PHOENIX--Federal regulators should either reconsider some of the dramatic changes they are making in the primary dealer system or eliminate the system altogether, the Public Securities Association warned in a paper released last week.
"We conclude that a long-term policy choice should be made," the paper says. "Either the system should be completely open, without any designation for those firms that seek to deal with the Federal Reserve because of the inherent value of the relationship, or the system should continue to distinguish such firms by imposing meaningful obligations and conferring commensurate benefits upon them."
The paper was prepared by the PSA's committee on emerging issues in the Treasury market.
The association objects to criteria issued by the Federal Reserve Bank of New York that the paper says "eliminated the requirement to act as an effective secondary-market maker in Treasury securities."
If the changes are combined with the Treasury's plans for a single-price open auction system, the group said that it is concerned there would be fewer market participants willing to bid in a "down" market. The lower volume of bids will bring higher prices to the Treasury market, says the paper.
"If the Federal Reserve wants a system in which primary dealers are to be committed to making secondary markets, it should reestablish the requirement to act as a market maker over the long term with customers," the group said.
The group applauded the Fed's elimination of a requirement that primary dealers each attain a minimum of 1% of total customer volume. But it said that some obligation should exist to ensure that firms seeking primary dealer designation are not doing so "simply as a shortcut to name recognition."
But the report says any obligation, whether at auction or in market making, should be coupled with some positive incentives. "The revised system lacks adequate incentives [for a firm] to seek to become or remain a primary dealer," the report says.
The PSA said that if the Treasury really wants a completely open auction system then "there should be no affirmative obligation on primary dealers to participate meaningfully in every auction." If the Treasury and Fed decide that some obligation is needed, it no longer should be tied to market share, in the absence of a market-making requirement, the group said.
The group, said that if an obligation to participate in auctions continues, the Treasury could consider some incentives to encourage auction participation, as is typical in the primary dealer framework of other countries. When French officials, for example, grant a one-day call option at the auction price to those of its primary dealers that bid successfully in the auction, up to an amount that is proportional to each primary dealer's auction award, the PSA said.
"In general, the Federal Reserve Bank of New York's revised primary dealer system lacks adequate positive reasons to seek the designation or to remain a primary dealer," the report says. "We recommend that the Federal Reserve revisit the criteria and rebalance the obligations and benefits, so that the system will continue to attract strong firms that are committed to the Treasury market."
In the course of this review, the group said, the Treasury and the Federal Reserve should consider instituting broader incentives for primary dealers, such as more flexible lending programs.
The PSA said that whatever policy choice federal regulators make, the market must begin immediately to develop tools to monitor the credit quality of counter parties. The group recommends that the Government Securities Clearing Corp. strengthen its credit standards and expand its monitoring of so-called netting member firms.
The association added that those investors who have relied mainly on the primary dealer designation to determine which dealers are acceptable counter parties are "particularly vulnerable to [any] increased credit risk" that may be introduced to the system. The group said that it has never been good business practice to pressume that primary dealers are the only acceptable counter parties or to assume that they are all equally credit worthy.
The PSA said the Treasury and Federal Reserve should take the initiative to inform investors of changes in the meaning of the "primary dealer" designation, especially public sector investors, many of whom are required by regulation, indenture, or investment guidelines to do business only with primary dealers.
