Simon M Potter: The Federal Reserve's counterparty framework - past,
present and future
Remarks by Mr Simon M Potter, Executive Vice President of the Markets Group of the Federal
Reserve Bank of New York, at the 2015 Roundtable on Treasury Markets and Debt
Management, Federal Reserve Bank of New York, New York City, 19 November 2015.
* * *
Good evening. I would like to thank the Office of Debt Management for inviting me to speak at
this year's roundtable. This forum provides a valuable opportunity for policymakers,
academics, and market participants to discuss issues related to the primary and secondary
markets for U.S. Treasury securities. I will focus my remarks tonight on the counterparty
framework employed by the Federal Reserve Bank of New York, which directly affects not only
our implementation of monetary policy, but also the underwriting and distribution of Treasury
debt issuance. I will begin with an overview of the objectives that underpin the framework,
continue by describing how those objectives have influenced the historical development of the
primary dealer system, and conclude by looking ahead as the private and official sectors adapt
to the evolving structure of the Treasury market. Before I begin, I would note that the views I
share with you this evening are mine and do not necessarily reflect those of the Federal
Reserve Bank of New York or the Federal Reserve System.1
Principles and objectives
Throughout the history of Federal Reserve operations in financial markets, our approach to
engaging with counterparties has been designed to serve the effective implementation of
monetary policy. The New York Fed, through its Open Market Desk (the Desk), is in the
business of implementing policy as directed by the Federal Open Market Committee (FOMC,
or the Committee), and the Desk has demonstrated a willingness to engage with a wide range
of counterparties to achieve this objective under the guidance of the Committee. In addition to
its role in the implementation of monetary policy, the New York Fed has a number of
responsibilities and duties as the fiscal agent for the U.S. Treasury. We have therefore also
used our counterparty relationships to assist the activities we undertake in support of the
Treasury. Indeed, for decades, the primary dealers have played a critical role not only in open
market operations, but also in the underwriting and distribution of newly issued Treasury
securities.
In addition to carrying out these domestic operations, we stand ready to conduct a number of
foreign exchange operations.2 Foreign exchange counterparties are essential to the successful
implementation of U.S. foreign exchange policy operations, which are conducted by the Desk
but directed and funded generally equally by the Fed and the Treasury. Similarly, the Desk's
foreign reserve management counterparties facilitate operations that are investments of the
Fed's and also the Treasury's foreign currency reserves.
Two other considerations underlie the counterparty framework and support the effective
execution of open market operations and primary issuance of Treasury securities. First, the
Desk has long recognized the importance of transacting with established, regulated market
participants that are capable of settling trades and financing long and short positions reliably
and on a consistent basis in a range of market conditions. Our counterparty framework must
be of an appropriate size to provide adequate execution capacity and competitive pricing.
Second, the execution of domestic open market operations and primary issuance of Treasuries
is facilitated by a liquid, smoothly functioning secondary market for Treasury securities.
The Federal Reserve's abiding interest in promoting the integrity and efficiency of the
secondary market has motivated our recent efforts to join other agencies in analyzing the
events of October 15, 2014, and to understand the implications of the evolution of Treasury
market structure and the increasing incidence of electronic and automated trading. The
Treasury Market Practices Group (TMPG), a private sector group of market professionals
sponsored by the New York Fed, has played an important role in these efforts. Building on
analysis that started before October 15, 2014, the TMPG released earlier this year an updated
set of best practice recommendations and a companion white paper discussing automated
trading.3 As is typical of TMPG initiatives, the group's work on automated trading was
undertaken to support market liquidity amid these changes in the market ecosystem. Much
work remains to calibrate an appropriate response to changes in market structure, and last
month's conference "The Evolving Structure of the U.S. Treasury Market" provided a valuable
opportunity for the official and private sectors to engage in a healthy and open debate on a
range of related topics.4 The conference, organized by the Treasury, the Federal Reserve
Board, the New York Fed, the Securities and Exchange Commission, and the Commodity
Futures Trading Commission, featured a review of the agencies' July 2015 Joint Staff Report
and highlighted a number of key issues, including the adequacy of the Treasury market data
currently available to the public and to the official sector, the impact of the current regulatory
environment on liquidity, and some potential operational risks posed by shifting market
structure and trading behavior.5 The Treasury made clear at the conference that work in this
area is ongoing when it disclosed plans for the agencies to issue in the near future a request
for information on the next steps outlined in the Joint Staff Report.
The Joint Staff Report presented data showing that primary dealers now account for less than
half of trading volumes in the interdealer broker market, but it is important to remember that
this is only a portion of the secondary market for Treasuries. As a forthcoming Liberty Street
Economics blog post will show, when these data on the interdealer broker market are
combined with the dealer-to-customer market data from the New York Fed's Primary Dealer
Statistics, we can see that primary dealers accounted for roughly two-thirds of overall Treasury
market secondary trading volume in April 2014, and about 60 percent on the day of October
15, 2014.6 (see the table) So while the primary dealer share of daily interdealer broker volume
has fallen below 50 percent, primary dealers still account for the majority of aggregate
secondary market trading activity, owing to their important role in the dealer-to-customer
market.
A robust counterparty framework, specifically one that provides reliable execution capacity of
sufficient scale and is facilitated by a liquid and smoothly functioning secondary market for
Treasury securities, aids the Desk in pursuing our objectives with respect to the implementation
of monetary policy and the activities we undertake in support of the Treasury. But these
benefits must be balanced against the cost of maintaining counterparty relationships. Staff time
and resources are required to monitor and manage these relationships to ensure that we are
getting good value not only in terms of trade execution, but also in terms of market monitoring,
an important function that the Desk provides for the benefit of the Federal Reserve System
and the Treasury. A large, diverse set of counterparties can contribute to competitive trade
execution and richer sources of market intelligence, as well as the increased operational
coverage and resiliency that support adaptation to changes in market structure or operating
directives. But diversity also entails complexity and requires initial and ongoing investment in
infrastructure to support a wider range of firm types. Evaluating and onboarding firms, setting
up transactional systems and account arrangements, and monitoring and evaluating
counterparty performance and risk all take time and resources that must be balanced against
the potential benefits of a larger list.7
One final consideration that bears mention is the concept of an imprimatur that some market
participants associate with status as a New York Fed counterparty. Despite this long-standing
perception among some market participants that primary dealer status represents an
endorsement by the New York Fed of a financial institution's creditworthiness or ability to
provide efficient execution of large transactions, we have repeatedly stressed the importance
of other market participants' engaging in their own assessment of potential counterparties'
capabilities. Recent history provides several reminders that the primary dealer designation
provides no guarantee against credit risk or other counterparty risks. While the New York Fed
certainly performs its own due diligence, we do so in pursuit of our unique business objectives,
which may differ from those of private agents. Market participants should therefore be
engaging in the appropriate level of due diligence required by their fiduciary responsibilities in
the context of their specific business requirements. Such independent assessments are in our
collective interest because they foster market discipline and a safer, more secure financial
system.
Primary dealer history
The pursuit of these objectives is reflected in the history of the Fed's counterparty framework,
of which the primary dealer system has long formed the foundation. But before I review that
narrative, I must acknowledge that most of what I know about the history of primary dealers
I've learned from Ken Garbade, who kindly introduced me tonight. Along with his superb
analysis of the evolution of the Treasury market, exemplary work for the TMPG and critical
contributions during the financial crisis, Ken has expertly researched more than 100 years of
history concerning the financial institutions and trading practices that ultimately became the
primary dealer system. Ken has published a staff report covering the early years of this system
from the 1930s to the 1950s, and we expect to publish more of his research on primary dealers
in the future.8
Looking back over the first century of the Fed's history, we can see how our counterparty
relationships have adapted over time in response to changing operational needs and the
evolution of financial markets to create a system that is unique among the world's leading
central banks. Open market operations were first established by the Federal Reserve as a tool
to control U.S. monetary conditions in 1922, in response to uncoordinated purchases of
Treasury securities by different Reserve Banks interested in acquiring earning assets. The
Banks formed an "Open Market Investment Committee" to coordinate their activities, and the
Committee soon began to make policy recommendations to increase or reduce the availability
of reserves to member banks. The Banking Act of 1935 created the modern Federal Open
Market Committee, and the Committee selected the Federal Reserve Bank of New York as its
operating agent.9 The Federal Reserve Act specifies the types of transactions that Reserve
Banks can undertake, but does not designate how they should be undertaken. Although other
possibilities exist, such as public auctions and reverse auctions, for more than 80 years the
Desk has conducted monetary policy operations with bank and nonbank dealers, primarily
because they were the core market makers - that is, liquidity providers - for Treasury
securities.
In 1942, the Fed and the Treasury agreed to cap Treasury yields for the duration of the Second
World War in order to facilitate funding the war effort. By the end of the war, open market
transactions were conducted with a small group of "qualified" dealers. The FOMC set the terms
and conditions of the counterparty relationship. In 1951, the Fed returned to using open market
operations as a tool for maintaining control over the monetary base and restored the
"recognized" dealer program that had been in place before the war.10
8
Kenneth Garbade, The Early Years of the Primary Dealer System (New York: Federal Reserve Bank of New
York, 2015).
9
In fact, the FOMC directs a "Selected Reserve Bank" to conduct open market operations. Since the centralization
of open market operations in a single Reserve Bank in 1935, the Federal Reserve Bank of New York has always
been designated as the Selected Bank, owing in part to New York City's historical importance to U.S. financial
markets.
10
According to Ken's research, "the concept of a recognized dealer was somewhat amorphous. An October 1939
Bank memo remarked that the term was 'not an exact appellation' and noted that 'the principal factors which we
consider in extending such recognition are (1) reputation for integrity, experience, and knowledge, (2) capital at
risk of the business, (3) willingness to make markets under all ordinary conditions and to take positions both
long and short, and (4) large volume [of business] of national scope, with the contacts which such trading
provides.'" (Garbade, The Early Years of the Primary Dealer System, pp. 8-9).
In the early 1960s, a reporting dealer regime was created, featuring reporting on positions and
a public list of the firms that communicated various data to the New York Fed. During the
1980s, in considering new firms for primary dealer designation, Desk staff increasingly looked
for evidence that a firm had a certain share of total customer trading activity. The working
threshold was generally 1 percent, with some fluctuations in this level over time. An explicit
requirement for primary dealers to participate in Treasury debt auctions was added in the
mid1980s. In 1992, following the Salomon Brothers Treasury auction scandal, the Desk altered its
primary dealer requirements and ended its dealer surveillance program, in an effort to eliminate
the perception that it had a regulatory relationship with primary dealers and to encourage more
firms to become primary dealers. Nevertheless, over the following decade, the list of primary
dealers contracted, largely as a result of declining profitability and industry consolidation in the
mid-1990s as well as the departure of some Japanese financial institutions following losses in
their home market. The number of primary dealers declined further with the failure and/or
consolidation of several large dealers during the recent financial crisis, but has begun to grow
slowly again in subsequent years. The last revision of our primary dealer operating policy,
published in 2010, formalized a pro rata Treasury auction bidding requirement for all primary
dealers, which requires primary dealers to bid for their proportional share of each Treasury
offering.11
Relative to domestic open market operations and auctions for primary Treasury issuance,
foreign market operations undertaken with private counterparties to further foreign exchange
policy and the investment of foreign reserves are relatively small and infrequent and have a
somewhat shorter history. The Fed first undertook very limited foreign exchange (sterling)
purchases in the market during the late 1920s and early 1930s in an effort to defend the gold
standard.12 The Gold Reserve Act of 1934 established the U.S. Treasury's Exchange
Stabilization Fund (ESF) to undertake such operations, but the ESF did not exercise its
authority very often until the Bretton Woods fixed-exchange-rate regime came under pressure
in the 1960s. In 1962, the Fed began to undertake foreign exchange operations in cooperation
with the ESF, and the Desk acted as agent for both accounts.
In those early years, the Fed and the Treasury focused on conducting swap operations with
foreign central banks, although some direct intervention with the private-market participants
did take place. In 1973, after the collapse of Bretton Woods, the dollar began to float, and
foreign exchange operations entered a new phase. Over the next two decades, interventions
in the private foreign exchange market became much more frequent and on some occasions
quite large. Since the 1990s, foreign exchange intervention has become less frequent. The
history of foreign reserves investment operations in the market is even shorter; the Desk began
to transact directly with market participants to invest foreign reserves held in the System Open
Market Account and ESF foreign reserves only in the mid-1990s. Before that, the U.S.
monetary authorities held all foreign currency reserves in the form of deposits at other central
banks.
International context
Comparing the Federal Reserve's counterparty framework with those of our foreign central
banking peers highlights a number of differences. To begin with, the Federal Reserve is among
the most transparent of central banks in disclosing the specifics of its market operations,
including the data reported under the requirements of the Dodd-Frank Act. Details about
foreign exchange transactions and foreign exchange investment operations are reported in the
quarterly foreign exchange reports released to the public by the New York Fed. In addition,
summary information about all operations appears on the weekly Federal Reserve balance
sheet, which is available on the Board's website. The Desk posts comprehensive results of all
domestic open market operations with primary dealers and expanded counterparties to the
New York Fed's public website within a few minutes of the operations' completion. Results of
Treasury auctions are likewise released to the public within a few minutes of the close of
competitive bidding and contain considerable detail regarding participation by primary dealers
and both direct and indirect bidders. Such reporting by the Treasury exhibits a high level of
transparency relative to foreign treasuries' reporting.
In most foreign jurisdictions, the central bank or monetary authority has the ability to conduct
open market operations with a large number of banks that make markets in government
securities and also have reserve accounts with the central bank, while the national treasury
separately manages relationships with financial institutions to underwrite and distribute its debt
issuance; these latter entities are termed "primary dealers" and are often the only entities
having access to primary market auctions. In the United States, by contrast, a comparatively
smaller number of firms simultaneously act as counterparties for the central bank's domestic
open market operations and as backstop underwriters and distributors for Treasury debt
issuance; firms designated as "primary dealers" are required to act in both capacities. In fact,
the United States is somewhat unique in that (i) being a "primary dealer" means that the firm
is a counterparty for central bank monetary policy operations and has certain obligations with
respect to primary national debt issuance and (ii) management of the primary dealer system
resides with the central bank rather than the national treasury.
This unique structure is a legacy of history. Beginning in World War I, the Treasury offered
coupon-bearing securities on a fixed-price basis. Small banks and securities brokers
commonly subscribed for their own and customers' accounts, and there was little need for any
formal or informal underwriting process. Market making in outstanding Treasury securities,
however, was a capital-intensive process conducted mostly by nonbank dealers, though a few
banks did have significant dealer operations. These dealers maintained the liquid secondary
market for Treasuries and served as counterparties for open market operations. This state of
affairs continued until 1970, when the Treasury introduced auction offerings of coupon-bearing
debt. Auction participation, like market making, was a risky, capital-intensive activity, and
dealers - especially primary dealers - began to play an increasingly important role in the
primary market. Though the transition was gradual, this period represented the moment in
history when the same set of counterparties began to participate in both open market
operations and the primary issuance of Treasury securities.
Recent changes
More recently, the Federal Reserve's approach to designing an effective counterparty
framework has been informed by our experience of conducting asset purchases as well as
other balance sheet actions and exercises necessary to implement policy in the post-crisis
period. In these years, we have ventured beyond the primary dealers to conduct open market
operations with a wider and more diverse range of market participants. The introduction of
daily reverse repurchase agreement (RRP) test operations in September 2013 required
several years of work by the Desk to establish relationships with an expanded set of
counterparties beyond the primary dealers or entity types that are currently eligible to be
primary dealers, and to develop an approach to evaluating the capabilities of these firms that
is distinct from the process for assessing primary dealers. This expansion is a requirement of
our business needs given the current size of our balance sheet, specifically the need to
maintain appropriate control of short-term interest rates with abundant excess reserves in the
banking system.13 Primary dealers, and entities of the type that are currently eligible to be
primary dealers, which typically exhibit structural demand for cash financing to support
inventories, are unlikely to satisfy this requirement.
To the extent that the ongoing evolution of the structure of the Treasury market, including
technological advancements and changing investor behavior, affects the role of primary
dealers as market makers, it is important to analyze the implications for the Fed's ability to
meet its objectives. The primary dealer system has proven to be very effective for both the
conduct of monetary policy and the issuance of Treasury debt. I am very confident that the
existing counterparty framework - continuing to utilize primary dealers for traditional domestic
policy open market operations, expanding to new counterparty types, as appropriate, for
targeted operations to increase the effectiveness of domestic policy implementation, and
maintaining relationships with a sufficient number of large market participants in the relevant
foreign exchange markets for possible foreign exchange policy and investment operations -
provides enormous capacity to implement a wide range of monetary policies. Moreover, we
have demonstrated a commitment throughout our history to make any adjustments necessary
to ensure a robust and effective operational framework. Toward that end, the Desk presented
at the June 2015 FOMC meeting an update on a review of the counterparty framework, and
indicated that we anticipate regular reviews of the counterparty framework roughly every three
years in the future.14 We look forward to working with our official and private sector partners
represented in this room as we pursue these goals.
Thank you.