Operating Policy

Administration of Relationships with Primary Dealers

January 22, 1992
The Federal Reserve Bank of New York (New York Fed) is adopting certain changes in the administration of its relationship with primary dealers in U.S. Government securities. The primary dealer system has been developed for the purpose of selecting trading counterparties for the Federal Reserve in its execution of market operations to carry out U.S. monetary policy. The designation of primary dealers has also involved the selection of firms for statistical reporting purposes in compiling data on activity in the U.S. Government securities market. These changes in the administration of these relationships have been developed after consultation with the Federal Reserve Board, the Federal Open Market Committee, the Treasury and the Securities and Exchange Commission.

The changes announced today have been prompted by two related factors:

First, decisions have been made to accelerate the automation of Treasury auctions and Federal Reserve open market operations with a view toward increasing the efficiency of the auction process and open market operations, and providing the potential for further broadening the base of direct participation in these operations. These automation initiatives are major undertakings, as they must be planned and executed with extreme care to ensure operating and communications systems of the highest level of reliability and integrity. They will require back-up systems comparable to those now in place for the Fed's funds and securities transfer systems. Planning for automation of the existing Treasury auction format is well underway and automation is scheduled for completion by the end of this year. Automation planning for Federal Reserve open market operations is just getting started, and completion of this automation will probably take about two years.

Second, and more important, while the system of designating primary dealers on the whole has served the Federal Reserve, the Treasury, and the nation well for many years, there also have been some drawbacks to the existing arrangements. Prominent among these is the public impression that, because of the Federal Reserve Bank's standards for selecting and maintaining these relationships, the Fed is in effect the regulator of the primary dealer firms. Moreover the primary dealer designation has been viewed as conferring a special status on these firms that carries with it elements of "franchise value" for the dealer operation and possibly for other aspects of the firm's standing in the marketplace.

The net result of these interrelated factors is that the Federal Reserve is amending its dealer selection criteria to begin providing for a more open system of trading relationships, while still exercising the discretion that any responsible market participant would demand to assure itself of creditworthy counterparties who are prepared to serve its needs.

For the most part, the changes in the administration of the primary dealer relationships will have no immediate effect on existing primary dealer--recognizing, of course, that they will, over time, be subject to the requirements noted below for maintaining a counterparty relationship with the Fed. However, existing as well as any new primary dealers will no longer be required to maintain a one percent share of the total customer activity reported by all primary dealers in the aggregate; this requirement is no longer deemed necessary given the active and liquid state of development now achieved in the U.S. Government securities market, and its retention could be an obstacle to achieving more open trading desk relationships. In addition, while continuing to seek creditworthy counterparties, and while continuing to exercise market surveillance, the New York Fed will discontinue its own dealer surveillance activities relating to primary dealer firms' financial characteristics.

New firms will be added on the basis of criteria listed below. As in the past, all primary dealers will be expected to (1) make reasonably good markets in their trading relationships with the Fed's trading desk; (2) participate meaningfully in Treasury auctions and; (3) provide the trading desk with market information and analysis that may be useful to the Federal Reserve in the formulation and implementation of monetary policy. Primary dealers that fail to meet these standards in a meaningful way over time will have their designation as a primary dealer discontinued by the New York Fed. It is contemplated that each dealer firm's performance relative to these requirements will be reviewed on an ongoing basis and evaluated annually beginning in June 1993. If a firm's relationship with the New York Fed is discontinued because of shortfalls in meeting these standards, the action by the New York Fed will be made strictly on a business relationship basis. As such, any decision by the New York Fed will carry no implication as to the creditworthiness, financial strength or managerial competence of the firm.

In evaluating a firm's market-making performance with the trading desk, the New York Fed will look to the amount of business of various types actually transacted and the quality of the firm's market-making and market commentary. Dealers that do little business with the Fed over a period of time, that repeatedly provide propositions that are not reasonably competitive, and that fail to provide useful market information and commentary, add little to the Fed's ability to operate effectively and will be dropped as counterparties for at least six months.
In evaluating participation in Treasury auctions, the Fed will expect a dealer to bid in reasonable relationship to that dealer's scale of operations relative to the market, and in reasonable price relationship to the range of bidding by other auction participants. Any decision to suspend a primary dealer designation because of inadequate auction bidding will be taken in close consultation with the Treasury.

Finally, consistent with the Omnibus Trade & Competitiveness Act of 1988, a foreign-owned dealer may not be newly designated, or continue to be designated, in cases where the Federal Reserve concludes that the country in which a foreign parent is domiciled does not provide the same competitive opportunities to U.S. companies as it does to domestic firms in the underwriting and distribution of Government debt.

I. Criteria for Accepting New Dealers
New primary dealers must be commercial banking organizations that are subject to official supervision by U.S. Federal bank supervisors or broker/dealers registered with the Securities and Exchange Commission. The dealer firms or the entities controlling the dealer firms must meet certain capital standards as follows:

  • Commercial banking institutions must--taking account of relevant transition rules--meet the minimum Tier I and Tier II capital standards under the Basle Capital Accord. In addition, commercial banks must have at least $100 million of Tier I capital as defined in the Basle Capital Accord.
  • Registered broker/dealers must have capital in excess of the SEC's or Treasury's regulatory "warning levels" and have at least $50 million in regulatory capital. Where such capital standards do not apply to a consolidated entity controlling a primary dealer--consistent with the treatment of banks under the Basle Accord--the New York Fed will also look to the capital adequacy of the parent organization.
    The minimum absolute levels of capital specified above (i.e., $100 million for commercial banks and $50 million for broker/dealers) are designed to help insure that primary dealers are able to enter into transactions with the Fed in sufficient size to maintain the efficiency of trading desk operations.

A bank or a broker/dealer wishing to become a primary dealer, must inform the New York Fed in writing. As a part of that notification a prospective dealer must also provide appropriate financial data demonstrating that it meets the capital standards outlined above. The New York Fed will consult with the applicable supervisory body to ensure that the firm in question is in compliance with the appropriate capital standards. When new firms are accepted as primary dealers, the nature and extent of the Bank's trading relationship with the firm will, as under current practices, evolve over time. As a result of this change and the elimination of the one percent market share criterion, there will no longer be any need for individual firms to be considered by the market as "aspiring dealers."

Of necessity, at least for the time being, the number of additional primary dealers will be relatively limited, because of resource constraints on trading desk operations. The selection of this limited number will be dependent on how many can be added without adverse impact on the efficiency of Federal Reserve trading desk operations. Applications received by March 31, 1992, will be evaluated in relation to the foregoing capital standards. If it is not feasible to add all of the qualifying firms as primary dealers, a selection will be made among those firms in a manner that gives primary consideration to their relative capital positions. Following the implementation of automated communications for trading purposes, further expansion in the number of primary dealers will be feasible, and further changes in the criteria for selection also could be considered, although there is no preconception at this time as to what, if any, further changes would be made.

II. Maintenance of Capital Standards
As a result of the adoption of the capital standards for accepting primary dealers, all primary dealers will be expected to maintain capital positions that meet the standards described above on an ongoing basis. Should a firm's capital position fall below these minimum standards, the New York Fed may suspend its trading relationship until the firm's capital position is restored to levels corresponding to these minimum standards. In making such determinations, the New York Fed will look to the firm's primary Federal regulator for guidance as to whether the firm has in place an acceptable plan to restore its capital position in a reasonable period of time. However, in no circumstances will the Bank maintain a trading relationship with a primary dealer that is unable to restore its capital position to the stipulated minimum level within a year. Over time, the maximum grace period of one year may be shortened and would not apply in any event if a firm's capital position were seriously impaired.

III. Elimination of Dealer Surveillance
While the Federal Reserve Bank of New York will continue to seek creditworthy counterparties--and will continue, or enhance, its market surveillance--it is planning to discontinue the "dealer surveillance" now exercised over primary dealers through the monitoring of specific Federal Reserve standards and through regular on-site inspection visits by Federal Reserve dealer surveillance staff. Rather, the New York Fed will seek to act as any reasonably well-informed and responsible firm might behave in evaluating the creditworthiness of its counterparties. Accordingly, the Federal Reserve will expect to receive periodic reports on the capital adequacy of primary dealers, just as any other responsible market participant should expect to receive such reports.

The elimination of the Bank's dealer surveillance activities should be viewed merely as confirmation of the long-standing reality that the Bank does not have--nor has it ever had--formal regulatory authority over the Government securities market or authority over the primary dealers in their capacity as such. The Bank is satisfied that the existing regulatory apparatus over the market and the regulatory apparatus as it applies to dealer firms is adequate--especially in light of changes outlined in the joint Treasury-SEC-Federal Reserve study--and it is satisfied that it can protect itself against financial loss without reliance on formal dealer surveillance.

IV. Sanctions of Primary Dealers for Wrongdoing
The Federal Reserve Bank of New York does not have civil or criminal enforcement authority over primary dealers in their capacity as primary dealers. This consideration and the dictates of fairness and due process require that the disposition of allegations of wrongdoing lies with the Government bodies having such authority--including the U.S. Treasury, the Federal bank supervisor, the Securities and Exchange Commission and the U.S. Department of Justice. In the future, if a primary dealer firm itself is convicted of a felony under U.S. law or pleads guilty or nolocontendere to felony charges under U.S. law for activities that relate directly or indirectly to its business relationship with the Federal Reserve, the firm will be subject to punitive action, possibly including suspension as a primary dealer for six months. Depending on the nature of the wrongdoing the penalty could be more severe, including permanent revocation of a trading relationship.

V. Statistical Reports on Government Securities Activities
The current statistical reporting program is expected to continue unchanged for the time being, but a review is being undertaken to determine how best to adapt this program to an environment in which market surveillance is receiving greater emphasis and a statistical reporting relationship is not necessarily tied to a trading relationship with the Federal Reserve. This review will take into account the needs of the Federal Reserve, the Treasury and the SEC as well as the burden of statistical reporting on dealer firms.

Summary
Taken as a whole, these changes are designed to facilitate an orderly and gradual move to a more open system of primary dealer relationships with the New York Fed while at the same time preserving certain key characteristics of the current system that have been beneficial to the Federal Reserve and the Treasury over the years. Over time, the successful implementation of highly automated systems for Treasury auctions and Federal Reserve open market operations will provide the room and the opportunity for still further changes. However, the desirability of further changes will have to be evaluated against the experience with these modest changes and the need to preserve both the efficiency and flexibility of Federal Reserve monetary policy operations, and the liquidity and efficiency of the market for U.S. Government securities.