To: Jeff Hunter, Director, Office of Debt Management 

From: Drew Forbes, Treasury Desk, Daiwa Securities America 

 Eric Welles, Repo Desk, Daiwa Securities America 

Re: Securities Lending Facility 

Date: August 10, 2006 

We strongly support the adoption of a securities lending facility at the Treasury 

Department. We agree with the view that such a facility would minimize or eliminate 

problems like those in 2003, thereby enhancing the efficiency and liquidity of the 

Treasury securities market. Your counterargument about promoting moral hazard and 

preempting private market solutions is well taken, but we suspect that usage of the 

facility would be so limited that these would not be problems in practice. 

The system described in your report is generally sound. We would like to highlight two 

aspects that we view as essential ingredients of the final program. First, the system 

should be of the fixed-rate, variable-quantity type. This is the only type of system that 

will adequately address issue shortages that might arise. Second, the implied repo rate 

should be zero percent. This will discourage unnecessary usage and make the system a 

backstop rather than frequently used borrowing facility. 

We recommend a change to another aspect of the system described in your memo. 

Specifically, we feel that forward settlement and term transactions would discourage 

usage and leave the system ineffective in countering many market disruptions. We feel 

the system should offer same-day settlement and overnight lending as the core transaction. 

Such a system would offer maximum flexibility and therefore be most effective in 

remedying market imbalances. Some might argue that same-day settlement and 

overnight borrowing might lead to abuse of the system or gaming by market participants. 

However, we do not feel this will occur, as the zero percent repo rate would discourage 

overuse and abuse. Moreover, if the Treasury detected abuse, the problem could be 

corrected with a verbal reprimand to the violating dealers and the imposition of 

administered limits on their access to the facility. 

We hope you find our comments useful. Please call if you have questions (212-612-

6800). 
Comments on Securities Lending Facility 

General Comments: We support the Treasury’s goal of alleviating periods of chronic fails, such as the 

2003 episode referenced in Treasury’s white paper, “Consideration Of A Proposed Treasury Securities 

Lending Facility.” 

As the Treasury mentions in its white paper, there exists the possibility that the creation of an SLLR 

“would undermine or reduce private sector incentives to better (and perhaps more efficiently) resolve the 

issues that the SLLR is intended to address.” We agree that this possibility exists, especially given steps 

market participants have made in the past year. These steps include: 

• CBOT position limits instituted 

• CBOT margin requirements made more stringent 

• BMA Negative Rate Trading Guideline agreed-upon & released 

The CBOT’s position limits appear to have reduced the likelihood of supply shortages in the CTD issues. 

As for negative rate trading, it may be something that could use some time to develop (perhaps with more 

BMA or Treasury prodding/involvement). If the market gets comfortable processing fails on negative-rate 

trades, normal market incentives could work to avoid periods of chronic fails. 

Also, a market-clearing price (& one in which there is significant incentive to make delivery) could also be 

arrived at via other mechanisms that utilize the existing private market- such as formalizing ‘guaranteed 

delivery’ (as opposed to 'prompt delivery') trades for which borrowers could ‘pay up’ to obtain greater 

protection against failing to receive. 

While ‘guaranteed delivery’ trades may never evolve, it is possible that the other recent changes (CBOT 

position limits, BMA’s negative-rate trading guidelines) could work sufficiently well, given time and the 

attention of market participants, to lessen the necessity of an SLLR. 

Comments On Possible SLLR Structure: If the facility is created, we agree with Treasury’s stated 

objective that the SLLR be structured such that “it would act as a form of ‘catastrophe’ insurance,” used 

solely when chronic fails “threaten the overall functioning of the Treasury and broader financial markets.” 

In addition, we agree that the facility should have minimal impact on the market when it is not being used. 

Given that the market’s awareness of large supply being available at a certain rate can impact market 

conditions for an issue (even when the supply is available at rates well below current market-clearing rates), 

we have some comments on an SLLR’s structure. In our view, these characteristics could help achieve the 

Treasury’s goals of limiting SLLR’s usage to periods of “extreme market disruption,” and ensuring that the 

SLLR has limited impact on the market’s normal incentives & operations. 

• Settlement & term periods: T+5 (or perhaps a longer lag) & a 1-week+ term seem ideal. 

o The settlement lag could assist in alleviating May 2013-type chronic fails, yet be long 

enough to limit usage to clearly dire situations. If a prospective borrower decides not to 

use the facility due to (for example) T+5 settlement - but would have if settlement had 

been T+2 or T+3 - then the fail situation likely does not meet Treasury’s definition of 

“acute and protracted fails.” 

o Lengthy forward-settlement & term periods would reduce the moral hazard mentioned by 

Treasury in the white paper, that of excessive risk-taking as investors know they can be 

‘bailed-out’ by the SLLR. 

o The market is more likely to get comfortable with negative-rate repo trading if the SLLR 

does not set an effective ‘floor’ rate of zero. Longer settlement & term periods increase 
the likelihood that dealers will have a chance to become comfortable with the BMA’s 

recommended negative-rate trading conventions. 

• Rate: Zero or lower; similar rationale as the comments on above regarding settlement & term 

periods. 

• Reporting requirements: If the requirements mentioned in the white paper (“daily cash, repo, and 

futures positions, and fails to deliver and receive in the security borrowed over an interval 

bracketing the period of borrowing”) do not already infer this, then we also suggest requiring the 

same information for the period immediately preceding the borrow request (perhaps for the prior 

week). This could be beneficial in discouraging active or ill-intentioned use of the SLLR. 

• Right of substitution: We agree with the suggested bonds vs. bonds lending basis, however 

offering borrowers the right of substitution may be an unnecessary trait of the transaction. While 

likely desirable by those who borrow from the facility, the right of substitution may be an 

accommodation that runs counter to the Treasury’s goal that the facility only being tapped in the 

most extreme situations. To wit: If the lack of right-of-substitution is what ultimately stops a 

dealer from borrowing from the facility on a given day, then it is unlikely that the dealer’s 

situation is the kind of acute, chronic need for which Treasury intends the facility be used. 

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Brothers Inc. All rights reserved. Member of SIPC. 
Joseph Shatz 

Senior Director, Government/FF&O Strategy 

Merrill Lynch 

4 World Financial Center, North Tower 

New York, NY 10080 

August 9, 2006 

Jeff Huther 

Director, Office of Debt Management 

Room 2412, Department of the Treasury 

1500 Pennsylvania Avenue, NW 

Washington, DC 20220 

 Re: Comments on Securities Lending Facility 

Dear Jeff: 

We strongly support the introduction of a Treasury securities lending facility and believe 

that if it is implemented properly, the benefits could be substantial. The purpose of the 

facility should be to relieve protracted fail situations associated with making delivery into 

Treasury bond and note futures contracts such as with the 4.875% 2/15/12, catastrophic 

events such as 9/11 which caused the Treasury to reopen the 5% 8/15/11, and other 

extraordinary circumstances such as occurred with the 3.625% 5/15/13 as the result of 

extremely low interest rates leading to a “low cost of fail”. 

The potential benefits of a well constructed securities lending facility outweigh the 

potential costs, in our opinion. We understand that there are some negatives associated 

with its construction. For example, one unintended consequence of the facility could be 

the possibility of a larger short base in some Treasuries because the shorts would know 

that they can always borrow the security from the Treasury. We also realize that there 

are a number of issues to address from a legislative and regulatory perspective such as 

changes in Treasury’s borrowing authority, debt limit accounting and tax treatment of 

borrowed securities. Yet, a properly constructed securities lending facility will protect 

the efficiency and liquidity of the Treasury market under extraordinary circumstances 

which could otherwise impair its functioning. This will safeguard investor confidence in 

the US Treasury markets and thus help fulfill Treasury’s objective of keeping borrowing 

costs as low as possible over time. 

Below we present our views on each of the design features discussed in the Treasury 

Securities Lender of Last Resort (SLLR) Facility White Paper "Consideration of a 

Proposed Securities Lending Facility." (referred to as “Proposed SLLR paper” 
hereafter).1

 In general, we agree with the large majority of the potential design features 

of the facility suggested by Treasury in their paper. 

Distribution Mechanism: Auctions versus Fixed-Rate (Price) Standing Facility

Securities borrowed from the SLLR, in our opinion, should be fixed in rate with the 

quantity determined by the borrower. We believe that the Treasury should stand ready to 

lend an unlimited amount of each issue through the facility. If the amount is limited, then 

the facility will suffer from the same problem as the Fed SOMA securities lending 

program; in situations where the market shortage is at an extreme, there will not be 

enough supply available for lending to prevent protracted fails. 

Rate, Maturity, Delivery and Reporting Options

The facility should be structured in a fashion that allows parties to borrow specific issues 

versus effectively lending money at an implied repo rate that is relatively close to or at 

zero. The rate should not be much above zero because the facility should not be designed 

in a manner that will prevent issues from trading “on special” (i.e. below general 

collateral repo). Allowing issues to trade on special is an important natural function of 

the market determined by supply and demand for individual issues. It is vital that any 

securities lending facility does not interfere with the normal functioning of the market. 

In order to ensure that borrowing from the facility will be economical only when delivery 

fails in a security become chronic or systemic, we recommend a loan maturity of about 

three to five days (unlike the UK non-discretionary repo facility which is overnight). The 

longer (shorter) the loan term, the less (more) the facility will likely be used by market 

participants. We believe that a three to five day loan maturity strikes a reasonable 

balance. 

We recommend same day settlement/delivery to alleviate the liquidity problem as quickly 

as possible. The Proposed SLLR paper discusses the possibility of a lengthy forward 

settlement to discourage strategic use of the facility in implementing short-run trading 

strategies, but we believe that the benefits of a rapid settlement process outweigh the 

risks. 

Finally, we agree that requiring borrowers to report daily positions and fails during the 

borrowing period could be useful in guarding against inappropriate uses of the facility. 

Collateral

We agree that the SLLR should lend securities on a ”bond-for-bond” basis (i.e. borrower 

must pledge other Treasury securities of equal market value, plus a margin, as collateral 

to borrow securities from the facility) in order to avoid affecting Treasury’s cash position. 

This is the method that the UK DMO non-discretionary repo facility uses successfully. 

 

1

 The UK Debt Management Office’s (DMO) non-discretionary repo facility, in our opinion, also provides 

a relatively good example of how many features of the facility could be structured. 
Treasury should allow borrowers to substitute collateral while borrowing from the SLLR. 

It is important to market participants to be able to substitute collateral in the event that the 

original collateral begins to trade “on special” (i.e. below general collateral rates) or, for 

example, if the borrower just needs back the original collateral to make delivery of that 

specific issue to a counterparty. Inclusion of a tri-party arrangement in the SLLR (as 

described in the Proposed SLLR paper) would be very helpful. 

Available Securities

The SLLR should stand ready to lend supply of any existing Treasurys, not just specific 

issues (e.g. on-the-run securities). It is too difficult to anticipate in advance which issues 

may have problems which require the use of the facility to address. For example, as the 

Treasury bond and note futures quarterly contracts expire and new contracts are listed, 

there are constantly new Treasuries which become the cheapest-to-deliver (CTD). 

Borrowing Mechanics and Public Transparency

We agree that borrowing requests should be submitted to the NY Fed, and that the 

aggregate daily volume of these requests by CUSIP should be promptly disclosed (with 

the names of individual borrowers kept confidential). 

Eligible Borrowers

Limiting direct participation in the SLLR to primary dealers, as discussed in the Treasury 

proposal, makes sense from an operational standpoint for Treasury and the NY Fed. 

Collateral Margin and Valuation

In order to protect Treasury, the amount of collateral (in market value of other Treasury 

securities) required from the borrower should be equal to the market value of the security 

borrowed plus some margin. This margin should be calculated as a percentage of the 

market value of the security borrowed rather than as an absolute dollar amount. The 

collateral and the borrowed securities should be marked-to-market daily, and margin calls 

should be made (or excess collateral returned) as required. 

Borrowing Limitations

There should not be any limit on the amount of securities that can be borrowed by any 

one participant, in our opinion. As long as there is daily reporting of borrowers’ cash, 

repo, and futures positions to the Treasury/NY Fed, and also prompt public disclosure of 

aggregate SLLR positions for each CUSIP (without disclosing positions of individual 

borrowers), we do not feel there is a need to limit the amount that can be borrowed. 

Rollovers/Loan Extensions
We agree that it would not make sense to impose significant penalties if borrowers are 

unable to return borrowed securities to Treasury on the closing leg of the lending 

transaction. Extending the loan on a day to day basis at an effective implied repo rate of 

zero percent (i.e. same way private fails are treated) seems appropriate. 

Sincerely, 

Joseph Shatz 

Senior Director, Government/FF&O Strategy 

Merrill Lynch 

(212) 449-9196 

Joseph_Shatz@ml.com 
 Wrightson ICAP 

Harborside Financial Center 

 Plaza V – 12th Floor 

 Jersey City, NJ 07311 

 Tel: (212) 815-6540 

 

August 10, 2006 

Mr. Jeff Huther 

Director, Office of Debt Management 

Room 2412 

Department of the Treasury 

1500 Pennsylvania Avenue 

Washington, D.C. 20220 

Re: Comments on Securities Lending White Paper 

Dear Mr. Huther: 

The proposed backstop securities lending facility would be a valuable tool for use 

in resolving, and indeed forestalling, systemic breakdowns in the clearing process 

for Treasury securities of the kind seen on several occasions in recent years. The 

Treasury delivery process has been smooth in recent quarters, but that does not 

mean that the risk of logjams has evaporated. We strongly support the Treasury’s 

efforts to design a low-impact mechanism for ensuring the efficiency of the 

government securities clearing process. To that end, we have taken the liberty of 

submitting below a previously published article on this subject in the form of a 

public comment. 

 Sincerely, 

 Louis vB Crandall 

 Chief Economist 

 LC@Wrightson.com 

 
Backstop Lending Facility Comment Page 2/4 

Proposed Securities Lending Facility. We’re big believers in the old adage that “if ain’t 

broke, don’t fix it”. However, we’re also big believers in an often-overlooked corollary to 

that rule: “If it’s breakable, build a safety net”. 

The current settlement system for Treasury securities is demonstrably breakable. The 

severe delivery logjams that developed in 2003 and 2004 haven’t been repeated lately, but 

the possibility of a recurrence cannot be ruled out. The market has made tentative progress 

toward facilitating negative-rate trading1, which might improve the elasticity of the supply 

of collateral in the financing market during a squeeze, but that doesn’t mean that the threat 

of future dislocations has been eliminated altogether. 

There are several possible ways of responding to future squeezes. On the regulatory side, 

the authorities might bring Treasury buy-in rules into line with those in effect in other, 

less-favored markets, or they might find a way to force customers to cooperate with dealers 

in industry-wide trade-netting round-robins in the event of a future logjam. Alternatively, 

the Treasury might lower the bar for future snap reopenings in response to endemic 

delivery fails. All of these solutions seem heavy-handed. A backstop lending facility, in 

contrast, would provide a temporary safety valve in the event that the clearing system 

comes under serious pressure again in the future. 

Unfortunately, the Treasury does not have the luxury of waiting until the need for such a 

facility once again becomes obvious before moving forward. The process of obtaining the 

necessary authorizations from 

Congress and working out the 

operational details could easily 

take a couple of years. The 

Treasury will have to start laying 

the groundwork now if it wants 

to have such a facility available 

to deal with future cases of 

settlement gridlock. The 

Treasury will naturally be 

cautious about tinkering with a 

system that has not caused 

problems in recent quarters, but 

we suspect that concerns about 

the lead-time involved will 

persuade the Treasury to proceed 

with the backstop lending 

proposal. 

In responding to the Treasury’s request for comments about how such a program should be 

structured, the Street has to address one fundamental issue: how far “back” from the 

market should a backstop facility be erected? Should the program be intended to be 

tapped, say, once a month? Once a year? Once a decade? Treasury officials have said 

-

250

500

750

1,000

1,250

1,500

1,750

98 99 00 01 02 03 04 05 06

Total Weekly Delivery Fails in Treasury Securities to 

Primary Dealers 

Sum of daily failures to receive at dealers 

In billions of dollars -- through July 12, 2006 
Backstop Lending Facility Comment Page 3/4 

that one possibility is to set the parameters of the program at levels that would make it 

uneconomical for dealers to borrow securities in all but the most extreme circumstances. 

Our own view is that borrowing from the facility should be expensive, but not 

prohibitively so. 

As some market participants have pointed out, capping the potential gains on a particular 

trade may remove an incentive for investors to participate, which ultimately could hurt 

liquidity. That’s a fair point about financial markets in general, and is relevant to the 

Treasury market up to a point. For example, that is the reason why the Treasury is 

scrupulous about not reopening securities opportunistically when markets are functioning 

well. It wants to leave room for market-makers to smooth out the normal underwriting 

swings in Treasury yields. 

At the same time, though, concerns about capping these sorts of arbitrage gains are 

probably less pertinent to active Treasury issues (on-the-runs, near on-the-runs, cheapest to 

deliver, etc.) than to almost any other class of security. Primary dealers report roughly half 

a trillion dollars of Treasury coupon transactions each day. The vast majority of those 

trades depend on the fact that individual Treasury securities don’t trade erratically relative 

to nearby issues. The liquidity of active Treasury securities owes more to their role as 

hedging instruments and trading vehicles than to the participation of speculative accounts 

exploiting special situations in individual issues. 

Placing boundaries on the potential mispricing of individual securities is not the main 

objective of the Treasury’s proposal, but we don’t view it as a negative side effect. A 

lending facility with an effective borrowing rate set, say, at 800 or 1000 basis points below 

the fed funds target would leave plenty of room for ordinary relative-value arbitrage while 

protecting market-makers and other participants from the adverse effects of the most 

severe dislocations. 

Ultimately, however, the justification for this proposal rests on the need to ensure the 

integrity of the market’s clearing mechanism. This is important in two respects: 

Treasury market liquidity. The logjams that developed in 2003 and 2004 forced marketmakers to curtail their exposure, and raised questions about the reliability of the Treasury 

market settlement process in general among suppliers of collateral to the sec lending 

market. In doing so, those disruptions posed a direct threat to the liquidity of the Treasury 

market. A recent issue of our newsletter2

 discusses the role played by the Fed’s securities 

lending program in allowing dealers to make liquid markets in bills in the face of declining 

supplies. We think a similar argument would hold for benchmark coupon issues in the 

event of a new outbreak of delivery failures. The inelasticity of supply in the issues that 

are cheapest to deliver into futures contracts has already induced the CBOT to place endof-contract position limits on Treasury futures.

3

 Those sorts of constraints would 

proliferate in less formal ways if a shift in market conditions were to produce a new 

epidemic of delivery fails. 
Backstop Lending Facility Comment Page 4/4 

Financial market stability. Financial markets have been able to support breathtaking 

increases in leverage in recent years by making more efficient use of collateral. That is 

true of asset-backed securities and collateralized derivatives markets in addition to repos. 

For a given level of capital, the amount of borrowing that can be done on a secured basis in 

any sector is a large multiple of what can be done on unsecured terms. The stability of 

today’s secured leverage system depends crucially on the timely, accurate posting of 

collateral. Anything that clogs the settlement system can result in collateral mismatches, 

which represents a more serious systemic danger in the context of today’s balance sheet 

practices than ever before. Furthermore, current trends suggest that the financial system’s 

dependence on collateralized financial arrangements will only grow over time. In this 

context, any obstacle to the smooth exchange of collateral poses unacceptable risks. The 

Treasury is unlikely to ignore the risk that the cascading delivery failures of 2003 and 2004 

might re-appear, with more damaging results, in the future. 

0

5

10

15

20

25

30

35

40

45

1970 1975 1980 1985 1990 1995 2000 2005

GDP

Credit Market 

Debt

Nominal GDP and Total Domestic Credit Market Debt

Quarterly observations in trillions of dollars

 

1

 http://www.bondmarkets.com/assets/files/Final%20Negative%20rate%20guideline.pdf 

2

 http://www.wrightson.com/mmo/2006/07/24/#Bills 

3

 http://www.cbot.com/cbot/docs/73604.pdf 
 360 Madison Avenue 

New York, NY 10017-7111 

Telephone 646.637.9200 

Fax 646.637.9126 

www.bondmarkets.com 

1399 New York Avenue, NW 

Washington, DC 20005-4711 

Telephone 202.434.8400 

Fax 202.434.8456 

St. Michael’s House 

1 George Yard 

London EC3V 9DH England 

Telephone 44.20.77 43 93 00 

Fax 44.20.77 43 93 01 

August 9, 2006 

Mr. Jeff Huther 

Director, Office of Debt Management 

Room 2412 

Department of the Treasury 

1500 Pennsylvania Avenue 

Washington, D.C. 20220 

 Re: Comments on Securities Lending Facility 

Dear Mr. Huther: 

The Bond Market Association (the “Association”)1

 appreciates the opportunity to comment on 

the Department of the Treasury’s (“Treasury”) White Paper “Consideration of a Proposed 

Treasury Securities Lending Facility” published in April 2006 (the “White Paper”). The 

Association broadly supports the efforts of the Treasury to address proactively issues that may 

compromise the high liquidity and efficiency in the market for U.S. Treasury Securities 

(“Treasury Securities”). Indeed, we believe, as noted in the White Paper, that the Treasury 

market is an invaluable national asset.2 However, given the importance of the Treasury 

market to the nation and financial markets globally, care should be taken to understand fully 

the costs and benefits of introducing a securities lender of last resort facility (“Lending 

Facility”) as outlined in the White Paper. A Lending Facility represents a significant 

structural change in the Treasury market and, while it may add to the tools Treasury already 

has to address certain market liquidity issues, the ancillary costs, in both increased moral 

hazard and possible diminution of the specials premium, need to be considered and addressed 

before moving forward with a Lending Facility. 

We would also urge Treasury to consider the impact of both the continued study of a Lending 

Facility and the implementation of such a facility on the market’s continuing efforts to 

examine and recommend market-based solutions to the liquidity and systemic risks posed by 

widespread and lasting fails in the Treasury market. We appreciate that Treasury has 

consistently since August 2005 engaged market participants on whether this change is 

advisable and we encourage Treasury, as it continues to study this option, to seek further 

market participant input. 

 

1

 The Association represents securities firms and banks that underwrite, distribute and trade in fixed income 

securities, both domestically and internationally. Our members are also actively involved in the funding markets 

for such securities, including the repurchase and securities lending markets. More information about the 

Association and its members and activities is available on its website, www.bondmarkets.com. The Association 

is expected to merge with the Securities Industry Association in November 2006. 

2

 See also Statement of Under Secretary for Domestic Finance Randal K. Quarles to the Association’s Annual 

Meeting, May 19, 2006 (“...[a]s we all know, the Treasury market is a critical national asset.”) at 

http://www.treas.gov/press/releases/js4274.htm. 
Mr. Jeff Huther 

August 9, 2006 

Page 2 

Executive Summary 

Given the length of this letter we thought it would be helpful to highlight the Association’s 

significant observations: 

► The Association supports the objectives and principles outlined in the White Paper 

for a Lending Facility but believes that it may be more efficient to address them in a way 

other than through a Lending Facility. The question, put more broadly, is whether there has 

been a market failure that can best be addressed through a government response, and whether 

the liquidity of the Treasury market has been negatively impacted by chronic fails. We 

believe that a governmental policy response is unwarranted because the market, as noted 

throughout this letter, has made significant progress to address identified market anomalies 

with respect to price and risk. Indeed, we believe that there is no evidence that recent 

incidents of chronic fails have negatively impacted the liquidity of the Treasury market. We 

believe, as well, that the current regulatory framework for the treatment of aged fails, 

including increased capital requirements and, in some cases, buy-in requirements provide 

sufficient additional safeguards to manage the risks posed by chronic fails. 

► The Association believes that while a Lending Facility may offer some marginal 

protection from the risks posed by continuing widespread fails in the Treasury securities 

market, on balance, the costs of setting up a Lending Facility and the potential ancillary 

negative consequences to the normal trading environment outweigh the potential benefits. 

► Changes in market practice and sensitivity to the risk issues raised in recent chronic 

fails events have lessened the probability that such events will occur with any frequency. 

► The market has adopted practices that, should a large-scale fails event occur, make 

it less likely that such an event would continue for any significant length of time. The market 

is also actively exploring and plans to implement market practices that will permit market 

participants to manage any risk that aged fails pose. 

► In addition, the Treasury has a number of current tools at its disposal that have 

proved effective during past chronic fails events. Since we believe that the risk of the 

occurrence of widespread, chronic and long-lived fails events is remote, current Treasury tools 

provide further protections against a fails event becoming the catalyst for an unprecedented 

systemic breakdown in the Treasury securities market. 

► Notwithstanding that we believe, on balance, that the costs of implementing a 

Lending Facility outweigh the benefits, if the Treasury decides to move forward with a facility 

care should be taken to address only the risks posed by an extreme market event. In no event 

should the normal trading environment—an environment that yields the most liquid securities 

market in the world – be compromised. Indeed, we believe that any Lending Facility should 

only address catastrophic infrastructure failures that prevent normal settlement. 

► The Association believes that Treasury should pay particular attention to pricing 

issues. In particular, to the maximum extent possible the market should be able to take 

advantage of market-based pricing incentives, including negative rate repo pricing. Any 
Mr. Jeff Huther 

August 9, 2006 

Page 3 

pricing formula should work on a coordinated basis with current market-based pricing 

mechanisms. 

► Other terms of the facility should reflect the expectation that the facility would be 

used only in the most extreme circumstances which market participants expect to continue for 

a significant period of time and which cannot be mitigated by available market practices. 

Settlement timing and term of transaction should be such that market participants will find a 

facility loan attractive only in extreme circumstances. 

I. Background: Treasury Market Generally 

The importance of the Treasury market to the global financial system cannot be overstated. 

There is no fixed-income market that is more crucial to the global economy, nor more liquid, 

than today’s primary and secondary market for U.S. government securities.3 U.S. Treasury 

securities exhibit a high level of liquidity with low transaction costs and no credit risk.4

 The 

liquidity of the Treasury market makes Treasury securities an important hedging vehicle 

because dealers may sell Treasuries short with confidence of obtaining the shorted security.5 

The ability to short Treasuries allows for efficient and transparent price discovery because it 

allows dealers to manage their positions and thus quote two-way prices. The attractiveness of 

the Treasury market is global in nature and, as cross-border capital flows increase, the 

importance of a liquid Treasury market only increases.6

 

Treasury securities’ importance to individual investors and the federal government should also 

not be underestimated. Many loan rates are set by reference to Treasury security yields. As 

the issuer of the world’s most liquid debt instrument, the Treasury –and thus U.S. taxpayers – 

benefits from the presence of this liquid secondary market by receiving the lowest financing 

costs available. As has been extensively noted, economists generally acknowledge that 

market participants will pay a liquidity premium7 in order to obtain a particularly liquid 

financial asset.8

 The Treasury captures this premium whenever it auctions new securities. 

 

3

 For example, in the first half of 2006, daily trading volume as reported by the primary dealers in Treasury 

securities averaged $ 547 billion. See Federal Reserve Bank of New York, 

http://www.ny.frb.org/pihome/statistics/. 4

 Robert P. O’Quinn, “Economic Benefits from U.S. Treasury Securities,” Report of the Joint Economic 

Committee, U.S. Congress, 2nd Session, Feb. 2002 at 2 (“O’Quinn”); see also White Paper, Introduction. 5

 Market participants who short a Treasury security may seek to cover the short in the repurchase (“repo”) and 

securities lending market. Thus, an active repo and securities lending market in Treasury securities plays an 

important role in our financial markets and our economy. The Federal Reserve also uses the repo market in 

Treasury securities to implement monetary policy. 

6

Information on net purchases of U.S. Treasury bonds and notes by foreigners is available at 

http://www.treas.gov/tic/tressect.txt. 7

See O’Quinn at 2-4; See also Association Comment Letter on Interagency White Paper on Structural Change in 

the Settlement of Government Securities, available at http://www.bondmarkets.com/legislative/t108-

001_appenda.pdf. 8

 A large and efficient Treasury market allows market participants to develop a “true” credit risk-free yield curve, 

thereby facilitating more efficient pricing of financial instruments and allowing financial institutions to hedge 

interest rate risk more effectively. Treasury securities also serve as a good source of collateral and funding for 

swaps and other derivative transactions. See O’Quinn. 
Mr. Jeff Huther 

August 9, 2006 

Page 4 

It is not surprising, therefore, that Treasuries are the most widely held debt securities in the 

world. It is also not surprising that protecting the liquidity premium associated with Treasury 

securities is of paramount concern to the Treasury and to market participants. The 

Association recognizes, therefore, that it is essential that every effort be made to ensure this 

high efficiency and unique liquidity be preserved during both normal times and during times 

of market stress. Market participants have, in the past few years, enhanced operational 

resiliency to address settlement disruptions, implemented trading practices -- both preemptive 

and risk mitigating practices -- and worked with industry utilities to limit the risk of 

widespread and chronic fails in the Treasury market. Work continues to be done and the 

Association believes that the Lending Facility proposal contributes to the ongoing dialogue 

between market participants and official policymakers. 

II. Fails in the Treasury Securities Market 

A. Fails in the Normal Course 

As the White Paper notes, Treasury market safety, liquidity and efficiency may be threatened 

by elevated levels of fails associated with market dislocation, catastrophic operational 

disruptions and very low interest rate environments. In order to address the risks posed by 

elevated and chronic levels of fails, a broader understanding of fails in the normal course is 

warranted.9

Fails to deliver contracted for securities occur in the Treasury securities market every day. 

The Federal Reserve Bank of New York (“FRBNY”) began publishing weekly statistics on 

fails in March 2004. The data includes historical information back to 1990. This data shows 

that fails occurred during every week in the period.10 Indeed, fails to deliver involving 

Treasury securities averaged $11.4 billion per day during the period July 4, 1990 to July 7, 

2006. Fails to receive averaged $12.9 billion per day over the same period. A graphic 

presentation of the FRBNY’s fails data is included in Annex A to this letter. 

Fails in a normal trading environment occur for a number of reasons. Operational issues 

cause the bulk of day-to-day fails. Incorrect trade details result in mismatches, but, generally, 

these types of fails are resolved very quickly through communications between the 

counterparties. These fails are usually fully resolved within a day or two of the originally 

scheduled settlement date. 

A market participant may also fail to deliver securities that it expected to receive from another 

counterparty in a different transaction. This original fail may occur for operational or other 

reasons, but it can set off a chain of fails that, in some circumstances, returns to the original 

failing party. Essentially what may happen is that Party A fails to deliver to Party B who then 

fails to deliver to Party C who had failed to Party A. Given the speed at which transactions 

occur in the Treasury market, a chain of fails or a round-robin of fails could involve a large 

number of dealers. 

 

9

 This discussion draws on Michael Fleming’s and Kenneth Garbade’s, “Explaining Settlement Fails”, 

September 2005, available at http://www.newyorkfed.org/research/current_issues/cill-9.html. 10 See http://ww.newyorkfed.org/markets/pridealers_failsdata.html. 
Mr. Jeff Huther 

August 9, 2006 

Page 5 

Finally, parties may fail to deliver a security if they have little economic incentive to deliver 

or to go to the market to borrow or otherwise obtain the security. This can occur as interest 

rates become very low and the related cost of failing becomes very low. It becomes less 

expensive to fail than to enter the repo or securities lending market to obtain the security 

needed for delivery. 

For these reasons fails never drop to zero and the fact that market participants have developed 

conventions for resolving these fails quickly and efficiently contributes to the significant 

liquidity enjoyed by the Treasury market. Market participants know that slight operational 

glitches will be resolved quickly. Market participants understand that minor operational 

issues will not cause them significant and enterprise-wide harm so the incentive to participate 

actively in the Treasury market remains high. For example, the market has developed a 

convention allowing a failing seller to make delivery the next business day at an unchanged 

delivery price. This convention allows parties to resolve operational glitches quickly without 

the threat of penalty, thus adding to the attractiveness of this market. 

Fails data indicate that the gross level of fails even in normal trading environments in the 

Treasury market has generally risen over the last five years. This is not surprising given the 

significant growth in both the volume of trading in the cash and repo markets and the dramatic 

growth in hedge fund community participation in the Treasury market, along with a 

corresponding growth in prime brokerage clearance, over this time. The attached graph in 

Annex B plots the settlement fails data against the rise in overall cash market trading volume. 

Annex D shows the significant rise in repo transaction activity in the recent past. 

The fact that fails never fall to zero and the ease with which market participants resolve them 

does not indicate that fails do not impose costs on the failing party. A failing seller loses the 

use of the funds it would receive at settlement for the period of the fail. Generally, the seller 

loses its ability to invest the funds in the general collateral repo market with a return roughly 

equivalent to the Fed Funds rate. The loss of the time-value of the cash for the period of the 

fail is usually (except in extraordinary market conditions) sufficient incentive for a failing 

party to resolve fails quickly. Thus, any Lending Facility should not seek to eliminate the 

day-to-day fails that occur in the Treasury market as these fails pose no significant risk to the 

market or to market participants and, indeed, contribute to the liquidity and efficiency of the 

market by making the market operationally attractive and efficient. 

B. Elevated and Chronic Levels of Fails 

As illustrated by Annexes A and C, the FRBNY’s data on fails also show incidents of 

significantly elevated levels of fails. Two prominent periods of elevated fails include the 

period immediately after the 9/11 attacks and during the summer of 2003. An examination of 

each of these incidents, and the differing triggering events that led to them, is helpful to 

understanding when a Lending Facility may be useful and any alternatives to a Lending 

Facility.11 

 

11 An additional period of elevated fails occurred during May/June 2005. This incident involved the security 

cheapest-to-deliver into the Chicago Board of Trade’s (“CBOT”) June 2005 futures contract. Because the fails 

in that instance resulted from a level of futures contracts that exceeded the supply of cheapest-to-deliver Treasury 

securities, CBOT has imposed position limits on Treasury futures contracts. See

http://www.CBOT.com/CBOT/docs/60840.pdf. 
Mr. Jeff Huther 

August 9, 2006 

Page 6 

1. Settlement Fails After 9/11 

Following the 9/11 terrorist attacks, fails in the Treasury market increased significantly, 

caused, in large part, by operational and infrastructure problems at significant market 

participants including inter-dealer brokers and the clearing banks.12 Fails had averaged $1.7 

billion a day during the week prior to 9/11 but rose to approximately $190 billion a day during 

the week of 9/19. This level is in sharp contrast with the previous fails high of $35 billion a 

day during the week of May 16, 2001.13 

On Thursday October 4, 2001, the Treasury announced that it would reopen an additional $6 

billion of the on-the-run ten-year note thereby increasing the outstanding supply of the note to 

$18 billion. This was the first unscheduled snap auction of a coupon-bearing security since 

the regularization of note and bond auctions in the late 1970s and early 1980s.14 Treasury 

clearly had become concerned with the chronically high fails rate and particularly concerned 

that a continued high-level of fails might begin to affect the performance and efficiency of the 

market. Under Secretary Peter Fisher stated that “we want to reduce the risk that these 

settlement problems turn into a much bigger problem to the Treasury market” and that “we 

wanted to prevent technical problems in the back office from causing wider problems in the 

pricing of government securities.” 

The fails data suggests that the reopening had a direct and immediate impact on the level of 

fails in the market. Daily average fails fell from $142 billion during the week ending October 

3 to $63 billion the next week and then to about $18 billion in each of the following weeks. 

The specials rate for the ten-year note also rose in the immediate aftermath of the reopening.15 

While the reopening in 2001 appears to have been effective in lowering the gross level of 

fails, Under Secretary Fisher was careful to alert the market that reopenings would be 

extremely rare and that Treasury undertook such extraordinary measures only in response to 

truly extraordinary conditions in the market. Well after the situation had been resolved he 

stated that “never is a long time, so it would be imprudent of me to say that the Treasury will 

never again hold such an auction. But you should not count on it...We want to rely on 

[market participants] to reconcile the forces of supply and demand.”16

 

12 While much of the increase in fails on 9/11 can be attributed to operational problems experienced by 

significant market participants, including inter-dealer brokers and the clearing banks, there is evidence that some 

market participants, reacting to the geo-political uncertainty, chose to increase cash balances and withhold 

Treasury securities from the lending market. This withholding of supply further hampered liquidity. See

“Summary of ‘Lessons Learned’ and Implications for Business Continuity”. Discussion Notes a2 (Feb. 13. 

2002), available at http://www.sec.gov/divisions/marketreg/lessonslearned.htm. 13 A full account of fails and settlement problems after 9/11 is available in Garbade’s and Fleming’s, “When the 

Back Office Moved to the Front-Burner: Settlement Fails in the Treasury Market after 9/11” 

(“Fleming/Garbade”), available at http://www.newyorkfed.org/research/epr/02v08n2/0211flem/0211flem.html. 

This discussion of the 9/11 fails incident draws on that account. 

14 See Fleming/Garbade. 15 See Fleming/Garbade. 16 Remarks by Under Secretary Fisher before the Association’s Legal and Compliance Conference, January 8, 

2002, available at http://www.treas.gov/press/releases/po906.htm. 
Mr. Jeff Huther 

August 9, 2006 

Page 7 

After 9/11 all market participants, including the clearing banks and settlement utilities, 

significantly upgraded backup facilities and operational resiliency. The Association believes 

that had these operational backups been in place before 9/11, the operationally caused 

settlement fails would not have occurred in significant size and would not have persisted for 

an extended period. 

2. Fails during the Summer of 2003 

Early in the summer of 2003 short-term interest rates reached their lowest level in forty-five 

years. By June of 2003 the Fed Funds target rate had been reduced to 1% (and thus the 

general collateral repo rate hovered around 1%). Interest rate expectations, though, were 

changing and intermediate-term yields rose sharply. In response, hedging activity, 

particularly with the on-the-run ten-year note, increased sharply. Market participants believed 

that rates would increase. In order to cover short positions, market participants looked to the 

repo market and the increased demand forced the specials rate on the on-the-run-ten year note 

down. In addition, the FRBNY had a relatively small position in this note, and thus had a 

limited supply to lend to the street through its securities lending program.17

Given that the Fed Funds/general collateral rate hovered around 1%, the rate at which special 

securities traded did not have far to go before the rate hit zero. As the specials rate approached 

zero there was little incentive to borrow the note to cover short positions. In fact, those 

shorting the on-the-run security were buying a low cost option on the expected rise in repo 

rates. If the specials rate rose they would benefit, but if rates remained static there was no, or 

very little, cost to continued fails. As long as the specials rate remained at or very near zero, 

leveraged market participants had strong incentives to add to short positions, thus adding to 

the fails in the market. 

In addition, some market participants with large positions were reluctant to lend into the 

market because they questioned whether securities could be returned. Thus, less supply –

supply that could have alleviated supply/demand imbalances – was available for delivery. 

The Association has engaged in educational efforts since 2003 –particularly in Asia – to 

describe for holders of large positions in Treasury securities the dynamics of the Treasury 

market. We believe that these efforts have encouraged these holders to participate actively in 

the Treasury lending and repo markets. 

III. Chronic Settlement Fails and the Market Response 

The Association shares Treasury’s concern with maintaining the deep liquidity and efficient 

market-pricing mechanism that characterizes secondary trading in Treasury securities and 

does not want to see a repeat of the chronic fails situation that developed in 2003. To that end 

the Association has worked with its members to address chronic fail issues with respect to 

risk, pricing and liquidity. 

Indeed, the Association has focused its efforts on developing preemptive practices that would 

make it unlikely that a significant fails event would occur. As noted extensively in studies of 

 

17 Information on FRBNY’s portfolio for lending is at http://ww.neyworkfed.org/markets/soma/tnotes.html. 
Mr. Jeff Huther 

August 9, 2006 

Page 8 

the 2003 incident, our members suffered a number of consequences as fails continued to 

remain unresolved. Most particularly, regulatory capital requirements imposed lost 

opportunity costs on dealers as capital requirements increased.18 Firm personnel spent 

significant time in back-office and industry-wide attempts to resolve fails. In addition, 

customer relations became strained as fails to receive and deliver in customer transactions 

increased. 

The Association agrees with Under Secretary Fisher’s remarks in discussing the snap 

reopening after the 9/11 attacks: “We want to rely on [market participants] to reconcile the 

forces of supply and demand.” To this end, the Association has instituted a number of 

initiatives that we believe will -- collectively, materially and preemptively -- reduce the risk of 

a chronic fails situation from developing and will, should a chronic fails event develop, 

provide the market-based solutions, incentives and pricing that will help reduce chronic aged 

fails and manage the risk posed by such fails. We have worked closely as well with the Fixed 

Income Clearing Corporation (“FICC”) on initiatives to reduce fails at the clearing 

corporation level. The Association believes that these mechanisms address the specific 

concerns that have led Treasury to explore the Lending Facility. We believe that had the 

recently developed mechanisms been in place prior to the 2003 event, that event would, most 

likely, not have occurred to the same extent. 

A. Prompt Delivery Repo Trading Practice 

The Association, through its Funding Division Executive Committee, published a trading 

practice guideline for “prompt delivery” repo trading in the fall of 2004. The guideline allows 

market participants to more easily source securities in situations where a particular 

government security is experiencing high levels of settlement fails. The guideline encourages 

entities with supply to make a security available by allowing for cancellation of a transaction 

without penalty if the seller fails to deliver within the prescribed 15 minutes. Prompt delivery 

trades now are available to market professionals when market conditions warrant and increase 

when shortages occur in the market, as was the case with fails associated with the CBOT 10-

year futures contract in the summer of 2005.19 

B. Negative Rate Repo Trading Practice 

The Funding Division of the Association approved a Negative Rate Repo Trading Practice. 

Published in March 2006, the trading practice enables the pricing of a repo transaction in a 

negative rate trading environment, and standardizes practices regarding failure to deliver on a 

repo transaction where the Repo Rate is negative. The mechanism described in the trading 

practice consists of resetting the Pricing Rate to the absolute value of the original negative 

Pricing Rate (i.e. negative rate 1 is reset to positive rate 1) upon the failure to deliver in the 

opening leg of a repo. If during the term of a Negative Rate Repo for which the Seller has not 

delivered the securities and the Buyer has not exercised its right to declare a default, the Seller 

delivers the securities subject to the transaction, the Pricing Rate will revert to the originally 

 

18 See 17 C.F.R. 240.15c3-1. 19 The prompt delivery trading practice is available at 

http://bondmarkets.com/assets/files/Revised%20Repo%20Trading%20Practices%20Guidelines.pdf. 
Mr. Jeff Huther 

August 9, 2006 

Page 9 

agreed upon Pricing Rate (i.e., the negative rate) but only for the remaining term of the 

transaction. The Association believes that this trading practice will promote liquidity by 

allowing market participants to continue to participate in the market during periods when rates 

for a particular security go negative, and by encouraging market participants who act as a 

Seller in negative rate repo transactions to deliver the underlying security. The Association 

has discussed the trading practice with the FICC to ensure its operational capability to flip 

repo pricing rates.20 

We believe that a robust negative rate repo market, with clearly defined practices, addresses 

one of the significant contributing factors to the elevated fails levels of 2003 and can be used 

to source and price securities whenever supply and demand imbalances dictate that a 

significant premium be paid for a particular security. In addition, the Association’s negative 

rate repo trading practice when combined with other incentives that raise the costs of 

continued failing (such as increased capital requirements for aged fails, increased labor costs 

and fraying customer relationships), should encourage market participants that would view a 

negative rate trade as uneconomic (and thus continue to fail) to source securities at a negative 

rate. During the summer of 2003, market participants were reluctant to enter into such trades 

as the repo buyer, because under conventions in place at the time, repo sellers would have a 

free option to fail and still get the benefit of negative rate financing. Clarifying the trading 

conventions will specifically encourage buyers to seek securities in the repo market in a way 

that didn’t occur in 2003. Had there been clarity around the trading conventions for negative 

rate repo transactions prior to 2003, we believe that that fails incident would, most likely, not 

have occurred to the same extent. 

C. Fails Margining

The Association, through its Government and Federal Agency Securities and Funding 

Divisions, continues actively to pursue fails margining as a method to reduce the credit 

exposures to which firms may become subject during prolonged fails events. These credit 

exposures become acute if a fail event crosses a coupon payment date and the market value of 

a security changes materially. Discussions are active in the Executive, Legal and Operations 

committees of the Divisions regarding the business, legal, operations and systems issues 

associated with margining fails. Fails margining and the legal infrastructure needed to 

implement fails margining will be reviewed by the Funding Division Legal Advisory 

Committee and the Government Division Legal and Compliance Committee in connection 

with a revision to master trading documentation. The groups are currently considering a 

trading practice that would recommend margining of fails that have aged beyond a set time 

limit. The Association believes that a fails margining trading practice can be available by the 

end of 2006. 

D. Buy-in Procedures for Government Securities

The Government and Funding Divisions have embarked on an initiative to review and update, 

as appropriate, the Association’s Buy-in Procedures for Government Securities. Specifically, 

 

20 The negative rate trading practice is available at 

http://www.bondmarkets.com/assets/files/Final%20Negative%20rate%20guideline.pdf. 
Mr. Jeff Huther 

August 9, 2006 

Page 10 

as has been discussed with Treasury staff, the Association continues to investigate whether to 

update its procedures to provide for a mandatory cash settlement of transactions that have 

been in a fail status for an extended period of time. The Association believes that a 

mandatory cash settlement will close-out transactions that remain on dealers’ books, reduce 

risk, minimize increased capital requirements, and decrease significantly operational labor 

costs.21 We expect to publish an Exposure Draft of revised buy-in procedures by the end of 

the third quarter of 2006. 

E. Operational Resiliency 

As noted above, subsequent to 9/11 all market participants, including the clearing banks and 

settlement utilities, significantly upgraded backup facilities and operational resiliency. The 

Association believes that these efforts reduce the potential for widespread operational and 

settlement failures similar to those that occurred after the 9/11 attacks. 

F. FICC Changes 

The Association has encouraged FICC to fully implement its fails netting service. The net 

settlement system of FICC’s Government Securities Division (“GSD”) is being modified to 

include all daily outstanding failed settlement obligations in GSD’s regular overnight netting 

process. After such modification, each participant’s fail obligations for the current business 

day will be netted with its other government securities transactions having the same CUSIP 

number and the next business day’s settlement date. A fail will therefore be outstanding for 

only one day on GSD’s books before entering the net settlement cycle for the next settlement 

date. Implementation of this service will eliminate clearance obligations by netting 

outstanding fails versus new activity, thereby lowering clearance costs and reducing 

participant risk exposure stemming from outstanding fail positions. FICC’s implementation 

for the fails netting service is slated for September 2006.22 

IV. Lending Facility 

In August of 2005, Treasury announced at its Quarterly Refunding that it was exploring the 

possibility of developing a backstop securities lending facility and solicited dealer input. The 

concept was also discussed at meetings of the Treasury Borrowing Advisory Committee.23 In 

April 2006, Treasury provided more detail with a straw man proposal for a facility and asked 

for input on fundamental questions regarding a potential facility. Specifically Treasury asked 

for comment on the question of whether establishment by Treasury of a Lending Facility 

would be an appropriate response to the potential threat of market dislocation, catastrophic 

operational disruptions and complications associated with historically low interest rates. As 

 

21 The Association previously submitted to the Treasury recommendations with respect to the buy-in rules for 

Treasury securities. The letter is available at 

http://www.bondmarkets.com/assets/files/letter_to_treasury_re_fails.pdf. 22 See the FICC Important Notice available here: http://www.ficc.com/gov/notices/GOV159.05.htm?NS-query. 23 The Treasury Borrowing Committee minutes for August 2005 and November 2005 are available at 

http://www.treas.gov/offices/domestic-finance/debt-management/adv-com/minutes/. 
Mr. Jeff Huther 

August 9, 2006 

Page 11 

described in the White Paper, Treasury continues to be concerned that these types of events 

could lead to distorted prices in the Treasury cash, derivative and collateral markets, and lead 

to deterioration in dealers’ market-making activities. Treasury is concerned that, if the issues 

raised by these types of events are unaddressed, the smooth functioning of the Treasury 

market could be compromised and thus result in increased borrowing costs for the Treasury 

over time. 

A. Need for the Lending Facility 

In order to determine if a Lending Facility is needed, we believe the following issues should 

be addressed: 

• What market conditions will a Lending Facility address? 

• What is the impact of widespread fails on Treasury market liquidity and Treasury’s 

cost of borrowing? 

• Will current Treasury tools address supply/demand imbalances? 

• Will private market solutions efficiently address these issues? 

In our discussion below we will address each of these issues, but we would first make some 

general observations about the need for a Lending Facility. 

The White Paper describes a number of objectives and principles which Treasury believes will 

need to be incorporated into any lending facility. The Association supports these objectives 

and principles but believes that it may be more efficient to address them in a way other than 

through a Lending Facility. The question, put more broadly, is whether there has been a 

market failure that can only be addressed through a government response, and whether the 

liquidity of the Treasury market has been negatively impacted by chronic fails. We believe 

that a governmental policy response is not warranted because the market, as noted above, has 

made significant progress to address identified market anomalies with respect to price and 

risk. Indeed, we believe that there is no evidence that recent incidents of chronic fails have 

negatively impacted the liquidity of the Treasury market. We believe, as well, that the 

current regulatory framework for the treatment of aged fails, including increased capital 

requirements and, in some cases, buy-in requirements provide sufficient additional safeguards 

to manage the risks posed by chronic fails. There could, of course, be extreme market 

conditions not yet identified for which a Lending Facility may be helpful to maintain orderly 

market conditions where a catastrophic settlement disruption makes it impossible for the 

market to address imbalances. The Association believes continued study of those extreme 

market conditions would be prudent given the importance of this market. 

In the White Paper, Treasury describes an objective of the Lending Facility to act as a form of 

“catastrophe” insurance in the Treasury market with minimal impact in normal circumstances. 

We believe, however, that, notwithstanding attempts to minimize the impact during normal 
Mr. Jeff Huther 

August 9, 2006 

Page 12 

circumstances, a significant structural change of this magnitude could force material changes 

in the dynamics of the Treasury market. If Treasury moves forward with the Lending Facility, 

the greatest challenge will be to create a structure that does not impact the current economics 

and incentives that the Treasury market enjoys today. 

Specifically, we believe that a lending facility consistent with the broad parameters described 

in the White Paper could potentially have a significant adverse impact on secondary market 

trading, particularly in specials trading in the repo market. Specials trading in the repo market 

is an important contributor to the overall liquidity enjoyed by the Treasury market. The 

specialness of a security contributes to the liquidity premium enjoyed by Treasury at auction. 

One study has noted that the “size of the price premium at the auction depends on the total 

number of basis-point days of ‘specialness’ that the security will generate during its life. The 

security’s total specialness can increase either through the overnight spread increasing or by 

the security being on special for a longer time.”24 

In developing a facility with an implicit floor on repo pricing, Treasury runs the risk of 

limiting the potential for market participants to profit from positions in on-the-run Treasury 

securities. This could discourage market participants from taking positions in those securities 

by reducing the premium associated with the on-the-run securities relative to the off-the-run 

securities and may limit the amount of securities that might be available in the specials 

market. This, in turn, would make shorting the on-the-run securities less attractive as a 

hedging and risk management tool. During the 2003 chronic fails event it became clear that 

there was an implicit floor on the specials repo rate of zero. This floor existed 

notwithstanding that market participants were clearly willing to pay the equivalent of a 

negative repo rate to the New York Fed’s securities lending program. 

 

Now that the Association has developed guidance on negative rate repo trades and that the 

significant market participants are, on the whole, in a position to implement that trading 

practice,25 the Association believes that the pricing mechanism in the market is better able to 

provide efficiently a source for securities than the Lending Facility which, at whatever price it 

is implemented, will inevitably reprice the floor for specials trading. 

In addition, and alternatively, any floor for the rate at which specials may trade could, in a 

very low rate environment, create incentives for market participants to put on short positions 

merely in order to speculate on the probability that the Lending Facility would be tapped 

shortly causing a rise in the specials rate. Market participants will see the short-term 

opportunity to take advantage of a very inexpensive option and thus increase the volume of 

potential fails in the system. Behavior during the 2003 incident illustrates the situation. Thus, 

care should be taken to ensure that a Lending Facility does not provide incentives that would 

permit market participants to game the system and thus weaken, rather than strengthen, 

investor confidence in the continued safety, liquidity and efficiency of Treasury markets. 

 

24 Mark Fisher, “Special Repo Rates: An Introduction”, Federal Reserve Bank of Atlanta, Second Quarter 2002, 

available at http://ww.frbatlanta.org/filelegacy.doc/fisher_2q02.pdf. 25See the discussion below in Paragraph V.2.(a). 
Mr. Jeff Huther 

August 9, 2006 

Page 13 

1. What market conditions will a Lending Facility address? 

Treasury identifies three types of incidents – severe operational disruption, very low shortterm interest rate environment, and market dislocation -- that may give rise to severe stress in 

the Treasury market. Simply put, each of these may create supply/demand imbalances that 

have not been easily remedied in the past. However, we note that different mechanisms may 

be appropriate to ease the stresses in different circumstances and that different mechanisms 

have, in fact, contributed to the easing of fails stresses. While it may be advisable to increase 

the supply of a security (either through a reopening or through a Lending Facility) in the case 

of severe operational disruptions, enforcement through market surveillance may be the 

preferred approach to combat large potentially manipulative positions. In most cases the 

Association believes that supply/demand imbalances are best addressed through the pricing 

mechanism in the market. For example, although the supply-side was addressed immediately 

after 9/11 by a snap and extraordinary reopening, the regulatory capital charges and the 

increased ancillary costs imposed by the market, as well as the probable introduction of 

additional supply because of attractive pricing contributed to the cleanup of the chronic fails 

in 2003. 

2. What is the impact of widespread fails on Treasury market liquidity and 

Treasury’s cost of borrowing? 

Before Treasury moves ahead with implementation of a Lending Facility, it should quantify, 

to the extent possible, the cost to Treasury of widespread and chronic fails. While we agree 

that both the post-9/11 settlement disruptions and the 2003 chronic fails event imposed costs 

on market participants through capital charges and labor costs, we have seen little evidence 

that there was either a cost to Treasury at auction at the time of the events or that a negative 

perception of the Treasury market lingered after the event. 

3. Will Current Tools Available to Treasury Address Supply/Demand Imbalances? 

Treasury has a number of tools that have been shown to be effective in addressing the market 

conditions that concern Treasury. One such tool authorized by the Government Securities Act 

authorizes Treasury to call for Large Position Reports (“LPR”) to monitor secondary market 

activity. 26 This authority specifically gives Treasury a potent tool to combat the development 

of positions in Treasury securities large enough to allow for manipulative behavior that could 

threaten secondary market liquidity. LPRs require entities with direct or indirect control of a 

specified amount in a Treasury security to maintain records in order to facilitate compliance 

with potential Treasury information requests. LPRs give Treasury a significant window into 

those firms that are large enough to control positions that could be used in a manipulative 

manner. Under Secretary Quarles noted his concern that large positions can, but do not 

necessarily, indicate potential manipulative behavior and intent.27 The Association believes 

that LPRs, coupled with the surveillance regime instituted after the Salomon incident in the 

early 90s, are more than sufficient to uncover real manipulative behavior in a changing market 

 

26 See 15 U.S.C. § 78o-5. 27 Under Secretary Quarles’ remarks to the Association’s Annual Meeting are available at. 

http://www.treas.gov/press/releases/js4274.htm. 
Mr. Jeff Huther 

August 9, 2006 

Page 14 

environment. In addition, LPRs allow Treasury to identify those holders of large positions 

that have chosen for good economic reasons to withhold supply from the lending market. 

In addition, Treasury may exercise its authority under the Treasury’s Uniform Offering 

Circular for the Sale and Issue of Marketable Book-Entry Treasury Bills, Notes and Bonds 

(the “UOC”) to reopen a security in order to provide additional quantities of securities to the 

marketplace.28 A reopening may take the form of a standard auction, a “tap” issue whereby 

the securities are offered to the market on a continuous basis until the shortage is alleviated, or 

through any other means that the Treasury deems appropriate. As noted above, unscheduled 

reopenings are extremely uncommon and will be generally undertaken by Treasury to 

alleviate liquidity concerns only after the normal market mechanisms have failed.29 As noted 

above, market conditions have caused Treasury to exercise this authority only once since the 

adoption of the regular and predictable auction schedule. 

The Association believes that these tools have proven effective in practice and address the risk 

of manipulative behavior and the risk of severe operational disruption. Further, while the 

unpredictability of a reopening may seem to threaten the regular and predictable schedule for 

issuance that Treasury has fostered,30 we believe that the rarity of such reopening and the 

extremity of the circumstances would not alter the ongoing benefits of regular issuance nor 

change market participants’ reliance on Treasury predictability. 

 4. Will private market solutions more efficiently address these issues? 

As described more fully above, the Treasury market through the Association has developed 

and continues to develop market-based solutions to the differing risks posed by chronic fails. 

We believe that each of these, while not a complete solution in its own right, will significantly 

reduce the risk of a severe supply/demand imbalance occurring and will reduce both the 

systemic and entity risk should such severe circumstances occur. We believe that the 

appropriate economic incentives and market discipline will make necessary supply available 

and allow demand to source needed securities. 

B. Criteria for a Lending Facility 

We believe, on balance, that the evidence does not support Treasury moving forward with a 

facility at this time. However, if Treasury determines that a Lending Facility is needed, the 

facility should meet the following criteria: 

● a Lending Facility should only be used in extreme circumstances and only in 

circumstances of a significant operational settlement disruption; 

● a Lending Facility should not reprice or alter the structure of the market; 

 

 

28 See 31 C.F.R. Part 356. 29 See Under Secretary of the Treasury for Domestic Finance Peter Fisher, Remarks before the Bond 

 Market Association Legal and Compliance Conference (January 8, 2002). 30 See Minutes of the Meeting of the Treasury Borrowing Advisory Committee of The Bond Market Association, 

May 2, 2006, at http://www.treas.gov/press/releases/54226.htm. 
Mr. Jeff Huther 

August 9, 2006 

Page 15 

● a Lending Facility should not diminish the benchmark liquidity premium of on-therun issues; 

● borrowings from a Lending Facility should be at a significantly higher cost than 

those available in the market; 

● a Lending Facility’s terms and conditions and use by market participants should be 

transparent; and 

● a Lending Facility should always be readily available, predictable and nondiscretionary. 

 

Again, we believe a few general observations would help frame the discussion. While the 

Association believes that, in the vast majority of cases, market-based incentives and practices 

are best placed to prevent elevated levels of fails and to alleviate the risks posed by such fails, 

a backstop Lending Facility may be worth further consideration for extreme situations such as 

catastrophic settlement disruptions. This consideration should carefully assess the types of 

events for which a Lending Facility is intended and receive further input from market 

participants to ensure that a Lending Facility will be available and will be used only in the 

most extreme circumstances in which no other less intrusive solution, either from Treasury 

itself or from market participants, is evident. Also, we believe that, in developing further the 

design features of a Lending Facility, Treasury should take into consideration the work that 

has been done in the market since the recent instances of high levels of fails and ensure that 

the terms of the facility complement those initiatives. 

 1. A SLLR should only be used in extreme circumstances and only in circumstances 

of a significant operational settlement disruption.

As noted throughout this letter, this facility should not be a substitute for the natural market 

mechanisms and its terms should ensure that it is used only during times of extreme stress 

when other mechanisms, both market-based and those that Treasury currently has, have failed 

to alleviate significant and unresolved risks to the system. We believe that these 

circumstances should be limited to significant disruptions to the settlement system and 

infrastructure. 

 2. A Lending Facility should not reprice or alter the structure of the market. 

As described more fully in Section V.2.a, care should be taken to ensure that the terms of a 

Lending Facility do not change the current price discovery process in the market or the current 

structure of this market and the benefits that flow to Treasury and market participants from 

this structure. 

 3. A Lending Facility should not diminish the benchmark liquidity premium of onthe-run issues.

A structural change of this significance to the market needs to be done with great care. As the 

liquidity of the Treasury market is unique and the low-cost financing that that liquidity affords 
Mr. Jeff Huther 

August 9, 2006 

Page 16 

Treasury is the underlying reason for studying the Lending Facility, Treasury will need to be 

sure that no ancillary negative effects will be evident in Treasury liquidity. 

 4. Borrowings from a Lending Facility should be at a significantly higher cost than 

that available in the market. 

The Association believes that a Lending Facility should be used only in the most extreme 

circumstances and only when all avenues to private sector availability of securities have been 

explored. The Lending Facility should truly be a lender of last resort and should provide 

incentives, either through its pricing mechanisms or otherwise, for market participants to 

source bonds in the private market before coming to the Treasury. 

 5. A Lending Facility should always be readily available, predictable and nondiscretionary.

Given the impact that additional supply of a given security could have on the market and the 

expectations of market participants, we believe that the availability of securities from a 

Lending Facility should not be discretionary. Rather, the terms at which securities will be 

available should be fully transparent and predictable for market participants. In essence, the 

facility should always be open. 

 6. A Lending Facility’s terms and conditions and use by market participants should 

be transparent.

As noted above, in order to avoid potential dislocations in the market, the terms of use and the 

use of a Lending Facility should be fully transparent. 

C. Other Potential Costs of a Proposed Lending Facility: Increased Moral Hazard 

In addition to the above discussion, the White Paper notes a number of benefits and costs that 

should be considered in implementing a Lending Facility including an increase in moral 

hazard that may exacerbate highly speculative trading. The moral hazard risk of bailing out 

and encouraging speculative short positions may be significant and may weaken investor 

confidence and impact normal trading conditions. While it may be hard to quantify these 

costs precisely, Treasury should not move forward until it is clear that the Lending Facility 

will not create such ancillary problems.31

V. Comments on the Possible Structure and Possible Terms 

While the Association is skeptical that a Lending Facility can be designed that meets all the 

objectives and principles outlined in the White Paper, we also believe that continued study of 

the concept may be warranted to address the limited case of catastrophic operational and 

 

31 The White Paper refers to securities lending facilities that have been implemented in other countries with 

minimal disruptive effects. We believe that the size of the Treasury market and the uses to which the Treasury 

market is put make comparisons to other sovereign issuer markets inapposite. As noted at the beginning of this 

letter, the Treasury market is global and the significant advantages to holding long positions and hedging through 

the use of short positions is unmatched in any other sovereign market. 
Mr. Jeff Huther 

August 9, 2006 

Page 17 

settlement disruptions. Unforeseen events that could serve to cripple the Treasury market and 

that are not easily addressed by current tools, both official tools and market trading practices, 

may require a policy response that includes use of a Lending Facility. The discussion below 

addresses the terms, conditions and other operational details specifically outlined in the White 

Paper and offers some suggestions that we believe, should Treasury choose to move forward 

with this proposal, would both address Treasury concerns and minimally affect the market in a 

normal trading environment. 

1. Auction vs. Fixed-Rate (Price) Standing Facility

Should the Treasury move forward with a form of Lending Facility, the Association strongly 

believes that it should be structured as a fixed-rate standing facility available to all eligible 

participants with the quantity borrowed determined by the borrower (perhaps with per dealer 

limits to avoid any one dealer getting an opportunity to dominate an issue). This method is 

consistent with an approach that would leave to the market a determination as to the 

appropriate amount that would reconcile supply/demand imbalances. Further, we believe that 

any facility that left discretion to the Treasury as to when borrowing would be available could 

create significant uncertainty in the market and undermine the regular and predictable 

schedule that has given Treasury securities their benchmark status. However, if Treasury 

moves forward with a facility that is meant only to be available in the event of a catastrophic 

settlement disruption, we believe that the criteria for the facility’s availability should be 

objective and publicly available. 

2. Rate, Maturity, Delivery and Reporting Options 

The Association believes that the pricing structure of a Lending Facility requires careful 

scrutiny as the pricing structure presents the greatest potential to change the dynamics of the 

market and to alter the price-discovery mechanisms that contribute to the liquidity of the 

Treasury market. 

a. Implied Rate of Zero Percent 

As noted above, the Association believes that the Lending Facility, if implemented, should be 

designed to address only those disruptions caused by catastrophic settlement and 

infrastructure failures. It should never be available to address market trading conditions as the 

market pricing mechanism is best suited to address market imbalances. Any pricing structure 

should reflect the limited scope that we believe a Lending Facility should address. 

The White Paper suggests that the Lending Facility make securities available at an implied 

repo rate of zero percent. The Association believes that a rate of zero percent would 

institutionalize an effective floor of zero percent on the repo market and would eviscerate the 

power of a market-based negative rate repo market to reconcile supply and demand through 

pricing incentives. Setting the rate at an implied rate of zero, without other terms that would 

increase the cost to a securities borrower (for example, a delayed settlement convention), 

would destroy the incentive for market participants to source the bonds at a market price that 

appropriately reflects the securities’ value. We believe, as discussed above, that an implied 
Mr. Jeff Huther 

August 9, 2006 

Page 18 

rate of zero raises the serious potential to undermine the specials market in a low-rate 

environment and that such a pricing structure could make it less attractive to market 

participants that hold a particular security to make that security available in the specials 

market. 

Should the Treasury move forward with a Lending Facility, a pricing methodology that allows 

market participants to capture the full specials price of a security should be sought. In a low 

rate environment, there may be little specials value to capture if there is an effective floor of 

zero percent. There may be little incentive to participate in the specials market in such an 

environment and there would be no incentive for market participants to continue to develop a 

robust negative repo rate capability. As Under Secretary Quarles noted in his remarks at the 

Association’s recent Annual Meeting, there would be a rationale for reconsidering the pricing 

structure of the Lending Facility “if market participants took the steps necessary to foster 

active negative rate repo trading.”32 As described above, the Association and its members 

have taken significant steps to provide the trading practice and operational infrastructure to 

allow for robust negative rate repo trading should the pricing environment require it. After 

the publication of the Association’s Negative Repo Rate Trading Practice, which was 

endorsed unanimously by the Association’s Funding Division, the Association engaged its 

primary dealer members to assess the operational readiness of firms to support negative rate 

repo trading. A majority of this group has represented that they have the operational and 

systems support in place today to allow for negative rate repo trading. For the remaining 

minority that would treat negative rate trading on an exception basis for operational purposes 

today, it was clear that they were committing the resources to implement the necessary system 

changes within a short time frame, in most cases within six months from the date of our 

discussions. The Association is committed to working with our member firms to ensure that 

systems capability can support negative rate repo trading in a seamless fashion. We believe 

that this commitment to negative rate repo trading by the primary dealer firms argues strongly 

against an implied rate of zero percent for the Lending Facility and we believe that the 

Treasury should clearly state that it will focus on other pricing structures so that firms will 

complete their operational changes to allow for negative rate trading. 

b. Alternative Pricing Structure of a Lending Facility 

In developing an alternative pricing structure for a Lending Facility, Treasury needs to 

consider two goals: (1) allow the market pricing forces of the Treasury market to operate 

unfettered to address supply/demand imbalances as much as possible; and (2) price the 

securities from the Lending Facility at a level that would only encourage market participants 

to borrow from the Treasury when there a clear threat to the market’s efficiency. 

In order to achieve these goals, a Lending Facility should only make securities available at a 

fee materially higher than the price quoted and available in the market. We believe that such a 

pricing mechanism would only encourage market participants to borrow from the Lending 

Facility if securities are, in fact, not clearing due to settlement disruptions. In these market 

conditions market participants would recognize that Treasury is the only source for securities. 

 

32 See http://www.treas.gov/press/releases/js4274.htm. 
Mr. Jeff Huther 

August 9, 2006 

Page 19 

c. Maturity and Settlement Timings 

 

The Association further believes that, whatever fee rate is chosen, both the maturity and 

settlement timings should be set in a way so that market participants will borrow from the 

Lending Facility only when conditions are extreme and it is expected that they would remain 

extreme for a significant period of time. For example, delayed settlement of the borrowing -- 

T+5 was suggested in the White Paper – is appropriate and would ensure that a market 

participant borrowing from the Treasury believes that the fails event is truly chronic and that 

the ancillary costs of continuing to fail (labor costs, capital costs, and relationship costs) are 

such that the market participant is willing to wait to secure the securities and that the 

securities will not become available in the market. However, there may be circumstances 

where it may be necessary, because of catastrophic settlement disruptions, to make securities 

available on an immediate basis. The criteria for making this determination should be 

objective and publicly available. 

Furthermore, the logic of severe and extended market disruption would support a structure 

that requires borrowing for a term rather than for overnight and the Association believes that 

in order to ensure that the facility is used very rarely, both delayed settlement and term 

transactions with a term not under a week be utilized. 

d. Reporting 

With respect to reporting, the Association believes that if the structure of the facility, 

particularly the economic, settlement and term parameters, is designed appropriately for use 

only during extreme circumstances, reporting daily cash, repo, and futures positions, and fails 

to deliver and receive in the security borrowed over the period bracketing the time of 

borrowing would be unduly burdensome on dealers that make use of the facility. As Treasury 

has noted throughout the White Paper, its intent is that the Lending Facility be used only 

during extreme market conditions. We believe that during such periods of extreme market 

stress personnel within firms will be focused on sourcing bonds, maintaining appropriate 

levels of capital and working with customers. Additional reporting requirements, while a 

marginal disincentive to using the facility, would not significantly add to the Treasury’s 

ability to police the Lending Facility’s use. Treasury continues to have its market surveillance 

tools, the LPRs and the Interagency Working Group, for example, to guard against possible 

inappropriate uses of the facility. 

3. Collateral 

The White Paper suggests that the Lending Facility would lend securities on a bond-for-bond 

basis. The Association believes that this approach serves best the needs of both the Treasury 

and the market. As noted in the White Paper, a bond-for-bond transaction would have no 

effect on the Treasury’s cash position and thus would have minimal impact on Treasury’s 

cash management and the Federal Reserve’s open market operations. However, should the 

Treasury adopt a bond-for-bonds collateral approach we would urge that, particularly if the 

borrowings are for periods beyond one day, a mechanism be put in place that would permit 

collateral substitution as dealers would not want to tie particular bonds for an extended period. 
Mr. Jeff Huther 

August 9, 2006 

Page 20 

4. Available Securities 

Assuming that Treasury designs a pricing mechanism that would attract borrowing from the 

Lending Facility only in extreme market conditions, we believe that any Lending Facility 

should not limit availability to the on-the-run sector but should be available to lend additional 

supply for any outstanding CUSIP. The causes and effects of future extreme conditions are 

impossible to predict and maximum flexibility would be consistent with the underlying 

rationale of the Lending Facility to address any severe disruptions in the supply/demand 

balance in the Treasury market. 

5. Borrowing Mechanics and Public Transparency 

As borrowings from the Lending Facility would immediately affect the available supply of 

securities, we believe that full transparency consistent with the information that the FRBNY 

makes available with respect to its securities borrowing program will be needed. Borrowing 

from the Treasury would be a crucial piece of market information that would need to be 

incorporated into prices immediately in order to address the supply/demand imbalance that a 

Lending Facility would be expected to remedy, and transparency would contribute to the 

achievement of the Lending Facility’s objectives quickly. In addition, transparency would 

prevent, as the White Paper noted, the borrowing firm from gaining an informational 

advantage over other market participants. 

6. Eligible Borrowers 

We agree that any Lending Facility should be limited to primary dealers. The primary dealers 

are the significant market makers in Treasury securities and have the necessary experience in 

dealing with the FRBNY on these types of operations. Full transparency of the rate at which 

securities will be available will allow other market participants to instruct a dealer to borrow 

on its behalf. 

7. Collateral Margin and Valuation 

The Association agrees that appropriate margin, at levels consistent with market norms, 

should be maintained at the Treasury, as this reflects the market convention for these types of 

transactions. 

8. Borrowing Limitations 

The Association believes that specific borrowing limitations should not be necessary if the 

facility is designed in a way that encourages its use only in extreme market conditions. By its 

terms, the Lending Facility should be uneconomic for purposes other than remedying a large 

scale disruption. Treasury could continue to use its other market surveillance tools to ensure 

that any large volume borrowings are for a purpose reflecting the goals of the Lending 

Facility. 
Mr. Jeff Huther 

August 9, 2006 

Page 21 

9. Rollovers/Loan Extensions 

Again, in keeping with the Association position that any Lending Facility should mirror, to 

the extent consistent with its goals, standard market practices for repos and securities 

borrowings, we believe that fails back to the Treasury should not be treated punitively. 

Creating unequal incentives for failing to different classes of counterparties could exacerbate a 

fails situation. 

Thank you for the opportunity to respond to the Treasury’s proposals as outlined in the White 

Paper. The Association and its membership looks forward to working with Treasury on the 

issues raised in the White Paper. Please feel free to contact Robert Toomey (646.637.9224 or 

rtoomey@bondmarkets.com) at the Association should you have any questions or comments 

regarding our response. 

Sincerely, 

/s/ Stephen G. Malekian /s/ John A. Roberts 

Stephen G. Malekian, Managing Director John A. Roberts, Managing Director 

Citigroup Barclays Capital Inc. 

Chairman Chairman 

Funding Division Executive Committee Government Division Executive 

 Committee 

/s/ Robert B. Toomey 

Robert B. Toomey, Vice President and Assistant General Counsel 

The Bond Market Association 

Principal Staff Advisor to the Funding and Government Divisions 

cc: Treasury Department: 

 Randall Quarles, Under Secretary for Domestic Finance 

 Emil Henry, Assistant Secretary for Financial Institutions 

Bureau of Public Debt: 

 Lori Santamorena, Executive Director 

 Michael Sunner, Deputy Assistant Counsel 

Federal Reserve Bank of New York: 

 Dino Kos, Executive Vice President 

 Debbie Perelmuter, Senior Vice President 

 Joyce Hansen, Deputy General Counsel and Senior Vice President 

 Michael Nelson, Vice President 

The Bond Market Association 

 Funding Division Executive Committee 

 Government Division Executive Committee 

 Primary Dealers Committee 

 Micah Green, President 

 Randy Snook, Executive Vice President 

 John Vogt, Executive Vice President 
 August 11, 2006 

BY FEDERAL EXPRESS AND E-MAIL

Mr. Jeff Huther, Director 

Office of Debt Management 

Room 2412 

Department of the Treasury 

1500 Pennsylvania Avenue, NW 

Washington, D.C. 20220 

Re: Comments on Securities Lending Facility – 71 Fed. Reg. 26174 (May 3, 2006)

Dear Mr. Huther: 

The Board of Trade of the City of Chicago, Inc. (“CBOT®” or “Exchange”) appreciates 

the opportunity to comment on the Department of the Treasury’s (“Treasury”) request for 

comment regarding whether it should establish a securities lender of last resort facility 

(“SLLR”). 

The CBOT is one of the world’s leading and most liquid derivatives exchanges based on 

contract volume. Our flagship U.S. Treasury products include futures and options on 30-

Year U.S Treasury Bonds, and futures and options on Ten-Year, Five-Year, and TwoYear U.S. Treasury Notes. The Exchange’s U.S. Treasury futures and options play an 

important role in the interest rate risk management strategies of a number of foreign and 

domestic market participants, including governmental entities, banks, insurance 

companies, pension funds, and mutual fund managers, among others. Approximately 

535 million futures and options contracts on U.S. Treasury securities were traded on the 

CBOT in 2005, representing a notional value of approximately $55.6 trillion.

The Exchange shares the Treasury’s interest in the maintenance of a safe, liquid and 

efficient U.S. Treasury securities market. At the same time, the CBOT desires to 

continue to be able to provide fair, efficient and orderly U.S. Treasury futures and options 

markets. The Exchange commends the Treasury’s continued proactive approach to 

promoting market efficiency in the Treasury securities market and the broader financial 

markets through its consideration of a proposed SLLR. 

The liquidity of the cash Treasury market and the ease of arbitrage between the cash and 

futures markets can either facilitate or impair the process of convergence of cash and 

futures prices. It is precisely this convergence of the two prices that makes a futures 

contract relevant and useful for market participants. The increased incidence of fails in 

recent years in the cash Treasury market, and especially in the Treasury repurchase 

market, has eroded trade certainty in the cash Treasury market in ways that impair the 
Mr. Jeff Huther 

August 11, 2006 

Page 2 of 2 

ability of market participants to perform cash-futures arbitrage. Therefore, we believe 

that the Treasury’s implementation of an SLLR would have a positive impact on the 

Treasury securities and futures markets by making available an additional, temporary 

supply of Treasury securities in those instances when market shortages might threaten to 

impair the functioning of these markets. 

The CBOT stands ready, in its role as the leading U.S. Treasury futures and options 

marketplace, to assist the Treasury with respect to the appropriate structure, including 

terms and conditions and other operational details, at such time as the Treasury 

determines to move forward in implementing an SLLR. 

If you have any questions, please feel free to contact Anne Polaski, Assistant General 

Counsel, at (312) 435-3757 or apolaski@cbot.com. 

 

Sincerely, 

 Bernard W. Dan