Joint Report 

on the 

Government Securities Market 

 Board of Governors 

 Department of Securities and of the

 the Treasury Exchange Commission Federal Reserve System 

January 1992 

For sale by the U.S. Government Printing Office 

Superintendent of Documents, Mail Stop: SSOP, Washington, DC 20402_9328

ISBN 0-16-036093-5
DEPARTMENT OF THE TREASURY 

WASHINGTON 

January 22, 1992 

The Honorable J. Danforth Quayle 

President 

United States Senate 

Washington, D.C. 20510 

Dear Mr. President: 

We are pleased to transmit our report on the government 

securities market, as promised in statements before 

Congressional subcommittees last year. 

The recent widely publicized events involving abuses 

in the government securities market have prompted us to 

undertake a thorough review of the market that the federal 

government relies upon to meet its borrowing needs. The Federal 

Reserve Bank of New York was a full participant in this review, 

and its views are reflected here as well. Our recommendations 

for legislation and changes in policies are contained in this 

report. We believe that these reforms will improve the fairness 

and efficiency of the market, to the benefit of taxpayers and 

investors alike. 

We urge the Congress to move swiftly in enacting our 

legislative recommendations. 

We are also transmitting the report to the Speaker of 

the House. 

Sincerely, 

Nicholas F. Brady 

Secretary 

Department of the 

Treasury 

Richard C. Breeden 

Chairman 

Securities and 

Exchange Commission 

Alan Greenspan 

Chairman 

Board of Governors 

Of the Federal 

Reserve System 

 
DEPARTMENT OF THE TREASURY

WASHINGTON 

January 22, 1992 

The Honorable Thomas S. Foley 

Speaker 

House of Representatives 

Washington, D.C. 20515 

Dear Mr. Speaker: 

We are pleased to transmit our report on the government 

securities market, as promised in statements before 

Congressional subcommittees last year. 

The recent widely publicized events involving abuses 

in the government securities market have prompted us to 

undertake a thorough review of the market that the federal 

government relies upon to meet its borrowing needs. The Federal 

Reserve Bank of New York was a full participant in this review, 

and its views are reflected here as well. Our recommendations 

for legislation and changes in policies are contained in this 

report. We believe that these reforms will improve the fairness 

and efficiency of the market, to the benefit of taxpayers and 

investors alike. 

We urge the Congress to move swiftly in enacting our 

legislative recommendations. 

We are also transmitting the report to the President of 

the Senate. 

Sincerely, 

Nicholas F. Brady 

Secretary 

Department of the 

Treasury 

Richard C. Breeden 

Chairman 

Securities and 

Exchange Commission 

Alan Greenspan 

Chairman 

Board of Governors 

Of the Federal 

Reserve System 
TABLE OF CONTENTS 

Page 

 

OVERVIEW OF THE GOVERNMENT SECURITIES MARKET.............................ix 

SUMMARY OF REFORMS............................................................................xiii 

JOINT REPORT.............................................................................................1 

APPENDIX A: Background on the Treasury Securities Market 

1. Characteristics of the Primary Market...................................................A-1 

2. Characteristics of the Secondary Market. . . . . . . . . . . . . . . . .........................A-7 

3. Regulation of the Treasury Market. . . . . . . . . . . . . . . . . . ...........................A-12 

APPENDIX B: Treasury Securities Market Issues 

1. Short Squeezes.................................................................................B-1 

2. Debt Management Approaches to Alleviating Squeezes. . . . . . . ....................B-4 

3. Treasury Auction Issues 

 A Auction Technique..................................................................B-17 

B. International Comparison. . . . . . . . . . . . . . . . . . . . . . . .....................B-25 

 C. Auction Automation...............................................................B-41 

D. Auction Rule Enforcement. . . . . . . . . . . . . . . . . . . . . . ......................B-48 

E. Concentration of Auction Awards. . . . . . . . . . . . . . . . . .....................B-54 

4. Hedge Funds..................................................................................B-64 

vii 
5. Government Securities Clearing Corporation. . . . . . . . . . . . . . .....................B-7l 

6.Sales Practice Rules .........................................................................B-83 

7.Information Access ..........................................................................B-87 

8.Reportingand Audit Trails .................................................................B-92 

APPENDIX C: The Events Involving Salomon Brothers and Alleged Government 

 Securities Market Abuses 

1. The Events Involving Salomon Brothers. . . . . . . . . . . . . . . . . . . .................... .C-l 

2.Short Squeezes ..................................................................................C-5 

3. Improper Practices Relating to GSE Securities. . . . . . . . . . . . . .. ...................C-7 

APPENDIX D: Background on the Government-Sponsored Enterprise 

 Securities Market.............................................................................................. D-l 

APPENDIX E: The Primary Dealer System 

1. Statement of the Federal Reserve Bank of New York. . . . . . . . .....................E-1 

2. Primary Dealers: Criteria and Procedures Applied to Firms

Interested in Becoming and Remaining Primary Dealers .....................E-11 

viii 
OVERVIEW OF THE GOVERNMENT SECURITIES MARKET 

Treasury Auctions 

The Treasury sells marketable bills, notes, and bonds in more than 150 regular auctions 

per year. Treasury bills are 13-week, 26-week, or 52-week securities that are auctioned at a 

discount from face value, rather than carrying an interest coupon. Short-term cash-management 

bills are also auctioned when required by the Treasury's cash-flow needs. Coupon-paying 

securities include notes and bonds. Treasury notes are currently auctioned in 2-year, 3-year, 5-

year, 7-year, and 10-year maturities. Treasury bonds are currently auctioned in a 30-year 

maturity. The Treasury also issues nonmarketable securities, such as savings bonds and certain 

government account issues. 

The Treasury uses a sealed-bid, multiple-price auction mechanism. Competitive bidders 

for Treasury securities to be held in the commercial book-entry system submit their tenders in 

writing at Federal Reserve banks. Each successful competitive bidder is awarded securities at a 

price that reflects the yield bid. As a result, successful bidders for a security may pay different 

prices for that security. 

Instruments 

Sophisticated financial instruments based on Treasury securities have been developed 

over time. For example, zero-coupon securities (such as those created through the Treasury's

program for Separate Trading of Registered Interest Principal - "STRIPS") and derivative 

instruments (including forward contracts, futures, and options) have become widespread. 

Repurchase agreements ("repos") are commonly used to fund positions in Treasury 

securities. A repo comprises two distinguishable transactions: the sale of Treasury securities, and 

a forward agreement to repurchase the same securities for a certain price at a certain time in the 

future. A reverse repo is the other side of a repo transaction. The maturities of repos are typically 

overnight or a few days but can extend for longer periods. 

Government agencies such as the Government National Mortgage Association, the Small 

Business Administration, and the Tennessee Valley Authority either guarantee securities or issue 

marketable debt. The Government-sponsored enterprises ("GSEs") - Federal National Mortgage 

Association, Federal Home Loan Mortgage Corporation, Farm Credit System, Federal Home

Loan Bank System, and Student Loan Marketing Association - also issue marketable debt, 

subordinated debt, and guaranteed asset-backed securities. Some GSEs also issue exchangetraded equity securities.

Markets and Market Participants

Government securities are traded predominantly in al1 over-the-counter market, 

comprised of a network of dealers, brokers, and investors who effect transactions in Treasury 

ix 
and other government securities over the telephone. The market is largely a wholesale one in 

which institutional investors, such as banks, thrifts, dealers, pension funds, insurance companies, 

mutual funds, and state and local governments operate. However, a significant number of small, 

retail investors also trade government securities through brokers and dealers. Although all 

marketable Treasury notes, bonds, and STRIPS are listed on the New York Stock Exchange 

("NYSE"), exchange trading volume is a small fraction of total over-the-counter volume. Some

derivative instruments on Treasury securities trade on regulated futures exchanges, while others 

are mainly over-the-counter instruments. 

Primary dealers are the firms with which the Federal Reserve conducts its open market 

operations. Although there are approximately 1,700 brokers and dealers (including banks) 

trading in the secondary market, the 38 primary dealers account for a majority of the trading 

volume. Daily trading volume by primary dealers in Treasury securities, excluding financing 

transactions, averaged $85 billion per day in September 1991, according to data reported to the 

Federal Reserve Bank of New York ("FRBNY"). By contrast, the average daily volume of 

equities trading on the NYSE is $6 billion. Though the aggregate dollar value of trading in the 

government securities markets is much larger than that in the equity markets, the number of daily 

trades is actually much smaller. Over 100,000 individual equity trades per day are reported 

through the current equity trade reporting systems. By way of comparison, about 2,000 trades per 

day in Treasury securities are being reported through the new GOVPX system (though it only 

captures a portion of all government securities trading). 

The primary dealers and some other market participants rely on interdealer brokers 

(currently seven in number) to trade in the market for government securities. Interdealer brokers 

compile the best bid and ask prices provided by the dealers and make this information available 

on computer screens. The brokers receive a commission for arranging trades. The identities of

the dealers who submit the price quotes are kept confidential, with the understanding that 

anonymous trading allows the dealers to protect the confidentiality of their trading strategies. 

Settlement - the exchange of securities for funds - is performed electronically and 

typically occurs one business day after a buyer and seller agree on a trade. The electronic system

used for settlement of Treasury securities and many other government securities is the 

commercial book-entry system maintained by the Federal Reserve System. Funds are transferred 

simultaneously over the system. This system enables government securities trades to be settled 

quickly (within seconds) and relatively cheaply, thus contributing substantially to market 

liquidity. 

Much of the trading activity in government securities is settled through the Government 

Securities Clearing Corporation ("GSCC"), a clearing organization that provides its members 

with automated trade comparison and netting services for Treasury and other government 

securities. The most active brokers, dealers, and banks in the government securities market are 

GSCC members. GSCC combines each member's total purchases and sales for each security with 

other GSCC members into a single net purchase or sale. This 

x 
process greatly reduces the amount of trades that have to be cleared through the commercial 

book-entry system and, along with the guarantee GSCC provides, substantially reduces 

counterparty risk for GSCC members. 

Regulation

The Secretary of the Treasury ("Secretary") is authorized under Chapter 31 of Title 31, 

United States Code, to issue Treasury securities and to prescribe terms and conditions for their 

issuance and sale. The Secretary may issue bonds under 31 U.S.C. § 3102, notes under 31 U.S.C. 

§ 3103, and certificates of indebtedness and Treasury bills under 31 U.S.C. § 3104. Under 31 

U.S.C. § 3121, the Secretary may prescribe the form of such securities and the terms and 

conditions for the issuance and sale of the securities. Treasury auction rules are issued under this 

authority. 

Compliance and enforcement responsibility for the auction rules rests with the Treasury. 

The Treasury may bar or suspend a firm from auctions, and the Treasury reserves the right to 

reject bids in auctions. However, the Securities and Exchange Commission ("SEC"), the 

Treasury, and the self-regulatory organizations ("SROs") are not authorized to examine 

government securities firms for compliance with Treasury auction rules. Securities fraud is the 

enforcement responsibility of the SEC and the Justice Department, and the Justice Department 

enforces the antitrust laws. 

Brokers and dealers in the secondary market for government securities are regulated 

under the authority of the Government Securities Act of 1986 ("GSA "). In addition, brokerdealers and banks are subject to regulation under the Securities Exchange Act of 1934 and the 

banking laws, respectively. Under the GSA, the Treasury has promulgated regulations 

concerning financial responsibility, protection of investor securities and funds, recordkeeping, 

reporting, and auditing of government securities brokers and dealers. The Treasury also was 

given responsibility for the development of regulations related to the custody of government 

securities held by depository institutions. The GSA required the SEC and the Federal Reserve 

Board to promulgate rules establishing the procedures and forms to be used by government 

securities brokers and dealers for the registration and notice process. 

In promulgating the regulations, the Treasury was required to consult with the SEC and 

the Federal Reserve Board. As a result of these consultations and the Treasury's analysis, most of 

the SEC regulations (e.g., customer protection, recordkeeping, reports, and audits) that applied to 

registered brokers and dealers were, with limited exceptions, adopted for firms registered 

pursuant to the GSA. Enforcement authority for these rules rests with the SEC and the SROs or 

with financial institution regulators, depending on the entity. Treasury rulemaking authority 

under the GSA expired on October 1, 1991. 

xi 
SUMMARY OF REFORMS1

ADMINISTRATIVE AND REGULATORY CHANGES

• Broadening participation in auctions: 

o All government securities brokers and dealers registered with the SEC are now 

allowed to submit bids for customers in Treasury auctions. Formerly, only 

primary dealers and depository institutions could do so (announced October 25). 

o Any bidder is now permitted to bid in note and bond auctions without deposit, 

provided the bidder has an agreement with a bank (an "autocharge agreement") to 

facilitate payment for securities purchased at auctions. Formerly, only primary 

dealers and depository institutions could do so (announced October 25).

o To facilitate bidding by smaller investors, the noncompetitive award limitation 

has been raised from $1 million to $5 million for notes and bonds (announced 

October 25). 

• Stronger enforcement of auction rules: 

o The Federal Reserve now engages in spot-checking of customer bids in Treasury 

auctions for authenticity (announced September 11). 

o The Treasury and the Federal Reserve are instituting a new system of 

confirmation by customers receiving large awards (over $500 million), to verify

the authenticity of customer bids. 

o The Treasury and the Federal Reserve have tightened enforcement of 

noncompetitive bidding rules. 

• Detecting and combatting short squeezes: 

o Improved surveillance of the Treasury market. A new working group of the 

Agencies has been formed to improve surveillance and strengthen interagency 

coordination. The Federal Reserve Bank of New York 

 1

 Reforms have the unanimous support of the Department of the Treasury, the Board of Governors of the

Federal Reserve, and the Securities and Exchange Commission ("SEC") (the" Agencies") unless otherwise noted. 

All actions listed are recommended or implemented as part of this report, unless otherwise indicated.

xiii 
("FRBNY") will enhance and expand its market surveillance efforts, in its role as 

the agency that collects and provides the SEC, the Treasury, and the Federal 

Reserve Board with information needed for surveillance purposes. 

o Reopening policy to combat short squeezes. The Treasury will provide 

additional quantities of a security to the marketplace when an acute, protracted 

shortage develops, regardless of the reason for the shortage. The reopening of 

issues will greatly reduce the potential for short squeezes. Reopenings could occur 

either through standard auctions, through "tap" issues whereby the Treasury offers 

securities to the market on a continuous basis, or through other means. 

• Changes to Treasury auction policies: 

o Automation. The Treasury and the Federal Reserve have accelerated the schedule 

for automating Treasury auctions. It is anticipated that the auctions will be

automated by the end of 1992 (announced September 11). 

o Proposal of uniform-price, open auction system. The Treasury will consider

implementing an open method of auctioning securities with repeated rounds of 

bidding at descending yields. The total bids received at the announced yield 

would be announced after each round. All securities would be awarded at a single 

yield. Such a system will be feasible once the auctions are automated and could

encourage broader participation in Treasury auctions. 

o Publication of uniform offering circular. Treasury auction rules and procedures 

have been compiled into a uniform offering circular, to be published in the 

Federal Register with a request for comments. 

o Change to noncompetitive auction rules. To limit noncompetitive bidding to the 

small, less sophisticated bidders for whom it was designed, the Treasury will not 

permit a noncompetitive bidder in a Treasury auction to have a position in the 

security being auctioned in the when-issued, futures, or forward markets prior to 

the auction. Furthermore, the Treasury will not permit bidders to submit both 

competitive and noncompetitive bids in a single auction. 

o Change in net long position reporting required on auction tender form. To 

streamline reporting requirements, the Treasury will not require competitive 

bidders to report net long positions at the time of the auction, unless the total of 

the bidder's net long position plus its bid exceeds a high threshold amount. This 

threshold amount will represent a substantial share of each auction and will be 

announced for each auction. 

xiv 
• Improvements to the primary dealer system: 

o Opening up the system by eliminating the market share requirement. The 

Federal Reserve will gradually move to a more open set of trading relationships. 

To this end, the FRBNY is eliminating the requirement that each primary dealer 

effect at least one percent of all customer trades in the secondary market. The 

FRBNY expects to add counterparties that meet minimum capital standards, 

initially in modest numbers, but on a larger scale once open market operations are 

automated. 

o Clarification of regulatory authority over primary dealers. In the future, direct 

regulatory authority over primary dealers will rest unambiguously with the 

primary regulator - in most cases, the SEC. Although the FRBNY has no statutory 

authority to regulate the primary dealers, the primary dealer system may have 

generated the false impression in the marketplace that the FRBNY somehow 

regulates or takes responsibility for the conduct of primary dealers. To make clear 

that its relationship with the primary dealers is solely a business relationship, the 

FRBNY will eliminate its dealer surveillance program, while upgrading its market 

surveillance program as described above. 

o Other features regarding primary dealers. To remain a primary dealer, firms 

must demonstrate to the FRBNY that they make reasonably good markets, 

provide it with market information, and bid in Treasury auctions. Primary dealers 

must also maintain capital standards. Failure to meet the Federal Reserve's 

performance standards, or the capital standards, will lead to removal of the 

primary dealer designation. In addition, any primary dealer that is convicted of (or 

pleads guilty or nolo contendere to) a felony will face suspension of its primary 

dealer designation. 

• Enhanced GSCC. The Agencies support enhancements to the Government Securities 

Clearing Corporation, which provides comparison and netting facilities for reducing risk 

in the government securities market. 

LEGISLATIVE RECOMMENDATIONS 

• Reauthorization of Treasury rulemaking authority under GSA. Treasury rulemaking 

authority under the Government Securities Act of 1986 for government securities brokers 

and dealers expired on October 1, 1991. The Agencies support prompt reauthorization of 

this authority. 

• Misleading statements as violation of federal securities laws. The Agencies support 

legislation that would make it an explicit violation of the Securities Exchange Act of 

xv 
1934 to make false or misleading written statements to an issuer of government securities 

in connection with the primary issuance of such securities. 

• Registration of GSE securities. The Agencies support legislation removing the 

exemptions from the federal securities laws for equity and unsecured debt securities of 

Government-sponsored enterprises ("GSEs"), which would require GSEs to register such 

securities with the SEC. 

• Backup position reporting. The Treasury, the FRBNY, and the SEC support legislation 

that would give the Treasury backup authority to require reports from holders of large 

positions in particular Treasury securities. This authority would not be used unless the 

reopening policy and other measures implemented fail to solve the problem of acute, 

protracted market shortages. The Federal Reserve Board believes that the reopening 

policy makes this authority unnecessary and that it would be difficult to resist activating 

this authority if it were granted; thus, it opposes this proposal. 

• Sales practice roles. The Treasury and the SEC support legislation granting authority to 

impose sales practice rules, but differ on the implementation and extent of such rules. The 

Federal Reserve does not believe that a case has been made for sales practice rules 

authority, but would not oppose application of such rules to National Association of 

Securities Dealers members. 

• Backup transparency authority. The SEC supports legislation that would grant it 

authority to require, if deemed necessary, expanded public dissemination of price and 

volume information in the secondary market for government securities. The Treasury and 

the Federal Reserve believe that private sector initiatives should be allowed to develop

and that the costs of such regulation would outweigh the benefits at this time; therefore, 

they oppose this proposal. 

• Audit trails. The SEC supports legislation that would give it authority to require audit 

trails - time-sequenced reporting of trades to a self-regulatory organization - in the 

government securities market. The Treasury and the Federal Reserve believe that the 

costs of such regulation would outweigh the benefits, and oppose this proposal. 

xvi 
JOINT REPORT 

I. Introduction 

The U.S. government securities market is the largest and most liquid securities market in 

the world. It has shown the ability to absorb efficiently the enormous amounts of Treasury 

securities made necessary by the massive borrowing requirements of the U. S. Government. The 

market also serves the needs of the Federal Reserve in conducting open market operations, the 

Federal Reserve's most important monetary policy tool. The enormous liquidity and pricing 

efficiency of the market provide incalculable benefits to other financial markets in the United 

States and worldwide by providing a continuous benchmark for interest rates on dollardenominated instruments across the maturity spectrum. Because of its demonstrated success in 

meeting both public and private needs, the U.S. government securities market has been a model 

for other government securities markets around the world. 

Over time, there has been significant innovation in the U.S. government securities 

market. Examples include the active trading of Treasury securities on a when-issued basis prior 

to Treasury auctions, which helps the market gauge demand and price the securities being 

offered; repurchase and reverse repurchase agreements, which serve both to increase liquidity 

and to allow dealers to finance their inventory of Treasury securities; the development of active 

futures and options markets related to Treasury securities, enabling market participants to pursue 

diverse hedging strategies in a liquid market setting; and the creation of zero-coupon instruments 

through the stripping of Treasury securities, which allows the market to restructure payment 

flows to meet the varying needs of different purchasers. These innovations have benefitted the 

market and the taxpayer by increasing liquidity, thereby lowering the government's financing 

costs. 

On the whole, this market has enabled the government to meet its large financing needs 

in a cost-effective manner for the taxpayer, which is the government securities market's primary 

public purpose. Nevertheless, the events of 1991 have focused public attention on some

shortcomings in this market. In August 1991, under the pressure of investigations by the 

Securities and Exchange Commission (the "SEC") and the Justice Department, Salomon 

Brothers Inc ("Salomon"), a major participant in the market, admitted deliberate and repeated 

violations of Treasury auction rules beginning in 1990. In addition, in two widely publicized 

instances during 1991, so-called "short squeezes" developed after an auction, in one case 

apparently as a result of very high concentration of auction awards. Taken together, these events 

threatened the public's confidence in this crucial marketplace, which ultimately could result in 

higher costs for taxpayers in financing the national debt. 

In September 1991, in the wake of Salomon's August admissions of wrongdoing, the 

Treasury Department, the Federal Reserve, and the SEC (collectively, the "Agencies") 

1 
undertook a joint review of the government securities market.1

 This report is the product of that 

review. The report addresses a broad range of government securities market issues that arose 

directly or indirectly from the events of 1991, including the need to strengthen enforcement of 

Treasury's auction rules; the need to automate the auctions; potential changes in Treasury's 

auction technique and debt management policies; and the role of the primary dealers. The report 

also addresses certain issues that were widely debated before the events of mid-1991, such as 

reauthorization of Treasury's rulemaking authority under the Government Securities Act, the 

need for sales practice rulemaking authority, and "transparency" - that is, the availability of

timely, accurate price and volume information to market participants. Finally, the report 

proposes to remove the exemption under the federal securities laws for certain securities issued 

by Government-sponsored enterprises ("GSEs"). 

The Agencies do not believe that the government securities market is flawed or broken in 

any fundamental economic sense. However, serious problems have arisen, and these problems 

suggest that various aspects of the efficient operation and regulation of this marketplace can be 

improved. Indeed, the events described above suggest several specific areas for improvement, 

including better enforcement of auction rules and more effective methods of preventing and 

alleviating "short squeezes."2

 The improvements recommended in this report include some basic 

reforms that are designed to lessen the potential for fraud and misconduct and to increase the 

Agencies' ability to detect such misconduct when it occurs. 

This report reflects an attempt of the Agencies to reach a consensus on the changes that 

are necessary in the regulation of this marketplace. There is substantial agreement among the 

Agencies on the necessary initiatives and the direction in which government policy should move. 

As described below, however, there remain some differences with respect to certain specific 

proposals for change. 

The Agencies share common objectives in evaluating potential changes in government 

policy. These objectives include preserving and enhancing the efficiency of the government's

financing mechanism, ensuring the integrity and fairness of the marketplace, deterring and 

detecting fraud, and protecting investors. In particular, there is a strong consensus that, while 

change is necessary, that change must be managed with care to assure that the national debt is 

financed at the lowest possible cost. 

 1 The SEC and the Department of Justice are conducting separate investigations from a law enforcement 

perspective. These investigations are not yet complete, and neither the SEC nor the Department of Justice has

reached any conclusions with respect to the actions of any particular market participant. As a result, the discussion 

contained herein should not be understood as reaching any conclusions of fact or law with respect to the SEC's or 

the Department of Justice's investigations. 

2 In fact, as described in this report, Treasury has already used its authority to correct some of the problems that 

were highlighted by these events. 

2 
Any degradation in the smooth functioning of the government securities market would 

result in higher costs to the taxpayer. An increase in financing costs of only one basis point - one 

hundredth of one percentage point - would cost taxpayers over $300 million each year. Thus, in 

pursuing the goal of market integrity, the Agencies are sensitive to the need to avoid unnecessary 

responses that could drive investors and market makers out of the market. Moreover, every 

avenue for achieving supervisory goals through market solutions should be explored. 

Background 

The Government Securities Act. Congress passed the Government Securities Act of 

1986 (the "GSA") with the support of the Reagan Administration, the SEC, the Federal Reserve, 

and many market participants. The GSA closed then-existing gaps in the regulation of market 

participants that had been highlighted by the failure of certain previously unregulated 

government securities dealers, involving losses for investors and, in some cases, fraudulent 

activity in the market for repurchase agreements. 

Prior to the enactment of the GSA, some government securities brokers and dealers were 

not registered with or regulated by any federal government agency. The GSA required this group 

of brokers and dealers to register with the SEC. In addition, the GSA granted to the Treasury 

limited rulemaking authority3

 over all government securities brokers and dealers, including 

financial institutions4

 engaged in this business. The Treasury rules are enforced by the 

appropriate regulatory agency. The federal banking regulators fill that role for financial 

institutions that are government securities brokers or dealers, and the SEC does so for all other 

government securities firms. 

Treasury's rulemaking authority under the GSA expired on October 1, 1991. Before both 

houses of Congress had voted to renew that authority, Salomon admitted its violations and 

triggered intense scrutiny of the market for government securities. In this atmosphere, the 

Treasury's authority under Section 15C of the Securities Exchange Act of 1934 (the "Exchange 

Act") to promulgate new rules was allowed to expire, although all rules already promulgated by 

the Treasury under the GSA remain in effect. The Agencies recommend that Treasury's

rulemaking authority be reinstated promptly. 

The Salomon episode and market squeezes. While the events referred to above have 

received widespread publicity, they are restated here as background for some of the

recommendations made in this report. 

 3 Treasury's GSA rulemaking authority was limited to matters involving financial responsibility, recordkeeping, 

reporting and confirmation requirements, and custody and use of customers' securities and funds balances. 

4

 The term "financial institution," for purposes of the GSA, means banks and savings and loans. 15 D.S.C. § 

78c(a)(46). 

3 
Fraudulent bids. The inquiries into Salomon's conduct began, seemingly innocuously, on 

February 21, 1991, when Federal Reserve Bank of New York ("FRBNY") staff called Salomon 

concerning a bid the firm had made in the Treasury five-year note auction that day on behalf of 

an entity identified by Salomon as "Warburg Asset Management." A Salomon official stated that 

the firm had made a mistake and that Warburg Asset Management was actually Mercury Asset 

Management5

. S.G. Warburg, a U.S.-based primary dealer, had separately submitted a tender at 

the same yield for its own account. Combined, the two bids exceeded 35 percent of the public 

offering amount. 

The two bids triggered a discussion between staff of the FRBNY and the Treasury's 

Bureau of the Public Debt. The sole issue then under consideration was whether Warburg (or 

Mercury) Asset Management and S.G. Warburg should be deemed a single bidder for purposes 

of the 35 percent rule.6 

The Treasury decided to accept both bids because the combined awards to the two 

bidders - after proration - did not exceed 35 percent of the public offering amount. Nonetheless, 

the Treasury subsequently further considered the relationship between S.G. Warburg and 

Mercury Asset Management for purposes of application of the 35 percent rule. The Treasury's 

Bureau of the Public Debt sent a letter dated April 17, 1991, to Mercury Asset Management, 

which provided details concerning the two bids submitted in the February five-year note auction 

and informed Mercury of the Treasury's decision to treat the two entities as a single bidder in the 

future for purposes of the 35 percent limitation. Copies of this letter were sent to officers of S.G. 

Warburg (the primary dealer), S.G. Warburg Group P.L.C. (the British parent company), and the 

FRBNY. In addition, a copy of the letter was sent to the Salomon official in charge of 

government securities trading. 

As Salomon subsequently admitted, the February bid from "Warburg Asset 

Management" was unauthorized. Salomon's top executives had learned in April that the 

securities in question were, in fact, purchased by Salomon itself. However, Salomon's senior 

management did not promptly inform the appropriate government officials of the unauthorized 

bid. 

Short squeezes. The problem of short squeezes in the market was drawn into sharp focus 

during 1991. While yields on Treasury securities of approximately equal maturity vary 

constantly, there were two instances during the Spring of 1991 in which particular securities 

traded well off the yield curve for an extended period. In the first case, a short squeeze 

 5 Mercury Asset Management P.L.C. is a subsidiary of S.G. Warburg Group P.LC. S.G. Warburg, a U.S. 

primary dealer, is also a subsidiary of S.G. Warburg Group P.LC. Warburg Asset Management is a subsidiary of

Mercury Asset Management that operates in the United Kingdom.

6 This rule limits the amount Treasury will recognize as bid at a single yield by a single bidder to 35 percent of 

the public offering amount and also limits awards to a single bidder to 35 percent of the public offering amount. 

4 
developed in the two-year note auctioned on April 24, 1991. When the squeeze first manifested 

itself in mid-May, the yield on the April two-year note moved considerably out of line with 

surrounding market rates, and the notes were "on special" in the repurchase agreement ("repo") 

market.

7 

The shortage of the April two-year note did not become evident until almost four weeks 

after the securities were auctioned. Awards at the auction itself were not particularly 

concentrated. It appears that the shortage developed when the securities were not made available 

to the repo market. 

As the squeeze in the April two-year note began, Salomon submitted large, aggressive

bids for itself and two customers in the auction of two-year notes on May 22. As a result of these 

bids and additional purchases in the aftermarket, Salomon's position on the settlement date was 

almost 94 percent of the issue, according to Salomon's subsequent public statements. 

A number of market participants contacted the FRBNY and the Treasury to Point out the 

shortage in the May two-year note. From the information available to Treasury officials, it 

appeared that the squeeze resulted from the concentration of auction awards to Salomon and 

some of its customers. Treasury officials thought the situation serious enough to warrant 

investigation by the SEC. On May 29, the Treasury told the SEC's Divisions of Market 

Regulation and Enforcement about the situation and provided them with information concerning 

auction awards. The SEC promptly began investigating the matter. In addition, the Antitrust 

Division of the Department of Justice requested and was provided information pertinent to its 

own investigation of the squeeze. As the investigations of the Warburg/Mercury incident and the 

May short squeeze progressed, Salomon asked outside counsel to investigate the firm's potential 

legal problems. 

The government investigations ultimately resulted in Salomon's August 1991 admissions 

that it had submitted unauthorized customer bids in several auctions in 1990 and 1991 and led to 

changes in Salomon's top management. 

Improprieties involving GSE securities. In addition to the falsified Treasury auction bids 

discussed above, Salomon admitted that it had engaged in the practice of overstating its customer 

orders in connection with distributions of the securities of GSEs. It now appears that this practice 

was widespread among GSE selling group members. 

On January 16, 1992, the SEC, the Federal Reserve, and the Office of the Comptroller of 

the Currency instituted administrative proceedings against 98 GSE selling group members for 

violating various recordkeeping requirements by preparing and 

 7 In other words, market participants desiring to borrow the two-year notes had to accept an interest rate 

significantly lower than the prevailing repo rate on funds they deposited with their counterparties. To look at it 

another way, owners of the scarce two-year notes could finance them at exceptionally low interest rates. 

5 
maintaining records reflecting inflated indications of customer orders or sales. Simultaneously 

with the order instituting proceedings, virtually all of these selling group members submitted 

offers of settlement, which were accepted. The terms of the settlements require each of such 

selling group members to: (1) cease and desist from future violations of the recordkeeping 

requirements; (2) pay civil money penalties of up to $100,000 to the U.S. Treasury; and (3) 

devise, implement, and maintain policies and procedures designed to ensure future compliance 

with the relevant provisions of the Exchange Act. The SEC also published a report pursuant to 

Section 21(a) of the Exchange Act concerning the results of its investigation of violations of law 

in connection with the distribution of GSE securities. 

Aftermath. The events described above have triggered a thorough examination of various 

aspects of the government securities market. Since August 1991, the Treasury has made 

important changes in its auction rules and other policy changes under its existing regulatory 

authority, as described below. This report recommends or implements a number of additional 

measures. The goal of all of these initiatives is to protect and improve the integrity and efficiency 

of the government securities market. 

II. Treasury Securities Market Issues 

Enforcement of auction rules 

The Salomon episode pointed out the need for more effective enforcement of auction 

rules.8

 The Agencies agree that legislation is desirable to strengthen auction rule enforcement 

and to enhance private sector oversight of auction practices. Moreover, since August 1991, the 

Treasury has taken a number of important steps to enhance rule enforcement, including large 

bidder certification and tighter enforcement of rules governing noncompetitive bidding. 

Misleading statements to issuers. The Agencies support legislation that would make it 

an explicit violation of the Exchange Act to submit false or misleading written statements to an 

issuer of government securities in connection with the primary issuance of securities. Such 

legislation would re-emphasize the applicability of the existing antifraud provisions of the 

federal securities laws to the government securities market. It would also serve to reaffirm the 

seriousness with which this matter is taken by the government by serving notice on participants 

in Treasury auctions and on purchasers of securities from federal agencies, as well as on

members of the selling groups of GSEs, that the SEC and other regulatory agencies will 

undertake investigations of, and enforcement actions against, those who make misleading written 

statements. 

 8 Treasury's remedy for breaches of its rules is to exclude the bidder from Treasury auctions. In addition,

persons who commit fraud in the context of a Treasury auction remain subject to potential civil and criminal actions

under Section 10(b) of the Exchange Act and Rule lOb-5 thereunder, the general antifraud proscriptions, as well as 

possible criminal actions under 18 U.S.C. §§ 1001 and 1005.

6 
Such a provision would also reaffirm management's responsibility to supervise the 

conduct of government securities market participants to ensure compliance with high ethical 

standards. The recommended statutory provision would therefore foster compliance by 

government securities brokers and dealers with the general antifraud provisions of the federal 

securities laws.9

The Treasury is developing written certification requirements for dealers, depository 

institutions, and others, including customers, who purchase securities in Treasury auctions. 

These written certifications, in conjunction with the proposed statutory provision, will provide an 

additional mechanism for enforcing Treasury auction rules. 

Spot checks and large bidder certification. In August 1991, the FRBNY (which 

receives almost all large bids) began making spot checks by contacting customers of primary 

dealers to verify the legitimacy of large winning bids submitted for customer accounts. In 

addition, the Treasury and the FRBNY are implementing a more formal system to require 

customers who make large winning bids through dealers or depository institutions to. verify their 

bids in writing to the Federal Reserve prior to the settlement date. While no verification system

is totally foolproof, it would now be extremely difficult for a firm to evade the 35 percent 

limitation by submitting large, unauthorized "customer" bids. While it is recognized that the new 

certification requirement will impose an additional regulatory burden, the Treasury and the 

FRBNY are implementing this requirement with a view to minimizing that burden. 

The new verification system will work as follows: 

1. All customers receiving awards of over $500 million will be required to confirm their bid 

to the Federal Reserve via facsimile on the bidder's letterhead. The deadline for 

confirmation will be 10:00 a.m. on the business day following the auction. 

2. The Federal Reserve will continue to spot check large bids both above and below the 

$500 million level by contacting bidders directly by telephone. 

3. When a customer award of over $500 million is made through a dealer that was awarded 

over 25 percent of an auction for its own account, Federal Reserve personnel will call the 

customer directly to seek additional confirmation. To preserve the confidentiality of the 

dealer's award, this call will be presented as part of the Federal Reserve's existing 

program of spot checking large bids. The size of the dealer's bid will not be discussed

with the customer. 

 9 Such a provision would not affect existing sanctions, such as penalties for false statements provided by 18 

D.S.C. §§ 1001 and 1005 and the general antifraud and recordkeeping provisions set forth in the Exchange Act. 

7 
4. Failure of a customer to confirm a bid in a timely manner will mean that the dealer will 

be held responsible to make good on the bid, unless doing so would cause a violation of 

the 35 percent rule, in which case the Treasury will reduce the size of the issue 

accordingly. Any failure to confirm will cause an investigation by the appropriate 

regulatory authorities. 

Noncompetitive abuses. The Treasury permits noncompetitive bids of up to $1 million 

for bills and $5 million for notes and bonds. Unlike competitive bidders, who receive the yield 

they actually bid, all noncompetitive bidders get the average yield. The Treasury permits 

noncompetitive bidding in order to make it easier for smaller, less sophisticated bidders to bid in

Treasury auctions. At the same time, it is necessary to maintain a large pool of competitive 

bidders to determine a price in the auction that accurately reflects market demand. 

Abuses of the Treasury's noncompetitive bidding rules have recently come to light, both 

before and after the industry-wide investigations triggered by the Salomon episode. These abuses 

generally involved dealers skirting these rules by effectively arranging to purchase for their own 

account large amounts of securities at the price paid by noncompetitive bidders. The pattern of 

abuse had been for a list of individuals - often employees of the firm - all to bid the maximum

noncompetitive amount and then sell their positions to the firm very shortly after the auction. In 

the Treasury's view, practices of this nature are not in keeping with the purpose of the 

noncompetitive bidding rules. 

As a result of these abuses, the Treasury and the Federal Reserve banks are now engaging 

in more aggressive policing of noncompetitive bids. The Federal Reserve banks are responsible 

for the first level of review and for submitting all questionable bids to the Treasury's Bureau of

the Public Debt. The Treasury pays particular attention to bidders who place large 

noncompetitive bids in auctions on a regular basis. In addition, the Treasury and the Federal 

Reserve are developing a mechanism for interdistrict policing of noncompetitive bids. The 

centralization of information that this requires will become easier as progress is made on auction 

automation. In cases of clear abuse, the Treasury will take appropriate measures, including 

referral of cases involving suspected fraud to the SEC for enforcement action. 

Uniform Offering Circular. Simultaneously with the issuance of this report, the 

Treasury is releasing for publication in the Federal Register for comment a uniform offering 

circular for marketable Treasury securities. The offering circular contains auction rules, 

including the new large bidder certification requirements, the existing 35 percent limitation, and 

the definition of a "single bidder." This effort by the Treasury to formalize the rules with input 

from market participants and other interested parties should result in rules that are more easily 

accessible and more readily understood. 

8 
Short Squeezes and Reopenings 

How short squeezes arise. Market shortages of recently issued Treasury securities arise 

from time to time. Such shortages are usually temporary and relatively mild and are corrected 

quickly through market forces. In rare cases, they can be acute and protracted. In these instances, 

market forces fail to relieve the squeeze, and questions of market manipulation may arise. 

Most market shortages appear to be a natural, temporary by-product of the way in which 

the Treasury distributes its securities.10 Before a security is auctioned, dealers often sell the 

security short to customers (or other dealers) in the when-issued market, with the expectation of 

covering short positions by subsequent purchases - either in the when-issued market, the auction, 

or the aftermarket. This process benefits the Treasury by serving a price discovery function and 

by stretching out the actual distribution period for each issue, thereby allowing the market more 

time to absorb large issues without disruption. 

When-issued trading in Treasury securities functions somewhat like trading in a futures 

market, in which positions may be taken and covered many times before the actual settlement 

date. In addition, the when-issued Treasury security displaces the most recently issued Treasury 

security as the benchmark, "on-the-run" issue in the cash market. In many auctions, the estimated 

aggregate size of outstanding positions in the when-issued market substantially exceeds the 

quantity of securities to be sold at that auction at some point between the date of announcement 

of the auction and the date on which the securities are delivered. Those positions can be taken 

more cheaply and potentially in greater size (due to the lack of a delivery requirement) during the 

when-issued period than in subsequent trading. 

Market forces ordinarily reduce the size of outstanding positions in the when-issued 

market as the issue date approaches. However, the leverage, liquidity, and volume of trading in 

the when-issued market can cause market participants to overestimate their ability to cover short 

positions prior to settlement. Nevertheless, when-issued trading contributes to the smooth, lowcost distribution of the federal debt, and it should not be discouraged. Solutions to the potential 

for shortages should be found that do not impede when-issued trading. 

Dealers sometimes carry large net short positions in a new Treasury issue immediately 

prior to the auction. In some cases, holders of short positions find that they cannot acquire the 

issue to deliver, either in the auction or in the secondary market, at the price anticipated. Instead, 

dealers may turn to the financing market after the settlement date, where they borrow the security 

for delivery in a "reverse repo" transaction. When a material shortage develops, the price of the 

security becomes noticeably higher than Treasury issues of similar maturity, and the cost of 

borrowing the particular security in the repo market becomes higher. 

 10 See Appendix A for a discussion of when-issued trading and the repo market. 

9 
Market shortages can develop in a number of ways. Short sellers may simply misgauge 

market demand because, for example, other market participants do not follow usual trading 

strategies or anticipated monetary policy actions are not forthcoming. As a general matter, 

temporary shortages that arise as a consequence of day-to-day trading - and not as a consequence 

of deliberate manipulation - do not represent a material flaw in the marketplace. These shortages 

arise from decisions by sophisticated market participants to establish short positions and are 

generally relieved by natural market processes within a short time. Such shortages are an 

inherent risk in the price discovery process. 

Market developments following the April and May 1991 two-year note auctions 

demonstrated the potential for acute, protracted squeezes in Treasury issues, despite the huge 

size of these issues. In fact, a market squeeze that resulted in large losses for some dealers had 

occurred five years previously in connection with the 30-year bond issued in February 1986.11

However, in the five years since the 1986 squeeze, there had been no demonstrated instances of 

such protracted, aggravated squeezes. 

In contrast to temporary shortages, an acute, protracted shortage. can cause lasting 

damage to the marketplace, especially if market participants attribute the shortage to market 

manipulation. Dealers may be more reluctant to establish short positions in the future, which 

could reduce liquidity and make it marginally more difficult for the Treasury to distribute its 

securities without disruption. Moreover, some market participants may perceive that a protracted 

squeeze is the product of a scheme by those who benefitted from it. Market manipulation - or 

even the perception of it - can undermine the integrity of the marketplace, cause participants to 

withdraw, and produce higher costs for the taxpayer. 

The Agencies agree that changes in government policy are needed to deal with acute, 

protracted squeezes in Treasury issues. The Agencies believe that the best course is to address 

the problem of short squeezes through changes to the Treasury's debt management practices - in 

particular" through a new policy of reopening Treasury issues whenever such squeezes occur. 

The proposed changes in auction technique, discussed below, may also prove helpful in 

mitigating the short squeeze problem. 

Reopenings. The Treasury has the ability to break a squeeze by issuing more of the 

particular security that is the subject of a squeeze - by "reopening" the issue. In a reopening, the 

Treasury would simply offer an additional amount of an outstanding issue. By sufficiently 

increasing the supply of the security, the Treasury can eliminate any shortage. 

The Treasury actively considered this option as a way of alleviating the squeeze in the 

May two-year note. The Treasury decided against this course - and has traditionally been 

 11 These dealers had sold this bond short as part of a trading strategy that had worked in the past as they

prepared to bid for a new 30-year bond in May 1986. However, the trading strategy did not work as expected, 

apparently because some institutional investors did not make the February 30-year securities available to the repo

market.

10 
reluctant to reopen securities issues outside of its normal financing schedule - for three distinct 

reasons. First is the concern that a policy of reopening securities might cause market participants 

to demand a higher yield on securities at auction, given the greater uncertainty about the eventual 

supply of the security. Second, the Treasury could be subjected to frequent calls for reopening. 

Since some issues would be reopened and others not, the Treasury would inevitably be accused 

of favoring one group of market participants over another. Third, the Treasury plans its 

borrowing schedule well in advance, based on the schedule of maturing issues and on projections 

of the government's cash needs. The unscheduled reopening of a security would_ by definition, 

produce excess cash and disrupt the Treasury's cash management planning. . 

The Treasury has concluded that, while a reopening policy could be difficult to 

implement, it is justified under certain circumstances. Uncertainty about the potential damage 

from acute, protracted shortages may weigh more heavily on the market than the concern that the 

Treasury might issue an additional amount of a relatively high-priced security. Moreover, 

adoption of a policy of reopening issues whenever an acute, protracted squeeze occurs would 

tend to discourage market participants from attempting to generate a squeeze. 

The Agencies support this initiative and believe that a policy of reopenings should be 

effective in addressing the problem of acute, protracted market shortages. 

Therefore, under this new approach, the Treasury will be prepared to provide the 

market with additional supply of any security that is the subject of an acute, protracted 

shortage. The Treasury will not require evidence of manipulation in deciding whether to 

reopen a particular issue, but instead will reopen any issue that, in its judgment, is the 

subject of such a shortage. 

Once a decision to reopen has been made, there are a number of ways in which an issue 

may be reopened.12 First, the Treasury may immediately auction an amount sufficient to 

eliminate any possibility that a squeeze could persist. The amount auctioned would depend upon 

all the facts and circumstances, but could be in the $1-5 billion range. 

Second, the Treasury could sell additional amounts of a security in a "tap" issue managed 

by the FRBNY. A tap issue would involve an incremental offering of securities by the Federal 

Reserve, acting as the Treasury's agent. The securities could be sold as market conditions 

warranted, or the market could be given notice that, at a given spread off the yield curve, the 

authorities stand ready to supply additional amounts in response to market demand. 

A third option that merits further study, but that would require legislation, would be for 

the Treasury to make additional supply of the securities temporarily available through securities 

lending, using the Federal Reserve as agent. The advantage of this approach is that 

 12 Potential ways of creating additional supply of an issue are discussed in detail in Appendix B. 

11 
it is a temporary response to a temporary market imbalance, and would be neutral from the 

standpoint of the Treasury's debt management - that is, it would not permanently affect the 

Treasury's cash balance or the amount of outstanding debt. 

The Treasury intends to select the appropriate reopening method on a case-by-case basis, 

and will consider the views of market participants and others concerning the relative merits of

alternative means of reopening issues. As experience grows with approaches to reopenings, the 

Treasury may modify them or develop new ones. 

Other measures to address short squeezes. There is a wide range of additional 

remedial initiatives that could be implemented to address the problem of acute, protracted market 

shortages. One possible solution would be to establish a new regulatory regime, using regulatory 

tools that have proved useful in the equity and derivative markets, such as enhanced position 

reporting and improved audit trails. Position limits in newly issued government securities could 

also be imposed. 

Such regulatory measures could be effective in deterring or alleviating short squeezes. 

However, such initiatives could also raise taxpayer costs by imposing possibly unnecessary 

regulatory burdens. Given the relative rarity of acute, protracted short squeezes, the ability to 

identify them from easily observable market price distortions, and the need to proceed 

judiciously in this marketplace, the Agencies agree that the reopening policy should be 

implemented and tested before regulatory measures designed to achieve the same ends are 

adopted. 

Treasury Auction Issues 

Background. In order to fulfill its duty to U.S. taxpayers, the Treasury must seek to 

obtain financing for the U.S. Government at the lowest possible cost. That goal is well served by 

minimizing the potential for manipulative and collusive behavior in the marketplace. 

In general, the Treasury believes that the current "multiple-price, sealed-bid" auction 

technique has worked well, with an active when-issued market and significant customer 

participation.

13 However, this technique, in which each successful bidder's award is made at the 

yield the participant actually bid, has been criticized by some for failing to minimize financing 

costs to the Treasury, as well as for encouraging manipulative behavior in the marketplace. 

In part as a result of the incidents described above, some have perceived that auctions can 

be manipulated, that collusive behavior is possible, and that insiders have an unfair advantage 

over other participants. Other factors that may have contributed to this perception 

 13 See Appendix B for a detailed discussion of Treasury's auction technique and various other possible auction

techniques. 

12 
include Treasury's auction rules and the auction technique itself, the information advantage 

historically possessed by the primary dealers, the lack of automation in the auction process, and 

the historical relative lack of publicly available transaction quotations. 

Some commentators have argued that the current multiple-price Treasury auction 

technique in effect forces bidders to bid through primary dealers to avoid placing bids at a level 

above the market consensus. As a result, these commentators argue, the primary dealers gain an 

information advantage due to their exclusive knowledge of the intentions of the large bidders. 

Moreover, until recently, only primary dealers and depository institutions could submit bids for 

customers, which further strengthened the market power of primary dealers by fostering the 

perception of an information advantage. 

The lack of automation in the auction process may also create an appearance that market 

insiders have an advantage over others. Under the current system, bidders submit bids manually 

at their local Federal Reserve bank. In practice, most of the large primary dealers station 

employees for this purpose in the lobby of the FRBNY. These employees receive last minute 

telephone instructions and then fill in and submit the bid sheets by hand. This system presents a 

logistical hurdle for bidders who might wish to bid directly rather than through a primary dealer. 

Steps have been taken or will be taken to address each of these concerns. 

Automation. As noted above, Treasury auctions rely to a large extent on a paper based, 

manual system for bidding and auction administration. Greater use of automation will make the 

auction process faster and more efficient, result in fewer errors, facilitate broader participation, 

and assist in monitoring of compliance with auction rules. It also will enable the Treasury to 

experiment more easily with different types of auction techniques. 

The delay between the submission of bids and the announcement of results inherent in a 

paper-based system may have an adverse impact on bidding, because bidders do not know for a 

period of time whether their bids have been successful. As a result, automation may also have the 

effect of encouraging more aggressive bidding, to the benefit of the taxpayer. 

In view of these expected benefits, the Treasury and the Federal Reserve have made the 

completion of a system to permit automated bidding a high priority. A project is nearing 

completion at the Federal Reserve Bank of Kansas City that will allow medium-sized and 

smaller bidders to submit bids to the Federal Reserve banks electronically. This project is 

expected to be completed by the second quarter of 1992. 

There is also a project under way at the FRBNY that will permit electronic bidding by 

large bidders. This project, which was under way before the Salomon events were disclosed, has 

already made substantial progress and is scheduled for completion by the end of 1992. The 

resulting system will be able to handle the multiple-price, sealed-bid auction technique currently 

in use or a uniform-price, sealed-bid auction. It is expected that it will also be 

13 
possible to implement the new open auction technique discussed below by early 1993, if the 

Treasury determines to do so. 

Auction technique. Because Treasury auctions are not automated, it has been impossible 

to place all potential competitive bidders in Treasury auctions in direct communication at the 

same time. As a result, the Treasury has used a sealed-bid auction, rather than an "open" auction 

in which bidding is public and competing bidders can respond. 

In addition, different bidders currently pay different prices for the same security, based on 

their bids. These multiple-price awards result in what economists refer to as the "winner's curse"

- the highest bidder "wins" the auction by paying the highest price, only to find that the price 

paid is higher than the consensus price, as reflected in the market. Because bidders are aware of 

this" curse," they tend to shade their bids below the maximum they are actually willing to pay. 

The other type of sealed-bid auction that some commentators have argued would produce 

superior results for the Treasury is the uniform-price, sealed-bid auction, sometimes called a 

"Dutch auction." In this type of auction, all bidders whose tenders are accepted pay the same

price for a given security. This price is the lowest of the accepted prices bid (or highest of the 

accepted yields). As a result, some of the bidders whose tenders are accepted pay a lower price 

than they actually bid. At first glance, this approach might appear to produce lower revenue, 

because money appears to be "left on the table." On the other hand, participants in a uniformprice, sealed-bid auction can be expected to bid higher prices than they would in a multipleprice, sealed-bid auction, since there is no "winner's curse" - that is, they do not run the risk of 

paying a higher price than others whose tenders are accepted. The expected revenue effects of 

uniform-price auction versus current practice thus turn on the following empirical question: Is 

the revenue generated from increased demand in uniform-price, sealed-bid auctions greater than 

the revenue that is apparently forgone due to the difference between prices 'bid and prices paid?

Aside from revenue considerations, a perceived advantage of a uniform-price, sealed-bid 

auction is that it would eliminate much of the need for pooling information to gauge the market 

consensus. Thus, the incentive for bidding through dealers would be lessened. It is argued that 

this could broaden auction participation and encourage a wider range of investors to bid directly 

for their own account rather than through primary dealers. This should naturally lead to less 

concentration of ownership of securities awarded at auction. 

During 1973 and 1974, the Treasury conducted six uniform-price, sealed-bid auctions. 

The results of this experiment were inconclusive. In the August 1973 uniform-price auction of 

20-year bonds, tenders received from the public were not sufficient to sell the entire issue. 

However, the failure of this auction appears to have been unrelated to the auction technique. 

Open auction alternative. Irrespective of whether the single-price, sealed-bid auction 

would prove superior to the current practice, the Agencies believe that there is an 

14 
auction technique that may be superior to both types of sealed-bid auction techniques discussed 

above. This is an ascending-price, open auction system, which will be feasible for the first time

once the auctions are automated. Auction theory suggests that, in general, Treasury revenue 

would not suffer, and indeed might increase, in the switch to an open, ascending-price system. 

In this type of auction, registered dealers and other major market participants would have 

terminals that are connected by telephone line (with appropriate security) to a central computer.14

The auction would begin with the Treasury announcing an opening yield somewhat above the 

yield at which the security is quoted in when-issued trading. All interested parties would then 

immediately submit tenders electronically for the quantity of securities they would be willing to 

purchase at that yield. 

Once all bids were submitted, the resulting total volume of bids at this high yield would 

be announced; presumably, the issue would be oversubscribed after the first round since the yield 

quoted would be higher than the when-issued yield. The yield would then be reduced, perhaps by 

one basis point, and the bidding process repeated. Bidding would proceed in successive rounds - 

perhaps at 10 minute intervals - with decreasing yields until the volume demanded was smaller 

than the size of the issue. All participants who bid at that closing yield would receive awards, but 

at the next higher yield. Those who bid in the next-to-last round but did not bid at the last round 

would receive prorated awards at the same yield. 

From the viewpoint of a bidder, this decreasing sequence of yields lessens the risk to 

participants of bidding too Iowa yield for the securities. Even if an investor had a much higher 

valuation of the securities than other bidders, the bidding would stop before the yield moved 

downward very far as other bidders dropped out of the bidding. The open nature of the bidding, 

along with the single price outcome, should eliminate the "winner's curse." Further, the public 

exposure of the volume of bids provides information about other bidders' valuation of the 

securities, perhaps augmenting overall demand. 

An open auction system allows participants to react to surprise bids, turning market 

forces against attempts at market manipulation. Entities attempting to comer this type of auction 

are effectively forced to disclose their intentions to their competitors, as they continually bid as 

the Treasury lowers the yield. This allows those not party to the attempted market manipulation - 

particularly those holding short positions from when-issued trading to bid along with those who 

are trying to comer the issue. Hence, the would-be market manipulators may fail to comer the 

security or, at the least, find it a more expensive proposition. 

 14 Those not pre-registered could appear at their local Federal Reserve bank with sufficient documentation and 

acceptable payment arrangements to be included in the auction through a computer hookup provided at the bank. 

15 
By contrast, in a sealed-bid auction - of either the multiple- or single-price variety the 

price reaction comes at the announcement of surprising awards, when dealers may realize that 

they are caught short and react. In a real-time, open auction, that reaction occurs when the 

bidding is still open, and thus the Treasury garners part of the profits of any attempted comer. 

The Agencies believe that this type of auction, in combination with other 

recommendations of this report, has the potential for reducing the incentives for market 

participants to engage in manipulation, and would also provide assurances to market participants 

that they are not seriously disadvantaged in participating in Treasury auctions. The Treasury will 

be discussing this form of auction with market participants, academic experts, and others, and it 

welcomes the views of all interested parties. 

Auction rule changes. The Treasury has made several important changes in auction rules

and practices. 

First, on October 25, the Treasury announced changes in its auction rules' that eliminated 

any distinctions in those rules with regard to primary dealers. The Treasury announced that all 

government securities brokers and dealers registered with the SEC would be eligible to submit 

bids for customers in Treasury auctions. Previously, only primary dealers and depository 

institutions were accorded this privilege. In addition, the Treasury announced the establishment 

of a payment mechanism by which any competitive bidder would be able to bid without making 

a deposit at a Federal Reserve bank or having an explicit payment guarantee.15 Prior to this 

change, only primary dealers and depository institutions could bid without a deposit or a 

guarantee in coupon auctions, and only responsible, recognized dealers and depository 

institutions could do so in bill auctions. 

Second, the Treasury has increased to $5 million from $1 million the maximum award to 

any single noncompetitive bidder in auctions of Treasury notes and bonds. This change is 

 15 Treasury, in conjunction with the Federal Reserve, has developed a standard "autocharge" agreement that

permits auction participants without a funds account at a Federal Reserve bank to pay for securities purchased at

auction. An autocharge agreement is a written arrangement by a bidder and a depository institution. This 

agreement, which is filed with the appropriate Federal Reserve bank, authorizes the Federal Reserve bank to charge

the depository institution's funds account on the issue date for securities purchased by the bidder. 

Autocharge agreements may be rescinded by the clearing bank up to 24 hours before settlement. Thus, risk 

exists from auction date until 24 hours before settlement that a successful bidder may become unable to pay 

Treasury for its auction purchases. Such an event would simply mean that Treasury would sell less of a

particular issue. 

As discussed below, the Agencies are analyzing whether Government Securities Clearing Corporation, a 

registered clearing agency that offers an efficient, automated clearance and settlement system, can alleviate this 

concern. 

16 
designed to encourage direct noncompetitive bidding by the smaller institutional investors in the 

government securities market. 

Third, effective with the November 1991 quarterly refunding, the Treasury now publicly 

releases data on quarterly borrowing needs two days prior to each quarterly refunding

announcement and before the meeting of the Treasury Borrowing Advisory Committee. 

Previously, this information had been released at the time of the announcement of the securities 

to be offered in the refunding. As a result of this change, the Borrowing Advisory Committee no 

longer receives any information about Treasury's borrowing needs that has not already been 

made public. 

The Treasury has considered other potential rule changes, but has decided that they are 

not currently necessary or appropriate. For example, no further changes are being made at this 

time to the 35 percent rule. The Treasury believes that this rule places an appropriate limit on 

auction awards. 

The Treasury is not imposing any limitation on the combined amount awarded to a dealer 

and the customers for whom the dealer has placed bids. Such a limitation would discourage 

aggressive bidding and raise the Treasury's financing costs without providing a compensating 

benefit. It would also force a dealer that plans to make a large bid or receives an unusually high 

level of customer bids to advise customers to take their auction business elsewhere. If the dealer 

did not do this, the customers might find that their auction awards were reduced. Customers 

should have the right to, place bids in the auction with the assistance of the dealer they prefer, 

without having to worry about rationing problems due to the dealer's auction participation for its 

own account or the account of other customers. 

The Treasury also will not compel large bidders to place bids directly, rather than going 

through a dealer. Large bidders have always had the option of placing bids directly. The 

Treasury does not believe it is appropriate to deny large bidders the advice and other services 

that a firm specializing in the government securities market can provide. 

The Primary Dealer System 

The primary dealer system was created (and is administered) by the Federal Reserve to 

assist it in implementing monetary policy. However, the system has also served the Treasury's 

crucial interest in financing the nation's deficit spending. 

In order to implement monetary policy, the Federal Reserve buys and sells government 

securities in the secondary market. The Federal Reserve determines the dealers with which it will 

trade, and these dealers, currently 38 in number, are called primary dealers. The FRBNY requires

these dealers to meet certain criteria. Of course, each of the primary dealers is subject to 

comprehensive regulatory oversight by the appropriate regulatory agency - generally, the SEC. 

309-597 0 - 92 - 2 QL 3 

17 
The Treasury does not determine which dealers can be primary dealers, and it does not 

set any criteria for this designation. However, the Treasury believes that the government 

securities market, and hence the Treasury, have benefitted from the primary dealer system. The 

FRBNY has required that the primary dealers make markets in all maturity sectors of Treasury 

securities, and that each primary dealer's share of customer trading volume must equal at least 

one percent of total secondary market volume. The FRBNY also expects primary dealers to 

demonstrate their continued commitment to the market for Treasury securities by bidding 

meaningfully in all Treasury auctions. If a dealer fails to bid meaningfully in an auction, the 

FRBNY typically contacts that dealer to remind it of its so-called "underwriting" responsibilities. 

The Treasury believes that the existence of a group of dealers with a commitment to the 

government securities market has been of great benefit to the Treasury. The dealers' underwriting 

responsibilities have served to "backstop" Treasury auctions, considerably reducing the risk of 

insufficient auction cover. This consideration perhaps receives less weight when market 

conditions are strong, but Treasury financing requirements are unrelenting and necessitate sales 

in uncertain or weak markets as well. The willingness of the primary dealers to assume

underwriting risk for the Treasury has served to ensure that, within yield levels reasonably 

related to current market quotations and trading experience, enough bids are received to sell all 

Treasury security offerings. 

Primary dealers routinely serve as intermediaries between the Treasury and ultimate 

investors. Since these dealers are in the business of developing customer business and meeting 

customer needs, competition for customer business is intense. This competition has served to 

broaden the market for Treasury debt. It has helped the Treasury to sell large amounts of debt 

quickly, with the knowledge that dealers will work to distribute securities to ultimate buyers. 

The relationship between the Federal Reserve and the primary dealers is purely a business 

relationship, and not a regulatory one. The FRBNY has required that primary dealers submit 

reports to it and permit FRBNY staff to inspect their operations and books and records. 

However, the FRBNY has imposed these requirements primarily in order to assure itself that the 

primary dealers meet the established requirements for primary dealership, and without any view 

to regulating or taking responsibility for the overall conduct of the primary dealers. 

Recent developments affecting primary dealers. The primary dealer system has 

evolved over time, in ways that have significantly reduced the advantages that primary dealers 

have in the government securities market. 

For example, there has been a growing consensus that the information to which primary 

dealers have access through the interdealer broker screens should be more widely available. One 

interdealer broker - Cantor Fitzgerald - has long made its screens available through Telerate. And 

beginning on June 16, 1991, information on pricing and trading 

18 
volume from the screens of five of the other interdealer brokers became available for the first 

time through GOVPX, a private joint venture. The Agencies support increased availability of 

information in this marketplace, and believe that, one way or another, more information will 

become available over time. As a result, the information advantage of the primary dealers over 

other market participants can be expected to continue to decline. 

The proposed change to an automated, open auction system may also serve to lessen the 

Treasury's reliance on primary dealers to distribute Treasury securities, if the new auction 

technique results in broader direct participation in the competitive auction process. Any 

information advantage that the primary dealers retain would be considerably less significant in a 

single-price, open auction. 

The creation of the Government Securities Clearing Corporation ("GSCC"), which 

registered with the SEC in 1988 and commenced netting operations on July 7, 1989, has made 

the government securities market even more efficient. The counterparty risk reduction that 

netting provides has led four interdealer brokers to broaden their customer lists beyond primary 

and aspiring primary dealers for the first time, to include potentially all netting members of 

GSCC, some of which are not primary dealers.16 As the group of dealers that are netting 

members broadens, the privilege of trading through the interdealer brokers - a privilege which is 

the product of private business decisions, not government regulation - will no longer be limited 

to primary dealers. 

Another development that changed the special status of primary dealers occurred on 

October 25, when the Treasury announced the changes in its auction rules discussed above that 

eliminated the remaining distinctions that favored primary dealers. 

Additional changes in the primary dealer system. The Treasury and the Federal 

Reserve believe that the primary dealer system has served the nation well for many years, but 

recognize that there also have- been drawbacks. Notably, there may be a mistaken public 

impression that, by setting and maintaining certain standards for its primary dealer relationships, 

the Federal Reserve is in effect the regulator of the primary dealer firms. Moreover, the primary 

dealer designation has been viewed as conferring a special status on these firms that carries with 

it an element of "franchise value" for the dealer operation and possibly for other aspects of the 

firm's standing in the marketplace. Given these concerns, and given the near-term prospect of 

automation of Treasury auctions and Federal Reserve open market operations, it has become

both feasible and appropriate for the Federal Reserve to amend its dealer selection criteria to 

provide for a more open system of trading relationships. The Federal Reserve still plans to 

exercise the discretion that any responsible market participant would demand to assure itself of 

creditworthy counterparties who are prepared to serve its needs. 

 16 Cantor Fitzgerald has permitted trading access for customers that are not primary dealers for a number of 

years. 

19 
One feature of the amended criteria is that existing as well as new primary dealers will no 

longer be required to maintain a one percent share of the total customer activity reported by all 

primary dealers in the aggregate. 

All primary dealers will continue to be expected to (1) make reasonably good markets to 

the FRBNY's trading desk; (2) participate meaningfully in Treasury auctions; and (3) provide the 

trading desk with market information and commentary. 

New primary dealers must be commercial banking organizations subject to official 

supervision by U.S. federal bank supervisors or broker-dealers registered with the SEC. The 

dealer fll1I1s and the entities controlling the dealer fll1I1s must meet certain minimum capital 

standards (these are spelled out in the appended FRBNY statement on Administration of 

Relationships with Primary Dealers; see Appendix E). 

For the time being, the number of additional primary dealers will be relatively limited by 

resource constraints on the FRBNY's trading desk operations. Following the implementation of 

automated trading, further expansion in the number of primary dealers will be feasible. 

While continuing to seek creditworthy counterparties, and while enhancing its market 

surveillance capabilities, the FRBNY plans to discontinue the "dealer surveillance" now 

exercised over primary dealers through the monitoring of specific Federal Reserve standards and 

through regular on-site inspection visits. The FRBNY will expect to receive periodic reports on 

the capital adequacy of primary dealers, just as any other responsible market participant should 

expect to receive such reports. 

Primary dealer firms that are convicted of felonies under U.S. law or that plead guilty or 

nolo contendere to felony charges relating directly or indirectly to their business with the Federal 

Reserve will be subject to suspension as primary dealers. 

Taken together, these changes are designed to facilitate an orderly and gradual move to a 

more open system of primary dealer relationships with the FRBNY, while preserving beneficial 

characteristics of the current system. Over time, the implementation of automated systems for 

Treasury auctions and Federal Reserve open market operations may well provide the room for 

still further changes. However, the desirability of further changes will have to be evaluated 

against the experience with these changes and the need to preserve both the efficiency and 

flexibility of Federal Reserve monetary policy operations, and the liquidity and efficiency of the 

market for U.S. government securities. 

Other Regulatory Issues 

Large position reporting. When market problems such as short squeezes occur, the 

Treasury and the FRBNY rely on major market participants for information concerning market 

developments. While the Treasury and the FRBNY believe that major market 

20 
participants will continue to provide such information, the Treasury, the FRBNY, and the SEC 

believe that backup legal authority for the government to compel disclosure of certain 

information is appropriate given the changes that are taking place in the government securities 

market. These changes include the evolution of the primary dealer system and the growing 

presence of a new set of large, relatively unregulated participants in the market - a group 

commonly called “hedge funds.” 

The Agencies believe that other measures announced in this report, including particularly 

the change in Treasury's reopening policy and potential changes in its auction technique, make 

acute, protracted short squeezes far less likely to occur in the future. The Agencies also believe

that the new reopening policy will probably make it unnecessary to impose a system of large 

position reporting on the marketplace. However, the Treasury, the FRBNY, and the SEC believe 

that legislation should be enacted to clarify and broaden Treasury's rulemaking authority under 

the GSA to authorize the Treasury to make rules requiring holders of large positions in Treasury 

securities, including when-issued positions, to report this information to the regulatory 

authorities.17 Such rulemaking authority would only be used if market problems persisted despite 

the other actions being taken. 

Unlike section 13(d) of the Exchange Act, which requires beneficial owners of more than 

5 percent of a corporation's equity to make a public disclosure of this information, any position 

reporting concerning Treasury securities would not be publicly disclosed. There is no intention to 

force market participants to disclose their trading strategies, and there would not be a 

presumption that the mere fact of holding a large position is evidence of manipulative or other 

illegal intent. The purpose of such reporting, if necessary, would be similar to the purpose of the 

position reporting in the commodity futures markets - it would enable government agencies to 

monitor market developments and have early warning of potential problems. 

The Federal Reserve Board believes that large position reporting authority is 

unnecessary, particularly in light of the new policy on reopening securities issues. Once backup 

authority was granted, it might be difficult to resist activating that authority as a precautionary 

step. Large position reporting would impose costs on the marketplace and could cause some

investors intent on protecting the confidentiality of their investment strategies to move their 

business offshore or to limit their participation in this market, raising the cost of financing the 

federal debt and yielding little net gain in avoiding disruptions in this market. 

The Agencies believe that, if there is to be authority to require large position reporting, 

the Treasury is the appropriate agency to receive that authority. 

 17 The Agencies do not believe that reporting of large trades appears to provide a desirable means for interested 

government agencies to discover the causes of any market difficulties or pricing anomalies. 

21 
Surveillance and regulation. Adequate surveillance of the government securities market 

is necessary if regulators are to detect and address disorderly market conditions and 

manipulation. Timely and accurate information is essential to effective surveillance and 

regulation of the government securities market. Each of the Treasury, the SEC, the Federal 

Reserve Board, and the FRBNY has access to different types of information about the 

government securities market, and each has different abilities to require market participants to 

furnish information. Surveillance and regulation of the government securities market will 

therefore require a high level of cooperation among the responsible authorities. 

Some information about the government securities market is already being shared among 

the Agencies. For example, the FRBNY now prepares daily reports concerning significant 

market developments that are distributed to the SEC, the Treasury, the Federal Reserve Board, 

and the Commodity Futures Trading Commission ("CFTC"). These reports, which combine 

readily available market information with market-sensitive analyses, have improved the ability of 

the Agencies to monitor developments in the government securities market. 

The current level of information provides a helpful start, but more information must be 

shared among the Agencies over time to assure effective surveillance. To this end, the Agencies 

have formed a surveillance working group to determine what types of information are needed for 

surveillance purposes, to develop mechanisms for collecting and disseminating that information 

to all of the Agencies, and to coordinate surveillance systems and procedures covering the 

government securities market. 

The working group has been developing a framework for enhanced market surveillance 

for Treasury securities. Under this framework, the Agencies would develop a consensus on the 

types of data to be used in such a program, allocate responsibilities within the working group for 

surveillance and investigatory efforts, and establish parameters for inquiries and procedures to 

facilitate interagency information sharing and coordination. 

The basis for any market surveillance program is collection and analysis of a range of 

market data. The Agencies believe that it would be appropriate that this data collection and 

monitoring function be conducted in the first instance by the FRBNY, which currently performs

this function. The FRBNY would transmit this information promptly to the Federal Reserve 

Board, the SEC, and the Treasury. 

In order better to fulfill this responsibility, the FRBNY plans to expand its current market 

data collection program. At present, some market data on prices, yields, and trading volume are 

received directly from automated systems operated by vendors. In addition, the FRBNY collects 

market information through daily telephone surveys of primary dealer operations. Dealerspecific transaction and position information is obtained through a series of weekly and daily 

reports. 

22 
In order to enhance its surveillance capabilities, the FRBNY plans to review and expand 

these data sources and develop automated feeds of market data to run computer exception 

reports. In assessing additional data requirements, the Agencies recognize that the need for 

regular and detailed position and transaction data is lessened to the extent that reopenings are 

effective in discouraging acute, protracted price anomalies. Such data will be more useful in 

particular instances in which misconduct or manipulation may have occurred. 

The expanded program of data collection is likely to involve revisions to the reports that 

are currently submitted on a daily basis by primary dealers showing their gross long, gross short, 

and net positions in when-issued securities. These revisions could include: (1) expansion of the 

reporting period beyond the when-issued period up to the commencement of when-issued trading 

in the next security of the same initial maturity; (2) enhancement of information on related 

positions in options and forward contracts; and (3) information on related activity in the 

financing market. In addition, an effort will be made to capture relevant information on positions 

in Treasury futures.18 Of course, as additional experience is gained with the surveillance system

and as other recommendations in. this report are implemented, consideration may need to be 

given to modifying the reports, perhaps to include additional information such as aggregate 

customer positions. 

Such revisions cannot be implemented overnight. The working group must agree on the 

precise formats and reporting thresholds that will be utilized, and regulatory requirements for 

revised reporting programs must be satisfied. In addition, new automated systems to process this 

information must be developed. As a result, actual implementation of this new system is 

expected to take approximately one year. In the interim, therefore, the FRBNY will utilize 

existing reporting requirements, to the extent possible, in order to collect position and transaction 

information on an ad hoc basis to carry out surveillance inquiries into questionable market 

activity. 

Separately, the working group is developing a framework to ensure that surveillance 

operations and inquiries into suspicious market developments are conducted systematically. 

Reports on surveillance exceptions, investor complaints, and trading inquiries will be distributed 

among the working group members in agreed-upon formats on pre-determined schedules. Every 

effort will be made to ensure that all relevant information is shared among the Agencies, and that 

inquiries and investigations are thorough and well-documented prior to their resolution. In 

addition, senior staff of the Agencies will coordinate through regular meetings in order to keep 

track of significant market developments that might affect surveillance programs and any other 

related matters. 

Audit trails. Audit trails are the primary surveillance tools produced and used by selfregulatory organizations ("SROs") to detect manipulation or fraudulent or illegal trading in the 

equity and options markets, and for investigative purposes in disciplinary proceedings.

 18 This will permit increased surveillance by the SEC and CFTC for possible intermarket trading abuses 

involving the cash and futures markets in Treasury securities. 

23 
They are automated, time-sequenced records of information pertaining to trades in securities. 

This computerized information permits SROs to sift through voluminous trading data to detect 

potential trading abuses and provides time-sequenced information on transactions that may 

reveal intermarket abuses. The GSA did not grant authority to set up a similar audit trail system

for government securities transactions. 

Treasury and Federal Reserve position on audit trails. The Treasury and the Federal 

Reserve do not believe that a strong case has been made for an audit trail system to be imposed 

on the government securities market. Given that the government securities market is less 

vulnerable to the types of insider trading and other abuses that occur in the equities and 

derivatives markets, the Treasury and the Federal Reserve do not believe that it has been 

demonstrated that sufficient benefits would accrue to the SEC in its enforcement activities to 

outweigh the costs of establishing and maintaining an automated audit trail system. The Treasury 

and the Federal Reserve also believe that improvements in transparency in the government 

securities market and other measures discussed in this report designed to make significant short 

squeezes even less likely reduce the value of an automated audit trail. 

SEC position on audit trails. The SEC believes that audit trails would be a valuable tool 

in conducting surveillance of the government securities market and in enforcing the rules that 

govern the market's operation. At present, the SEC can only monitor unusual price or yield 

movements in Treasury securities through its market data and news retrieval systems, and 

through the summary market data provided by the FRBNY. As a result, the SEC's information 

regarding the government securities market is not comprehensive and is clearly inferior to the 

information that is available to the SEC and the SROs with respect to the equity and options 

markets. Indeed, the conduct of the SEC's investigation of Salomon was made more difficult by 

the absence of comprehensive audit trail data. 

The SEC recognizes that, because of the government securities market's unique 

characteristics, regulatory tools that are appropriate in other securities markets may need to be 

tailored to fit the government securities market, and that any regulatory measure proposed for the 

government securities market should be evaluated carefully on a cost/benefit basis prior to 

implementation. As a result, the SEC is not convinced that the full equity market audit trail need 

be replicated in the government securities market at this time. 

However, the SEC believes that an audit trail system for the government securities 

market would not need to be expensive or burdensome on market participants. In particular, the 

SEC believes that a partial audit trail could be constructed by combining transaction information 

from GSCC with price and volume information from GOVPX (and perhaps Cantor).19 Such a 

partial audit trail would not involve significant expense to market participants, and the process 

would be nearly invisible from their point of view. 

 19 GOVPX was not designed to provide regulators with the types of detailed, party-specific information

provided by audit trails in the stock and options markets. GOVPX is not an audit trail for regulatory purposes. 

24 
The SEC believes that creation of this sort of audit trail in the government securities 

market could provide significant benefits in terms of improved oversight and surveillance, and 

that there should be legislative authority for the SEC to effectuate an audit trail system. 

However, to the extent that trading in government securities becomes significantly more 

transparent, and given the Treasury's intention to reduce the potential for short squeezes by 

reopening Treasury issues when necessary, the SEC believes that the desirability for new 

legislative authority concerning audit trails would be reduced, but not eliminated. 

Internal controls. It is essential that firms conducting a government securities business 

maintain an effective system of internal controls and supervisory procedures. Recent events in 

the market, however, have cast doubt on the effectiveness of internal controls employed by 

certain government securities brokers and dealers. 

Existing SRO rules require each member to establish an internal supervisory system that 

includes a requirement that it maintain and enforce written procedures for conducting its 

business. Once legislation is enacted concerning misleading written statements to issuers of

government securities, SRO authority in this area would explicitly extend to Treasury auctions

and primary distributions of GSE securities. Enactment of this legislation would accomplish the 

desired extension to Treasury and GSE securities of requirements for appropriate written 

procedures to implement adequate internal controls. It would then be superfluous to enact 

additional legislation to mandate internal controls. 

Transparency. An important characteristic of fair and efficient markets is transparency, 

defined as the degree to which real-time trade and quotation information and other marketrelated information, such as information about the depth of the market, is available to all market 

participants.

Transparency is important for several reasons. Availability of market information serves 

the public interest because it ensures that a broad spectrum of market participants can obtain 

current, accurate information concerning market conditions, thus fostering the integrity, 

competitiveness, liquidity, and efficiency of the market. The derivative markets are also 

strengthened by the availability of timely and accurate information on the underlying securities 

used for pricing and hedging strategies. Further, access to accurate market information enhances

the ability of regulatory examiners and independent auditors to carry out their respective 

responsibilities to ensure that securities transactions and positions are priced appropriately. 

Finally, transparency enhances customer protection, since customers are in a better position to 

determine actual or potential prices for securities and to evaluate the fairness of trades. 

In a completely transparent market, all market participants have equal and immediate 

access to all firm quotations, including the size of those quotations, as well as reports of prices 

and volumes on all trades effected in the market. Of course, complete transparency represents a 

theoretical model that has not been achieved in any market. Of all securities 

25 
markets, the level of transparency is probably highest in the U.S. equity markets.20 In contrast, 

there is substantially less market data publicly available for U.S. debt markets, including the 

government securities market. 

Interdealer broker quotations and trade reports currently represent the best source for 

deriving market prices for government securities, because they include the current bids and 

offers of the primary and many other large active dealers, the principal market makers in the 

government securities market. The Agencies believe that all useful information on the screens of 

the interdealer brokers should be made available to the public, either through GOVPX or 

otherwise. 

Recent developments in transparency. Significant progress was made during 1991 in 

increasing information access in the government securities market. A private sector initiative - a 

joint venture known as GOVPX, Inc. - became operational on June 16, 1991. GOVPX 

disseminates real-time price and quotation information on all Treasury bills, notes, and bonds on 

a 24-hour, global basis. The system provides information regarding all trading of Treasury 

securities (other than zero-coupon instruments) that is executed through five interdealer brokers. 

The information disseminated is a composite picture of the trading activity, showing executed 

trade prices, volume of executed trades, best bids and best offers, and running aggregated 

volumes traded for each security on a daily basis. This information is provided to on-line vendors 

for distribution to the public. 

While GOVPX is a promising step, it has deficiencies. For example, it does not provide 

the size associated with published bids and offers; it does not allow users to capture the data or to 

apply financial analytical techniques; and it does not include information on stripped Treasury 

securities or on non-Treasury government securities. In addition, the Agencies recognize that 

even a greatly expanded GOVPX system has certain inherent limitations in its coverage of the 

Treasury market. GOVPX was not designed to cover all trading volume, only trading volume 

effected through contributing interdealer brokers.21 It does not report trading volume among 

primary dealers or between a primary dealer and a customer, such as a hedge fund, that is not 

effected through an interdealer broker. Thus, a substantial amount of market activity is not 

reflected in GOVPX reports. However, despite its limitations, GOVPX is an important step 

forward in bringing increased transparency to the Treasury market. 

 20 For a large percentage of equity securities traded in the United States, all current, sizable quotations are 

immediately disseminated to market data subscribers, and trade reports are required to be reported and disseminated 

within 90 seconds of execution, although the average is around 10 seconds. 

21 One of the major interdealer brokers, Cantor Fitzgerald, Inc. (“Cantor”) has made its price information 

available to the public through Telerate Systems, Inc. ("Telerate") since the early 1970s. Telerate disseminates to its 

customers the same information that Cantor disseminates to the dealers that trade through Cantor. While Cantor does

not report trades to GOVPX, and GOVPX is not available through Telerate, market participants who subscribe to 

both GOVPX and Telerate are able to obtain quotation information from all but one of the interdealer brokers. 

26 
In a letter to GOVPX's Board of Directors, dated October 25, 1991, the Treasury strongly 

encouraged GOVPX to address certain of these deficiencies and urged that all useful interdealer 

broker screen information be made available to the public as promptly as possible. 

Treasury and Federal Reserve position on transparency. The Treasury and the Federal 

Reserve believe that the transparency problem in the government securities market has been 

greatly alleviated, and that the private sector initiatives already under way should be allowed 

additional time to develop before any new rulemaking authority is deemed necessary. The two 

Agencies therefore support S.1247, which calls for a joint Treasury/SEC/Federal Reserve Board 

evaluation of private sector initiatives regarding the dissemination of price and volume 

information. 

The Treasury originally proposed that it be granted rulemaking authority in this area in 

order to ensure that private sector initiatives, such as GOVPX, continue to take further steps to 

disseminate government securities price and volume information. However, for now, the 

Treasury accepts the judgment of the Senate in passing S.1247 that adequate private sector 

solutions are likely to be found without the need for additional federal regulation. The 

commencement of operations by GOVPX in June was an important factor in Treasury's decision 

to support the Senate approach. The continued positive response of the industry in enhancing 

transparency will be an important determinant of whether the Treasury eventually comes to 

support additional regulatory authority in this area. 

SEC position on transparency. The SEC supports legislation providing it with backstop 

authority to adopt requirements for dissemination of data concerning transactions in government 

securities where private efforts, such as GOVPX, do not meet standards established in 

legislation. In order to enable the SEC to respond to structural shifts in the market, including 

either a consolidation of brokerage firms or a move to direct dealer to dealer trading, the SEC 

believes that the backstop authority should be broad and flexible. 

The SEC believes that markets are stronger and less susceptible to manipulation and 

unfair pricing when there is broad public access to real-time pricing information. Furthermore, 

access to more complete pricing information would enhance fair competition among primary and 

secondary dealers by increasing the ability of secondary dealers to quote competitive markets. 

The SEC further believes that there should be authority to collect pricing information from all 

government securities brokers and dealers. This should include both dealer quote and trade 

information, including price and volume on all government securities. 

Private sector initiatives to provide this information are, of course, preferable to 

regulatory solutions. In recent months, GOVPX has made progress in improving the 

transparency of the government securities market. Without backstop legislation, however, the 

SEC believes that the impetus for further improvements could diminish. With backstop authority, 

if GOVPX or other private efforts prove unreliable or inadequate in delivering 

27 
valuable market data, the SEC could act to ensure adequate information is available to all market

participants.

The SEC believes that it should be the agency to exercise this authority, because it 

already exercises similar, though more extensive, responsibility for overseeing a large number of 

electronic trading and reporting systems. Its experience and expertise would enable it to monitor 

the development of private sector systems with largely existing capability and without significant 

additional cost. The SEC also has the existing expertise to take any necessary action should 

GOVPX or other private efforts prove inadequate. Any alternative would result in one agency 

exercising oversight over transparency in every market but the government securities market. 

Sales practice and other SRO rules. The imposition of sales practice rules on the 

government securities market has been controversial. The Agencies were not able to develop a 

common position on this subject. The Treasury and the SEC agree that this market should have 

sales practice rules, but they disagree on precisely how such rules should be implemented. The 

Federal Reserve does not believe that the necessity for sales practice rules has been 

demonstrated, but would not oppose removal of the prohibition on the National Association of 

Securities Dealers ("NASD") applying its sales practice rules to government securities. 

Treasury position on sales practice rules. The government securities market is the only 

regulated securities market in which not all brokers and dealers are subject to sales practice rules. 

The Treasury's concern in this area is not for the large, institutional investors, who should be 

expected to have the ability to judge the suitability of particular securities, but for the smaller, 

less sophisticated customers who are attracted to the government securities market because of 

their desire for safe and secure investments. Adding to this concern is the proliferation in the 

market of instruments that are far riskier than the traditional Treasury and agency securities on 

which they are based. These instruments include mortgage-backed securities and real estate 

mortgage investment conduits ("REMICS") issued or guaranteed by government agencies or 

GSEs, zero-coupon instruments such as STRIPS, agency mortgage-backed securities stripped 

into interest-only ("IOs") and principal-only ("POs") pieces, and over-the-counter options on 

government securities. Many of these securities are backed by a U.S. government guarantee or 

are highly rated by nationally recognized statistical rating organizations, and are attractive due to 

their apparent higher returns. However, unsophisticated investors may not fully understand their 

complexity, risks, and speculative nature. In addition, it is necessary to prevent unscrupulous 

persons, who may have operated in other markets, from gravitating to the government securities 

market.

The Treasury supports the regulatory structure for sales practice rules set out in S.1247, 

which in its view reflects a balanced and appropriate role for each of the regulatory agencies. 

The primary rulemaking powers pertaining to such rules for financial institution brokers and 

dealers and members of registered securities associations rest with the appropriate federal 

financial institution regulator and the NASD, respectively. This approach utilizes the 

28 
expertise and experience of the bank regulatory agencies and the NASD in implementing and 

enforcing sales practice rules that are in place for other markets. Additionally, the Treasury 

believes that the regulatory structure of S.1247 preserves the SEC's oversight role for selfregulatory organizations. 

By permitting sales practice rules to become effective only if the Treasury has not 

determined that the rules would "adversely affect the liquidity and efficiency of the market for 

government securities" or "impose any burden on competition not necessary or appropriate," this 

regulatory framework also ensures that the Treasury retains an oversight role, consistent with the 

regulatory approach set out in the GSA. This structure is appropriate given Treasury's interest in 

minimizing the cost to the taxpayer of financing the public debt by maintaining the liquidity, 

efficiency, and integrity of the government securities market. A Treasury oversight role would 

also help to minimize disparities in sales practice rules for the various types of brokers and 

dealers. 

SEC position on sales practice rules. The SEC believes it would be appropriate to extend 

normal sales practice standards and other NASD rules22 to transactions in government securities 

by removing the statutory restriction on NASD authority in the government securities market. 

The SEC does not oppose granting the appropriate regulatory agencies for financial institutions 

the authority to adopt similar sales practice rules governing transactions in government 

securities.23 First, expansion of the NASD' s authority is consistent with Congress's preference 

for self-regulation of the securities markets.24 The NASD already has experience in the sales 

practice area and maintains an ongoing relationship with its members. Second, this approach is 

the most cost-effective means of preventing sales practice abuse. Sales practice abuses are not 

security-sPecific, and existing sales practice rules may be sufficient without significant 

modifications. The extension of these rules to the government securities market would reduce 

training and compliance burdens because basic sales practice rules are already known and 

understood by the sales forces of integrated securities broker-dealers. Of course, the existing 

NASD rules could, if necessary, be tailored 

 22 The SEC believes that, in addition to sales practice rules, the NASD should be free to apply other types of just

and equitable principles of trade and anti-fraud rules to the government securities activities of its members. In

addition, the SEC believes that the NASD should be authorized to adopt appropriate other rules for the government

securities markets. Examples of such rules include fidelity bonding requirements and qualification and testing

requirements, which would allow the NASD to assure that personnel associated with member firms had the requisite 

knowledge to comply with sales practice and fmancial responsibility rules. 

23 The SEC also does not oppose provisions in H.R. 3927 introduced by Chairman Markey and other members 

of the House Subcommittee on Telecommunications and Finance that would amend Section 15(c)(2) of the 

Exchange Act to remove the exemption for brokers and dealers in government securities from rules designed to 

prevent fraudulent and manipulative acts. Such authority, together with the rulemaking authority under Section

10(b) of the Exchange Act, would permit the Commission to adopt effective antifraud and antimanipulative rules, if 

necessary . 

24 See Securities Industry Study Report of the Subcommittee on Securities, Senate Committee on Banking, 

Housing & Urban Affairs, S. Doc. No. 93-13, 93rd Cong., 1st Session 149 (1973). 

29 
to the specific market conditions and specific types of abuses that may occur in the government 

securities market. Finally, the principle of "functional regulation," which the SEC has long 

supported,25 suggests that for purposes of NASD rules government securities should not be 

treated differently from other types of securities. As a result, the SEC believes that the statutory 

prohibition on application of NASD rules (including sales practice rules) to the government 

securities market should be lifted, so that all securities receive equivalent treatment (and all 

customers receive equivalent protection) under the NASD's rules. 

The SEC opposes the provisions in Senate bill S.1247 that would permit sales practice 

rules to become effective only if the Treasury has not determined that the rules would "adversely 

affect the liquidity and efficiency of the market for government securities" or "impose any 

burden on competition not necessary or appropriate." Such provisions give the Treasury a veto 

over the actions of independent financial regulators in connection with the exercise of new sales 

practice rulemaking authority. This would set a negative precedent of direct intrusion into the 

decisions of independent regulators. This veto provision has been opposed by the Chairmen of 

the SEC, the Federal Reserve, and the Federal Deposit Insurance Corporation on these grounds. 

The Treasury's legitimate interest in financing the debt at the lowest possible cost to federal 

taxpayers could easily be recognized through consultation requirements associated with the new 

rulemaking authority. The SEC, an independent financial regulator, shares the Treasury's concern 

with the liquidity and efficiency of the markets and believes it has established an excellent record 

of carrying out consultation and coordination requirements in other federal laws.26 For example, 

the SEC routinely consults with the banking regulatory agencies regarding proposed rule changes 

for the clearance and settlement of securities and SEC rule proposals for lost or stolen 

securities.27

Federal Reserve position on sales practice rules. The Board of Governors believes that a 

decisive case has not yet been presented for adding statutory requirements in this area.

Nevertheless, the Board would not oppose a modest broadening of current law, with adequate 

safeguards. 

If Congress believes that a provision for sales practice rules is a necessity, perhaps the 

least costly and most responsive added measure would be a simple removal of the prohibition on 

the NASD applying its sales practice rules to government securities transactions. That 

 25 As a general matter, the SEC believes that functional regulation can provide important benefits by promoting 

efficiency, effectiveness, and consistency. Testimony of Richard C. Breeden, Chairman, SEC, before the 

Subcommittee on Securities, Committee on Banking, Housing and Urban Affairs (June 12, 1991). 

26 Letter from Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve System, Richard C.

Breeden, Chairman of the Securities and Exchange Commission, and L. William Seidman, Chairman of the Federal 

Deposit Insurance Corporation, to the Honorable Christopher J. Dodd, Senate Securities Subcommittee, Committee 

on Banking, Housing and Urban Affairs, dated July 19, 1991.

27 See 15 U.S.C. § 78q-l(d)(3).

30 
change would bring NASD firms into line with what is already the case for New York Stock 

Exchange member firms, extending sales practice rules to all nonbank brokers and dealers. In 

this process, which would in essence take place with oversight by the SEC, the Federal Reserve 

would favor substantive consultation and cooperation with the Treasury as the primary regulator 

of this market. In general, the Federal Reserve favors consultation and cooperation and opposes 

the granting of veto powers over other agencies' regulations in this market. 

GSCC enhancements. GSCC has the potential to provide the basis for further 

improvements to the government securities market. 

(1) Repo processing. The market for repurchase and reverse repurchase agreements could 

benefit from automated comparison. GSCC could benefit the market by offering a system that 

clearly defines which stage of the transaction is occurring (e.g., opening, closing, setting up a 

reverse repo or closing a reverse repo) and that automatically generates a comparison of the 

transaction.28 Such a service, if capable of capturing a high percentage of repo transactions, 

could enable regulators to obtain data on repos as necessary for surveillance purposes at little or 

no cost to market participants.29 The Agencies urge GSCC to develop efficient processing 

systems for market participants' repo activity. 

(2) More trades in the net. The benefits of netting are greater as more trades are included 

in the net. In addition, as more trades are included in GSCC's netting system, a larger percentage 

of market trades become guaranteed trades, thereby freeing members from certain counterparty 

risk associated with those trades. To this end, GSCC is planning to include more types of trading 

activity in the netting process and to expand its membership. Specifically, GSCC has proposed to 

add yield-based trades and auction take-down activity to the netting process. The Agencies agree 

that the benefits of netting should be expanded to a greater universe of trades. 

(a) Yield-based trades. The SEC recently approved GSCC's proposal to include 

yield-based trades in the netting system beginning in January 1992.30 By including yield-based 

trades in the netting system, members will enjoy the credit protections of GSCC's trade guarantee 

for their yield-based trades sooner than under the current procedure, whereby 

 28 Some clearing agencies currently offer repo processing services. For example, DTC operates a Repo 

Tracking System that is designed to ensure that distributions on the securities underlying the repo are paid to the 

proper party.

29 Activity in the government securities repo market is sizable. Centralized repo processing would give

regulators a truer picture not only of the government securities market, but also of each market participant's total risk

profile, enabling GSCC, other clearing agencies, and regulators to refine their risk reduction policies. 

30 Securities Exchange Act Release No. 29732 (September 24, 1991), 56 FR 49937. In order to include yieldbased trades in the netting system, GSCC will convert the yield trades into priced trades at the time of comparison.

To convert, GSCC will use a standard Treasury conversion formula. 

31 
compared yield-based trades are deleted from the system and re-submitted for netting after the 

Treasury auction. 

(b) Auction take-down activity. Another type of trading activity that GSCC could 

include in the netting process is auction take-down activity. GSCC has proposed that its services 

be used in connection with the delivery of auction purchases. Under its proposal, GSCC would 

accept and report in its comparison system data on securities purchases made at auctions by 

GSCC netting members, net the purchases with when-issued trades of such members in the same

securities through the netting system, and assume responsibility for the delivery of the purchased 

securities through GSCC's clearing mechanism.

31 If this proposal is implemented, additional 

information on the overall distribution process required to settle Treasury auction purchases and 

on the true net settlement positions of members during a when-issued period would be available 

at GSCC. 

GSCC's proposal is especially significant in light of the risk to the Treasury resulting 

from the auction settlement process and the use of autocharge agreements. GSCC's proposal 

would reduce the risk to the Treasury to the extent that GSCC assumes responsibility for auction 

purchases that are netted against when-issued sales. 

(3) Increasing membership. Currently, a significant number of GSCC's netting members 

are primary dealers, aspiring primary dealers, and interdealer brokers. GSCC represents that it is 

actively developing changes to its membership standards to admit a second tier of market 

participants beyond these entities. GSCC believes this tier of potential members is composed of 

two categories of market participants: a small group of arbitrage firms and registered or noticed 

government securities brokers and dealers. Interest from the second group principally is to meet 

the government securities needs of their retail equity customers. The Agencies believe that 

GSCC should accelerate its efforts to expand membership to more government securities brokers 

and dealers. 

(4) Confirmation systems for institutional customers. Ideally, centralized comparison 

systems might be adapted and expanded to include non-dealer, institutional customers. 

 31 GSCC has refined its proposal so that any Treasury auction purchase by a netting member - whether 

competitive or noncompetitive in nature and whether or not for a customer - automatically would be delivered to 

GSCC's clearing bank and encompassed within GSCC's net. GSCC would allocate auction deliveries to allow for the 

most complete netting process and to ensure timely delivery so that each member would take , possession of the 

entire amount of its auction purchases that it needs on the morning of issue date. 

32 
Comparison systems for institutional customers generally offer automated confirmation32 and 

affirmation33 services. 

Although GSCC does not yet offer centralized, automated confirmation and affirmation 

systems, such systems exist today at other clearing agencies. With adaptation or change, these 

systems could be expanded to include government securities trades involving institutions. For 

example, the Depository Trust Company's ("DTC")34 Institutional Delivery ("ID") and

International Institutional Delivery ("IID") Systems provide automated confirmation and 

affirmation services to brokers, banks, and institutional customers.35 The Agencies urge GSCC to 

explore with DTC whether benefits would accrue to government securities market participants if

GSCC and DTC were to provide them with access to existing confirmation and affirmation 

systems. 

III. Government-Sponsored Enterprise Issues 

In connection with the investigation of unlawful behavior in the government securities 

market, certain misconduct has been revealed in the primary market for GSE securities. Many 

members of GSE selling groups submitted inflated indications of customer interest to the fiscal 

agents for GSE securities. This practice had persisted for a significant period of time. . 

To address this situation, the Agencies recommend adoption of an amendment to the 

Exchange Act, discussed above, that would make it an explicit violation of that Act to provide 

misleading written information in connection with a primary offering of any 

 32 In a typical institutional trade, the customer's executing broker must confirm the terms of the trade in

writing to the investment manager.' See 17 C.F.R. § 240.10b-10.

33 If the confirmation conforms to the investment manager's records of the customer's ordered trades, the 

investment manager must issue instructions (affirmation) to the custodian bank authorizing the receipt or delivery of 

securities against payment to or by the broker. 

34 DTC is a registered clearing agency and the largest securities depository in the United States. 

35 Adapting DTC's ID or IID Systems for use in the government securities markets would mean that 

dealers who participate in GSCC might be required to interact with more than one clearing agency to compare their 

government securities trades. It might be possible, however, for GSCC to act as a conduit for its members, by

accepting trade data from them and transmitting the data to DTC for confirmation processing. Output from DTC 

could be transmitted to GSCC for distribution to its members. 

DTC would need to adapt the ID system in at least one way in order to accommodate the need for earlier 

confirmations in the government securities market. Currently, the ID system trade input is in batch form and is 

processed only once a day - too late for the needs of the government securities market. Plans to enhance the ID 

system are under discussion. The IID system currently uses a multi-batch system that could accommodate earlier 

confirmations that would be useful for government securities trades. 

33 
government security. Although deliberate misstatements to GSEs or their fiscal agents are 

already covered by the general antifraud provisions of the securities laws, adoption of such a new 

statutory provision would highlight the importance of compliance in this area and facilitate SRO 

compliance reviews. 

Exempt Status of GSE Securities 

The Agencies believe that the exemptions under the federal securities laws for equity and 

unsecured debt securities of GSEs should be eliminated.36 The securities of GSEs are generally 

exempt from registration and are treated as government securities for purposes of the federal 

securities laws. 

Securities issued by the U.S. Government are exempted from certain provisions of the 

federal securities laws, due primarily to the credit quality of the securities, which eliminates the 

need for disclosure of information relating to the financial condition of the issuer. Unlike 

Treasury securities, however, the securities of GSEs do not have a government guarantee (except 

for the obligations issued by the Farm Credit System Financial Assistance Corporation). Indeed, 

in many cases Congress has been careful to specify explicitly that securities of a particular GSE 

are not guaranteed by the U.S. Government, and in other cases it has required GSEs to disclose 

that fact to the public. The debt securities of GSEs normally are priced in the market at a spread 

over the rate on Treasury securities of similar maturity, in order to compensate for lower 

liquidity than Treasury securities and for the implicit risk that the U.S. Government might not 

honor the debt obligations of a GSE that was unable to meet its obligations. Debt securities 

issued by GSEs thus do not have the unquestioned credit quality that justifies the exemption for 

government securities under the federal securities laws. 

The case is clearest with respect to equity securities of GSEs. All the GSEs except for 

one small entity are now completely privately owned, and the value of GSE equity securities 

rests primarily' on their financial condition and value as going concerns. Therefore, investors 

need the same basic financial and operational information about GSEs as they would need from

any company in order to evaluate the merits of an investment in its equity securities. All this 

information should be provided in the same form, and under the same time frames, as for similar 

securities of other issuers. For these reasons, the Agencies support repeal of the exemption of 

GSE equity and unsecured debt securities under the federal securities laws. 

 36 Any legislation should make clear that such securities would maintain their current eligibility for use in repo

transactions and for trading by government securities brokers and dealers that have registered or filed notice under 

section 15C of the Exchange Act. 

34 
APPENDICES 
APPENDIX A 

BACKGROUND ON THE TREASURY SECURITIES MARKET 
1. Characteristics of the Primary Market 

The public debt amounted to $3,665 billion on September 30, 1991, including $2,114 

billion of marketable securities held by private investors.1

 Nonmarketable Treasury securities 

(including those issued directly to federal trust funds), United States savings bonds, state and 

local government series securities, and marketable securities held by federal government 

accounts and the Federal Reserve System comprise the rest of the public debt. 

Size of borrowing needs. The Treasury has auctioned large amounts of marketable 

Treasury securities in the past ten years. In fiscal year 1981, Treasury sold over $670 billion of 

marketable Treasury securities. By fiscal year 1991, this figure had increased to over $1.7 

trillion. As long as there is a budget deficit, the amount of securities the Treasury is required to 

sell will tend to increase, not only to raise funds to cover the shortfall between receipts and 

expenditures, but also to refinance maturing debt. 

Evolution of Treasury financing techniques. The Treasury has employed auctions for 

Treasury bills since the securities were introduced in 1929. Since then, the only major 

modifications to bill auctions have been a provision for noncompetitive bids in 1947 and a 

change in 1983 to receiving bids on the basis of yield (bank discount basis) rather than price. 

Prior to the early 1970s, the traditional methods for selling notes and bonds were 

subscription offerings, exchange offerings, and advance refundings. Subscriptions involved the 

Treasury setting an interest rate on the securities to be sold and then selling them at a fixed price. 

In exchange offerings, the Treasury would allow holders of outstanding maturing securities to 

exchange them for new issues at an announced price and coupon rate. In Some cases, new 

securities were issued only to holders of the specific maturing securities; in others, additional 

amounts of the new security would be issued. Advance refundings differed from exchange 

offerings in that the outstanding securities could be exchanged before their maturity date. 

A fundamental difficulty with subscription offerings was that market yields could change 

between the announcement of the offering and the deadline for subscriptions. Increased market 

volatility in the 1970s made fixed-price subscription offerings very risky for the Treasury. 

A modified auction technique was introduced in 1970, in which the interest rate (coupon 

rate) was still preset by the Treasury, and bids were made on the basis of price. Setting the 

coupon rate in advance, however, still involved forecasting interest 

 

 1 Privately held marketable securities exclude holdings of federal government accounts, such as the Social 

Security trust funds, and holdings of the Federal Reserve System. 

A-1 
rates, with the risk that the auction price could vary significantly from the par value of the 

securities. In 1974, Treasury started to auction coupon issues on a yield basis. Bids were 

accepted on the basis of an annual percentage yield, with the coupon rate based on the weighted 

average yield of accepted competitive tenders received in the auction. This freed Treasury from

having to set the coupon rate prior to the auction and ensured that the interest costs of new note 

and bond issues would accurately reflect actual market demand and supply conditions at the time 

of the auction. 

Another sale method was used in six auctions of long-term bonds in Treasury mid-quarter 

refundings between February 1973 and May 1974. This was the sealed-bid, uniform-price, or 

"Dutch," auction method. The coupon rate was preset by the Treasury and bids were accepted in 

terms of price, starting with the highest price and moving through successively lower prices until 

the offering had been fully placed. All successful bidders were awarded securities at the lowest 

price of accepted bids. 

Current auction technique. Today, all Treasury auctions are conducted, on a yield basis. 

Competitive bidders submit tenders stating the yield (discount rate for bill auctions) at which the 

bidder wants to purchase the securities. The bids are ranked from the lowest yield to the highest 

yield required to sell the amount offered to the public. Competitive bidders whose tenders are 

accepted pay the price equivalent to the yield that they bid. In an auction of Treasury notes or 

bonds, the coupon rate is based on the average yield of accepted competitive bids. 

Noncompetitive bids from the public for up to $1 million of Treasury bills and up to $5

million of notes and bonds are awarded in full at the weighted average yield of accepted 

competitive bids. The ability to bid on a noncompetitive basis ensures that small investors, who 

may not have current market information, can purchase securities at a current market yield. 

Noncompetitive bidding eliminates the risk that a prospective investor might bid a yield that is 

too high and not obtain the securities desired or might bid a yield that is too low and pay too 

much for the securities. It also helps serve the goal of achieving a broad distribution of Treasury 

securities. 

To participate in a Treasury auction, any potential investor may submit tender forms to a 

participating Federal Reserve bank or branch,2

 which acts as the Treasury's fiscal agent in the 

auction, or to the Treasury's Bureau of the Public Debt. Currently, tenders are received at 37 

sites. The deadline for competitive bids is usually 1:00 p.m., Eastern time; noncompetitive 

tenders must be received one hour before the closing time for competitive tenders, or, if sent by 

mail, must be postmarked by midnight on the day before the auction and received on or before 

the issue date. 

 2 Currently, 36 of the 37 Federal Reserve banks and branches accept auction tenders, with the Helena, Montana 

branch the only exception.

A-2 
Typically, between 75 and 85 bidders submit competitive tenders in Treasury auctions for 

securities to be held in the commercial book-entry system.

3

 Additionally, between 850 and 900 

bidders submit noncompetitive tenders in Treasury auctions for securities to be held in the 

commercial book-entry system. Also, on average there are about 19,000 noncompetitive tenders 

per auction for securities to be held in the TREASURY DIRECT book-entry system.

4

The 38 primary dealers account for a large proportion of the participation in Treasury 

auctions, as discussed in Section 3 of Appendix B. The Federal Reserve expects primary dealers 

to demonstrate their continued commitment to the market for government securities by 

participating in Treasury auctions. It should be emphasized, however, that auctions are open and 

that others besides primary dealers can and do participate, either directly, or through any 

government securities brokers and dealers that are registered with the Securities and Exchange 

Commission ("SEC") or through a depository institution. 

Depository institutions and government securities brokers and dealers registered with the 

SEC may submit either competitive or noncompetitive tenders for their own account and for the 

accounts of customers. All other entities or individuals may submit either competitive or 

noncompetitive tenders only for their own accounts. Depository institutions, brokers, and dealers 

are required to submit customer lists when submitting bids for the accounts of customers. 

Customer lists for competitive bids must be submitted either with the tender or by the close of

the auction. Customer lists for noncompetitive tenders submitted by mail must be received prior 

to the issue date, although customer lists for all other noncompetitive tenders must be received 

by the close of business on the auction date. 

Prior to the auction of three-year notes on November 5, 1991, bidders in Treasury auctions 

had the option to pay in full at the time the tender was submitted or, 

 

 3 The commercial book-entry system for Treasury securities is operated by the Federal Reserve banks, acting as 

the Treasury's fiscal agents. It is a multi-tiered, automated system in which marketable Treasury securities are 

issued, serviced, maintained, and traded. Ownership is not evidenced by physical securities, 

but rather by computerized records, with the top tier of records maintained at the Federal Reserve banks. The 

Federal Reserve maintains book-entry accounts for depository institutions and other entities such as government and

international agencies and foreign central banks. In their book-entry accounts at the Federal Reserve, the depository 

institutions may maintain their own security holdings and holdings for customers, which include other depository 

institutions, dealers, brokers, institutional investors, and individuals. In turn, the depository institutions' customers 

maintain accounts for their customers. Brokers and dealers that are not depository institutions are not permitted to

maintain securities accounts directly with the Federal Reserve. 

4 The TREASURY DIRECT system is designed primarily for those who wish to hold Treasury securities to

maturity; no custodial or transaction fees are charged. As of September 30, 1991, 1.1 million investors held 2.3 

million security accounts in TREASURY DIRECT with a par value of nearly $64 billion. 

A-3 
in the case of notes and bonds, to present a guarantee from a commercial bank or primary dealer 

of five percent of the par amount tendered.5

 The deposit requirements did not apply to primary 

dealers, depository institutions, states, political subdivisions or instrumentalities thereof, public 

pension and retirement and other public funds, international organizations in which the United 

States holds a membership, and foreign central banks and foreign states. 

Effective with the November three-year note auction, the Treasury established a payment 

mechanism, called an auto charge agreement, which supplements the other existing payment 

mechanisms. The autocharge agreement is a written arrangement by a bidder and a depository 

institution that authorizes the Federal Reserve bank to charge the depository institution's funds 

account on the issue date for securities purchased by the bidder. 

Auction schedule. The Treasury has a regular, predictable schedule for offering 

marketable securities, which is well known to market participants. The Treasury makes an 

announcement as far in advance as is practical any time there is a change in the usual pattern, so 

that the market can digest the information and prepare for the offerings. 

The Treasury sells 13- and 26-week bills every week and 52-week bills every four weeks, 

Two-year and five-year notes are auctioned every month for settlement at the end of the month. 

Seven-year notes are issued on the 15th of January, April, July, and October. The quarterly 

financings, which settle on the 15th of February, May, August, and November, typically consist 

of three- and ten-year notes and a thirty-year bond. These regularly scheduled issues amount to 

about 157 separate securities auctions each year.6

 

 

 5

 Full payment for securities to be held in TREASURY DIRECT is required when the tender is submitted.

6 The Treasury also offers cash management bills from time to time to raise funds to cover low points in the 

Treasury cash balance. The maturity dates for cash management bills usually coincide with the Thursday maturities 

of regular weekly and 52-week bills. For example, cash management bills may be issued in early April, before the 

April 15 tax payment date, and mature later in April, when cash balances are at seasonal highs. Short-term cash

management bills maybe announced, auctioned, and settled in a period as short as one day, if necessary, to ensure 

that the government does not run out of cash. To shorten the time for the auction and reduce the cost of issuing

short-term cash management bills, they usually are issued only in large minimum purchase amounts - $1 million or 

more - and noncompetitive tenders are not accepted. 

Longer term cash management bills are also issued from time to time. For example, the Treasury's borrowing

requirement in the final calendar quarter of the year is typically larger than for the April-June quarter, when 

seasonally high tax payments are due. Cash management bills maturing after the April 15, 1991 tax date were issued

in November 1990, for example, to manage Treasury borrowing in light of this seasonal pattern. 

A-4 
The details concerning an offering of marketable securities are announced about one week 

prior to the auction, and the settlement date occurs from a few days to about one week after the 

auction, depending upon holidays and other vagaries of the calendar. 

Treasury auction rules. Treasury auction rules have, for the most part, been contained in 

the official offering circulars, public announcements relating to specific auctions, and single 

bidder guidelines.7

 Other auction rules have been announced in separate press releases; they are 

not reiterated in individual offering circulars and announcements. 

The rules regarding the $1 million and $5 million maximum awards on noncompetitive 

bids and payment requirements were discussed above. The most significant other auction rules 

concern limitations on awards, limitations on tender amounts recognized at single yields, 

requirements for bidders to report net long positions, single-bidder guidelines, and when-issued 

trading. 

The 35 percent rule. Since 1962, the Treasury has limited the maximum amount of 

securities awarded to a single bidder in a Treasury offering. The primary reasons for the 

limitation are to ensure broad distribution of Treasury securities and to make it less likely that 

ownership of Treasury securities will become concentrated in a few hands as a result of the 

auction. 

Under the restriction that has been in effect since September 1981, no single bidder is 

awarded more than 35 percent of the amount of a Treasury security that is offered to the public. 

The application of the 35 percent limit to any bidder includes consideration of that bidder's net 

long position in the futures, forward, and when-issued markets. 

Also, while a bidder can submit tenders for more than 35 percent, the Treasury does not 

recognize amounts tendered at anyone yield from a single bidder in excess of 35 percent of the 

public offering. This limit was adopted to prevent bidders from 

 7 Treasury has updated its offering circular to put in one place all of the basic ground rules for Treasury auctions 

and is releasing it simultaneously with this report for publication in the Federal Register for comment. The circular 

will be supplemented by an offering announcement for each separate offering. It will also be amended from time to

time to reflect any changes in rules. 

A-5 
benefitting from submitting huge tenders in order to obtain large prorations of securities at the 

stop-out, or highest accepted, yield.8

Net long position reporting. For purposes of enforcement of the 35 percent rule, each 

competitive bidder is required to report on the tender form its net long position in the security 

being auctioned when the total of all of its bids for the security plus its net long position in the 

security exceeds the reporting amount specified in the offering announcement. Net long positions 

include positions in the futures, forward, and when-issued markets for the security being offered. 

In the case of a security that is being reopened, it also includes positions in the outstanding 

security. 

Single-bidder guidelines. On June 1, 1984, the Treasury issued guidelines concerning the 

definition of a single bidder for the purpose of administering the limitation on noncompetitive 

awards. Since then, the guidelines have also been applied to administer the 35 percent rule. The 

definitions of single bidders include as criteria: (1) whether the parties who will acquire 

securities from the Treasury are related to one another, such as family members living in the 

same household or a parent corporation and its majority-owned subsidiaries; and/or (2) whether 

investment decisions of bidders are controlled centrally. For example, a money market fund and 

all other funds that have common management are treated as a single bidder for purposes of the 

guidelines. 

The guidelines include a listing of categories that are used to determine whether two or 

more entities are related and/or under common management. The guidelines do not cover all 

situations, and interpretations by the Treasury often are necessary to apply the guidelines to 

particular situations.9

When-issued trading. Ordinarily, there is a period of almost two weeks between the time a 

new Treasury issue is announced and the time it is actually issued. The Treasury permits trading 

during this period, and the issue is said to trade "when, as, and if issued.”10 When-issued trading 

is important to the distribution process for Treasury securities. Most importantly, it reduces 

uncertainties surrounding Treasury auctions by serving as a price discovery mechanism.

Potential competitive bidders look 

 8 In a few cases that occurred immediately before the imposition of this rule on July 12, 1990, dealers 

had bid at one yield for more than 100 percent of the amount offered to the public. 

9 The Treasury has been working to develop clarifications of its single-bidder guidelines and plans to

circulate them as part of the proposed uniform offering circular. 

10 Although pre-auction trading of bills has never been prohibited, pre-auction trading of notes and bonds was 

effectively prohibited from 1941 to 1975. It was permitted between February 1975 and July 1977, before being

officially proscribed until August 1981, when Treasury decided to allow it. The only significant rule change since 

1981 was an October 1983 Treasury announcement prohibiting pre-auction trading in securities awarded to

noncompetitive bidders. This prohibition applies to all Treasury securities. 

A-6 
to when-issued trading levels as a market gauge of demand in determining how to bid at an 

auction. Noncompetitive bidders can also use the quotes in the when-issued market to assess the 

likely auction average yield. 

Auction awards. The Federal Reserve banks review the tenders for accuracy, 

completeness, and compliance with Treasury rules and guidelines. The Federal Reserve banks 

consult with the Treasury prior to taking any action on questionable tenders that could materially 

affect auction results or that may be in violation of a Treasury rule. The Treasury reserves the 

right to reject any tender. 

Once it has been determined that the tenders have complied with Treasury requirements, 

the Federal Reserve banks compile the auction summaries. The noncompetitive summary shows 

the total amount of noncompetitive bids received by each Federal Reserve district. The 

competitive bid summary shows the total amount bid at each yield. The summaries include 

information on specific bidders only when needed to apply the 35 percent limitation on the 

amount awarded or bid at a given yield by a single bidder or when specific bids appear irregular. 

This information is forwarded to the Treasury. 

The Treasury first accepts noncompetitive bids in full. Competitive bids are then accepted 

beginning with the lowest yields until the offering amount has been reached or “covered.” The 

amount awarded at the high yield is prorated based on the amount bid at that yield to obtain the 

offering amount. 

Auction results are released to the public about one hour after the deadline for the receipt 

of competitive tenders, usually around 2:00 p.m., Eastern time. 

2. Characteristics of the Secondary Market 

The Treasury securities market is the largest, most liquid market in the world, and 

Treasury securities are generally considered to be the most secure financial instruments in the 

world. Daily trading volume in Treasury securities by primary dealers, excluding financing 

transactions, averaged $85 billion per day in September 1991, according to data reported to the 

Federal Reserve Bank of New York (“FRBNY”). By contrast, the average daily trading volume 

of equities on the New York Stock Exchange (“NYSE”) was $6 billion. 

Unlike securities traded in a centralized marketplace, such as an exchange, Treasury 

securities are traded largely in an over-the-counter market11 that is 

 

11 Although all marketable Treasury notes and bonds, including STRIPS, are listed on the New York

Stock Exchange, trading volume is a small fraction of total over-the-counter volume. Treasury securities have been

traded on the New York Stock Exchange since it opened in 1793. In fact, U.S. government debt issued to finance the

Revolutionary War was originally the principal type of security traded on the Exchange. Treasury securities 

continued to be traded actively on the Exchange until the early 20th century, when increased telephone use led to a 

sizeable over-the-counter market. Today, exchange-listed Treasury securities are traded mostly by foreign mutual 

funds that are required to trade through exchanges. 

A-7 
comprised of a network of dealers, brokers, and investors who effect transactions in Treasury 

securities over the telephone. The market is largely a wholesale market in which institutional 

investors, such as banks, thrifts, dealers, pension funds, insurance companies, mutual funds, and 

state and local governments operate. However, a significant number of small, retail investors also 

trade Treasury securities through brokers and dealers. 

The liquidity, efficiency, and safety of the Treasury securities secondary market result 

directly from the creditworthiness of the issuer, the volume of securities issued, the large number 

and diversity of participants, the financial strength and integrity of those participants, and the 

continual willingness of brokers and dealers to participate actively in the markets. Relatively low 

transactions costs and efficient securities transfer and settlement systems also expedite activity 

and enhance liquidity. 

Instruments traded in the secondary market. The majority of the activity in the 

Treasury secondary market involves trades in the cash market of the most recently issued 

Treasury bills, notes, and bonds (the "on-the-runs" or "benchmarks").12 Also, as discussed above, 

during the period between the announcement and the issuance of a new Treasury security, there 

is a very active when-issued market. 

During the when-issued period before an auction, dealers and customers contract to buy 

and sell the Treasury security in terms of yield quotes because the coupon and price are not yet 

known. After the auction results are released, trades are conducted in terms of price. Settlement, 

the exchange of the actual securities for payment, is made on the issue date, with the yields at 

which the pre-auction trades were executed converted into prices. 

In addition to the standard cash market, including the when-issued market, a market for 

many other sophisticated instruments based on Treasury securities has developed over time. For 

example, STRIPS (Separate Trading of Registered Interest and Principal of Securities) and other 

derivative instruments (e.g., forwards, futures, options, and swaps) have become quite 

widespread.

 12 Outstanding Treasury securities auctioned immediately prior to the most recently auctioned issues ("off-theruns") are also highly liquid. 

A-8 
STRIPS. STRIPS are principal and interest components of selected Treasury notes and 

bonds that have been separated, or stripped, at the option of the owner under terms prescribed by 

the Treasury. STRIPS are often referred to as zero-coupon instruments, reflecting their similarity 

to non-interest-bearing securities with a fixed maturity and fixed value at maturity. STRIPS can 

be reconstituted by repackaging the principal component and all of the remaining interest 

components back into the original security. 

Financial futures. Financial futures are standardized contracts that are made and traded on 

futures exchanges that set a price level for securities to be delivered on a specified future date. 

Markets for financial futures are an outgrowth of the traditional futures markets for agricultural 

commodities. Futures contracts are available for Treasury bills, notes, and bonds and are 

authorized by, and traded on, exchanges that are regulated by the Commodity Futures Trading 

Commission ("CFTC"). 

Forward contracts. Forward contracts are trades that settle on a date in the future beyond a 

normal settlement time frame and, in that regard, are similar to futures. However, while futures 

contracts are standardized, traded on exchanges, and usually closed out by offsetting transactions 

prior to delivery, forward contracts are normally custom-tailored and traded on over-the-counter 

markets, with delivery of securities contemplated on the settlement date of the contract. 

Options. Options give the purchaser a right, but not an obligation, to buy or sell securities 

or futures contracts for securities at a given price for a set period of time. Standardized options 

for Treasury securities are traded on exchanges, but the over-the-counter market for Treasury 

options is the principal market. The over-the-counter market permits the counterparties to 

customize the options, which increases flexibility.

Swaps. In addition to other derivatives, investors often use interest rate swaps as part of 

their hedging and investment strategies for managing interest rate exposure. In most swaps, 

fixed-rate payment streams are exchanged for floating-rate payment streams. Countless varieties 

of swaps have developed, however, because such agreements permit market participants to swap 

any two interest streams that they deem commercially appropriate. While the trading activity for 

other derivative products generally is concentrated in the near-term months, interest rate swaps, 

by contrast, generally are for time periods of two to ten years. 

Brokers and dealers. While there are approximately 1,700 brokers and dealers (including 

banks) trading in the secondary market for government securities, anecdotal evidence suggests 

that the 38 primary dealers account for the major share of the trading volume. 

The primary dealers and other dealers often rely on interdealer brokers to trade in the 

market for Treasury securities. Interdealer brokers compile the best bid and ask 

A-9 
prices reported to them by the dealers who subscribe to their service and make this information 

available on computer screens. The identities of the dealers who submitted the price quotes are 

kept confidential, with the understanding that anonymous trading allows the dealers to protect 

their trading strategies. Dealers pay the brokers a commission for arranging trades. 

Interdealer brokers display the bids and offers placed with them for bills, notes, bonds, 

and STRIPS, as well as Government-sponsored enterprise ("GSE") securities, on several screens. 

When a new bid or offer at a better price is placed with a broker, the new quote will appear on its 

screen in the dealers' trading rooms within seconds. Generally, brokers consider these bids and 

offers good until canceled. Brokers will, however, take bids and offers off the screen or make 

them subject to reconfirmation when an event occurs that may have a major impact on the 

market, such as the release of an important economic statistic.

There are currently seven interdealer brokers13, three of which provide trading access for 

primary dealers only. Another three interdealer brokers allow access to their screens not only to 

primary dealers and "aspiring" primary dealers but also to other dealers who participate in the 

Government Securities Clearing Corporation ("GSCC") netting system.

14 One interdealer broker 

goes one step further, by also including certain other government securities dealers, regional 

banks, pension funds, and others that the broker considers to be creditworthy trading partners. 

Through this broker, these market participants can obtain market information and can buy and 

sell Treasury securities without using the facilities of a primary dealer or GSCC participant. In 

addition, a newly formed electronic information dissemination service, GOVPX, now provides 

dealer price and volume information on Treasury securities to anyone who pays for the service.15

To effect a trade, an investor may refer to one or more of the available information 

services and call a dealer, or several dealers, for the most recent quotes and then place an order. 

The dealer trades with the customer as a principal for its own account or as an agent for the 

account of another investor. 

 

 13 The seven interdealer brokers are: Cantor Fitzgerald Securities Corp.; EJV Brokerage, Inc.; Garban Ltd.; 

Gnubrokers of Government, Inc., doing business as Fundamental Brokers Inc.; Hilliard Farber & Co., Inc.; Liberty 

Brokerage, Inc.; and RMJ Securities Corp. 

14 The GSCC is a clearing organization that provides its members with automated trade comparison 

and netting services for Treasury and other government securities. More than 60 of the most active brokers, dealers, 

and banks in the government securities market are GSCC members. See discussion of GSCC in Appendix B. 

15 See discussion of information access in the government securities market in Appendix B. 

A-10 
Settlement. Settlement, the exchange of securities for funds, usually occurs one business 

day after a buyer and seller agree on a trade, in the case of "regular way" trades. "Cash" trades 

settle on the trade date. Settlement is effected in the Treasury commercial book-entry system

operated by the Federal Reserve through an electronic transfer message initiated by the seller or 

the seller's depository institution. This message causes securities to be debited from the seller's

account and credited to the buyer's account while simultaneously causing the debiting of the 

payment from the buyer's account and the crediting of the funds to the seller's account. The 

commercial book-entry system enables Treasury securities trades to be settled quickly (within 

seconds) and relatively cheaply, thus contributing substantially to market liquidity.16

Financing techniques. The principal method of financing Treasury securities for brokers 

and dealers is repurchase agreements (“repos”). The repo market is huge, as is evident in the 

almost $500 billion of repos outstanding at primary dealers, on average, in 1991.17

A repo is a contract comprising two distinguishable acts: the sale of an asset, often 

Treasury securities, and a forward agreement to purchase the same asset.18 Repo sellers obtain 

funds in exchange for securities. The seller agrees to repurchase the same securities at a given 

point in the future, which determines the amount of interest for the use of the funds. The repo 

contract sets both the sale and the repurchase price. The terms of repos are often overnight or a 

few days but can extend for longer periods. A reverse repo refers to the other side of a repo 

transaction. In a reverse repo, the repo buyer delivers the funds and receives the securities in 

exchange. At contract maturity, the buyer receives funds (including interest) and returns the 

securities. 

Dealers rely on repos to finance their Treasury security inventories primarily because of 

the low cost, flexible terms, and administrative ease. Repo rates are usually the cheapest 

overnight interest rates for the seller because of the liquidity of the market and the characteristics 

of the underlying security. The chief alternative to this type of financing, commercial bank loans, 

is more expensive, and dealers typically rely on these loans only as a last resort. 

 

 

309-597 a - 92 - 3 QL 3 

16 In recent years, the GSCC has had a substantial impact on Treasury secondary market settlement. One of 

GSCC's most important functions is to "net" its members transactions. GSCC combines each member's total 

purchases and sales for each security with other GSCC members into a single net purchase or sale. This process 

greatly reduces the number of trades that have to be cleared through the commercial book-entry system and, along

with the guarantee GSCC provides, substantially reduces counterparty risk for GSCC members. 

17 Table 1.43, "U.S. Government Securities Dealers: Positions and Financing," Federal Reserve Bulletin

18 Under a continuing term repo, the seller typically reserves the "right of substitution"; that is, the seller can

take back particular securities it needs for other purposes and substitute similar collateral. 

A-11 
The major participants in the repo market are dealers, corporations, municipalities, 

financial institutions, and pension funds. Most dealers use repos primarily to finance or cover 

securities positions and to conduct "matched book" operations. A dealer that operates a matched 

book enters into a repo and matches it with a mirror image reverse repo. Most matched books are 

not perfectly matched in maturities, but instead include some managed mismatches. The dealer's

profit is derived from the difference, or spread, between the interest earned on the reverse repo 

and the interest paid on the repo. Dealers also use reverse repos to obtain securities temporarily 

to complete other transactions, while other market participants typically use them to invest idle 

cash balances or to improve portfolio yield. 

Repo brokers are sometimes used to facilitate these transactions. Dealers use repo brokers 

most often for term repos and reverse repose Repo brokers are most important for arranging 

repos when securities are in short supply, as reflected by a rate that is lower than the rate for 

general collateral ("on special"). Brokers estimate that the daily volume of the overnight repo 

market that is transacted through brokers is approximately $10 billion per day, which represents 

only a small percentage Of the overnight repo market. 

The largest, most creditworthy dealers also use the commercial paper market indirectly to 

finance their secondary market trading. Commercial paper is unsecured, short-term debt (usually 

30 days and under). 

Dealer income. Dealers profit from their market making activities in three ways: (1) 

through the difference in their bid/ask quotes (the "spread"); (2) from the net price appreciation 

of their inventories or the price depreciation of the securities they have sold short in the market, 

including profits from hedging and arbitrage; and (3) from their inventory financing activities, 

i.e., the difference between the interest return on the securities they hold and the financing costs 

of these securities. When the return on the securities held in inventory is greater than the 

financing cost, a "positive carry," or profit, exists. Conversely, a negative carry, or loss, exists 

when the financing cost is greater than the return on the securities. 

3. Regulation of the Treasury Market 

Regulation of issuance of Treasury securities 

Authority of the Secretary of the Treasury. The Secretary of the Treasury (the 

"Secretary") is authorized under Chapter 31 of Title 31, United States Code, to issue Treasury 

securities and to prescribe terms and conditions for their issuance and sale. Specifically, the 

Secretary may issue bonds under 31 V.S.C. § 3102, notes under 31 V.S.C. § 3103, and 

certificates of indebtedness and Treasury bills under 31 V.S.C. § 3104. 

A-12 
In addition, under 31 V.S.C. § 3121, the Secretary may prescribe the form of such 

securities, and the terms and conditions for the issuance and sale of the securities. In 31 V.S.C. § 

3121(a) the Secretary is authorized to "prescribe ... regulations on the conditions under which the 

obligation will be offered for sale ..."

The Secretary reserves the right, under the offering circulars for issues of Treasury 

securities, to accept or reject any or all tenders in whole or in part. The Secretary also reserves 

the right to award more or less securities than the amount of securities specified in the offering 

announcement. 

Under the above specific provisions, the Secretary has authority to declare any bidder or 

bidder's customer ineligible to participate in any auction if a bidder or bidder's customer violates 

auction rules, makes an improper certification, or otherwise misrepresents information required 

to purchase securities at an auction. 

Finally, the Secretary reserves the right to supplement or amend terms and conditions 

governing the sale and issuance of securities, if such supplements or ' amendments do not 

adversely affect existing rights of holders of securities. Public notice of any changes is provided. 

Enforcement. As noted earlier, the Treasury and the Federal Reserve banks, as fiscal 

agents of the Treasury, receive tenders from bidders. Compliance and enforcement responsibility 

for the auction rules rests with the Treasury. As fiscal agents for the Treasury, the 36 Federal 

Reserve sites receiving and reviewing tenders have the primary responsibility for identifying 

tenders that are not in compliance with Treasury rules and regulations. Accordingly, the Federal 

Reserve has a responsibility to notify the Treasury when information in tenders suggests that 

Treasury rules may have been violated. 

Treasury auction authority includes powerful, but limited, sanctions to punish violators of 

these rules. The Treasury's remedy for breaches of its rules is to exclude bidders from Treasury 

auctions. In addition, persons who commit fraud in the context of a Treasury auction remain 

subject to potential civil and criminal actions under Section 10(b) of the Securities Exchange Act 

of 1934 and Rule 10b-5 thereunder, the general anti-fraud provisions, as well as criminal actions 

under 18 V.S.C. §§ 1001 and 1005. 

The Treasury reserves the right to reject any or all bids in an auction, and therefore, may 

bar, suspend, or limit a firm's participation in auctions. For example, in the wake of recent events 

the Treasury has prohibited Salomon from bidding in auctions on behalf of customers. 

Neither the SEC nor any of the self-regulatory organizations ("SROs"), such as the NYSE 

and the National Association of Securities Dealers ("NASD"), is authorized 

A-13 
to enforce directly Treasury auction rules. However, the SROs do enforce compliance with rules 

applicable to all brokers and dealers registered with the SEC requiring that all purchases and 

sales of securities are recorded, and that confirmations are sent to customers. The SEC and the 

Justice Department are responsible for enforcement of the federal securities laws, which cover 

deliberate violations of auction rules accompanied by false statements to the Treasury and 

market manipulation. The Justice Department enforces federal antitrust laws. 

Regulation of the secondary market 

Participants in the secondary market for U.S. government securities, including previously 

unregulated brokers and dealers, are regulated under the authority of the Government Securities 

Act of 1986 (“GSA”). In addition, broker-dealers and banks are subject to regulation under the 

Securities Exchange Act and the banking laws, respectively. The GSA granted the Treasury 

authority to promulgate rules and regulations for government securities brokers and dealers 

concerning financial responsibility, protection of investor securities and funds, recordkeeping, 

and financial reporting and audits. The Treasury also was given responsibility for the 

development of regulations relating to the custody of government securities held by depository 

institutions. 

In promulgating these regulations, the Treasury was required to consult with the SEC and 

the Federal Reserve. As a result of these consultations and the Treasury's analysis, most of the 

SEC regulations (e.g., customer protection, recordkeeping, reports, and audits) that applied to 

registered brokers and dealers were, with limited exceptions, adopted for firms registered 

pursuant to the GSA as government securities brokers and dealers. 

Registration requirements and oversight of market participants. The GSA required, 

for the first time, previously unregistered brokers and dealers that limit their business to

government and other exempt securities (except municipal securities) to register with the SEC 

and join an SRO. It also specified that firms registered as general securities brokers or dealers or 

as municipal securities brokers or dealers under Sections 15 or 15B, respectively, of the 

Securities Exchange Act must notify the SEC if they conduct government securities 

transactions.19 The GSA also required financial 

 

19 The term "registered government securities broker or dealer" means a broker or dealer conducting a business 

exclusively in government and other exempted securities (excluding municipal securities) and that is registered 

pursuant to Section 15C(a)(A) of the Securities Exchange Act, 15 D.S.C. § 78o-5(a)(1)(A). The term "registered

broker or dealer" means a broker or dealer conducting a general or municipal securities business that is registered 

pursuant to Sections 15 or 15B, respectively, of the Securities Exchange Act, 15 D.S.c. § 780 or 780-4 and that filed

notice pursuant to Section 15C(a)(l)(B) of the Securities Exchange Act, 15 D.S.C. § 78o-5(a)(1)(B), but does not

include a municipal securities dealer that is a bank or separately identifiable department or division of a bank. A 

government securities broker or dealer is any entity, including a fmandal institution, that acts as a broker or dealer of 

government securities. 

A-14 
institutions (banks and S&Ls) that engage in government securities broker or dealer activities to 

notify their appropriate regulatory agencies of such activities.20 The GSA required that the SEC 

and the Federal Reserve promulgate rules establishing the procedures and forms to be used by 

government securities brokers and dealers for the registration and notice process. 

The GSA, rather than creating a separate agency to enforce the new regulations, relied, for 

the most part, on the existing regulatory structure when assigning oversight responsibility. For 

previously regulated entities, examination and oversight of government activities is conducted by 

the federal agency with which the entity has an existing regulatory relationship. Thus, financial 

institution government securities brokers or dealers are subject to oversight by the federal 

financial institution regulatory agency that has responsibility for other supervisory and

enforcement activities, namely, the Federal Deposit Insurance Corporation ("FDIC"), the Office 

of the Comptroller of the Currency ("OCC"), the Federal Reserve, and the Federal Home Loan 

Bank Board ("FHLBB"), whose responsibilities under the GSA have been assumed by the Office 

of Thrift Supervision ("OTS"). Government securities brokers and dealers that do not fit within 

any of the categories of financial institution government securities brokers or dealers are subject 

to oversight by the SEC. 

All of the government securities brokers and dealers that registered pursuant to the GSA 

have joined the NASD, making them subject to certain of its rules, as well as its examination and 

disciplinary authority.21 Firms that were registered as brokers or dealers prior to the GSA 

continue to be subject to oversight by the SEC mid each of the SROs of which they are a 

member.

The regulatory structure that Congress established for government securities is somewhat 

different from that governing the secondary market for other types of securities under the 

Exchange Act. For example, the provisions of the Exchange Act that give the SEC and the SROs 

authority to develop surveillance systems to detect manipulative activity or other rules to deter 

manipulative activity are not applicable to the government securities market. Similarly, there is a 

disparity in the degree to which the normal rules and standards for sales practices apply. 

Standards such as just and 

 20 In this context, the term "financial institution" means banks and savings and loans. 15 U.S.C. § 78c(a)(46). 

The definition of "appropriate regulatory agency" with respect to a government securities broker or dealer is set out 

at 15 U.S.C. § 78c(a)(34)(G).

21 Section 15A(t)(2) of the Securities Exchange Act specifies which of the NASD's rules are applicable to its 

members' government securities transactions. Generally, they are limited to rules necessary to ensure compliance 

with Treasury rules. 

A-15 
equitable principles of trade do not apply in the government securities market. However, the 

general anti-fraud provisions of the Exchange Act and the rules the SEC has adopted pursuant to 

that authority are applicable to all persons who engage in transactions in any security. 

Nevertheless, anti-fraud proceedings under Rule 10b-5 of the Exchange Act require proof of 

scienter,22 which is a higher standard in bringing what would otherwise be a routine disciplinary 

action under a specific sales practice rule. 

Treasury rulemaking authority under GSA lapsed on October 1, 1991. To date, Congress 

has not acted to renew this authority. Treasury rules already promulgated remain in effect and are 

enforced by the appropriate regulatory agencies. 

Government Securities Act regulations. In its rulemaking capacity pursuant to the GSA, 

Treasury has issued rules for government securities brokers and dealers. Many of the rules issued 

by Treasury incorporated the existing SEC regulations that applied to registered brokers and 

dealers before the passage of the GSA. In addition, with limited modifications, compliance by 

financial institution government securities brokers and dealers with existing regulations of their 

appropriate regulatory agencies was also deemed in most cases to be compliance with Treasury 

regulations. 

Financial responsibility. The GSA regulations require that every government securities 

broker or dealer be subject to financial responsibility requirements. The GSA contains a specific

mandate to promulgate regulations in this area.23 As is the case with other sections of the 

regulations, a primary objective was to produce consistency in the level of regulation across 

different groups- in the market and to avoid duplication of existing regulations where possible. 

Therefore, registered brokers or dealers must comply with the SEC net capital rule for purposes 

of compliance with the financial responsibility rules of the GSA regulations. Likewise, financial 

institution government securities brokers and dealers must comply with the respective capital 

requirements of their appropriate regulatory agencies for purposes of compliance with the GSA 

regulations. 

With the passage of the GSA, financial responsibility regulation has been most significant 

for previously unregistered entities, because these firms were not, prior to registration, subject to 

any mandatory requirements regarding their capital. The Treasury capital rule differs from the 

SEC capital rule both in its risk measurement principles and ratio measurements. In the risk 

measurement area, the Treasury 

 

 22 The term "scienter," as applied to conduct necessary to give rise to an action for civil damages under the 

Securities Exchange Act and Rule 10b-5, refers to a mental state embracing intent to deceive, manipulate, or 

defraud. 

23 15 U.S.C. § 780-5 (b)(l)(A).

A-16 
“haircut”24 methodology provides a different system for recognizing the reduced risk of hedged 

positions. With respect to ratio measurements, the Treasury rule links a government securities 

firm's required liquid capital to measured risk because firms specializing in government 

securities generally bear insignificant risk from customer-related assets or liabilities and 

generally have low levels of unsecured debt.25

To provide for effective consultation in order to balance regulatory standards among 

market participants, the Treasury, the SEC, and the FRBNY have established an informal study 

group to research and discuss the issues that need to be resolved to reach a uniform capital rule 

for both registered brokers and dealers and registered government securities brokers and dealers. 

A uniform capital standard applicable to all nonbank brokers and dealers is a desirable goal, and 

through cooperative efforts to date, progress has been made toward reducing the differences 

between the Treasury and SEC capital rules. 

The financial responsibility regulations take into account the diverse categories of 

registered government securities brokers and dealers. To that end, the regulations for specialized 

government securities brokers and dealers contain an alternative capital treatment that can be 

elected by interdealer brokers. The regulations also assign different requirements to futures 

commission merchants that are government securities brokers or dealers and that are subject to 

the capital rule of the CFTC. These requirements are virtually identical to those for regular 

broker-dealers. The regulations also provide assurance that market participants have sufficient 

capital to support their positions and operational risks. 

Customer protection: hold-in-custody repo rules. The most significant and far-reaching 

requirements of the GSA regulations pertaining to customer protection are the rules for hold-incustody repurchase agreement transactions (hold-in-custody repos). The hold-in-custody repo 

rules strengthen customer protection by requiring that: (1) information be provided to investors, 

in writing, explaining the nature and specifics of the transaction; (2) specific disclosures be made 

concerning the risks associated with granting the broker or dealer the right to substitute securities 

and with the lack of coverage under either the Securities Investor Protection Act of 1970 or by 

the FDIC; (3) specific securities be clearly and separately held for, and a description of them

disclosed to, the customer; and (4) securities used to collateralize a repurchase agreement be 

maintained free of lien.

These hold-in-custody repo requirements make mandatory the use of written repurchase 

agreements containing the required disclosures. These agreements are required to be executed 

prior to the broker or dealer conducting a repo transaction. 

 

 24 "Haircuts" are measures of risk of a dealer's or broker's positions, reflecting market and credit risk. 

25 For a discussion of Treasury's capital rule, see 52 FR 1%42, 19651.

A-17 
Written agreements inform customers of their rights and liabilities in a repo transaction and 

reduce the possibility that they will misunderstand the terms of the transaction. 

The requirement that firms maintain and segregate specific securities is intended to 

eliminate the duplicative use of securities by brokers and dealers, as well as the practice of 

segregating customers' securities in pooled or bulk form. In pooling, a broker or dealer sets aside 

a pool of securities with an aggregate value at least equal to the amount of the repurchase 

transactions, but specific securities are not identified as belonging to individual customers. The 

requirement to allocate and maintain specific securities under a hold-in-custody repo not only 

reduces the likelihood of the double use of securities but also provides the owner with a clearer 

legal claim to the securities. 

Confirmations. Treasury regulations pertaining to hold-in-custody repurchase agreements 

mandate that the specific securities subject to the hold-in-custody repurchase agreement be listed 

on the confirmations - issued to customers along with, among other information, the market 

value of those securities. Confirmations benefit customers by providing information with which 

they can promptly act or react' in current transactions. Confirmations also enable customers to 

monitor the sufficiency and appropriateness of the securities provided by the counterparty. In 

addition, the Uniform Commercial Code assigns significant value to a confirmation in 

establishing a customer's interest in securities. Inclusion of market value on the confirmation 

ensures that the customer can verify that securities of sufficient value, including substitute 

securities, have been allocated to the transaction. This is particularly important because in some

sectors of the government securities market, securities are normally allocated to repo transactions 

based on the par value of the securities, and a less sophisticated customer could be unaware that 

the market value could differ substantially from the par value. This could cause the transaction to 

be under collateralized, and therefore, more risky for the customer. 

Nonbank government securities brokers and dealers are also subject to SEC confirmation 

requirements (SEC Rule 10b-10) for their general purchase and sale transactions, and financial 

institution brokers and dealers are subject to their appropriate regulatory agencies' confirmation 

rules. 

Recordkeeping. Treasury's recordkeeping requirements apply to registered brokers and 

dealers, registered government securities brokers and dealers, and financial institutions that are 

government securities brokers and dealers. In developing its regulations, Treasury relied heavily 

on existing recordkeeping rules of the SEC and the appropriate bank regulatory agencies. Thus, 

the regulations avoid overlap, duplication, and unnecessary burden. Therefore, Treasury's

recordkeeping rules, with only limited modifications, are familiar to the registered and financial 

institution brokers and dealers. 

A-18 
For registered brokers and dealers, the only material difference from existing SEC rules 

are additional provisions to the books and records requirements pertaining to repurchase and 

reverse repurchase agreement transactions that are intended to ensure proper accountability for 

the cash and securities involved in such transactions. 

Under the GSA regulations, registered government securities brokers and dealers are 

required to maintain and keep current books and records, preserve those records, and conduct 

quarterly security counts in accordance with SEC rules, with limited modifications. The 

differences between the respective SEC and GSA regulations relate primarily to the different 

financial responsibility requirements that apply to registered government securities brokers and 

dealers. 

The GSA regulations require financial institutions that are government securities brokers 

or dealers to comply with the SEC recordkeeping rules pertaining to making, keeping current, 

and preserving records, unless they are subject to, and comply with, specific recordkeeping 

requirements of their appropriate regulatory agency. In addition, there are two other records, 

securities positions and associated persons ' records, that financial institution brokers or dealers 

must maintain and preserve. When developing the regulations for financial institutions that are 

government securities brokers or dealers, the Treasury adopted the recordkeeping requirements 

imposed by the OCC, FDIC, and the Federal Reserve Board. Within the group of financial 

institutions, only savings associations (including savings banks) must comply with the SEC 

recordkeeping rules. The reason for this is that neither the FHLBB nor its successor, the OTS, 

the appropriate regulatory agency for savings associations, has promulgated comparable 

securities-related recordkeeping requirements for these entities. 

Reporting and audit. The financial reporting and audit requirements of the GSA for 

registered government securities brokers and dealers generally follow those of the SEC and the 

regulatory agencies. Except for interdealer brokers operating under the alternative capital 

treatment and futures commission merchants registered with the CFTC, registered government 

securities brokers and dealers file financial reports utilizing Treasury-prescribed forms pursuant 

to the GSA regulations. The format of reporting under the GSA regulations is substantially 

similar to that required pursuant to SEC rules. The GSA regulations require that interdealer

brokers operating under the optional alternative capital rule and CFTC-regulated entities that are 

government securities brokers or dealers file reports pursuant to the SEC rules. Financial 

institution government securities brokers and dealers that are subject to the financial reporting 

rules of their regulatory agencies are exempt from this portion of the regulations. 

A-19 
APPENDIX B 

ISSUES IN THE TREASURY MARKET 
1. Short Squeezes 

The term "squeeze" is used by market participants to refer to a shortage of supply relative 

to demand for a particular security, as evidenced by a movement in its price to a level that is out 

of line with prices of comparable securities - either in outright trading quotations or in financing 

arrangements. 

A short squeeze can arise in a number of ways. A squeeze can develop during the whenissued ("WI") period before a security is auctioned and settled. During this period, dealers sell 

the soon-to-be-available security and thereby incur an obligation to deliver such security at the 

issue date. These dealers, now short in the WI market, must cover this position by buying back 

the security at some point in the WI market, in the auction, or in the post-auction secondary 

market. If the dealers who are short do not bid aggressively enough in the auction to be awarded 

sufficient supply, or if other demand unexpectedly materializes, these dealers may experience 

difficulty in covering their positions. 

Such misses in the Treasury auction process by individual dealers are not uncommon. 

However, if a sizable number of dealers fail to cover their short positions in an auction, a 

squeeze can develop and the relative price of that particular security will rise. Yet, as the 

security's price rises relative to other issues with similar characteristics, the increasing price 

generally tends to create arbitrage opportunities that would bring supply and demand more 

closely in line. 

A short squeeze can also result as dealers set up typical arbitrage trades ahead of an 

auction. For example, dealers may sell the outstanding security short ahead of the auction to 

prepare for their customers to roll into the WI security. If a number of dealers adopt a similar 

strategy, a short squeeze may develop.1

Short squeezes are not only related to auctions; they may materialize independently of the 

auction process in secondary market trading and in the financing of positions as well. Such a 

situation might occur, for example, if aggressive participants acquired large positions in the 

secondary market. Other participants, not expecting such demand to develop, may have difficulty 

covering their short positions. Squeezes in outstanding issues may reflect various trading 

strategies that cause demand to center in a particular part of the yield curve. 

 

 1 This situation was exemplified around the time of the May 1986 Treasury mid-quarter refunding as 

participants sold the outstanding 9 1/4 percent bond due in February 2016 to prepare for the roll into the WI 3O-year

bond. Demand for the 9 1/4 percent bond grew, however, as securities needed to cover short positions were not

readily available to the repo market. 

B-1 
A squeeze also may be manifested in the financing, or repo, market. Dealers that have

short positions, by definition, have sold securities they do not own. In order to deliver those 

securities on settlement date, these dealers can either buy the securities from another party or 

acquire them under a reverse repurchase agreement. When a specific issue becomes scarce 

relative to demand, dealers wishing to acquire that issue in the repo market must provide some

sort of concession to those who own the securities to prompt them to make the securities 

available. When such a concession is granted, the scarce issue is said to be "on special" For the 

owner of the scarce securities, this means that these "special" issues can be financed (that is, 

delivered out against cash collateral) at a relatively low interest rate, while the borrower of the 

securities has to "pay up" to acquire the securities needed to satisfy its delivery obligation. 

Squeezes in the repo market also can be created or exacerbated by market participants that 

hold a relatively large portion of a security. For example, a participant that holds a large amount 

of a scarce security can increase its scarcity value by financing a portion of the holdings away 

from the "special" repo market. That portion presumably would be financed at rates around the 

general repo rate, while the balance could be financed at very favorable depressed rates. 

The directed placement of repo collateral with certain entities could help a market 

participant create or sustain an issue's scarcity. Some have cited the so-called tri-party agreement 

in this regard. Tri-party agreements generally involve an investor often a pension fund, money 

market fund or corporate treasurer - that wishes to invest large sums of money overnight or for 

some brief period on a collateralized basis.2

 These agreements by the investor, the dealer, and the 

dealer's bank were developed in response to credit concerns about hold-in-custody tri-party repos 

and have been generally encouraged. One key feature in these or any other type of arrangement 

where collateral is directed "off the street" is the ability to finance scarce securities with the 

knowledge that the securities will not be lent back into the market to participants that have short 

positions to cover, thus sustaining the scarcity. 

Financing market squeezes are not uncommon. In recent years, one or more actively 

traded Treasury securities have been "on special" on most days. In general, squeezes appear to 

result from relatively heavy demand from a number of market 

 2 Under normal practice, the investor specifies the conditions which the collateral must meet and the range of 

funds it stands ready to invest each day. The investor works with a bank, which in turn takes instructions from the 

dealer firm for delivery of collateral and for payment of funds. Some investors find the market yield and flexibility 

of repo transactions attractive, but also wish to avoid the transactions and back office costs of taking delivery of 

securities in repos. Such participants may choose to enter into a triparty agreement with a bank and dealer. 

Normally, the bank monitors the collateral provided by the dealer on the investor's behalf and segregates it into a 

special account to protect the investor's interest. 

B-2 
participants for a particular security, rather than occurring either through a calculated shortage 

engineered by a limited number of participants or by collusive behavior. 

Squeezes reported in 1991 in the April and May two-year Treasury notes were manifested 

in both the cash and financing markets. The situation in the April two-year note developed after 

the Treasury's auction of that issue. Reportedly, several large participants purchased a large 

portion of this issue. The squeeze became particularly acute towards the end of May. In addition, 

the April two-year note reportedly became quite difficult to borrow in the financing markets. As 

a result, dealers and investors who held short positions in this security were forced to pay higher 

than expected prices to buy those securities back or to acquire such issues at special rates in the 

repo market, if available.

In contrast, the reported squeeze in the May two-year note developed at the time of the 

Treasury auction. During that auction, certain dealers were not awarded as many notes as they 

needed to meet their obligations to their customers. While WI trading and pre-auction market 

talk centered around an average rate of 6.83 percent, more aggressive bidding interest resulted 

(accepted yields averaged 6.81 percent), thereby closing out many participants from awards they 

had expected to receive in the auction. 

Soon thereafter, the price of these May two-year notes rose in the secondary market and 

exacerbated the loss of those participants who were short the issue. Some participants may have 

chosen, however, to retain short positions in the hope that the price of the issue would fall (as 

owners of the security took profits) or that financing could be obtained. The high price persisted 

for a long period of time, and financing was expensive. 

B-3 
2. Debt Management Approaches to Alleviating Squeezes

As discussed in this report, the Agencies have decided that short squeezes can reach a 

level of severity that can cause the integrity of the entire market to be questioned. This can 

eventually result in higher costs to the taxpayer if some market participants drop out of the 

government securities market because they perceive the market as being unfair. 

This section examines debt management options that could be used to alleviate short 

squeezes. The most obvious option is for the Treasury to supply the market more of the security 

that is subject to an acute, protracted squeeze. This could be done in a variety of ways. In 

addition to the Treasury making available additional supply of a security, another option is the 

setting up of a facility for the market to create more of a given security than was originally issued 

from the stripped components of other securities. This option is discussed at the end of this 

section. 

The Treasury has concluded, and the other Agencies concur, that, while a policy of 

supplying more of a security subject to a squeeze could be difficult to implement, it is justified 

under certain circumstances. Uncertainties about the potential for prolonged shortages may 

weigh more heavily on the market than the concern that the Treasury might provide an additional 

quantity of a relatively high-priced security. In the event of an acute, protracted squeeze, in 

which a recently issued Treasury security is priced significantly higher in the market than near 

substitutes and financing rates also indicate that market participants are having difficulty 

borrowing the security in order to avoid fails to deliver, the Treasury will provide the market 

additional supply of that security, either temporarily or permanently, unless legal constraints, 

such as the debt limit or tax provisions, prevent it from doing so. Because of the near 

impossibility of determining whether a squeeze is the result of deliberate manipulation in time to 

correct it by intervention, the decision to alleviate a squeeze will not be based on the perceived 

intent of those holding long positions but rather on whether the pricing anomalies are serious 

enough to result in a disorderly market. 

Issues in deciding to increase the supply of a security 

The Treasury has, in the past, been reluctant to reopen securities outside of its normal 

financing schedule. There was a concern that, if the Treasury were to announce and implement a 

policy of reopening securities when it perceived price distortions, market participants might 

demand a higher yield from the Treasury on securities at auction, given the greater uncertainty 

about the eventual supply of the security. Moreover, it has been argued that traders and dealers 

know the risks of taking short positions and should not expect to be bailed out when the market 

behaves differently than expected. 

B-4 
Effect on prices and participants. The price of a given Treasury security can vary such 

that its yield at any particular time can be above or below the yield of near substitute securities. 

Normally, arbitrage activity will serve fairly promptly to remove inconsistencies in the price of

near substitutes. However, in more severe cases, it may take time for the natural workings of the 

market to eliminate price anomalies. 

Through a reopening policy, the Treasury will attempt to enhance the function of 

arbitrageurs by speeding the removal of certain pricing inconsistencies. Because of the 

Treasury's ability to create virtually any amount of a given security, a reopening policy to 

alleviate a squeeze cannot be defeated by market manipulators. This does not mean, however, 

that a reopening policy will be easy to implement in practice.

First, it should be noted that a reopening policy to alleviate squeezes in Treasury securities 

implies that the Treasury will intervene only when the price of a given security is perceived as 

being too high. Consequently, given an announced Treasury reopening policy, market 

participants know that any "winnings" on a bet that a new security will be priced higher than near 

substitute outstanding issues are effectively subject to a cap. On the other hand, market 

participants betting that the price of the new issue will be lower than that of near substitutes will 

not face such a cap on profits by Treasury policy. This means that a Treasury reopening will lean 

effectively in favor of arbitrageurs who hold short positions in the new issue, because their 

potential losses are capped by the Treasury, while no such protection is afforded those who are 

long the new issue. 

Conversely, those holding long positions in the new issue not only have no such 

protection concerning the magnitude of their loss if their bet is wrong but face a limit on their 

gain. In fact, depending on how the reopening is implemented, a market participant betting that a 

new issue will be priced relatively high may be better off if the pricing difference remains 

modest. Otherwise, the Treasury may enter into the market and the pricing difference may 

completely disappear or even reverse. The effect of this change on the behavior of market 

participants is very difficult to gauge.

Clearly, supplying the market more of a particular security, either temporarily through 

lending transactions or more permanently through a sale, raises difficult issues of judgment. A 

decision to alleviate a squeeze by either a temporary or permanent issuance of more of the 

squeezed security would benefit some market participants and harm others. The Treasury might 

not know the causes of a pricing distortion and would not know how long the distortion would 

likely last. It would also not be clear how much additional supply of the security would be 

needed to break a squeeze. If the Treasury were to sell more than was needed, it is possible that 

the pricing relationships could reverse and the new supply of securities could be a relatively 

expensive form of borrowing. It is also possible that by the time a reopening decision had been 

made, the profits from a squeeze deliberately created may have already been taken. 

B-5 
It should also be noted that two factors can constrain the Treasury's ability to provide an 

additional supply of a security. The first is the debt limit, which at times limits the Treasury's 

ability to issue securities. The second is the federal income tax rules governing original issue 

discount. 

The tax rules would come into play if the security being squeezed is trading significantly 

below its original issue price.3

 If the price of the security is sufficiently below the original issue 

price, then the proposed tax regulations on original issue discount may effectively preclude the 

Treasury from issuing more of the security.4

When to reopen. It should be emphasized that the decision to reopen a security cannot be 

simply based on a mechanical rule. A commonly held view is that additional supply of a given 

security should be provided when its yield is significantly below the yield curve. While this may 

seem simple in concept, it is in fact more complex than it may initially appear. 

The yield curve is not directly observable. It is a line drawn on a graph where the 

horizontal axis denotes time remaining to maturity and the vertical axis denotes yield. A point on 

the line is used to estimate the yield of a security with a given maturity. There are different ways 

to draw such a line. One way is to fit a curve through the most recently issued Treasury securities 

using statistical techniques. This method of course would not work to solve the present problem, 

since the question at hand is whether the most recently issued Treasury security is off the curve. 

Older issues must thus also be used to estimate the curve in order to determine whether a new 

issue is out of line. 

 3 In general, a security is subject to the original issue discount rules for tax purposes if it is issued at a price 

which is lower than the par value by more than a de minimis amount. Under Internal Revenue Code section 

1273(a)(3), original issue discount is ignored if it is less than the number of complete years to maturity multiplied by

25 basis points. Thus, tax issues would arise if a two-year note were reopened at a price of 99.75 or less, because the 

security would have less than two complete years to maturity at the time of the reopening. 

4 Under Prop. Reg. § 1.1275-1(e), two or more publicly offered debt instruments are not part of the same "issue" 

unless they are sold at substantially the same time pursuant to a common plan of marketing. If securities issued at a 

significant discount in a reopening were considered a different "issue" than the squeezed securities that share the 

same payment terms, the different tax treatment of the two issues would prevent the reopening from alleviating the 

squeeze. 

Even if all Treasury securities with the same payment terms were considered to be part of one "issue" for tax

purposes, Prop. Reg. § 1.1273-(2)(b)(1)(ii) defines the "issue price" that is used to determine whether Treasury 

securities are subject to the original issue discount rules as the average price of the debt instruments sold. Thus, if a 

large amount of securities were issued at a significant discount in a reopening, the average selling price of the new 

and old securities could fall below the de minimis amount, and the entire "issue" could become subject to the

original issue discount rules. 

B-6 
Unfortunately, a yield curve estimated by using older issues raises other problems, 

because the securities used in the estimation will bear different coupons due to the different 

prevailing levels of interest rates at their issuance dates. Even assuming perfect arbitrage across 

the maturity spectrum and ignoring tax considerations for the moment, the yield on Treasury 

securities is not solely a function of time to maturity but also of the periodic coupon payment. 

A Treasury note or bond is actually a package of payments that the Treasury promises to 

make at future dates. The government securities market determines what investors are willing to 

pay at the present time for these future payments. The yield of a given Treasury security is the 

single rate whicht when used to discount all the future payments of a Treasury security to the 

present time, will produce values that sum to the current price of the security. Finance theory 

shows that, even given perfect arbitrage, this yield, in virtually all cases, will not be the same in 

equilibrium for Treasury securities that mature on the same date but carry different coupon rates. 

In addition, other factors, such as the lesser liquidity of seasoned issues, affect yield differentials 

among Treasury securities. 

Tax considerations add to the complexity of comparing securities with different coupon 

rates. A Treasury security initially issued close to its par value but whose price has declined will 

have a tax advantage over a security that has the same yield but a higher coupon rate and is thus 

selling close to its par value. The reason is that the "market discount" on the first security will 

only be taxed at maturity, sale, or other disposition of the security,5

 while the security with the 

higher coupon rate does not receive this deferral on the taxation of its return to the investor. 

Prices and yields on Treasury securities with different coupon rates will to some extent reflect 

this difference in taxation. 

For these reasons, a-simple mechanical rule is inadequate to determine whether 

the Treasury should provide additional supply of a given security. Analysis and judgment will 

need to be exercised each time there is an acute, protracted squeeze in a given security. 

Methods of providing the market additional supply of a security 

There are a number of methods which the Treasury could use to supply the market more 

of a given security, including (1) an auction, (2) an offering of additional supply in increments 

through the Open Market Desk of the FRBNY (a "tap"), (3) an issuance window, and (4) an offer 

to lend securities to government securities dealers using the FRBNY as fiscal agent. 

 5 See Internal Revenue Code sections 1276-1278. 

B-7 
As discussed above, there are difficult issues to be addressed in making a decision to 

supply more of a security to the market by any of these means. A fifth possibility, which does not 

pose these same difficulties, is to allow market participants to create more of a security than was 

originally issued from the components of debt already outstanding. This option is discussed in 

some detail at the end of this section. 

Each of the four methods that require the Treasury to decide to make additional securities 

available has advantages and disadvantages. The Treasury will decide which method is 

appropriate given the specific market conditions prevailing when there is an acute, protracted 

squeeze. However, it should be noted that, as discussed below, in order for the Treasury to use 

the securities lending option, additional legislative authority is necessary.

Auctions. If the Treasury determined that a squeeze of sufficient severity existed, it could 

decide to offer an additional amount of the security through an auction. The timing of the auction 

would be affected by the already announced schedule of auctions, but it could be done fairly 

quickly, with issuance to take place on the day following the auction. In any case, the 

announcement of an auction to reopen a squeezed security would be considered a major event by 

the government securities market, and the announcement effect might be manifested almost 

instantaneously, as the price of the targeted security adjusted to the anticipated increase in 

supply. 

In order to protect itself from having to accept unfavorable prices in this type of 

reopening, the Treasury might announce that it is offering up to a certain maximum amount of 

the security but reserves the right to award less, or none at all, if prices bid in the auction were 

deemed to be too low. 

Reopening by auction is an aggressive government intervention. It is a straightforward, 

forceful way to deal with serious short squeezes. Consequently, the Treasury might not have to 

do this type of reopening very often once its willingness to reopen by auction was established. 

However, reopening by auction is neither a very flexible nor a very subtle approach to 

dealing with squeezes. Also, it is not evident that the Treasury will be able to capture any of the 

pricing anomaly for the benefit of the taxpayer by resorting to an auction. 

Tap issues. Another alternative to reopening a security through an auction would be for 

the Treasury to sell more of the security through the FRBNY's Open Market Desk. The Desk 

could sell a little of the security at a time until a sufficient amount had been sold to eliminate 

pricing distortions. This method of selling more of an existing security is commonly referred to 

as offering it "on tap," and the security so offered is called a "tap issue," using the financial 

market terminology of the United 

B-8 
Kingdom, where the Bank of England sells some of the U.K. Treasury's securities in this 

manner.6

 

There are different ways to operate a tap. Decisions that would need to be made include: 

• How will the willingness of the Treasury to sell securities through a tap operated by the 

Open Market Desk be communicated to the market? 

• Which market participants will be eligible to buy the offered security? 

• How will the price at which the Treasury is willing to sell the security be determined? 

• At what point will the Treasury decide to end the tap?

Offering the market additional supply of a security through a tap has some advantages 

over the auction technique, specifically enhancing the ability to move quickly and fine tune the 

amount needed to break a squeeze. However, tap offerings may not be the best method to sell 

securities quickly in large amounts, if that is what is needed to alleviate a squeeze. Also, a policy 

of offering securities on tap could lead to greater demands to fine tune the market than would a 

policy of reopening by auction. 

Issuance window. In the initial auction announcement, the Treasury could commit to 

provide more of the security to any market participant at a yield that was fixed at a specified 

amount below that of a near substitute security that is identified. In effect, this notice would 

serve as a call option (an option to buy at a specified price) issued to the market, which would be 

in force for a set period of time. 

The advantage of this method would be to give the initiative back to the market in 

enforcing a limit on the size of any price anomaly: the Treasury sets the maximum spread and 

market participants respond when conditions warrant. With the bounds publicly announced, any 

uncertainty about potential Treasury actions is reduced. However, determining the maximum 

spread would be difficult. Tax and operational issues would also need to be addressed. 

 6

 In the United Kingdom, the Bank of England may buy some of the securities offered by the U.K Treasury and

offer them on tap. In this case, the U.K Treasury has already received the funds from the Bank of England. This 

would be prohibited in the United States, because the Federal Reserve is prohibited from buying securities directly 

from the Treasury for its own account. Consequently, Treasury would receive funds from a tap issue only' as the 

securities are sold and the funds from the purchasers are received. 

B-9 
Securities lending. One way of providing securities to alleviate a squeeze in a more 

flexible and less permanent manner is for the Treasury to lend to market participants an 

additional supply of a security subject to a serious squeeze. 

Legal constraints limit the Treasury's ability to lend an additional supply of a security 

directly. The reason is that the Treasury's authority to issue debt generally can be for one of two 

purposes: to borrow funds to meet government expenditures or to buy, redeem, or refund 

outstanding debt.7

 The Treasury does not have the authority to issue securities solely for the 

purpose of lending them in order to counter apparent price discrepancies. Consequently, before a 

securities lending program such as the one described below could be implemented, legislation 

authorizing it would need to be enacted. 

Under the proposal, once the Treasury had determined the need to alleviate an acute, 

protracted squeeze through securities lending, the FRBNY's Open Market Desk, acting as the 

Treasury's fiscal agent, would implement the operational aspects of the program with market 

participants. If it were desired that the program not affect bank reserves nor add to the Treasury's 

cash balance, the securities lent could be collateralized by the borrower with other Treasury 

securities of similar market value pledged to the Treasury. In this case, in addition to pledging 

securities to the Treasury, the borrower would also pay a fee for borrowing the squeezed 

security. After the market problem had abated, the borrowers would return the security they had 

borrowed to the Treasury in return for their original securities. Alternatively, the Treasury could 

engage in repurchase transactions with government securities dealers and receive cash for the 

securities. 

The securities lending approach has some significant advantages over auctions and taps. It

would be a temporary measure to deal with a temporary market problem. It provides for a better 

possibility for the Treasury to capture some of the pricing anomaly and thus in effect make 

money for the taxpayer. Finally, like a tap, it is a more flexible approach than auctions to ending 

a squeeze. 

There are also some disadvantages with this approach. Many of the same questions that 

arise with respect to operating a tap issue need to be answered to operate this type of securities 

lending program. The most significant issues to be resolved would be how to price the lending 

transaction and how to determine eligibility to borrow the security. Also, like a tap, 

implementation of a securities lending program could lead to expectations or demands that the 

Treasury fine tune the market to eliminate even small perceived price discrepancies. 

 

 7 31 U.S.C. 3102-3104, 3111. 

B-10 
"Synthetic reopenings" using STRIPS. Another debt management idea to break 

squeezes is to let market participants effectively create more of a given security using the 

Treasury's Separate Trading of Registered Interest and Principal of Securities ("STRIPS") 

program. The underlying notion is to create a market mechanism to break a squeeze. The appeal 

of this method is that the market would determine how much of a given security was needed to 

break a squeeze. If this method could be made to work, market participants would have an 

additional arbitrage tool available to them to bring the pricing of various Treasury securities in 

line with each other. In this way, the problems with having the Treasury create an additional 

supply of a security subject to a squeeze would be avoided. 

Background on STRIPS program. In February 1985, the Treasury implemented a facility 

to allow certain Treasury securities to be separated into their interest and principal components 

on the commercial book-entry system for Treasury securities operated by the Federal Reserve 

banks. The system allows original issue 10-year Treasury notes and 30-year Treasury bonds to 

be separated into these components. The amount of a note or bond that is stripped must be such 

that both the principal component and each semiannual interest payment is divisible evenly by 

$1,000. 

Each Treasury note or bond issue has a unique CUSIP number assigned to it. When an 

issue is stripped under the current STRIPS program, the principal component is assigned another 

CUSIP number that is unique for that principal component, and each interest payment is assigned

a "generic" CUSIP number that is given for all stripped interest components that come due on a 

specific date.8

 Once stripped, the components are transferred separately on the book-entry system

in multiples of $1,000. 

In May 1987, the Treasury enhanced the STRIPS program by allowing components to be 

reconstituted into the original note or bond. In order to reconstitute a stripped note or bond, a 

market participant must acquire the principal component, or corpus, of the note or bond to be 

reconstituted in an amount evenly divisible by $1,000 that will produce interest payments that 

are also evenly divisible by $1,000. The market participant must also acquire all the remaining 

stripped interest payments in an amount that corresponds to the principal amount to be 

reconstituted.9

Since stripped interest and principal components are each firm promises by the Treasury 

to pay fixed amounts at specific dates in the future, there is no economic 

 

 8 Generic CUSIP numbers for stripped interest components were instituted on July 29, 1985. Since in 

most cases more than one Treasury security that is eligible to be stripped under the STRIPS program pay interest on

the same dates, it is usually not possible to identify a stripped interest component with a particular note or bond.

9 Note that while the corpus must come from the security that had originally been stripped, the interest 

components need not come from that security. 

B-11 
difference between stripped interest and principal components.10 Consequently, it would appear 

that one way to enhance the STRIPS program and allow the market to create more of a particular 

security for which there is strong demand is to eliminate the requirement that, in order to 

reconstitute a given security, the principal component derived from the security to be 

reconstituted must be presented as part of the package of payments. The CUSIP number of a 

security the Treasury has issued could be assigned on request to a package of stripped 

components that exactly match all interest payments and the principal payment of that security.11

H this were allowed, it would be possible for the market to create more of a given" security than 

was originally issued without requiring the Treasury to sell more securities. The timing and the 

amount of total payments that the Treasury has contracted to pay at original issuance would not 

have changed. The market would effectively decide how much of a given security to create and 

thus could break a squeeze through this mechanism.

This idea has substantial theoretical appeal; however, there are some formidable practical 

difficulties. 

Tax issues. A reconstitution of a note or bond currently selling at a discount from par may 

result in less current tax revenue. The subsequent purchaser of the reconstituted security would 

be able to characterize the discount from par as market discount and obtain deferral of the tax on 

that amount until maturity, sale, or other disposition of the security. However, a portion of the 

discount at which the stripped components (corpus or interest) were acquired by a taxpayer is 

includible in current income, since the entire amount of this discount is characterized for tax 

purposes as original issue discount. Consequently, reconstitution has the potential effectively to 

convert some original issue discount into market discount, which lowers the tax burden on the 

subsequent purchaser by allowing deferral of income. 

 

 10 In the U.S., the tax treatment of stripped interest and principal components is identical. Each time these 

components are sold, they are viewed as newly issued discount instruments for purposes of determining original

issue discount. A portion of the original issue discount is includible in the taxable income of the holder each year. It

is not possible to obtain market discount treatment for a stripped component. Market discount is only includible in

taxable income upon maturity, sale, or other disposition of the security acquired with such discount. See Internal 

Revenue Code sections 1276-1278. 

11 By way of example, assume a Treasury note that has an 8 percent coupon payable every six months and has 

five interest payments remaining. The payment stream of this security for $100,000 of principal would be four

payments, at six month intervals, of $4,000 and a final payment of $104,000 ($100,000 of principal and $4,000 of

interest). Under the current reconstitution program, five generic interest components of $4,000 each coming due on 

the correct dates and the correct principal component in an amount of $100,000 would have to be assembled in order 

to reconstitute the note. The enhancement suggested above would allow the last payment of the package of $104,000

to be composed entirely of a stripped interest component (or a principal component from a different security) in that

amount coming due on the appropriate date.

B-12 
The reconstitution program outlined above raises the possibility of significant tax revenue 

losses if the market were to seize the opportunity to create additional supplies of low coupon 

bonds selling at a discount. A solution to this problem, without resorting to significant changes in 

tax law concerning the tax treatment of original issue discount and market discount, would 

involve some restrictions on the ability to reconstitute securities without the correct corpus. 

One possible solution to this problem would be to limit the securities that can be 

synthetically reconstituted to those that have been issued within a limited period, for example, 

six months, prior to the reconstitution date. These securities are unlikely to be selling at a large 

discount unless there was a significant increase in interest rates shortly after the security was 

issued. Also, even with this restriction, the ability of the market to resolve squeezes would be 

enhanced, since squeezes usually develop for recently issued securities, not seasoned issues. 

Another possibility would be to allow only those securities to be reconstituted synthetically that 

are not selling currently at discount from par greater than a specified amount. 

An additional tax complication that requires further study derives from the realization rule 

in Internal Revenue Code section 1001(c). Because the proposal involves the transformation of 

an interest component into the principal of the reconstituted security, it is possible that the 

issuance of the new CUSIP number for the bundle of payments would be a realization event for 

tax purposes under section 100l. In any case, the tax rules in this regard would need to be 

clarified. 

Legal and accounting issues. There may be legal obstacles with respect to the Treasury 

setting up a facility for synthetic reconstitution. It is not clear what the treatment of the 

synthetically reconstituted security would be for the purposes of the debt limit and for 

appropriation purposes. 

The Treasury has a permanent indefinite appropriation to pay interest on the public debt.12

Repayment of principal is not treated as a budget outlay, which requires an appropriation, but as 

a financing transaction. Redemption of principal is a negative means of financing, while the 

issuance of the security is a positive means of financing. The amount of financing that can be 

accomplished through the issuance of securities is restricted by the statutory limit on the public 

debt. 

The implication of the conversion of interest components into the principal of a note or 

bond is not clear under the public debt statutes, which were enacted in their basic form long 

before the idea of stripping and reconstituting securities was conceived. It might make most 

sense from the government's point of view to ignore the conversion for purposes of determining 

the debt subject to limit and interest paid on the public 

 12 31 U.S.C. 1305. 

B-13 
debt, since nothing has happened to the total amount the Treasury has contracted to pay in 

originally issuing the securities. Achieving this result may require amending the public debt 

statutes and other laws. 

Whatever the legal characterization of the conversion, significant changes would have to 

be implemented to the Treasury's public debt accounting systems in order to keep track of 

interest and principal payments. Currently, these systems verify the amount of interest paid on 

each security, or loan, by reference to the principal outstanding of that particular security. H the 

interest payment from another security were to become an addition to the outstanding principal 

of a shorter maturity security, modification' to this method of accounting for interest and 

principal payments would have to be made. Before such modifications could be even 

characterized, the legal implications and the budget and accounting rules with respect to 

synthetic reconstitutions would have to be determined. 

Timing issues. The most serious constraint on the utility of the synthetic reopening 

proposal is the availability of sufficient strippable interest and principal components. Only with 

significant modifications to the current financing schedule and payment dates for new Treasury 

securities could this proposal become an effective means for combatting squeezes and market 

manipulation in all segments of the market. However, major changes to the financing schedule 

would create additional operational and cash flow problems for the Treasury. 

First, in order for a synthetic reopening/reconstitution program to become operational, the 

STRIPS program would need to be expanded to allow stripping of all marketable Treasury notes 

and bonds. This modification would pose few problems for the Treasury, aside from the need to 

expand administrative capacity of the STRIPS program. 

The larger problem is that without major changes to the financing and payment schedule, 

the potential for synthetic reopening or reconstitution of different Treasury securities would 

differ markedly depending on the ultimate maturity date of each security. For example, under the 

current financing schedule, synthetic reconstitution would be impossible for new five-year and 

seven-year notes and 30-year bonds. For two-year notes, the potential increase in overall supply 

from synthetic reopenings would be highly variable, depending on the month of maturity. The 

potential to create new to-year and three-year notes would be much greater. 

The underlying reason for this disparity is quite simple: securities that share maturity and 

interest payment dates with longer-term securities can be replicated much more easily with 

stripped components of other securities. For example, a newly issued 30-year bond, the longest 

maturity Treasury security currently offered, does not share its maturity date with any other 

marketable Treasury securities; consequently, its principal component and last interest payment 

component cannot be replicated by 

B-14 
using components originally stripped from other Treasury issues.13 Also, seven-year notes are the 

only coupon securities that mature and pay interest on a January 15, July 15, April 15, October 

15 schedule, and therefore no strippable components from other securities exist to replicate their 

payment stream. 

For two-year and five-year notes, principal and semiannual interest payment dates occur 

on the last day of each month, unlike three- and 10-year notes and 30-year bonds, which make 

payments in the middle of the month. This means that the five-year note does not share its 

maturity date with any other security, and therefore cannot be replicated. While every two-year 

note has a payment schedule that is consistent with one or more five-year notes, until 1994, only 

the interest payments, not the principal components, of five-year notes would be available for 

stripping and reconstitution as two-year notes. This interest amount is a fairly small, though 

growing, amount in relation to the issue size of recent two-year notes. In contrast, the potential to 

reconstitute synthetically three-year and 10-year notes, which are issued at the Treasury's

quarterly refundings, would be much greater because they share payment dates (February 15 and 

August 15 or May 15 and November 15) with 30-year bonds. 

To make reconstitution easier for most notes and bonds, it would clearly be necessary to 

standardize payment dates so that each security matured on a common payment date with other 

securities. This would require extensive modifications to the current Treasury financing 

schedule, which would take years to have their full effect on the potential to reopen synthetically 

any particular security. In the transitional period after such changes were made, a progressively 

larger amount of strippable components would be available as more securities were issued under 

the consistent payment schedule. For longer term securities switched to a new payment regime, it 

would be years before adequate strippable components existed to allow synthetic reopenings to 

mitigate a squeeze. 

In addition, modifications to the current financing schedule might create cash management 

problems for the Treasury. There are currently 20 payment dates per year for interest and 

principal on Treasury notes and bonds. To be effective, the synthetic reopening scheme would 

probably require the Treasury to auction securities of all maturity lengths on a quarterly, 

monthly, or semi-monthly schedule. (Alternatively, the Treasury could issue securities on 

different auction schedules but with standardized interest payment and maturity dates. This 

would require issuing some securities with accrued interest.) If the financing schedule were 

modified in this way to accommodate synthetic reopenings, it would smooth out debt related 

cash outflows from month to month. However, this might create serious cash management 

problems in the short term, since the Treasury would still need to fund the large interest and 

principal amounts associated with past quarterly refundings. In other 

 13 Note that the synthetic reconstitution approach cannot be made to create an additional supply of the most

recent issue of the longest maturity security that the Treasury offers. 

B-15 
words, even moving to a smoother financing pattern would create transitional cash flow

irregularities that might persist for years. 

More volatile Treasury cash balances would create problems for the Federal Reserve in 

implementing monetary policy. The Treasury tries to maintain a stable cash balance at the 

Federal Reserve of about $5 billion. Additional amounts of cash are held in Treasury Tax and 

Loan ("TT&L") accounts at commercial banks and other financial institutions. The total capacity 

of TT&L accounts is about $35 billion, however, and large, uneven cash inflows occasionally 

spill over into the Treasury's account at the Federal Reserve. When this happens, reserves are 

taken out of the banking system, and the Federal Reserve must undertake open market 

transactions in order to offset this drain. 

In summary, the synthetic reconstitution idea, while having substantial theoretical appeal, 

has some large practical difficulties associated with it. Even assuming that all the tax, legal, and 

accounting issues could be resolved, the proposal implies some major changes in Treasury's debt 

issuance schedule. This has implications beyond transitory market problems associated with 

squeezes. Of course, a synthetic reconstitution program could be implemented without debt 

issuance schedule changes, but the ability of such a program to facilitate the breaking of market 

squeezes would be much more limited. 

B-16 
3. Treasury Auction Issues 

A. Auction Technique 

This section examines simple descriptions of auction organization and discusses in more 

detail two specific proposals for reform of the auction process. While much of this discussion is 

in theoretical terms, it should be understood that market specifics make it difficult to translate 

theory into practice, with the goal of assessing the efficacy of any auction reform. 

For example, unlike most of the simple theoretical constructs that appear in the economics 

literature, the Treasury offers multiple units of the auctioned security, with open trading in those 

securities preceding (in the when-issued market) and following (in the secondary market) the 

issuance of securities. Another deviation from common theoretical assumptions is that investors 

can adjust their behavior in many ways, such as by varying the amount of information collected, 

by altering the volume of bids, or by placing bids indirectly through dealer intermediaries. These 

considerations are important in the policy context, and this section attempts to address them as 

well as presenting a basic theoretical framework for assessing auction methods. 

Auction methods 

There have been many important contributions to the academic literature on auctions, 

including early efforts by William Vickrey and Milton Friedman, as well as significant later 

work by Paul Milgrom, among others.14 This research has classified the types of auctions, 

modelled the bidding strategies rigorously, and ranked the outcomes by various criteria. A 

number of similarities among auctions have emerged, as well as equivalence propositions 

concerning the revenue to the seller. Unfortunately, members of the financial and academic 

communities describe auction formats by a variety of names, some overlapping and others 

conflicting. To reduce confusion, this section will use explicit, if somewhat unwieldy, names for 

each auction type. 

 14 The early references include William Vickrey, "Counterspeculation, auctions, and competitive sealed

tenders," Journal of Finance, Vol. 16 (March 1961), pp. 8-37, and Milton Friedman, "Comment on Collusion in the 

auction market for Treasury bills,’" Journal of Political Economy, Yol. 72 (October 1964), pp. 513-514. Recent

work is summarized and reviewed in R. Preston McAfee and John McMillan, "Auctions and bidding," Journal of

Economic Literature, Vol. 25 (June 1987), 699-738; Paul Milgrom, "Auctions and bidders: a primer," Journal of

Economic Perspectives, Vol. 3 (Summer 1989), pp. 3-22; and Paul Milgrom and Robert J. Weber, "A theory of

auctions and competitive bidding," Econometrica, Vol. 50 (September 1982), pp. 1089-1122. A less rigorous

overview with applications to Treasury securities is provided by Loretta J. Mester, "Going, going, gone: setting

prices with auctions," Federal Reserve Bank of Philadelphia Business Review, (MarchjApril1988), pp. 3-13. 

B-17 
William Vickrey originated the standard auction taxonomy, classifying auction types 

based on the order in which prices were quoted, as well as the auction forum. First, awards can 

be made at prices that are progressively lowered (or, equivalently, at yields that are raised) until 

all of the goods or securities are sold; alternatively, the bids can be arranged in ascending order 

by their price and a single price determined that just places the total issue. Second, the auction 

can be conducted with sealed bids entered any time up to a deadline and subsequently opened by 

the auctioneer; on the other hand, the auction can be conducted with open bids put forth by 

participants in an open gathering or some other means of direct communication with the 

auctioneer (such as by telephone). This two-by-two classification scheme yields four auction 

types, described below. 

Beyond these categories, models can be stratified further by the assumption concerning 

bidders' information about the value of the auctioned object. In the "private-values" case, bidders 

make subjective decisions as to the value of the object on the auction block, independent of each 

other. In the "common-values" case, each participant attempts to measure the item's value by the 

same objective yardstick. The auction of a unique piece of art is the prototypical private-values 

example, while a Treasury auction - with each bidder guessing at the security's resale value - 

matches the common-values assumption. 

Multiple-price, sealed-bid auction. The Treasury's current auction methodology falls 

into this category, which in the financial community is termed an English auction (except by the 

English, who call it an American auction). Bidders spell out their intentions on tender forms that 

must be turned in before an established deadline. An individual sealed bid, known only to the 

tenderer and to the auctioneer, reports the quantity and price for the auctioned security that the 

bidder is willing to pay.15 The auctioneer then ranks those bids by tendered price (or equivalent 

yield) and makes awards at the highest prices covering the total auction size. Thus, participants 

pay differing prices reflecting the strength of their bids, with the surest winner the one furthest 

above the market consensus. This type of auction is called a "first-price" auction when a single 

unit is for sale because it is the first, or highest, price that is accepted. 

In this case, winning is losing, as entering the highest bid signals that the bidder's 

valuation exceeds that of all other interested parties. Because all participants, in effect, are 

guessing about the same common value - the price at which the security will trade after the 

auction - a high bid signals a heightened probability of subsequent loss for that bidder. This is the 

"winner's curse" and gives bidders an incentive to rein in their

 15 A bidder's intention will be measured here in terms of the price he or she is willing to pay for the security 

rather than the equivalent yield he or she is willing to earn on the security. 

B-18 
enthusiasm. The optimal strategy is to shade a bid toward the perceived market consensus.16

The risk of the winner's curse puts a premium on market information entering the auction, 

and this incentive shapes bidders' behavior before and at the auction in three major ways. First, 

when-issued trading before the auction allows a market consensus about auction pricing to 

coalesce. Second, a core of bidders at the auction routinely exchanges information about 

probable market conditions. Third, participants who are unable or unwilling to commit the 

resources needed to collect market information pool their bids, as a group of investors is more 

likely to have a clearer view of the market consensus and is less likely to place off-market bids. 

The pooling of bids is one service provided by primary dealers, who collect customer business 

and place large-scale orders. 

Uniform-price, sealed-bid auction. In this type of auction, the auctioneer collects sealed 

bids, arranges them by price, and makes awards at the single price that just places the entire 

issue. This type of auction is called a "second-price" auction when a single unit is sold because 

the price charged would be that of the highest failed bid, or the second-best price. It is often 

called a "Dutch" auction in the financial press and has recently gained some prominence as a 

potential substitute for current Treasury practice. Aggressive bidders receive sure awards but pay 

a price closer to the market consensus. As a result, there should be less of the shading of bids that 

marks the response to the winner's curse. With the threat of awards above the consensus reduced, 

there is less of a need for large bidders to compare notes before the auction and customers might 

be more willing to place their business directly by bidding at the auction rather than going 

through a primary dealer. 

Descending-price, open-outcry auction. This procedure has been used to auction flowers 

in the Netherlands; hence, academics refer to it as a Dutch auction. Bidders congregate in one 

room, or its electronic equivalent, and the auctioneer calls out a sequence of decreasing prices. In 

an auction of one unit of a good or security, the auction stops when one bidder is willing to pay 

the price called out. For multiple units, the eager bidder would be awarded the security and the 

auction would continue, selling the remaining securities at progressively lower prices. In fact, the 

strategic decision is identical to that of the multiple-price, sealed-bid auction: the optimal bidder 

does not want to be too aggressive and stop the auction well above the likely market consensus, 

but rather, will shade his or her bid to avoid the winner's curse.

17 As a result, investors have the 

same incentive to trade information and to pool bids by placing customer orders at primary 

dealers. 

 16 This strategy is explained in James L. Smith, "Non-aggressive bidding behavior and the 'winner's curse'," 

Economic Inquiry, Vol. 19 (July 1981), pp. 380-388.

17 This strategic equivalence was first noted by Vickrey, op. cit. 

B-19 
Ascending-price, open-outcry auction. The auctioneer could announce an ascending 

sequence of prices to a group of bidders, who would submit their bids at each price. The auction 

would stop when just enough bids were received to sell the total issue of securities or total units 

of the good for sale. One form of this auction category is the method commonly used to sell, for 

example, works of art, when a single unit is on the block.18

In selling multiple units of securities, the auction would begin as a price was called out 

and all interested parties submitted their quantities demanded. The volume of bids at that price 

would be announced and, in successive rounds, the price would be raised until the volume 

demanded was smaller than the size of the issue. When that point was reached, the auctioneer 

would know that the price previously called was the highest price consistent with selling the 

entire issue. In other words, the second highest price clears the auction market. Bidders who bid 

above that market-clearing price plus some fraction of the bidders at the market-clearing price 

would receive awards. Those partial awards to the bidders that had not moved up to the highest 

price either could be based on a common fraction of the bids of all members of that group or 

could be allotted to those who were electronically timed as having placed their bids soonest at 

the market-clearing price. 

From the viewpoint of an investor, this increasing sequence of prices lessens the 

possibility of the winner's curse, as the public announcement of bids provides information about 

the security's common value. That is, the presence of other bidders provides support that a bidder 

is not alone in valuing the security highly. Even if an investor truly valued the security far above 

his or her competitors, the bidding would cease before the price moved very far from the 

consensus. 

Potential changes to the Treasury auction method 

Milton Friedman's proposal. Recent events have kindled enthusiasm for reform of the 

auction process. In a recent contribution, Milton Friedman has repeated a proposal he advanced 

in 1959 concerning the auction of Treasury securities.19 Essentially, Friedman argues for a 

uniform-price, sealed-bid auction, commonly called a Dutch auction. In the one alteration to 

current practice, the Treasury would no longer award securities at the price equivalent to the 

yield bid but instead charge a uniform price (award a uniform yield) to winning bidders. 

 

 18 Academics term this an English auction. Indeed, in the private-values model (which is not analyzed here), 

another equivalence proposition holds: what has been popularly referred to as a Dutch auction is strategically

identical to what academics refer to as an English auction. When there is a time limit on bidding, it is called a Scotch

auction.

19 Milton Friedman, "How to sell government securities," Wall Street Journal (August 28, 1991).

B-20 
Friedman asserts that the switch would end cornering attempts by eliminating the profit 

potential in market manipulation. And, perhaps paradoxically, he also argues that total revenue to 

the Treasury would be higher by surrendering the ability to "price-discriminate" or charge 

bidders different prices based on their bids. 

Friedman argues that the current Treasury technique reduces demand at auctions, as well 

as making it more price sensitive relative to the demand of the ultimate buy-and-hold investor. 

As explained above, this is the rational response to multiple-price awards: the investor is 

reluctant to expose his or her true valuation to a seller (the Treasury) whose stated intention is to 

gamer the highest price possible. But with this induced difference in demands in the primary and 

secondary markets, a potential market cornerer can buy at the auction just above the market 

consensus and sell in the secondary market to a larger group of investors. 

Moving to a uniform-price award method permits bidding at the auction to reflect the true 

nature of investor preferences. This should allow investors to bypass the dealer intermediaries 

and bid directly in the auctions. In the case envisioned by Friedman, uniform-price awards would 

make the auction demand curve identical to the secondary market demand curve. This integration 

of the auction and secondary markets would eliminate the incentive to comer an issue, because 

any cornerer who bids securities away from investors at an auction would not find buyers willing 

to pay a higher price in the secondary market. Thus, under Friedman's assumptions, the cornering 

motivation would be eliminated by removing the potential for profit. 

This result requires that the switch in auction technique completely unifies the primary 

and secondary markets. In other words, Friedman assumes that dealers exist solely to bear the 

bidding risk because of the Treasury's discriminatory pricing. However, even after the adoption 

of uniform-price awards, presence at auctions may still be limited to a segment of the investor 

populace, perhaps to those who are more price sensitive. Participants at an auction face uncertain 

outcomes, since they may not be awarded securities if they have not appropriately cast their bids. 

Those particularly adverse to this quantity risk well may delay purchase to secondary trading. 

Those who sell the auctioned securities short in the when-issued market may prefer to cover their 

positions quickly at the auction. Furthermore, direct bidding requires incurring the costs of 

arranging for the placement of bids and the payment of awards - the prospects for which depend 

on the pace of automation and changes in the regulatory environment. As a result, the infrequent 

purchaser may remain in the secondary market. In general, if dealers provide any service in the 

distribution of securities, then a wedge will remain between the auction and secondary-market 

demand schedules. A sufficiently large wedge provides an opportunity for market manipulation. 

With demand at the auctions still differing somewhat from that in secondary trading and 

with the Treasury continuing to solicit sealed bids, Friedman's proposal would not discourage 

attempts to comer the market. For example, under Friedman's

309-597 0 - 92 - 4 QL 3 

B-21 
"Dutch" auction regime, a market manipulator could place bids for a substantial fraction of an 

issue well above the market consensus price, ensuring significant awards, but would pay only 

that price required to allocate the remaining portion of securities to unsuspecting competitors. 

However, even if the threat of manipulation remains, the lessened importance of bidding near the 

market consensus should reduce the desire to share information and the associated pre-auction 

discussion and pooling of bids that could provide cover for market manipulation. 

With regard to revenue, Friedman would have the Treasury surrender part of the revenue 

from its current auction practice - that earned from charging winners the price that they bid rather 

than a common price - in the expectation that added investor demand and more aggressive 

bidding would more than replace that loss. This assertion can be spelled out using Henry 

Goldstein's 1962 analysis.20 As figure B-1 shows, part of the Treasury's total revenue owes to its 

charging winners the price that they bid, which for the current practice is measured by the area 

under the demand schedule labeled "multiple-price." That price discrimination, however, 

discourages some demand, as investors shade their bids for fear of the winner's curse. Adopting 

Friedman's uniform-price system turns part of that surplus back to the bidders, thus shifting out 

the demand schedule to that labeled "uniform-price." Under a multiple-price scheme, the 

Treasury works its way down the inner demand schedule, awarding securities at lower prices to 

place the total issue (marked by the vertical dashed line). Under the uniform-price scheme, one 

price, depicted by the horizontal line, would exhaust the issue. The consequences for revenue 

depend on whether the area of the first triangle, the loss from the inability to price discriminate, 

outweighs the area of the second triangle, the gain from added demand. 

The Friedman proposal has some support in the economics literature, as analysts working 

with explicit models of bidder behavior in a Treasury-like regime, rather than simple demand 

schedules, generally find that a uniform-price scheme does produce higher revenue for the 

seller.21 Friedman himself, in 1962, made a persuasive argument that revenue would increase.22

 20 Henry Goldstein, "The Friedman proposal for auctioning Treasury bills," Journal of Political Economy, Vol.

70 (August 1962), pp. 386-392. 

21 Early support for Friedman's contention can be found in Vernon L. Smith, "Bidding theory and the Treasury

bill auction: does price discrimination increase bill prices?" Review of Economics and Statistics, Vol. 48 (1966), pp. 

141-146. Exact conditions under which revenue increases in a model closer to current practice are given in Sushil 

Bikhchandari and Chi-Fu Huang, "Auctions with resale markets: an exploratory model of Treasury bill markets," 

The Review of Financial Studies, Vol. 2 (1989), pp. 311-339. Also see Theorem 4 in Robert J. Weber, "Multipleobject auctions," in Richard Englebrecht-Wiggans, Martin Shubik, and Robert M. Stark, editors, Auctions, Bidding,

and Contracting: Uses and Theory, New York: New York University Press, (1983), pp. 165-191. 

22 Correspondence quoted in Goldstein, op. cit.

B-22 
Figure B-1

Dealers devote considerable energies to the auction only to sell those securities almost 

immediately to customers - and most profit from doing so. Part of those resources devoted to that 

distribution could accrue to the Treasury if it could directly deal with those customers. A 

uniform-price auction, since it is less penalizing to the uninformed, may be the best vehicle to 

attract those people. Nonetheless, the little empirical evidence available is considerably more 

ambiguous than this theorizing would suggest. In the few instances in which organizations have 

run the two types of auctions virtually side by side, neither has come out as clearly resulting in 

higher revenue to the seller. Friedman's proposal may mark an improvement on current Treasury 

practice. However, it might not deter manipulative bidders from profiting from the inherently 

closed nature of sealed bids, which does not give other participants a chance to react. 

Open-outcry, ascending-price auction. In contrast to the sealed-bid framework, applying 

an open-outcry bidding system would let participants react to surprise bids during the auction. If 

the Treasury were to conduct an open-outcry, ascending-price auction, registered dealers and 

other financial institutions would connect by phone 

B-23 
(with appropriately designed security) to a central computer. Those not pre-registered could 

appear at their local Federal Reserve bank with sufficient documentation to be included as 

bidders. These gathered bidders would state their demands as the auctioneer announced an 

increasing sequence of prices.23 Prices called out at the auction would climb to the point where 

total demand was just below the issue size. At that point, the previously announced price would 

mark the single, market-clearing price that placed the entire issue. 

A bidder (or bidders) attempting to corner this type of auction would effectively disclose 

its intentions to its competitors, as it would continually bid in size as the Treasury auctioneer 

raises the price. This allows those not party to the attempted market manipulation - particularly 

those short the security in the when-issued market to bid along with the manipulators. Hence, the 

bidders may fail in cornering the security or, at the least, would find it a more expensive 

proposition. 

In a sealed-bid auction, by contrast, the bulk of the increase in price comes at the 

announcement of surprising awards - when other bidders realize that they have not been awarded 

securities as expected and react by bidding up the price in the secondary market. In a real-time 

auction, that reaction occurs when the bidding is still open, and thus the Treasury garners part of 

the profits of the attempted comer. Indeed, auction theory suggests that, in general, Treasury 

revenue would not suffer and indeed might increase in the switch to an open-outcry, ascendingprice system. Since awards are made at a single price and a bidder is aware of the strength of the 

competition, the possibility of a winner's curse is eliminated. 

Of course, a real-time auction may pose a daunting technical challenge and, unlike 

Friedman's uniform-price, sealed-bid auction, would require a substantial development cost. The 

goal of equal access to the Treasury auction requires that every effort be made to decentralize the

system: anyone willing to pay the fixed expense of a properly configured terminal for bidding 

should be allowed to participate in the auctions. At the same time, each bidder would need to be 

screened to ensure payment if their bid were to be successful. If the fixed cost of entry were too 

large, then participation at the auction would be limited, perhaps perpetuating a two-tiered 

distribution system for the securities and all the attendant risks. If access were too open, then the 

physical demands of directing a large volume of electronic messages in a narrow span of time 

could prove prohibitively expensive. The private sector provides some precedents, but those 

efforts are small relative to what is required to automate the Treasury auction. 

 23 Announcing an ascending sequence of prices would bolster demand at the auction. Recalling Vickrey's result

discussed earlier, starting high and progressively lowering the price (a descending-price, open-outcry auction) raises 

the specter of the winner's curse that results in bid shading.

B-24 
B. International Comparison 

Methods of sale of government securities: OECD countries 

Central government debt managers in the countries that belong to the Organization for 

Economic Cooperation and Development ("OECD") largely have been moving toward selling 

government securities domestically in auctions since the early 1980s. Prior to that time, 

government debt managers had relied heavily on selling bonds through underwriting syndicates, 

private placements, and sales to financial institutions on a fixed-price subscription basis. The 

increased financing requirements of the governments in the OECD countries in the 1980s and the 

more competitive capital markets generally contributed to the movement toward competitive 

market pricing of securities. 

Methods of sale of central government securities in the OECD countries are summarized 

below and presented in more detail in the country-by-country descriptions following this 

summary. Several of the OECD central governments borrow in foreign currencies abroad for 

balance of payments reasons. These borrowings, which largely are done through underwriting 

syndicates and private placements, are not discussed in this paper. Table B-1 presents data on the 

size of the central government surplus or deficit for the most recent fiscal year, the size of the 

central government debt held by the public (excluding holdings of central banks and government 

accounts, such as social security trust funds), debt as a share of gross domestic product or gross 

national product, and market trading volume statistics for a recent period in 1991. These data are 

indicators of the magnitude of the government's financing in absolute terms and relative to the 

size of the country's economy and the liquidity of the domestic bond markets. 

A number of countries have used sales of marketable U.S. Treasury debt securities by 

multiple-price/yield, sealed-bid auctions as a model. Currently, such auctions are used

exclusively in Australia, France, and New Zealand to sell marketable securities. 

Other central governments that use multiple-price/yield auctions to sell portions of their 

marketable debt are: Belgium, for securities issued to institutional investors; Canada, for all 

marketables, except about one-quarter of long-term bonds which are sold by fixed-price 

subscription (the rest of these bonds are sold at multiple-yield auctions); Germany, for mediumterm notes since July 1991 and for a portion of longer term bonds since July 1990; Italy, for 

short-term bills denominated in lire; Japan, for short-term bills and longer term notes and bonds, 

including 60 percent of 10-year bonds, which account for a major proportion of Japanese 

government borrowing; and the United Kingdom, for bills and longer term debt (gilts). The 

Netherlands used 

B-25 
multiple-price auctions for long-term bonds but changed in 1991 to selling long-term bonds on 

tap. 

Several of the governments use sealed-bid, uniform-price auctions, in which all securities 

are awarded at the highest yield (lowest price) of accepted tenders, to sell portions of their debt. 

OECD countries using uniform price auctions are: Denmark, for short-term bills; Italy, for bills 

denominated in European Currency Units and bonds maturing in two to 10 years (longest sold); 

and Switzerland, for bills, notes, and bonds. The United Kingdom uses the minimum price tender 

method of selling gilts, a modified form of uniform price auction. Uniform-price auctions have 

been used only seldom in the Netherlands in recent years. 

Trading on a when-issued basis before an auction of securities occurs in Canada, France, 

Germany, Italy, and the United Kingdom. In the Netherlands, where tap issues remain open for a 

relatively short period of one or two weeks, when-issued trading may occur before a tap issue is 

closed. 

Tap issues are used by a number of OECD countries to sell nonmarketable savings 

instruments to small investors. In a tap issue, the government announces the interest rate and 

maturity of the security, sets the price, and allows the market to subscribe. Tap issues may 

remain open for short or long periods of time, depending upon the government's financing needs 

and market conditions. 

Marketable securities are sold on tap by: Australia, to sell marketable government 

securities in small amounts to small investors; Denmark, for notes and bonds - the most 

important instruments sold domestically; Germany, for the portion of long-term bonds that is not 

sold by competitive price auction or underwriting syndicates and for sales of five-year special 

notes to individuals and charitable organizations; the Netherlands, for most long-term issues; and 

the United Kingdom, to sell the portion of gilts that remain unsold from minimum price tender 

sales or to sell additional amounts of existing issues placed with the Bank of England. 

Sales of central government securities are conducted domestically through underwriting 

syndicates and private placements in several of the OECD countries. In an underwriting

syndicate sale, the country negotiates with the syndicate with regard to volume and price of the 

security, as well as timing. Negotiations of private placements are similar, but they usually are 

brought to a government debt manager by an intermediary that does not act as principal in the 

transaction, and securities are distributed to fewer investors. It is standard procedure for the 

government to pay fees in syndicate and private placement sales. 

Underwriting syndicates are used by: Germany, to sell the portions of long-term bonds 

that are not sold by multiple-price auction or on tap; Japan, to sell the 40percent portion of 10-

year bonds that is not sold at auction and to sell small amounts 

B-26 
of five-year bonds; and Switzerland, to sell securities maturing in three to 10 years. In the case of 

Japan, the price for the syndicated underwriting is the price that results from the auction of the 

to-year bonds, which immediately precedes the placement of the underwritten portion of an 

issue. 

Several OECD countries sell marketable securities in several tranches to increase the 

overall size of issues for the purposes of enhancing market liquidity and preventing price 

distortions. The sales may be through reopenings of securities that are auctioned or through 

issues that remain on tap. This technique is used by Australia, Belgium, Denmark, France, the 

Netherlands, New Zealand, Switzerland, and the United Kingdom.

In many of the OECD countries, the central banks have arrangements with the equivalents 

of U.S. primary dealers, through which they conduct monetary policy. These same dealers 

usually are the major market-makers for government securities, although that is not necessarily 

the case. In some other countries, the Ministry of Finance/Treasury selects primary dealers 

specifically to distribute government' securities. Firms in OECD countries generally, however, 

must have a primary dealer designation, be approved by the central bank, or belong to a stock 

exchange to bid without a deposit in government security auctions. 

There are no primary dealers in Denmark, Germany, Japan, the Netherlands, or New 

Zealand. In Japan, central bank open market operations are conducted through several money 

market brokers, who are not part of the underwriting syndicate. In New Zealand, open market 

operations are conducted through entities that register with the Reserve Bank of New Zealand to 

bid in auctions of government securities. Australia, Belgium, Canada, France, Italy, and the 

United Kingdom have primary dealers. 

There is no uniformity of structures for regulation of the government securities markets 

among the OECD countries. In Canada, Germany, and Switzerland, there is central government 

prudential regulation of depository institutions and provincial or state supervision of securities 

trading. The Bank of England provides prudential regulation of depository institutions, while the 

Securities and Investments Board supervises the protection of investors. In Australia and New 

Zealand, the central banks provide prudential regulation of depository institutions, but there is no 

specific regulation of the government securities market. The Japanese Ministry of Finance and 

the Danish Supervisory Authority for Financial Affairs provide centralized regulation of the 

government securities markets in their respective countries, while the Amsterdam Stock 

Exchange provides centralized regulation of the government securities market in the 

Netherlands. 

B-27 
Table B-1 

DECD Country Debt Statistics 

In U.S. Dollar Equivalents 

Privately-held

Surplus or Government Debt Debt to 

Deficit FY'91 12-31-90 GNP/GDP Turnover Rate 

Country (Billions) (Billions) (Percent) 1991

Australia -8.4 37.4 12.8% 390 mil./day

Belgium -12.7 233.0 109.6 1.4 bil./day

Canada -26.3 265.5 45.9 173.6 bil./month

Denmark -6.5 83.8 60.0 21 .4 bil./month

France -18.4 350.1 27.5 9.8bil./day*

Germany -40.0 381.3 22.0 n.a.

Italy -128.4 1,168.6 99.2 3.8 bil./day

Japan -22.5 765.2 24.0 82.5 bil./day

Netherlands -12.6 196.4 70.0 9.8 bil./month

New Zealand -2.2 73.7 63.5 5.0 bil./month

Switzerland -1.2 11.1 4.3 n.a.

United Kingdom +1.0 314.0 28.9 8.8 bil./day 

United States -268.7 2,492.0 43.9 122.5 bil./day 

* Medium- and long-term (original issue) OAT bonds only. 

Sources: Data for each country from respective government. 

B-28 
OECD Countries: Techniques to Sell Central Government Debt Internally

Australia General Comments

The Treasury is responsible for government debt management and the Reserve Bank of Australia isits fiscal agent. There is no permanent lending by the RBA to the government although a short-termoverdraft facility at market-related interest rates is available. Australia had surpluses in FYs 1988-91 (ended 6/30/91). This year the economy has been inrecession, and a deficit of US$8.4 billion equivalentis estimated in the 1991-92 budget. The types of debt instruments issued are: short-termnotes (5-,13-, and 26-week maturities) sold weekly, and short- (1 to 3 years), medium- (3 to 5 years),and long-term (over 5 years) bonds. Australian government securities are in book-entry form. There are two groups of authorized dealers, withwhich RBA conducts open market operations. First, 8 "authorized short-term money-market dealers" have a contractual relationship with RBA toprovide liquidity to the government securities market. RBA conducts most open market operations through short-term market-makers. Second, there are 18 "reporting bond dealers" through which RBA conducts OMO in bonds. The reporting bond dealers have no privileges orobligations regarding issuance of government debt. The government securities market is informally regulated by the RBA. 

Auction

All government securities have been sold throughmultiple-yield auctions since 1982. Bids are 

accepted from parties registered for this purpose with RBA. Any potential bidder that can establishits financial capability can bid without deposit. The minimum competitive bid is US$77,800 equivalent. No limit is set on awards to one entity, nor is there any restriction on the number of bids any entity can submit. Usually reopen outstanding issues rather than issuing new ones. Bids usually amount to 3 to4 times the amount offered. There is no whenissued trading.

Other Sale Methods

Australian government saon tap until 1987. The gobonds targeted specificallThe RBA stands ready to marketable government sUS$39,OOO equivalent) price prevailing in the macharge. Small amounts caunder the same terms. From time to time the govhas repurchased outstandor has exchanged current improve the overall liquid

B-29 
OECD Countries: Techniques to Sell Central Government Debt Internally

Belgium General Comments

The Ministry of Finance is responsible for publicdebt management, and the National Bank ofBelgium is its fiscal agent. The government may borrow up to US$485 million equivalent for day-today cash management from NBB. In FY 1990(ended 12/31/90) the budget deficit totaledUS$12.69 billion equivalent. The types of debt instruments issued are: short-termbills (3-, 6- and 12-month), longterm public subscription bonds and "linear" bonds maturing in 3to 15 years. The bills and linear bonds are issued in book-entry form to institutional investors anddealers. Public subscription bonds are in paper form. Most trading is on stock exchanges. The MOF has selected 14 primary dealers to bid inauctions and make secondary markets in short-termbills and linear bonds. Immediately after an auction, they have the sole right to purchase, on anoncompetitive basis at the auction average, additional amounts of the securities. Primary dealers and other intermediaries may be used by NEB to conduct open market operations. The Securities Regulation Fund, established under the authority of the MOF and the NEB regulatesparticipants in the government securities market. 

Auction

Short-term certificates and "linear" bonds havebeen sold by multiple-yield auctions since January 1991. "Linear" bonds are issued monthly as reopenings of bonds with the same maturity, interest rate, and identifying number. Bids areaccepted without deposit from parties registered for this purpose with the NBB. No limit is placed on awards to anyone entity, nor is there a limit on the number of bids that can besubmitted. The minimum bid is for US$322,OOO equivalent for bills and US$1.6 million equivalentfor linear bonds. There is no when-issued tradingprior to the auction.

Other Sale Methods

Long-term public subscritimes per year. The coupothe MOF and subscriptionweeks. The bonds are targThe minimum purchase aequivalent. MOF pays baselling them to the public

B-30 
OECD Countries: Techniques to Sell Central Government Debt Internally

Canada General Comments

The Department of Finance is responsible for debtmanagement, and works closelywith its fiscal agent, the Bank of Canada to developpolicy. The budget deficit has been stable at about US$26 billion equivalent for the last 5 years. Bonds are bullet maturities with fixed rates and are redeemable at maturity. Bonds mature in 2 to 30years. Canada auctions each week 3- and 6-month bills and year bills. About 90% of bonds are inbook-entry form in the Canadian Depository for Securities. Bills are in bearer paper form. Marketable government bonds are sold only to a group of primary distributors, includingcommercial banks (5) and investment dealers (55). Primary distributors and all Canadian banks can bid for bills. The Bank of Canada conducts openmarket operations through 10 jobbers, a subset ofthe primary distributors. Most trading is over the counter, although some is done through securities exchanges. Bank dealers in government securities are regulated by the Canadian federal banking regulator. Other government securities dealers are regulated byprovincial securities commissions, the key one of which is the Securities Commission of Ontario.Canada began selling index-linked bonds inNovember 1991.

Auction

About 3/4 of marketable bonds and all short-termbills are sold in multiple-yield auctions. Awards,

including awards for customers, are limited to 20 percent of amount offered of bonds and one-third ofthe amount offered of bills. When-issued trading begins when an issue is announced for auction. Nocommissions are paid for bonds and bills sold byauction. Canada is moving toward using auctions tosell all marketable securities. 

Other Sale Methods

Fixed-price subscription oabout 1/4 of marketable bprice are announced 1 1/2 for subscriptions. The Baportion of an issue that thnot buy. A commission is the syndicate. Canadian savings bonds aoutstanding stock is also rThey are puttable at any tFees are paid for sale and Savings Bonds.

B-31 
OECD Countries: . Techniques to Sell Central Government Debt Internally

DenmarkGeneral Comments

Debt management is the responsibility of the Ministry of Finance, with the central bank as fiscal agent. The budget deficit has widened in recentyears, and is estimated at US$6.5 billion equivalentin 1991. The government has a cash account withthe central bank, which makes it possible for government borrowing to lead or lag the government's borrowing needs. Main types of securities issued to the public are: fixed and floating rate bonds (5-10 years); notes (1.1 to 2.2 years); and bills (3 and 6 months). Government securities are in book-entry form. In the domestic market there are no primary dealers or private underwriters for government bonds. Trading is over-the-counter and through theCopenhagen Stock Exchange. The governmentborrows in foreign currencies abroad for exchange stabilization purposes and uses underwritingsyndicates to place the securities. Foreign investors participate in the domestic market. The central bank conducts open market operations through the Copenhagen Stock Exchange.Participants in the government securities market are regulated by the Supervisory Authority of Financial Affairs.

Auction

Domestically, bills are sold through uniform-price 

auction quarterly. Also, the central bank purchases 

them and sells them on tap. Banks and non-bank dealers that are connected to the Danish Securities Center, a private non-profit depository clearance and settlement system, can submit bids in auctions. There is no limit on awards to a single bidder. Trading is not permitted prior to the auction. 

Other Sale Methods

Treasury notes and bonds issues are sold by the cenStock Exchange. Banks aapplications which are paExchange like orders for purchases. The National Bthe Treasury, may set new discretion during Stock Enote issue is usually sold after original issue. There the length of the tap periotax-related minimum interequire closing a tap issue 

B-32 
OECD Countries: Techniques to Sell Central Government Debt Internally

France General Comments

The Ministry of the Economy and Finance is responsible for debt management, and the Bank ofFrance is its fiscal agent. Budget deficits widened in the 1980s, and the deficit amounted to US$18.4 billion equivalent in 1990. The Bank of France does not lend directly to the government. The Treasury has selected 15 primary dealers (SVTs) that are responsible for bidding in auctions, making markets, and providing screen quotations tothe public. There are also 2 reporting dealers(CVTs). The primary dealers established aninterdealer broker in 1987; only SVTs and CVTs have access to it. The Bank of France executes open market operations through a group of 26interbank market agents that are selected separately by the Bank. All marketable securities are in book-entry form. Participants in Treasury auctions must have anaccount at the Bank of France or bid through aninstitution that has an account at the Bank of France. Secondary market trading is over the counter. The government does not pay commissions to purchasers of marketable securities. Bankparticipants in the government securities market are regulated by the Banking Commission. The Stock Exchange Operations Commission supervises other participants in the government securities market.

Auction

Multiple-price auctions are used to sell coupon 

securities which pay interest annually and principal at maturity. The "fungible" OAT bond, which is the most important security from the standpoints ofnew issues and trading, matures in 4-30 years and is reopened in new tranches to increase the size of each issue and enhance liquidity. Until midday the day after an auction, each SVT is permitted. tosubmit noncompetitive bids for the most recently auctioned OAT bond at the auction average price inan amount up to 30 % of its average awards in the previous 3 OAT bond auctions. The minimumpurchase in the auction is US$9.8 millionequivalent. The Treasury also auctions 2-year and5-year fixed rate bonds in a minimum of US$l96,000 equivalent. Multiple-rate auctions are used to sell short-term

bills (maturing in 13, 26, and 52 weeks) issued at a discount. The minimum purchase amount in the auction is US$196,OOO equivalent. When-issued trading begins when a security isannounced. 

Other Sale Methods

There are US$5.9 billion nonmarketable savings boeffort is made to promote 

B-33 
OECD Countries: Techniques to Sell Central Government Debt Internally

Germany General Comments

Ministry of Finance is the issuer and Bundesbank isits fiscal agent. German budget deficits have beenwidening in recent years, and in FY 1991 is estimated at US$40.0 billion equivalent. Temporary cash advances of up to US$4 billion equivalent are regularly made from the Bundesbank to the government. The most important debt instruments are longerterm bonds, called Bunds, and 5-year special notes. Very little financing is done in short-termmaturities under one year. All new public debt is in book-entry form. A 110-member consortium of banks (including 49affiliated with foreign banks) comprise the syndicate for negotiated placements and the eligible bidders in auctions. Consortium members are selected by the Bundesbank, acting as MOF's agent. The consortium members are also used by the Bundesbank to execute open market operations and to sell government securities on tap. Noncompetitive bidding is through consortiummembers.Public debt securities are traded on stockexchanges. The Federal Banking SupervisoryOffice licenses all entities that trade securities for the accounts of third parties. The eight regional stock exchanges, which are under the supervisionof the state (Laender) governments, are SROs and have broad authority to regulate market participants and trading.

Auction

Medium-term notes, mostly with 4 years tomaturity, have been sold in multiple-price auctions

since May 1991. A portion of each sale of Bunds has been auctioned since 1990. When-issued trading begins with the announcement of anauction. There is no limit on awards to anyone entity. There is no commission paid to entities that are awarded securities in an auction. 

Other Sale Methods

Bunds usually have 10 ye1990, Bunds have been sonegotiated through syndic

price auctions,39%; and (

tending portion, 29 %, disfavorable to the governmhave been based on auctio1991. Commissions are punderwritten portion of setap.5-year special notes are isindividuals and charitable issue is completed, it is trmarket.Private placements of shoused in the past, but were 

B-34 
OECD Countries: Techniques to Sell Central Government Debt Internally

Italy General Comments

The Treasury Ministry is responsible for debtmanagement and the Bank of Italy is its fiscalagent. Italian budget deficits widened in the 1980s, and the deficit was the equivalent of US$128.4billion in 1990. The government may borrow directly from the Bank of Italy. Only 4 % of the public debt is foreign-owned.The government issues: short-term Treasury bills inlire and in ECU; medium and long-term variable and fixed rate bonds in lire and ECU. Short-termbills and longer term bonds indexed to short-termrates account. for over 70% of the public debt. The longest maturity is 10 years. More than 90% of marketable government securities are in book-entry form through the Central Depository System run bythe Bank of Italy. Most trading is on a wholesale screen-basedmarket, whose participants are regulated by the Bank of Italy. There are 23 primary dealers selected by the Bank of Italy, which uses them together with other market participants to execute open market operations. Membership in the screen-based market is voluntary. There are entities acting as dealers that are not subject to any regulatory regime.

Auction

Short-term bills denominated in lire are auctionedin multiple-price auctions. The Treasury sets no 

minimum acceptable price for multiple-price 

auctions. A set amount is reserved for 

noncompetitive awards. Treasury bills denominatedin ECU are sold in uniform-yield auctions. 

Treasury bonds in lire and ECD maturing in 5 to 10years are sold in uniform-price auctions. The 

government sets the maximum acceptable yield (minimum price) in uniform yield/price auctions.

Trading begins when new security issues areannounced by the Treasury. Minimum competitive bids in all auctions are US$88,550 equivalent of lire or US$73,350 equivalent ECU. While there is nocap on the value of awards, no entity may submit more than 5 bids per auction. Noncompetitive bids are not accepted in uniform price/yield auctions. Participation in the auction' is limited to banks, credit institutions, insurance and financial companies and stockbrokers. 

Other Sale Methods

About 9% of the public dform of small investor savdeposits in the Post Officsignificant contributor to System has declined in im

B-35 
OECD Countries: .. Techniques to Sell Central Government Debt Internally

Japan General Comments

The Ministry of Finance is responsible for debtmanagement and the Bank of Japan is its fiscalagent. Budget deficits have been declining since the mid 1980s. The 1990 deficit was OS$22.5 billionequivalent. The Japanese government bond market is thesecond largest in the world. Most trading is in anOTC market, though some transactions are on the eight stock exchanges. About one-third of OTCtrading volume is done through one brokers' broker, which is owned by its members. MOF sells short-term bills and intermediate and long-term bonds. Monthly sales of 10-year bonds account for 80% of government debt outstanding and are the most actively traded issues in thesecondary market. All marketable Japanese bonds are in book-entry form. There are no firms designated as primary dealers, although the market and the underwriting group are dominated by several large participants. The Bankof Japan uses several brokers, which are not part ofthe underwriting syndicate, .as intermediaries toexecute open market operations. The government securities market is regulated bythe Ministry of Finance.

Auction

Multiple-price auctions are used for securities 

maturing in 2, 3, and 6 months and 2, 3, 4, and 20years. When-issued trading is illegal at any price prior to the auction and is illegal at a discount in the immediate post-auction period. F9r 10year bonds, 60% are awarded in multiple-price auctions and 40% are distributed through an 833-member syndicate (includes 675 banks and 158 securities firms). Awards are limited to 30% of amount auctioned; thus, 18% of the total of a 10-year. The government pays commissions to purchasers in theauction and to the underwriting syndicate. 

Other Sale Methods

The remaining 40% of eabond is sold through the sthe bonds at the average otenders. 5-year bonds are placed funderwriting syndicate, bproportion of total issues. Government compensatiofamilies. Such nonmarketonly about 1 % of govern

B-36 
OECD Countries: Techniques to Sell Central Government Debt Internally

Netherlands General Comments

The Ministry. of Finance is responsible for debtmanagement and the central bank is its fiscal agent. Budget deficits have been declining since the mid 1980s. The deficit amounted to US$12.8 billion equivalent in FY 1991. The central bank may lend temporarily directly to the government in limitedamounts. It also purchases government securities through open market operations. The MOF often purchases and sells government bonds to stabilize prices. Bonds maturing in 10 years accounted for 75% ofMOF borrowing in 1990/91. Short-term bills were not sold in 1990/91. Subscriptions on original issue are limited exclusively to members of the Amsterdam Stock Exchange (banks and securities broker/dealers). Foreign investors hold23 % of Netherlands government securities. MOF emphasizes debt lengthening and does not borrowin foreign currencies or sell indexed or variable ratesecurities. Government securities are available in bearer definitive and registered forms. There are no primary dealers. The market for government securities is regulated by the Amsterdam Stock Exchange.

Auction

During the late 1980s through early 1991, MOF sold bonds in multiple-yield auctions. Since March 

1991, however, government bonds have been sold on tap exclusively.

Other Sale Methods

Bonds are all sold on tap. one or two weeks. There trading before the issue is may change the price durare paid by MOF to subscminimum purchase amouequivalent. Private placements of lonmost of the rest of governmediaries in private placethe MOF. Nonmarketable savings bthe government. 

B-37 
OECD Countries: Techniques to Sell Central Government Debt Internally

New Zealand General Comments

The Treasury is responsible for de management andthe Reserve Bank of New Zealand is its fiscal agent for internal borrowing. New Zealand had surplusesin FYs 1988-90 and a surplus of US$1.0 billionequivalent in 1991. Nearly half of the debt is owned by foreign investors. The government may borrowfrom RBNZ. Securities include short-term bills 2 % of internal public debt) and government stock maturing in upto 10 years (57% internal public debt). Outstandingissues reopened to foster market liquidity. All bidders in auctions must be registered with the RBNZ or bid through an entity that is registered. The RBNZ conducts open market operations, including issuing 63-day RBNZ bills, through dealers that are registered with RBNZ as counterparities for open market operations. There are no primary dealers. All marketable debt is inbook-entry form. Tenders in auctions are in paper form. There is no specific regulation of the government securities market. The RBNZ provides prudential regulation of banks.

Auction

All marketable securities are sold in multiple-yield

auctions. There is no limit on the proportion of an

auction that can be purchased by any bidder. Whenissued trading begins when a security is announced. No commissions are paid by the Treasury to purchasers in auctions. The government does notset a maximum acceptable yield. 

Other Sale Methods

Nonmarketable Kiwi boninvestors on tap. They arand the minimum purchaFees are paid to institutiotransactions. Kiwi bonds internal public debt. 

B-38 
OECD Countries: Techniques to Sell Central Government Debt Internally

Switzerland General Comments

The Federal Department of Finance is responsible for debt management and Swiss National Bank isits fiscal agent. The Swiss central government borrows little and the public debt is small. Most governmental activity is carried out by the cantons,or states. Foreign participation in the governmentsecurities market is small. The amount is unknown, because all securities are in bearer form. There are no primary dealers. The Swiss central bank rarely conducts open market operations. The government issues a variety of securities including 3- and 6-month bills, medium-term notes and long-term bonds. Trading is over-the-counter and through regionalstock exchanges. There is no comprehensive government securities regulation. Banks are subject to the supervision of the Federal BankingCommission. The cantons regulate the regionalstock exchanges. The cantons of Zurich and Basle, where the most important financial centers are located, license over-the-counter market participants as well as exchange participants.

Auction

Swiss Debt Register Claims maturing in 3 and 6months are issued every two weeks through uniform-price auctions. Long-term bonds, which 

account for the majority of the debt, are sold fromtime to time through uniform-price auctions. No

tender price limits are applied. The government gives a rough indication of the desired issue amount. All categories of investors are authorized toparticipate in auctions. There are no limits on the amount that can be awarded to any bidder in an auction. When-issued trading is permitted prior tothe auction. Noncompetitive bids are accepted, and usually are small relative to the size of auctions. 

Other Sale Methods

Bills usually with maturitsold on a discount basis oThe price is set by the censubscribe for a fixed overGovernment notes with mare sold through private pcommission basis. 

B-39 
OECD Countries: Techniques to Sell Central Government Debt Internally

United Kingdom General Comments

The Treasury works closely with the Bank of England (fiscal agent) to develop debt managementpolicy. The budget has been in surplus in recentyears, with the surplus in 1991 05$960 millionequivalent. The government borrows directly fromthe Bank of England. Bidding in gilt auctions is open to all investors, either on a competitive basis (minimum ofOS$960,000 equivalent) or noncompetitive basis (bids from US$l,920 to $960,000 equivalent). The bulk of bids are submitted by primary dealers (18gilt-edged market makers) either on behalf of customers or for their own account. The GEMMs ensure the liquidity of the secondary market by quoting continuous two-way prices in all gilts in all trading conditions; they have a direct dealing relationship with the Bank of England andexclusive access to interdealer brokers and gilt borrowing facilities. Participants in the gilt-edged market are subject toprudential supervision of the Bank of England. The Securities Investment Board, which is under the Department of Trade and Industry, oversees protection of investors.

Auction

Multiple-price auctions are used for bills and 

longer-term debt (gilts). When-issued trading is allowed, beginning with the announcement of auction details. Bank of England has discretion not to allot more than 25% of the amount offered to anindividual bidder if to do so would be likely to leadto market price distortion. The Bank of Englanddoes not set a minimum price, but securities may not be allotted if the price is unacceptably low. Minimum price tender sales are used to sell gilts; 

bidding is open to all investors. The minimum price is set in advance for fixed-rate gilts. Gilts are allotted at a common price, either minimum price or price at which all gilts offered are sold (if higher). Tenders for index-linked stocks normallyhave no minimum price, but authorities do not usually allot at a price that they perceive to be below market. Any unsold gilts are bought by the Bank of England for sale on tap to GEMMs.

Other Sale Methods

Bank of England buys gilminimum price tender salsold on tap to the GEMMthat the Bank refrains from falling market. There usufollowing an auction duriamounts are not sold on tGilts can be issued and plBank of England for sale the same way as above. Utranchettes (small additio

stocks), but sometimes in Nonmarketable savings inindividual investors throu

B-40 
C. Auction Automation 

The current auction process 

Submission of tenders. Bidders in Treasury auctions can submit tenders through the 

Federal Reserve banks and branches or directly to the Treasury's Bureau of the Public Debt. 

Competitive tenders must be received by the closing time for each auction, which is typically 

1:00 p.m. Eastern Time on the day of the auction. Noncompetitive tenders must be submitted by 

12:00 p.m. Eastern Time on the day of the auction or can be submitted by mail provided they are 

postmarked no later than midnight of the day prior to the auction and the tender is received on or 

before the issue date. 

Procedures for submitting tenders currently vary among Federal Reserve districts. Bidders 

can send a facsimile message containing all required tender information (in a few districts), by 

sending an administrative message over the Federal Reserve's communications network 

containing all required tender information (in a few districts), or by sending representatives to 

the lobby of a Federal Reserve bank or branch to submit paper tenders (in all districts). 

Some Federal Reserve banks with large competitive bidders in their district provide 

telephone access for use by the bidders' representatives to establish communications with the 

bidders' trading desks. Typically, these representatives first enter all the information required on 

the tender form except for the par amounts and yields (or discount rates in the case of Treasury 

bills) to be bid. In the closing moments of the auction, following instructions from their trading 

desks, the representatives enter the par amounts and yields and submit the tender form to the 

Federal Reserve bank. 

Processing of tenders. Competitive and noncompetitive tenders are manually processed 

by Federal Reserve bank staff upon their receipt. This includes checking to ensure that each 

tender has been signed by an authorized official and that those submitting tenders for customers 

are duly authorized and are depository institutions or registered broker-dealers. Payment 

arrangements are also verified at this stage; if full payment does not accompany the tender, 

auction staff check that an autocharge agreement or a guarantee from a commercial bank or 

primary dealer of 5 percent of the par amount tendered is on file for the bidder if it is not a 

depository institution with a funds account. 

At each Federal Reserve bank, competitive tenders are manually sorted by rates or yields. 

The tenders are checked to ensure that those received at one rate/yield from anyone bidder do not 

exceed 35 percent of the public offering. Bidders who have tendered for over 35 percent of the 

public offering at one yield have these bid amounts cut back to the 35 percent maximum. Bidders 

that have indicated a net long 

B-41 
position greater than $200 million in the auctioned security are noted at this stage. 

Noncompetitive tenders are totaled, and an initial check is made to ensure that noncompetitive 

bids would not exceed the award limits for a single bidder. A second, more thorough check for 

compliance with the Treasury's single bidder guidelines is made after the noncompetitive totals 

have been transmitted to the Treasury in the interest of timely auction processing. 

Competitive bid totals are posted by yield to an auction summary report, together with the 

noncompetitive total.24 While specific bids are generally not reported separately in the 

summaries, the tenders of bidders with net long positions greater than $200 million are recorded 

on the auction summary report if the tenders suggest that the entity might receive 35 percent of

the auction after including the pre-auction position and noncompetitive bids.25 The tenders of 

bidders who have tendered for an aggregate total of more than 35 percent of the public offering 

are noted on the report. In addition, any tenders for more than 35 percent of the public offering at 

one yield from a single bidder (that have been reduced to the allowable bidding limit) are noted. 

At each Federal Reserve bank, the auction summary report is signed by an authorized 

employee and transmitted by facsimile to the Treasury Department's Bureau of the Public Debt. 

At the Bureau of the Public Debt, the auction summary information is manually entered into an 

automated auction program, which computes the range of accepted bids based on the yields 

tendered by competitive bidders and the total amount of noncompetitive awards. The weighted 

average accepted yield for competitive tenders and any proration necessary at the stop-out (or 

highest accepted) yield, as well as supplementary auction statistics, are also computed. Two 

computers are used for verification purposes, both of which independently compute the auction 

statistics from the summary data. Manual backup procedures are also provided for additional 

flexibility. The appropriate Federal Reserve banks are contacted if the summaries are incomplete 

or if there are questions about particular tenders. Any questions regarding the 35 percent award 

limitation to a single bidder or the noncompetitive award limitations are also resolved before 

finalizing the auction results. 

After reviewing the auction results, the Bureau of the Public Debt prepares the press 

release containing the information on the range of accepted bids, proration at the stop-out yield, 

and other pertinent auction statistics. This press release is transmitted to the Treasury press room

and released to the public at approximately 2:00 p.m. on the day of the auction. 

 24 Additional noncompetitive tenders may arrive by mail after this time. 

25 With this report, the Treasury is announcing that bidders may not submit both competitive and

noncompetitive tenders in one auction.

B-42 
Between the auction date and the settlement date (usually about five days) the tender and 

award information necessary for issuing securities to successful bidders is manually entered into 

a computer system that processes securities issued in the commercial book-entry system and in 

the TREASURY DIRECT system. On the settlement date, the securities are issued against 

payment 

The automation project 

Strategy and project scope. The strategy for automating the auction process is first to

automate the current auction process in order to move auction participants and administrators 

from the current manual process to an electronic, automated environment. The systemdevelopment phase of this effort is currently being conducted at two Federal Reserve banks, as 

fiscal agents of the Treasury. The Federal Reserve Bank of Kansas City is nearing completion on 

one phase of the project, described below. The core of the project is a centralized tender 

receiving and processing computer system called the Treasury Automated Auction Processing 

System ("TAAPS") which is under development at the Federal Reserve Bank of New York. 

The first two phases are scheduled to be completed by the end of 1992. At that time, a 

telecommunications infrastructure will be in place, all participants will have the necessary 

terminal and communications equipment to submit tenders electronically, and the Federal 

Reserve banks and the Treasury will have the capability to process electronic tenders. Once this 

is accomplished, it will be possible to implement the open, iterative, ascending-price auction 

process described elsewhere in this report by modifying the operation of the existing system. The 

design requirements for this new auction process are still being formulated. 

The automation project can be thought of as having four phases, as outlined below. The 

elements of each phase are described in more detail later in this section. 

Phase 1: The electronic acceptance and processing of bids submitted nationwide by 

smaller bidders and depository institutions. 

Phase 2: The electronic acceptance and processing of bids submitted nationwide by large 

aggressive bidders. 

Phase 3: The automation of the Treasury's auction procedures on the centralized 

processing system. 

Phase 4: Automation and centralization of issuance of securities to successful bidders 

through the commercial book-entry system. 

Electronic bidding systems. Completion of Phases I and II will allow bidders to submit 

tenders either from a "Standard FedLine" connection, a "FaST Fedline" 

B-43 
connection, or computer interface ("CI") connections that meet the Federal Reserve System's

Computer Interface Protocol Specifications standards. 

The Standard Fedline is a software and communication application project that is ongoing 

at the Federal Reserve Bank of Kansas City. This system will provide a capability principally for 

smaller bidders and depository institutions to submit electronic tenders using a standard Federal 

Reserve System terminal for securities to be held in both the commercial book-entry and 

TREASURY DIRECT systems. This project is scheduled for completion by mid-1992. 

The FaST Fedline is a software and communications application being developed at the 

FRBNY, as part of TAAPS, that is designed for use by large competitive bidders. Large 

competitive bidders require the capability to submit bids quickly in the last seconds before an 

auction closes on their own behalf and on behalf of their customers. The FaST FedLine software 

application, which will run on a personal computer, is being developed to meet these specialized 

requirements. 

FaST FedLine terminals will be linked by telephone to the central TAAPS computer. 

When the Treasury announces an issue, a broadcast message will be sent to all FedLine terminals

announcing the auction, and a description of the security, including issue date and maturity date, 

will be downloaded to the FaST FedLine terminals. At any time prior to the auction closing time, 

a bidder will complete an electronic copy of a tender form for the particular auction containing 

empty "fields" for security description, clearing bank information, and customer information. 

The bidder will be able to quickly fill in the FaST FedLine fields using "pop-up" menus linked to 

the bidder's database. The bidder will also be required to fill in a net long position field if 

necessary. The bidder will then be able to transmit the tender to the central computer at the 

FRBNY within seconds. 

Tender acceptance. The central T AAPS host computer application will receive and 

process electronic tenders from the Standard FedLine, the FaST FedLine, and CI connections. It 

will also provide a mechanism for inputting data from paper tenders submitted to Federal 

Reserve banks over the counter and via mail. Though processing will be centralized, Federal 

Reserve districts will continue to serve their current customer base and maintain primary control 

of tenders submitted by their customers. Districts will continue to be responsible for reviewing 

their tenders and oversight of original issue processing for their district; the centralized system

will be a vehicle for supporting these operations.

While Fast FedLine terminals will have direct communications connections with the 

TAAPS host computer at the FRBNY, Standard FedLine tenders will be routed through the 

Federal Reserve banks. All tenders and customer lists from submitting institutions will be printed 

upon receipt at the Federal Reserve bank and stored in a machine-readable format. Additionally, 

submitting institutions will receive an 

B-44 
acknowledgement indicating the tender was received. Once T AAPS is operational, a "tender 

forwarding" capability will be implemented to transmit all Standard FedLine tenders through the 

Federal Reserve's communication network to the TAAPS computer for centralized processing. 

Once transmitted to the FRBNY, the electronic tenders will be stored at the primary 

computer and also at the contingency processing site at the East Rutherford Operations Center 

("EROC"). Should there be a failure at the FRBNY computer, or communications failure of any 

kind, the FaST FedLine users will reestablish a communications connection with the EROC and 

continue transmitting tenders. It is expected that this recovery could be accomplished in less than 

five minutes. If FRBNY's primary centralized processing system fails, Standard FedLine users 

will have their electronic tender submission capability restored by establishing communications 

between the local Federal Reserve bank's computer and the contingency site at the EROC. This 

recovery is expected to take 30 to 45 minutes. If the local Federal Reserve bank's computer fails, 

Standard FedLine users will use manual backup procedures to submit their bids. To support 

contingency processing, the system's operators will be able to reassign a district's processing 

responsibilities to another district. For example, if Minneapolis were unable to process its 

tenders, Chicago could be reassigned to perform this function. 

Tender processing. As tenders are transmitted to the central computer, a series of checks 

will automatically be performed on them. As a result, each tender will be added to one of two 

tender databases. The tenders that successfully pass all checks will be added to the "good" 

database; tenders that fail one or more checks will be added to the "questionable" database. 

TAAPS will send a message to each bidder's terminal advising the bidder that the tender has 

been received and stored and informing the bidder which checks, if any, the tender failed. 

Some of these checks will simply involve examining the tender to determine whether all 

required information has been included in the tender and that tenders were received before the 

designated closing time. Some of the checks will require T AAPS to search its database of bidder 

information to determine that, for example, bids submitted on behalf of customers have been 

authorized and payment arrangements have been made. T AAPS will also flag any tenders that

may require auction rule enforcement. This would include bids for more than 35 percent of the 

public offering at one yield, bids from related entities, and tenders submitted by one entity 

through multiple broker-dealers or depository institutions. 

In order to screen bids for obvious data-entry errors, the TAAPS system will flag tenders 

that exceed a par amount that is a predetermined percentage above an amount based upon the 

bidder's prior submissions, and bids at a rate or yield that exceeds a predetermined band on either 

side of the when-issued market for that security. This 

B-45 
type of monitoring should catch errors such as a bid for a yield of 7.08 percent instead of 8.08 

percent, or for $5 billion instead of $5 million. 

All flagged bids will be reviewed by Federal Reserve bank staff. After consultation with 

the bidder and with the Treasury in these cases, the auction staff will have the ability - with the 

Treasury's approval - to correct obvious keying errors (or allow the bidders to submit corrected 

tenders), reject questionable bids, or return them to the "good" database. Any tender that is 

changed must be reviewed and approved by the appropriate officials before being included in the 

auction, and complete documentation of these changes will be maintained. 

After the process of reviewing tenders and resolving any questions is complete, the 

Treasury will be notified that district-level processing of tenders is complete. The Treasury 

auction staff will then execute a program that will use the information in the "good" tender 

database, aggregated by yield, to calculate the range of accepted bids and all relevant auction 

statistics. The Treasury will review the results, and then broadcast the auction results to all 

FedLine users and simultaneously issue a public press release. 

Successful bidders in the auction will be notified of their awards via a message to their 

FedLine terminals. The TAAPS system will instruct the commercial book-entry system to issue 

the securities against payment to the successful bidders on the issue's settlement date. T AAPS 

will also be able to accommodate the requirements of the new commercial book-entry system

being implemented in the next few years. 

Automation benefits 

Speed and productivity improvements. The current process is labor intensive at all 

stages of the auction for the Treasury, the Federal Reserve banks, and the bidders. Automation 

should allow fewer people to conduct the auctions faster, as it will reduce significantly the 

amount of time devoted to manually entering data from tender forms, both for auction processing 

and for original issue of the securities. Bidders will be afforded the ease and convenience of 

electronic bidding, and savings will result for some bidders from eliminating the need to send 

messengers to submit tenders. 

Electronic bidding should also reduce bidding errors. Bids communicated over a telephone 

and hastily transcribed by a messenger at the last moment may be inaccurate, illegible, or 

difficult to interpret. Bids entered at a terminal will not have these problems. While different 

types of errors, such as keying errors, may be introduced, the automatic screening procedures 

described above should mitigate these problems. 

Wider participation in the auctions. Over 9,000 depository institutions have FedLine 

terminals connected to their local Federal Reserve banks. Upon completion of the project for 

electronic bidding by depository institutions, all of these institutions 

B-46 
will have the capability of electronically submitting competitive and noncompetitive bids for 

securities to be held in either the commercial book-entry or TREASURY DIRECT systems. 

Registered brokers and dealers and other large bidders will have the opportunity to install 

computer terminals for auction bidding purposes. Depository institutions with FedLine terminals 

- particularly those in remote locations - may find it easier and more convenient to submit 

electronic bids on behalf of TREASURY DIRECT participants than it is with current procedures. 

More efficient monitoring of the auction rules. TAAPS will be able to collect, organize, 

and present information quickly about potential or actual rule violations to Federal Reserve bank 

and Treasury staff reviewing bids. For example, the computer will be able to sort tenders and 

customer lists by name independently of the dealer or depository institution through which the 

bids were submitted. This will make it easier to aggregate bids of related entities or of customers 

that bid through several dealers or depository institutions, which will facilitate enforcement of 

the 35 percent bid and award limitations and the noncompetitive award limitations. 

Standardized auction procedures. With standard Federal Reserve terminals, standard 

FedLine applications, and centralized processing, all bidders and districts will have the same

screens and procedures for submitting and processing tenders. Use of standard Federal Reserve 

terminals and communications facilities allows the use of existing mechanisms for distributing 

and supporting terminals, and the use of existing and planned Federal Reserve backup sites, 

systems and arrangements. 

B-47 
D. Auction Rule Enforcement 

The Treasury's longstanding policies of encouraging widespread ownership of Treasury 

securities and limiting concentration of awards at auctions have led to the two primary auction 

rules, or policies: the 35 percent limitation of overall awards to a single bidder and the total 

dollar limitations on noncompetitive "bidding. 

Recent events, as well as the Treasury's "examination of auction activity in light of 

disclosures by Salomon Brothers Inc (“Salomon”), have resulted in certain abuses and 

enforcement problems being uncovered regarding each of these rules. This section discusses the 

enforcement of current Treasury auction rules, including identified problems, possible causes, 

and potential solutions. Further discussion of policies that might address these issues, such as 

changes to auction rules and techniques, is contained in other sections of this report. 

The 35 percent limitation 

The 35 percent limitation on awards to single bidders in an auction is designed to prevent 

excessive concentration of ownership of a particular Treasury security as a result of an auction. 

A limitation of this kind has been in effect since 1962. Since July 1990, an additional Treasury 

rule has been in effect that limits the amount Treasury will recognize as bid by a single bidder at 

a single yield to 35 percent of the public offering.26

Contrary to what is commonly suggested, the Treasury does not prohibit tenders for more 

than 35 percent of a particular auction amount or require bidders to certify that they have not 

done so.27 The Treasury has, however, stated that bids at one yield for more than 35 percent of 

the public offering amount at any auction from a single bidder will be recognized only up to the 

35 percent limit, and that the Treasury will not award more than 35 percent of the public offering 

amount to a single entity. While this policy encourages bidders to limit their bids voluntarily, it 

places a substantial degree of enforcement responsibility on the Treasury and the Federal 

Reserve banks that act as the Treasury's fiscal agents in conducting the auctions and referring 

any potential problems to the Treasury. 

 26 This rule was a response to a strategy in which bidders would attempt to increase their prorated awards at the 

highest accepted yield in an auction. Large bidders would place bids well in excess of 35 percent of the public 

offering amount at what they guessed to be the highest accepted yield, assuming that they would be awarded some

fraction of this amount. This strategy disadvantaged other bidders who could not risk being awarded much more of 

the securities than they intended to purchase. 

27 In fact, for Treasury bills, it is impossible for bidders to know precisely what the public offering amount will 

be prior to the announcement of the auction results. 

B-48 
In addition, the Treasury requires bidders to certify on the auction tender form that the 

bidder's or customer's net long position in the securities auctioned does not exceed $200 million 

or to report on the form any net long position of more than $200 million as of 12:30 pm on the 

day of the auction, one-half hour before the closing time for receipt of competitive tenders.

This requirement was designed to aid in the administration of the 35 percent limitation, allowing 

the Treasury to aggregate bidders' existing net long positions with potential auction awards in 

determining the maximum securities awarded to a particular entity. In recent years, the Treasury 

has reduced awards based on bidder's long positions in a number of auctions, although such 

action has not often been necessary. 

 

28

Problems and abuses. The Treasury's enforcement of the 35 percent limitation on auction 

awards has generally been effective. The unauthorized customer bids submitted by Salomon that 

allowed it to purchase more than 35 percent in several Treasury auctions are the only instances of 

which the Treasury is aware since the 35 percent limitation has been in place in which a single 

bidder was awarded more than 35 percent of the publicly offered auction amount. 

In the widely publicized Salomon case, several of the unauthorized bids submitted for

customers by Salomon resulted in awards to Salomon in excess of 35 percent of the public 

offering amount. These include the February 21, 1991 five-year note auction, in which Salomon 

bought 57 percent of the notes through a bid for itself and two unauthorized bids in customer 

names, and the May 22, 1991 two-year note auction, in which Salomon effectively purchased 38 

percent of the auctioned notes. Salomon has also admitted that it failed to report a sizeable long 

when-issued position in the May 1991 two-year note auction.29 Had the position been duly 

reported, the amount awarded would have been reduced by the amount of the long position. 

The noncompetitive award limitation 

Securities awarded noncompetitively earn a yield equal to the weighted average yield of 

accepted competitive bids. Bidding noncompetitively assures an investor of receiving a desired 

amount of securities, with a market-based yield determined by the auction results. The 

noncompetitive award process was designed for smaller investors that do not have the resources 

or information to bid competitively. Noncompetitive 

28 With this report, Treasury is announcing that in order to reduce the reporting burden, it will not require 

bidders to report their-net long positions at the time of the auction unless the total of the bidder's net long position

plus its bid is greater than a significant amount of the auctioned issue.

29 See Statement of Salomon Inc submitted in conjunction with the testimony of Dervck C. Maughan. Chief 

Operating Offer of Salomon Brothers Ine. and Robert E. Denham. General Counsel of Salomon Inc before the 

Subcommittee on Oversight. Committee on Ways and Means, United States House of Representatives. September 

24, 1921.

B-49 
bidding was never intended to serve as a substitute for competitive bidding by sophisticated and 

large bidders who have the resources, knowledge, and expertise to bid competitively. For this 

reason, and because the Treasury desires a predominantly competitive pricing system for its 

securities, noncompetitive awards to each bidder are limited. The noncompetitive award limits 

have changed over time and are currently $1 million for bills and $5 million for notes and bonds. 

Every auction tender form states that noncompetitive tenders are not to exceed the 

specified amount allowable for a single bidder. In addition, the tender form indicates that a 

noncompetitive bidder may not have entered into an agreement with respect to noncompetitive 

awards prior to the closing time for receipt of tenders. This rule is intended to prevent an investor 

from obtaining more than the specified amount of securities at the average yield by arranging to 

acquire them from other investors who plan to bid noncompetitively. 

Problems and abuses. There have been several instances of investors using 

noncompetitive awards for what appear to be arbitrage purposes. Market participants have 

discerned a tendency of prices of Treasury securities to be slightly higher than the average 

auction price immediately following the announcement of the auction results. This means that 

securities purchased noncompetitively at the average yield can be resold immediately after the 

announcement of the auction results in the when-issued market, often for a profit. 

The pattern is similar in most of these cases that the Treasury has uncovered. An 

investment or trading firm submits bids for the maximum noncompetitive award in the names of

a list of employees or customers. The bids are either pooled through a primary dealer, or spread 

throughout a number of different dealers. The securities are then resold immediately after the 

auction and before payment is required. Only if the securities are sold at a loss does the bidding 

entity require any payment from participants. However, in some cases, it may be that pool 

participants were actually required to put up a certain amount of margin towards the positions. 

Often the same list of participants is used repeatedly in different auctions. 

The Treasury has investigated these schemes, and, in some cases, referred them to the 

SEC. Participants have maintained that they are not violating any specific auction rule, as they 

claim that all bids are properly authorized and that they have not made any pre-auction 

agreements regarding the securities. While the Treasury has not taken the position of prohibiting 

resale of noncompetitively awarded securities immediately following the auction, these activities 

do appear to have gone against the spirit of the noncompetitive award system, and, in some

cases, may have violated the prohibition on pre-auction agreements. 

In several other instances, related entities, such as multiple bank subsidiaries or branches 

within a single bank holding company, have submitted bids, either through the 

B-50 
same dealer or through other dealers, that combined exceed the noncompetitive bidding limits. In 

most of these cases, the entities do not appear to have been acting in concert to garner a larger 

share of noncompetitive awards, but rather were probably unaware of their affiliates' auction 

activities. In several of these instances, the potential problem was detected by the Federal 

Reserve and Treasury auction staff, and auction awards were appropriately reduced to conform

to the single-bidder limitations. However, there have also been a few instances in which Federal 

Reserve bank and Treasury staff were not aware of the multiple bids and therefore did not limit 

the combined awards as would be appropriate. 

Another potential problem is that primary dealers often submit auction tenders for the 

maximum noncompetitive amount for their own accounts. Treasury has not rejected 

noncompetitive bids in these cases, even though primary dealers also bid competitively and often 

take pre-auction positions in the securities being auctioned. 

Underlying causes and potential solutions 

Changes to the underlying auction technique or policies towards market "squeezes" could 

alleviate the problems discussed above because such changes would likely remove the benefits to

evading either the 35 percent limitation or the noncompetitive limitation.30 The major 

contributing factors to the enforcement problems and abuses under the current auction 

framework are discussed below. 

Bidding by related entities. Despite the much-publicized Warburg/Mercury case, in 

which Salomon submitted an unauthorized bid in the name of an S.G. Warburg affiliate, the 

problem of bids from related entities has mainly arisen in the noncompetitive bidding area due to 

the thousands of noncompetitive bids that are submitted at each auction. 

The wide array of corporate and partnership affiliations makes it difficult to determine 

which entities should be considered together as a single bidder for purposes of the 35 percent 

auction award and bidding limitations and the noncompetitive award limitation. A bank holding

company, for example, may have numerous subsidiaries throughout the country that may not 

communicate with one another on a regular basis, and may submit bids through different Federal 

Reserve districts. Partnerships with essentially identical memberships and different family 

members are also considered to be a single bidder under the Treasury's guidelines. 

 30 Under a uniform-price auction method, for example, the Treasury would probably maintain the

noncompetitive bidding mechanism, as this would allow small investors to be assured of receiving the desired 

amount of securities. However, since all investors would receive the same yield, the incentives for noncompetitive 

relative to competitive bidding would be greatly reduced. 

B-51 
To date, most single-bidder issues have been handled on a case-by-case basis, usually after 

the auction has taken place. More systematic enforcement of the single-bidder guidelines would 

require the Treasury and the Federal Reserve banks to maintain a comprehensive database of 

corporate affiliations that could be used as a ready reference tool. 

Bidder certifications. As mentioned previously, auction tender forms currently include 

several statements regarding noncompetitive purchases. and a certification with respect to net 

long positions of bidders and their customers. Treasury currently has no satisfactory way of 

independently verifying the position certifications. The prohibition against pre-auction 

agreements regarding noncompetitive awards has also required some clarification. 

The Treasury is clarifying these issues in the new offering circular, which also should 

eliminate any current ambiguity as to the appropriate usage of noncompetitive awards. While the 

Treasury has traditionally maintained that covering short when-issued positions with 

noncompetitive awards violates the auction rules, the auction rules will further disallow 

noncompetitive awards to bidders who also bid competitively in a particular auction and who 

hold when-issued, futures, or forward positions in the security being auctioned. This policy 

change should ensure that the noncompetitive bidding privilege is not misused by sophisticated 

traders and dealers rather than smaller, less sophisticated investors. 

Lack of centralized surveillance system. The auction bidding system is very 

decentralized, with tenders being submitted at many locations around the country. Much of the 

enforcement of the auction award limitations is administered at the Federal Reserve banks. There 

is currently no automated surveillance system in place that would capture all tender information 

and perform a timely and comprehensive check that any multiple bids by the same or related 

entities do not exceed the bidding and award limitations in the short span of time available 

between submission of tenders and announcement of results. As a result, surveillance and 

enforcement of bidding limitations is currently very labor and time intensive. 

As discussed elsewhere in this report, electronic bidding and automation of the auction 

process will alleviate many of the operational problems in auction rule enforcement. Automation 

would allow nationwide policing of any single-bidder problems and verification of customer bids 

and would facilitate a rapid response to such problems by auction administrators. 

In the meantime, the Treasury and the FRBNY have already implemented a policy of 

spot-checking large customer bids for authenticity. Because of the verification policies in place 

or currently being developed, it is less likely that circumvention of the 35 percent limit through 

unauthorized bidding will be a problem in the future. The 

B-52 
Treasury and Federal Reserve staff have also strengthened the routine policing of any potential 

noncompetitive award problems. 

309-597 0 - 92 - 5 QL 3 

B-53 
E. Concentration of Auction Awards 

The Treasury has pursued policies over the years to make Treasury marketable securities 

available to a broad range of investors and to diminish the likelihood that ownership of the 

securities will be heavily concentrated as a result of Treasury auction awards. Treasury actions to 

broaden distribution of Treasury securities in the auction include limiting awards to anyone 

bidder to 35 percent of the amount offered to the public and making marketable Treasury 

securities available on a noncompetitive basis. The Treasury offers securities across the maturity 

spectrum in order to appeal to a wide range of types of investors and to balance the maturity 

structure of the outstanding debt. 

It is advantageous for the Treasury to distribute new marketable securities to a number of 

auction participants, rather than to allow any entity, even through competitive bidding, to obtain 

all or nearly all of a Treasury security. If there were a market perception that awards in Treasury 

auctions may be to only one or a few entities, over the longer term, other potential participants in 

Treasury auctions may be discouraged from submitting tenders and Treasury borrowing costs 

could rise. The ability of any investor to purchase Treasury securities on original issue, directly 

from the Treasury or through a government securities dealer, ensures that sales of Treasury 

securities are perceived as fair by market participants. Distribution of securities to a number of 

market participants also has the advantage that the securities may be sold to a broader customer 

base than would be the case if auction awards were more concentrated. 

Statistical evaluation of concentration of auction awards. The primary dealers, as a 

group, purchase large proportions of Treasury securities in auctions. This is not surprising, since 

the primary dealers are the major market makers for Treasury securities and they focus' their 

capital and expertise on trading government securities. The primary dealers are expected by the 

FRBNY to be “consistent and meaningful participant[s] in Treasury auctions of new 

securities.”31 This section of the study presents data on competitive awards to primary dealers, 

their customers, and other competitive and noncompetitive bidders for the period of January 

1990 through the end of September 1991, using tenders submitted in Treasury auctions as the 

source of data. The data have been adjusted to count as awards to a primary dealer the awards on 

unauthorized bids submitted by Salomon.32 

 

 31 Federal Reserve Bank of New York, Primary Dealers: Criteria and Procedures Applied to Firms

Interested in Becoming and Remaining Primary Dealers, 1988. 

32 See Statement of Salomon Inc. submitted in conjunction with the testimony of Warren E. Buffet, Chairman

and Chief Executive Officer of Salomon Inc, before the Securities Subcommittee of the Senate Committee on

Banking, Housing, and Urban Affairs, September 10, 1991.

B-54 
Primary dealers bidding for their own accounts were awarded about 72 percent of 

Treasury bills, notes, and bonds awarded to private investors during the January 1990 through 

September 1991 period33 (see Tables B-2 and B-3). Auction awards to customers of primary 

dealers accounted for about 5 percent of private awards of Treasury bills and about 15 percent of 

notes and bonds. Noncompetitive awards accounted for 20 percent of Treasury bill auction 

awards to private investors on average but less than nine percent of note and bond auction 

awards. 

Awards in each auction were ranked as to amounts awarded to primary dealer firms and 

their customers. The top 10 firms and their customers combined took 50 percent of total private 

awards in bill auctions and 66 percent in note and bond auctions during the January 1990 through 

September 1991 period (see Tables B-4 and B-5). 

One primary dealer and its customers were awarded 35 percent or more of the total 

offered to the public in 17 out of a total of 66 Treasury note and bond auctions. The 35 percent 

maximum was purchased by one primary dealer for its own account in 6 of the 66 auctions. 

Awards to the top three bidders (a primary dealer for its own account or another entity, not 

combined) averaged nearly 41 percent of total private awards in note and bond auctions between 

January 1990 and September 1991 (see Table B-6). 

The figures on awards to primary dealers for their own accounts overstate the 

concentration of ownership of Treasury securities as a result of the auction, because primary 

dealers in the aggregate usually have large net short positions going into the auctions. Part of the 

primary dealers' market making function is to distribute Treasury securities in the when-issued 

market prior to the auction. Primary dealers in the aggregate had net short positions prior to 

every auction of notes and bonds in the January 1990 through September 1991 period. Net short 

positions averaged nearly 40 percent of auction awards to primary dealers for their own accounts

during that period (see Table B-7). 

Potential ways to lessen concentration. The squeeze in the May two-year note, following 

the auction on May 22, 1991, pointed up the need to review ways to lessen the potential for 

concentration of auction awards. In that auction Salomon and its customers were awarded 87 

percent of the total amount offered. This highly concentrated auction result, while not 

unprecedented, was followed by unusual distortions in the cash and repo markets for that note. 

With these distortions in mind, the Treasury began a review of auction procedures following the 

May 1991 two-year 

 33 Awards to private investors include awards on competitive and noncompetitive tenders and exclude 

noncompetitive awards to the Federal Reserve banks for the System open market account and official foreign 

custody accounts. Awards to foreign accounts held outside of the Federal Reserve are included with awards to 

private investors. 

B-55 
note auction and has made changes to lessen the potential for a repeat of the experience. 

Steps that have been taken

1. The Treasury has changed auction rules since May 1991 by increasing the maximum 

amount of notes and bonds that can be purchased by a single bidder through noncompetitive 

tenders from $1 million to $5 million, effective with the three-year note auction on November 5, 

1991. 

In the auction of the three-year notes on November 5, 1991, the Treasury awarded $852 

million of noncompetitive tenders to the public, compared with the average of $1.311 billion in 

the three-year note auctions between January 1990 and September 1991. In the 10-year note 

auction on November 6, $614 million of noncompetitive tenders were awarded to the public, 

compared with the $597 million average in January 1990 through September 1991, and $937 

million of 30-year bonds were awarded to the public on a noncompetitive basis in the auction on

November 7, compared with an average of $368 million. Thus, total noncompetitive awards to 

the public in November 1991 were slightly higher than average. The distribution of awards 

among the three securities in November appears to reflect an investor preference for the 

relatively higher yields on longer term securities at the time of the November auctions. 

2. Also effective with the November three-year note auction, the Treasury allows all 

registered and noticed government securities brokers and dealers to bid for customer accounts, a 

privilege that previously had been granted only to primary dealers and depository institutions. 

Possible further measures

1. The Treasury could require that an auction participant who bids for more than a specific 

amount of a bill, note, or bond (for example 10 or 15 percent of the amount offered to the public) 

bid directly at a Federal Reserve bank rather than submit its tender(s) through a dealer(s). The 

advantages of direct bidding are that it would: (1) eliminate the information advantage of a 

dealer who bids in large size for customers; (2) make it more difficult for dealers - and customers 

to act in concert in an auction and in the secondary market immediately after the auction; and (3) 

make the auction more competitive and therefore attract potential bidders who may be 

discouraged from taking the risks involved in participating in an auction if awards can be 

expected to be concentrated. 

The disadvantages would be that: (1) it would force a dealer that was planning to submit a 

large bid for its own account, or that had a large volume of customer bids, to advise its customers 

to take their business elsewhere or face a cutback in the 

B-56 
amount the customer wants to buy; (2) it would deny a customer the advice and other services of 

a dealer firm that the customer prefers; (3) in the current manual data processing environment, 

bidders would have to arrange to submit tenders physically to a Federal Reserve bank; (4) 

bidders would have to arrange for a payment mechanism with a depository institution; and (5) 

bidders might not have sufficient information on current market conditions to be able to bid 

competitively. 

The Treasury has decided to facilitate direct bidding, rather than to require it. Requiring 

large bidders to tender directly might not achieve the desired end, but could instead provide 

impetus for retail accounts to purchase securities from dealers in when-issued trading and 

circumvent the auction entirely. 

The FRBNY and the Treasury are working to automate Treasury auctions. When the 

automated bidding system becomes operational late in 1992, depository institutions and 

government securities brokers and dealers will be able to submit tenders electronically. In 

addition, the Treasury and the FRBNY plan to extend electronic bidding capability to other large 

bidders, who could arrange to pay for their securities through autocharge agreements. It is likely

that large bidders would have existing banking relationships that could be expanded to include 

autocharge agreements. In addition, the Agencies are working- on ways to encourage the 

expansion of coverage of information on prices and trading volume in the government securities 

market and to extend the availability of on-line, real-time interdealer broker information systems. 

The greater availability of information that is expected to result from these efforts should 

promote an increase in direct bidding. 

2. The Treasury could lower the 35 percent award maximum. The 35 percent maximum 

award ensures that awards will be made to at least three competitive bidders, after taking into 

account noncompetitive awards. Lowering the maximum to 25 or 30 percent of the amount 

offered has been proposed and could result in distributing awards to a larger number of market 

participants, which potentially would encourage more entities to participate in the auction. A 

disadvantage of a lower maximum award limit would be that it could discourage aggressive 

bidding, which could tend to reduce demand for the securities and increase the cost of financing 

the debt. 

3. The Treasury could increase the noncompetitive award limit further. As indicated

above, the Treasury is reviewing the results of the recent increase in the noncompetitive award 

limit. It is too early to assess whether the change will result in a change in bidding behavior. An 

advantage of a higher limit might be that bidders would be willing to submit larger 

noncompetitive tenders, which could result in larger amounts being awarded to entities other 

than government securities brokers and dealers, thus potentially reducing the concentration of 

auction awards. A disadvantage could be a reduction in the size of the competitive pool that

might impair efficient pricing in the auction. 

B-57 
Table B-2 

Awards in Treasury Bill Auctions * 

January 1990 Through September 1991 

(Millions of Dollars) 

Competitive Private

Primary P. Dealer Other Total Non- Total

Dealer Customer Total Direct Comp. Comp. ** Private

13-week $428,186 $32,509 $460,695 $26,868 $487,563 $145,559 $633,122

26-week 417,449 24,998 442,447 14,421 456,868 114,895 571,763

52-week 154,753 11,008 165,761 7,895 173,656 19,789 193,445

Total $1,000,388 $68,515 $1,068,903 $49,184 $1,118,087 $280,243 $1,398,330

Percent of Private Awards 

Competitive Private

Primary P. Dealer Other Total Non- Total

Dealer Customer Total Direct Comp. Comp. ** Private

13-week 67.6% 5.1 % 72.8% 4.2% 77.0% 23.0% 100.0 %

26-week 73.0 4.4 77.4 2.5 79.9 20.1 100.0

52-week 80.0 5.7 85.7 4.1 89.8 10.2 100.0

Total 71.5% 4.9% 76.4% 3.5% 80.0% 20.0% 100.0 %

*Based on auction date, not issue date. Excludes cash management bills. 

** Excludes awards to foreign custody accounts and to the Federal Reserve for its own account. 

Source: U.S. Treasury Department. 

B-58 
Table B-3 

Awards in Treasury Note and Bond Auctions * 

January 1990 Through September 1991 

(Millions of Dollars) 

Competitive Private

Primary P. Dealer Other Total Non- Total

Dealer Customer Total Direct Comp. Comp.** Private

2-year $174,133 $32,769 $206,902 $20,406 $227,308 $29,389 $256,697

3-year 61,731 12,786 74,517 1,947 76,464 9,176 85,640

4-year 23,362 4,989 28,351 1,180 29,531 3,384 32,915

5-year 87,058 18,540 105,598 2,384 107,982 8,594 116,576

7-year 46,654 5,985 52,639 1,807 54,446, 3,387 57,833

10-year 53,453 17,566 71,019 1,536 72,555 4,183 76,738

30-year 59,226 12,047 71,273 1,966 73,239 2,577 75,816

Total $505,617 $104,682 $610,299 $31,226 $641,525 $60,690 $702,215

Percent of Private Awards 

Competitive Private

Primary P. Dealer Other Total Non- Total

Dealer Customer Total Direct Comp. Comp.** Private

2-year 67.8 % 12.8 % 80.6% 7.9% 88.6% 11.4 % 100.0 %

3-year 72.1 14.9 87.0 2.3 89.3 10.7 100.0

4-year 71.0 15.2 86.1 3.6 89.7 10.3 100.0

5-year 74.7 15.9 90.6 2.0 92.6 7.4 100.0

7-year 80.7 10.3 91.0 3.1 94.1 5.9 100.0

10-year 69.7 22.9 92.5 2.0 94.5 5.5 100.0

30-year 78.1 15.9 94.0 2.6 96.6 3.4 100.0

Total 72.0% 14.9 % 86.9% 4.4% 91.4% 8.6% 100.0 %

* Based on auction date, not issue date. 

** Excludes awards to foreign custody accounts and to the Federal Reserve for its own account. 

Source: U.S. Treasury Department. 

B-59 
Table B-4 

Awards to Top Ten Dealers and Customers 

In Treasury Bill Auctions * 

January 1990 Through September 1991 

(Millions of Dollars) 

Competitive Private

Primary P. Dealer Other Total Non- Total

Dealer Customer Total Direct Comp. Comp. ** Private

13-week $280,313 $27,389 $307,702 $179,861 $487,563 $145,559 $633,122

26-week 260,695 21,307 282,002 174,866 456,868 114,895 571,763

52-week 103,058 10,090 113,148 60,508 173,656 19,789 193,445

Total $644,066 $58,786 $702,852 $415,235 $1,118,087 $280,243 $1,398,330

Percent of Private Awards 

Competitive Private

Primary P. Dealer Other Total Non- Total

Dealer Customer Total Direct Comp. Comp. ** Private

13-week 44.3% 4.3 % 48.6% 28.4 77.0% 23.0% 100.0 %

26-week 45.6 3.7 49.3 30.6 79.9 20.1 100.0

52-week 53.3 5.2 58.5 31.3 89.8 10.2 100.0

Total 46.1% 4.2% 50.3% 29.7% 80.0% 20.0% 100.0 %

*Based on auction date, not issue date. Excludes cash management bills. 

** Excludes awards to foreign custody accounts and to the Federal Reserve for its own account. 

Source: U.S. Treasury Department. 

B-60 
Table B-5 

Awards to Top Ten Primary Dealers and Customers 

In Treasury Note and Bond Auctions * 

January 1990 Through September 1991 

(Millions of Dollars) 

Competitive Private

Primary P. Dealer Other Total Non- Total

Dealer Customer Total Direct Comp. Comp.** Private

2-year $113,315 $29,781 $143,096 $84,212 $227,308 $29,381} $256,697

3-year 46,408 10,867 57,275 19,189 76,464 9,176 85;640

4-year 19,700 4,855 24,555 4,976 29,531 3,384 32,915

5-year 66,992 17,466 84,458 23,524 107,982 8,594 116.576

7 -year 33,590 5,286 38,876 15,570 54,446 3,387 57,833

10-year 40,747 16,388 57,135 15,420 72,555 4,183 76,738

30-year 44,828 10,566 55,394 17,845 73,239 2,577 75,816

Total $365,580 $95,209 $460,789 $180,736 $641,525 $60,690 $702,215

Percent of Private Awards 

Competitive Private

Primary P. Dealer Other Total Non- Total

Dealer Customer Total Direct Comp. Comp.** Private

2-year 44.1 % 11.6 % 55.7 % 32.8% 88.6% 11.4 % 100.0 %

3-year 54.2 12.7 66.9 22.4 89.3 10.7 100.0

4-year 59.9 14.8 74.6 15.1 89.7 10.3 100.0

5-year 57.5 15.0 72.4 20.2 92.6 7.4 100.0

7-year 58.1 9.1 67.2 26:9 94.1 5.9 100.0

10-year 53.1 21.4 74.5 20.1 94.5 5.5 100.0

30-year 59.1 13.9 73.1 23.5 96.6 3.4 100.0

Total 52.1 % 13.6 % 65.6% 25.7% 91.4 % 8.6% 100.0 %

* Based on auction date, not issue date. 

** Excludes awards to foreign custody accounts and to the Federal Reserve for its own account. 

Source: U.S. Treasury Department.

B-61 
 

Table B-6

Awards to Top Three Bidders in

Treasury Note and Bond Auctions*

January 1990 Through September 1991

(Millions of Dollars)

Percent of Awards to Top Percent of

Awards to Comp. Pvt. 3 Dealers and Comp. Pvt.

Top 3 Bidders** Awards Awards Customers*** Awards Awards

2-year $92,223 40.6% 35.9% $102,689 46.2% 40.0%

3-year 39,103 51.1 45.7 42,454 55.5 49.6

4-year 18,439 62.4 56.0 21,108 71.5 64.1

5-year 55,160 51.1 47.3 64,661 60.0 55.5

7-year 21,312 39.1 36.9 26,020 47.8 45.0

10-year 32,289 44.5 42.1 42,868 59.1 55.9

30-year 28,548 39.0 37.7 36,657 51.4 49.7

Total $287,074 44.7% 40.9% $337,461 52.6% 48.1%

* Based on auction date, not issue date. 

** Bidder may be a primary dealer or a customer of a primary dealer. 

*** Primary dealer plus customer of the primary dealer. 

Source: U.S. Treasury Department. 

B-62 
Table B-7 

Primary Dealer Net Position Before Auctions* 

as a Percent of Account Awards to Primary Dealers 

January 1990 Through September 1991 

(Millions of Dollars) 

Primary Dealer Account Primary Dealer Net Position 

Competitive Net Position Before as Percent of

Awards Auction** Awards

2-year $173,633 -$80,637 -46.4%

3-year 61,731 -22,194 -36.0

4-year 22,852 -5,338 -23.4

5-year 83,058 -39,890 -48.0

7 - year 46,654 -11,221 -24.1 

10-year 53,453 -14,262 -26.7

30-year 58,356 -17,387 -29.8

Total $499,737 -$190,929 -38.2%

* Based on auction date, not issue date. 

** Aggregate primary dealer net position as of 3:30 p.m. the day before the auction.

Sources: U.S. Treasury Department and Federal Reserve Bank of New York. 

B-63 
4. Hedge Funds 

The recent events involving Salomon and the much-publicized "squeezes" of Treasury 

notes have focused public and regulatory attention on a type of investment entity popularly 

referred to as a "hedge fund." These investment funds, which are operated so as to be exempt 

from most types of regulatory oversight and restraints, have recently begun to playa major role in 

the government securities market. They apparently have the capability to assume large positions 

in Treasury securities because of their size, capacity for leverage, and willingness to take 

substantial risks with their capital. This section discusses why regulators have little access to 

information about these entities and their day-to-day activities and what the possible implications 

are for the government securities market. 

What is a "hedge" fund? 

The term "hedge fund" was in use as early as the 1960s to describe a new speculative 

investment vehicle that used sophisticated hedging and arbitrage techniques in the corporate 

equities market.34 In the late 1960s, former Securities and Exchange Commissioner Hugh Owens 

described "hedge funds" as "private investment partnerships which employ the investment 

techniques of leveraging and hedging."35 In the 1970s and 1980s, the activities of similar types of 

funds broadened into a range of financial instruments and activities. These funds grew 

tremendously in terms of assets, particularly in the 1980s, and now operate in the cash, futures, 

and options markets and engage in foreign currency, government securities, and commodity 

transactions, as well as merger and acquisition activities. 

The term "hedge fund" does not have a precise definition, but it has been used to refer 

generally to a cadre of private investment partnerships that are engaged in active trading and 

arbitrage of a range of different securities and commodities. For the purposes of this report, the 

discussion presented here will focus on characteristics of those funds that are large and active 

participants in the government securities market and will use the term "hedge fund" to refer to 

this sort of private investment fund, regardless of its actual activities. 

 34 The AW. Jones Group may have been the first entity to be nicknamed a "hedge fund" in the early 1960s 

because of its strategy of taking offsetting long and short positions in the stock of companies in the same industry, 

thus hedging macroeconomic factors but benefitting from company specific performance. 

35 "A Regulator Looks at Some Unregulated Investment Companies: The Exotic Funds," Remarks of SEC 

Commissioner Hugh Owens before the North American Securities Administrators Association (October 21, 1969). 

B-64 
Publicly available data on hedge funds and their activities are limited. In fact, hedge funds 

are organized in such a way as to minimize the amount of information that they need to disclose 

about their operations. No comprehensive statistics exist as to their overall number in the United 

States, assets under management, types of transactions, degree of leverage, rates of return, or 

positions in particular securities, aside from large positions in futures contracts and corporate 

equities. 

Media reports, discussions with market participants, and the limited information disclosed 

to regulatory agencies suggest some rough estimates. Total assets invested in hedge funds 

certainly run into the tens of billions of dollars; several funds have assets of more than $1 billion 

each. In fact, many hedge funds are reported not to be accepting new money, as some have 

grown too large and unwieldy for the sort of trading strategies they typically employ. Rates of 

return on leading hedge funds are reported to be well above average market returns, even over a 

period of years.36 Many hedge fund managers began their careers as commodity traders and 

continue to use sophisticated trading and arbitrage techniques. 

AS hedge funds have grown in size, requiring fund managers to seek markets that can 

easily absorb huge amounts of money, several of the largest funds have recently become

aggressive participants in the government securities market. While hedge funds have regularly 

placed bids in Treasury auctions in the past, it was not until late 1990 that funds began making 

large and aggressive bids in Treasury auctions. These funds have been placing bids in amounts 

that suggest highly leveraged positions. The funds typically bid through major primary dealers, 

and the combined awards of dealer and hedge fund would often represent a significant portion of 

the publicly offered amount of securities. 

Hedge funds are also reported to have acquired even larger positions in the secondary 

market for Treasury securities (including the when-issued market) and are likely to have engaged 

in repurchase transactions in order to finance these positions and those purchased in the primary 

market. Certain hedge funds that are large participants in the government securities market have 

also been the focus of some publicity as a result of unauthorized bids submitted in their names by 

Salomon in several Treasury auctions.

37

 

 36 Stephen Taub, "Hedging your way to prosperity," Financial World, (April 3, 1990). 

37 See Statement of Salomon Inc. submitted in conjunction with the testimony of Warren E. Buffet. Chairman

and Chief Executive Officer of Salomon Inc. before the Securities Subcommittee, Committee on Banking Housing

and Urban Affairs. United States Senate. September 10, 1991.

B-65 
Legal and regulatory structure 

Hedge funds are generally structured as limited partnerships, organized either in a U.S. 

state or "offshore" in a tax-haven country.38 This structure affords the investors important legal 

distinctions from other types of investment vehicles, distinctions without which their activities 

would be severely curtailed. 

An entity structured as a limited partnership is permitted under the tax laws to pass 

through its profits to the partners, avoiding entity-level taxes that would be levied on other forms 

of organization. Equally important, hedge funds can be structured so as to be exempt from a 

variety of securities and investment company regulations. This leaves hedge funds structured in 

this way with a much greater degree of flexibility in both investment techniques and 

compensatory structure than would be possible for a conventional regulated investment 

company. 

Each limited partnership must have a general partner, who is responsible for managing the 

fund, making investment decisions (or selecting who will make investment decisions) and raising 

new capital when necessary. The general partner of a hedge fund (or its owner) sometimes has a 

large personal stake invested in the fund. The limited partners purchase an interest in the 

partnership, in return for which they receive a fixed percentage of the fund's profits. The 

minimum purchase unit for a partnership interest is usually in the $100,000 to $1 million range 

and is thus geared towards high net worth individuals or institutions. A partnership interest 

cannot be easily sold or transferred, unlike shares in a mutual fund. There may be a minimum 

holding period before sale is allowed or a substantial delay in liquidating the partnership interest 

by selling it to the general partner. 

Securities laws. Hedge funds are not generally subject to SEC oversight.39 Most 

investment interests in' hedge fund partnerships are privately offered and not registered pursuant 

to the Securities Act of 1933; therefore, no offering documents for them are filed with the SEC, 

although an offering document may be required to be distributed to the limited partners. 

Hedge funds also claim an exclusion from registering as securities dealers under Section 

15(a) of the Securities Exchange Act of 1934 ("Exchange Act"), based on the so-called "trader" 

exception to the definition of "dealer." In general, a trader is an 

 

 38 Offshore funds may also be organized as corporations, which affords their foreign investors exemption from

U.S. taxes but allows the shares to trade on foreign stock exchanges.

39 The anti-fraud provisions of the federal securities laws do apply to hedge funds whether or not they are 

registered with the SEC. See Tamar Frankel, The Regulation of Money Managers, (1978), Vol. 4, pp. 318-323, for a 

discussion of the treatment of hedge funds under the securities laws. 

B-66 
entity that trades securities solely for its own investment account and does not carry on a public 

securities business, while a dealer buys and sells securities as part of a regular business, deals 

directly with public investors, engages in market intermediary activities, and may also provide 

other services to investors. To date, the SEC has not taken a formal position on the issue of 

hedge fund registration as dealers, and the funds that this report has focused on have not, on their 

own initiative, sought advice from the SEC as to whether to register. 

If appropriately structured, a hedge fund is not an investment company under the 

Investment Company Act of 1940. Under Section 3(c)(I) of this statute, funds with less than 100 

persons and no intention of making a public offering are exempt from registering as an 

investment company. A fund excluded from the definition of investment company is not subject 

to any provisions of the Investment Company Act. 

Investment company status imposes substantial regulatory requirements, including 

conflict of interest regulations, financial statement and audit requirements, and disclosures to 

customers and to the SEC. Investment companies are also subject to leverage limitations, 

including an overall 300 percent asset-to-debt coverage rate. This would be a particularly 

troublesome restriction for hedge funds, which reportedly often rely on a high degree of leverage 

in order to take larger positions and raise their potential rate of return on capital. 

The Investment Advisers Act of 1940 requires registration of professional money 

managers with the SEC. Fund managers may avail themselves of the small adviser exemption 

from registration in Section 203(b)(3) of the Investment Advisers Act if they have less than 15 

clients. In 1985, the SEC adopted rule 203(b)(3)-I, which permits a general partner to count a 

limited partnership as a single client, rather than counting each partner as a separate client, under 

certain circumstances. Under this rule, it appears that managers and general partners of hedge 

funds would be exempt from registration. 

Hedge funds are probably particularly eager to avoid investment adviser registration. In 

addition to record-keeping and disclosure requirements associated with investment adviser 

registration, fund managers might also have to comply with Rule 205-3, which prohibits an 

investment adviser from charging performance-linked fees.40 Of course, as general partner, the 

manager of a hedge fund would be entitled to a fair return on capital invested, but the SEC would 

probably view any compensation above a return on capital and payment for services which are 

not linked to performance as a performance fee. 

 40 Rule 205-3(e) permits performance fees when all clients have a minimum of $500,000 under management or

a net worth of $1 million each. 

B-67 
Commodity Exchange Act. Because most hedge funds make use of futures markets, their 

operators, advisers and trading activities fall within the regulatory domain of the Commodity 

Futures Trading Commission ("CFTC"). The CFTC requirements for hedge funds are disclosure 

oriented and less prescriptive than those for investment companies and investment advisers, but 

at the same time, CFTC registration is harder to avoid. 

Under the Commodity Exchange Act ("CEA"), registration of hedge funds themselves is 

not required; rather, registration is required of the hedge fund manager and any adviser(s) to the 

fund under certain circumstances. The manager may have to register as a commodity pool 

operator ("CPO") and the adviser(s) may have to register as a commodity trading advisor 

("CTA"). Every commodity pool must have a pool operator responsible for operational aspects 

of the fund and for raising funds from investors. A CPO can manage more than one pool, and a 

pool can have more than one CPO or CTA. Several major hedge fund managers or their affiliates 

are, in fact, registered with the CFTC as CTAs or CPOs. 

The CFTC's regulations define a commodity pool as "an investment trust, syndicate or 

similar form of enterprise operated for the purpose of trading commodity interests." Accordingly, 

an investment fund generally must be considered a commodity pool if it makes use of 

commodity futures and options contracts. The CFTC generally makes a determination as to when 

pool status is appropriate depending on the importance of commodity futures trading to the entity 

and its other characteristics. An offshore operator of an offshore investment entity, however, may 

be granted relief from CPO registration if it is not marketed to U.S. investors, regardless of the 

scope of its activities in the U.S. futures markets.

The CEA also prescribes that any person who provides advice regarding commodity 

futures and options trading must register as a CTA. Exemption is provided for those who advise 

15 or fewer clients and do not hold themselves out generally to the public as a CTA. However, 

unlike the SEC, the CFTC will usually count each investor in the partnership separately for the 

purposes of determining CT A status. 

CPOs are required by the CFTC to provide disclosure documents and certified annual 

reports to investors and to the CFTC. CTAs must provide disclosure documents to clients and to 

the CFTC. CPOs and CTAs must keep and maintain ' books and records which must be 

accessible to the CFTC and the Department of Justice for inspections. Information that must be 

maintained includes records of commodity and cash market trading activity and information 

concerning the pools. 

Regulatory Issues 

The regulatory issues relevant to these funds involve not so much the protection of the 

investors who invest in them, typically high net worth individuals or institutions, 

B-68 
but the potential of these funds, due to their size, active market presence, and use of leverage, to 

cause market disruptions. 

For example, Salomon has disclosed that it purchased large amounts of securities for two 

large hedge funds in the May two-year note auction and was aware of a large position in the 

notes by a third fund. This concentration of ownership of the securities may have contributed to a 

squeeze in the market. 

In addition, hedge funds are large enough to prompt concern about market stability. 

However, regulators, except for the CFTC in some circumstances, have little, if any, authority to 

gain access to information about hedge fund activities. While the SEC can obtain through its 

subpoena powers records relevant to its investigations, which must be approved by a vote of the 

Commission, there appears to be little access for regulators outside of an investigatory

proceeding.

Reporting and information access. The CFTC is the only regulatory agency with any 

regular reporting contact with certain hedge funds. In the futures market, the CFTC requires 

large position reporting identifying the positions of large traders in specific futures contracts, and 

several of the major hedge funds are regularly included in these reports. As mentioned above, the 

CFTC also receives annual reports from CPOs regarding their pools' operations and has the 

authority to inspect records of cash market transactions of the pools, their CPOs, and their 

clients, although this authority is not routinely exercised. 

The CFTC's large trader reporting authority derives from Section 4i of the CEA which 

requires large traders and position-holders in particular futures contracts to maintain books and 

records of their transactions and positions in both the futures and cash market for the particular 

commodity and allows the CFTC, along with the Department of Justice, to inspect these records. 

It is not clear, however, whether the CFTC could use this authority to acquire information for 

purposes other than to investigate concerns in the futures market. 

In some instances, hedge funds must also report to the SEC. Hedge funds are subject to 

Section 13(d) of the Exchange Act, which requires investors to report large positions in equity 

securities. In addition, investment managers of hedge funds may be subject to the reporting 

requirements of Section 13(f) of the Exchange Act, which requires investment managers that 

exercise investment discretion with respect to equity securities having an aggregate fair market 

value of at least $100 million to file quarterly reports with the SEC regarding their equity 

securities positions. These reports are made public. Information on hedge funds also is reportable 

by brokers and dealers under the SEC's new large trader reporting provision (Section 13(h)), 

although these regulations will cover only publicly traded corporate equities and options. 

309-597 0 - 92 - 6 QL 3 

B-69 
The SEC has little additional authority to obtain regular information on the activities of

hedge funds. In order to claim the exemptions from the Investment Advisers Act and the 

Investment Company Act, the funds are not required to submit any documentation or to petition 

for exemption. In fact, the existence of a particular hedge fund may not even come to the SEC's 

attention unless the SEC receives a complaint about that fund's activities. 

Treasury also has little regulatory contact with hedge funds or access to information on 

their activities. While Treasury does, of course, have information on auction bidding and 

Treasury securities awarded to hedge funds in auctions, it currently has no access to information 

on hedge funds' when-issued and other secondary-market activity in government securities, aside 

from the limited position reporting required on auction tender forms. 

Systemic market risk. Events in the government securities market have shown that their 

capacity for leverage allows hedge funds to take large trading positions disproportionate to their 

capital base. Thus far, fund managers have proved very adept at controlling their market risk, and 

their lending counterparties appear to consider them creditworthy. However, the sheer size of the 

positions taken by the hedge funds raises concerns about systemic risk that these funds may 

introduce into the financial markets. 

It is unclear to what extent the failure of a major hedge fund would affect the functioning 

of the financial markets. Market participants have indicated that hedge funds' use of leverage is 

usually implemented through margined or collateralized transactions, which would tend to 

mitigate the effect of a failure on counterparties. For example, transactions on commodity futures 

exchanges, in which hedge funds are very active, are subject to margin and mark-to-market rules. 

Repurchase agreements are collateralized by government securities, which would allow the 

counterparty that held the collateral securities to retain or sell them in the event of a failure. 

However, regulators currently have little information that might help them assess the market 

impact of a failure of a hedge fund or that would warn of an impending failure. 

B-70 
5. Government Securities Clearing Corporation 

The Government Securities Clearing Corporation ("GSCC") is a clearing agency 

registered with the SEC pursuant to the Exchange Act.41 GSCC currently is the only registered 

clearing agency that offers a centralized, automated system for the clearance and settlement of 

trades in Treasury securities. GSCC offers comparison and netting services to members. GSCC's

clearance and settlement system also functions as a risk assessment, credit risk reduction, and 

risk containment facility for eligible trades in government securities that are submitted to GSCC 

for comparison and netting. GSCC collects and stores information about a significant percentage 

of trades in the government securities market. The data GSCC currently receives and maintains 

include the number and value of submitted and compared trades; dollar and par values of whenissued and other net settlement positions; debit and credit marks; and fails to deliver and duration 

of fails. Such information is available by CUSIP, by member, and in the aggregate. 

Comparison 

GSCC offers a centralized, automated comparison system for government securities 

trades. Comparison is the matching of the purchase and sale sides of a trade. Successful 

comparison occurs if the information submitted by both sides to a trade agrees as to quantity, 

security identification, contra party, trade price or trade value, buy or sell, and trade and 

settlement dates. Each comparison generated by GSCC evidences a valid, binding and 

enforceable contract between the members with 

 

 41 GSCC was temporarily registered as a clearing agency in 1988 (Securities Exchange Act Release No. 25749 

(May 24,1988), 53 FR 19639 ("GSCC Registration Order"». Temporary registration of GSCC has been extended 

through May 31, 1993 (Securities Exchange Act Release No. 29236 (May 24, 1991), 56 FR 24852). GSCC is owned

(about 19 percent) by National Securities Clearing Corporation ("NSCC"), a registered clearing agency and the 

largest equity clearing corporation in the U.S., and (about 81 percent) by approximately 48 government securities 

brokers and dealers. 

As a clearing agency registered pursuant to Section 17A of the Securities Exchange Act, GSCC is a selfregulatory organization ("SRO") and is subject to statutory obligations pursuant to Section 19 of the Exchange Act. 

Each SRO is required to me with the SEC for publication and approval any proposed changes to its rules. Each SRO 

also is required to comply with the 1934 Act and rules thereunder, and its own rules, to enforce compliance with its 

rules by its members, and to impose disciplinary sanctions on members for violations of rules. Section 17A further 

requires registered clearing agencies, among other things, to have rules designed to promote the prompt and accurate 

clearance and settlement of securities transactions, to assure the safeguarding of securities and funds and, in general, 

to protect investors and the public interest. 

B-71 
respect to the trade.42 Centralized, automated comparison systems at clearing agencies have 

eliminated the need for brokers to match trades manually and have given brokers and dealers 

better control over operational aspects and financial risks involved in settling trades. Automated 

comparison gives trading parties time to concentrate on resolving differences with counterparties 

and to prepare for settlement. In volatile markets, automated comparison enables market 

participants to liquidate their exposure from uncompared trades quickly, before changes in 

market prices increase potential losses. Automated comparison in the government securities 

market also permits brokers and dealers to submit delivery and payment instructions to clearing 

agent banks earlier in the day, which reduces late Fedwire deliveries.43

Members submit trade data to GSCC until 10:00 p.m., and receive reports of compared 

and uncompared trades by 2:30 a.m. the next morning, which is settlement day. GSCC's 

comparison system thus allows members to reduce fails by reconciling uncompared trades at the 

start of the day and resolving differences in time for the afternoon settlement period. 

Approximately 61 GSCC members participate in the comparison system. In 

1991, on average, 22,376 sides44 were submitted daily to GSCC for comparison, of which 94 

percent, with a dollar value of $153 billion, were successfully compared. 

Currently, GSCC compares submitted trades that occur in the when-issued market, including 

yield-based trades,45 trades that occur in the post-issuance, secondary market, and exercises of 

over-the-counter options. 

In December 1991, the SEC approved for one year a GSCC proposal to enhance the 

comparison system by allowing submitting members to enter the name of a non- 

 42 GSCC Rule 7. Also see Jeffrey F. Ingber, Overview of the Government Securities Clearing Corporation 

(August, 1991) ("Overview"). If comparison does not result in a matched trade, the trade will pend in GSCC's 

system until it is either compared or deleted by GSCC. 

43 GSCC Registration Order at 19641-2. 

44 A side is either the purchase or sale piece of a trade. Both the purchasing side and the selling side submit data 

for processing.

45 Yield-based trades are when-issued trades that occur after the auction announcement but before the security is 

auctioned and that trade on a yield rather than a price basis because the coupon on the security has not yet been set. 

GSCC compares these trades using the yield instead of a price. After comparison, 

these trades are deleted from GSCC's system. After final price information is determined, the trades may be

resubmitted to GSCC for comparison and netting. As discussed infra, GSCC plans to expand processing of yieldbased trades. 

B-72 
member as the executing firm.

46 An executing firm could be a customer or a nonclearing broker. 

The executing firm data can be used as a surveillance tool. Once captured, this data would reside 

at GSCC and would be available to identify, after the fact, the party for whom a dealer entered 

into a trade.

Centralized comparison could benefit other market segments. Ideally, centralized 

comparison systems might also be adapted and expanded to include nondealer, institutional 

customers.47 Comparison systems for institutional customers generally offer automated 

confirmation48 and affirmation49 services. Although GSCC does not yet offer centralized, 

automated confirmation and affirmation systems, such systems exist today at other clearing 

agencies. With adaptation or change, these systems could be expanded to include government 

securities trades involving institutions. For example, Depository Trust Company's ("DTC")50

Institutional Delivery ("ID") and International Institutional Delivery ("llD") Systems provide 

automated confirmation and affirmation services to brokers, banks, and institutional customers.51

 46 Securities Exchange Act Release No. 30078 (December 13, 1991),56 FR 66110. Initially, GSCC will 

compare trades even if the executing firm data do not match. As members become more comfortable with the new 

format, however, GSCC intends to use the executing firm data as a required comparison element.

47 Because dealers are required to send confirmations of transactions that include more data than are usually 

included in a comparison report, expanding comparison systems to those customers would not necessarily eliminate 

dealer confirmation distribution.

48 In a typical institutional trade, the customer's executing broker must confirm the terms of the trade in writing

to the investment manager. See 17 CFR § 240.10b-10. 

49 If the confirmation conforms to the investment manager's records of the trades ordered by the customer, the 

investment manager must issue instructions to the custodian bank authorizing the receipt or delivery of securities 

against payment to or by the broker.

50 DTC is a registered clearing agency and the largest private securities depository in the U.S. 

51 Adapting DTC's ID or IID Systems for use in the government securities markets, however, would mean that 

dealers who participate in GSCC might' be required to interact with more than one clearing agency to compare their 

government securities trades. It might be possible for GSCC to act as a conduit for its members, by accepting trade 

data from them and transmitting the data to DTC for confirmation processing. Output from DTC could be 

transmitted to GSCC for distribution to its members. 

DTC would need to adapt the ID system in at least one way in order to accommodate the need for earlier 

confirmations in the government securities market. Currently, the ill system trade input is in batch form and is 

processed only once a day - too late for the needs of the government securities market. Plans to enhance the ID 

system are under discussion. The IID system currently uses a multi-batch system that could accommodate earlier 

confirmations that would be useful for government securities trades. 

B-73 
Another market segment that might benefit from automated comparison is the market for 

repurchase and reverse repurchase agreements ("repos").52 Centralized repo processing not only 

would give regulators a truer picture of the government securities market, but also would give a 

better picture of each market participant's total risk profile, enabling GSCC, other clearing 

agencies, and regulators to refine their risk reduction policies. GSCC could benefit the market by 

offering a system that clearly defines which stage of the transaction is occurring, e.g., opening, 

closing, setting up a reverse repo or closing a reverse repo, and that automatically generates a 

comparison of the transaction. Such a service, if capable of capturing a high percentage of repo 

transactions, also could enable regulators to obtain data on repos for surveillance purposes at 

little or no cost to market participants. 

Netting and Guaranteed Settlement 

GSCC also operates a netting system through which each netting member's compared 

trades are reduced to one net settlement position in each security, which is in turn reduced to a 

minimum number of deliver or receive obligations.53 Centralized, multilateral trade netting 

systems can increase market efficiency and reduce counterparty credit risk and market risk.54

Trade netting reduces delivery and payment obligations for dealers, thus reducing both exposure 

and settlement costs. A netting system that includes novation of the trade, in which the clearing 

entity interposes itself as the counterparty to every deliver and receive obligation, effectively 

guarantees settlement of trades and reduces significantly the risk that the counterparty will fail to 

settle the trade.55 In addition, netting has the potential to reduce daylight 

 

 52 Some clearing agencies currently offer repo processing services. For example, DTC operates a Repo 

Tracking System that is designed to ensure that distributions on the securities underlying the repo are paid to the 

proper party.

53 Essentially all Treasury and Agency securities that are Fedwire-eligible, other than mortgage-backed and 

floating-rate securities, are eligible for netting. For a list of netting eligible securities, See Overview, supra note 41,

at 8. 

54 Counterparty credit risk is the risk to one party to a trade that the other party to the trade will default on its 

payment or delivery obligations. Market risk is the risk that, in the event of a default, the value of the securities 

bought or sold will change, so that a subsequent trade to complete the purchase or sale will result in a financial loss. 

55 The Bank for International Settlements has observed that "multilateral netting by novation and substitution 

has the potential to reduce liquidity risks more than any other institutional form, but this depends critically on the 

financial condition of any central counterparty to the netting. . ." Bank for International Settlements, Report on

Netting Schemes (February, 1989) at 6.

B-74 
overdrafts on Fedwire and the risk that the failure of one institution to settle may cause losses or 

the failure of other institutions.56

GSCC's netting system aggregates and matches offsetting deliver and receive obligations 

resulting from netting members' compared trades57 in order to establish a net settlement position 

for a member's activity in each security. After net settlement positions have been determined, 

resulting deliver and receive obligations are established. All deliver, receive, and related 

payment obligations between members that were created by trades that comprise the net 

settlement positions are terminated and replaced by the settlement obligations issued by GSCC.58

Net settlement positions and resulting deliver and receive obligations are fixed at the time that 

they are reported by GSCC to the member. 

GSCC accepts trade data from members until 10:00 p.m. and nets the submitted trades. At 

approximately 2:30 a.m. on the morning of settlement date, GSCC makes available netting 

reports to members. Each day, GSCC establishes and reports, by CUSIP and by product for the 

trades of a netting member: net settlement positions; fail net settlement positions,

59 which are 

marked to market daily with accrued interest; forward net settlement positions,60 which are 

netted on a rolling basis from the date of comparison to the current day and which automatically 

convert into net settlement positions on the scheduled settlement date; and deliver and receive 

obligations necessary to accomplish the settlement of a member's net and fail net settlement 

positions.

61 At the time reports of the net settlement positions are reported to members, the 

deliver and receive obligations are novated. 

 56 The problem of daylight overdrafts has led the Federal Reserve Board to adopt guidelines on the use of

Fedwire. See "Reducing Risk on Large Dollar Systems - Interim Policy Statement," Fed. Res. Reg. Servo Par. 9-

1006. In addition, the Federal Reserve Board has addressed methods for controlling the risk on private deliveryagainst-payment systems. See "Private Delivery-Against-Payment Security Systems," Fed. Res. Reg. Servo Par. 9-

1000. 

57 Each netting member, other than an interdealer broker, is required by GSCC rules to submit all trades with 

other netting members to GSCC's netting system. GSCC Rule 11. 

58 There is no provision for unwinding positions that have been netted and novated.

59 A fail net short position results from the failure of a netting member to deliver, and a fail net long position

results from a netting member's failure to receive. 

60 A forward net settlement position is the amount of securities that GSCC anticipates a netting member will be 

obligated to receive or deliver on the scheduled settlement date. The forward net settlement position arises from the 

netting member's when-issued and forward trades. 

61 Deliver and receive obligations on fail net settlement positions are not netted with other deliver and receive 

obligations, but are maintained on an independent basis until settled, except in cases of close-out. 

B-75 
Once a netting member receives the report of its net delivery obligations, it is obligated to 

instruct its clearing bank as to securities and funds transfers to and from GSCC's clearing bank. 

All settlements are made over the Fedwire, thereby ensuring delivery versus payment and finality 

of settlement.62 Securities movements take place throughout the day over Fedwire from 8:30 a.m.

until the Fedwire closes for securities transfers, usually 2:30 p.m. or later. Securities deliveries 

made to GSCC's clearing bank are instantaneously redelivered to members.63 All deliveries are 

made against full payment of GSCC's system price.64

GSCC also conducts funds only settlements. The funds only settlement amount is the daily 

aggregate of funds owing to GSCC for Trade Adjustment Payments, forward mark allocation 

payments, fail mark adjustment payments, clearance difference amounts, fees, and any 

miscellaneous adjustments. GSCC's clearing banks collect debit amounts from members by 

10:00 a.m. and pay credit amounts to members by 11:00 a.m.

Currently, about 44 GSCC members are netting members. This group includes all the 

interdealer brokers, 34 of the 38 primary dealers, and several non-primary dealers. In 1991, on 

average 17,015 sides, valued at $135 billion, were submitted to the net daily, and were reduced 

to 3,719 obligations, valued at $39 billion. GSCC nets members' forward settling trades, 

including when-issued trades that are traded on a price basis, and post-issuance secondary trades. 

GSCC's netting system routinely reduces deliver and receive obligations by nearly 80 percent. 

The benefits of netting are greater as more trades are included in the net, because a greater 

number of deliver and receive obligations are reduced to as small a number as possible. In 

addition, as more trades are included in GSCC's netting system, a larger percentage of market 

activity is novated, becoming guaranteed trades and freeing members from certain risks

described above. To this end, GSCC is planning to include more types of trading activity in the 

netting process and to expand its membership in order to extend the benefits of netting to a larger 

universe of its current members' trades and to a larger universe of participants. Specifically, 

GSCC has proposed to add yield-based trades and auction take-down activity to the netting 

process. In addition, GSCC has begun discussions with the futures contract markets about 

including futures transactions in the netting process. 

 

 62 Fedwire transfers are immediate and irrevocable. 

63 If GSCC receives securities late in the day that it cannot redeliver, the financing costs are shared by netting

members, other than interdealer brokers, on a pro rata basis.

64 The system price is the par-weighted average of all compared trades in each issue on that date, excluding 

trades with suspect prices. Because the system price is an average, GSCC also calculates a trade adjustment 

payment, or "TAP," that is the difference between the system price and the contract price. Each business day, each 

member must pay or receive a net debit TAP or net credit TAP. 

B-76 
The SEC recently approved GSCC's proposal to include yield-based trades in the netting 

system beginning in January 1992.65 In order to include yield-based trades in the netting system, 

GSCC will convert the yield trades into priced trades at the time of comparison. To convert, 

GSCC will use a standard Treasury Department conversion formula. This change will permit 

GSCC to extend the credit protection of the trade guarantee to members' yield-based trades 

sooner than under the current procedure, whereby compared yield-based trades are deleted from

the system and resubmitted for netting after the Treasury auction. 

Another type of trading activity that could benefit from netting is auction takedown 

activity. GSCC has proposed that its services be used in connection with the delivery of auction 

purchases. Under its proposal, GSCC would accept and report in its comparison system data on 

securities purchases made at auctions by GSCC netting members, net the purchases with whenissued trades of such members in the same securities through the netting system, and assume

responsibility for the delivery of the purchased securities through GSCC's clearing mechanism.

66

If implemented, additional information on the overall distribution process required to settle 

Treasury auction purchases and on the true net settlement positions of members during a whenissued period would be available at GSCC. Treasury and FRBNY staff have been working with 

GSCC on implementing this concept for the past eighteen months. 

Safeguards Underlying Guaranteed Settlement 

By guaranteeing settlement of trades included in the net, GSCC has given market 

participants greater certainty. of settlement. GSCC does this by interposing itself between all 

receive and deliver obligations, and thus becoming the delivering party to all members with 

receive obligations and the receiving party to all members with deliver obligations. Nevertheless, 

the guarantee is only as good as GSCC's ability to meet its obligations. GSCG therefore has 

adopted many safeguards to ensure that members and GSCC are able to meet their settlement 

obligations.

GSCC's safeguards encompass risk assessment capability and risk reduction and 

containment measures. GSCC's system of risk assessment is based on historical data. GSCC's

system of risk reduction is designed to protect GSCC from identifiable risks in its clearing 

agency activities and to ensure settlement of trades. In the event GSCC 

 65 Securities Exchange Act Release No. 29732 (September 24, 1991), 56 FR 49937. 

66 GSCC has refined its proposal so that any Treasury auction purchase by a netting member whether 

competitive or non-competitive in nature and whether or not for a customer, would be automatically delivered to

GSCC's clearing bank and encompassed within GSCC's net. GSCC would allocate auction deliveries to allow for the 

most complete netting process and to ensure timely delivery so that each member would take possession of the

entire amount of its auction purchases on the morning of issue date. 

B-77 
incurs a loss resulting from its clearing agency functions, GSCC's system of risk containment is 

designed to limit each member's loss to a pro rata assessment. Safeguards include member 

operational and financial standards, collection and maintenance of a clearing fund, collection of 

forward marks, monitoring of open positions, and procedures in the event of default by a GSCC 

member.

GSCC's credit and market risk reduction features may be particularly appealing in light of 

the anonymous nature of trading in the government securities market. Four interdealer brokers 

may have recognized that GSCC's system promotes risk reduction and effectively screens 

members' creditworthiness. These four have broadened their customer lists beyond primary and 

aspiring primary dealers to include all netting members of GSCc. As the group of GSCC netting 

members expands, therefore, access to interdealer broker screens should expand as well. 

Membership Standards and Monitoring. GSCC's rules permit the following types of

entities to become comparison members: registered government securities brokers and dealers, 

government securities brokers or dealers that have provided notice under Section 15C of the 

Exchange Act, clearing agent banks, and entities that demonstrate they could materially benefit 

from access to the service. Each comparison applicant must have sufficient operational capability

and must be in compliance with the capital requirements imposed by its regulator. 

For netting members, admission standards are more stringent. Unlike comparison 

members, all netting members must be registered government securities brokers or dealers, 

government securities brokers or dealers that have provided notice under Section 15C, or 

clearing agent banks. In addition, netting members must have used the comparison service for at 

least six months and have an established, profitable business history of a minimum of six months 

or personnel with sufficient operational experience. Netting members must be well-capitalized, 

with net worth of at least $50 million and excess net capital or excess liquid capital of at least 

$10 million (or $4.2 million in liquid or net capital for an inter-dealer broker and $250 million in 

equity capital for a bank).67

The SEC has emphasized that a clearing agency's rules must be designed to prevent unfair 

discrimination in the admission of members.68 The SEC has voiced to GSCC its view that 

GSCC's services should be opened to all applicants enumerated in 

 67 Membership standards are set forth in GSCC Rule 2. 

68 Securities Exchange Act Release No. 16900 (June 17, 1980),45 FR 41920.

B-78 
the Exchange Act based on appropriate credit and operational standards, and not based on 

primary and aspiring primary dealer status.69

The financial condition of each GSCC member is continuously monitored through the 

shared facilities of NSCC's compliance department. The compliance department receives from

members financial reports made to regulators, as well as audited financial statements.70 The 

compliance department also is in regular contact with regulatory, supervisory and examining 

entities, including self-regulatory organizations. Monitoring determines whether each member 

remains in compliance with its minimum admission standards and whether it poses any financial 

or other risks to GSCC.71 Members that pose risk to GSCC may be placed on surveillance 

status.72

GSCC uses the data submitted for comparison and netting services to monitor the 

aggregate positions of members and to assess their risk profiles. By having as complete a picture

as possible about its members' aggregate positions, GSCC is better able to assess risks to its 

members resulting from their activity and risks to itself as guarantor of netted trades. GSCC's

current netting system produces a good picture of netting members' trades with each other. 

GSCC also has a data base of activity among comparison-only members and between these 

members and netting members. Trades with non-members, however, do not appear anywhere in 

GSCC's data base. 

GSCC represents that it is actively developing changes to its membership standards to

admit a second tier of market participants beyond the primary dealers, aspiring primary dealers, 

and interdealer brokers. GSCC believes this tier of potential members is composed of two 

categories of market participants: a small group of arbitrage firms and registered or noticed 

government securities brokers and dealers. Interest from the second group principally is to meet 

the government securities needs of their retail equity customers. The Treasury, the SEC and the 

Federal Reserve 

 

 69 See GSCC Registration Order, supra note 40, at n.38, and Securities Exchange Act Release No. 27006 (July 

7, 1989), 54 FR 29798 at n.82. 

70 By sharing monitoring facilities, GSCC benefits by seeing the regulatory reports not only of GSCC members, 

but also of the members' affiliates who are NSCC members. NSCC's monitoring capability is similarly enhanced. 

71 GSCC may cease to provide services generally or for a particular transaction for a member that no longer 

complies with membership standards and a member whose financial or operational condition has deteriorated such

that GSCC believes the member will be unable to meet its obligations. GSCC Rule 18.

72 GSCC's rules provide GSCC with the discretion to require a member that is placed on surveillance status to

make and maintain an additional deposit to the clearing fund of up to 200 percent of its highest single business day's 

required clearing fund deposit during the most recent 20 business days. Securities Exchange Act Release No. 27006, 

supra note 68, at n.52. 

B-79 
believe that GSCC should accelerate its efforts to expand membership to more government 

securities dealers and brokers. 

Clearing Fund, Marks and Loss Allocation Procedures. The basic risks posed to GSCC 

by netting members are that a member might not pay a settlement amount due to GSCC or might 

fail to deliver or to take delivery of securities. A member's default or insolvency could expose 

GSCC to significant financial losses. To protect against this risk, GSCC has established a 

clearing fund the purposes of which are: (1) to have on deposit from each netting member cash 

or other collateral sufficient to satisfy a loss to GSCC as a result of that member's default and 

close out of settlement positions; (2) to maintain a total asset amount sufficient to satisfy 

potential losses to GSCC resulting from the default of more than one member and the failure of 

the counterparties of that member to pay their pro rata allocation of loss; and (3) to ensure that

GSCC has sufficient liquidity at all times to meet its payment and delivery obligations.73

A netting member's clearing fund requirement is a percentage of its money settlement 

obligations over a recent period plus a margin amount on the member's net settlement 

positions.

74 A minimum of the greater of $100,000 or 10 percent of a dealer's clearing fund 

required deposit must be in cash. Eligible Treasury securities and letters of credit from approved 

banks also are acceptable forms of clearing fund deposits. Clearing fund requirements are 

calculated daily and collected if there is a deficit.75 The clearing fund recently has been valued at 

about $225 million.76

The margin requirements are based on historical daily price volatility data with protection 

to two standard deviations.77 "Disallowance percentages" were established among classes of 

offsetting securities, to allow GSCC to give credit for offsets only to 

 73 Overview, supra note 41, at 17. 

74 Currently, the clearing fund requirement is 125 percent of the member's average funds-only settlement

amount over the most recent 20 business days plus the greater of the margin amount on the member's net settlement 

positions averaged over the most recent 20 business days, taking into account offsetting positions, or 50 percent of

the margin for that business day on the member's net settlement positions without allowing for offsetting positions. 

GSCC, Form CA-1 (March 15, 1991) at 8-9.

75 Currently, interdealer broker netting members must make a deposit to the clearing fund of $1.6 million each 

in collateral to cover losses that may be allocated against them. As users of GSCC's netting system, interdealer 

brokers are required to share in the loss allocation scheme. 

76 Telephone conversation with Thomas F. Costa, Senior Vice President, GSCC, October 31, 1991. 77 Two

standard deviations encompass approximately 95 percent of the measurements from the mean. 

77 Two standard deviations encompass approximately 95 percent of the measurements from the mean. 

B-80 
the extent appropriate. Irrespective of the nature of the offset, a minimum margin of 50 percent 

of the margin amount on the member's "gross" positions is collected.78

While technically not a part of the clearing fund, a special margining system was designed 

for forward-settling trades, including when-issued trades, to ensure that the failure of up to all of 

the five members with the largest debit mark levels on any given day would not disrupt the 

ability of the system to settle successfully that day's government securities trades. To this end, 

GSCC collects forward mark allocation payments from certain non-interdealer broker netting 

members. The basis for these payments is the daily mark-to-market obligation associated with a 

member's ongoing forward net settlement position in each security from the time of comparison 

and novation of the trades that underlie such position.79

Another risk reduction policy is the collection of daily marks on fail net settlement 

positions. The daily mark-to-market payment for fails takes into account accrued interest.80

Netting members have obligations for loss sharing. Three principles underlie GSCC's loss 

allocation scheme. First, GSCC will look to the collateral put up by the member whose default 

caused the loss.81 Second, if the loss remains unsatisfied, the members that dealt with the 

defaulting member will be asked to satisfy the loss in full 

 78 GSCC maintains a separate margin factor schedule for zero-coupon securities because of the tendency of

zero-coupon securities to display greater volatility than other Treasury securities. 

79 A member's net securities and funds only settlement obligations arising from forward-settling trades are 

included in the calculation of such member's clearing fund requirement during the post-auction forward-settling

period. 

80 This mark to market procedure has in some cases replaced certain capital and customer protection 

requirements imposed by the Treasury Department. Overview, supra note 41, at 9. 

81 Under GSCC Rule 4, each member grants to GSCC a fIrst priority perfected security interest in all assets and

property placed by a member in the possession of GSCC (or its agents acting on its behalf), including all securities 

and cash on deposit with GSCC in satisfaction of a netting member's required fund deposit or additional fund

deposit as security for any and all of its obligations and liabilities. GSCC is entitled to its rights as a pledgee under 

common law and as a secured party under Articles 8 and 9 of the New York Uniform Commercial Code with respect

to such collateral. GSCC maintains a lien on securities that have been delivered to it by the selling side of each trade 

until it receives payment via Fedwire from the buying side. Securities Exchange Act Release No. 27006 supra note 

68, at n.39. 

B-81 
on a pro rata basis.82 Third, if the members that traded with the defaulting member do not satisfy 

the loss in full, other members will be asked to share in the loss.83

 

 

82 The affected members are those with trading activity to be settled on the day of default.

83 GSCC, Form CA-1 (March 15, 1991) at 9. If a non-counterparty member determines to withdraw from

GSCC, its maximum exposure is limited to the amount of its clearing fund requirement. Maximum interdealer 

broker liability is $1.6 million, the amount of the clearing fund deposit. 

B-82 
6. Sales Practice Rules 

Background and discussion 

In enacting the GSA in 1986, Congress did not grant Treasury or any other regulatory 

body new authority to develop sales practice rules pertaining to transactions in government 

securities except for advertising rules. The legislative history of the GSA shows Congress'

previous intent that the GSA not result in excessive regulation that would impair the efficient 

operation of the market and recognition that the SEC has authority under Section 10(b) of the 

Exchange Act to promulgate rules to prohibit fraudulent, manipulative, and deceptive acts and 

practices. The scope of the GSA and the new authority thereunder generally were limited to 

those areas of documented abuse and weakness in the government securities market.84

Congress' initial judgment was that the potential costs of sales practice rules in the 

government securities market would outweigh the potential benefits. Congress had the 

opportunity to authorize sales practice rules for the government securities market in its 

development of the GSA but, with the exception of advertising, chose not to do so. The scope of 

the GSA was therefore narrower than other securities legislation designed to regulate the equities 

and municipal securities markets. 

The GSA continued the restriction placed on the NASD that prohibits it from applying its 

sales practice rules to government securities transactions, although it provided an exception to 

that restriction, authorizing the NASD to prohibit fraudulent, 

 84 "The legislation would grant to the Secretary specific rulemaking authority in the areas of financial 

responsibility and related practices, financial statements, recordkeeping and exemptions from registration.

Rulemaking authority in additional areas does not appear to be necessary to address the weaknesses that have been

identified in the government securities markets." ***

"The Committee views these rules as being generally sufficient to achieve the purposes of the rules to be

adopted under Section 15C(b) ................ " *** 

"Since government securities would continue to be treated as exempted securities for purposes of the 

Exchange Act, a registered securities association would have no authority with respect to government securities 

brokers, government securities dealers, and government securities transactions except as specifically authorized in

the bill or as already exists in current law. ... a registered securities association would not be authorized to regulate 

transactions in exempted securities by member brokers or dealers. For example, a registered securities association 

would be precluded from adopting ... any rules of fair practice applicable to government securities brokers and 

government securities dealers..." S. Rep. 99-426, supra at 14, 16, 20. 

B-83 
misleading, deceptive, or false advertising in connection with government securities.85

Registered securities exchanges have no such restriction on the application of their sales practice 

rules to their members' transactions in government securities. 

The appropriate regulatory agencies for financial institutions do not have explicit authority 

to impose sales practice rules on the institutions they supervise, although the OCC currently 

applies the Municipal Securities Rulemaking Board's ("MSRB") sales practice rules as 

benchmarks for the government securities transactions of national banks.86 Most banks that are 

dealers act as such both for municipal and government securities. 

As a result, the vast majority of brokers and dealers that conduct a business in government 

securities, as well as financial institutions that have filed notice as government securities brokers 

or dealers, are not subject to sales practice rules prescribing just and equitable principles of 

trade.87 These brokers and dealers are subject to SEC rules adopted under Section 10(b) of the 

Exchange Act and, with the exception of financial institutions, are subject to SEC rules adopted 

under Section 15(c)(1) of the Exchange Act.88 However, the enforcement of Section 10(b) and 

the rules promulgated thereunder generally requires a showing that the respondent acted with 

scienter.89

 85 Section 15A(t)(l) of the Securities Exchange Act, 15 U.S.C. § 780-3(t)(1), as amended. The restriction against 

the NASD's application of its sales practice rules to transactions in government securities does not, however, apply 

to the NASD's enforcement of compliance by its members with the , provisions of the Exchange Act and the rules 

and regulations thereunder. See Section 15A(t)(2) of the Securities Exchange Act, 15 U.S.C. § 780-3(t)(2), as 

amended.

86 See, e.g., MSRB rule G-17. 

87 Registered brokers or dealers that have filed notice as government securities brokers or dealers and that are 

members of the NYSE or other national securities exchanges are subject to exchange sales practice rules. The 

exchanges' rules, however, are not always easily adaptable to over-the-counter markets. For example, the exchanges

do not have specific rules addressing mark-ups, which are not charged on exchange transactions.

88 Section 15(c)(l) of the Securities Exchange Act, 15 U.S.C. § 780(c)(1), proscribes a broker or dealer from

using any manipulative, deceptive or fraudulent device or contrivance, as defined by the SEC, in connection with 

transactions in securities otherwise than on a national securities exchange. See 17 CFR § 240.15c1-1 et. seq. 

89 The term "scienter," as applied to conduct necessary to give rise to an action for civil damages under the 

Securities Exchange Act and Rule 10b-5, refers to a mental state embracing intent to deceive, manipulate, or 

defraud. Ernst and Ernst v. Hochfelder, 425 U.S. 185 (1976). Most courts have followed the standard in Sunstrand 

Corp. v. Sun Chemical Corp., 553 F.2d 1033 (7th Cir. 1977), which describes the necessary mental state as one in

which "the danger of misleading buyers must actually be known or so obvious that any reasonable person would be

legally bound as knowing..." Id. at 1045. In other circuits, see Kehr v. Smith Barney Harris Upham & Co., 736 F.2d

1283, 1286 (9th Cir. 1984); Wa1Ten v. Reserve Fund, Inc., 728 F.2d 741, 745 (5th Cir. 1984); Kennedy v. Tallant, 

710 F.2d 711, 720 (11th Cir. 1983); Hackbart v. Holmes, 675 F.2d 1114, 1117 (10th Cir. 1982); Sharp v. Coopers & 

Lybrand, 649 F.2d 175, 193 (3d Cir. 1981), celt. denied, 455 U.S. 938 (1982); Mansbach v. Prescott Ball& Turoen, 

598 F.2d 1017, 102325 (6th Cir. 1979).

B-84 
The types of sales practice abuses that may be most likely to occur in the government 

securities market are those related to mark-up or pricing practices; failure to ensure that

recommendations to customers are suitable based on customers' investment objectives and 

financial backgrounds; excessive trading in customer accounts; failure to obtain proper customer 

authorization before trading; and false, deceptive, or misleading advertising practices. These 

types of abuses can occur in customer accounts regardless of product. However, it has been 

difficult to assess the magnitude and severity of the problem given the lack of specific evidence 

of widespread sales practice abuses in the government securities market. 

While the government securities market is still principally a wholesale market in which 

brokers, dealers, large commercial banks, and experienced institutional investors participate, a 

significant number of smaller and less experienced investors also participate in this market. 

Additionally, this market increasingly encompasses instruments that can pose considerably 

greater risk of adverse price movements and loss than traditional investments in Treasury or 

agency securities, which may increase the need for more specific investor protection rules. These 

instruments, some of which are very complex, include mortgage-backed securities and real estate 

mortgage investment conduits ("REMICS") issued or guaranteed by government agencies or 

Government-sponsored enterprises, zero-coupon instruments such as STRIPS, agency mortgagebacked securities stripped into interest-only (“IOs”) and principal-only ("POs") pieces, and overthe-counter options on government securities. Some of these instruments are quite similar to 

instruments already covered by sales practice rules or that trade in combination strategies with 

instruments that are covered by such rules. 

Currently, proceedings under Rule 10b-5 may be brought in response to mark-up 

practices, excessive trading in customer accounts, and other sales practice abuses, and a body of 

case law has developed as a result.90 Also, abuses in which a broker effects 

 90 See, e.g., Costello v. Oppenheimer & Co., 711 F.2d 1361, 1368 (7th Cir. 1983); Thompson v. Smith Barney, 

Harris, Upham & Co., 709 F.2d 1413 (11th Cir. 1983); In re Catanella and E.F. Hutton & Co., 583 F. Supp. 1398, 

1405, 1410-1411 (E.D. Pa. 1984); and Ryan v. SEC, Sec. Reg. & L. Rep. (BNA) No. 26 at 1273 (July 1, 1983) (9th

Cir. May 23, 1983), affg. In re James E. Ryan, 47 SEC 759 (1982). In the mark-up area, the SEC, in 1987, issued a 

release designed to clarify the application of mark-up policy, including the federal anti-fraud provisions, to zerocoupon securities. Securities Exchange Act Release No. 24368 (April 27, 1987), 52 FR 15575 (1987). 

B-85 
unsuitable transactions in discretionary accounts may be prosecuted by the SEC and the SROs as 

violations of Rule 15c1-7 under the Exchange Act.91

Nevertheless, adopting sales practice rules for the government securities market would 

allow most disciplinary actions to be taken without having to prove scienter. In addition, such 

rules could provide more objective or specific criteria that would serve as standards to be applied 

in routine examination programs. Application of such rules to the government securities market 

also would be consistent with the rules applied to the equity and municipal securities markets. 

Moreover, government securities sales practice rules should strengthen investor confidence and 

integrity in the market and enhance investor protection. 

In its September 1990 report,92 the GAO stated that, although actual sales practice abuse is 

hard to document in the government securities market, the limitations on the NASD's authority to 

enforce its sales practice rules should be removed and Treasury should be granted authority to 

write such rules. The GAO's recommendation was largely based on its view that sales practice 

rules that supplement the basic antifraud statutes have become a fixture in securities markets in 

the United States. The GAO indicated that these rules make sense for government and other 

securities markets because there are similar opportunities for abuse in both markets. The GAO 

also indicated that increased risk characteristics of certain government securities now increases 

the need for sales practice rules, particularly for the benefit of some individuals and smaller 

institutional investors. 

 91 17 CFR § 240.15c1-7. 

92 U.S. Government Securities: More Transaction Information and Investor Protection Measures Are Needed,

GAO/GGD-90-114 (September 1990), at 4,5,6, and 48. 

B-86 
7. Information Access 

Background and discussion 

An important aspect of the government securities market is the role played by seven 

interdealer brokers. Their system of "blind brokering" provides a trading mechanism for primary 

dealers that maintains the anonymity of the traders and increases the liquidity of the market. The 

interdealer brokers' systems are a significant price discovery vehicle for the dealers. Initial efforts

to increase transparency have focused on the interdealer brokers. 

A significant characteristic of fair and efficient markets is transparency, defined as the 

degree to which real-time trade and quotation information and other market-related information, 

such as information about the depth of the market, is available to all market participants. 

Transparency is important for several reasons. First, it is crucial to market participants'

evaluation of the investments they are considering. Participants without knowledge of the current 

buying and selling interest in the form of firm bid and ask quotations and transaction reports, are 

at a distinct disadvantage in assessing the value of securities. Thus, transparency is crucial to 

efficient pricing mechanisms. Second, access to accurate market information enhances the ability 

of regulatory examiners and independent auditors to carry out their respective responsibilities to 

ensure that securities transactions and positions are priced appropriately. In addition, 

transparency permits investors to evaluate whether their brokers are treating them fairly by 

obtaining the best available price for them and by charging them reasonable markups and 

markdowns on their transactions. Without access to the prices other market, participants are 

paying for-the same security, they cannot effectively determine whether they have paid a fair 

price. This can be a problem in the government securities market, in which the best market data 

has traditionally been available only to the primary dealers and generally has not even been 

available to the majority of intermediaries. 

In a completely transparent market, all market participants have equal and immediate 

access to all firm quotations, including the size of those quotations, and reports of prices and 

volumes on all trades effected in the market. Of course, complete transparency represents a 

theoretical model that has not been achieved in any market. 

B-87 
The need for increased access to interdealer broker price and volume information93 has 

been a topic of discussion for at least the past five years. Congress has shown interest in the 

activities of these firms and has previously requested the General Accounting Office to report on 

certain aspects of their business. Congressional concern focused on the barriers to expanding the 

number of dealers who could trade through the interdealer brokers beyond primary and aspiring 

primary dealers and to making available interdealer price information to the public. In its 1987 

report,94 the GAO recommended that market participants be provided increased access to 

government securities pricing information. At that time, the GAO did not support a federal 

regulatory structure to achieve expanded access because it believed private sector initiatives 

should be allowed time to develop.95

Also, at that time, Treasury, the Federal Reserve, and the SEC concurred with GAO's

conclusion on the need for increased information access but had differing views on the best 

means to achieve it. The Federal Reserve and Treasury agreed with the GAO that a regulatory 

structure was not then required to achieve improved information access, because private sector 

initiatives, which could obviate the need for such action, should be allowed time to develop. The 

SEC expressed the view that it was not necessarily in the interest of the interdealer brokers and 

primary dealers to disseminate price information and, accordingly, it did not agree that this 

information necessarily would be made available on a voluntary basis. As a result, the SEC 

believed that Congress should establish a date certain by which information access should be 

expanded. The SEC recommended that if this objective were not achieved, Congress should 

grant rulemaking authority to a federal agency to ensure that information access would be 

expanded. 

In its follow-up report issued in September 1990,96 the GAO recommended that Congress 

legislatively mandate that government securities transaction information, from interdealer 

brokers and 'any trading systems that serve a similar function be made 

 93 The phrase "price and volume information" is used in this section to refer to both actual prices at which trades 

are effected, i.e., trade reports, including volume, and prospective prices, i.e., quotations, including size.

94 U.S. Government Securities: An Examination of Views Expressed About Access to Brokers' Services, 

GAO/GGD 88-8 (December, 1987). 

95 GAO also concluded that, while it theoretically supported the notion that access to interdealer broker trading 

services should be expanded, no viable proposals had been put forth on how to account for the increased

counterparty risk that such an expansion could cause. The Federal Reserve, Treasury, and the SEC agreed. The SEC, 

however, encouraged the interdealer brokers to work voluntarily to develop appropriate credit risk assessment

systems that would permit the participation of non-primary dealers in the brokers' systems.

96 U.S. Government Securities: More Transaction Information and Investor Protection Measures Are Needed, 

GAO/GGD 90-114 (September, 1990). 

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available on a real-time basis to anyone willing to pay the appropriate fees. GAG further 

recommended that regulatory authority be assigned to Treasury to prescribe regulations as 

needed to ensure that such transaction information is available. In their Joint Report of October 

1990, Treasury, the Board and the SEC did not reach a consensus on the best approach for 

addressing the need for expanded access to and dissemination of government securities price and 

volume information but instead identified issues to be considered.97 These issues included: 

• what is the best means to achieve expanded access; 

• what is the reasonable prospect that private-sector initiatives will be successful; 

• should standards be developed to ensure the adequacy of private-sector systems; 

• if authority is granted to a federal agency, which agency would be best able to exercise 

this authority; 

• should a deadline be established for a federal agency to evaluate the adequacy of private 

sector initiatives; and 

• should the authority be utilized only in the event that findings regarding the inadequacy 

of private-sector initiatives are made?

Interdealer broker screens represent the best source for deriving market prices for 

government securities, because they include the current bids and offers, and transaction reports 

of the primary dealers, the principal market makers in the government securities market. Broader 

access to this information, as well as transaction information, supports the efficiency and 

liquidity of the government securities market. 

Dissemination of quotation and trade information allows customers to judge execution 

quality, especially for inactively traded issues. The expanded availability of such information 

would serve the public interest because it would ensure that a broad spectrum of market

participants could obtain current, accurate facts related to market conditions, and thus, the 

competitiveness, liquidity and efficiency of the government securities market could improve. 

Improvements in the derivative markets are also likely to accrue due to the availability of more 

timely and accurate information on the underlying securities used for pricing and hedging 

strategies. 

 97 Department of the Treasury, Securities and Exchange Commission and the Board of Governors of the Federal 

Reserve System, Study of the Effectiveness of the Implementation of the Government Securities Act of 1986, 

(October, 1990), p. 87. 

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Market solutions 

Industry Initiatives. Through a number of attempts, the market has experienced a 

significant increase in the dissemination of government securities price information.98 Currently, 

the quotes of one broker, Cantor Fitzgerald Securities Corp., which does not conduct an 

exclusively interdealer business, are publicly available through Telerate Systems Inc. These 

quotes represent a substantial portion, approximately 25 percent, of the interdealer market. 

Additionally, in June 1991 Cantor Fitzgerald expanded the range of information that it 

disseminates to include agency and additional Treasury security price information, including offthe-run issues and zero coupon instruments, and analytical capabilities for the government 

securities market. 

One private sector initiative, a joint venture known as GOVPX, Inc., became operational 

on June 16, 1991. GOVPX disseminates real-time price and quotation information on all 

Treasury bills, notes and bonds on a 24-hour, global basis. The system provides information 

regarding all trading of Treasury securities (other than stripped zero-coupon instruments) that is 

executed through five interdealer brokers. The information disseminated is a composite picture 

of the trading activity, showing executed trade prices, volume of executed trades, best bids and 

best offers, and aggregated volumes traded for each security on a daily basis. This information is 

provided to on-line vendors for redistribution to the public. 

While GOVPX is a promising beginning, it has deficiencies when compared with the 

interdealer broker screens in that it does not provide information on stripped Treasury securities 

and non-Treasury government securities. It also provides neither the size associated with 

published bids and offers nor an indication of the depth of the market. Finally, it does not 

provide the capability for analytics and does not provide historical price information. In addition, 

GOVPX disseminates quotation and transaction information only from the interdealer brokers 

who participate in the venture. It thus does not provide price information from other interdealer 

brokers or from dealers that trade with each other or with their customers outside of the 

interdealer broker system. In this regard, Treasury, in a letter to GOVPX's Board of Directors 

dated October 25, 1991, strongly encouraged GOVPX to address certain of these deficiencies 

and urged the interdealer brokers to make their screens independently available to the public. 

Expanded trading access. With the exception of one interdealer broker, access to trading 

through interdealer broker screens had traditionally been restricted to primary and aspiring 

primary dealers as a means to provide control over the credit risk inherent in a system of

anonymous trading. Limiting the number of potential counterparties eases specific evaluation of 

their individual creditworthiness. However, 

 98 A description of some of the various initiatives can be found in U.S. Government Securities. More 

Transaction Information and Investor Protection Measures are Needed GAO/GGD 90-114. 

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only with an appropriate credit review mechanism can a system of anonymous trading operate 

efficiently. The operation of the Government Securities Clearing Corporation ("GSCC") has 

provided an additional means of addressing the creditworthiness of trading counterparties. 

GSCC has increased the efficiency and decreased the risk of government securities 

settlement. This is particularly important for the interdealer brokers, since GSCC allows them to 

be netted out of every compared trade. In a typical interdealer transaction, Dealer A sells 

securities to Dealer B through the Interdealer Broker. Because the trading is anonymous, two 

trade tickets are written; one between Dealer A and the Interdealer Broker and one between the 

Interdealer Broker and Dealer B. The GSCC netting system replaces these two steps with one net 

transaction between the two dealers, each of whom now has GSCC as a counterparty and each of 

whom settles with GSCC. This greatly reduces any counterparty or fails previously inherent in 

interdealer broker systems. Additionally, by removing the fails risk, the interdealer broker does 

not face the possibility of having to incur the financing cost for securities positions. This system

also provides significant credit comfort to the dealer because his counterparty is GSCC and 

GSCC has systems in place (e.g., margining systems and a clearing fund) to ensure the 

settlement of all netted trades. 

Accordingly, four interdealer brokers (Liberty Brokerage, RMJ Securities, Garban and 

Fundamental Brokers) have recently expanded their customer bases to include all netting 

members of GSCC. All of the interdealer brokers are members of GSCC. Their recent actions

represent the potential for significant broadening of interdealer trading access because the pool 

of broker/dealers eligible to be netting members of GSCC, as determined by capital levels, is 

currently about 75 firms. GSCC has proposed creating a new class of netting member to allow 

the participation of brokers and dealers that do not meet the current standards for netting 

membership but who still have a substantial level of capital. If approved, this proposal could also 

lead to even broader interdealer trading access. 

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8. Reporting and Audit Trails 

It has been suggested that regulatory authority to prevent fraud or manipulation in the sale 

of government securities is limited compared with other securities markets because of the lack of 

certain surveillance tools. 

Large Position Reporting 

One tool that the Agencies have considered to augment government surveillance ability in 

this market is the ability to require large position reports in particular Treasury issues from

government securities market participants. In order to minimize the gaps in coverage, such 

authority would have to include the ability to require reports from entities that are not 

government securities dealers or brokers. 

Large position reporting could give the Agencies advance notice of a potential problem, 

such as a large concentration of positions in a particular security. If a problem did develop, such 

reports could also assist regulators in an investigation. 

A scheme of large position reporting, if determined to be necessary, would raise a large 

number of issues. Foremost would be a definition of what constitutes a large position in

government securities for reporting purposes. Items that would have to be considered for 

inclusion would be when-issued positions, repurchase and reverse repurchase transactions, bonds 

borrowed and lent, options, fails to receive and deliver, and forward settling contracts. Other 

issues which would need to be decided include: 

• which securities would be covered by the regulations; 

• to what type of positions (proprietary, custodial) would the rules apply; 

• what reporting threshold would be considered a large position; 

• what would be the frequency and timing of the reporting requirement; 

• what specific information would be ,reported; and 

• which agency(ies) would be the recipient(s) of the information. 

Unlike Section 13(d) of the Exchange Act, which requires owners of more than five 

percent of a class of a corporation's equity securities to make a public disclosure of this

information, it is not contemplated that any position reporting concerning Treasury securities 

would be publicly disclosed. There is no intention to force market participants to disclose their 

trading strategies, nor is there a presumption that the mere fact of holding a large position is 

evidence of manipulative or other illegal intent. 

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The purpose of such reporting would be similar to the purpose of the position reporting that is 

done in the commodity futures markets - it would enable government agencies to monitor market 

developments and have an early warning system of potential problems. 

In addition, a possibility that could be considered is to grant the Treasury and the SEC 

authority similar to that of the Commodity Futures Trading Commission with respect to making 

a special request for information. The CFTC and the Justice Department can ask futures market 

participants for information concerning their futures market positions and related cash market 

positions without the necessity of issuing a subpoena. Because of the presence of large and 

mainly unregulated entities, such as hedge funds, in the government securities market, 

consideration could be given to granting similar authority in the government securities market to 

be used in the case of serious market problems. 

Large Trader Reporting 

If there were concerns about the ability of traders to take large hidden positions, authority 

such as that granted by Section 13(h) of the Exchange Act could be extended to government 

securities traders. Section 13(h) presently authorizes and requires the SEC to create a large trader 

recordkeeping and reporting system for publicly traded equities and options on equities.99

While a large trader reporting system may be appropriate for the stock market, the balance 

of costs and benefits may be very different in the government securities market. It appears 

unduly cumbersome given that current concerns relate primarily to short squeezes. As is 

demonstrated by the CFTC, large position rather than large trader reporting is more effective for 

monitoring members for such problems. 

Audit Trails 

Audit trails are automated, time-sequenced records of essential information pertaining to 

trades in securities. Accurate audit trails are important to market surveillance functions 

performed by SROs in the equity markets for two reasons. First, 

 99 See Securities Exchange Act Release No. 29593 (Aug. 28, 1991), 56 FR 42550. Proposed Rule Bh1, which

was published for public comment on August 22, 1991, would define a "large trader" as any person that (1) effects 

aggregate transactions in publicly traded securities during a 24-hour period equal to or exceeding 100,000 shares or 

$4 million total market value or (2) conducts program trading. Under the proposed rules, these "large traders" would 

be required to report to the SEC certain information, such as the traders' names, addresses, telephone numbers, and 

account names and numbers. These traders would then be assigned "large trader identification numbers" to provide 

to each brokerage firm where the traders have accounts. The firms would then be required to maintain, and to report 

to the SEC on request, records of transactions by large traders; these reports could be required as soon as the end of 

the business day after the trades in question. 

B-93 
automated audit trails permit SROs to sift through voluminous trading data to detect potential 

trading abuses. Second, audit trails provide timing information for transactions that may uncover 

trading abuses.100

In addition to such real-time reporting, the SROs have developed computer systems that 

sort trading records and create exception reports that flag unusual or suspicious- trading patterns 

and price or volume movements. These volume and price parameters are uniquely and 

automatically calculated for each stock based on that stock's historical trading pattern. This 

information is then correlated with relevant news announcements that may affect trading in a 

security. Additionally, various computer reports are available for review that cover quotes, 

trades, reported times and other trading areas. By using these automated systems, which are 

continually upgraded and expanded, the SROs can monitor member broker-dealer firms, market 

professionals, and other traders. 

Neither the Treasury nor the SEC has the authority under the Government Securities Act 

of 1986 to require centralized trade and price reporting. Consequently, there are no centralized 

audit trail or exception reports systems in place for the government securities market.

 100 SRO audit trails generally have. the same basic structure. A transaction journal is compiled by merging two

separate data streams, the quotation and last sale tape, and comparison data, which is the information transmitted by

firms to a clearing agency to provide for the clearance and settlement of transactions. The systems attempt to match

trade prints to the compared trades using price, quantity, execution time and broker identification numbers. The 

matching of such reported and cleared securities transactions produces an accurate sequencing of trades. 

B-94 
APPENDIX C 

THE EVENTS INVOLVING SALOMON BROTHERS 

AND ALLEGED GOVERNMENT SECURITIES MARKET ABUSES 
1. The events involving Salomon Brothers 

The current analysis of the government securities market and the effectiveness of the 

existing regulatory scheme was triggered by unusual events surrounding the May 22, 1991, 

auction for two-year Treasury notes.1 Even before the May two-year notes were settled on May 

31, 1991, rumors began to surface of a short squeeze in the market for those notes. On May 29, 

1991, Treasury staff called the SEC's Divisions of Market Regulation and Enforcement to notify 

them of possible problems stemming from the auction. Following that notification, the Treasury, 

the Federal Reserve, and the SEC jointly began an informal investigation, actively monitoring 

the market for the notes.

On May 30, 1991, the SEC's Division of Enforcement opened an inquiry into the matter. 

During the next few weeks, the SEC gathered information concerning the market for the notes, 

including, through the FRBNY, identification of all the purchasers of large amounts of the twoyear notes in the auction. In late June, the Division of Enforcement sent detailed requests for 

documents and information to Salomon Brothers Inc ("Salomon") and other major purchasers in 

the May two-year note auction concerning their activities in the when-issued market, the auction, 

and the secondary market for the notes. 

Shortly after receiving the SEC's document requests and learning that the Antitrust 

Division of the Department of Justice had begun an investigation of the May 22 auction, 

Salomon hired outside counsel to conduct its own investigation, which eventually led to a series 

of disclosures by Salomon. The first came on August 9, 1991, when Salomon advised the 

Treasury and the SEC that it had discovered irregularities in connection with certain Treasury 

auctions and issued a press release describing its initial findings.2

The factual discussion below with respect to Salomon's conduct is based primarily on 

public disclosures by Salomon. 

Unauthorized customer bids submitted by Salomon 

In its August 9 press release, Salomon stated that it placed unauthorized bids in certain of 

its customers' names at several Treasury auctions. On August 14, 1991, 

 1 The SEC and the Department of Justice are conducting separate investigations from a law enforcement 

perspective, which are not yet complete, and the SEC has not yet reached any conclusions with respect to the actions

of any particular market participant. As a result, the discussion contained herein should not be understood as

reaching any conclusions of fact or law with respect to the SEC's investigation. 

2 See Salomon Press Release dated August 9, 1991. 

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Salomon disclosed that it placed unauthorized bids in five auctions to obtain a greater amount of 

the securities being auctioned, and, in one case, as a result of a "practical joke." Salomon's 

internal investigation revealed that, from late July, 1990 through August 1991, Salomon had 

submitted unauthorized customer bids and bids in excess of the amount authorized by the 

customer in five Treasury auctions.3

 The auctions where these admitted violations occurred were 

the: (1) December 27, 1990, four-year note auction; (2) February 7, 1991, 30-year bond auction; 

(3) February 21, 1991, five-year note auction; (4) April 25, 1991, five-year note auction and (5) 

May 22, 1991, two-year note auction.4

 In addition, Salomon uncovered evidence of three 

additional unauthorized bid violations.5 

The December 27, 1990, four-year note auction. In connection with the December 27, 

1990, $8.5 billion four-year note auction, Salomon stated that it submitted a bid for its own 

account for $2.975 billion, or 35 percent of the offering amount, and an unauthorized customer 

bid in the amount of $1 billion. Aggregation of the unauthorized customer and Salomon bids 

resulted in a bid for 46 percent of the auction amount. The bids were at the stop-out rate and thus 

were subject to 51 percent proration. Salomon was awarded approximately $1.52 billion of the 

four-year notes and the customer was awarded $510 million. Immediately after the auction, 

Salomon transferred to its own account, or "bought" at the auction price, the $510 

 3 See Salomon Press Release dated August 14, 1991 ("August 14 Press Release"). Treasury rules limit the 

amount a single bidder can purchase at any auction to 35 percent of the total public offering amount of the securities 

available. In addition, Treasury will not recognize amounts tendered by a single bidder at anyone yield in excess of 

35 percent of the public offering amount, and will reduce tenders at anyone yield exceeding the limit to the 35

percent amount. See Treasury News Releases dated September 8, 1981 and July 12, 1990. Under the rules in effect 

before July 1990, the Treasury would award no more than 35 percent of the securities publicly available for 

purchase at the auction to any single bidder, but would recognize bids in excess of 35 percent of the public offering

at any particular yield. Therefore, a bidder could enter a bid greater than 35 percent at a yield thought to be the

highest accepted to increase its chances of being awarded a larger amount of securities in the event of proration at 

the high yield. The rule was changed, however, after Salomon bid for an amount in excess of 100 percent of an issue

during a Resolution Funding Corporation ("REFCORP") 30-year bond auction in July 1990. REFCORP did not

recognize the amount of the bid in excess of 35 percent. After the auction, Treasury announced a change in auction 

rules, restricting the amount recognized as bid by anyone bidder at a single yield to 35 percent of the public offering

amount of the issue.

4 See Statement of Salomon Inc Submitted in Conjunction with the Testimony of Warren E. Buffet. Chairman 

and Chief Executive Officer of Salomon Inc.. Before the Securities Subcommittee. Committee on Banking. Housing

and Urban Affairs. United States Senate. September 10. 1991 at 8 ("Salomon September 10 Testimony"). See also

Statement of Salomon Inc. Submitted in Conjunction with the Testimony of Deryck Co Maughan. Chief Operating 

Officer of Salomon Brothers Ine. and Robert E. Denham. General Counsel of Salomon Inc. Before the 

Subcommittee on Oversight. Committee on Ways and Means. United States House of Representatives. September 

24. 1991, ("Salomon September 24 Testimony"). 

5 See Salomon September 24 Testimony at 9. See also Salomon Press Release dated October 3, 1991.

C-2 
million of four-year notes awarded to the customer. Salomon suppressed the customer 

confirmation for the amount purchased at the auction.6

 As a result of the submission of both bids, 

Salomon effectively bid for 46 percent of the auction, but acquired only 24 percent. Salomon 

thus bid for more than 35 percent at a single yield, but did not exceed the 35 percent award 

amount to a single bidder. However, Salomon did acquire more securities than it would have 

been able to if it had bid at a single yield for only 35 percent of the public offering amount. 

The February 7, 1991, 30-year bond auction. Salomon disclosed that it submitted an 

unauthorized customer bid in the amount of $1 billion in the February 7, 1991, $11 billion 3Dyear bond auction as the result of a “practical joke.”7

 Salomon claims that an employee arranged 

to have a customer submit a bid to a salesperson at Salomon for $1 billion of the 3D-year bonds 

as part of a practical joke on the salesperson. The Salomon employee was to have stopped the 

customer bid from actually being submitted and, following the auction, the customer was to 

complain that its bid was not filled. The Salomon employee was then to blame the salesperson 

for the failed bid. 

Salomon has stated that the employee attempted to prevent the customer bid from actually 

being submitted prior to the auction by crossing out the bid on the work sheet of the clerk 

responsible for calling in the bids. According to Salomon the clerk did not understand the 

meaning of the cross-out and submitted the bid, which resulted in the customer being awarded 

$870 million of the bonds, as the $1 billion bid was subject to 87 percent proration. After the 

auction, the $870 million in bonds was placed into the account of another Salomon customer and 

then sold from that account to Salomon, allegedly without the customer's authorization. Salomon 

has stated that its customer confirmations were suppressed. As a result, Salomon bid $2.331 

billion for its own account and $1 billion as a result of the "practical joke." The combined total 

of the two bids represented 30.2 percent of the issue and thus did not exceed 35 percent of the 

public offering. 

The February 21, 1991, five-year note auction. During the February 21, 1991, five-year 

note auction, Salomon has admitted to placing a bid for itself and two unauthorized customer 

bids, all at the 35 percent bidding limit at a single yield of $3.15 billion. As a result of the bids, 

Salomon effectively bid for 105 percent of the offering amount and was awarded approximately 

57 percent of the issue (the bids were at the 

 6 Salomon's internal investigation uncovered the fact that the daily customer confirmations for the $510 million

customer purchase and the subsequent sale were not mailed to the customer. It appears, however, that the monthly

statements Salomon mailed to its customer did include the allegedly unauthorized transactions. See Salomon 

September 10 Testimony at 10. 

7 Id. at 12-13. See also August 14 Press Release. 

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stop-out yield, and thus were subject to 54 percent proration), thus evading the 35 percent bid 

and award limits.8

 Again, customer confirmations were suppressed. 

It was in this auction that the much publicized "Warburg/Mercury" bid took place. 

Minutes after the closing time for receipt of competitive tenders, a FRBNY staff person notified 

the Treasury auction staff of two bids that appeared to be from related entities. One tender, for an 

amount equal to 35 percent of the total public offering, had been placed by Salomon in the name

of Warburg Asset Management. S.G. Warburg & Co., Inc., a primary dealer, separately 

submitted a tender at the same yield for its own account. Upon questioning, a Salomon clerk had 

stated that its bid was actually from Mercury Asset Management, which was previously called 

Warburg Asset Management. Treasury decided to accept both bids for the meantime, because the 

relationship between the two entities was not clear, and because after proration, the combined 

awards to both would not exceed 35 percent of the public offering of securities. 

After researching the relationship between Warburg and Mercury, the Treasury sent a 

letter on April17 to Charles Jackson, Senior Director, Mercury Asset Management, which 

informed him of the decision to treat S.G. Warburg & Co., Inc., and Mercury Asset Management 

as a single bidder for purposes of the 35 percent rule. This letter provided details of the two bids 

submitted in the February five-year note auction. Copies of the letter were sent to officers of S.G. 

Warburg, S.G. Warburg, PLC (the British parent company), and the FRBNY. In addition, a copy 

of the letter was sent to Paul Mozer, a Managing Director of Salomon. It was this letter that, 

according to Salomon, Paul Mozer showed to his superiors that alerted them to the unauthorized 

customer bid. 

The April 25, 1991, five-year note auction. With respect to the April 25, 1991, $9 billion 

five-year note auction, Salomon has stated that it submitted a bid on its own behalf for $3 billion 

and a customer bid for $2.5 billion. According to Salomon, the customer claims that it did not 

agree to purchase more than $1.5 billion. Salomon obtained $600 million of the amount awarded 

to the customer immediately after the auction. Aggregation of the Salomon bid in its own name

and the alleged unauthorized portion of the customer bid resulted in an aggregate Salomon 

purchase of greater than the 35 percent award limit. 

The May 22, 1991, two-year note auction. In its public disclosures, Salomon stated that 

it failed to report an existing $590 million net long when-issued position in 

 8

 See Salomon September 10 Testimony at 13-14. 

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connection with the May 22, 1991, auction of the May 1993 two-year notes.9

 Salomon also 

submitted several bids at an aggressive yield of 6.81 percent (the May 1993 two-year notes were 

trading on a when-issued basis at a yield of approximately 6.83 percent directly prior to the 

auction) at the auction: one on its own behalf for $4.2 billion (the 35 percent limit was $4.287 

billion); one on behalf of a customer for $4.287 billion; one on behalf of another customer for $2 

billion; and several on behalf of other customers for a total of $130 million. Salomon and its 

customers submitted the best-priced bids at the auction and were awarded the full bid amounts 

without proration.10

On the $2 billion bid, Salomon reported that the customer claimed to have authorized only 

a $1.5 billion bid. Salomon obtained the extra $500 million of the notes for which the customer's

bid was submitted at the auction price. Customer confirmations generated in connection with the 

customer purchase at the auction reflected only a $1.5 billion purchase and not the $500 million 

sale to Salomon. As a resul4 Salomon bid for and received the maximum 35 percent, obtained 

$500 million that had been awarded with respect to a customer's bid, and was long $590 million 

going into the auction, thereby circumventing the 35 percent bidding and award limit.11

2. Short squeezes 

Short squeezes can occur when an event unanticipated by short sellers reduces the supply 

of securities available in the marketplace, such as unexpected demand for the securities resulting 

from an unanticipated change in Federal Reserve policy with respect to interest rates. A short 

squeeze can also occur as a result of deliberate behavior by one or more market participants to 

restrict the supply of securities and thereby to drive up prices.12

When one market participant, or a group of market participants acting in concert, manages 

to purchase a significant proportion of the available supply of a particular security, that single 

participant or group is said to have "cornered the market" When that happens, the single 

participant or group can withhold the securities from the market and at the same time demand the 

return of any securities that they have loaned to short sellers. In such a situation, the short sellers 

must purchase or borrow the securities in order to redeliver them to those controlling the 

 

309-5970 - 92 - 7 QL 3 

 9 Treasury rules require that bidders report net "long" positions greater than $200 million at the time of the 

auction. Any net long when-issued position, when it exceeds $200 million, counts toward the 35 percent award limit. 

10 See Salomon September 10 Testimony at 23-24. 

11 August 14 Press Release at 2. See also Salomon September 10 Testimony at 20-23.

12 See Appendix B, Section 1 for a discussion of short squeezes. 

C-5 
securities,13 driving up the price of the securities and, presumably, increasing the profits of the 

single participant or group that controls the securities. 

After the May 22, 1991, two-year note auction, a "short squeeze" occurred in the 

security.14 Salomon has admitted that the firm and its customers purchased 94 percent of the 

auctioned securities. While the bulk of this amount represented authorized bids from customers 

that were within the 35 percent limitation, Salomon has also admitted its failure to report its net 

long when-issued position and that it submitted a customer bid that was larger than authorized in 

that auction.

Prior to the auction, Salomon determined to finance its own position through repos with 

short sellers and institutional lenders. In addition, Salomon agreed to finance positions of its 

customers.15 As a result of having purchased a large part of the supply of the May two-year 

notes, Salomon and its customers were able to lend through repos a portion of the notes held at 

"special" repo rates. A security is said to be "on special" when, due to its scarcity, a holder can 

enter into a repo at a lower rate of interest, and thus a lower financing cost, than the prevailing or 

general repo rate. The rates Salomon actually received were generally 100-200 basis points 

below then-prevailing general repo rates.16

Whatever its cause, the May squeeze prompted regulators to investigate Salomon's 

purchases of the notes. On May 29, Treasury staff notified the SEC's Divisions of Market 

Regulation and Enforcement of the "squeeze" on the May two-year note that had become evident 

in market price movements and complaints of market participants. The squeeze also attracted 

Congressional interest. 

On June 10, John Gutfreund, Chairman of Salomon, initiated a meeting with Treasury 

officials to explain the firm's point of view with respect to the May two-year notes. As the 

Treasury-officials were aware that the SEC was already investigating the May two-year note 

squeeze, they did not press an opposing viewpoint. The issue of unauthorized auction bidding 

was not discussed at the meeting because Treasury had no cause to suspect fraudulent activity at 

that time. During the months of June and July, Treasury, Federal Reserve, SEC and Justice 

Department officials had numerous discussions about the persistent squeeze, and about progress 

on investigating its causes. 

 13 Cf. 3 L. Loss, Securities Regulation 1538 n.25 (2d ed. 1961). 

14 The SEC is also investigating other reports of possible short squeezes in connection with recent Treasury 

auctions. Because these investigations are ongoing, more detailed information cannot be disclosed publicly at this 

time. 

15 Salomon September 10 Testimony at 23-33.

16 Salomon September 10 Testimony at 30.

C-6 
It was these investigations that eventually prompted Salomon's public disclosures acknowledging 

the auction abuses. 

On August 18, the Treasury Department announced that it would not, for an indeterminate 

time, allow Salomon to participate in Treasury auctions. This penalty was modified later in the 

day, following actions taken by Salomon's board of directors, to allow Salomon to bid in 

auctions for its own account but not on behalf of its customers.

3. Improper practices relating to GSE securities 

In August 1991, Salomon disclosed that it had engaged in the practice of overstating the 

amounts of government-sponsored enterprise ("GSE") securities sold when it reported sales to 

GSEs. The SEC's Division of Enforcement commenced an investigation of the extent to which 

such practices were widespread and obtained trading data and other documentary evidence from

all participants in the market for such securities for the period January 1, 1990, through August 

31, 1991.17 During that period, the amount of customer orders reported to the GSEs by their 

selling group members far exceeded the amount of securities available. The SEC's investigation 

revealed that nearly all selling group members engaged in one or more improper practices in 

connection with the primary distribution of GSE securities.18

As described below, a number of selling group members reported to GSEs inaccurate 

information concerning customer orders during the pre-allocation period and nearly all selling 

group members reported inaccurate information concerning their sales of the securities after 

settlement. In providing such inaccurate information, selling group members prepared and 

maintained books and records reflecting the inaccurate information. 

Pre-allocation period 

In the initial phase of the distributions, many selling group members routinely inflated the 

number and dollar amount of their customer orders in reports to the GSEs. For example, one 

trader testified that, because the GSEs placed such reliance on historic allocation in allocating 

securities, he was able to estimate with reasonable 

 17 The SEC is conducting an ongoing investigation of alleged misconduct by dealer members of various GSE

selling groups in connection with initial offerings of GSE securities. Although settlements have been reached with 

certain firms, the investigation has not yet been completed, and the SEC has not reached any conclusions with 

respect to the actions of other firms. As a result, the discussion contained herein should not be understood as

reaching any conclusions of fact or law with respect to the SEC's investigation. 

18 The Office of the Comptroller of the Currency ("OCC") and the Federal Reserve, as well as the New York 

Stock Exchange and the National Association of Securities Dealers, coordinated with, or assisted, the SEC's 

Division of Enforcement in the investigation. 

C-7 
accuracy the amount of securities his employer was likely to receive in anyone offering. He then 

"tripled" that estimated amount, and reported the inflated number to the GSEs as customer 

orders. 

Some traders added random amounts to their actual customer orders. Others increased the 

number and amount of customer orders reported to the GSEs to include "anticipated" or 

"historic" sales, i.e., an amount that the trader believed, based on past experience, the selling 

group member would be able to sell after the GSE announced the price. Even in those instances 

where a selling group member had identifiable customers for the number and amount of the 

customer orders reported to the GSEs, the trader would not indicate to the GSEs that many of the 

orders were subject to significant conditions. 

Most of the traders prepared work sheets reflecting customer orders for, or interest in, the 

securities, and updated the work sheets as they learned of additional customer orders or interest. 

Several selling group members divided their work sheets into sections or columns to reflect two 

sets of numbers: actual customer orders and the inflated customer orders reported to the GSEs. 

Most traders denied inflating customer orders to obtain a larger allocation, and hence a 

larger concession. Indeed, because most GSEs allocated securities based largely on a historic 

basis, a selling group member would not necessarily receive a larger allocation simply by 

inflating its reported customer orders. Rather, entities which had been members of the selling 

group for a longer period of time testified that they inflated customer orders to avoid losing any 

of their historic allocation percentage. Newer selling group members testified that they inflated 

customer orders because other selling group members were inflating orders and the newer 

entities felt that they needed to report a larger number of orders to appear competitive.

Distribution reports 

Nearly all selling group members inflated the number and/or amount of customer sales in 

the distribution reports or analyses submitted to the GSEs. Usually the number and amount of 

customer sales reflected in the distribution reports matched the number and amount of customer 

orders that the selling group member had reported to the GSE prior to allocation. In most 

instances, distribution reports stated that selling group members had assumed large short 

positions in a GSE's securities when, in fact, they had not. Often the distribution reports stated 

that selling group members had purchased securities in the secondary market in order to cover a 

short position when, in fact, no such purchases had occurred. The distribution reports also 

contained inaccurate representations regarding the type, and/or geographic location, of

customers. 

C-8 
A number of traders testified that they inflated sales, and/or provided other inaccurate 

information, in the distribution reports either to conceal their initial inflation of customer orders, 

or to conceal the loss of a customer. Several testified that they simply followed what they 

perceived to be an industry practice of reporting customer orders rather than actual sales in the 

distribution reports. Although some traders testified that the GSEs expected the distribution 

reports to reflect customer orders rather than actual sales, the distribution reports were prepared 

after the primary distribution had ended, and called for information concerning the sales that had 

taken place during the primary distribution. 

Most of the GSEs appear to have suspected that information selling group members 

provided regarding the amount of customer orders and sales was not reliable. However, the GSEs 

stated that they were not able to determine which of the selling group members were inflating 

orders and/or sales, nor were they able to determine the amount by which any report was 

inflated. 

Although selling group members prepared and maintained an accurate set of books and 

records reflecting transactions in the GSEs' securities, they also prepared and maintained a 

second set of records - the work sheets and distribution reports that were inaccurate. This second 

set of records cast doubt upon the integrity and reliability of the accurate records, and posed the 

exact danger that Rule 17a-3 was designed to eliminate - that the SEC and the securities industry 

self-regulatory organizations would be unable to assure that broker-dealers conduct their 

business in accordance with the federal securities laws. Strict compliance with the books and 

records requirements is a keystone of the surveillance of registered broker-dealers.19

Administrative Proceedings Against Selling Group Members 

On January 16, 1992, administrative proceedings were instituted jointly by the SEC, the 

OCC and the Federal Reserve against 98 registered broker-dealers, registered government 

securities brokers and/or dealers and banks (the "respondents"). In those proceedings, the three 

agencies found that, in connection with their participation in the primary distributions, each of 

the respondents made and kept certain records that did not accurately reflect the respondent's

customers' orders for the GSEs' securities and/ or offers, purchases or sales by the respondent of 

the GSEs' securities. 

Ninety-eight selling group members submitted Offers of Settlement to the agencies. 

Pursuant to the settlements, each of the respondents, without admitting or

 19 The preparation and maintenance of such false books and records by an issuer whose securities are registered 

pursuant to Section 12 of the Securities Exchange Act would likely also violate Section 13(b )(2) of the Securities 

Exchange Act, which, among other things, requires such issuers to "make and keep books, records, and accounts, 

which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer." 

C-9 
denying the allegations in the order instituting the proceedings, consented to the issuance of an

order by the appropriate regulatory agency: 

• finding, in the case of registered broker-dealers, that the respondent willfully violated 

Section 17(a) of the Exchange Act and Rules 17a-3 and 17a-4, or, in the case of 

registered government securities brokers and/or dealers, that the respondent willfully 

violated 17 C.P.R. Part 404 promulgated under Section 15C of the Exchange Act;20

• directing the respondent to cease and desist from future violations of the relevant 

provisions of the Exchange Act; 

• directing the respondent to pay a civil money penalty to the United States Treasury;21 and 

• directing the respondent to devise, implement and maintain policies and procedures 

reasonably designed to ensure future compliance with the relevant provisions of the 

Exchange Act. 

In addition, on January 16, 1992, the SEC issued a Report Pursuant to Section 21(a) of the 

Securities Exchange Act of 1934 Regarding the Distribution of Certain Debt Securities Issued by 

Government-Sponsored Enterprises. The 21(a) Report summarized the results of the SEC's 

investigation, and described the GSEs' distributions of debt securities, the respondents" 

participation in the distributions, and the practices giving rise to the violations of the 

recordkeeping provisions of the Exchange Act described in the Report. In the 21(a) Report, the 

SEC emphasized that, regardless of how widespread a practice is, or is perceived to be, and 

regardless of whether a firm believes that a particular practice does not harm its customers or 

other persons, the SEC will not tolerate a disregard for the recordkeeping provisions of the 

Exchange Act. The Report concluded that the creation of inaccurate books and records by the 

respondents was a necessary part of a scheme to inflate customer orders in an effort to maintain 

or increase allocation. 

 20 Section 17(a) and Rules 17a-3 and 17a-4 and 17 C.F.R. Part 404 promulgated under Section 15C require 

registered broker-dealers and registered government securities brokers and/or dealers, respectively, to make and 

keep accurate books and records relating to securities transactions.

21 The amount of the civil money penalty to be paid by each respondent was determined on the basis of a 

formula developed by the SEC, the acc, and the Federal Reserve based upon the "concessions" received during a 

defined period. Thus, the differences in amounts are based upon concessions, rather than the number of violations or

degree of wrongdoing. 

C-10 
APPENDIX D 

THE GOVERNMENT-SPONSORED ENTERPRISE SECURITIES MARKET 
Government-sponsored enterprises ("GSEs") are financial intermediaries established 

pursuant to federal law to facilitate lending for purposes the federal government has deemed 

socially important, such as education, agriculture, and housing.1

 Congress believed such 

intermediaries were necessary because credit for these purposes was either insufficient or too 

expensive. In essence, these institutions borrow funds from the public and make the funds 

available to particular sectors of the economy. The total amount of GSE obligations outstanding 

as of December, 1990 was about $1 trillion dollars.2

Although the GSEs each were established by an Act of Congress and have special 

relationships with the federal government,3

 they are each wholly privately owned. They do not 

receive direct funding from the federal government, nor are their operating policies directly 

determined by Congress. However, each of the GSEs may have special Congressionally granted 

powers, such as limited authority to borrow from the Treasury, and each may enjoy special 

advantages, including exemptions for securities they issue from most provisions of federal and 

state securities laws and exemption for the GSEs from certain state and local taxes. 

Primary market 

In general, the GSEs are required to obtain the approval of the Treasury on the timing, 

maturity, and pricing of their debt offerings. After receiving recommendations from each of the 

GSEs, the Treasury establishes a general calendar for GSE securities offerings that includes sales 

announcement, pricing, trading release, and settlement dates. The Treasury coordinates the 

offering dates for each of the GSEs to avoid competition among the offerings which potentially 

could drive up yields or cause market dislocation or confusion. 

 1 For purposes of this report, a GSE is a federally chartered entity or group of entities that is authorized to issue 

debt securities in its own name. Using this definition, the GSEs discussed in this report are: the Federal National 

Mortgage Association, the Federal Home Loan Mortgage Corporation, the Farm Credit System, the Federal

Agricultural Mortgage Corporation (Farmer Mac), the Federal Home Loan Bank System and the Student Loan

Marketing Association.

2 Of this figure, $365 billion constituted debentures and discount notes and $616 billion constituted mortgagebacked securities.

3 Some of the GSEs have Presidentially appointed Board members (e.g., Sallie Mae, seven of 21, 20 V.S.C. §

1087-2(c)(3); Fannie Mae, five of 18,12 U.S.C. § 1723(b); and Freddie Mac, five of 18,12 V.S.C. § 1452(a) (2) (A). 

In addition, the five members of the Federal Housing Finance Board are appointed by the President. 12 V.S.C. §

1422a(b)(1)(B». The Treasury also has approval rights over the issuance of debt and mortgage-backed securities for 

four of the GSEs. 12 V.S.C. § 1717a (Fannie Mae); 12 V.S.C. § 14550)(1) (Freddie Mac); 20 V.S.C. § 1087-2(h)(1)

(Sallie Mae); and 31 V.S.C. § 9108(a) (Federal Home Loan Banks). The Farm Credit Administration approves the 

borrowing of the Federal Farm Credit Banks. 12 V.S.C. §§ 2153(d), 2160(b )(2). 

D-1 
The GSEs distribute a variety of securities, including short-term discount notes, mediumterm notes, longer-term debt in the form of bonds or debentures, and mortgage-backed securities. 

Only a small percentage of GSE bonds (other than mortgage-backed issuances) and debentures 

have maturities of greater than 10 years. 

In general, securities issuances by GSEs, except for Farmer Mac, historically have been 

exempt from registration under the federal securities laws. This longstanding exemption was not 

disturbed by the Government Securities Act of 1986. In addition, securities issued by GSEs 

generally are deemed to be "government securities" within the meaning of the Securities 

Exchange Act of 1934 ("Exchange Act").4

 like other securities deemed to be government 

securities, however, GSE securities continue to be subject to the anti-fraud provisions of Section 

17(a) of the Securities Act of 1933 and Section 10(b) of the Exchange Act. As a result, purchases 

and sales of GSE securities, whether during initial issuance or in the secondary market, are 

subject to the SEC's regulatory authority only in cases of actual or suspected fraud.5

The process by which the GSEs distribute most of their securities differs substantially 

from the auction procedure used by the Treasury. The GSEs use a variety of distribution 

mechanisms, including competitive bidding, placements with individual customers or through 

particular dealers, allocation among selling group members, underwritten transactions, and 

exchanges of mortgage-backed securities with institutions. In practice, however, most of the 

GSEs rely for sales of unsecured debt securities principally on allocation among selling groups 

composed of both primary and non-primary government securities dealers and dealer banks. 

Each GSE maintains several selling groups, ranging in size from five to approximately 

100 members, composed of government securities dealers and dealer banks who have signed an 

agreement with the GSE to participate in its allocation process. The GSE's fiscal agent fills the 

role ordinarily filled by a managing or lead underwriter in a corporate offering, overseeing the 

issuance according to the terms of the applicable selling group agreement and allocating the 

securities to be distributed to the members of the selling group. Selling group members are 

compensated by a concession, which is expressed as a fixed percentage of the face amount of 

securities sold and deducted from the proceeds of the sale due to the agency. 

 4 15 U.S.C. § 78c(a)(12)(A)(i).

5 Securities issuances by GSEs may require regulatory approval, however, under each GSE's enabling statute. 

For example, neither Freddie Mac nor Fannie Mae may issue stock or convertible debt without the approval of the

Secretary of Housing and Urban Development. 12 U.S.C. §§ 1452(b)(6), 1723c. Similarly, the Farm Credit System

must obtain FCA approval for each issuance of System-wide debt securities. 12 U.S.C. §§ 2153(d), 2160(b)(2). 

D-2 
concession, which is expressed as a fixed percentage of the face amount of securities sold and 

deducted from the proceeds of the sale due to the agency. 

Each selling group member's responsibilities are spelled out by the terms of a selling 

group agreement that each GSE requires each selling group member to sign as a condition of 

participating in the selling group. Selling group agreements are between the GSE and each dealer 

and do not establish a relationship between or among selling group members. 

The terms of the selling group agreements vary but they usually expect the member to 

support secondary trading in the GSE's securities and to provide market and trading information 

before and during the allocation. In addition, the selling group agreements generally prohibit 

members of the selling group from purchasing securities in the allocation for their proprietary 

trading accounts or for reallocation to other dealers and ordinarily require members to produce 

reports on the distribution of the securities they have been allocated and to keep certain records. 

When customer demand is light, however, the fiscal agent may ask selling group members to 

take positions for their own accounts. 

Each GSE establishes standards that prospective selling group members must satisfy to 

join the selling group. In general, the GSEs require prospective selling group members to 

demonstrate certain capitalization levels, participation in other sectors of the government 

securities market, a commitment to the secondary market for the GSE's securities, and an 

established customer base. Most of the GSEs also reserve the right at a minimum to expel 

members of the selling group for failing to participate fully in the allocation process or in the 

secondary market. Nonetheless, the GSEs, for the most part, have admitted or expelled relatively

few members, and the selling groups have tended to remain relatively stable over time. In recent 

years, however, several GSE selling groups have decreased in size as members have merged or 

left the government securities business. 

When-issued trading in GSE securities usually does not begin until the day after the 

pricing of the initial offering. Therefore, when-issued trading does not serve the same price 

discovery function in the GSE market that it does in the Treasury market. Instead, each GSE sets 

the price for each security that it issues based on its own judgment about demand for its 

securities in the market. To reach that judgment, the GSEs take into consideration information 

provided by selling group members about market demand for their securities, as well as other 

government, GSE, and corporate securities. Representatives of the GSEs speak with the larger 

members of their selling groups on a regular basis and are in contact with all members of the 

selling group daily during the sale period. When determining the structure, maturity, and size for 

an issue, each GSE consults selling group members for indications of market demand for 

D-3 
information about offerings by other GSEs, the Treasury, and comparable corporate issuers. 

Most significantly, the GSEs maintain that selling group members provide the GSEs with market 

information that enables the GSEs to price their securities at yields designed to clear the market, 

thereby assuring the continued marketability of those securities at the lowest possible cost to the 

borrower. 

The GSEs' reliance on members of their selling groups for market information is 

magnified by the difficulty that market participants other than primary dealers have in obtaining 

important market information independently. As noted elsewhere in this report, they generally do 

not have access to market information on GSE securities displayed on inter-dealer broker 

screens.7

 Therefore, although GSEs do have access to news wires and vendor services, the 

information provided by selling group members about demand for that GSE's securities in the 

market is a critical component of each GSE's pricing process. Selling group members compete to

provide that information accurately and on a timely basis, and agents and dealers indicate that 

there is a perception in the market that supplying accurate and timely market information will be

rewarded in the allocation of securities. 

The GSEs consider indications of demand they receive from the selling groups in 

determining the initial offering price of a particular security. Other significant factors affecting 

each GSE's pricing decision are the price and availability of Treasury and other agency securities

of comparable maturities. Because GSE securities generally are not explicitly backed by the full 

faith and credit of the federal government and thus are perceived by the market to present a 

somewhat, if minimally, greater credit risk to investors, they trade at a spread over Treasury 

securities (i.e., GSE yields are higher than Treasury yields on instruments of the same maturity).

The perceived liquidity and credit quality of each GSE also affect the size of the spread. 

If the market 'perceives instability in a particular GSE's economic sector, the spread will widen. 

For instance, during the mid-1980s, Farm Credit securities traded at a relatively large spread over 

Treasuries, reflecting the downturn in the agricultural sector and the resulting difficulties of 

many Farm Credit institutions. The Agricultural Credit Act of 1987 granted assistance to 

troubled institutions, which the market perceived as implicit federal government backing of the 

Farm Credit System and its securities. Thereafter, the spread for Farm Credit securities

narrowed. 

The spread for each GSE's securities tends to vary over time. In addition, as maturity 

lengthens, the spread usually widens, reflecting the investors' exposure to GSE credit risk over a 

longer period and the lesser liquidity of GSE securities. Thus, when selling group members make 

pricing recommendations to a GSE, they may do so as a 

 7 The GSEs currently do have access to Cantor Fitzgerald information through Telerate. Cantor Fitzgerald, 

however, represents only 20 percent to 25 percent of the interdealer market. 

D-4 
The spread for each GSE's securities tends to vary over time. In addition, as maturity 

lengthens, the spread usually widens, reflecting the investors' exposure to GSE credit risk over a 

longer period and the lesser liquidity of GSE securities. Thus, when selling group members make 

pricing recommendations to a GSE, they may do so as a price or a yield, but more typically they 

do so as a spread over the benchmark Treasury security. 

The allocation process used by each GSE varies slightly, but in general, is conducted as 

follows. For several days prior to announcing an issue, the GSE consults with members of its 

selling group to gauge market conditions. Selling group members provide feedback and 

information on other activity in the market. At a preset time, the GSE announces the actual 

terms, including the maturity and amount of the issue or issues offered. 

Following the announcement of terms (other than rate and price), selling group members 

contact customers to obtain or verify orders. The members report the information to the GSE. 

GSE personnel probe selling group members for specific information regarding firmness of the 

member's book. Orders for securities that are not conditioned on any particular price generally 

are known as "market orders." Orders that will only be executed at or within specific price 

frames generally are known as "price conditional."8

During the time period following announcement, the GSE makes allocations of the 

debentures to selling group members based on a number of factors that vary among the GSEs, 

but often include: (1) customer demand; (2) the strength and consistency of the selling group 

member's past participation in the primary market and its demonstrated commitment to the 

secondary market; (3) cultivation of new investor segments; and (4) breadth of distribution, 

including geographical interest. 

The GSEs typically receive price recommendations from selling group members in the 

course of communications throughout the allocation process. In addition, the GSE may consult 

with selected selling group members shortly before pricing the issue to get final, specific pricing 

recommendations. The GSE then prices the issue and makes a public announcement over news 

wires. 

 8 The Public Securities Association Agency Task Force has proposed standardized order definitions for selling

group members and fiscal agents that would eliminate the distinction between "market" and "conditional" orders. 

Under its proposal, all orders would be categorized as "customer orders," "member orders," or "reallowance orders." 

Customer orders would include any orders: (1) without condition, or (2) subject to the satisfaction of one or more 

specific conditions, such as spread, coupon or as otherwise expressed. Customer orders would be based on actual

communications between a selling group member and a customer. 

D-5 
Selling group members typically call the GSE after the announcement to confirm their 

allocations. The GSEs also require selling group members to submit a written report or analysis 

of each distribution. Selling group members may be asked to provide a breakdown of sales by 

category of investor or information on when-issued activity in the distribution report.

The GSEs maintain that the allocation process is the best mechanism for issuing debt 

because, in their opinion, it meets their paramount financing objective: to assure a steady and 

predictable stream of funds at the lowest possible cost. This assertion has not been proven or 

disproven empirically, although some GSEs have monitored the stability over time for various 

issues of the spread over the benchmark Treasury security in the secondary market as a method 

of monitoring the efficiency of their initial pricing. In addition, the GSEs believe that use of the 

allocation process assures the liquidity of GSE securities in the secondary market because it 

achieves a broad-based distribution of securities. 

D-6 
APPENDIX E 

THE PRIMARY DEALER SYSTEM 
FEDERAL RESERVE BARK OF NEW YORK 

Administration of Relationships with Primary Dealers 

The Federal Reserve Bank of New York (FRBNY) is adopting 

certain changes in the administration of its relationship with 

primary dealers in U.S. Government securities. The primary 

dealer system has been developed for the purpose of selecting 

trading counterparties for the Federal Reserve in its execution 

of market operations to carry out U.S. monetary policy. The 

designation of primary dealers has also involved the selection 

of firms for statistical reporting purposes in compiling data on 

activity in the u.s. Government securities market. These changes 

in the administration of these relationships have been developed 

after consultation with the Federal Reserve Board, the Federal 

Open Market Committee, the Treasury and the Securities and 

Exchange Commission. 

The changes announced today have been prompted by two 

related factors: 

First, decisions have been made to accelerate the 

automation of Treasury auctions and Federal Reserve open market 

operations with a view toward increasing the efficiency of the 

auction process and open market operations, and providing the 

potential for further broadening the base of direct 

participation in these operations. These automation initiatives 

are major 

E-1 
undertakings, as they must be planned and executed with extreme 

care to ensure operating and communications systems of the 

highest level of reliability and integrity. They will require 

back-up systems comparable to those now in place for the Fed's 

funds and securities transfer systems. Planning for automation 

of the existing Treasury auction format is well underway and 

automation is scheduled for completion by the end of this year. 

Automation planning for Federal Reserve open market operations 

is just getting started, and completion of this automation will 

probably take about two years. 

Second, and more important, while the system of 

designating primary dealers on the whole has served the Federal 

Reserve, the Treasury, and the nation well for many years, there 

also have been some drawbacks to the existing arrangements. 

Prominent among these is the public impression that, because of 

the Federal Reserve Bank's standards for selecting and 

maintaining these relationships, the Fed is in effect the 

regulator of the primary dealer firms. Moreover the primary 

dealer designation has been viewed as conferring a special 

status on these firms that carries with it elements of 

"franchise value" for the dealer operation and possibly for 

other aspects of the firm's standing in the marketplace. 

The net result of these interrelated factors is that 

the Federal Reserve is amending its dealer selection criteria to 

begin providing for a more open system of trading relationships, 

while still exercising the discretion that any responsible 

market 

E-2 
participant would demand to assure itself of creditworthy 

counterparties who are prepared to serve its needs. For the most 

part, the changes in the administration of the primary dealer 

relationships will have no immediate effect on existing primary 

dealers--recognizing, of course, that they will, over time, be 

subject to the requirements noted below for maintaining a 

counterparty relationship with the Fed. However,existing as well 

as any new primary dealers will no longer be required to 

maintain a one percent share of the total customer activity 

reported by all primary dealers in the aggregate; this 

requirement is no longer deemed necessary given the active and 

liquid state of development now achieved in the u.s. Government 

securities market, and its retention could be an obstacle to 

achieving more open trading desk relationships. In addition, 

while continuing to seek creditworthy counterparties, and while 

continuing to exercise market surveillance, the FRBNY will 

discontinue its own dealer surveillance activities relating to 

primary dealer firms' financial characteristics. 

New firms will be added on the basis of criteria listed 

below. As in the past, all primary dealers will be expected to 

(1) make reasonably good markets in their trading relationships 

with the Fed's trading desk; (2) participate meaningfully in 

Treasury auctions and; (3) provide the trading desk with market 

information and analysis that may be useful to the Federal 

Reserve in the formulation and implementation of monetary 

policy. Primary dealers that fail to meet these standards in a 

meaningful 

E-3 
way over time will have their designation as a primary dealer 

discontinued by the FRBNY. It is contemplated that each dealer 

firm's performance relative to these requirements will be 

reviewed on an ongoing basis and evaluated annually beginning in 

June 1993. If a firm's relationship with the FRBNY is 

discontinued because of shortfalls in meeting these standards, 

the action by the FRBNY will be made strictly on a business 

relationship basis. As such, any decision by the FRBNY will 

carry no implication as to the creditworthiness, financial 

strength or managerial competence of the firm. 

In evaluating a firm's market-making performance with 

the trading desk, the FRBNY will look to the amount of business 

of various types actually transacted and the quality of the 

firm's market-making and market commentary. Dealers that do 

little business with the Fed over a period of time, that 

repeatedly provide propositions that are not reasonably 

competitive, and that fail to provide useful market information 

and commentary, add little to the Fed's ability to operate 

effectively and will be dropped as counterparties for at least 

six months. 

In evaluating participation in Treasury auctions, the 

Fed will expect a dealer to bid in reasonable relationship to 

that dealer's scale of operations relative to the market, and in 

reasonable price relationship to the range of bidding by other 

auction participants. Any decision to suspend a primary dealer 

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designation because of inadequate auction bidding will be taken 

in close consultation with the Treasury. 

Finally, consistent with the Omnibus Trade & 

Competitiveness Act of 1988, a foreign-owned primary dealer may 

not be newly designated, or continue to be designated, in cases 

where the Federal Reserve concludes that the country in which a 

foreign parent is domiciled does not provide the same 

competitive opportunities to U.S. companies as it does to 

domestic firms in the underwriting and distribution of 

Government debt. 

I. Criteria for Accepting New Dealers

New primary dealers must be commercial banking 

organizations that are subject to official supervision by U.S. 

Federal bank supervisors or broker/dealers registered with the 

Securities and Exchange Commission. The dealer firms or the 

entities controlling the dealer firms must meet certain capital 

standards as follows: 

• commercial banking institutions must—taking account of 

relevant transition rules--meet the minimum Tier I and Tier 

II capital standards under the Basle Capital Accord. In 

addition, commercial banks must have at least $100 million 

of Tier I capital as defined in the Basle Capital Accord. 

• Registered broker/dealers must have capital in excess of 

the SEC's or Treasury's regulatory "warning levels" and

have at least $50 million in regulatory capital. Where such 

capital standards 

E-5 
do not apply to a consolidated entity controlling a primary 

dealer--consistent with the treatment of banks under the 

Basle Accord--the FRBNY will also look to the capital 

adequacy of the parent organization. 

The minimum absolute levels of capital specified above 

(i.e., $100 million for commercial banks and $50 million for 

broker/dealers) are designed to help insure that primary dealers 

are able to enter into transactions with the Fed in sufficient 

size to maintain the efficiency of trading desk operations. 

A bank or a broker/dealer wishing to become a primary 

dealer, must inform the FRBNY in writing. As a part of that 

notification a prospective dealer must also provide appropriate 

financial data demonstrating that it meets the capital standards 

outlined above. The FRBNY will consult with the applicable 

supervisory body to ensure that the firm in question is in 

compliance with the appropriate capital standards. When new 

firms are accepted as primary dealers, the nature and extent of 

the Bank's trading relationship with the firm will, as under 

current practices, evolve over time. As a result of this change 

and the elimination of the one percent market share criterion, 

there will no longer be any need for individual firms to be 

considered by the market as "aspiring dealers." 

Of necessity, at least for the time being, the number 

of additional primary dealers will be relatively limited, 

because of resource constraints on trading desk operations. 

The 

E-6 
selection of this limited number will be dependent on how many 

can be added without adverse impact on the efficiency of Federal 

Reserve trading desk operations. Applications received by March 

31, 1992, will be evaluated in relation to the foregoing capital 

standards. If it is not feasible to add all of the qualifying 

firms as primary dealers, a selection will be made among those 

firms in a manner that gives primary consideration to their 

relative capital positions. Following the implementation of 

automated communications for trading purposes, further expansion 

in the number of primary dealers will be feasible, and further 

changes in the criteria for selection also could be considered, 

although there is no preconception at this time as to what, if 

any, further changes would be made. 

II. Maintenance of Capital Standards

As a result of the adoption of the capital standards 

for accepting primary dealers, all primary dealers will be 

expected to maintain capital positions that meet the standards 

described above on an ongoing basis. Should a firm's capital 

position fall below these minimum standards, the FRBNY may 

suspend its trading relationship until the firm's capital 

position is restored to levels corresponding to these minimum 

standards. In making such determinations, the FRBNY will look to 

the firm's primary Federal regulator for guidance as to whether 

the firm has in place an acceptable plan to restore its capital 

position in a reasonable period of time. However, in no 

circumstances will the Bank maintain a trading relationship with 

E-7 
a primary dealer that is unable to restore its capital position 

to the stipulated minimum level within a year. Over time, the 

maximum grace period of one year may be shortened and would not 

apply in any event if a firm's capital position were seriously 

impaired. 

III. Elimination of Dealer surveillance

While the Federal Reserve Bank of New York will 

continue to seek creditworthy counterparties--and will continue, 

or enhance, its market surveillance--it is planning to 

discontinue the "dealer surveillance" now exercised over primary 

dealers through the monitoring of specific Federal Reserve 

standards and through regular on-site inspection visits by 

Federal Reserve dealer surveillance staff. Rather, the FRBNY 

will seek to act as any reasonably well-informed and responsible 

firm might behave in evaluating the creditworthiness of its 

counterparties. Accordingly, the Federal Reserve will expect to 

receive periodic reports on the capital adequacy of primary 

dealers, just as any other responsible market participant should 

expect to receive such reports. 

The elimination of the Bank's dealer surveillance 

activities should be viewed merely as confirmation of the long 

standing reality that the Bank does not have--nor has it ever 

had--formal regulatory authority over the Government securities 

market or authority over the primary dealers in their capacity 

as such. The Bank is satisfied that the existing regulatory 

apparatus over the market and the regulatory apparatus as it 

E-8 
applies to dealer firms is adequate--especially in light of 

changes outlined in the joint Treasury-SEC-Federal Reserve 

study--and it is satisfied that it can protect itself against 

financial loss without reliance on formal dealer surveillance. 

IV. Sanctions of Primary Dealers for Wrongdoinq

The Federal Reserve Bank of New York does not have 

civil or criminal enforcement authority over primary dealers in 

their capacity as primary dealers. This consideration and the 

dictates of fairness and due process require that the 

disposition of allegations of wrongdoing lies with the 

Government bodies having such authority--including the U.S. 

Treasury, the Federal bank supervisor, the Securities and 

Exchange Commission and the U.S. Department of Justice. 

In the future, if a primary dealer firm itself is 

convicted of a felony under u.s. law or pleads guilty or nolo

contendere to felony charges under U.S law for activities that 

relate directly or indirectly to its business relationship with 

the Federal Reserve, the firm will be subject to punitive 

action,possibly including suspension as a primary dealer for six 

months. Depending on the nature of the wrongdoing the penalty 

could be more severe, including permanent revocation of a 

trading relationship. 

V. Statistical Reports on Government Securities Activities

The current statistical reporting program is expected 

to continue unchanged for the time being, but a review is being 

undertaken to determine how best to adapt this program to an 

E-9 
environment in which market surveillance is receiving greater 

emphasis and a statistical reporting relationship is not 

necessarily tied to a trading relationship with the Federal 

Reserve. This review will take into account the needs of the 

Federal Reserve, the Treasury and the SEC as well as the burden 

of statistical reporting on dealer firms. 

Summary

Taken as a whole, these changes are designed to 

facilitate an orderly and gradual move to a more open system of 

primary dealer relationships with the FRBNY while at the, same 

time preserving certain key characteristics of the current 

system that have been beneficial to the Federal Reserve and the 

Treasury over the years. Over time, the successful 

implementation of highly automated systems for Treasury auctions 

and Federal Reserve open market operations will provide the room 

and the opportunity for still further changes. However, the 

desirability of further changes will have to be evaluated 

against the experience with these modest changes and the need to 

preserve both the efficiency and flexibility of Federal Reserve 

monetary policy operations, and the liquidity and efficiency of 

the market for U.S. Government securities. 

E-10 
PRIMARY DEALERS: CRITERIA AND PROCEDURES

APPLIED TO FIRMS INTERESTED IN 

BECOMING AND REMAINING PRIMARY DEALERS

This statement outlines the criteria used in administering the 

list of reporting U.S. Government securities dealers ("primary 

dealers") and describes the process used by the Federal Reserve Bank 

of New York to handle requests from firms interested in becoming 

primary dealers. 

General criteria

All primary dealers are expected to make markets in the full 

range of U.S. Government securities for a reasonably diverse group of 

customers and to participate meaningfully in Treasury auctions. They 

are expected to facilitate the Federal Reserve's Open Market 

Operations and to provide the central bank with' information to assist 

it in performing its duties. Dealers should evidence a strong 

commitment to continued participation as a market-maker over the longterm. Management depth and experience, a reasonable profitability 

record, and good internal controls are essential. Primary dealers must 

have sufficient capital to support comfortably their activities and 

must manage their/risk exposures prudently, with due regard for the 

limitations of their capital and their ability to identify and control 

risks. 

The minimum criteria discussed in this statement should be 

considered benchmarks rather than absolute levels at which a dealer is 

designated a primary dealer reporting to the Federal Reserve. The 

benchmarks are meant to provide dealers with guidance regarding the 

general level of development they must attain to qualify for and 

retain the designation. A dealer's qualifications are evaluated in 

total. It is expected that each dealer will achieve and maintain 

overall levels of performance above the minimum standards; a dealer 

that barely achieves the minimum standards may not be designated or 

retained as a primary dealer. 

Firms are designated primary dealers because they can be of 

service to the Federal Reserve. Other firms may be sound and capable, 

but it would be impractical for the Federal Reserve Bank of New York 

to maintain a reporting or dealing relationship with all such firms. 

The designation is not an endorsement, is not 

conferred under regulatory authority, and does not entail official 

supervision by the Federal Reserve. The Federal Reserve does 

monitor dealer activities to determine that the primary dealer 

performance standards are being met I and to obtain information about 

market developments. The process is not designed to assist the public 

in determining dealer creditworthiness. 

E-11 
Primary dealers are expected to be active and competitive 

participants in the Federal Reserve's Open Market Operations. They 

are also expected to freely and. candidly supply the Federal Reserve 

with information about developments in the U.S. Government securities 

markets and in all other markets in which they participate. Trading 

performance and the quality of other support of Open Market Desk needs 

will be taken into account in decisions regarding primary dealer 

designation. While all dealers trading with the Open Market Desk must 

be primary dealers, newly designated primary dealers do not 

immediately begin a trading relationship with the Reserve Bank. To 

establish such a trading relationship, a dealer is expected to 

demonstrate the ability to improve upon and sustain the levels of 

performance initially required for designation as a primary dealer. 

Those firms not demonstrating this capacity within a reasonable period 

of time may have the designation discontinued. 

Primary dealers are expected to cooperate with the Federal 

Reserve in endeavors to increase the efficiency, effectiveness, and 

safety of the marketplace. They are" also required to submit reports 

reflecting their activities to the Federal Reserve on a regular basis. 

Primary dealers must be effective market-makers. The diversity 

and quality of a dealer's customer base, the breadth of its activity 

and the consistency of its performance carry significant weight in an 

evaluation of market-making. In addition, trading volume with 

customers provides a convenient numerical estimate of a dealer's 

performance as a market-maker. At a minimum, the dollar volume of a 

dealer's customer transactions in Treasury and Federal agency issues 

(excluding mortgage pass through instruments) should average one 

percent of the aggregate of primary dealer volume with customers if 

the dealer expects to present a convincing case that it is an 

effective market-maker. Transactions with other primary dealers or 

inter-dealer brokers are excluded from this measure. Also excluded 

from customer volume are (1) intra-firm transactions or trading with 

affiliates of the dealer unless the dealer can demonstrate that such 

transactions represent competitive market-making; and, (2) activity in 

repurchase agreements or similar transactions. 

In addition to the standards for secondary market-making, a 

primary dealer is expected to be a consistent and meaningful 

participant in Treasury auctions of new securities. A dealer is 

expected to submit auction bids of a size roughly commensurate with 

the dealer's capacity. A dealer is expected to submit bids in 

every auction. At a minimum, the bids should be a percentage of the 

total being sold that is comparable to the dealer's share of total 

customer transaction volume reported to the Federal Reserve. A dealer 

is not required to be awarded a particular amount of 

E-12 
securities, but the minimum amount of bids a dealer is expected to 

submit should be in a realistic price range relative to current market 

conditions. Under ordinary conditions, a dealer would be expected to 

submit a significant amount of bids close to the prices accepted by 

the Treasury. 

The experience of a firm and its key personnel are also 

considered. A primary dealer is expected to have strong management, 

experienced trading personnel, a seasoned sales staff, and welltrained back-office personnel. The dealer must possess operational 

capabilities to process and account for its transactions efficiently 

and accurately. Clearing of securities must be performed expeditiously 

and with due regard for the integrity and safety of the clearing 

process [see separate statement on dealer clearance behavior, dated 

April 1988]. Proper controls over all operations by management and 

auditing staffs are also essential. 

The capitalization of a primary dealer must reflect a solid 

financial commitment and a strong capacity to participate in the 

market. Firms should have sufficient capital to provide an adequate 

cushion relative to risk exposures and overall leverage, and to more 

than meet the minimum capital levels required by the supervisory 

authorities. The main focus on capital is relative to risk, rather 

than level of capital. Most primary dealers have substantially more 

than $50 million of capital; major market-makers would have difficulty 

functioning prudently with less than $50 million in capital. Indeed, 

most primary dealers with moderate amounts of capital are affiliated 

with very substantial firms that can provide additional capital 

support if needed. In looking at a dealer's capital strength, the 

Federal Reserve considers the composition of capital, the variety and 

nature of the firm's activity, typical risk exposure, the quality of 

risk controls, and a dealer's affiliate and subsidiary relationships. 

A dealer's earnings history is also considered. The earnings of a 

risk-taker understandably fluctuate; however, over a reasonable time 

period earnings should evidence a healthy business strategy. Poor 

earnings weaken a dealer's commitment to market-making and its ability 

to continue functioning as an effective primary dealer. 

The ownership of a firm can have a bearing on its suitability as 

a primary dealer, particularly the reputation and conduct of the 

owners. The continuation of a primary dealer designation after a 

change in ownership is not automatic. New ownership arrangements will 

be evaluated based on the capacity to maintain or strengthen a 

dealer's performance in terms of financial, operational, managerial, 

and market-making criteria. In weighing whether to continue a primary 

dealer designation or request that a firm requalify, particular 

attention is placed on maintenance of continuity in the riskmanagement and market-making operations of the firm. When only the 

firm's primary dealer business, or a 

E-13 
portion thereof, is being acquired by a new owner, the strong 

presumption is that the designation will not be continued without a 

period of requalification. The requalification process will be 

administered flexibly, with due regard for the qualifications of the 

new owner and the performance of the dealer operation during the 

transition. 

Primary dealers may be foreign-owned though they should be 

incorporated in the United States with dedicated dollar capital. 

In keeping with a basic policy of national treatment, there are no 

limits on representation among primary dealers for firms with parent 

companies or shareholders based in foreign countries. The maintenance 

of an appropriate degree of balance and diversity within the primary 

dealer group will continue to be a factor in considering firms newly 

interested in becoming or acquiring primary dealers. In seeking to 

maintain such diversification weight may be given to firms looking to 

develop business relationships on a de novo rather than acquisition 

basis. Consistent with the Omnibus Trade & Competitiveness Act of 

1988, a foreign-owned firm may not be newly designated, or continue to 

be designated, a primary dealer after August 1989, in cases where the 

Federal Reserve concludes that the country in which the foreign parent 

is domiciled does not provide the same competitive opportunities to 

u.s. companies as it does to domestic firms in the underwriting and 

distribution of Government debt. 

As noted earlier, primary dealers are designated because they can 

be of service to the Federal Reserve Bank of New York; however, it is 

not practical for the Bank to maintain a relationship with all firms 

who could potentially meet the minimum standards. Recognizing that a 

large expansion in the dealer list has been accommodated in recent 

years, it is believed that fifty or so primary dealers will more than 

meet the business needs of the Federal Reserve in conducting Open 

Market Operations. As the number of qualified dealers approaches this 

level, the Bank will be somewhat more selective in determining whether 

and when to add new dealers to the list and will also move more 

quickly to discontinue relationships with existing primary dealers. 

Recognizing that new dealers can add vitality to the market and that 

it is desirable to maintain an open system, the Bank will consider 

substituting newly qualified dealers which demonstrate particularly 

solid performance for existing primary dealers whose performance is 

not as strong as others in meeting the needs of the Bank. Such an 

event should not be interpreted as disapproval of the latter dealer's 

overall qualifications. Rather, such changes will only reflect the 

fact that it is impractical for the Bank to deal with every firm that 

might meet the minimum requirements. 

E-14 
Process for Aspiring Dealers

There is no formal application to be filed. Once a firm has a 

basic appreciation of the requirements of being a primary dealer and 

makes the decision to pursue designation it may make an informal 

indication of intent to the Federal Reserve Bank of New York. This 

step simply presents an opportunity to clarify criteria and 

procedures. It does not establish a reporting relationship. 

At quarterly intervals, the Federal Reserve Bank of New York will 

decide whether to accept reports from additional dealers who have 

demonstrated significant potential to become primary dealers. Reports 

will be accepted only from dealers believed likely to qualify as a 

primary dealer within a reasonable time interval and, for a trading 

relationship a short time thereafter. To be considered an aspiring 

dealer from whom reporting would be warranted, a dealer should have 

daily customer transaction volume for some time of at least half of 

that required for designation as a primary dealer. That amount of 

volume should evidence a broad, high-quality customer base, and a 

steady growth trend. The firm should also exhibit appropriate 

financial and managerial strength, internal controls, diversity of 

trading and customers, and a commitment to the market that is likely 

to continue. Each of these elements will be subjected to further and 

more intense scrutiny during the period before designation as a 

primary dealer. This Bank may discontinue receiving reports in cases 

where an aspiring dealer ceases to meet these criteria, such as if 

trading volume drops too low, a significant amount of capital is 

withdrawn, or key personnel are lost. 

Before accepting reports, the Bank's Dealer Surveillance Staff 

will visit the dealer to review the firm's operational and financial 

capabilities. In addition, the Bank will generally limit the period in 

which reports will be accepted from aspiring dealers. Within about one 

year an aspiring dealer should be able to achieve, and sustain for 

some months, a level of activity qualifying it as a primary dealer. If 

an aspiring dealer has not built sufficient volume within about a year 

or fails to meet other standards, reporting may be discontinued. The 

Bank would normally not consider accepting such reports again from 

that dealer for at least one year. 

Reporting List

While the list of primary reporting dealers is available to the 

public--because this information is needed so that reporting dealers 

can distinguish trading activity with other primary reporting dealers 

from activity with "customers"--this Bank does not plan to comment on 

whether reports are being accepted from 

E-15 
E-16 

particular firms aspiring to be primary dealers. This is consistent 

with our view that acceptance of reports by the Federal Reserve for 

statistical purposes carries with it no official endorsement of the 

firm in. question. More generally, it is also worth restating that 

appearance of a firm's name on the publicly available list of 

reporting primary dealers should not be taken as an official 

endorsement either; market participants are advised to make their own 

credit evaluations in selecting counterparties. 

Federal Reserve Bank of New York 

Dealer Surveillance Function 

November 17, 1988 

U.S. GOVERNMENT PRINTING OFFICE: 19920 - 309-597 QL 3