY B. GONZALEZ, Texas
STEWART B. McKINNEY, Connecticut
JOSEPH G. MINISH, New Jersey
GEORGE HANSEN, Idaho
FRANK ANNUNZIO, Illinois
JIM LEACH, Iowa
PARREN J. MITCHELL, Maryland
RON PAUL, Texas
WALTER E. FAUNTROY, District of
ED BETHUNE, Arkansas
Columbia
NORMAN D. SHUMWAY, California
STEPHEN L. NEAL, North Carolina
STAN PARRIS, Virginia
JERRY M. PATTERSON, California
BILL McCOLLUM, Florida
CARROLL HUBBARD, JR., Kentucky
GEORGE C. WORTLEY, New York
JOHN J. LAFALCE, New York
MARGE ROUKEMA, New Jersey
NORMAN E. DAMOURS, New Hampshire
BILL LOWERY, California
STAN LUNDINE, New York
DOUGLAS K. BEREUTER, Nebraska
MARY ROSE OAKAR, Ohio
DAVID DREIER, California
BRUCE F. VENTO, Minnesota
JOHN HILER, Indiana
DOUG BARNARD, JR., Georgia
THOMAS J. RIDGE, Pennsylvania
ROBERT GARCIA, New York
STEVE BARTLETT, Texas
MIKE LOWRY, Washington
CHARLES E. SCHUMER, New York
BARNEY FRANK, Massachusetts
BILL PATMAN, Texas
WILLIAM J. COYNE, Pennsylvania
BUDDY ROEMER, Louisiana
RICHARD H. LEHMAN, California
BRUCE A. MORRISON, Connecticut
JIM COOPER, Tennessee
MARCY KAPTUR, Ohio
BEN ERDREICH, Alabama
SANDER M. LEVIN, Michigan
THOMAS R. CARPER, Delaware
ESTEBAN E. TORRES, California
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
WALTER E. FAUNTROY, District of Columbia, Chairman
GEORGE HANSEN, Idaho
STEPHEN L. NEAL, North Carolina
RON PAUL, Texas
DOUG BARNARD, JR., Georgia
BILL McCOLLUM, Florida
CARROLL HUBBARD, JR., Kentucky
BILL LOWERY, California
BILL PATMAN, Texas
JOHN HILER, Indiana
BUDDY ROEMER, Louisiana
BRUCE A. MORRISON, Connecticut
JIM COOPER, Tennessee
THOMAS R. CARPER, Delaware
HOWARD LEE, Staff Director
<ll)
CONTENTS
STATEMENT OF
Page
Solomon Anthony M., president, Federal Reserve Bank of New York
4
ADDITIONAL MATERIAL SUBMITTED FOR INCLUSION IN THE RECORD
Fauntroy, Chairman Walter E., opening statement
Solomon, Anthony M.:
Additional information submitted at the request of Chairman Fauntroy....
Prepared statement on behalf of the Federal Reserve Bank of New York ..
3
51
12
APPENDIXES
Appendix
Appendix
Federal
Appendix
A: Notice of subcommittee hearing and additional material
B: Amicus curiae brief in the Lombard-Wall case filed by the
Reserve Bank of New York
C: Daily report of dealers
(hi)
57
63
90
IMPACT ON MONEY AND CREDIT POLICY OF
FEDERAL DEBT MANAGEMENT
MONDAY, APRIL 25, 1983
HOUSE OF REPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY,
COMMITTEE ON BANKING, FINANCE AND U R B A N AFFAIRS,
Washington, D.C.
The subcommittee met, pursuant to call, at 1 p.m., in room 2128,
Rayburn House Office Building; Hon. Walter E. Fauntroy (chairman of the subcommittee), presiding.
Present: Representatives Fauntroy, Patman, and Hiler.
Chairman FAUNTROY. The subcommittee will come to order.
Slightly more than 1 year ago this month, this subcommittee
began to assess the management of the national debt and the
impact of Treasury borrowings on general credit conditions. This
oversight hearing continues within that general framework but
with the more specific focus on the safety, soundness, structure and
function of domestic institutions which are engaged in the purchase and sale of U.S. Government debt instruments.
The markets in Government securities are largely unregulated.
Relying on oral agreements, informal understandings and mutual
trust, a relatively small number of securities dealers trade billions
of dollars worth of Government securities each day. A large part of
these transactions take the form of repurchase agreements in
which the securities serve as collateral.
These transactions rest on the ultimate soundness of the Government securities, but the extent to which such collateral will be
stretched to finance speculation has been limited only by the fear
of loss, not by affirmative regulation. As the volume of trading has
increased and new dealers have entered the secondary market, the
marketplace's restraints against excessive underfinanced dealings
have become attenuated. The collapse last summer of Drysdale
Government securities, Lombard-Wall, and Comark demonstrated
the risks in this situation from overextended dealers with hundreds
of millions of dollars in short-term liabilities.
The failure of Drysdale and Lombard-Wall weakened the confidence in the soundness of the Government securities market and
raised questions about one of the most common transactions; the
repurchase agreement. If there are new failures, there will be new
questions and new problems which will severely affect our present
system for the marketing of Treasury securities.
The Federal Government is expected to borrow an additional
$200 billion this year. Its refinancing operations will be even more
(1)
2
substantial. If we do not have an efficient and smoothly functioning Government securities market, that volume of borrowing will
overwhelm the financial community, raising interest rates and
choking off the economic recovery. This is why this subcommittee
has been interested in this issue.
I understand that in the aftermath of last summer's failures, the
Federal Reserve System, acting through the Federal Reserve Bank
in New York, has increased its surveillance of the market. I also
understand there are a number of regulatory schemes currently
under discussion which would enhance the safety and soundness of
the major security dealers. This subcommittee wants to know precisely what new regulatory efforts and oversight have been undertaken. We also want to know what is contemplated.
Specifically, we on this subcommittee want to hear from our witnesses today on the following issues:
First, what concerns do you hold with respect to the financial
and operating conditions of various Government security firms?
Second, will the size of the pending Government deficit have an
adverse effect on the ability of the market to absorb the deficit
without undue upward pressures on interest rates and the safety
and soundness of the Government security firms?
Third, should there be a specific effort made to expand the
number of primary dealers? How would this be done?
Fourth, should there be more direct regulation of all Government security dealers?
Fifth, what about possible new capital rules? I am particularly
interested in the discussions which are being held about the imposition of capital ratio rules. How would you propose to attract capital to a firm? What would be the advantages of such a rule and
would there be any lessening of the number of qualified dealers?
Here to testify on these issues today is the Hon. Anthony M. Solomon, president of the Federal Reserve Bank of New York. Accompanying President Solomon are Edward J. Geng, senior vice president of the New York Federal Reserve Bank, who has been monitoring the Government securities market and preparing new regulations to deal with this problem, and Peter D. Sternlight, executive vice president of the Federal Reserve Bank of New York, who
supervises its trading in Government securities on behalf of the
Federal Open Market Committee.
[The full text of Chairman Fauntroy's opening statement follows:]
3
OVERSIGHT HEARINGS ON THE SAFETY, SOUNDNESS, STRUCTURE AND FUNCTION OF
DOMESTIC INSTITUTIONS ENGAGED IN THE PURCHASE AND SALE OF
UNITED STATES GOVERNMENT DEBT INSTRUMENTS
OPENING STATEMENT OF THE HONORABLE WALTER E. FAUNTROY
CHAIRMAN, SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
Monday, April 25, 1983 — 1:00 P.M.
The Rayburn House Office Building, Washington, D.C.
The Subcommittee will come to order.
Slightly more than one year ago this month, this Subcommittee began to
assess the management of the national debt and the impact of Treasury
borrowings on general credit conditions. This oversight hearing continues
within that general framework but with the more specific focus on the safety,
soundness, structure, and function of domestic institutions which are engaged
in the purchase and sale of United States Government debt instruments.
The markets in government securities are largely unregulated. Relying on
oral agreements, informal understandings, and mutual trust, a relatively s m a M
number of securities dealers trade billions of dollars worth of government
securities each day. A large part of these transactions take the form of
repurchase agreements in which the securities serve as collateral. These
transactions rest on the ultimate soundness of the government securities, but
the extent to which such collateral will be stretched to finance speculation
has been limited only by the fear of loss, not by affirmative regulation. As
the volume of trading has increased and new dealers have entered the secondary
market, the marketplace's restraints against excessive underfinanced dealings
have become attenuated. The collapse last summer of Drysdale Government
Securities, Lombard-Wall, and Comark demonstrated the risks in this situation
from overextended dealers with hundreds of millions of dollars in short-term
I iabiIities.
The failures of Drysdale and Lombard-Wall weakened the confidence in the
soundness of the government securities market and raised questions about one of
the most common transactions—the repurchase agreement. If there are new
failures, there will be new questions and new problems which will severely
affect our present system for the marketing of Treasury securities.
The
Federal government is expected to borrow an additional $200 billion this year.
Its refinancing operations will even more substantial. If we do not have an
efficient and smoothly functioning government-securities market, that volume of
borrowing will overwhelm the financial community, raising interest rates and
choking off the economic recovery. This is why this Subcommittee has been
interested in this issue.
I understand that in the aftermath of last summer's failures, the Federal
Reserve System, acting through the Federal Reserve Bank of New York, has
increased its surveillance of the market. I also understand there are a number
of regulatory schemes currently under discussion which would enhance the safety
and soundness of the major security dealers. This Subcommittee wants to know
precisely what new regulatory efforts and oversight have been undertaken. We
also want to know what is contemplated.
4
Specifically, we on this Subcommittee want to hear from our witnesses
today on the following issues:
1. What concerns do you hold with respect to the financial and operating
conditions of various government security firms?
2. Will the size of the pending government deficit have an adverse effect on
the ability of the market to absorb the deficit without undue upward pressures
on interest rates and the safety and soundness of the government security
f irms?
3. Should there be a specific effort made to expand the number of primary
dealers? How would this be done?
4. Should there be more direct regulation of all government security dealers?
5. What about possible new capital rules?
I am particularly interested in the
discussions which are being held about the imposition of capital ratio rules.
How would you propose to attract capital to a firm?
What would be the
advantages of such a rule and would there be any lessening of the number of
qua Ii f ied dealers?
Here to testify on these issues today is The Honorable Anthony M. Solomon,
President of the Federal Reserve Bank of New York. Accompanying President
Solomon are Edward J. Geng, Senior Vice President of the New York Federal
Reserve Bank, who has been monitoring the government-securities market and
preparing new regulations to deal with this problem, and Peter D. Stern!ight,
Executive Vice President of the Federal Reserve Bank of New York, who
supervises its trading in government securities on behalf of the Federal Open
Market Committee.
Chairman FAUNTROY. Gentlemen, we are happy and pleased to
have you respond to our request to come for this hearing. I am
pleased you have submitted your testimony in advance and we
have studied it carefully. We also are pleased to have a new
member of the committee, Mr. Hiler, here.
We are ready now to proceed, Mr. Solomon, with your testimony
in whatever manner you may choose to offer it.
STATEMENT OF ANTHONY M. SOLOMON, PRESIDENT, FEDERAL
RESERVE BANK OF NEW YORK
Mr. SOLOMON. Thank you, Mr. Chairman.
Since the statement that we presented was rather lengthy, I
have prepared a shorter statement which I would like to read. I
think it will give the subcommittee a sense of the main issues. And
then my colleagues and I of course, are pleased to answer any questions you have.
We are here in response to your invitation to Chairman Volcker
to discuss the recent efforts of the Federal Reserve System to increase its surveillance of the Government Securities market and
thereby contribute to the orderly and effective operation of that
market. The New York Reserve Bank serves as the operating arm
of the System in the conduct of open market operations, primarily
through transactions involving U.S. Government securities.
Mr. Chairman, nearly 1 year has elapsed since the Drysdale Government Securities firm sent shock waves through the Government
securities market when it proved unable to pass on to counterparties interest on securities purchased under repurchase agreements,
or repros. The Drysdale default also contributed to the collapse of
two other Government securities dealers, Comark and Lombard-
5
Wall. While none of these three firms were eligible to transact
business with the Federal Reserve, their failures were a cause of
concern to us in terms of the threat they posed to the orderly functioning of the market as a whole.
With this in mind, in my statement last May 25 before the Subcommittee on Securities of the Senate Banking Committee, I indicated that the New York Reserve Bank would reexamine its traditional informal surveillance role and would work with the dealer
community in seeking remedies for the practices that led to these
failures.
I am pleased to report today that while much remains to be
done, considerable progress has been made since that time. I will
begin with a brief overview of the Government securities market
and a review of the past year's developments before turning to address the specific questions you have raised. My written statement
which I have submitted for the record today contains additional
background material, including some of the details behind the
three failures last year.
Chairman FAUNTROY. Without objection, that entire statement
will be entered into the record, in addition to the statement which
you now give.
Mr. SOLOMON. Thank you, sir.
The market for U.S. Government securities, which comprises
trading in Treasury bills, notes, and bonds, is the most active capital market in the world. Although hundreds of firms participate to
some extent, the core of the market is comprised of 36 dealers at
the present time, including 12 commercial banks and 24 nonbanks,
which submit to the Federal Reserve Bank of New York, daily position and volume reports as well as periodic financial statements.
We refer to these dealers as the reporting or primary dealers. In
addition to making active secondary markets in Treasury securities, the reporting dealers typically purchase and distribute from
35 to 75 percent of the total amount sold by the Treasury at each
auction.
This market has functioned quite well over the years as an
unregulated market subject only to informal surveillance by the
Federal Reserve. Historically, the lack of a perceived need for a
more formal regulatory structure probably was due primarily to
the essentially riskiness nature of Government securities from a
credit standpoint, and limited participation by unsophisticated investors.
Another reason is that many of the dealers already are subject to
formal regulation in some form, either as banks or subsidiaries of
bank holding companies or because they also operate in regulated
markets. Additional measures of protection include the general
antifraud provisions of the Federal securities laws and the self-regulatory constraints implicit in the interrelationships among market
participants.
The Federal Reserve also plays an important role in this respect.
In order for a firm to qualify as a primary dealer, we require that
it submit to us daily transaction and position reports, as well as
monthly financial statements; be actively engaged in the distribution of Treasury securities; have adequate capital and capable management; and stand ready to make markets in Treasury issues. All
6
of these requirements must be met over a period of time before we
will consider adding a firm to our reporting list, and firms that
have failed to maintain these standards have been dropped from
the list from time to time.
The failures of Drysdale, Comark and Lombard-Wall, who were
not reporting dealers, differed in some respects, but the common
thread running through all three cases was that the firms were
able to exploit opportunities to circumvent the self-regulating
mechanisms of the market. They were thus able to support levels
of activity far beyond what would have been prudent given their
own resources by raising capital from careless or unwitting customers. From the Fed's standpoint, these events drove home two essential lessons: First, that it was incumbent upon us to exercise leadership in working with market participants to correct the practices
that led to these breakdowns in the market's functioning; second,
that a stepped-up level of surveillance was called for, encompassing
a broader spectrum of market participants than just the 36 firms
that report to us and trade with us on a daily basis.
Since that time, we have moved forward actively on both of these
fronts. Last August, the New York Reserve Bank announced the
appointment of a senior officer, Mr. Geng, with broad public and
private experience to head a new unit within our open market
function devoted exclusively to market surveillance and related
issues. We have since completed what we see as the necessary initial staffing of the new area, with an additional officer, five professional employees with experience in financial analysis, dealer operations and law, and support personnel. The surveillance effort also
draws upon the bank's other professional resources and we are, of
course, prepared to expand the staff if necessary in light of new developments. The basic ongoing work of this surveillance unit includes reviewing the financial condition and daily position reports
of the reporting dealers. The primary objective of this review, aided
by computer programs and other analytical tools, is to identify incipient undesirable trends and abnormal dealer behavior. The impressions we form from these analyses are supplemented by regular telephone calls and visits to the reporting dealer firms.
One significant change in market practices that has already been
accomplished by the dealer community with the strong encouragement of the Fed is the inclusion of accrued interest in accounting
for repurchase transactions. Failure in the past to include interest
in determining the value of a security in a repurchase transaction
enabled Drysdale to raise additional capital that it was then able to
use in its own activities.
Through repurchase agreements it would borrow securities that
had a considerable amount of accrued interest, paying only the
principal amount. Then it would sell the securities for their full
value including the accrued interest. Drysdale used the extra funds
raised in this fashion to finance its own activities. But when it incurred losses, it lacked the resources to honor its commitments to
make the interest payments when due on the securities.
In the wake of the Drysdale failure, the way to prevent a recurrence was clear; simply require that accrued interest be included in
repurchase accounting. The Primary Dealer Association endorsed
this change, and I addressed a letter to the head of each primary
7
dealer firm informing them that we would adopt the new accounting procedure for our own transactions beginning last August. We
had had earlier meetings in June, starting shortly after Drysdale,
in June and July, and there have been communications by letter as
well. By October 4, 1982, all of the reporting dealer firms had completed the changeover in their accounting procedures for repurchase transactions with other customers as well.
One other practice that contributed to the Drysdale failure and
in which significant improvement has been seen is that of "blind
brokering." In the Drysdale case, major New York banks had acted
as brokers, bringing together the parties in repurchase transactions, but neither party knew who its counterparty was. In effect,
this practice would permit a weak dealer firm to hide its identity
behind that of the bank acting as broker, and thus to build up its
positions with counterparties to a level that the counterparties'
credit review procedures might not have allowed it they had realized with whom they were dealing. But since the Drysdale failure
we have seen a new atmosphere of caution and attention to one's
counterparties, and consistent with this the practice of blind brokering of repos has diminished substantially.
Turning to current issues, Mr. Chairman, and the specific questions raised in your letter to Chairman Volcker, the number of primary reporting dealers has grown over the years as the size of the
market has expanded—from around 20 in the 1960's to the present
level of 36. The door is always open to additional firms that meet
our criteria and who are prepared to comply with our reporting requirements. Although the present reporting list is adequate for our
trading needs in conducting open market operations, we have concluded that it is not sufficient for monitoring purposes in light of
last year's developments, even though we believe these firms actually account for the bulk of trading activity in government securities.
While our plans are still in a formative stage, we plan to seek
submission of data from a sizable number of nonreporting dealers
in addition to the primary dealers. This information would not be
as detailed or frequent as it is from the primary dealers. Moreover,
since banks are already under close regulatory scrutiny and the
purpose here is market surveillance and the financial viability of
dealers, this additional data collection effort would be directed only
to the nonbank dealers. As with the present reporting group, the
submission of reports by the second group would be entirely voluntary. However, we see this group as forming a logical pool of candidates from which future primary dealers might emerge, thus giving
them an incentive to comply with our request. I also believe that a
sizable market participant would not want to be in a position of declining to disclose information in confidence to the Federal Reserve.
Mr. Chairman, you have asked whether imposing more demanding standards on the dealers could reduce the number of firms
available to handle the forthcoming heavy volume of Treasury financings. I do not see any of our plans as posing a problem in this
regard. I think a moderately stepped-up program of disclosure is a
rather small price to pay for a firm which has the resources and
the desire to be a significant market participant. You also have ex-
8
pressed some concern regarding the market's ability to absorb the
expected volume of Treasury financing without compromising the
soundness of the dealer firms or causing undue upward pressure on
interest rates. As for the primary dealers, their capital has increased substantially during recent years and particularly last
year, and I am confident that they are up to the underwriting
tasks that lie ahead.
With the economy just beginning to recover from a deep recession, I do not regard the current year's Federal deficit as a significant problem from the standpoint of undue interest rate pressures.
As in past recessions, weak private credit demands have allowed
the Government to increase its demands on the credit market, and
in fact as you know, rates have fallen substantially in the last 10
months or so. To be sure, this could change as the Treasury begins
to compete on a massive scale with rising private credit demands
during recovery, and this could affect interest rates and the recovery itself adversely, but this would be attributable not to the current structure of the market but simply to the outsize Federal deficits at a time when a much more nearly balanced Federal fiscal
posture is called for.
While the issue of accrued interest accounting in repurchase
agreements has been dealt with to our satisfaction, there is another issue concerning repos about which we have some concern;
namely, the treatment of repos in a bankruptcy proceeding. When
Lombard-Wall failed last summer, the bankruptcy court determined that its repos should be treated as secured loans, rather
than purchase and sale transactions; thus making them subject to
the automatic stay provisions under the Bankruptcy Code. This
ruling caused a significant deterioration in market confidence in
repos, since it meant in effect that the purchaser of securities, or
lender of funds, could see his funds tied up for a protracted period
if his counterparty went bankrupt. Furthermore, if the securities
were to decline in value he could lose money in what he had
thought of as a riskless transaction.
While the repo market has shown some adverse effects from
these events, it has held up reasonably well to date—in part, I believe, due to the expectation by market participants that the repo
legislation pending in the Congress as part of a package of Bankruptcy Code reforms will be ultimately enacted. That legislation
would exempt repo transactions in Treasury securities and certain
other money market instruments from the automatic stay provisions, without taking a position as to whether they are secured
loans or purchases and sales. Chairman Volcker has recommended
that the Congress enact this legislation in letters to Chairman Dole
of the subcommittee on courts, Senate Judiciary Committee, and to
Chairman Rodino of the House Judiciary Committee. I certainly
endorse that recommendation and urge the Congress to move forward in this area.
While I cannot state with certainty to what further extent the
market would deteriorate if this legislation does not pass, at the
least we would likely see a decline in liquidity and higher rates in
the repo market, which would hamper to some degree both the
Treasury's ability to market its offerings and the Fed's ability to
conduct open market operations. In the wake of the failures of
9
Drysdale, Comark, and Lombard-Wall, all of which were thinly capitalized in relation to their activities, we have recognized capital
adequacy as the single most basic issue to be addressed in our surveillance efforts. Unfortunately, developing objective criteria on
any basis that attempts to give weight to different circumstances in
a fair and realistic manner can be enormously complex.
In the past, we have looked at capital adequacy on a case-by-case
basis, and have cautioned reporting dealers from time to time
when their position risks or balance sheet totals seemed excessive
in relation to their capital. But since our ultimate objective is to
create a model of capital adequacy which may be used not only by
the Fed but also by dealers and customers, we feel that more specific and objective criteria that can be applied across the board
must be developed. Our surveillance staff is presently developing
statistical measures and computer programs that look toward a
systematic analysis of both sides of the equation—how to measure
capital in a meaningful way and also how to measure whether the
risks a firm is taking in its operations are within prudent limits in
relation to that capital. Ultimately we expect to have objective criteria of capital adequacy that we can apply to the primary reporting dealers—and we would also suggest and expect voluntary compliance with these standards by the large or active secondary dealers as well. In effect, we expect the guidelines developed by the Fed
to become the generally accepted standards to which lending banks
and customers would look for guidance.
But I must emphasize that no purely mechanical approach is
adequate in a market where the rapidity of developments could
lead to serious difficulties for a poorly managed firm even if its
capital appears to be adequate. Thus, we intend to continue our
case-by-case approach to assessing individual firms in a more subjective way, as well as applying the objective criteria we are developing. In our discussions with dealers following the Drysdale failure, "when issued" trading was often identified as an area of potential danger. In effect, this involves a transaction in which the
parties agree to trade a security prior to its actual issue date—perhaps 2 or 3 weeks ahead—with actual settlement to take place on
the issue date. Since no money changes hands until the securities
are actually issued and delivered, it is possible for a market participant to trade in very large volume without employing any capital
at all. Indeed, the volume of this type of forward trading has
reached very high levels in recent years.
In addition to the lack of margin or some other form of capital to
support these transactions, a significant problem area is that a
single market participant could enter into numerous transactions
with many different counterparties, none of whom would have
reason to know the extent of that participant's total commitments.
Thus, normal standards of prudence, such as credit limits between
firms, are not sufficient to prevent the dangers we see in this type
of trading. We are actively discussing a number of possible solutions with market participants, most of whom share our concern
with this practice, at least to some extent. While we are prepared
to insist on a Federal Reserve solution if necessary, we would much
prefer, and indeed expect, that a satisfactory system for limiting
risk will be agreed upon on a voluntary basis, as the dealers per-
10
ceive their own long-term interest will be best served by having
adequate safeguards.
Turning to the question: Should the Federal Reserve have a
formal regulatory role, in the wake of last year's failures? I have
heard some sentiment expressed that the Federal Reserve's regulatory role should be made more formal and explicit. Whether such a
move is necessary or desirable in the public interest at the present
time is not a question that should be answered in the abstract or
by ideological preference, and my judgment is that a change in the
existing structure is not necessary at the present time. The principal consideration on which I base this conclusion, and which I believe should guide the Congress, is the efficacy of any particular approach in containing the shock waves that could spread through
the market from an event such as the failure of a single firm. As
last year's experience shows, the present structure affords us the
means and the flexibility to act promptly and decisively through
several avenues—the open market desk, the discount window, and
not least in importance the exercise of moral leadership, such as
we displayed in the accrued interest question.
To put the discussion in perspective, between the extremes of
direct and detailed Government regulation on the one hand and
total absence of an official oversight presence on the other hand—
which I would regard as imprudent given the importance of the
Government securities market—there are two viable approaches to
regulating this market. First, one could rely on the self-regulating
mechanisms inherent in the market, fortified by informal monitoring by the Federal Reserve—essentially the present structure.
Second, a more formalized and structured self-regulatory organization could be established, under which the market participants
would set and enforce rules governing such matters as trading
practices and capital adequacy, under the oversight of a governmental body such as the Fed with explicit legislative authority to
enforce those rules. This is essentially the case with such self-regulatory organizations as the New York Stock Exchange and the National Association of Securities Dealers.
On balance, I conclude that the more formal structure is not necessary or desirable at the present time. I think we should keep in
mind that the losses incurred in last year's failures—unpleasant
and undesirable though they were—fell entirely on large and sophisticated market participants, rather than on small individual
investors. In such cases we usually see these participants take the
lead in promoting necessary reforms, which they may have somewhat less incentive to do under a more formal structure. In the
final analysis, this is a market that has generally functioned quite
well in a self-regulatory environment, and no degree of regulation
will guarantee that accidents won't happen from time to time. The
existence of the Securities Investor Protection Corp. is, after all, a
tacit recognition that even those securities firms that operate in
regulated marketed with strict capital ratios are not immune from
failure. Much the same could be said of deposit insurance for banks
and thrift institutions. But while I conclude that formal regulatory
authority is not the best way to go, let me emphasize that our
minds remain open on this score. At times I have sensed that a
measure of complacency may be returning now that the immediate
11
threat is over. If this attitude became more widespread and could
not be overcome by us in our intensified surveillance capacity, I
would become concerned that the momentum of self-regulatory
reform could be lost. If that were to happen, we would not hesitate
to ask the Congress for more formal regulatory authority.
Thank you.
[The prepared statement of Mr. Solomon, on behalf of the Federal Reserve Bank of New York, follows:]
12
Statement by
Anthony M . Solomon
P r e s i d e n t , F e d e r a l Reserve Bank of New York
before the
Subcommittee on Domestic Monetary Policy
Committee on B a n k i n g , Finance and Urban Affairs
United States House of Representatives
Washington, D.C.
A p r i l 2 5 , 1983
13
Introduction
Good a f t e r n o o n , M r . C h a i r m a n .
I am Anthony S o l o m o n ,
P r e s i d e n t of the F e d e r a l Reserve Bank of New Y o r k .
W i t h your
p e r m i s s i o n , I am here today in response to your invitation to
Chairman Volcker to review the recent efforts of the F e d e r a l Reserve
System in its surveillance of the G o v e r n m e n t securities m a r k e t , in
order to contribute to the orderly and effective operation of that
market.
The F e d e r a l Reserve Bank of New Y o r k , acting on behalf of
the Federal Open M a r k e t Committee
(FOMC) , conducts "open m a r k e t
operations to implement the FOMC's monetary policy d i r e c t i v e s ,
mainly through transactions involving U . S . G o v e r n m e n t S e c u r i t i e s .
M o s t dealers in such securities are located in New York C i t y , and
many of the nation's largest banks are also headquartered
there.
A d d i t i o n a l l y , in common with the other eleven Federal Reserve Banks
the New York Reserve Bank acts as fiscal a g e n t for the United States
Treasury in the sale of new Treasury debt i s s u e s .
A l t o g e t h e r , more
than half of the Treasury's securities are sold through New York
financial
institutions.
M r . C h a i r m a n , nearly one year has elapsed since a dealer, in
G o v e r n m e n t s e c u r i t i e s , Drysdale G o v e r n m e n t S e c u r i t i e s , I n c .
(Drysdale) was unable to pass on to counterparties interest on
securities purchased under repurchase a g r e e m e n t s .
In addition to
causing two major banks to absorb significant l o s s e s , Drysdale's
default sent shock waves through the market which contributed to the
20-953 0 — 83
2
14
subsequent failure of two additional firms--Comark and
Lombard-Wall.
These events led to a heightened degree of awareness
among all the participants in the market regarding the risks
inherent in certain m a r k e t practices and the need to be more
c o g n i z a n t of the financial conditions of one's counterparties in
conducting m a r k e t t r a n s a c t i o n s .
None of the three firms that failed was a primary dealer
conducting G o v e r n m e n t securities transactions with the F e d e r a l
Reserve Bank of New Y o r k .
H o w e v e r , the Federal Reserve had
previously transacted business in b a n k e r s ' acceptances with
Lombard-Wall.
In November 1981* the Federal Reserve discontinued
dealing in b a n k e r s ' acceptances with L o m b a r d - W a l l because of
dissatisfaction over its financial c o n d i t i o n .
Comark and Drysdale
had approached the F e d e r a l Reserve to establish formal reporting
relationships in G o v e r n m e n t securities but Comark failed to qualify
and Drysdale applied only day,s before its c o l l a p s e .
Nonetheless,
their failures were a cause of concern to us in that such events
tend to affect the functioning of the m a r k e t as a w h o l e .
In my
statement before the Subcommittee on Securities of the Senate
Committee on B a n k i n g , Housing and Urban Affairs on May 25 of last
y e a r , I expressed this c o n c e r n , and indicated that the F e d e r a l
Reserve would reexamine its traditional informal surveillance role
and work with the dealer community in seeking to remedy the
practices that led to these d i f f i c u l t i e s .
Much progress has been made in the ensuing eleven m o n t h s .
With the active encouragement of the New York Reserve B a n k , dealers
have effectively eliminated one of the market practices that enabled
Drysdale to overextend i t s e l f — t h e failure to include accrued
15
interest in valuing securities for repurchase transactions--and are
at p r e s e n t considering a number of proposals to address other m a r k e t
practices where a need for change has been r e c o g n i z e d .
For our
p a r t , the New York Fed's surveillance efforts have shifted into high
gear with the increase in our p r o f e s s i o n a l staff devoted to this
effort.
In m y remarks t o d a y , I would like to begin with a brief
overview of the G o v e r n m e n t securities m a r k e t and a review of the
developments of the p a s t y e a r .
I w i l l then discuss in some d e t a i l
the specific areas of concern that we see at the p r e s e n t time with
respect to financial and operational m a t t e r s affecting the d e a l e r s
and the m a r k e t .
I w i l l address the question you r a i s e d , whether the
m a r k e t w i l l be able to absorb the Treasury's financing needs
resulting from the next few y e a r s ' projected deficits w i t h o u t undue
upward pressure on interest r a t e s .
F i n a l l y , I w i l l turn to the
issues tha«t remain to be r e s o l v e d , including the questions you posed
regarding the number of dealers with whom the Federal Reserve has a
d i r e c t relationship; whether the Federal Reserve should be d i r e c t l y
empowered to regulate the G o v e r n m e n t securities dealers; the
treatment of repurchase transactions in G o v e r n m e n t s e c u r i t i e s and
certain other instruments for p u r p o s e s of the bankruptcy law; and
your questions regarding the level of c a p i t a l needed to s u p p o r t a
given level of operations for a dealer firm and whether
specific
c a p i t a l ratios should be imposed on the f i r m s .
Overview of the G o v e r n m e n t Securities M a r k e t
The m a r k e t for United States G o v e r n m e n t s e c u r i t i e s , which
comprises trading in Treasury b i l l s , n o t e s , and b o n d s , is the m o s t
active c a p i t a l m a r k e t in the w o r l d .
While hundreds of firms
16
participate, in the m a r k e t , it centers chiefly on some 36 primary
dealer firms which s u b m i t to the Federal Reserve Bank of New York
daily and periodic s u p p l e m e n t a l position and volume reports as w e l l
as regular financial s t a t e m e n t s .
M o s t of these primary dealers are
located in New Y o r k , although several are in C h i c a g o , Los A n g e l e s ,
and San F r a n c i s c o ,
This primary dealer group presently includes 12
bank d e a l e r s , which are among the nation's largest c o m m e r c i a l
banks.
There are also 24 nonbank d e a l e r s , which range from
comparatively small specialty firms confining their activities to
this m a r k e t to several of the largest diversified investment banking
firms.
Some m e a s u r e of the importance of the 36 primary d e a l e r s is
provided by their p a r t i c i p a t i o n in the m a r k e t for new Treasury
issues.
While the amounts v a r y , these dealers usually p u r c h a s e from
35 to 75 p e r c e n t of the total amount sold by the Treasury at each
auction.
In a d d i t i o n , they make secondary m a r k e t s in these i s s u e s ,
standing ready to bid or offer outstanding T r e a s u r y obligations to
customers and to each o t h e r .
By and l a r g e , this m a r k e t functions
q u i t e w e l l , with the r e s u l t that over the years the T r e a s u r y ' s huge
financing requirements have been m e t e f f i c i e n t l y .
Investor
confidence in Treasury issues is fortified by the knowledge of their
extraordinary liquidity in the secondary m a r k e t .
Although the F e d e r a l Reserve has for decades exercised
informal surveillance of the m a r k e t , p r i m a r i l y through its
monitoring of reports submitted by dealers with which it does
b u s i n e s s , there has never been any formal regulation of the m a r k e t .
H i s t o r i c a l l y , the lack of a perceived need for formal regulation was
17
due in part to the essentially riskless nature of Government
securities from a credit s t a n d p o i n t .
Several other factors are
relevant here as w e l l .
- - F i r s t , many of the dealers are subject to formal
regulation in some f o r m , either as banks or subsidiaries of
bank holding companies or because they are p a r t of nonbank
securities firms that operate in regulated m a r k e t s .
— S e c o n d , although the purchase and sale of G o v e r n m e n t
securities is not regulated as s u c h , it remains s u b j e c t to
the general anti-fraud provisions of the Federal s e c u r i t i e s
l a w s , thus affording protection to the individual investor
in those r e s p e c t s .
— T h i r d , in the usual case the ability of any m a r k e t
participant to carry excessive security positions or engage
in other imprudent practices is constrained by its
relationships with the other p a r t i c i p a n t s , including the
degree of credit risk exposure they are willing to assume
toward that p a r t i c i p a n t .
The role of the Fed as a key p a r t i c i p a n t in the m a r k e t has
also served as an important deterrent to abusive p r a c t i c e s .
In
order to qualify as a primary dealer that may trans'act business with
the F e d , we require that a firm be actively engaged in the
distribution of Treasury securities among i n v e s t o r s , have adequate
c a p i t a l and capable m a n a g e m e n t , make m a r k e t s , and have a "track
record" manifesting a long-term commitment to the m a r k e t .
a d d i t i o n , the dealer m u s t submit periodic audited
In
financial
statements to u s , as well as daily reports of its m a r k e t p o s i t i o n s .
N o t until all of these requirements are m e t , over a period of t i m e ,
18
w i l l a dealer be added to the "reporting list."
From time to t i m e ,
dealers that have not maintained these standards--for reasons such
as insufficient a c t i v i t y , inadequate c a p i t a l , or a business decision
to reduce their level of participation in the G o v e r n m e n t securities
m a r k e t — h a v e been dropped from the l i s t .
It m i g h t be noted that inclusion in the reporting list does
not ensure a trading relationship; at any given t i m e , one or more of
the firms on the reporting list may not actually have a trading
relationship with the F e d .
A firm in this position may have been
added to the reporting list while we are still evaluating its
a b i l i t y to m e e t our s o m e w h a t m o r e stringent criteria for a trading
relationship.
A l t e r n a t i v e l y , it m i g h t be a firm which has been
suspended from a trading relationship while a reporting
continues.
relationship
In e f f e c t , we do w h a t other participants in the m a r k e t
should be d o i n g — c o n s t a n t l y review the soundness of the firms with
whom w e do b u s i n e s s ,
We do n o t , h o w e v e r , represent that a trading
or reporting relationship with the Fed is a guarantee of a firm's
soundness.
Developments over the p a s t year
The m o s t s i g n i f i c a n t development in the G o v e r n m e n t
securities m a r k e t in the p a s t year w a s , of c o u r s e , the Drysdale
failure and the subsequent problems of Comark and L o m b a r d - W a l l .
On
September 1 5 , 1 9 8 2 , the F e d e r a l Reserve Bank of New York submitted
to the C o n g r e s s a report on these d e v e l o p m e n t s .
To review b r i e f l y ,
the common thread running through the three cases was that the firms
were able to c i r c u m v e n t in some fashion the self-regulating
m e c h a n i s m s of the m a r k e t , thereby raising working c a p i t a l from
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careless or unwitting c u s t o m e r s , which capital they then used in
their own a c t i v i t i e s .
In the Drysdale c a s e , the firm essentially raised funds by
borrowing s e c u r i t i e s , typically securities with large amounts of
accrued i n t e r e s t , and then selling them to realize p r i n c i p a l and
accrued interest in excess of the cash margin it provided when it
borrowed the s e c u r i t i e s .
It was able to engage in this activity on
a large scale by exploiting two m a r k e t practices--the failure to
include accrued interest in the value of securities used in
repurchase transactions in determining how much cash should be
p o s t e d , and the p r a c t i c e of "blind brokering" which enabled Drysdale
to conceal its identity from its c o u n t e r p a r t y — i n effect hiding
behind the banks that acted as brokers in arranging the
transactions.
In the Comark s i t u a t i o n , some of the firm's customers
apparently allowed Comark to retain custody of securities they had
purchased from i t .
The firm's accounting system had fallen into
d i s a r r a y , and it is alleged that it posted the securities as
collateral to secure borrowings that allowed it to continue
f u n c t i o n i n g , even though its capital had been d e p l e t e d .
It
eventually proved unable to meet its c u s t o m e r s ' demands for their
securities.
In the L o m b a r d - W a l l s i t u a t i o n , some customers advanced
funds in excess of the value of the securities they received under
repurchase a g r e e m e n t s . ,Others received funds from L o m b a r d - W a l l of
lesser value than the securities they p r o v i d e d .
A g a i n , the firm was
able to. employ these excess funds to support activities w e l l beyond
the level warranted by its own c a p i t a l .
20
In the wake of these d e v e l o p m e n t s , the F e d e r a l Reserve
moved to take the lead in working with dealers and other m a r k e t
participants to improve procedures and eliminate the practices that
were identified as having caused or contributed to these breakdowns
in the market's normal self-corrective m e c h a n i s m s .
A t the same
t i m e , the dealers began moving toward needed changes in some areas
w i t h o u t the Fed being actively
involved.
In the immediate aftermath of the disclosure that D r y s d a l e
could not honor its c o m m i t m e n t on some $160 million of accrued
securities interest payments due to Chase Manhattan Bank last May
1 7 , our primary concern a t the Federal Reserve was to preserve the
orderly functioning of the m a r k e t until the situation could be
resolved.
We recognized some risk that failure to make these
payments could cause a widespread "seizing up" of the m a r k e t in
which normally major participants would be reluctant to undertake
new commitments or perhaps even to perform on their existing
commitments.
As the major intermediary between Drysdale and its
counterparties in these t r a n s a c t i o n s , the Chase Manhattan Bank
contacted the New York F e d e r a l Reserve Bank and arranged for a
meeting at our offices with the dealer firms that were
involved.
The key issue was who should bear the loss resulting from D r y s d a l e ' s
default.
The firms which had provided the securities through Chase
expected that bank to honor the interest payments d u e , while Chase
was looking to Drysdale as the responsible p a r t y .
The immediate
crisis was resolved two days later on May 1 9 , with the announcement
by Chase and Manufacturers H a n o v e r , which was involved to a lesser
21
e x t e n t , that they would make the interest payments in question and
would undertake to unwind Drysdale's securities p o s i t i o n s .
During these difficult two d a y s , the New York F e d e r a l
Reserve Bank took a number of actions aimed at facilitating a
resolution of the crisis and making sure to the extent possible that
the m a r k e t continued to function s m o o t h l y .
On May 18 we informed
the 12 New York Clearing House banks and all of the primary dealers
that we were closely monitoring the situation and stood ready to
assist any bank facing an unusual liquidity problem with a loan at
our discount w i n d o w .
In a d d i t i o n , we extended normal d e a d l i n e s for
our securities and funds transfer systems to make sure that the
day's transactions could be c o m p l e t e d .
The Open M a r k e t Desk also helped by acting a bit earlier
than usual in meeting projected reserve needs on May 1 8 , and in the
period immediately thereafter we tended to resolve any doubts as to
the timing of our actions on the side of meeting anticipated needs
more promptly and f u l l y .
But I should emphasize that the reserve
objectives themselves were shaped by monetary policy considerations
and were not affected by Drysdale-related
factors.
Following the commitment of Chase and Manufacturers Hanover
to unwind Dirysdale's p o s i t i o n , the Federal Reserve also helped out
by alerting the dealers that we would temporarily liberalize our
rules for making short-term loans of G o v e r n m e n t securities from our
portfolio.
As a r e s u l t , the volume of Fed-owned securities out on
l o a n , normally in the vicinity of about $200 m i l l i o n , briefly
reached a high of about $2 billion on May 2 5 , before dropping back
by early June as dealers found other sources for the securities they
needed.
22
Beyond helping to contain the effects of the immediate
situation last spring and s u m m e r , the F e d e r a l Reserve has moved to
strengthen its own c o m m i t m e n t to overseeing the m a r k e t .
Last
A u g u s t , we announced the appointment of a Senior V i c e P r e s i d e n t to
head a new unit within our Open M a r k e t Function devoted exclusively
to m a r k e t s u r v e i l l a n c e .
This i n d i v i d u a l , Edward G e n g , has had broad
prior experience in G o v e r n m e n t securities at s e v e r a l private f i r m s ,
as w e l l as a previous stint at the F e d e r a l Reserve and at the U . S .
Treasury.
Early this year we filled o u t , for the time b e i n g , the
staffing of this new a r e a , which presently includes two o f f i c e r s ;
five professional e m p l o y e e s with experience in financial a n a l y s i s ,
dealer operations and law; and a few support p e r s o n n e l .
We
anticipate that this staff w i l l be adequate to m e e t our p r e s e n t
n e e d s , although w e are prepared to expand it if warranted by new
d e v e l o p m e n t s — s u c h a s , for e x a m p l e , a significant increase in the
number of dealers reporting data to u s .
In a d d i t i o n , our
surveillance effort d r a w s upon the Bank's other p r o f e s s i o n a l
resources as necessary for l e g a l , a n a l y t i c a l , and operating
support.
The basic ongoing work of the surveillance unit c o n s i s t s of
receiving and reviewing the regular daily and weekly reports of
securities positions and transactions submitted by the reporting
d e a l e r s , as w e l l as their monthly and annual reports of f i n a n c i a l
condition.
With the aid of computer p r o g r a m s and other a n a l y t i c a l
t o o l s , this review is aimed at identifying abnormal dealer behavior
and incipient undesirable t r e n d s .
The inferences and opinions
formed by our analytical team from examining these statistical
reports are supplemented by regular telephone calls and visits to
the reporting dealer f i r m s .
While we have traditionally made
23
on-site surveillance visits to the reporting d e a l e r s , now the
procedure for conducting such visits is more s y s t e m a t i c , and they
have been expanded in both scope and f r e q u e n c y .
E s s e n t i a l l y , every
reporting dealer w i l l be visited at least once a n n u a l l y , and more
often as necessary if areas of concern have been i d e n t i f i e d .
As I
mentioned e a r l i e r , w e would be prepared to suspend a trading
relationship with a reporting d e a l e r , or if necessary to remove the
dealer from the reporting l i s t , if our surveillance efforts reveal
that it is not complying with our standards and it does not take
appropriate steps to alleviate our c o n c e r n s .
A little further on I w i l l address some of the s p e c i f i c
issues of concern currently being examined by our
staff.
surveillance
To bring you u p - t o - d a t e , h o w e v e r , I would like to m e n t i o n
briefly several issues that already have been dealt with
successfully.
F i r s t , the Drysdale situation m a d e clear that the failure
to include accrued interest in valuing securities for r e p u r c h a s e
transactions carried a p o t e n t i a l for abuse that was inconsistent
with the sound functioning of the m a r k e t s .
The A s s o c i a t i o n of
Primary Dealers in G o v e r n m e n t Securities put itself on record as
favoring inclusion of accrued interest for evaluation p u r p o s e s , and
we in the Fed strongly endorsed this change as w e l l .
In a letter
dated July 2 9 , 1982 addressed to the head of each dealer firm I
expressed the New York Reserve Bank's support for this change and
informed the dealers that we would make the change in A u g u s t with
respect to our own repurchase t r a n s a c t i o n s .
I should add that this
change was not necessary to protect our own position; r a t h e r , we
24
undertook it with a view to providing leadership and e n c o u r a g e m e n t
to the rest of the m a r k e t .
A bit later we became concerned that the initial m o m e n t u m
in the dealer community toward making this practice more g e n e r a l had
bogged down as dealers considered the time and expense to m a k e
c h a n g e s , for e x a m p l e , to their computer s y s t e m s .
In individual
consultations with reporting d e a l e r s , we concluded that it would be
feasible for m a r k e t p a r t i c i p a n t s to make the change in accrued
interest accounting with customers other than the Fed by early
October.
A c c o r d i n g l y , in late A u g u s t we wrote to each reporting
dealer once a g a i n , indicating that we expected the changeover to be
completed by October 4 , 1 9 8 2 — a s it eventually was with few p r o b l e m s .
The self-corrective mechanisms of the m a r k e t have also
contributed to inhibit some of the practices that led to last year's
problems.
In g e n e r a l , m a r k e t participants became much more c a u t i o u s
about with whom they were willing to deal and in w h a t a m o u n t s .
As a
r e s u l t , the total of reported repurchase agreements fell from some
$100 billion on May 1 2 , just before the Drysdale i n c i d e n t , to about
$87 billion by m i d - J u n e .
S u b s e q u e n t l y , as confidence has returned
to the market the volume of repurchase transactions has recovered in
the a g g r e g a t e .
But for a while thereafter those dealers regarded as
less creditworthy continued to experience some difficulty securing
repurchase f i n a n c i n g , or found they had to pay higher
rates.
interest
C o n s i s t e n t with this atmosphere of renewed caution and
attention to one's c o u n t e r p a r t i e s , the practice of blind brokering
of repurchase agreements has diminished s u b s t a n t i a l l y .
Moreover,
m a r k e t participants are giving closer attention to the role of
intermediaries in all types of t r a n s a c t i o n s .
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C u r r e n t Issues
Let me turn now to more current issues.
By and l a r g e ,
these are the matters identified in your l e t t e r , M r . C h a i r m a n :
whether the number of reporting dealers should be expanded and how
this m i g h t be accomplished; the d e v e l o p m e n t and implementation of
more explicit c a p i t a l adequacy standards for the dealer firms; and
the treatment of repurchase agreements under the bankruptcy l a w s .
In a d d i t i o n , I w i l l touch upon another area to which we have been
devoting considerable thought and e f f o r t , "when-issued"
trading--
transactions in new issues between announcement and s e t t l e m e n t
date.
Number of dealers
As I have m e n t i o n e d , there are currently 36 d e a l e r s on the
Fed's reporting l i s t , including 12 c o m m e r c i a l banks and 24
nonbanks.
Although this number has been fairly stable in r e c e n t
y e a r s , it has grown considerably from the level that prevailed
historically.
Through the 1960*s the number of dealers remained
stable at around 2 0 , including 12-14 nonbanks and 5-8 b a n k s .
In the
1 9 7 0 ' s , h o w e v e r , the number of dealers increased as the T r e a s u r y ' s
financing needs grew and the market expanded in depth and b r e a d t h .
The present level was reached in the latter p a r t of the 1 9 7 0 ' s .
From the standpoint of conducting open m a r k e t operations
competitively and f l e x i b l y , the present number of reporting dealers
appears to be s a t i s f a c t o r y .
We do not believe that a large
expansion in the number of firms with reporting or trading
relationships would significantly improve our ability to operate in
the m a r k e t .
I n d e e d , a sizable expansion in trading
relationships
could be an encumbrance to speedy and flexible o p e r a t i o n s .
26
N e v e r t h e l e s s , the door is open to additional firms,"if they m e e t our
criteria and are prepared to comply with our reporting
requirements.
As n o t e d , a dozen or so firms have been added to the
primary dealer reporting list over the p a s t decade and we c o n t i n u e
to look at the p o s s i b i l i t y of some further additions on a case-bycase b a s i s .
The addition of new firms has tended to b e n e f i t the
m a r k e t not only by p r o v i d i n g a broadened base of participation and
increased c a p i t a l , but also by keeping the older established
firms
on their toes through enhanced c o m p e t i t i o n .
H o w e v e r , while our present reporting list is adequate to
m e e t our foreseeable trading n e e d s , we h a v e concluded that it is not
sufficient for monitoring purposes--even though we believe these
firms account for the bulk of trading activity in G o v e r n m e n t
securities.
The experience of last year has shown that p r o b l e m s
among the non-reporting dealers can cause shock waves that a f f e c t
the entire m a r k e t , including the reporting d e a l e r s .
With this in
m i n d , we have been giving considerable thought in recent m o n t h s to
the question whether there should be some more systematic
surveillance of p r e s e n t l y non-reporting firms that are relatively
active in the G o v e r n m e n t securities m a r k e t .
We have concluded
that
effective surveillance of the Government securities m a r k e t calls fo-r
our getting acquainted with a greater number of firms on a m o r e
regular b a s i s , and we plan to do s o .
Our plans are still in a formative s t a g e , but our p r e s e n t
intention is to request cooperation in terms of data submission from
a group of dealers that are less sizable and active than the p r i m a r y
reporting d e a l e r s .
This g r o u p would include only nonbank f i r m s , as
the chief focus here is on the financial viability of the f i r m s , and
27
bank dealers are already under close regulatory scrutiny that we
would not seek to duplicate in our market s u r v e i l l a n c e .
We are
thinking in terms of a substantial number of additional dealer
firms
that would be invited to submit regular reports to the New York
Reserve Bank--on a considerably less frequent and detailed basis
than the primary reporting d e a l e r s .
As with the existing reporting g r o u p , the submission of
reports from a second dealer group w i l l be entirely v o l u n t a r y .
This
second reporting group would form a logical p o o l of candidates from
which future primary reporting firms might e m e r g e , which
furnishes
an incentive for the firms to comply with our r e q u e s t s .
I also
believe that as a matter of policy any sizable p a r t i c i p a n t in the
Government securities m a r k e t would not w a n t to be in the position of
declining to disclose information in confidence to the F e d e r a l
Reserve.
We are not suggesting a detailed and comprehensive
reporting system such as would be entailed in a formal regulatory
relationship with all dealers in G o v e r n m e n t s e c u r i t i e s .
A t this
p o i n t , it is our judgment that a fully comprehensive and m a n d a t o r y
reporting system is not justified on the basis of likely costs and
benefits.
We do b e l i e v e , t h o u g h , that there is enough activity in
Government securities beyond the current primary reporting dealer
group to warrant a more systematic effort to receive some
information from the more active and sizable nonreporting
dealers.
This would serve the purposes of helping to provide leads on which
follow-up inquiries can be p u r s u e d , and additionally foster a
greater awareness of standards in regard to good market practice and
capital adequacy across a broader spectrum of.market p a r t i c i p a n t s .
28
In your letter to Chairman V o l c k e r , M r . C h a i r m a n , you asked
whether we had any concern that imposing additional standards on the
G o v e r n m e n t securities dealers could reduce the number of firms
available to handle the forthcoming heavy volume of Treasury
financings.
I do not see either our present reporting
requirements
or our plans for the foreseeable future as posing any problem in
this r e g a r d .
It seems to me that as long as our standards are
reasonable and geared to the legitimate business practices of the
dealer f i r m s , a firm which has the resources and the desire to be a
significant market p a r t i c i p a n t is not likely to withdraw from this
market--which i s , after a l l , a large and profitable source of
business.
As a related m a t t e r , you have expressed some concern
regarding the budget d e f i c i t and the market's ability to absorb the
expected volume of Treasury financing without compromising the
soundness of the dealer firms or causing undue upward pressure on
interest r a t e s .
With the economy just beginning to recover from a
deep recession, I do not regard the current year's Federal deficit
as a significant p r o b l e m .
As in past r e c e s s i o n s , weak private
c r e d i t demands have allowed the government to increase its demands
on the credit market w i t h o u t exerting undue pressure on r a t e s .
In
f a c t , as you k n o w , rates have fallen substantially in the last ten
months or so in reflection of weakened private credit demands and a
growing perception that inflation has slowed s u b s t a n t i a l l y .
As
recovery p r o c e e d s , h o w e v e r , there is a real danger that
still-excessive Federal deficits would mean that the Treasury is
competing on a massive scale with the rising private credit demands
that are the natural accompaniment to a reviving e c o n o m y .
This
29
would inevitably have an effect on interest r a t e s , and pose the
p o t e n t i a l danger of inhibiting orderly economic r e c o v e r y .
Such an outcome would not be a function of the c u r r e n t
structure of the G o v e r n m e n t securities m a r k e t , h o w e v e r , but simply
of the outsize F e d e r a l d e f i c i t s at a time when a much m o r e nearly
balanced F e d e r a l fiscal posture is called f o r .
The G o v e r n m e n t
securities dealers that r e p o r t to the F e d e r a l Reserve are in a
position to withstand the possible strains that the d e f i c i t and
resulting large public sector borrowing requirements could g e n e r a t e
in the m a r k e t .
The c a p i t a l positions of these dealers have
strengthened in recent y e a r s .
Despite the d i f f i c u l t i e s of
predicting m a r k e t m o v e m e n t s , m o s t dealers have ably weathered
periods of m a r k e t v o l a t i l i t y , in p a r t due to their
increasingly
sophisticated trading techniques and ability to adapt to shifting
market environments.
During periods of favorable m a r k e t c o n d i t i o n s
they have added significantly to their c a p i t a l b a s e , which I believe
is adequate to the tasks a h e a d — p r o v i d e d , as a l w a y s , that attention
is paid to m a r k e t and c r e d i t r i s k s .
This does not m e a n , of c o u r s e ,
that heavy Treasury d e f i c i t s w i l l not p r e s e n t problems for the
o v e r a l l e c o n o m y , but only that the dealers should be able to p e r f o r m
their underwriting
task.
Repurchase A g r e e m e n t s
As I have n o t e d , one major area of concern
involving
repurchase a g r e e m e n t s — t h e inclusion of accrued interest in
repurchase a c c o u n t i n g — h a s largely been dealt with to our
satisfaction.
There is another issue involving "repos" that has
arisen in the p a s t y e a r , h o w e v e r , specifically as an outgrowth of
20-953 0 — 8 3
3
30
the L o m b a r d - W a l l b a n k r u p t c y .
I refer to the question of how
repurchase agreements may be treated in a bankruptcy
proceeding.
On A u g u s t 12 of last y e a r , L o m b a r d - W a l l filed a voluntary
bankruptcy petition under Chapter 11 of the Bankruptcy C o d e .
Most
of its c u s t o m e r s , who had entered into repurchase or reverse
repurchase agreements with the f i r m , found that their
transactions
w e r e frozen pending a d e c i s i o n by the court on how to d e a l with
these t r a n s a c t i o n s .
The inability of these customers to use either
their funds or their securities weakened confidence in the repo
market.
The underlying legal issue was whether these transactions
should be characterized as secured loans or as purchases and s a l e s .
The p r i n c i p a l problem with the former characterization is
that if a repo is treated as a l o a n , the "lender" of funds
(purchaser of securities) runs the risk that his funds could be tied
up for a protracted period of time if the counterparty were to enter
bankruptcy proceedings before the repurchase portion of the
transaction were c o m p l e t e d .
In addition to tying up his f u n d s , this
could place the "lender" in the position of unsecured creditor with
respect to any portion o f his loan not covered by the value of the
securities.
T h u s , if the securities were to decline in v a l u e , he
could lose money in w h a t he had thought to be an essentially
riskless
transaction.
While I c a n n o t define precisely the extent to which the
G o v e r n m e n t securities m a r k e t would be impaired if the secured loan
characterization of repos were to p r e v a i l , I am confident that some
deterioration would r e s u l t .
I n d e e d , there has already been some
d e t e r i o r a t i o n , which m i g h t w e l l have gone further but for the
anticipation by many m a r k e t participants that the legal q u e s t i o n s
31
overhanging the status of
repos
will be favorably r e s o l v e d .
A t the
l e a s t , the m a r k e t would lose a significant measure of liquidity as
some risk-averse participants withdrew or reduced their exposure;
the interest rate paid on such transactions would rise to r e f l e c t
the greater risk and lessened willingness of temporary investors to
participate; and m a r k e t participants with less-established
records would experience some loss of business and higher
costs.
track
financing
In t u r n , I would foresee these factors hampering to some
degree the Treasury's ability to m a r k e t its offerings as w e l l as
increasing its financing
costs.
Repurchase a g r e e m e n t s have emerged over the years as a
particularly useful tool in conducting F e d e r a l Reserve open m a r k e t
o p e r a t i o n s , since they allow us to adjust reserves for short p e r i o d s
of t i m e .
T h u s , a d i m i n u t i o n in the liquidity of the repo m a r k e t
could also hamper the conduct of monetary p o l i c y .
In letters dated September 2 9 , 1982 to Chairman Dole of the
Subcommittee on C o u r t s , Senate Judiciary C o m m i t t e e , and J a n u a r y 2 0 ,
1983 to Chairman Rodino of the House J u d i c i a r y C o m m i t t e e , C h a i r m a n
Volcker recommended that the Congress enact proposed
legislation
that would exempt repos in G o v e r n m e n t and Federal agency securities
and certain other instruments from the automatic stay p r o v i s i o n s of
the Bankruptcy C o d e , which would otherwise operate to p r e v e n t the
orderly liquidation of these t r a n s a c t i o n s .
I certainly e n d o r s e
these recommendations and urge the C o n g r e s s to move forward in this
area.
E a r l i e r , because of our concern a b o u t potentially
significant
effects on the repo m a r k e t , and thus on the Federal Reserve's
ability to conduct monetary p o l i c y , the F e d e r a l Reserve Eank of New
York had filed an amicus curiae brief in the Lombard-Wall c a s e .
We
32
took the position that public policy would be better served if
repurchase agreements in G o v e r n m e n t securities were not
characterized as secured
loans.
C a p i t a l Adequacy
The question of whether a particular dealer's c a p i t a l is
adequate to support its l e v e l of operations is perhaps the single
m o s t basic issue of concern in our surveillance e f f o r t s .
The three
firms that failed last y e a r — D r y s d a l e , C o m a r k , and
L o m b a r d - W a l l — w e r e all thinly-capitalized in relation to their
volume of b u s i n e s s .
T h u s , the importance of capital adequacy
guidelines lies not only in monitoring the reporting d e a l e r s , but
also in furnishing objective criteria for dealers and others to use
in appraising their trading
counterparties.
U n f o r t u n a t e l y , the evaluation of capital adequacy on any
basis that attempts to give weight to d i f f e r e n t circumstances in a
fair and realistic manner can be enormously c o m p l e x .
The v a s t
changes in m a r k e t p r a c t i c e s and trading vehicles in recent y e a r s ,
including the d e v e l o p m e n t of f o r w a r d , future and option
t r a n s a c t i o n s , as w e l l as the increasingly intricate use of repos and
reverse r e p o s , have all complicated the t a s k .
Up to n o w , our surveillance staff has looked at c a p i t a l
adequacy on a case-by-case b a s i s .
Reporting dealers have from time
to time been cautioned when position- risks have seemed excessive in
relation to capital or when they have financed certain
that have swollen balance sheet totals e x c e s s i v e l y .
transactions
In light of
these increasing complexities and the desire to create a m o d e l of
capital adequacy which may be used also by dealers and customers to
33
evaluate their trading c o u n t e r p a r t i e s , it is our feeling that more
specific and objective criteria m u s t be developed that apply across
the b o a r d .
The surveillance staff has assigned this p r o j e c t top
priority and efforts are underway to develop objective criteria for
measuring dealer c a p i t a l and its u s a g e .
Clearly the starting p o i n t
is a concept of available or liquid c a p i t a l .
To measure the
adequacy of such c a p i t a l an evaluation system should encompass
s e v e r a l broad c o n s i d e r a t i o n s .
F i r s t , a dealer's portfolio
p o s i t i o n s , both gross and n e t , must be measured and risk evaluated
for each maturity and type of i n s t r u m e n t , taking account of
acceptable hedging techniques which may be employed to limit
exposure.
S e c o n d , the risk entailed in financing
especially in "matched books"
transactions,
(offsetting repurchase and reverse
repurchase a g r e e m e n t s ) , should be analyzed as part of any such
system.
The surveillance staff is presently developing a v a r i e t y of
statistical measures and computer programs that look toward
systematic analysis of dealer positions and risk e x p o s u r e .
It is our expectation that when d e v e l o p e d , such o b j e c t i v e
criteria of capital adequacy w i l l be applied in the first instance
to the primary reporting d e a l e r s .
We would suggest and expect
voluntary compliance with such standards of capital adequacy by the
large or active nonreporting dealers as w e l l , on the assumption that
clearing and lending banks as well as customers would look for such
compliance with generally accepted standards of capital a d e q u a c y .
It would of course be essential that any evaluation
system
also continue to take into account more subjective measures of risk
such as the type of c u s t o m e r s , internal controls and credit and
34
margin monitoring p r o c e d u r e s , as well as management's o v e r a l l
business p h i l o s o p h y , capacity and e x p e r i e n c e .
For our p a r t , I know
of no way to assess these factors other than through a case-by-case
approach including the surveillance visits and individual firm
contacts we have been p u r s u i n g .
Even a firm with apparently
adequate or conservative capital could nonetheless find itself in
serious difficulty in a short period of time if it is p o o r l y
managed.
O b v i o u s l y , a purely mechanical approach to the c a p i t a l
adequacy question can not guarantee the elimination of such
problems.
When-Issued Trading
In the aftermath of the Drysdale s i t u a t i o n , we discussed
with dealers other areas in which future problems might a r i s e .
area mentioned frequently involves "when-issued" t r a d i n g .
One
This
refers to transactions in which the parties commit to trade a
security which has not yet been issued but w i l l be issued in the
near f u t u r e , with the transactions to be completed when the security
is issued.
The volume of this type of forward trading has reached
very high levels in recent y e a r s .
Under current m a r k e t practice no money changes hands until
the securities are actually issued and d e l i v e r e d .
It i s , t h e r e f o r e ,
possible for a market participant to trade in very large v o l u m e on a
when-issued basis w i t h o u t employing any capital at a l l .
A d d i t i o n a l l y , while p r u d e n t practices might lead an individual firm
to limit its exposure to a particular counterparty in this type of
t r a d e , nothing in the p r e s e n t system would prevent a market
participant from entering into a large number of such trades with
many different firms--each of which would be unaware of the e x t e n t
35
of that participant's total c o m m i t m e n t s .
Since these
transactions
can remain open for up to three weeks before the security is i s s u e d ,
the possibility exists that an adverse m a r k e t move could render such
a trader unable to honor his commitments when the security is
issued.
A t the p r e s e n t t i m e , we are actively discussing a variety
of proposals regarding when-issued trading with m a r k e t p a r t i c i p a n t s ,
most of whom share our concern about this practice in varying
degrees.
The m o s t comprehensive proposal would set up a c e n t r a l
facility to clear when-issued trading and to maintain m a r g i n s on
transactions.
The organized futures exchanges typically d e a l with
this problem through a "mark to market" mechanism run by the
exchange itself.
We are continuing to have discussions with the
dealers as we seek a generally acceptable solution that w i l l d e a l
with potential excessive exposure from when-issued t r a d i n g .
While
we are prepared to insist on a "Federal Reserve" solution if
n e c e s s a r y , we would much prefer--and i n d e e d , expect--to reach a
satisfactory agreement with the dealers on a voluntary b a s i s , as
they perceive that their own long-term interests are best served by
adequate safeguards on when-issued
trading.
Should the Federal Reserve Have a Formal Regulatory Role?
The final question I would like to address this afternoon
is whether the surveillance role of the Federal Reserve should be
made formal and expanded through a legislative m a n d a t e .
A t the
present t i m e , I continue to believe that the failure of a h a n d f u l of
nonreporting dealers does not in itself justify a move to a more
encompassing regulatory structure--any more than the absence of such
failures for a number of years before that should have been cause
36
for c o m p l a c e n c y .
C e r t a i n l y , these recent events indicated a need
for more active and forceful m a r k e t monitoring and s u r v e i l l a n c e , and
as my remarks here have indicated we at the New York Reserve Bank
have taken responsive actions along these l i n e s .
But in the final a n a l y s i s , whether it is necessary or
desirable to impose a m o r e formal regulatory structure in the p u b l i c
interest is not a q u e s t i o n that can be answered in the a b s t r a c t or
by ideological p r e f e r e n c e , but only on the basis of carefully
evaluated e x p e r i e n c e .
In m y j u d g m e n t , the p r i n c i p a l consideration
that should guide the C o n g r e s s should be an assessment of the
efficacy of any particular approach in containing the "shock waves"
caused by occurrences such as these three f a i l u r e s — i n other w o r d s ,
preventing a single firm's f a i l u r e , which in itself may not be a
serious or even an undesirable e v e n t , from becoming a systemic
failure.
In this c o n t e x t , I think the events of last y e a r , and the
F e d e r a l Reserve response to those events I alluded to e a r l i e r , show
that the present structure affords us the m e a n s and the flexibility
to act promptly and d e c i s i v e l y through several a v e n u e s — t h e
open
m a r k e t D e s k , the d i s c o u n t w i n d o w , and not least in i m p o r t a n c e , by
exercising m o r a l leadership as we did in the accrued
interest
question.
As a second c o n s i d e r a t i o n , the Congress might also w a n t to
consider the likelihood that members of the public participating in
this m a r k e t m i g h t suffer losses resulting from the types of abuses
we have d i s c u s s e d — b a l a n c e d against the costs associated with the
e s t a b l i s h m e n t of a formal regulatory s t r u c t u r e .
In considering the
c o s t s , I would include not just the "out-of-pocket" e x p e n s e , but
37
also the potential costs that could result from hampering
market's flexibility and
the
responsiveness.
To put the discussion in p e r s p e c t i v e , there are essentially
three g e n e r a l approaches to regulating a m a r k e t such as the
G o v e r n m e n t securities m a r k e t .
F i r s t , one could rely in the first
instance on the self-regulating mechanisms inherent in the m a r k e t
i t s e l f , fortified by informal oversight by the F e d e r a l R e s e r v e .
T h i s , of c o u r s e , is essentially the structure in effect at the
present time.
S e c o n d , a more formalized and structured
self-regulatory organization could be e s t a b l i s h e d , with m a r k e t
participants setting and enforcing rules governing such m a t t e r s as
trading practices and c a p i t a l a d e q u a c y , under the o v e r s i g h t of a
g o v e r n m e n t a l body with explicit authority to enforce those r u l e s .
This is essentially the approach followed with respect to such
organizations as the New York Stock Exchange and the N a t i o n a l
Association of Securities D e a l e r s .
T h i r d , the g o v e r n m e n t a l
authority in question could directly regulate the m a r k e t , imposing
rules pursuant to a legislative mandate and taking d i s c i p l i n a r y
action as necessary to enforce those r u l e s .
Based on the considerations I have o u t l i n e d , I can see no
justification for the third a p p r o a c h , d i r e c t r e g u l a t i o n .
In my
j u d g m e n t , it would be inconsistent with the objective s o u g h t , that
of preventing a recurrence of lapses of proper p r a c t i c e s or
overcommitments in relation to capital that led to the failures of
the three dealer firms last y e a r .
As you k n o w , the C o n g r e s s has
moved affirmatively to reduce the level of regulation in b a n k i n g , as
it has in other i n d u s t r i e s , and I think it would be
38
counterproductive to start thinking at this time about d i r e c t
regulation of a m a r k e t which traditionally has functioned quite w e l l
without it.
The next q u e s t i o n is whether the current self-regulatory
structure should be m a d e m o r e formal than it has b e e n , ana whether
the F e d e r a l Reserve's o v e r s i g h t role should be made more e x p l i c i t
through the legislative p r o c e s s .
On b a l a n c e , I conclude that those
steps are not necessary at this t i m e .
I think we should keep in
mind that the losses incurred in last year's three
failures--unpleasant and undesirable though they w e r e — f e l l
almost
entirely on large and sophisticated m a r k e t p a r t i c i p a n t s , rather than
on small individual i n v e s t o r s .
Logic and experience tell us that
where significant m a r k e t participants incur losses of this type they
are likely thereafter to take the lead in promoting the necessary
reforms and insuring that the market's normal self-corrective
mechanisms come into p l a y .
I have some concern that there is less
incentive for them to do so under a more formal s t r u c t u r e .
It is sometimes t e m p t i n g , in the wake of market
disturbances such as those of last y e a r , to jump to the conclusion
that more formal regulation would have prevented the p r o b l e m , but I
seriously doubt that such a conclusion is warranted at this t i m e .
This is a m a r k e t that has generally functioned quite w e l l in a
self-regulatory environment--and no degree of regulation can
guarantee that accidents w o n ' t happen from time to t i m e .
The
existence of the Securities Investor Protection Corporation
(SIPC)
is, after a l l , a tacit recognition that even those securities
that operate in regulated markets with strict capital ratio
firms
39
requirements are not immune from failure.
The same could be said of
deposit insurance for banks and thrift institutions.
So at this time I conclude that formal regulatory authority
for the Federal Reserve is not the best way to g o .
emphasize that our minds remain open on this score.
But I would
A t times it
appears that some of the dealers have permitted a measure of
complacency to return now that the immediate threat of market
disruption is o v e r .
To the extent that this attitude becomes more
widespread and cannot be overcome by us in our surveillance r o l e ,
I
would have some concern that the momentum of self-regulatory reform
could be lost as the events of last year recede into the p a s t .
If
this were to h a p p e n , the time may yet come when formal regulation
imposed by Congress will be necessary.
And in closing, let me
emphasize that we would have no hesitation in recommending such an
action if we were to reach that conclusion.
Chairman FAUNTROY. I thank you, Mr. Solomon.
I have a number of questions as I am sure my colleagues do.
As you know, the short-term interest rates for Treasury securities have remained relatively high compared to inflation—around 8
percent, compared with the 3- to 4-percent inflation we have recently had. In your view, has the aftereffect of the Drysdale and
the Lombard-Wall collapses contributed to these high real shortterm rates by creating uncertainties in the Government securities
market at a time of high Federal borrowing demand?
Mr. SOLOMON. I think I can answer that pretty unequivocally,
Mr. Chairman, that the immediate impact of the Drysdale shock
was what we call a flight to quality. Actually, there was a reduction in interest rates of Treasury securities—particularly shortterm Treasury securities. But that has long since evaporated. I
would say that there is no causal connection or sequence that I can
see that those events of last year are affecting the level of interest
rates of Government securities today. I think the transitory effect
was there, but it was the other direction, actually lowering them,
because there was a flight to the greater quality of Treasury securities at the expense of some other short-term instruments—at least
the spread between them widened. But today there is no effect.
Chairman FAUNTROY. What would be the impact on the credit
markets in your view and on interest rates if there were another
Drysdale type failure?
Mr. SOLOMON. What would be the effect on credit markets and
interest rates?
Chairman FAUNTROY. And interest rates, yes.
Mr. SOLOMON. Well, I would assume that the scenario that you
have posed might not be very different than what we saw last time.
It is a matter, of course, of degree. Drysdale had a big effect,
40
Comark and Lombard-Wall had a much, much smaller effect. But I
would suppose that the direction of the impact would be similar—
namely, that you might have a small movement in interest rates,
probably on the down side. You would have some greater questioning of the creditworthiness of other market participants, some
drying up of liquidity, temporarily at least, in the market, some
greater sense of caution in whom you were dealing with, some contracting of outstanding credit lines. We saw all of this. And it may
very well be that my colleagues here who are closer to the details
of the market than I am might want to add something.
Peter?
Mr. STERNLIGHT. I have no further comment.
Mr. GENG. I would agree completely with Mr. Solomon on that.
Chairman FAUNTROY. Mr. Solomon, you explained in some detail
the problems arising out of bankruptcy in the treatment of a repo,
if it is treated as a loan rather than a sale. Would you further clarify precisely the problem as you understand it, and would you also
make available to us the amicus brief which was filed in the Lombard-Wall case?
Mr. SOLOMON. Yes, we would be pleased to do so, make that brief
available. It is quite simple, sir. If there is an unexpected bankruptcy by a counterparty with whom one has an RP transaction,
then there normally is an automatic stay, preventing a holder from
disposing of any collateral and liquidating anyone's position for as
much as 2 months and maybe much longer. The whole point of the
RP is that it is 100 percent liquid and riskless, because it is based
on Government securities. Since the markets believe that this situation—the legal precedent that has been established by the Lombard-Wall case should continue—then an element of risk enters,
that is that the money will be tied up during the working out of a
bankruptcy proceeding. Since this is considered liquid money, it
can force some major disruptions for the institution that is deprived of that liquidity. Also, there is a danger of actual loss even
at the end of that long delay, because interest rates may change in
the meantime. Therefore, from both points of view we are concerned that the shrinkage of liquidity in the RP market will adversely affect our open market operations and the market for
Treasury securities.
Now, I would not want to go so far as to say that this will result
in a rise in interest rates on the debt, because I don't know how far
this shrinkage in liquidity will go. But we have seen some shrinkage, and we think the markets are standing still, waiting to see
whether the Congress will pass as expected this exemption from
the automatic stay provisions of the Bankruptcy Code. But I would
hope, sir, that you would see fit to support this, given your interest
in monetary policy operations.
Chairman FAUNTROY. YOU indicated that you have had some discussions with Chairman Rodino and apparently with Mr. Dole as
well, for the enactment of legislation. Has a bill been introduced?
Mr. SOLOMON. My understanding of it, sir, is that on the House
side there have been no hearings on this question of the RP's, the
narrow question, although there have been hearings on other aspects of modifying the Bankruptcy Code. However, on the Senate
side there have been hearings and there is a separate bill being
41
marked up, or already reported out of committee, which addresses
this question as recommended by the Federal Reserve. So I presume it would be a matter of this being resolved in Congress, if
Chairman Rodino's bill on other aspects of modifying the Bankruptcy Code goes forward without this particular point.
I think the provision is a relatively noncontroversial one. I don't
know whether there is anything further on the present legislative
status of that.
Do you have anything you want to add, Mr. Sternlight?
Mr. STERNLIGHT. I think it is as you described, Mr. Solomon.
Chairman FAUNTROY. A S you indicated, we do have an interest in
it. I would appreciate if you could provide us a copy of any correspondence you provided either committee, and any draft legislation
or any report language which may have been developed thus far.
Mr. SOLOMON. We certainly will do so.
Chairman FAUNTROY. Last year after Drysdale you told the
Senate Banking Committee that the private market was itself capable of undertaking the changes needed to prevent another such
crisis. Later after the failure of Lombard-Wall, you indicated to the
press that the failure of Drysdale itself was not an immediate
reason to impose a regulatory structure on the government market.
How do you view the situation now, and if there are any changes,
what are the reasons?
Mr. SOLOMON. Well, the minute that we had the Drysdale failure,
we began a series of investigations and meetings, with the whole
spectrum of dealers, and I participated in some of those. Most of
those were handled by Mr. Sternlight. Mr. Geng was still not with
us at that point. We came to the conclusion that even though it
was not a unanimous view among the dealers, that we had to make
this change in the accrued interest that I have described. And we
insisted on it, even though we do not have formal regulatory authority, and we insisted on it through a dialog, and a process of
logic and reason, and the consensus of the dealer association was
that this was a correct decision. We then moved that step along
even faster by starting the practice ourselves. And then when we
still saw some foot dragging, we advised them by letter that we expected them all to do this by October 4, and everybody complied.
Now in a certain sense that is a kind of illustration of the approach we are using under this intensified surveillance approach.
We believe that you get a two-way dialog with the industry, pointing out to them the situation of the possible defects as we see it.
Then they in turn point out to us all the technical problems—there
are enormously complex technical problems with every so-called solution. So that it is a two-way dialog that goes on. We believe that
if we can continue with this, and we are making progress now—we
certainly are making progress on monitoring capital in relation to
the risk. If we can continue this whole process, this will be a better
outcome for the Government securities markets and for us as a
Nation in a sense, because you are getting the ideal advantages of
both the regulatory input in a nonformalistic way, and you are getting the two-way dialog from the people who are most technically
expert and know the situation better than any possible Government regulator can.
42
Now, if we find—and I am putting it very crudely—that the competing views and the self-centered views of different dealers prevents them from coming to a consensus of action with us after a
sufficient dialog, then we would have no recourse in our view but
to say to you, the Congress: This is the situation as we found it—
and we can be wrong and some of those dealers who resisted may
be right—but we think we are right that this does need action. And
since this has not moved along now, we would recommend that we
be given the formal regulatory oversight authority.
That is the situation quite honestly as I see it. We have made
enough progress that we are encouraged to continue this process.
But if we find that that progress does not continue, then we certainly will be back.
Chairman FAUNTROY. Thank you.
I want to yield to my colleague from Indiana, Mr. Hiler.
Mr. HILER. Thank you, Mr. Chairman.
Mr. Solomon, what I would like to do here, so I can better understand some of the changes that you have proposed—if we were to
go back in time several years ago, how would the changes that you
have made in terms of reporting requirements and accrued interest
and blind brokering and those type of things how would they have
affected Drysdale?
Mr. SOLOMON. Well, just the accrued interest change alone would
mean that Drysdale would not have been able to accumulate the
working capital to take speculative positions on interest rates, and
therefore there is a good chance that they would not have gone
down this road at all or that their volume of operations would have
been much, much smaller. In addition, Drysdale was not a primary
reporting dealer. If we had in place the new reporting system that
we are developing for nonprimary dealers—even if Drysdale were
still able to use the accrued interest and all the other things—I can
say to you that we would have detected somewhat earlier, with a
smaller volume of operations of Drysdale, a problem that was potentially brewing. We probably would not have been able to avert a
failure—when a firm takes enormous speculative risks with thin
capital and guesses wrong—those things will happen. But we probably would have caught it earlier and therefore it would have had
less of a ripple effect.
We are interested in the system and the soundness of the
market. We are not interested in the question of whether an individual firm fails from time to time in the normal course of business. So that would be my best answer to those two questions.
Mr. HILER. SO in terms of the accrued interest that affects everyone who is in the business, and in terms of some of the reporting
requirements, the new requirements that you are developing would
affect Drysdale.
Now, you mentioned that Lombard-Wall was a much smaller operation than Drysdale. Would the reporting requirements affect
Lombard-Wall as well?
Mr. SOLOMON. Yes; they were not that small that they would not
be required to report. I don't remember the numbers on the volume
of operations. Do you?
Mr. STERNLIGHT. I don't think their volume of trading activity
was exceptionally large, but they had taken some sizable positions.
43
Thus, while we have not yet formulated in detail just what level
we want to reach to in this secondary group of dealers, I suspect we
would want to have reached a firm the size of Lombard in its Government securities operations.
Mr. HILER. There are 3 6 primary dealers and I think you mentioned—or did you mention there are another 20 or so
Mr. SOLOMON. NO, sir. I simply said it had grown from 22 to 36.
Mr. HILER. O K . And then how many in the secondary area that
you are looking at with reporting requirements? How large would
that universe become?
Mr. SOLOMON. I would like to ask Mr. Geng, head of that surveillance unit.
Mr. GENG. It is my guess at this time, Mr. Hiler, that something
in the neighborhood of 50 to 75 additional firms might be included.
We have not obtained enough detailed information yet to actually
pinpoint the exact number, but there are, in fact, perhaps 100 or
200 firms that do business in Government securities in some
manner or another.
Mr. HILER. HOW many?
Mr. GENG. My estimate would be that in the neighborhood of 100
or 200 nonbank firms trade in Government securities in some
degree. However, I would suspect the number that deal in meaningful sizes, such as could cause a problem for the market, would
be probably no more than 50 to 75.
Mr. HILER. In terms of the computer programing that you are
setting up for analysis, I think you mentioned that at the tail end
of your statement, would that affect the secondary tier as well?
Would you try to get the people there to use that type of analysis
for capital requirements?
Mr. GENG. I think we would, to some extent. Our proposal at this
point—it is still in the formative stage—would be for somewhat
less elaborate reporting. However, I think what we perceive to be
needed would be sufficient to enable us to do some critical evaluation of their impact on the market and the risk exposure they
might be taking in relation to their capital.
Mr. HILER. Would they be obligated to perform this type of analysis?
Mr. GENG. Our proposal essentially would be for a total voluntary system. However, those that would be included in this reporting list would certainly be expected to conform with the broad
framework of capital adequacy that we would propose. In fact, we
would hope and expect that this system that we are proposing will
be accepted by other participants in the market as a model of capital adequacy. Then customers and banks and others who deal with
any dealer will look upon this as a guide to whom they might do
business with, just as methods of evaluation in other industry studies give people guidance as to what kind of firms they will do business with in any area.
Mr. SOLOMON. I would like to add to that. We are trying to be
very careful in drawing this up so as not to impose an undue
burden in terms of reporting. Once they report to us, it will go into
our computers, but we will not expect them to have to go through
elaborate computer programs in order to meet these relatively
modest reporting requirements.
44
Mr. HILER. Mr. Chairman, I just have one final question, if I
could beg your indulgence.
In terms of the blind brokering, Mr. Solomon, you mentioned
that there appears to be a greater interest on the part of dealers to
look at who they are doing business with. But blind brokering still
exists, it is still going on. Is that correct?
Mr. SOLOMON. Well, blind brokering among the primary dealers,
reporting dealers is, of course, less risky by far than the Drysdale
type of blind brokering. There is blind brokering still going on
among the primary dealers. I think you have to make a distinction
between the outright Government securities and the RP's.
Mr. STERNLIGHT. YOU have now, as Mr. Solomon referred to, a
degree of blind brokering that goes on in outright transactions as
distinct from repurchase type transactions among the group of 36
primary dealers. However, while party A doesn't know precisely
who party B is on the other side, he knows that it is a firm among
the group of 36. Contrast to that the Drysdale case, where the
counterparties did not know precisely that Drysdale was the other
party.
The other distinction is that there is a difference in doing a repurchase type transaction. When you do that, you are dependent
on someone performing at some future date that might be several
days later. It might be months later, and a lot can happen in the
market in that interval of time.
The blind brokering that still exists in the intradealer market
among the primary dealers is mostly for same-day or next-day settlement. And while the market can move in a day, it typically
doesn't move so much as to create great vulnerability.
I will, however, footnote my remarks and say we do have some
concern about the blind brokering in the primary-dealer market
where it concerns when-issued trading, because there you do have
a delivery that might be delayed for 1 week or 2 or possibly even 3.
And that is why President Solomon referred to our concerns about
potential vulnerability in that when-issued trading market. Thus,
we have certain proposals that we are discussing with the dealer
market to address that.
Mr. HILER. YOU think, then, that the risky aspects of the blind
brokering, with the exception of the last part that you mentioned,
that the market essentially is taking care of that itself by no
longer tolerating blind brokering for the repos and for the nonprimary remarket area?
Mr. STERNLIGHT. That would be my impression, Congressman
Hiler.
Mr. HILER. I yield back, Mr. Chairman.
Chairman FAUNTROY. I thank you.
Mr. Solomon, did not the Fed have word of Drysdale's problems
in advance, and did you not choose to sort of ignore it at that
point?
Mr. SOLOMON. What we had word of was a few rumors in the
market that Drysdale was being unusually aggressive in his operations. There is one point further I think would be appropriate to
add, that in one case on an auction bid by a primary dealer it
seemed when we learned that he was bidding for a very large
amount on behalf of Drysdale, Mr. Sternlight and the operations
45
people raised a question with that primary dealer as to whether he
was sure of the firm he was dealing with to justify such a large
order. I don't know whether there is anything more that we knew
before the direction of this action. Let me ask Mr. Sternlight.
Mr. STERNLIGHT. TO elaborate, we did hear market reports to
suggest that this was a relatively active trading operation. The information we received did not, it seemed to us, convey any sense of
the losses and vulnerabilities that were building. I think that given
the kind of surveillance intensity that we engage in now, we would
have been in a position to follow up much more pointedly on the
kind of scraps of information that we had received shortly prior to
Drysdale's collapse. So I think we are in a better position now to
deal with that kind of hearsay information.
Mr. SOLOMON. YOU know, there is always a certain amount of
competitive gossip in the streets and a certain amount at times of
bad-mouthing which is inevitable, particularly on a newcomer firm.
And it is hard to move in, or at least we used to feel that it was
kind of hard to move in, simply on the basis of rumors. Now that
we have put everybody on notice that we have formalized much
more our surveillance, our monitoring, and our followup, even
though we still have not yet got into the point of systematic reporting by the secondary dealers, we feel less inhibited now about a detailed investigatory followup when we hear rumors, even though
most of them are without credence.
Chairman FAUNTROY. Thank you.
I want to yield to our distinguished colleague from Texas, Mr.
Patman.
Mr. PATMAN. Thank you, Mr. Chairman.
Good to see you, Mr. Solomon.
Do you have any regulatory authority over European bonds or
Eurobonds?
Mr. SOLOMON. NO. They have to be registered, if they are sold in
this market, with the SEC and, as far as I know, there is no other
U.S. authority. I am not too familar with this, but I do not think
there is any U.S. Government authority that has any jurisdiction
over a Eurodollar bond unless, of course, they were being issued by
a U.S. resident; namely, a U.S. corporation.
Mr. PATMAN. Just for the record, would you describe what a Eurobond is? Or one of the two gentlemen with you?
Mr. SOLOMON. I interpret that as being a bond that is sold outside the U.S. market, mainly in Europe, and it could be in any currency. Normally the bulk of them are Eurodollars. They could be
Euro-Deutsche mark or Eurosterling or what have you. It is, by
definition, an instrument issued outside of the jurisdiction of the
home currency, so to speak. So that in the case of the United
States, it is in an offshore market outside of the United States. In
the case of Germany, it would be outside of Germany.
Mr. PATMAN. A substantial number of Eurobonds have been
issued backed by U.S. currency; have they not?
Mr. SOLOMON. There have been a substantial number of Eurobonds issued by both United States and non-U.S. issuers denominated in dollars. I am trying to answer as accurately as I can.
Mr. PATMAN. Were they backed by U . S . currency?
20-953 0 — 8 3
4
46
Mr. SOLOMON. I do not know exactly what that means, but if you
mean by that that when the bond matures they have to pay it off
in dollars, yes, because that is the denomination.
Mr. PATMAN. Are they competitive as against U.S. bonds backed
by the full faith and credit of the United States?
Mr. SOLOMON. These are all private bonds. The U . S . Treasury has
never issued bonds in the Euromarket.
Mr. PATMAN. But the bonds our country issues are in competition with these, are they not, in the market?
Mr. SOLOMON. The bonds that those corporations issue are very
analogous to the bonds that they issue in the domestic markets.
And in that sense you can argue that they raise capital in both
markets and only in that sense would they be competitive. However, I am not sure I understand what you are driving at, sir.
Mr. PATMAN. IS it in the nature of a bond similar to the one
issued by the U.S. Government in any way? Does it bear interest?
Is it secured by U.S. dollars or promise to pay in U.S. dollars?
Mr. SOLOMON. The credit rating of the issuer, which in this case
is a private corporation, is the key factor. So that only in that
sense, to the extent that you would argue that there are private
corporate bonds competitive with U.S. Treasury bonds in this
market, then you are right. In that same sense there are Eurodollar bonds which are competitive as well with the private bonds
here and the U.S. Treasury bonds here, and indeed bonds of foreign
governments.
Mr. PATMAN. NOW, do the foreign national companies which own
U.S. securities pay the same income taxes on the interest received
from that security ownership as U.S. citizens and companies pay or
are they exempt?
Mr. SOLOMON. I don't think I can answer that. I would have to
submit that for the record.
Mr. PATMAN. HOW about the other two gentlemen?
Mr. STERNLIGHT. I would not have a detailed authoritative
answer to give you.
Mr. GENG. I might say it varies from country to country based on
legislation, but I, too, do not have available immediately the specific tax regulations for individual countries.
Mr. PATMAN. YOU couldn't tell whether or not an English national or a French national who owned U.S. bonds kept in the banks
here in the United States has to pay income tax on the interest he
receives on those bonds?
Mr. SOLOMON. Income tax in his own country?
Mr. PATMAN. NO, in this country.
Mr. SOLOMON. Well, there are a whole series of double tax treaties and in some cases the withholding rate has been reduced. In
other cases it is actually at zero—it varies from country to country.
There are literally dozens and dozens of those double tax treaties. I
don't think that there is a general answer that I can give you, sir,
and only if that foreign national were a resident in this country
would he have an ultimate income tax responsibility as distinguished from the withholding tax.
Mr. PATMAN. NOW, I don't know if you saw the programs last
week by ABC and NBC at 10 o'clock at night eastern time about
the critical banking situation we have here.
47
Mr. SOLOMON. I read a review of it in the newspaper. I did not
see it.
Mr. PATMAN. I just wondered if the fast action that was shown in
at least the latter of those shows was typical of action which occurs
in the buying and selling of U.S. Government securities. I assume
it is. Is that true? Is it pretty much people standing by telephones,
operating phone banks, boilerroom-type activities by appearance?
Mr. SOLOMON. In all the markets—the foreign exchange markets,
the government securities market, the municipal bond markets,
the stock market—it is a very fast pace with increasing volume.
Mr. PATMAN. Does that hamper your regulatory authority in any
way, the fact that this goes on at such a rapid pace and is mixed in
with other transactions?
Mr. SOLOMON. I think it is always more complicated to do surveillance over a market with larger volume in transactions and which
means a faster pace of transactions. Yes, I think in that sense it
complicates the surveillance.
Mr. PATMAN. NOW, we hear a lot about the subject of crowding
out. The Federal debt is simply crowding out all other possible debt
or other creditors, other debtors.
What is the real truth about that? How much does our Federal
debt, and how much does our annual deficit impact upon the credit
market? What percentage of the total private investment is absorbed by the U.S. Government securities?
Mr. SOLOMON. Well, I hate to rely on my memory and a lot of
these estimates vary among different people but roughly, I think
there is a view right now that the current size of the U.S. Treasury
requirement in this fiscal year probably absorbs something in the
neighborhood of 40 percent of current savings in the country. That
has been projected out 2 or 3 years and will go up to somewhere
between 60 and 70 percent of all current savings that will be absorbed by the deficit that is envisaged at this time.
Mr. PATMAN. Does that take in to account any other sources perhaps of investment in these bonds or in these securities such as
from O P E C nations or persons in foreign countries?
Mr. SOLOMON. NO; that does not assume any change, either new
investment or disinvestment in the present foreign holdings of the
U.S. Government securities.
Mr. PATMAN. Well, I guess it is expressed in terms of the amount
of capital that is available to private companies and private individuals in this Nation as compared with the amount that has to be
absorbed.
Is that how it is calculated?
Mr. SOLOMON. Well, at the moment since the demand for capital
by the private sector is weak, since they are running such low utilization of capacity and we are just beginning to come out of a recession. So far you probably can make a pretty good argument that
the heavy U.S. Treasury borrowing is not having a significant
impact on rates. But when we reach a point in the recovery where
the private sector's credit demands are up substantially, if your
Treasury requirements are as large as presently envisaged, there is
no question that the combined effect will be very heavy on interest
rates.
48
Mr. PATMAN. HOW are the calculations made on the percentages
of total U.S. capital in private hands being devoted toward purchasing these Government bonds? Can you tell me about that?
Mr. SOLOMON. Well, there are different ways of calculating this,
including all the way from technical flow of funds analysis to savings and percentage of GNP. I would have to send you a letter explaining the different methodologies that are used in approaching
this and why people are concluding that the combination of a
strong private sector credit demand and the high U.S. Treasury
borrowing levels will, together, have a very major impact on the
capital markets.
Mr. PATMAN. In general, are the assumptions made that other
competing purchasers are excluded, such as foreign nationals and
investors from outside the United States?
Mr. SOLOMON. In most of the analyses but not all by any means,
one tends to assume a neutral situation as far as the foreign capital flow goes.
Mr. PATMAN. Let me interject something there. What percentage
of the U.S. securities is owned by Americans right now?
Mr. SOLOMON. What percentage of the U . S . Government securities are owned by Americans?
M r . PATMAN. Y e s .
Mr. SOLOMON. I would say about seven-eighths, maybe.
Mr. PATMAN. Eighty-seven and a half percent?
Mr. STERNLIGHT. Eighty to 90 percent sounds reasonable to me.
Mr. SOLOMON. Yes. That is about right. When I was Under Secre-
tary of the Treasury I can remember the foreign proportion of the
U.S. debt holding going, I think, as high as one-sixth but I think it
is lower today. I think it is between a seventh and an eighth.
Mr. PATMAN. And, of course, that is the percentage that may be
dependent upon a treaty for our taxation of the interest, I assume,
the one-sixth to one-eighth owned by foreign nationals would be
maybe subject to tax and maybe not in the United States depending on the treaties.
Mr. SOLOMON. Most of the foreign holdings of U . S . Government
debt, Mr. Patman, are held by foreign central banks. Very little of
it is held by private foreigners abroad. It is just not a worthwhile
investment from their point of view. The foreign central banks
hold it because it is such a wonderfully liquid market and it gives
them liquid dollar reserves to meet their balance of payments
needs.
Chairman FAUNTROY. If the gentleman would yield? When I
raised a similar question at a hearing last year with Mr. Stallecker, he responded that as of the end of the calendar year 1981
private investors held about $695 billion in outstanding debt.
Foreign and international investors held a little over $141 billion of
that amount which represented 20.4 percent of the debt held by
private investors.
Mr. SOLOMON. That ratio would be lower today, and it is virtually
all held by foreign governments or foreign central banks or official
institutions. Very little is held by foreign private individuals.
Mr. PATMAN. DO you undertake to keep a running total of this or
running percentage?
49
Mr. SOLOMON. We, ourselves, at the New York Federal maintain
the accounts of all foreign central banks who have accounts in the
United States with the Federal Reserve. We have approximately
140 accounts representing about 130 governments or countries. And
we also have the accounts of the International Monetary Fund and
the World Bank. These holdings are all Treasury obligation holdings in one form or another, that is what is in those accounts. So I
can simply tell by looking at the grand total what that is and why
that represents, based on both Treasury data and our data, virtually all of the Treasury obligations that are held by foreigners.
Mr. PATMAN. YOU mention your obligations and your responsibilities on the relationships between seller and borrowers and purchases of U.S. Government securities, I believe.
Do you have similar obligations and responsibilities in respect to
foreign securities bought and sold in the United States?
M r . SOLOMON. NO, n o t a t a l l .
Mr. PATMAN. HOW about State and local government securities?
Mr. SOLOMON. NO. Aside from our interests in Government secu-
rities, because of our open market operations, we also are agents
for the Treasury in auctioning off U.S. Treasury obligations. Mr.
Sternlight can go into more detail on this if you want, Mr. Patman,
that is what he does every day. But that is why we have a special
interest in the U.S. Treasury obligations, the Government securities market which we do not have in the others. Now, we have a
general interest, as a central bank of the country, in the soundness
of all financial markets but we don't have the kind of monetary
surveillance role in other markets that we have in the Government
securities market.
Mr. PATMAN. YOU get into it through your sales and purchases
on the Federal open market committee and you are interested, of
course, now in receiving the money that we are due upon the sale
of those securities, but how does this extend to what the dealers
and brokers do among themselves?
How do you assume responsibility beyond that, once we get paid
and once you sell and once you buy and once you receive the security?
Mr. SOLOMON. We are only interested in the soundness of the
market. Therefore, we would want to be sure that a situation
would not develop that caused a ripple effect all through the
market. Now, there are certain types of practices that are more
conducive and others that are less conducive. We are not that interested in whether Mr. x pays Mr. y.
Mr. PATMAN. But if you start talking about your interest because
of the ripple effect that could give you a pretty broad interest,
couldn't it?
Mr. SOLOMON. YOU are right. It has to be defined in specifics and
we have tried to, by illustrating in my testimony the kinds of
issues—the practices—that we are concerned about at the moment,
the ones that we feel have been successfully addressed and the
ones that we think can cause risk to the system. We are not trying
to prevent the failure of any particular firm. We don't feel that
that is appropriate for us to be involved in.
Mr. PATMAN. Thank you, Mr. Chairman.
50
Chairman FAUNTROY. Mr. Solomon, the when-issued market has
expanded greatly, as I understand it. I wonder if you can tell us
what you are doing to assure that transactions which rest upon
these future securities are being prudently undertaken? Are you
establising limits on when-issued obligations? Should there be
limits?
Mr. SOLOMON. Mr. Geng has put to the dealers various proposals
on different ways of structuring the question of how to have a more
prudent when-issued market and he is engaged in getting differing
reactions to that proposal because there is a very wide range of
opinion among the dealers. He will go into specifics, if you wish,
Mr. Chairman, on these various proposals.
Chairman FAUNTROY. Mr. Geng?
Mr. GENG. Yes, Mr. Chairman. We have addressed this in three
proposals to the dealer community. One issue concerns the item
Mr. Sternlight referred to earlier, the activity between dealers.
During this period of 1 to 3 weeks, when a new issue is first being
traded. Trading volume in the dealer community adds up to very
large numbers, in the multibillion dollar class on large financing
operations by the Treasury. We have suggested that one possible
method of dealing with this situation to minimize risk would be to
establish a clearing facility where the dealers that were active in
the market would clear their own transactions. Every trade between dealers would be netted against each other, and there would
not be any broker in between—they would be netted out. That information in that pool would be made available to the Federal Reserve, which would then see the exposure of each individual dealer.
We have also suggested that in that kind of an arrangement it
would be useful to have a margin payment made by those who
have exposure. That is, if one dealer were to have a long position of
x million and the price moved down, that some margin be held in
the clearing arrangement to assure that protection of all participants. We have suggested also that that kind of treatment be extended to customer business, and I think this is analogous to the
way the current futures market transactions are undertaken. They
are done on exchanges where each participant maintains margins
against their long and short positions in the futures market. Those
are the main elements, Mr. Chairman.
Mr. SOLOMON. They are very complicated, so if you don't understand them, Mr. Chairman, you are in good company because there
are a lot of complexities involving the differences between each of
these three approaches. Those three don't preempt the entire spectrum either. We are still very much in the dialog stage here.
Chairman FAUNTROY. Mr. Solomon, you touched upon the final
question I wanted to ask you and the panel, which stems from the
fact that some of these terms and some of these procedures are not
very clear to many of us as laymen in the country. Would you provide the subcommittee, for inclusion in the record, further descriptions and diagrams showing, for example, the complete, whenissued transaction, the repurchase agreements, reverse prepurchase agreements, and so forth. They are all rather confusing to a
layman like myself, so if you or your staff could prepare, for inclusion in the hearing record, a brief description, preferably with diagrams, of how a repurchase agreement and a reverse repurchase
51
agreement, work, what happens to Treasury securities by using
those transactions and how a string of transactions would work. I
have had staff to describe this to me, but I would like to see you
take your hand at it with a diagram.
Mr. SOLOMON. Well, it is a real challenge.
[In response to the request of Chairman Fauntroy for additional
information, the following response was received from Mr. Solomon
for inclusion in the record:]
WHEN-ISSUED TRADING
In the process of issuing new Treasury debt there is a period of time between the
Treasury's announcement of the terms of the sale, the auction of the securities, and
the payment for the securities. During the period between announcement and issuance of the securities a considerable amount of trading of the securities takes place.
This trading is referred to as "when-issued" trading because such transactions can
only be completed when the new securities are issued. In other words, delivery of
the securities is stipulated to take place "when issued".
When-issued periods can vary from about 8 days for a Treasury bill to as much as
3 weeks for a Treasury coupon-bearing security. For example, the sale of regular
three- and six-month Treasury bills is announced on a Tuesday. The auction takes
place on the following Monday and payment and issuance occurs on Thursday. As a
second example, the Treasury announced its quarterly refunding on April 27 but
the issuance of the securities will not take place until May 16.
When-issued trading benefits the market because investors can make commitments to take on the new securities before payment is due. Prices would be depressed and the cost to the Treasury would be higher if a large amount of new securities were sold in the market for immediate payment.
A trader's capital ordinarily serves as a restraint on unsound position-taking because most trading in Treasury securities is paid for the same day or the next day.
When payment is not made immediately a trader can be tempted to take larger positions than tapital would allow. Such a trader is essentially buying with unsecured
credit. Market participants realize such trading involves unsecured credit and monitor their exposure carefully. However, an individual trader does not know the total
amount of credit extended by the market to any other trader. Consequently a trader
could be extending credit on the false assumption that the counterparty has no
other when-issued obligations.
EXAMPLE OF A WHEN-ISSUED PERIOD
Issue to be sold: An additional $33A billion of Treasury bonds due November 15,
2012.
Announcement date of sale: April 27, 1983.
Date of auction: May 5, 1983.
Settlement date (payment and delivery): May 16, 1983.
Number of calendar days during when-issued period: 20.
HYPOTHETICAL SET OF TRANSACTIONS BY ONE TRADER
Assume that on April 27 a trader buys $4 million of the Treasury bonds at a price
of 100 from each of 5 other parties—a total of $20 million. On April 29 assume that
the price has declined one-half point and the trader buys an additional $20 million
of the bonds at 99 V2—$4 million from each of 5 other parties. And on May 7, with
the price down one-fourth point, he buys $40 million of the bonds, this time $4 million from each of 10 other parties. This is illustrated in the following table, along
with an assumed closing market price each day and a resultant unrealized loss.
nu aa tl eP
April 2 7
April 2 9
May 7
May 15
Amount
purchased
$20,000,000
20,000,000
40,000,000
Number of
counterparties
5
5
10
Price
100
99%
99 y 4
Average price
paid to date
100
99%
99%
99%
Closing
price
100
99 y 4
99
98%
Unrealized loss
0
$200,000
400,000
800,000
52
Result: The trader has lost $800 thousand during the when-issued period. The
trader has not paid for the securities and, given the size of the loss, may be unable
to meet the commitment. Each of the counterparties from whom the securities were
purchased stands to lose $40 thousand. Each of the 20 counterparties sold only $4
million of the securities to the trader, an amount they believed was within the capabilities of the trader. They did not know the trader had accumulated commitments
totaling $80 million.
REPURCHASE AND REVERSE REPURCHASE AGREEMENTS
A repurchase agreement (RP) is a transaction which obligates the seller of a security to buy it back from the purchaser at a later date. The other party to the transaction has a corresponding obligation to return the security to the seller. The same
transaction may also be referred to as a reverse repurchase agreement (reverse RP).
That is to say, when a dealer obtains a security under a repurchase agreement the
dealer will refer to the transaction as a reverse repurchase agreement. In fact,
under the same transaction, a seller is said to put the security out on "RP" and the
purchaser, particularly a dealer, is said to "reverse" the security in.
By means of this transaction, the seller obtains funds from the purchaser while
simultaneously transferring a security to assure repayment of the funds. Dealers
use such transactions to finance their inventories of securities. If dealers use such
transactions to obtain securities they are doing the opposite or the "reverse". Dealers may do a "reverse" to borrow securities which were sold short.
The date set for the repurchase of the security may be as short as overnight or
extend for a number of months. Both the price at which the security will be repurchased and an interest rate charge for the funds borrowed are determined at the
initiation of the transaction. The amount of funds borrowed is normally less than
the security's money value. This difference exists in order to protect the purchaser
from a loss if the seller fails to repurchase the security and its price has fallen.
Since the Drysdale failure, the security's money value is calculated to include any
accrued interest due from the issuer of the security as well as the market price at
which the security trades. The difference between the security's money value and
the funds borrowed is referred to as the margin. Sufficiently large changes in the
market price (up or down) of the security during the life of the repurchase agreement can require adjustments in the margin.
Because each purchaser of a security under a reverse repurchase agreement essentially has the unrestricted use of the security during the life of the contract, the
security may change hands a number of times as it is sold outright or used for subsequent repurchase agreements. When the purchaser has used the security for an
outright sale to a third party (a short sale), the purchaser may satisfy his obligation
under the reverse repurchase agreement by obtaining the equivalent securities from
any customer and returning them to the original seller under the agreement.
The following diagram illustrates an example of these transactions which link the
movements of a security. In the example, dealer A purchases a security for $100
million and in order to replenish his bank balance before the close of business
places the security on repurchase with dealer B. In so doing, dealer A obtains $99
million after margin and uses $1 million of his own capital to complete payment for
the original purchase. Dealer B, having done a reverse repurchase with dealer A,
then sells the security outright to customer C for $100 million. At the maturity of
the contract, dealer B purchases the comparable security outright from customer D
for $100 million, returns the security to dealer A and receives repayment of his
original $99 million loan. In order to repay dealer B, dealer A must either sell the
security outright or enter into a new repurchase agreement.
Attachment.
ILLUSTRATIVE SECURITY TRANSACTIONS USING A REPURCHASE/REVERSE REPURCHASE AGREEMENT
Dealer A
Dealer B
Customer C
Customer D
Transactions
Funds
Dealer A purchases security outright
Dealer A RP's security with dealer B
(Dealer B executes a reverse RP)
Dealer B sells security outright to
customer C
Securities
- 1 0 0
+100
+99
- 1 0 0
Funds
- 9 9
+100
Securities
Funds
Securities
+100
- 1 0 0 - 1 0 0 +100
Funds
Securities
53
ILLUSTRATIVE SECURITY TRANSACTIONS USING A REPURCHASE/REVERSE REPURCHASE
AGREEMENT—Continued
Dealer A
Dealer B
Customer C
Customer D
Transactions
Funds
Dealer B buys security outright from
customer D
RP and reverse RP matures
Net change upon maturity of
RP contract
Securities
- 9 9
+100
- 1 0 0
+100
Funds
Securities
- 1 0 0
+99
0
Funds
+100
- 1 0 0
0
Securities
Funds
Securities
+100 - 1 0 0
- 1 0 0
+100 +100 - 1 0 0
Chairman FAUNTROY. Thank you.
I think Mr. Patman has a final question.
Mr. PATMAN. Really, it involves several concepts, the law of
supply and demand and how it affects the interest rates and also
the expectations argument that we hear continually. You are right
on the ground floor there where people buy these securities or they
don't buy them.
First of all, when a person doesn't buy U.S. securities because he
is not satisfied with the interest rate, what does he do with his
money?
Mr. SOLOMON. Well, he can buy commercial paper, he can buy
CD's, certificates of deposit, from the banks, he can buy various
kinds of short-term instruments, he can go long in the non-Government security corporate bond market, he can go to the stock
market, he can buy gold and put it under his mattress, he can buy
real estate or antiques. There is a whole variety of things. I think
you would have to give me a more specific question.
Mr. PATMAN. DO people generally come in and out of the U . S .
Government security market, or do you have a pretty solid list of
customers and buyers and sellers that do nothing but that?
Mr. SOLOMON. I think it is fair to say that many of the institutions in this country are steady buyers and hold those securities in
their portfolios at least for some period of time, as distinct from
those who would buy in order to take advantage of market opportunities in a very quick turnaround sense.
I don't know whether you want to get into a lot of detail in this,
and my colleagues could probably give you some percentage estimate or guesses as to what percentages are currently or customarily bought by, say, the banks as against the other types of financial
institutions and as against individuals. What do you say?
Mr. PATMAN. I will tell you. Could you just give me a percentage
of those people who buy Government securities customarily over
the last year who are likely to buy gold as an alternative investment or commerce paper or something of that nature?
Mr. SOLOMON. I don't think there is any way of giving you that.
For one thing, the Government does not keep track of who buys
gold. What percentage are individuals that are flexible in their investments?
Mr. STERNLIGHT. There is such a lot of flexibility, Congressman.
There is a sort of hard core, if you will, of buyers, many of them
institutional, who are in Government securities all the time. There
54
is also a fairly sizable group at the margin who will be in or out of
Government securities depending on yield relationships.
I am tempted to note that the Treasury, in all of its auctions has
some portion of the securities that is sold in a noncompetitive form.
They are sold in smaller amounts. In the case of weekly Treasury
bills, that averages about three-quarters of a billion to 1 billion out
of the weekly issues that now average about 6 billion. But that
would be an extremely crude proxy for individual participation because many small institutions also use that noncompetitive route.
Mr. PATMAN. Let me ask you, we have had these huge deficits
projected. I think I read the other day in the Heritage Foundation
paper that they put out that the estimates have gone up 2,500 percent.
Chairman FAUNTROY. YOU read the Heritage Foundation's publications?
M r . PATMAN. O h , y e s .
Chairman FAUNTROY. Oh, I see, thank you.
Mr. PATMAN. From March 1 9 8 1 , to, I guess, February 1 9 8 3 . Why
hasn't the market reacted by causing interest rates to go up in the
last few months by simply depreciating the value of the Government securities that are on the market? Is it because the amount
of money supply has been integrated to compensate for that?
Mr. SOLOMON. NO, that is not it at all. In fact, if you increased
the money supply, you would probably get a reverse reaction in the
longer end of the market—that is, interest rates would rise.
Mr. PATMAN. Excuse me. Would you explain why if we inflated
the money supply we would get a reverse effect, as long as you
brought it up?
Mr. SOLOMON. Well, it is that old business that the attitudes of
buyers and sellers do determine, of course, the equilibrium price in
those markets.
Mr. PATMAN. HOW about the supply-and-demand equation?
Mr. SOLOMON. Right, that also.
Mr. PATMAN. Well, if you have more money buying the same
bonds, you would probably have more money chasing after the
same goods and have a higher price, wouldn't you?
Mr. SOLOMON. Except that what happens if people believe, and I
am not saying it always happens this way, but if they believe that
inflating the money supply is going to mean a significantly higher
rate of inflation farther down the road even if it is 18 months or so
from now. They will then be very reluctant to lock themselves into
longer term securities unless the yield is high. They will stay short,
or they will go into anti-inflationary hedges.
Mr. PATMAN. Right. And staying short for 9 1 days or 1 8 8 days
with Treasury bills would mean that the rates of interest on those
would drop significantly, wouldn't they?
Mr. SOLOMON. That is right.
Mr. PATMAN. Why haven't they dropped? The chairman earlier
mentioned there is a more direct relationship to inflation?
Mr. SOLOMON. Well, short-term rates can drop for various reasons. They can drop either because of the particular situation you
are talking about, namely, inflating the money supply and, therefore, people being afraid of the long end of the market and staying
short. That is one way.
55
But it could also drop simply because of an increasing realization
that inflation rates are coming down and, therefore, rates both in
the short end and the long end of the market would tend to come
down when and as people are really convinced of that.
Mr. PATMAN. Can you give us any projections, just based on what
these Government deficits are going to be in the next few years, as
to what effect that is going to have on the interest rates?
Mr. SOLOMON. NO, sir; I can't. All I know is that if you get a recovery, as we assume we are in now, the private sector credit demands will increase, which is only natural as part of a recovery.
Then I am convinced, that if you are running a U.S. Treasury borrowing requirement of roughly 6 or 6V2 percent of GNP, or another
way of looking at it, using up 70 percent of the current savings in
the country, and that is combined with a stronger private sector
credit demand, you are clearly going to have major upward pressure on interest rates. How much I don't know and nobody would
know. There is no way of predicting that. Even if you knew the
exact amount of increase in the private sector demand for credit
and for medium and long-term capital as part of the recovery, you
still would not be able to make a calculation as to how much interest rates will be higher than they otherwise would be without such
a big deficit. But they certainly will be significantly higher, Mr.
Patman, that you can be assured.
Mr. PATMAN. Regardless of expectations?
Mr. SOLOMON. Not only that, but the actual demand for money—
for capital for medium and long-term capital—would also be part of
this whole process so that you would get an actual tilting of the
demand/supply balance aside from expectations.
Mr. PATMAN. Thank you very much.
Chairman FAUNTROY. I thank you, Mr. Patman and Mr. Solomon, Mr. Geng, Mr. Sternlight. Your testimony here certainly contributed to our understanding of the impact of these money and
credit policies on Federal debt management and in particular, our
concern on the domestic institutions that are engaged in the purchase and sale of our U.S. Government debt instruments.
We look forward to your continuing counsel with this, particularly with respect to any future legislative initiative that you think
may be necessary, and also with respect to some of the requests we
have made for diagrams and data that should help us to understand better our oversight requirements as a subcommittee. Thank
you so very much, and we look forward to seeing you in the future.
And with that, the subcommittee hearings will come to a close.
[Whereupon, at 2:40 p.m., the subcommittee was adjourned, subject to the call of the Chair.]
APPENDIXES
ADDITIONAL MATERIAL SUBMITTED FOR INCLUSION IN THE RECORD
w»iTim rAuNiBor.oc.ch«ibm«j<
SltrH(MLNtM.NC.
i r f S S ^ co.N
Appendix a A: Notice of subcommittee hearing
.
miscellaneous
material
D
aon JIX."'
»«^ow(«r.uuf.
Bill McCOUUM fix
U.S. HOUSE OF REPRESENTATIVES
tmomaj'R CA«nVotu
H^tO.^NO.,
W i I 7o G J^ 0 ^2^ I ( i ^ l 0 , , ,
S U B C O M M I T T E E ON D O M E S T I C M O N E T A R Y POLICY
0FTHE
C O M M I T T E E ON B A N K I N G . FINANCE A N D U R B A N A F F A I R S
NINETY-EIGHTH C O N G R E S S
W A S H I N G T O N . D.C.
20 515
April 20, 1983
REMINDER OF SUBCOMMITTEE HEARING AND WITNESS LIST
To
:
Members, Subcommittee on Domestic Monetary Policy
Members, Committee on Banking, Finance and Urban Affairs
From :
Walter E. Fauntroy, Subcommittee Chairman
Re
Impact on Money and Credit Policy of Federal Debt Management
Oversight Hearings on the Safety, Soundness, Structure and Function
of Domestic Institutions Engaged in the Purchase and Sale of United
States Government Debt Instruments
:
MONDAY
APRIL 25
1:00 PM
2128
RAYBURN
The Subcommittee on Domestic Monetary Policy will meet on Monday,
April 25, 1983, at 1:00 p.m. in Room 2128 Rayburn House Office
Building in exercise of its oversight authority on the Impact on
Money and Credit Policy of Federal Debt Management to examine
proposals being advanced by the Federal Reserve System relating to
the safety, soundness, structure and functions of domestic
institutions engaged in the purchase and sale of United States
Government debt instruments.
The Federal Reserve System, acting through the Federal Reserve Bank
of New York, has increased its regulatory efforts over major
government security dealers following the collapse of Drysdale
Government Securities, Inc. and Lombard-Wall, Inc. last year.
There are both present regulatory efforts and contemplated regulatory
schemes which have been undertaken that are intended to enhance the
safety and soundness of the major security dealers. The Subcommittee
intends to explore these and possible proposed regulations to
ascertain the following:
1.
WITNESSES
What concerns are held by the System with respect to the
conditions of firms engaged in the purchase and sale of
government securities included in both financial and
operational matters.
2.
Whether the size of the pending government deficit will
have an adverse effect on the ability of the market to
absorb the deficit without undue upward pressures on
interest rates and the safety and soundness of the
government security firms.
3.
Whether the number of dealers with whom the Federal Reserve
has a direct relationship should be expanded, how this
might be accomplished, and whether there should be changes
in the standards governing those who are engaged in the
purchase and sale of government securities.
4.
Whether direct regulation of all government security firms
by the Federal Reserve should be undertaken and what
legislative changes are required to implement such a scheme.
5.
Exemptions from certain provisions of the bankruptcy laws
controlling assets when those assets are repurchase agreements.
The Honorable Anthony M. Solomon, President, The Federal Reserve
Bank of New York. He will be accompanied bv Edward J. Geng,
Senior Vice-President, and Peter D. Sternlig'ht, Executive VicePresident.
(57)
58
WALTM E. FAUNTROT 0 C .
U.S. HOUSE OF REPRESENTATIVES
^OMASPRHCIRPER. DEL
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
H2-109 ANNEX NO. 2
WASHINGJON.^C^ M5I5
OF THE
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
NINETY-EIGHTH CONGRESS
W A S H I N G T O N , D.C.
20515
April 6 , 1983
The Honorable Paul A . Volcker
Chairman
Board of Governors
Federal Reserve System
20th and Constitution Avenue, N.W.
Washington, D. C. 20551
Dear Paul:
On Monday, April 25, 1983 the Subcommittee on Domestic Monetary
Policy in exercise of its oversight authority will meet to take testimony
on the structure and function of those domestic institutions engaged in
the purchase and sale of United States government debt instruments.
This has been a matter which has previously been studied by this Subcommittee
and this hearing continues my deep interest and concern about the safety,
soundness, function, and structure" of our debt markets.
I understand that the Federal Reserve Bank of New York has increased
its regulatory efforts in this area since the failures of Drysdale
Government Securities, Inc. and Lombard-Wall Inc. last year, and that
additional regulatory schemes are being contemplated. I also understand
that both this regulatory effort and any subsequent schemes would be
applied first, and only directly, to the 36 dealers with whom the New
York Bank has a specific relationship with the further effectiveness of
any regulatory effort occuring through the insistence by this group that
the same standards be followed by other dealers with whom they maintain
business relationships.
I would like you or your designee to testify on this date to
these matters. Specifically, I hope your testimony will address the
following questions:
1.
What concerns are held by the System with respect to the
conditions of firms engaged in the purchase and sale of
government securities including both financial and operational
matters?
2.
Whether the size of the pending government deficit will have
an adverse effect on the ability of the market to absorb the
deficit without undue upward pressures on interest rates and
the safety and soundness of government security firms.
59
Chairman
Volcker
April
6 , 1983
3.
Whether the number of dealers with whom the Federal Reserve
has a direct relationship should be expanded, how this might
be accomplished, and whether there should be changes in the
standards governing those who are engaged in the purchase and
sale of government securities;
4.
Whether direct regulation of all government security firms by
the Federal Reserve should be undertaken and what legislative
changes might be required to implement such a scheme;
5.
Exemptions from certain provisions of the bankruptcy law
controlling assets when those assets are repurchase agreements.
I am also very much interested in discussions which have been
ongoing at the Federal Reserve Bank of New York related to the possible
imposition-of capital ratios. I would like a thorough discussion of the
issues surrounding this matter which should include the advantages such
a rule could conceivably bring and the disadvantages such as a narrowing
of the number of qualified dealers.
I realize that the System has not yet finalized any proposal or
suggestion. I am not looking for any finalized version of any potential
regulatory scheme. Rather, I want to be sure that all of the issues are
being fully examined and discussed. Towards that end, I will be holding
further hearings on this matter. There will not, however, be any other
witnesses at this hearing since I have determined that it would not be
useful to engage in any debate before there has been adequate time to
assess Federal Reserve System comments or concepts. The industry will
be given adequate time to comment on a subsequent date.
The hearing will commence at 1:00 p.m. on Monday, April 25, 1983
in Room 2128 of the Rayburn House Office Building. Committee Rules
provide that witnesses should provide 100 copies of their testimony at
least 24 hours before the hearing. Witnesses should also bring with
them additional copies if they want to be sure that members of the press
and the public who may be in attendance are to be provided with copies
of their testimony.
Any questions concerning this oversight hearing should be directed
to the Staff Director of the Subcommittee, Howard Lee, who may be reached
at 226-7315.
Sincerely yours,
Walter E. Fauntroy
Chairman
Paul, I understand
to testify on this matter
officials of the New York
am most pleased to extend
that Tony Solomon has been designated by you
and that he will be accompanied by other
Fed. That is an acceptable arrangement and 1
to him my welcome.
60
BOARD
OF
D OVER NOR5
• F TH E
FEDERAL RESERVE
SYSTEM
W A S H I N G T O N , •. C. 2 0 5 5 1
A p r i l 7 , 1983
CHAIRMAN
The H o n o r a b l e W a l t e r E . F a u n t r o y
Chairman
Subcommittee on Domestic M o n e t a r y Policy
Committee on B a n k i n g , Finance and
Urban Affairs
H o u s e of R e p r e s e n t a t i v e s
Washington, D. C.
20515
Dear C h a i r m a n
Fauntroy:
T h a n k y o u for y o u r l e t t e r of A p r i l 6 c o n c e r n i n g
your S u b c o m m i t t e e ' s h e a r i n g s o n the s t r u c t u r e a n d
function
of d o m e s t i c i n s t i t u t i o n s e n g a g e d in t h e p u r c h a s e and
of U n i t e d S t a t e s g o v e r n m e n t d e b t
instruments.
As you are aware, I have asked M r . Anthony
S o l o m o n , P r e s i d e n t of t h e F e d e r a l R e s e r v e B a n k of N e w
Y o r k , to a p p e a r b e f o r e y o u r S u b c o m m i t t e e on b e h a l f of
the B o a r d on M o n d a y , A p r i l
25.
sale
M.
61
10
THE WALL STREET JOURNAL
Tuesday, March 22, 1983
New York Fed Weighs Rule Fixing Levels
Of Capital for Big U.S.-Securities Dealers
By a WAUL S T R E E T JOURNAL Staff
Reporter
NEW YORK-The Federal Reserve Bank
of New York Is considering establishing capita] requirements for major government-securities dealers, as part of a stepped-up regulatory effort following last summer's collapse of Drysdale Government Securities
Inc. and Lombard-Wall Inc., two relatively
small houses.
_
Edward J. Geng, a New York Fed senior
vice president hired to do market surveillance in the wake of the failures, told a
news luncheon yesterday that the bank may
set up a formula under which dealers would
be required to have fixed amounts of capital
to support particular levels of exposure in
the government-securities market.
Mf. Geng disclosed that "there have been
occasions" during the past six months when
the New York Fed was concerned that certain dealers hadn't enough capital to support
their trading positions. As a result, the bank
had the dealers pare their positions. He
didn't identify the dealers involved.
Mr. Geng also said the bank is thinking
about restricting "when-issued" trading of
government securities. In such trading,
which has burgeoned in re«ent years, dealers trade securities that are going to be offered but that haven't yet actually been issued. He explained that often there can be
three weeks between the time an issue is announced and offered. Dealers are at risk if,
for any reason, other dealers fail to make
good on delivery of cash or securities once a
security Is issued.
Mr. Geng suggested that the bank may
require margin payments among dealers as
means of minimizing such risks. Margin is
the amount of cash that must be put up in a
purchase of securities.
Any new rules in the government-securities area would take the form of standards
set for the 36 dealers with which the Federal
Reserve Bank deals. Smaller dealers outside
this group-such as Drysdale and LombardWall—wouldn't be affected directly.
Mr. Geng said he hopes that once new
regulations are applied to the 36 dealers,
this group will insist on the same standards
at smaller firms with which they trade.
Overall, Mr. Geng, formerly a senior vice
president of Baer American Banking Corp.,
said, "a primary goal is to raise the level of
awareness" among all government-securities dealers and institutional investors.
20-953
0 — 8 3 —— 5
Drysdale's collapse nine months ago sent
shudders through the financial community,
which had generally played down the risk
underlying the massive government-securities market, where aboflt $30 billion of
trades occur daily. Diysdale folded after
building a multibillion-dollar portfolio of repurchase agreements, far out of proportion
to its capitalization. These contracts, generally known as "repos," allow dealers to
raise cash by selling securities under an
agreement to buy them back later
Since joining the Fed last September, Mr.
Geng has set up a staff of seven people to
monitor the government-securities market
Had this group been in place a year ago,
Mr. Geng said, it would probably have detected problems in Drysdale's ballooning repurchase agreements.
; He said the surveillance team reviews
data provided by the 36 major dealers and
often follows up with visits to dealers.
Mr. Geng warned that dealers shouldn't
grow complacent because last summer's
failures didn't create the industry-wide damage some feared they would. Improved market conditions "tend to let the events of last
year fade," he said.
Mr. Geng also called for enactment of a
U.S. legislative amendment that would exempt repurchase agreements from bankruptcy-law provisions that automatically
freeze assets and obligations of a company
filing under the Bankruptcy Code. The
amendment, which industry officials support
strongly, would allow dealers to unwind repurchase agreements after entering bankruptcy proceedings.
Questions over how repurchase agreements were to be treated in the bankruptcy
courts brought additional confusion to the
Lombard-Wall collapse last August.
62
14
T H E W A L L S T R E E T J O U R N A L , Tuesday, April 5, 1983
U.S.-Debt Dealers Face Antitrust Probe
On Use of Closed-Circuit Trading System
By a WAI-L S T R E E T JOURNAL Staf J
Reporter
WASHINGTON—A large and profitable
segment of the market for Treasury securities has come under U.S. antitrust scrutiny
because it is limited to slightly more than
three dozen companies, Justice Department officials said.
The department has begun a preliminary
inquiry into the limits on the number of
companies that can have access to closed
systems for making anonymous trades in
U.S. Treasury securities. A department
spokesman said the civil inquiry has been
going on "for some time."
Currently, the four companies that serve
as brokers in this segment of the securities
market allow access only to 36 banks and
brokerages that are approved by the Federal Reserve Bank of New York as primary
or reporting dealers. To qualify, these companies must, among other things, make a
market in all Treasury issues, handle more
than about 1% of trading in Treasury securities, maintain an adequate balance sheet
and report daily to the Fed on their trading.
The brokers also give access to the system
to a few other companies among those that
have applied to the Fed to become reporting
dealers.
Each of the brokers operates a closed-circuit network of televisions carrying information on amounts asked or offered for specific
transactions in Treasury securities, without
identifying the companies involved. The systems' users can then phone in,orders to the
brokers, who flash "hit" next to the offers
that are accepted.
Volume of trading among these large
dealers in Treasury securities could be as
large as $15 billion to $20 billion a day, according to federal regulators. And because
the volume is so large, the prices carried on
the closed-circuit systems tend to be the
best available, giving insiders an advantage
over others that trade in the securities, a
Justice Department lawyer said.
Users of the system prefer to limit access
to it because they want assurances that all
the companies with which they trade anonymously are able to execute their agreements, according to a Justice Department
official.
It's understood that the department is interested in whether the ability to trade
through the system or access to its information on transaction prices-without the authority to trade through it-could be more
widely available without serious risks.
Also of interest to the trust busters is
whether the companies with access to the
system are able to use their influence to restrict its availability to other concerns that
might compete with them, a government
lawyer said.
The four main brokers of Treasury securities are Fundamental Brokers Inc., a subsidiary of Mercantile House; R.M.J. Securities Corp., a subsidiary of Security Pacific
National Bank; Garban Ltd., a subsidiary of
Mills & Allen International PLC of Britain,
and Chapdelaine & Co. A similar system is
operated by Cantor, Fitzgerald Securities
Corp., though it is available to more subscribers and carries less information.
The Justice Department investigation
highlights a dilemma confronting securities
dealers and brokers. If they keep the current system, they run the risk of antitrust
charges. But if they remove all barriers,
they fear that they expose themselves to the
risk of trading with financially unsound
companies.
The issue is especially fresh in the minds
of securities dealers because of the collapse
last summer of Drysdale Government Securities Inc. and Lombard-Wall Inc. Since the
failure of the two small concerns, many securities dealers have tightened their creditchecking procedures, and some have also
shortened the list of companies they do business with.
Still, some dealers and federal regulators
argue that the securities industry hasn't
done enough to protect itself against more
such incidents. As a result, some bankers
and securities dealers feel as though they
are being pulled in opposite directions by
two government branches. On one hand,
they note that the Federal Reserve System
has been encouraging them to be more careful of whom they trade with, while on the
other hand, the Justice Department is probing possible antitrust violations.
"Before we go about making major
structural changes in this marketplace, we
should consider the potential disruptive effects on the efficient day-to-day functioning
of the market," said Larry F. Clyde, an executive vice president of Crocker National
Bank in San Francisco.
"This system, I think, has served the industry, the Treasury, and the investing public very well," said Mr. Clyde, who was
chairman last year of the Public Securities
Association, a trade group. "The Treasury
market is. by any definition, a highly efficient and highly liquid-perhaps the most efficient and liquid market on earth."
The issue that the Justice Department is
looking into is "nothing new," Mr. Clyde
added. "This is something people have been
discussing back and forth, pro and con, for
years."
Federal regulators insist that there isn't
any contradiction between the Justice Department probe and the Fed's efforts to encourage dealers to tighten credit-checking.
One official said that securities dealers can
easily do an adequate job of ereuit-checking
without violating antitrust laws.
Some smaller companies complain that
the current system is rigged against them.
But others point out that numerous smaller
concerns have expanded in recent years and
joined the ranks of the major ones. "There
are various tiers to any business." says one
federal regulator. "The smallest guys in any
business are going to h a * trouble initially
doing business with the biggest guys. In any
business, you have to earn your wings."
63
Appendix
B : A m i c u s c u r i a e b r i e f in the L o m b a r d - W a l l c a s e ,
f i l e d b y t h e F e d e r a l R e s e r v e B a n k of N e w Y o r k
UNITED STATES BANKRUPTCY COURT
SOUTHERN DISTRICT OF NEW YORK
In re
LOMBARD-WALL INCORPORATED,
In Reorganization
Case N o . 82 B 11556 (EJR)
Debtor.
LOMBARD-WALL INCORPORATED,
Plaintiff,
Adversary N o . 82-5998-A
-againstCOLUMBUS BANK AND TRUST COMPANY;
MERCANTILE-SAFE DEPOSIT AND TRUST
COMPANY? THE FIRST BOSTON CORPORATION; A . G . BECKER INCORPORATED;
and others similarly situated,
Defendants.
MEMORANDUM OF LAW IN
SUPPORT OF FEDERAL RESERVE'S
MOTION TO INTERVENE AS AMICUS CURIAE
AND
BRIEF AS AMICUS CURIAE
64
PRELIMINARY STATEMENT
This document is respectfully submitted on behalf
of the Federal Reserve Bank of New York ("Reserve Bank") so that
it may make its views known to the Court on an important principle
of commercial law:
namely, whether in a bankruptcy proceeding, a
repurchase agreement should be characterized as a purchase and sale
transaction or as a secured loan.
The Reserve Bank submits, as a
matter of public policy, that a repurchase agreement should be
characterized as a purchase and sale transaction.
If the Court
characterizes a repurchase agreement as a secured loan, this
characterization could have an adverse impact on the Federal
Reserve's ability to conduct domestic monetary policy effectively
and to invest dollar deposits of foreign central banks efficiently.
Moreover, such a characterization could also increase the cost
of financing the public debt of the United States.
STATEMENT OF FACTS
The defendants in this motion are involved in contractual
agreements with Lombard-Wall Incorporated ("Debtor").
Pursuant to
these agreements, the Debtor sold securities to the defendants and
also agreed to repurchase securities from the defendants at a
future date.
After the Debtor filed its petition for reorganiza-
tion relief under Chapter 11 of the Bankruptcy Code on August 1 2 ,
1982, the Debtor breached its contractual obligation to repurchase
securities from the defendants.
Defendants are contemplating,
and may have already effected, sales of the securities to third
- 1 -
65
parties.
The Debtor has moved the Court for a preliminary injunc-
tion enjoining the defendants from liquidating the securities in
this manner and the Court has scheduled a hearing on the Debtor's
Motion for August 23, 1982.
The central legal issue to be decided
at this hearing is whether a repurchase agreement should be characterized as a purchase and sale transaction or as a secured loan.
POINT Is THE MOTION
TO INTERVENE AS AMICUS
CURIAE SHOULD BE GRANTED.
A.
The Federal Reserve Uses The Repurchase Agreement As A Vehicle
For Carrying Out Certain Of Its Public Responsibilities.
A repurchase agreement ("Repo") is used by the seller of
securities as a means to acquire funds, and by the buyer of securities as a means to invest funds, over a short period of time.
As
part of the terms of sale, there is included a simultaneous agreement between the parties that the seller will repurchase the securities at a later date.
The Federal Reserve uses the Repo in two ways.
it is used as a tool of monetary policy.
First,
The objective of Federal
Reserve monetary policy is the achievement of a steady and sustained growth in the economy, along with reasonably stable prices.1/
Achievement of this objective is sought through encouraging the
nation's money supply to grow within ranges deemed appropriate and
Yj
In fact, the FOMC is required by the Full Employment and
Balanced Growth Act of 1978 (Pub. L . 95-523, Oct. 27, 1978) to
establish objectives for national monetary growth and to report
on these objectives periodically to appropriate committees of
the Congress.
-
2
-
66
desirable by the Federal Open Market Committee ("FOMC").
In turn,
the FOMC instructs the Reserve Bank to achieve the FOMC's monetary
growth objectives by controlling the supply of reserves available
to commercial banks.
These reserves are controlled through open
market purchases and sales, which are described more extensively in
Point 2(c) below.
A purchase of securities by the Federal Reserve
will increase reserves, whereas a sale of securities will decrease
reserves.
Because the supply of reserves tends to fluctuate widely
over short periods of time, the Federal Reserve often uses the shortterm Repo to buy and sell securities.
Accordingly, the Repo has become
an important tool used by the Federal Reserve to control the nation's
monetary growth over the short term.
The Reserve B a n k , therefore,
has a substantial interest in the Repo remaining an efficient and
readily usable instrument of the money market.
Second, the Reserve Bank provides a variety of banking
services to about 140 foreign central banks, monetary authorities,
and international institutions.such as the International Monetary
Fund.
As of September 1980, the Reserve Bank held over $100
billion in dollar-denominated assets and $249 billion of gold
for these entities.
Among the banking services provided these
entities are investment services, and the Repo is an important
vehicle used by Reserve Bank to provide these investment services.
Consequently, the viability of the Repo is an issue that has not only
domestic monetary policy implications, but international financial
implications as well.
- 3 -
67
B.
The Court Can And Should Permit the Reserve Bank To Intervene
As Amicus Curiae.
Rule 724 of the Bankruptcy Rules incorporates by refer-
ence Rule 24 of the Federal Rules of Civil Procedure.
Rule 24 of
the Federal Rules of Civil Procedure authorizes intervention by permission and as of right.
The Reserve Bank acknowledges that it has
no right to intervene in the subject proceeding, but asks the Court
to exercise its discretionary authority and permit it to intervene
as amicus curiae.
Although no policy or regulation of the Reserve Bank is
directly involved in the subject proceeding, there is case law
supporting the principle that the court has the power to permit a
party to intervene as amicus curiae (and not as a party plaintiff
or defendant), if the party can show a substantial interest in an
issue involved in the litigation.
The leading case is Brewer v . Republic Steel Corporation,
513 F.2d 1222 (6th C i r . 1975).
In Brewer, the Ohio Civil Rights
Commission moved to intervene in a private employment discrimination suit brought under 42 U.S.C. S 1981 and Title VII of the Civil
Rights Act of 1964.
After finding that the movant was not entitled
to intervene as of right, and after refusing to exercise its discretion to allow permissive intervention, the Court ruled that the
movant could participate by filing an amicus curiae brief.
Movant
appealed.
On appeal, the Sixth Circuit affirmed the ruling of the
district court, and supported the trial court's resolution of the
dispute through the amicus curiae device.
- 4 -
68
We believe that [movant can make its views known]
if the Commission accepts the District Court's
invitation to participate in the litigation as
amicus curiae. Surely this role will afford the
Commission ample opportunity to give the court
the benefit of its expertise. Moreover, the District Court apparently will receive and consider
any admissible evidence that the Commission
chooses to offer.
513 F.2d at 1225.
Several district courts in other jurisdictions
have followed this procedural innovation of the Sixth Circuit, and
have permitted parties that are not authorized to intervene under a
literal reading of Rule 24 to intervene as amicus curiae.
National
Association for Neighborhood Schools of Pittsburgh, Inc. v . Board of
Public Education of the School District of Pittsburgh, Pennsylvania,
90 F.R.D. 3 9 8 , 405 (W.D. P a . 1981); United States v . Massachusetts
Merchant Marine Academy, 76 F.R.D. 595, 598 (D. Mass. 1977).
The Reserve Bank has been involved with Repo transactions
since 1917 and wishes to give the court the benefit of its expertise.
The Reserve Bank does not wish to become involved in the
litigation as a party plaintiff or defendant, nor does it wish to
become involved in details of specific proceedings.
Instead, the
Reserve Bank desires to intervene in the litigation and brief the
court as amicus curiae on the single issue of whether a Repo should
be characterized as a purchase and sale transaction or as a secured
loan.
The Reserve Bank believes that the court has the power to
permit such participation under the above-cited case l a w , and
respectfully requests the court to grant its motion to intervene
as amicus curiae.
See also SEC v . U.S. Realty C o . , 310 U . S . 4 3 4 ,
459-60 (1940) (agencies representing public interest should be
allowed to intervene and be heard).
69
POINT 2: ASSUMING THAT THE COURT
GRANTS THE RESERVE BANK'S MOTION TO
INTERVENE AS AMICUS CURIAE , THEN IT
ALSO ASKS THAT THE COURT TREAT THE
REPO AS A PURCHASE AND SALE TRANSACTION.
A.
There Is No Case Law Controlling This Issue In The Southern
District of New York.
One court in the Southern District of New York has
impliedly held, in a nonbankruptcy context, that repurchase
agreements involve the purchase and sale of securities.
In
SEC v . Miller, 495 F . Supp. 465 (S.D.N.Y. 1980), the SEC sued
for an injunction alleging that the principal of a bankrupt
government securities dealer engaged in deceptive conduct in
connection with repurchase agreements.
The SEC alleged that
the failure to keep proper accounting records and the failure
to disclose that fact constituted violations of Section 10(b)
of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder.
Both Section 10(b) and Rule 10b-5 apply
only to deceptive conduct in connection with the purchase or
sale of a security.
Implicit in the court's analysis of whether
the defendant had violated Section 10(b) and Rule 10b-5, is the
court's tacit determination that the repurchase agreements
involved purchase and sales of securities.
The court's
general statements that "from a purely economic perspective . . .
a repo is essentially a short-term collateralized loan . .
(495 F . Supp. at 467, 469) were offered merely to indicate the
- 6 -
20-953
0 — 8 3 —— 6
70
general nature of a repurchase agreement and were not intended
as conclusions of law.
Furthermore, the general statements did
not affect the court's analysis.
In making such statements, the
court was merely drawing attention to the economic purpose of
repurchase agreements.
For example, the court also pointed out
that the Reserve Bank treats federal funds transactions, which
"resemble considerably" repurchase agreements (495 F . Supp. at
468), differently from ordinary loans because of their economic
purpose (495 F . Supp. at 468).
B.
Case Law From Other Jurisdictions Indicates That The Court May
Characterize Repurchase Agreements As Purchase and Sale Transactions.
The characterization of Repos either as secured loans or
as independent contracts for the sale and purchase of securities
"is the subject of conflicting precedent."
Letter dated July 20,
1982 to the Chairman of the House Commerce, Consumer and Monetary
Affairs Subcommittee from Debtor's counsel.2/
The recent amend-
ments to the Bankruptcy Reform Act of 1978 "do not resolve the
central issue under the Code concerning repos, which is whether
they will be treated as secured loans or as involving executory
contracts."
Letter dated August 6 , 1982 to Chief Economist of the
House Commerce, Consumer, and Monetary Affairs Subcommittee from
Debtor's counsel.3/
Case law confirms "the equivocal status of
17
Attached as Exhibit A .
3/
Attached as Exhibit B .
-7-
71
repo transactions."
Letter dated August 9 , 1982 to General Counsel
of the Board of Governors of the Federal Reserve System from Debtor'
counsel.j4/
There are no cases characterizing Repos in the context
of bankruptcy proceedings.
Furthermore, the few reported cases
characterizing repurchase agreements in other contexts appear to
turn on the particular legal context in which they arise.
For
example, in cases arising under the income tax law, courts have
generally characterized a securities repurchase transaction as a
secured loan.
First A m . Nat'l Bank of Nashville v . United States,
467 F.2d 1098 (6th Cir. 1972); Union Planters Nat'l Bank of Memphis
v . United States, 426 F.2d 115 (6th Cir.), cert, denied, 400 U . S .
827 (1970); American Nat'l Bank of Austin v . United States, 421
F.2d 442 (5th Cir.), cert, denied, 400 U . S . 819 (1970).
However,
these characterizations were made for the purposes of determining
the tax treatment of the income earned on securities which were
tax-free State, county, or municipal obligations.
In the context of Federal securities law, there has been
considerable controversy over the characterization of a Repo for
the purpose of determining whether it is an "offer or sale" or
"purchase or sale" of securities within the meanings of the
Securities Act of 1933 or the Securities Exchange Act of 1934,
respectively.
4/
Generally, courts have held that such transactions
Attached as Exhibit C .
72
constitute a sale of securities.
Hadsell v . Hoover, 484 F.2d
123, 127 (10th Cir. 1973); Cosmopolitan Credit & Inv. C o r p . v .
Blyth Eastman Pillion & C o . , 507 F . Supp. 954 (S.D. Fla. 1981).
There are two cases that directly address the rights of
a buyer in a Repo transaction when the seller is unable to perform
the repurchase.
These cases do not appear to reach the same con-
clusions regarding either the nature of a Repo transaction or the
consequences that follow from the seller's default on his obligation to repurchase.
Compare Financial Corp. v . Occidental Petroleum
C o r p . , N o . 75-1623 W , 4 (W.D. M o . May 7, 1979) aff'd, 1 B . R . 522
(W.D. M o . 1979), aff'd, 634 F.2d 404 (8th Cir. 1980) (Repos treated
sui generis) with Gilmore v . State B d . of Administration of F l a . ,
N o . 78-1794 (Fla. Cir. C t . July 24, 1979), aff'd, 382 So.2d 861
(Fla. Dist. C t . A p p . 1980) (Repos treated as a purchase and sale
transaction).
In conclusion, what little case law exists is split;
some cases characterize Repos as secured loans and some characterize them as purchase and sale transactions.
Accordingly,
the Court is free to decide the key issue in this litigation
in whatever way it feels appropriate.
C.
The Court Should Find Repos To Be Purchase And Sale Transactions.
The Reserve Bank uses Repos involving U.S. Government and
agency securities ("Government securities") to supply funds to the
banking system, in execution of monetary policy, because Repos are
a highly flexible and effective short-term device for doing s o .
-9-
In
73
addition, wide public and private sector participation in the Repo
market enhances the attractiveness of Government securities as
investments; such broad-based participation permits the Treasury
and other Federal agencies to finance the country's public debt at
rates of interest lower than would otherwise exist.
Moreover,
smooth functioning Repo markets provide additional incentive for
foreign central banks and other foreign holders of U . S . dollar
reserves to participate in financing the nation's public debt.
The Federal Reserve System establishes monetary policy
through the FOMC and executes policy through the Domestic Trading
Desk at the Reserve Bank.
The Trading Desk regularly engages in
purchases and sales in the Government securities market.
The
Federal Reserve Systems Open Market Account contains approximately
$142 billion of Government securities as of August 18, 1982.
Federal Reserve Open Market transactions are the principal means
by which the Federal Reserve implements monetary policy.
For
example, when the Desk purchases $1 million worth of Treasury securities in the open market, this adds $1 million to the reserves of
the banking system when payment is made to the seller.
While
outright purchases and sales are used extensively in the Federal
Reserve's open market operations, experience has shown that Repos
are often a far preferable alternative.
The Repo can be a superior
instrument of monetary policy because it permits the Desk to
affect reserve supplies in large volume for a few days at a time
without exerting a large and possibly undesirable impact on
interest rates.
-10-
74
For example, if attainment of reserve objectives required the Desk
to add funds, say, $3 billion to bank reserves for just three days
—
not an unusual occurrence —
and the Desk sought to do this by
outright purchases and sales, it would purchase Government securities at market price on the first day and sell them, again at
market, three days later.
Outright purchases and sales of this
size could have an appreciable and possibly undesirable impact on
interest rates that can be avoided if the Repo instrument is used
instead.
Indeed, it is not unusual for the Desk to have to add as
much as $7 billion to bank reserves through one-day Repos, an
amount that probably could not be accomplished via outright
transactions without causing significant market disruption.
Moreover, use of Repos permits the Desk, and the market
participants, to undertake large short-term transactions without
being exposed to the impact of short-run changes in market interest
rate.
If the Federal Reserve bought a large amount of securities,
on an outright basis, and sold them out a few days later, and if
market rates had risen in the meantime, the Fed could incur a
substantial capital loss.
Alternatively, if rates had fallen
sharply then dealers or other market participants could suffer a
large loss, probably making them less willing to participate in
operations with the Desk, underwritings of Treasury issues, or
market-making for other customers.
In 1981, the Desk entered into $111 billion of Repo
transactions for Federal Reserve monetary policy purposes, and
$88 billion on behalf of official foreign accounts.
-II-
To conduct
75
operations at this level, the Repo market must attract a variety
of responsible participants. Such participants are likely to be
much less willing to undertake Repo transactions if, upon failure
of a counterparty to repurchase securities, the participant would
not be free to liquidate its holdings to minimize potential loss
from price movements in securities, or to meet pressing liquidity
needs.
Currently, a wide variety of institutional investors
and public entities participate in the Repo market.
Both the
United States Treasury and the public benefit from this broad
involvement and from the efficient operation of this market.
From the standpoint of those who purchase securities,
the Repo transaction permits them to invest funds for precisely
the period desired.
Of course, an investor wishing to invest funds
for a period of a few days could purchase a security outright and
then resell it in the market at the end of the period, but this
would subject him to a risk of capital loss in the event that prevailing interest rates rose, and the value of the security
declined, between the date of purchase and sale.
Alternatively,
the investor could seek out securities with maturities matching
his own unique liquidity needs.
However, such securities may
not be available, especially if the investor sought Treasury or
Federal Agency securities.
In addition to flexibility, Repos involving Government securities attract investors because they are secure.
The
investor views the Government security as a virtually riskless
-12-
76
asset to be realized upon in the event that the seller breaches
his agreement to repurchase.
From the standpoint of those dealers who sell Government securities, the ability to attract investors in the Repo
market is essential to the efficient financing of their positions.
T h i s , in turn, benefits the United States Treasury and
other agencies in financing the public debt.
A Government
securities dealer who takes a position in a particular new
issue of Government securities may need to finance a portion
of his position until purchasers are found.
excellent means of financing.
own portfolio through Repos.
The Repo is an
Also, a dealer may finance his
It is through the larger, more
active dealers in Government securities that the Federal Reserve
is able to conduct its open market operations, including Repos.
As previously mentioned, the Reserve Bank maintains accounts for approximately 140 foreign central banks,
monetary authorities, and international institutions.
dollar is the principal reserve currency in the world.
The
With
such large international holdings of the dollar, it has become
important to the orderly financing of the public debt that these
institutions purchase Government securities.
In 1979, for
example, the dollar volume of investment activity for these
foreign accounts at the Reserve Bank exceeded $1.4 trillion,
most of which involved purchases and sales of Government securities.
A substantial amount of this activity was in Repos.
A
decision by this Court characterizing the Repo as a secured loan
77
may well decrease the amount of participation in the Repo market
by foreign investors.
Such a decrease would have an adverse
impact of indeterminate proportion on direct financing of the
public debt.
From the foregoing discussion, the Court will appreciate that the Repo is an essential tool for conducting monetary policy and financing the national debt.
From the buyer's
perspective, the purpose of purchasing the security is cash
management:
the purchaser desires to maximize the return on his
assets over a short period through the use of a secure investment
vehicle.
In most cases, assuming astute cash management on the
part of the purchaser, the purchaser will require funds on the
date repurchase is to occur.
If repurchase does not occur because
the seller of the securities is unable to perform, then the
purchaser must be able to meet his liquidity needs by selling the
security to some third party.
The purchaser can have assurance of
meeting this need only if the Court treats the Repo as a purchase
and sale transaction.
If purchasers believe that their need for
liquidity might be unsatisfied, then the attractiveness of the
Repo as an investment instrument will diminish.
Such a result
would hinder the conduct of domestic monetary policy by the
Federal Reserve, and would make dollar investment by the Reserve
Bank on behalf of foreign institutions more difficult.
Moreover,
it would increase the cost to the Treasury of financing the public
debt.
Therefore, considerations of public policy favor character-
izing the Repo as a purchase and sale transaction.
-14-
78
CONCLUSION
For the reasons stated, movant should be permitted
to intervene as amicus curiae, and the Court should characterize the Repos in the subject litigation as purchase and
sale transactions.5/
Respectfully submitted,
James H . Oltman
General Counsel and
Attorney for
Federal Reserve Bank
of New York
33 Liberty Street
New Y o r k , New York 10045
(212) 791-5026
By:
Don N . Ringsmutn
Thomas C . Baxter, J r .
57
The Reserve Bank assumes in reaching this conclusion, that to the
extent proceeds of the sale of the securities held under agreement
to repurchase exceed the consideration stated in the agreement to
repurchase, these "excess" proceeds will eventually become a part
of the estate of the debtor.
^J
Julie S . Fox and David Kroop, both law clerks in the General
Counsel's office, assisted in preparing this document.
-15-
79
Exhibit A
American Banker
August 13, 1982
Hearings Needed to Settle
Repo Market Uncertainties
Congress has been urged to bold comprehensive hearing* on the Implication* of the
Drysdale affair, with particular attention to the application of the bankruptcy code
to the market for repurchase agreements. In the view of Thomas A. Russo, a member
of the New York-Washington-Palm Beach law firm of Cadwalader, Wlckeraham & Taft,
the most important legal uncertainty concerning repos is whether in an insolvency they
wilJ be characterized as secured loans or independent contracts for the sale Mad
repurchase of securities. The consequences of that characterization are substantial, be
tays, and the issue is not likely to be settled soon in the courts. Mr. Hnsso set forth
his views in a letter requested by Rep. Benjamin S. Rosenthal, D-N.Y., chairman of
the commerce, consumer and monetary affairs subcommittee of the Rouse Government
Operations Committee.
In a letter dated June 23, 1982, you
asked me to provide the commerce,
consumer, and monetary affairs subcommittee with additional analysis con-
cerning the potential risks and legal
ambiguities involved in the use of repos
and reverse repos. I continue to believe,
that there are problems in the repo
markets which deserve the most serious
and careful attention, and I hope that
the views expressed in this letter will
be of assistance to the subcommittee.
As has been extensively chronicled in
the 1980 Report of the Joint TreasurySEC-Federal Reserve Study of the Government-Related Securities Markets
and elsewhere, the market for repos,and
reverse repos has grown dramatically in
recent years and has become one of the
principal means by which dealers and
other participants in the governmentrelated securities market finance their
positions.
Moreover, by providing liquidity to
the market for Treasury securities as a
means for the Federal Reserve to conduct open markets operations, an orderly functioning repo market has come to
have substantial and growing
significance for the implementation of
national economic policy. As a result,
it has become increasingly apparent
that a major disruption of the repo
market could have a serious adverse
impact on that policy.
The much discussed Drysdale affair
and the recent financial problems of
Comark have given rise to uncertainties
and concerns among participants in the
frepo market about the possible failure
of additional firms and about the future
of the market as a whole. These concerns have already been reflected to
some extent in the news media, as is
exemplified by the June 27, -1982,
article from The New York Times and
July 6, 1982. article from The Wall
80
Street Journal, and by my May 23,
1982, New York Timet article, and I
believe that a number of additional
disclosures and discussions of these
deep-seated conoerns will appear in the
coming months.
There are a variety of causes for the
substantial uncertainties and concerns
which pervade the repo market. Many
of these causes relate, of course, to the
complexity of the transactions involved,
the volatility of the credit markets
generally, a n d t h e a n t i c i p a t e d
enormous borrowings by the Treasury
and are beyond the scope of this letter.
Other causes, however, stem at least in
part from shortcomings in the legal
framework governing repos, particularly ^ the bankruptcy context, and it is
to those shortcomings that this letter is
addressed
«
Diversity of Applicable Uw»
An initial source of uncertainty concerning the effect of the insolvency of
a participant in the repo market is the
diversity of laws which might apply to
the ensuing proceeding. Repo market
participants are widely varied and include government securities dealers.
Industrial corporations, municipalities,
and a variety of financial institutions.
Notwithstanding the broad coverage of
the'bankruptcy code, in many cases
different insolvency laws would apply
depending on the nature of the insolvent entity.
Savings and loan associations, banks,
and insurance companies, for example,
are generally excluded from the coverage of the code and insolvency proceedings involving such entities might
be conducted under a wide variety ot
largely unconstnied federal and state
laws. Adjustment of the debts of a
municipality, for another example,
might or might not be accomplished
under the provisions of the code.
The diversity of laws other than the
code which might apply in the event
of the Insolvency of a repo market
participant reflects the variety of those
participants and, in the case of
municipalities, the requirements of our
scheme of federalism. In my view this
diversity would not be especially
troublesome if the code was clear in its
treatment of insolvent entities with
repo commitments since courts or agencies construing the other laws would
generally be able to rely on the code
for explicit guidance in those areas.
However, since the code's current
treatment of repos Is fundamentally
unclear, the possible applicability of
other laws magnifies the already sub-
stantial uncertainty which a repo
market participant faces In attempting
to evaluate the risk of a counterpart's
insolvency.
Even in those bankruptcy cases governed by the code, there is substantial
uncertainty concerning the nature of
the proceeding which would be involved. This uncertainty results from
the eligibility of almost all entities
subject t o . the code, other than
stockbrokers and commodity brokers, to
reorganize rather than liquidate.ln the
case of an insolvent industrial corporation, the possibility of a lengthy reorganization proceeding is something to
which creditors have long since adjusted.
However, an Insolvent government
securities dealer which did not deal
with members of the general public
might not be a "stockholder," as defined in the code, and thus might be
eligible for a reorganization proceeding
rather than the generally more expeditions liquidation proceeding required
for stockbrokers. Since the possibility of i
dealer failures teems to be of greatest
current concern to market participants.
It is a matter for concern that the code's
stockbroker liquidation provisions may
not prevent protracted dealer reorganization proceedings.
The most Important legal uncertainty
concerning repos, however, is whether
they will ultimately be characterized,
for purposes of the code or other
applicable insolvency laws, as secured
loans or as independent contracts for
the sale and repurchase of securities.
Although the consequences of this
characterization are very substantial, it
is doubtful that this issue, which is the
subject of conflicting precedent and
which has been debated for years, will
be resolved in the courts in the near
future.
1
In assessing the significance of tliis
Issue it is important to note than upon
filing of a bankruptcy petition under
the code a creditor is automatically
•stayed from setting off obligations of
the debtor to the creditor against obligations of the creditor to the debtor
and from liquidating any property
which is property of the estate of the
debtor. Violations of the automatic stay
may be punishable as being in contempt of the bankruptcy court.
If a repo to the debtor was treated
as a secured loan from the debtor to
a borrower for which the borrower had
provided securities to the debtor as
collateral, the borrower might have
difficulty in obtaining the securities
from the debtor or trustee (if one was
appointed) upon tender of payment if
the securities had increased in value.
Although the borrower might successfully maintain a so-called reclama-
"—
in fnw*> th#» (fohtnr Or
trustee to return the securities to the
borrower on the theory that the
securities were merely collateral and
not property of the estate, it Is likely
that substantial delay and expense
would be involved
If a reverse repo to the debtor was
treated as a secured loan from a lender
to the debtor for which securities had
been delivered by the debtor to the
lender as collateral, the lender would
be automatically stayed by the filing of
a petition from setting off the reverse
repo against other obligations of the
debtor to the lender and from liquidatIng the securities held as collateral.
Although the lender could make a
motion In the bankruptcy court to have
the stay lifted. It Is uncertain whether
or when the motion would be granted.
On the other hand, the debtor or trustee,
/could commence a so-called turnover
proceeding to require the lender to
transfer to the debtor or trustee the
securities held as collateral in exchange
for "adequate protection" provided to
the lender.
Two issues concerning the reverse
repo lender's security are worthy of
note. First, the debtor or trustee might
successfully attack as a preference the
transfer by the debtor of additional
collateral to the lender within BO days
of the filing of a petition. As a result,
mark-to-market procedures might not
provide the protection anticipated by
the lender notwithstanding the protection afforded by the code to margin
payments in other contexts.
The second lender's security issue
•.relates to the usual practice of dealers
of running "matched books" by balancing their commitments of repos and
reverse repos and, accordingly, assuring
that they generally have very low inventories of cash and securities compared with the aggregate size of their
outstanding repo and reverse repo positions. In effect, the dealer receives
securities from a borrower in a reverse
repo and concurrently delivers them to
a third party lender in a repo, resulting
in a flow of securities from the borrower
to the third party lender and a flow of
' cash from the third party lender to the
borrower.
Assuming the bankruptcy of the borrower during the term of the transactions, the security issue raised by this
practice Is whether the dealer has a
security interest in the securities then
held by the third party lender which
is perfected against the borrower.
If the dealer's security interest was
perfected, then upon repurchase of the
securities from the third party lender
81
the dealer woudl have a secured claim
aganist (he estate of the debtor which
could not be avoided under the Code's
"strong a r m " provisions. On the other,
hand, if the dealer's security Interest
was not perfected, the debtor or trustee
'd avoid the creditor's security In; under the "strong a r m " provisions and demand that the dealer turn
over the securities, and the dealer
wpuld have only an unsecured d a i m
against the debtor's estate.
'Although most dealers appear to assume that the repo to the third party
lender involves only a repledge of the
borrower's securities which would not
Impair t h e p e r f e c t f o o of the dealer's
• security Interest, in my view it is not
nearly as d e a r as it should be. based
on this or various other theories of
perfection under the uniform com-'
m e i d a l code or the federal book entry
securities regulations, that perfection
would b e upheld in a bankruptcy pro*
ceeding.
• The second possible characterization.
of repo and reverse repo transactions is
that they involve, for purposes of the
code, completed sales or purchases of
securities, respectively, and independent executory contracts to repurchase
or resell t h e securities. Under the code
the debtor or trustee would have the
• right to d e d d e which of these executory
c|
acts, to assume and perform and
irewh to reject.
In a liquidation proceeding, the deb' tor or trustee would generally have 60
days within which to make his decision,
although special rules would generally
apply in • stockbroker liquidation. In
a reorganization proceeding, however,
this decision would not be required to
be made, absent a court order, until
confirmation of the reorganization plan,
an event which might occur several
yean after the petition was filed.
If the debtor or trustee rejected.the
executory portion of a reverse repo,
perhaps because the value of the)
securities the debtor had agreed to I
repurchase declined In the period
following filing of the petition, the
creditor probably would have only an
unsecured claim for damages. In addition, the debtor or trustee might attack
margin payments made to the creditor
within 90 days of the filing of the
petition as preferences. If the debtor or
trustee rejected the executory portion
of a repo, perhaps because the value of
the securities the debtor had agreed to
v(
increased in the period following
fihv.& of the petition, the creditor probably would have only an unsecured
d a i m for damages.
r
The possibility that a bankrupt dealei'
might be eligible for a protracted reorganization proceeding leads to a
variety of problems for creditors due,
in part, to the code's general provision
that interest does not accrue after the
date the petition is filed.
If the reverse repos to the debtor in
a proceeding were characterized as
loans, the lenders would generally receive Interest on the repos after the
petition only to the extent of their
collateral less any margin payments
successfully attacked as preferences. At
current rates _ of Interest this would
generally mean that the lenders would
receive interest for only a short time,
if at all, after the filling of a petition.
On the other hand, during the proceeding the debtor or trustee would be able
to invest the funds owed to the creditor
and use the interest income to satisfy
other claims^
The reluctance of market participants
to deal with small or troubled firms has
recently increased substantially. 'This
reluctance and especially the development of strategies designed to fadlitate
pre-petition actions raise the possibility
that cautious firms will act precipitously
and induce the problems they are so
concerned to avoid.
In my view the legal uncertainties
concerning repos have added substantially to the concerns of market participants. Although some of those participants view the uncertainties as desirable in providing a set of available
"options" for them to consider, I f e d
that this view is shortsighted for at least
three reasons.
First, due to the uncertainties involved, the results obtained in a given
proceeding might be completely conIf the reverse repos to the debtor in trary to the objectives of the particular
a proceeding were characterized as "options" employed.
involving executory contracts, the deSecond, the diversity of available
cision to affirm or reject the executory
strategies for all participants makes it
portion of the transactions might not be
very difficult for any market participant
made until confirmation of the reto predict the behavior of other particiorganization plan. T h e lenders propants.
bably would not be entitled to any
Third, the existence of a. "hair triginterest after the date of the petition
g e r " mentality among at least some
and the funds owed to the lenders could
partidpants
leads to the possibility that
be invested as described above.
.
bankruptcies might be induced which
The code's treatment of post-petition
otherwise would not have occurred and
interest creates the possibility that a
which might lead to financial problems
reorganizing dealer could fund the refor previously solvent counterparts of
organization, in part, through investthe bankrupt firms.
ment of funds owed to secured creditors
It is crucial that a process b e
or parties to executory contracts which
established in the immediate future
would ultimately be assumed. Even if
which
will result in resolving the legal
the creditors were required to be paid
uncertainties in the repo m a r k e t I
the legal rate of interest, the spread
believe
that the best approach at this
between that rate and current market
stage is for Congress to hold comfrates would present very attractive fun-'
prehensive
hearings on the implications
ding opportunities and would create a
of the Drysdale affair and, in particular,
strong incentive to protract the pro-'
on
the
application
of die code and
ceeding.
' • •<
•
related laws to the repo m a r k e t
The manifold uncertainties concernThe hearings would provide a public
ing the- treatment of repos In aforum for consideration of various ap'bankruptcy context provides a strong
proaches t o the problem, including
incentive to repd market participants to
amendments to the bankruptcy code,
avoi<j entering into, or to attempt to
amendments to state uniform comextricate themselves from, commitmercial codes, adoption of preemptive
ments with firms who have or are
federal regulations along the lines of
rumored to have financial difficulties.
the federal book entry securities regulaIn light of Drysdale and Comark, and
tions, imposition by the Federal Reof rumors of difficulties at a variety of
serve or '.requirements on t o e primary
other firms, market participants and
dealers t&nd formation of a self-retheir counsel are devoting substantial
gulatory organization for dealers.
attention to devising strategies deI also believe that the Federal Resignee) to permit the taking of various
serve should form a broad-based adactions against troubled firms before
visory committee to consider the issues
the firms actually file bankruptcy petiraised at the hearings as they might
tions. The goal of these strategies is to
affect the national economic policy
attempt to reduce or avoid the effects
objectives
of the Federal Reserve. T h e
of the automatic stay and the uncertainadvisory committee would provide an
ties and delays of possibly protracted
ongoing
framework
for refining the
proceedings.
82
various proposed approaches Into a
coherent solution consistent with those
policy objectives.
Congressional hearings and the advisory committee would establish a firm
basis for resolving the issues raised by
Drysdale. Unless action on these issues
b taken soon, it is likely that all of the
intensive and valuable effort which has
recently been expended by market
participants and regulators will be
wasted and that nothing of real value
will be done until the next and quite
possible far more serious crisis occurs.
83
Exhibit B
A mrtNCMHi* i-etuomo MorcatioMAi CO«»O«ATIONS
< k'lw KMMNiat AVL,«.<
• taiMOtOM, e.c. »eo»»
wet)
SCACM, rtA. »*««c
ODD ••(-•»0C
twi: i)o-»»i-riii
I I I O O O
SZtyA***.
U/Jj
$08-7000
C A » L C A D O M C S B : LABCKKWM
*C*Ox: (tit) »|.|«io
August 6, 1982
K r . Donald .P. Tucker
Chief Economist
Commerce, Consumer and Monetary
Affairs Subcommittee
B377 Rayburn Building
Washington, D.C. 20525
Dear Don:
She technical amendments to the Bankruptcy Code
(the "Code") which vere signed into law on July 27,. 1982
(the "Amendment3") are of considerable value in reducing
the likelihood that a "ripple effect" would follow an insolvency in the securities or commodities industries. 3he
Amendments clarify "she treatment of repo and reverse repo
transactions 3 _howeverj,..onlv 'tcTa^limited. extent. As you
suggested "aur'ing'our~recent discussion/ 'in "this letter I .
will briefly describe the major effects of the Amendments on
the matters discussed in Tom Russo's July 20, 1982 letter to
Representative Rosenthal (the "Russo Letter").
Bills containing provisions substantially similar
to the Amendments were passed by both Houses in the last
Congress, but failed to become law due to differences between the two Houses concerning the retirement system for
bankruptcy judges. Although H . R . 4935* the bill which became the Amendments, was resurrected and passed in response
to concerns over such r.atters as the Drysdale failure, the
Amendments'do not reflect specific consideration of the
treatment of repos.
84
K r . Donald F . Tucker"
- 2 -
August 6 , 1982
No Change in Loan or Executory Contract
ghe .Amendments.do net resolve the central Issue
under the _Code^ concerHing repcs7 jwhich "is v;hether they will
be treated ^as_
^involving "e x e c ut or y con- ""
tracts".'"^'The J&iendments~'add "to* the "Code the "significant new
term "securities contract," which is defined as follows:
"rs3ecuriti.es contract" means contract
for the purchase "sale" or loan of a
security, .including an..Qption „for..;fche
purchase...or. s a 1 e ,p,f_ a,_s,eeuriiy^orjfcjbfeguaranteV of' any settlement 0fc£sh_0£_
securities by or "to" a'securities "clearing; agency. T E m p h a s i s supplied7) ^
IT repos and reverse repos are characterized, for purposes
or the Coaei as"completed;*s'alesT"or"purchases of securities,
r ^ p e c t i v e l y , and independent executory contract~s~jt"ore--~
purchase or "resell the securities', then' these executory
contracts woj/ld ^
.contracts,""as*"defined'above.
On the other hand, if repo transactions are
characterized, for purposes of the"'C6'de7.'*"as_ secured loans,
he* securiti'e.s'^contracts, since" they^involve^ lojyis^of. funds and not^lpa'ny of securities." A repcPfrora'"'a
dealer to a bank',' for example, is a loan" of funds from t h e .
bank to the dealer on which the dealer pays interest, not a
loan of securities from the dealer to the bank on which the
bank pays interest. The securities in repo and reverse repo
transactions thus are not themselves loaned, but rather
serve as collateral security for obligations to repay loans
of funds.
Setoff, Liquidation and Margin
The major changes mace by the Amendments which
concern repos relate to setoff, liquidation of securities
contracts and protection of margin payments, but these provisions probably will be of substantial importance to repo
market participants only if repos are characterized as involving-executory "securities contracts." If repos are so
85
K r . Donald ? . Tucker
- 3 -
August 6, 19B2
characterized,, the provisions in the Amendments concerning
setoff and liquidation will be helpful to commodity brokers,
forward contract merchants, stockbrokers and securities
clearing agencies (collectively, "Covered Firms"), but not
to government securities dealers which are not "stockbrokers"
cr "forward contract m e r c h a n t s o r tc banks, money market
funds cr other market participants (collectively, "Uncovered
Firms"). If- repos are characterized as secured loans. the
provisions concerning setoff ana liquidation will not apply
sSTnce no^securities contracts will be involved. Regardleis
or w h i c F characterization of "repos"is" adopted, the provisions in the Amendments concerning margin will be helpful to
Covered Firms, and possibly to Uncovered Firms.
The new setoff provision revises an exception to
the automatic stay and expands the actions which a Covered
Firm may take after the filing of a petition. ?he new provision penerally_p erni t s_a _ Covered Firm to s e t ^ f ^ a ^ l a i a
against a debtor for a margin payment under a commodity
ct^ractTHtorward^
securities contract (ccllec^
tivelyj' a "Covered Contract") against property .of*"the"jd^btor
held by the Covered Firm to margin, guarantee or secure a*"
Covered ' Con'tract*. "'IT "repos were characterized as .involving
executory' securities contracts",' the setoff provision Vould
beHh'eipful' to' a Covered Firm which had made a margin 'call
prior to_jthe filing of "a petition by a debtor. She setoff
prov!slon~in effect before passage of the Amendments probably would not have been available in the repo context.
The Amendments include new provisions expressly
preserving the ability"of Covered Firm's to "liquidate open
Covered Contracts of a debtor .pursuant to contractual rights,
which .are, in general, triggered by the insolvency, or"the
filing of a petition by.the debtor. The exercise of such
contractual rights was not specifically allowed under preexisting lav:, and the new provision would be very helpful to
Covered Firms if repos are~6e't ermiri e"d to' involve executory
contracts! M o r e o v e r , the hew'provision preserving contractual rights to liquidate open positions will probably
have practical significance for repo market participants
even though the characterization of repos as loans or
20-953 0 — 8 3
7
86
K r . Donald P . Tucker
- 4 -
August 6 , 1982
executory contracts remains unclear. Since at least some
courts and governmental agencies have concluded that repos
involve executory contracts, it_is like}y_that.jtnany_repo
market participants will conclude that in most or all cases
they_sbouTd "exercise their contractual rights to liquidate
the"o£er.' repo positions of a debtor immediately upon._tbe. ..
filing of a petition by the debtor in an attempt to fore-__
stall additional losses on the positions. £his_j5tra.tegy
would"be risky, however, if the law became clear that repos
vere secured loans for purposes of the Code.
The Amendments include provisions which protect a
margin payment on a Covered Contract made by or to a Covered
Firm from "being set aside by a trustee except where the recipient of the payment did not take it in good faith. These
provisions would benefit Covered Firms and also Uncovered
Firms, which might receive margin payments from or make
margin payments to Covered Firms, if repos were determined
to involve executory securities contracts.
The margin provisions might be helpful to repo
market participants even if repos were characterized as
loans. The term "margin payment" is defined as follows:
["K^argin payment" means payment or deposit of cash, a security, or other
property, that is commonly known to the
securities trade as original margin, or
variation margin, or as a mark-to-market
payment, or that secures an obligation
of a participant in a securities clearing agency.
This definition does not depend on the existence of a
s^'urities contract and should include the securities and
any^additional collateral given to secure performance in .a
repo characterized as a secured loan. Thus the trustee
should not be able to set aside the margin payments except
where they were not taken in good faith.
87
Er. Donald P . Tucker
- 5 -
August 6 , 1982
The other matters raised in the Russo Letter are
largely unaffected by the Amendments. Thus, a variety of
laws other than the Code, as amended, may apply to the insolvency of a market participant, repo dealers may be
eligible to reorganize and nay attempt to take advantage
of the Code's provisions concerning post-petition interest,
the security position of dealers running."matched books"
is unclear, and there is in general a strong incentive for
market participants to take pre-petition action against'
troubled firms. In light of these uncertainties, and those
discussed above relating to the Amendments, there continues
to be a substantial need for clarification of the legal
status of repos. •
Very truly yours,
John "W. Osborn
JWO:st
88
Exhibit C
MCW MAM»«MinC AVC, M-W.
wMHiMotew, o. e.
•«• ROTAl WAT
MU.M StACM. fLA. 11«*0
OOt) ••••••oo
too**
(ton u i - t t o o
SfyjLn*:
(2/2)
TW*: »io-»»t-j« t «
S0S-7000
CA»Lt ADOUCSS: LA«CILUM
TCLtX:
MAPirAx:ttis)*•»•*»>
xcnox: uit)
rtf-ieto
August 9 , 1982
Michael Bradfield, Esq.
General Counsel
Board of Governors,
Federal Reserve System
Washington, D.C. 20551
Dear Mr. Bradfield:
As he mentioned in his August 6, 1982 letter, Tom
Russo is out of the office on vacation and he has asked me
to assemble and furnish to you and Robert Plotkin cases
confirming the equivocal status of repo transactions.
Enclosed please find copies of the following cases:
1. Securities and Exchange Commission v .
Miller» 495 F . Supp. 465 (S.D.N.Y. 19B0).
2. Matter of Legal, Braswell Government
Securities, 64b F.2d 321 (5th Cir. 1 9 B 1 K
3. In re Financial Corporation, Bankrupt,
Case Nos. 79-0544 (U.S.D.C. W.D. M o . 1979) and
80-1050, 634 F.2d 404 (8th Cir. 1980).
4 . Gilmore v . State Board of Administration of
Florida, Case Nos. 7B-1794 (including a portion of
the defendant's brief) (Circuit Court of the
Second Judicial District, Florida 1979) and PP-34
(District Court of Appeals, First District, Florida
1980).
89
Michael Bradfield, Esq.
-2-
August 9, 1982
5. Union Planters National "Bank of Memphis v .
United States, 425 F.2d 115 (1970).
6. -Cosmopolitan Credit and Investment
Corporation v. Blyth Eastman Dillon and Co., Inc.,
507 F . Supp. 95^ (19bl).
7. Miller v. Schweickart, 413 P. Supp. 1062
(1976);
Cases 1 and 2 consider repos to be loans and cases 3 and 4
consider them to be sales and repurchases. Case 5 is one of
a number of cases considering certain municipal bond transactions involving repurchases to be loans, and cases 6 and
7 discuss repos and appear to assume that they are sales
and repurchases.
The enclosed cases are not an exhaustive collection
n-r -hhA
which discuss repos, but I think they are a fair
indication of the uncertainty which exists concerning the
characterization of repos. Moreover, various administrative
positions of the SEC, the Comptroller of the Currency, the
Federal Reserve, the IRS and the state agencies active in
the repo market, although not binding in the bankruptcy
context, serve to confirm this uncertainty.
I hope that the enclosed cases are helpful, and
that you will not hesitate to contact Tom (when he returns)
or roe if we may be of any further assistance.
JWO/hlw
Enclosures
90
Appendix
C:
Daily
report
of
dealer
DAILY REPORT OF DEALER POSITIONS
(Par value; in millions of dollars to one dacimal)
FR2004A
OMB NO. 055-R-0205
Approved by Federal Reserve Board
and OMB February 1980
Approval Expires June 1983
91
"THIS REPORT IS AUTHORIZED BY LAW (12 U.S.C. 248 (A) AND 12 U.S.C. 248 II). YOUR VOLUNTARY COOPERATION IN SUBMITTING
THIS REPORT IS NEEDED TO MAKE THE RESULTS COMPREHENSIVE, ACCURATE, AND TIMELY."
'THE FEDERAL RESERVE SYSTEM REGARDS THE INDIVIDUAL DEALER INFORMATION PROVIDED BY EACH RESPONDENT AS
CONFIDENTIAL. IF IT SHOULD BE DETERMINED SUBSEQUENTLY THAT ANY INFORMATION COLLECTED ON THIS FORM MUST BE
RELEASED, RESPONDENTS WILL BE NOTIFIED."
GENERAL INSTRUCTIONS
1.
Nonbank dealers should report security positions of all accounts of the firm including investment accounts. Bank dealers should report only
the positions of their dealer departments.
2.
Figures should be reported in terms of par value expressed in millions of dollars rounded to one decimal. For example, $20,693,000should
be reported as $20.7.
3.
This report should be submitted daily to the Market Reports Division of the Federal Reserve Bank of New York by 10 A.M. of the
following business day.
SPECIFIC INSTRUCTIONS
A.
POSITIONS
U. S. Government and Federal Agency Securities other than Mortgage-Backed Agency Securit
The immediate long (short) positions should include securities purchased (sold) on an oi
in addition, securities that have
(sale) delivery was specified fo
organized exchange regardless of the maturity of the contract.
The immediate long (short) position should als'o show "when-issued" U. S. Government securities that have been purchased (sold)
in trading between the time of announcement of an offering and its issue date, even though the time until delivery may exceed five
from the date of the transaction should be reported in either the future or forward positions on this schedule, depending oi
of the transaction. On the settlement day of these l-atter agreements, the securities should be transferred to the immediate p
When immediate positions reflect sales of securities obtained under reverse repurchase agreements which mature on th
as the underlying securities, the amount of such sales should be indicated as specified in the footnote.
(b)
Mortgage-Backed Agency Securities:
(c)
Other Money Market Securit
The immediate long (short) positions
Future positions reflect contracts which are standardized agreements arranged on an organized exchange in which parties commit to
purchase (sell) securities for delivery at a future date. All positions in future contracts should be reported in the futures column, even if a
contract is acquired that calls for delivery of securities within five business days from the date of acquisition. Gross long positions in each
security category should be netted against gross short positions in those categories. When futures contracts are settled by actual delivery of
securities, the settlement should be reflected in the immediate position on Schedule A. (Do not record a transaction on Schedule B at this
Forward positons reflect agreements made in the over-the-counter market which specify a delayed delivery, defined as follows:
(a)
U. S. Government and Federal agency securities other than mortgage-backed securities are to be reported as forward positions when
delivery is schedule for more than five business days after the date of the tranaction. All "when-issued" securities purchased (sold)
tjefore the ant ouncement date are to be reported in the net forward position until the settlement date. (Note: "when-issued"
securities tradec after the announcement date are to be included in the immediate position.)
(b)
Forward transactions in mortgage-backed agency securities are those which call for delivery in 31 or more days. All forward contracts
to purchase should be netted against all forward contracts to sell for each security category. On the settlement date of the forward
commitment the securities should be removed "from the forward position and reflected in the immediate position. (Do not record a
after the transaction.
1.
Domestic Certificates of Deposit are dollar-denominated obligations of banks and banking offices payable in the United States.
2.
Foreign Certificates of Deposit are dollar-denominated obligations of banks and banking offices payable outside the United States.
3.
Standbys, for the purpose of this report, are put options, i.e., the purchaser of the standby has the right to sell a security at a specified time
and price. A dealer who is obligated to buy a security under a standby contract, for which he has received a fee, should report a standby to
purchase (long position). A dealer who has paid a customer for the right to sell securities under a standby contract should report a standby
to sell (short position).
Report as "in the money" all standbys that can be exercised at a price in excess of the market price or at a price equal to the market
price, regardless of whether the market price is or is not favorable for the dealer. All other standbys should be reported as "out of the
money ".
4.
Options for the purpose of this report are call options, i.e., the owner of the option has the right to purchase a security at a specified time
and price. A dealer who has acquired an option under which the dealer may purchase a security should report an option to buy (long
position). A dealer who has sold an option under which a customer may purchase a security from the dealer should report an option to sell
(short position).
5.
Shifts in Maturity Classifications. Securities should be shifted from one maturity category to another on the actual date that the security
moves into a new group. Securities to be included in each maturity category are indicated in the Weekly Guide Sheet.
6.
Allotments oi new issues should be included in the positions figures as soon as the amount is known.
Report as "in the money" all options that can be exercised, at a price below or equal to the market price regardless of whether the
market price is or is not favorable for the dealer. All other options should be reported as "out of the money".
7.
Redemptions. Securities redeemed for cash should be removed from the position figures on the maturity date.
8.
Memorandum items. When requested on the Weekly Guide Sheet, specific securities are to be reported in the Memorandum section.
Note: Positions in such issues should also be reported in the proper security category in the main table.
FR 2004B
OMB NO. 055-R-0205
Approved by Federal Reserve Board and OMB February 1980
Approval Expires June 1983
DAILY REPORT OF DEALER TRANSACTIONS
(Par value; in millions of dollars to one decimal)
MARKET REPORTS DIVISION, ROOM 942, FEDERAL RESERVE BANK OF NEW YORK, WITHIN TWO BUSINESS DAYS AFTER THE TRADING DAY.
REPORTING
T R E A S U R Y BILLS
15
se
DEALERS
TRANSACTIONS FOR IMMEDIATE D E L I V E R Y
A L L OTHERS
DELAYED
DELIVERY
93
' T H I S REPORT IS A U T H O R I Z E D BY LAW (12 U. S. C. 248 (A) A N D 12 U. S. C. 248 (I). YOUR V O L U N T A R Y
COOPERATION IN S U B M I T T I N G T H I S REPORT IS N E E D E D T O M A K E T H E RESULTS COMPREHENSIVE,
ACCURATE, A N D T I M E L Y . "
' T H E F E D E R A L RESERVE SYSTEM REGARDS T H E I N D I V I D U A L DEALER I N F O R M A T I O N PROVIDED BY
EACH RESPONDENT AS C O N F I D E N T I A L . IF IT SHOULD BE D E T E R M I N E D SUBSEQUENTLY T H A T A N Y INFORM A T I O N COLLECTED O N T H I S F O R M MUST BE RELEASED, RESPONDENTS W I L L BE N O T I F I E D . "
General Instructions
1.
Nonbank dealers should report all market transactions of the entire firm. Bank dealers should report only transactions of the dealer department, which may include dealer department transactions with nondealer accounts of
the bank, such as investment and trust accounts.
2.
Figures should be reported in par value in millions of dollars rounded to one decimal. For example, $20,693,000
should be reported as $20.7.
3.
This report should be delivered to the Domestic Reports Divsion, Federal Reserve Bank of New York, within two
business days after the reporting date.
Specific Instructions
A.
D E L I V E R Y BASIS:
1.
Immediate:
All purchases and sales of securities (other than mortgage-backed agency securities) for which delivery is
scheduled for five business days or less should be reported as transactions for immediate delivery. "When-issued"
trades in U. S. Government securities which occur between an announcement and issue date should also be
reported, even though delivery is scheduled for more than five business days from the date of the trade. Report
as immediate transactions purchases and sales of mortgage-backed agency securities if the transaction is scheduled
to settle in 30 days or less.
2.
Forward:
Forward transactions should reflect agreements arranged in the over-the-counter market in which securities
other than mortgage-backed agency securities are purchased or sold for delivery after- five business days from the
date of the trade. Securities purchased (sold) on a "when-issued" basis prior to the date on which the offering is
announced should also be reported as forward transactions. (However, "when-issued" trades in U. S. Government
securities that occur between announcement and issue dates should not be reported as forward transactions, even
though delivery is scheduled for more than five business days from the date of trade.) Forward transactions in
mortgage-backed securities are those which call for delivery in 31 or more days.
3.
Future:
Futures transactions should include standardized agreements that are arranged on an organized exchange in
which parties commit to purchase or sell securities for delivery on a future date. All transactions in futures
contracts should be reported in the futures column even if the delivery is scheduled for less than five business
days.
B.
C.
REPORTING CATEGORIES:
1.
Dealers in U. S. Government Securities. Report trades with other dealers (including the dealer departments of
banks) that report to the Domestic Reports Division of the Federal Reserve Bank of New York. If the dealer
is a department of a bank, report in this column only transactions with the dealer department. A list of the
reporting dealers may be obtained from the Division. •
2.
Brokers in U. S. Government Securities. Reports trades with firms whose principal business is the brokerage of
securities for dealers in U. S. Government securities.
3.
All other. Report trades with all customers (including the Federal Reserve) other than those in B.1 and B.2 above.
MISCELLANEOUS:
1.
Domestic Certificates of Deposit are dollar-denominated obligations of banks and banking offices payable in the
United States.
2.
Foreign Certificates of Deposit are dollar-denominated obligations of banks and banking offices payable outside
the United States.
3.
Transactions should be reported gross. Do not net.
4.
Exclude all transactions under repurchase agreements and reverse repurchase agreements.
5.
Do not record allotments, redemptions, exchanges, or securities purchased from the Treasury for customers.
6.
Cancellations and corrections. Purchase and sale tickets written to cancel or correct prior trades should be reported
on Schedule B only to the extent they affect the par amounts of previously reported transactions. For example,
the correction of a previously reported sale of $1.0 million to $0.1 million should reduce today's sales by $0.9
million. Do not correct by reporting a purchase of $0.9 million. Similarly, a $1.0 million sale previously reported
as a purchase should reduce today's purchases by $1.0 million and increase today's sales by the same amount.
Do not correct by reporting a sale of $2.0 million. (Negative sales or purchases on any day may thereby be
reported.)
7.
Odd-lot transactions. Transactions of less than $25,000 may be included either with "Other" customers or in
their proper customer category.
94
WEEKLY REPORT OF DEALER FINANCING
SCHEDULE c
(See Instructions below and
on the reverse side)
' i n millions of dollars to one decimal)
FR 2004 c
OMB NO. 055-R-0205
Approved by Federal Reserve Board
and OMB February 1980
Approval Expires June 1983
"THIS REPORT IS AUTHORIZED BY LAW (12 U. S. C. 248 (A) AND 12 U. S. C. 248 (I)). YOUR VOLUNTARY
COOPERATION IN SUBMITTING THIS REPORT IS NEEDED TO MAKE THE RESULTS COMPREHENSIVE,
ACCURATE, AND TIMELY."
"THE FEDERAL RESERVE SYSTEM REGARDS THE INDIVIDUAL DEALER INFORMATION PROVIDED BY
EACH RESPONDENT AS CONFIDENTIAL. IF IT SHOULD BE DETERMINED SUBSEQUENTLY THAT ANY
INFORMATION COLLECTED ON THIS FORM MUST BE RELEASED, RESPONDENTS WILL BE NOTIFIED."
DOMESTIC REPORTS DIVISION, FEDERAL RESERVE BANK OF NEW YORK. THIS REPORT SHOULD BE SUBMITTED
WEEKLY, TO REFLECT FINANCING OUTSTANDING ON THE WEDNESDAY OF EACH WEEK (OR THE PREVIOUS DAY IF
A HOLIDAY). IT SHOULD BE RETURNED ON THE FIRST BUSINESS DAY OF THE FOLLOWING CALENDAR WEEK.
DEALER NUMBER
• MONTH, DAY, YEAR
E OF DEALE.R
NAME OF PERSON COMPLETING T
[TELEPHONE NO. (INCLUDE AREA CODE)
1 120 DAYS
REMAINING
TO MATURITY
i
i
21
wm
SELECTED CUSTOMERS
1
MORE THAN 120 DAYSl
REMAINING
'
TO MATURITY
11
2
'1
WtTH AtJlJWFttEftS
H
4
i
H
1
i
1
2
2
•
• 1
1WTH SELECTED CUSTOMERS
3
3
WtTH M.L.OTH£ftS
4
4
WITH wts&rm
5
5
6
6
DUE BIL LS
CUSTOMERS
WITH ALL OTHERS
m
• i
QDLLflXEBftLfZ£D LOANS
|
|
|
|
|
|
M
j
7
7
•
MEMORANDA: "M ATCHED BOOK" It C L U D E D I N LINES
n
0
HS
10
9
TOTAL (LINES 1-9)
^
INSTRUCTIONS
This report covers the outstanding balance of borrowings and lendings (as defined below) of reporting government securities
dealers as of the close of business each Wednesday. All financings involving U. S. Government and Federal agency securities,
negotiable certificates of deposit, bankers' acceptances and commercial paper should be included. Bank dealers should only report
those financings of the dealer department of the bank, including those arranged with nondealer accounts of the bank, such as
investment and trust accounts.
II - HOW AND WHEN TO REPORT
All data should be reported on a "gross" basis - that is, borrowings should not be netted against loans made by the dealer,
and loans should not be netted against borrowings. Amounts reported on this schedule should be in terms of "principal" value,
i.e., actual funds, paid or received
All amounts should be reported in millions of dollars to one decimal as of the close of business each Wednesday (or the
preceding business day if Wednesday is a holiday) and delivered to the Domestic Reports Division of the Federal Reserve Bank of
New York on the first business day of the following calendar week.
m
III - SPECIFIC INSTRUCTIONS
m
Borrowings and loans are to be reported by maturity category. Those items reported in Column 1 have an original maturity of
one business day or continuing contract (as defined below), and those reported in Columns 2 and 3 have an original maturity
greater than one day (as defined below).
Overnight — Overnight borrowings are defined as:
• those made on one business day and maturing on the next business day; or
• those made on Friday to mature on Monday; or
• those made on the last business day prior to a holiday (for either or both parties to the transaction) that mature on
the first business day after the holiday.
I
Continuing Contract — a continuing contract is defined as an agreement that:
• remains in effect for more than one business day but has no specific maturity; and
• does not reouire advance notice bv the lender or the borrower to terminate.
<
•
95
I N S T R U C T I O N S (continued)
Term Agreements — borrowings or loans with an original maturity of more than one day that are not under continuing contract. Those items classified as "Term Agreements" (reportable in column 2 or column 3) should be reported by the
time remaining to maturity.
Due bills that explicitly call for delivery or refunding in one business day or that are open-ended should be included in the
"Overnight or Continuing Contract" maturity category; others should be included in the "Term Agreements" maturity
category.
Borrowings or loans that have a specified fixed maturity but that do. not require advance notice to terminate should be
reported as "Term Agreement" maturities.
BBEI
T T y B
OP CUSTOMER [
Within each of the maturity categories, transactions should be reported by type of customer (as defined below).
1.
Selected customers are:
(a) Commercial banks in the United States, consisting of national banks, state-chartered commercial banks, trust companies
and private banks performing a commercial banking business, industrial banks, U. S. offices of Edge Act and Agreement
corporations, and U. S. branches and agencies of foreign (non-U. S.) banks (Include dealer departments of banks);
(b) Building and savings and loan associations, mutual and stock savings banks, cooperative banks, and credit unions;
(c) Foreign (non-U. S.) commercial banks, savings banks, discount houses, branches of other U. S. banks, branches of Edge
Act and Agreement corporations, and other short-term depository institutions located outside the 50 United States and the
District of Columbia;
(d) Foreign governments, central banks, treasuries, and other official institutions located outside the 50 United States and the
District of Columbia;
(e) The U. S. Treasury, the Federal Reserve System, and other U. S. Government agencies and instrumentalities, including
the Federal Home Loan Bank Board, Federal Home Loan Banks, Federal Intermediate Credit Banks, Federal Land Banks,
Banks for Cooperatives, the Federal Home Loan Mortgage Association, Federal Deposit Insurance Corporation,, and Federal
National Mortgage Association;
(f) Export-Import Bank of the U. S.;
(g) Government Development Bank of Puerto Rico;
(h) Minbanc Capital Corporation; and
(i) Nonbank dealers and brokers in U. S. Government securities.
2.
"All Others": include any entity not stipulated in selected customers above, including individuals, partnerships, and business
corporations and other business organizations; states and political subdivisions; nonprofit organizations; international institutions; and financial institutions.
The transactions to be reported consist of the amount outstanding of the following items:
Lines 1 & 2: Reverse repurchase agreements are contractual arrangements in which securities are purchased from a customer
(including the Federal Reserve) with the agreement to sell them back on a specified future date (or within a specified
time). Report all reverse repurchase agreements involving U. S. Government and Federal agency securities (including
obligations that are fully guaranteed as to principal and interest by the U. S. Government or a Federal agency),
negotiable certificates of deposit, bankers' acceptances and commercial paper entered into with any entity, wherever
located. Include those reverse repurchase agreements that have been arranged to obtain securities to make delivery on
sales and those for which the securities obtained have been used as collateral on borrowings.
Lines 3 & 4: Repurchase agreements are contractual arrangements in which securities are sold to a customer (including the
Federal Reserve) with the agreement to buy them back on a specified future date (or within a specified time). Report
all repurchase agreements involving U. S. Government and Federal agency securities (including obligations that are
fully guaranteed as to principal and interest by the U. S. Government or a Federal agency), negotiable certificates of
deposit, bankers' acceptances and commercial paper entered into with any entity, wherever located. Exclude R P due
bills from lines 3 and 4; report them on lines 5 and 6.
Lines 5 and 6: Due bills are instruments which acknowledge that payment has been received on securities sold and promise
delivery of the securities at a later time. Securities include U. S. Government and Federal agency securities (including
obligations that are fully guaranteed as to principal and interest by the U. S. Government or a Federal agency),
negotiable certificates of deposit, bankers' acceptances and commercial paper. Include due bills which the dealer
agrees to buy back on a later date (i.e., R P due bills).
Line 7: Collateralized loans are borrowings secured by pledging U. S. Government and Federal agency securities (including
obligations that are fully guaranteed as to principal and interest by the U. S. Government or a Federal agency),
negotiable certificates of deposit, bankers' acceptances and commercial paper.
Lines 8 and 9: Matched book primarily includes transactions in which a dealer acquires a security on a reverse repurchase
agreement specifically to place it with a customer on a repurchase agreement, but should also include those reverse
repurchase agreements financed by other sources such as collateralized loans or due bills. For the purpose of this
report, the term matched book does not necessarily refer to matched maturities but to the matching of a borrowing
and a lending transaction. Report those transactions arranged in most cases to profit from the difference between
borrowing and lending rates. Do not report those transactions which serve to finance the dealer's position or to
facilitate the delivery of securities.
Report in line 8 the principal value of reverse repurchase agreements, financed by repurchase agreements, due bills or collateralized loans. Since the matched book is memoranda, the transactions reported in line 8 should also be reported in linesj and 2.
Report in line 9 the principal value of repurchase agreements, due bills and collateralized loans which were used to finance
reverse repurchase agreements. Since the matched book is memoranda, the transactions reported in line 9 should also be
reported in lines 3 through 7.
OMB NO. 055-R-0205
Approved by Federal Reserve Board and OMB February 1980
Approval Expires June 1983
"THE FEDERAL RESERVE SYSTEM REGARDS THE INDIVIDUAL DEALER INFORMATION
RESPONDENT AS CONFIDENTIAL. IF IT SHOULD BE DETERMINED SUBSEQUENTLY THAT
COLLECTED ON THIS FORM MUST BE RELEASED, RESPONDENTS WILL BE NOTIFIED."
"THIS REPORT IS AUTHORIZED BY LAW (12 U. S. C. 248 (A) AND 12 U. S. C. 248 (I)). YOUR VOLUNTARY
COOPERATION IN SUBMITTING THIS REPORT IS NEEDED TO MAKE THE RESULTS COMPREHENSIVE,
ACCURATE, AND TIMELY."
Domestic Reports Division, Federal Reserve Bank of New York. This report should be submitted semimonthly, to reflect positions on the second Wednesday of each month (or the previous day if a
holiday) and the last business day of each month. It should be returned within two business days after the trading date.
I NAME OF PERSON COMPLETING T
TELEPHONE NUMBER (AREA CODE)
CLOSE OF T R A D I N G
^
IMONTH, DAY, YEAR
97
SCHEDULE D
Instructions
1.
Futures contracts are standardized agreements
arranged on an organized exchange in which parties commit
to purchase (sell) securities for delivery at a future date. All
positions in futures contracts should be reported on this
schedule, even if a contract is acquired that calls for delivery
of securities within five business days from the date of
acquisition. The maturity of the contract, and not the
underlying security, should be reported in this schedule.
Contracts should be netted only in the case in which they
specify delivery of the same securities on the same date and
have been obtained on the same exchange. When futures
contracts are settled by actual delivery of securities, the
delivery should be reflected in positions on Schedule A.
2.
Forward contracts are agreements arranged in the
over-the-counter market in which securities are purchased
(sold) for delivery after five business days from the date of
the transaction. Do not report mortgage-backed securities if
settlement was scheduled to occur in 30 days or less.
"When-issued" trading after an offering is announced is not
considered a forward contract for the purpose of this
report. The maturity of the commitment, and not of the
underlying security, should be reported in this schedule. A
forward contract to purchase a given amount of a security
should not be netted against a forward contract to sell the
same amount of the security, except in the case where both
contracts are with the same customer and have the same
delivery date. Forward commitments should continue to be
reported on Schedule D until the settlement day.
3.
Standbys for the purpose of this report are put
options, i.e., the purchaser of the standby has the right to
sell a security at a specified time and price. A dealer who is
obligated to buy a security under a standby contract, for
which he has received a fee, should report a standby to
purchase (long position). A dealer who has paid a customer
for the right to sell securities under a standby contract
shoald report a standby to sell (short position).
If the standby (put option) can be exercised at a
price that is in excess of the market price or the same as the
market price, it is considered "in the money" and should be
so reported regardless of whether the market price is favorable or unfavorable for the dealer.
4.
Options for the purpose of this report are call
options, i.e., the owner of the option has the right to
purchase a security at a specified time and price. A dealer
who has acquired an option under which the dealer may
purchase a security should report an option to buy (long
position). A dealer who has sold an option under which a
customer may purchase a security from the dealer should
report an option to sell (short position).
If the option (call option) can be exercised at a price
that is below the market price or the same as the market
price it is considered "in the money" and should be so
reported regardless of whether the market price is favorable
or unfavorable for the dealer.
5.
This report should be submitted semimonthly to
reflect positions on the second Wednesday of each month
(or the previous day if a holiday) and the last business day
of each month. The report should be delivered to the
Domestic Reports Division, Federal Reserve Bank of New
York within two business days after the trading date.
@FedFRASER