Regulatory Structure

Rather than creating a separate agency to issue and enforce new regulations for government securities, the GSA relied on the existing regulatory structure. Generally, an entity that previously had been regulated or supervised by the SEC or a federal bank regulatory agency⁶ continues to look to that agency for oversight. Previously unregistered brokers or dealers were required to register with the SEC and join a self regulatory organization (SRO),⁷ usually the National Association of Securities Dealers (NASD). Newly registered government securities brokers or dealers are subject to SEC oversight. The NASD imposes sales practice standards on its members, including government securities brokers and dealers.

The primary rule-making authority under the GSA is vested in the Secretary of the Treasury (Treasury), although this authority is exercised after consultation with the other government securities regulatory agencies. The GSA required the Treasury to adopt rules and regulations implementing the GSA concerning (i) financial responsibility, (ii) protection of investors’ securities and cash balances on deposit with the dealer, (iii) recordkeeping, (iv) reporting, and (v) audit. Treasury proposed and published final rules pursuant to the GSA shortly after its enactment in 1987.

The GSA was not materially amended until 1993 when the U.S. Congress enacted the Government Securities Act Amendments of 1993 (1993 Amendments), which required, among other things, that the Treasury issue additional rules concerning recordkeeping and large-position reporting. Such rules were finalized by the Treasury in 1996. The 1993 amendments also authorized the bank regulatory agencies to issue rules concerning sales practices for financial institutions acting as government securities brokers or dealers, and allowed the NASD to subject the government securities business of its members to the NASD’s sales practice rules.

Government Securities Brokers and Dealers

The provisions of the GSA concerning registration, financial responsibility, customer protection, and recordkeeping apply to government securities brokers and government securities dealers. The GSA defines government securities broker, generally, as any person regularly engaged in the business of effecting transactions in government securities for the account of others. Government securities dealer, generally, includes any person engaged in the business of buying and selling government securities for its own account.

Registration

The GSA requires any government securities broker or government securities dealer (other than a broker or dealer already registered with the SEC or a financial institution)⁸ to register with the SEC if it engages in a government securities business. Entities previously registered with the SEC as brokers or dealers were only required to file a notice with the SEC that they intended to carry on a business in government securities. Financial institutions were required to notify their appropriate bank regulatory agency. With respect to those entities registering with the SEC as government securities brokers or dealers for the first time, the SEC may either grant the registration or institute proceedings to determine whether the registration should be denied. Entities that cease to be government securities brokers or dealers must notify the SEC or the appropriate bank regulatory agency that they no longer intend to engage in a government securities business. The SEC maintains, for public inspection, a central depository of the notifications and registrations made pursuant to the GSA, even if they are made to one of the other agencies.

The GSA further requires any government securities broker or dealer required to register with the SEC to become a member of a national securities exchange or the NASD. The national securities exchange or NASD has responsibility for providing rules for its members and for enforcing compliance with the GSA and rules promulgated thereunder.

Financial Responsibility

Treasury rules include minimum capital requirements for government securities brokers or dealers not subject to either the capital requirements of the SEC or an appropriate regulatory agency if the government broker or dealer is a financial institution. These rules require government securities brokers and dealers to maintain capital sufficient to protect customer assets in the event of a failure of the broker or dealer.⁹

Customer Protection

The GSA required the Treasury to issue rules providing safeguards with respect to the acceptance of custody and use of customer securities, the carrying and use of customer deposits or credit balances, and the transfer and control of government securities subject to repurchase agreements and similar transactions. The customer protection rules largely adopt the nongovernment securities rules promulgated by the SEC, which were designed to protect customer funds and securities held by registered brokers or dealers. These rules require that government brokers and dealers immediately obtain possession or control of all fully paid customer securities. The possession and control rule is designed to ensure that customer securities are maintained free of all liens and encumbrances. Brokers and dealers must also set aside in a special reserve account free credit balances and other amounts owing to customers. Further, a broker or dealer may not use customer free credit balances unless the customer receives regular statements indicating the amount owed to the customer and notifying the customer that such funds are not segregated from funds of the broker or dealer and may be used in its business.¹⁰

The underlying rationale for customer protection rules is to protect customer assets in the event of the failure of the broker or dealer and to prevent unwarranted expansion of a firm’s business through the use of customer funds and securities.

Recordkeeping, Reporting, and Audit

The GSA requires government securities brokers and dealers to make, keep current, and preserve records relating to their business. The required records generally include all records with respect to the purchase and sale of securities, the receipt or delivery of securities, confirmations of purchases or sales, and other records reflecting the government securities business. With respect to repurchase transactions, government brokers and dealers are required to (i) maintain a separate ledger reflecting assets and liabilities resulting from repurchase and reverse repurchase transactions, (ii) record separately on their records those securities subject to repurchase and reverse repurchase agreements, and (iii) maintain copies of confirmations they send out with regard to repurchase and reverse repurchase agreements. Government securities brokers or dealers subject to specific recordkeeping rules of a bank regulatory agency are exempt from the recordkeeping and preservation requirements, except that they must keep records pertaining both to securities positions and to transactions involving associated persons of such broker or dealer.

The reporting and audit regulations generally follow SEC rules for brokers and dealers. Specifically, registered government securities brokers and dealers that clear transactions or carry customer accounts are required to file monthly reports demonstrating compliance with capital adequacy requirements. All registered government securities brokers and dealers are required to file quarterly reports containing unaudited financial statements, and an annual report certified by an independent public accountant. Government securities brokers and dealers are also required to report to the SEC if capital levels are not maintained.¹¹

Repurchase Agreements

Repurchase agreements represent a substantial portion of the daily activity of the government securities market and provide a significant financial and cash management tool for both investors and government securities dealers. The failures of the government securities dealers that led to the enactment of the GSA precipitated investor losses in connection with repurchase agreements between the failed dealers and their customers. Of particular concern to the drafters of the GSA were so-called hold-in-custody repurchase agreements. In a typical hold-in-custody arrangement, the seller of the securities does not deliver the securities out to either the buyer or a third-party agent, but rather retains custody of the subject securities. While not forbidding this type of arrangement, the GSA and the GSA rules adopted a number of requirements designed to protect investors who engage in hold-in-custody repurchase agreements. The rules require disclosure if the dealer will not maintain possession of the securities during the trading day, or, if the dealer wishes to substitute securities for those subject to the agreement, the dealer must obtain, in certain circumstances, the prior permission of the counterparty. The rules also require that repurchase agreements be in writing and contain certain disclosures to alert counterparties to the limited protections available to them should the dealer fail.

The 1993 Amendments to the GSA and the Salomon Scandal

Regulation and supervision of the government securities market was increased as a result of a scandal involving Salomon Inc. (“Salomon”) and certain of Salomon’s activities in the government securities market. As a result of the Salomon scandal and other perceived abuses in the government securities market, the U.S. Congress passed the 1993 Amendments. Salomon’s activities came to light over the course of a lengthy investigation that began in February 1991. The investigation focused on irregularities in connection with the Treasury auction bidding practices of Salomon. As the investigation revealed, Salomon had submitted a number of fraudulent bids at auction, specifically bids for customers never authorized by these customers. The securities that were the subject of the fraudulent bids were, in fact, purchased by Salomon itself, and thus, Salomon received more securities than auction rules permitted. Further, when the fraudulent activity came to the attention of senior management at Salomon, the appropriate government officials were not notified.

Large-Position Reporting

The 1993 Amendments provided for, among other things, rulemaking authority for recordkeeping and reporting requirements pertaining to very large positions in certain government securities. The 1993 Amendments authorized the Treasury to draft rules requiring persons holding, maintaining, or controlling large positions in to-be-issued or recently issued government securities to keep records and file reports of such large positions. The large-position reporting rules envisioned by the 1993 Amendments were to be for the purpose of monitoring the impact in the government securities market of concentrations of positions in government securities and for the purpose of assisting the SEC in the enforcement of the GSA.

The large-position reporting rules adopted in 1996 require any person or entity that controls a position equal to or greater than $2 billion in a specific government security to maintain and preserve certain records that enable the person or entity to compile, aggregate, and report large-position information. If the Treasury requests large-position information, the reporting rules require entities to file a large-position report with the Federal Reserve Bank of New York (FRBNY) if their reportable position equals or exceeds the large-position threshold in a particular government security as specified by the Treasury in the notice requesting the large-position information.¹² These rules provide the Treasury and other securities regulators with information on concentrations of control that enable them to understand better the possible reasons for apparent significant price distortions and the causes of market shortages in certain government securities, and provide them with the tools to understand unusual conditions in the government securities market.

Sales Practice Regulations

The 1993 Amendments provided both the NASD and the bank regulatory agencies with the authority to prescribe sales practice rules for participants in the government securities market. Pursuant to this authority, the bank regulatory agencies adopted rules that were deemed necessary to prevent fraudulent and manipulative acts and practices and to promote just and equitable principles of trade. Further, the 1993 Amendments eliminated the GSA limitations on NASD authority to apply sales practice rules to transactions in government securities by government securities brokers or dealers who are members of the NASD. To implement this expanded sales practice authority, the NASD applied the NASD Conduct Rules to transactions in government securities. The NASD rules and the banking agency rules include a business conduct rule and suitability rule, as well as a suitability interpretation.¹³

The business conduct rules generally require that a government securities broker or dealer and its associated persons (i) observe high standards of commercial honor and just and equitable principles of trade in the conduct of its business, and (ii) have reasonable grounds for believing that recommendations are suitable for a customer based on the facts, if any, disclosed by a customer regarding the customer’s other securities holdings and financial situation and needs. If the government securities broker or dealer is doing business with a noninstitutional customer, the broker or dealer must make reasonable efforts to obtain information concerning the customer’s financial situation and tax status and investment objectives before executing a transaction it has recommended to the customer.

Auction Rules

In July 1995, the Treasury published a Uniform Offering Circular that contained the rules for participation in auctions of United States government securities. Among other things, the Uniform Offering Circular describes the bidding and payment procedures for auctions, including large bidder certification requirements, a 35 percent limitation on the amount of securities any one bidder may take from an auction, and the definition of “single bidder” for purposes of determining such limitation. In order to allow monitoring of concentrations of securities with single entities, with respect to the large bidder certification requirements, a bidder must report the amount of its net long position when the total of all of its bids in an auction plus the bidder’s net long position equals or exceeds $2 billion.¹⁴

Surveillance

Adequate surveillance of the government securities market is necessary if regulators are to detect and address disorderly market conditions. To this end, the principal regulators and supervisors of this market (the Treasury, SEC, Federal Reserve, and the Commodities Futures Trading Commission) have formed a working group (Working Group) to coordinate efforts and share information with respect to this market. Information about the market, generally, is collected in the first instance by the FRBNY and shared by FRBNY with the members of the Working Group. FRBNY is able to gather information because it participates in the secondary market through its business relationships with the primary dealers¹⁵ and through its conduct of the auctions for the original issue of U.S. government securities.

Background on U.S. Government Book-Entry Securities

Government securities are sold, generally, by way of regularly scheduled auctions (held by the Federal Reserve Banks as fiscal agents of the Treasury), which involve public bidding processes. For each auction, the Treasury provides advance public notice of its intent to sell securities of specific types and maturities. Prospective purchasers of large amounts of securities may submit a bid specifying an interest rate yield or discount rate for the securities; others may submit a noncompetitive bid to purchase smaller amounts of the securities at the average bid rate. The Treasury will accept all noncompetitive bids and the lowest competitive bids and proceed to issue the securities. In the past, U.S. government securities were issued only in definitive (certificated) form;¹⁶ government securities are now issued only in book-entry (uncertificated) form.¹⁷

The Treasury will issue a government book-entry security directly into one of two holding systems—the Treasury/Reserve Automated Debt Entry System (TRADES) or “Treasury Direct.” The vast majority of government securities are held in TRADES, which is also known as the commercial book-entry system. Primarily individual investors hold government securities in Treasury Direct. Both natural persons and organizations may hold an interest in a security held in one of the two systems. Interests in government securities generally may be transferred back and forth between TRADES and Treasury Direct.

TRADES is operated by the Federal Reserve Banks as fiscal agents of the Treasury. For government securities within this commercial book-entry system, persons hold interests in securities in a “tiered” system of ownership. The top tier holders have direct securities accounts in their own names with a Federal Reserve Bank. As a general matter, only banks and other depository institutions are permitted to maintain accounts with a Federal Reserve Bank; these account holders are known as “Participants.” While Participants may be the beneficial owners of interests in government securities, Participants often hold interests in securities in their accounts at Federal Reserve Banks on behalf of other individuals or organizations that do not have accounts. The beneficial owner may be a direct customer of the Participant or may hold its interest through one or more tiers of securities intermediaries.¹⁸

The following diagram illustrates one possible example of a chain of ownership established within the tiered structure of TRADES. Here, the beneficial owner is an individual who holds an interest in a government book-entry security with a broker or dealer, which in turn holds an interest through an account with a Participant, which in turn has an interest in the security recorded in the Participant’s own account with a Federal Reserve Bank.

Persons holding an interest in government securities in Treasury Direct, on the other hand, hold their securities accounts on records maintained by the Treasury through its fiscal agents, the Federal Reserve Banks. The primary characteristic of Treasury Direct is that the beneficial owner has a direct account relationship with the Treasury.¹⁹ Treasury Direct offers the sole means by which investors, other than depository institutions with direct accounts at the Federal Reserve Banks, may establish an account relationship with the Treasury. Within the past year, the Treasury has expanded the ability of investors to sell in the secondary market securities held in Treasury Direct. An investor may continue to transfer his or her interests in securities to an account he or she maintains with a broker or dealer for sale through TRADES. Alternatively, the investor may now authorize a Federal Reserve Bank²⁰ to sell the securities in the secondary market on the investor’s behalf. Nonetheless, since Treasury Direct provides a less fluid mechanism for secondary market transfers of securities and does not generally recognize pledges of securities, this system is best suited for individual investors who plan to purchase and hold government securities until maturity.

Law Governing TRADES

The commercial book-entry system is governed by regulations issued by the Treasury (the TRADES regulations).²¹ The TRADES regulations were developed in the context of a broad revision of the commercial law governing securities in book-entry form. The old legal framework envisioned a holding and transfer system for uncertificated securities that essentially mirrored the holding and transfer system for definitive securities. It was assumed that each change in ownership of an interest in a book-entry security would be reflected on the books of the issuer. Thus, the only difference between the transfer of definitive versus book-entry securities would be that while a transferor of the former would have to surrender an endorsed certificate for registration of the transfer, a transferor of the latter would instead send an instruction to the issuer directing it to register the transfer on its books.

The assumption under the old legal framework—that all transfers of interests in book-entry securities would be registered on the books of the issuer (or its transfer agent)—was not followed in practice. Instead, the modern securities transfer system emerged as a tiered holding system: the majority of transfers were effectuated through offsetting entries on the books of a clearing corporation or securities intermediary, rather than on the books of the issuer. A new legal framework was developed in the TRADES regulations and in revisions of State law²² to address the issues raised by the tiered holding system.

The TRADES regulations delineate the rights and obligations of the Treasury and the Federal Reserve Banks with respect to government securities held in the commercial book-entry system and provide that such rights and obligations are governed exclusively by federal law.²³ The regulations also provide that the rights and obligations of persons that hold an interest in government book-entry securities indirectly through a securities intermediary are governed by state law, specifically Revised Article 8 of the Uniform Commercial Code.²⁴

The TRADES regulations contain detailed choice of law rules to determine whether federal or state law applies, and in the latter case, which state’s law should be applied to a given interest in a security.

The Tools of Monetary Policy in the United States

Open market operations in practice are currently confined to purchases and sales of existing government securities in the secondary market. When the Desk, acting on behalf of the FOMC, buys securities from a private counterparty in the market, it pays for its purchases by crediting the reserve account maintained at the Federal Reserve by the correspondent bank designated by the counterparty. Such purchases directly increase reserve supplies in the banking system and add to the portfolio of securities in the SOMA; sales of securities out of the SOMA reduce reserve supplies.

Current policy directives issued by the FOMC to the Desk specify a desired level for the overnight federal funds rate, which is the interest rate commercial banks and other depository institutions pay to borrow from other banks’ reserve balances maintained at the Federal Reserve. The Desk attempts to meet this objective by using open market operations to adjust the supply of reserves.

Open market operations are formulated in conjunction with the other instruments available to the Federal Reserve to influence either the supply of or demand for reserve balances—reserve requirements and discount window borrowing. The Board of Governors of the Federal Reserve System sets reserve requirement ratios within the parameters set forth in the Monetary Control Act of 1980, which require depository institutions to hold reserves in the form of either vault cash or reserve balances on deposit at District Banks in proportion to their own deposit liabilities. Current reserve requirements apply only to transactions deposits, with a top fractional requirement of 10 percent. The Board has only changed reserve requirements infrequently over the past decade.

Banks and other depository institutions must meet reserve requirements on a two-week average basis. This ability to average reserve balance holdings over two-week maintenance periods to meet requirements provides banks with flexibility in managing their daily reserve balance positions. Banks are penalized if they fail to meet their reserve requirements, while they also have little incentive to hold more reserves than needed to meet requirements because the Federal Reserve pays no interest on reserve balances. Thus, the aggregate level of reserve requirements provides the Desk with a good indication of banks’ demand for reserves, at least averaged over a two-week maintenance period.

Banks may borrow reserve balances to meet short-term liquidity needs directly from the Federal Reserve at the discount window under the adjustment credit program.¹ Directors of the 12 District Reserve Banks propose changes in the discount rate, subject to the approval of the Board of Governors. Adjustment credit, which is collateralized, is granted at the discretion of the discount window and only for appropriate reasons, although these reasons are set by guidelines rather than fixed rules. Banks may borrow only when they have no alternative to avoid ending a day overdrawn or if they would fall short of meeting their reserve requirements at the end of a maintenance period. A borrower must first seek other reasonably available sources of funds before turning to the discount window. Discount officers routinely monitor banks’ requests to ensure that they are made for appropriate purposes. For this reason, borrowing at the discount window is normally quite light even though the discount rate is lower than the federal funds rate. Nonetheless, when reserve balances are in short supply, banks will borrow at the window, but usually only after market rates have been bid substantially higher.

Operating Procedures

The Desk’s operating procedures are designed to control the supply of reserve balances so that they conform to the aggregate demand depository institutions have for holding these balances because the federal funds rate will usually trade around the targeted level when the available supply of reserves is in line with demand. Open market operations are the tool used to adjust reserve supplies so that they will equate demand. Demand for reserve balances is largely set by the level of reserve requirements, while the discount window operates as a safety valve to control pressures in the interbank market in the event of an unanticipated reserve shortage.²

While control over the federal funds rate is maintained by using open market operations to align reserve supply with estimated demand, the transparency of the FOMC’s policy objective also helps to keep the funds rate close to its targeted level. Since February 1994, the FOMC has publicly announced all changes in its policy directive immediately after they have been made. This transparency enables changes in the desired funds rate to be immediately incorporated into all financial variables. At the same time, transparency about the current objective for the funds rate helps the Desk maintain the funds rate near its desired level by providing market participants with a clear sense of what the Desk’s operations are, or will be, aimed at achieving. Market awareness of the policy objective, along with competition among market participants, can prevent the funds rate from diverging far from its targeted level even when transitory reserve imbalances arise, and can hasten the return of the funds rate to its intended level when divergences do arise.³

Central Role of Financial Markets in Implementing Policy

The effectiveness of the Desk’s current practices used to implement monetary policy rest on the efficiency of two sectors of the money market: the federal funds market and the market for repurchase agreements (RPs). The primary policy guide used by the Federal Reserve is the overnight federal funds rate. By convention, a decline in the targeted level of the federal funds rate is associated with an easing in the stance of monetary policy, while a rise in the rate constitutes a tightening. Changes in the funds rate will influence longer-term rates and other financial prices, and thereby affect the aggregate level of economic activity. From the perspective of the Desk, the federal funds market is the mechanism by which reserve balances created by open market operations are distributed throughout the banking system; and the result that the funds rate will remain close to target when aggregate reserve supply equals demand rests upon an efficient distribution of available reserve supply.

Open market operations used to adjust the aggregate supply of reserves are conducted in the government securities market. Most of these operations are structured as RPs, although permanent transactions also play an important role in the Desk’s management of reserves. The counterparties to the Desk’s market operations are “primary dealers” active in the government securities market. Thus, as a general rule, the Desk does not intervene in nor do its counterparties participate directly in the federal funds market that the Desk is trying to influence with its operations.

Organization of the Financial Markets Used to Implement Monetary Policy

The Desk’s Market Counterparties

The counterparties of the Federal Reserve Bank of New York in the execution of domestic open market operations, called “primary dealers,” are all active participants in the secondary market for government debt. The primary dealer arrangement has facilitated the Desk’s ability to transact efficiently in the RP market to affect the level of bank reserves as well as to conduct other business. The relationship between the Desk and the dealers also provides a means for the exchange of information regarding financial markets that is useful for the implementation and formulation of monetary policy.

Primary dealers are expected to participate in the primary market for Treasury securities. Primary dealers have a responsibility to provide reasonably competitive bids at every Treasury auction, and to purchase securities at auctions over time. As a result, the primary dealer community facilitates the efficient issuance and distribution of U.S. Treasury securities.

Federal Reserve Balance Sheet and Factor Behavior

The structure of open market operations in the United States is driven by the behavior of the market factors that shape the composition of the balance sheet of the Federal Reserve. In sheer size, assets on the Federal Reserve balance sheet are dominated by the SOMA portfolio of domestic securities, which totaled $448 billion at the end of 1997, the result of many years of cumulative purchases made by the Desk.⁶ Foreign currency and gold holdings totaled $37 billion while most other assets were relatively small in magnitude. Currency in circulation, far and away the greatest liability, totaled $480 billion at the end of the year. Commercial bank deposit balances currently range from $15 billion to $20 billion on most days, and other Federal Reserve liabilities are relatively small.

Most of the expansion of the SOMA over the years has supported the steady growth of currency. But day-by-day, open market operations are most actively used to counter the impact that erratic, often temporary, movements in many of the other factors outside the control of the Desk have on reserve supplies. Most notably, the balance maintained by the U.S. Treasury at the Federal Reserve is subject to large and often unpredictable daily swings. The Federal Reserve cooperates with the Treasury to target a $5 billion working balance for the Treasury at the Fed, investing the remainder of Treasury’s cash holdings in commercial bank deposits. But the Treasury balance is still subject to uncertainty associated with unpredictable government receipts and payments that flow directly through their Fed account. Swings in other assets and liabilities on the balance sheet—cash items in the process of collection (float), foreign deposits, etc.—can have an equally unpredictable impact on reserve supplies on any day. The Desk’s operating procedures rely on balancing reserve supply with demand daily, so movements in any of these factors that affect reserve supply can create a need to arrange offsetting open market operations.

Intervention Techniques

The Desk has developed several intervention techniques to manage reserve supplies, which are summarized in Table 1.

Table 1.

Reserve Impact of Open Market Operations

Table 1.

Reserve Impact of Open Market Operations

Description	Direction	Duration	Counterparty	Frequency
Repurchase agreements	Add	Temporary	Primary Dealers	Frequent
Matched sale-purchase agreement	Drain	Temporary	Primary Dealers	Occasional
Outright market purchase	Add	Permanent	Primary Dealers	Occasional
Outright market sale	Drain	Permanent	Primary Dealers	Uncommon
Purchase/sale with foreign accounts	Add/Drain	Permanent	Foreign Accounts	Irregular
Redemption of maturing holdings at auctions	Drain	Permanent	Treasury	Irregular
Exchange of maturing holdings at auctions	Neutral	Permanent	Treasury	Weekly

View Table

Table 1.

Reserve Impact of Open Market Operations

Description	Direction	Duration	Counterparty	Frequency
Repurchase agreements	Add	Temporary	Primary Dealers	Frequent
Matched sale-purchase agreement	Drain	Temporary	Primary Dealers	Occasional
Outright market purchase	Add	Permanent	Primary Dealers	Occasional
Outright market sale	Drain	Permanent	Primary Dealers	Uncommon
Purchase/sale with foreign accounts	Add/Drain	Permanent	Foreign Accounts	Irregular
Redemption of maturing holdings at auctions	Drain	Permanent	Treasury	Irregular
Exchange of maturing holdings at auctions	Neutral	Permanent	Treasury	Weekly

Almost all these operations are arranged in the secondary market for Treasury debt. Operations can be distinguished by whether their impact on reserve supplies is permanent or temporary. Given the day-to-day volatility in the factors that can affect the supply of reserve balances, temporary RP operations are heavily used by the Desk. As a general rule, permanent changes in the portfolio through outright operations are arranged when reserve estimates indicate an upcoming interval of extended and large reserve shortages or surpluses, usually lasting at least a few maintenance periods. Temporary operations are used to fill the remaining gaps between reserve demand and supply, the exact size of which may fluctuate from day to day.

Under an RP the Desk buys securities from dealers who agree to repurchase them at a specific price on a future date. The added reserves are extinguished automatically when the RPs mature. Because of the flexibility the Desk has in setting the size and maturity of RPs, they are an ideal instrument for offsetting day-to-day fluctuations in reserves arising from movements in operating factors. Moreover, the liquidity of the RP market ensures that the Desk can arrange RPs of varying size as needed without regard to possible impact on market rates. By combining RPs of varying size and duration, virtually any daily pattern of reserve needs can be addressed. The FOMC currently authorizes the Desk to arrange temporary operations for up to 60 days.

RPs can be arranged very quickly, as they require few staff for planning or execution. The dealer has the right to choose the specific securities to deliver to the Fed from all outstanding Treasury issues and other eligible debt issued by government sponsored agencies. Once an RP settles, dealers are not allowed to substitute collateral delivered to the Fed except on RPs longer than 14 days in duration, but the Desk reserves the right to request substitution of the dealer at any time. Settlement occurs that same day, although on one occasion the Desk did arrange an RP that settled two business days after it was arranged.

Term System RPs, those of more than one business day, may be specified by the Desk as being either fixed or withdrawable. Under a withdrawable RP, a primary dealer has the option to unwind any portion of its outstanding RPs with the Desk before the maturity date. (The Desk reserves this right for itself on all the RPs it arranges.)

To drain reserves on a temporary basis, the Desk can arrange matched sale-purchase agreements (MSPs) with the dealers, effectively reverse RPs. The Desk will select the specific securities from the SOMA to sell in return for cash payments from the dealers. Usually just a single Treasury bill is selected. Because the Desk mostly positions itself through the size and timing of its outright operations to leave reserve shortages that must be addressed with temporary operations, MSPs have been arranged infrequently in recent years.

Outright purchases by the Desk are arranged with much less frequency than RPs, although over time they have accounted for the cumulative buildup in the SOMA portfolio.⁷ Large purchases are usually arranged in the secondary market for Treasury debt, but transactions may be arranged internally with foreign institutions that wish to sell some of their holdings.

Morning Estimation and Decision-Making Routine

The management of daily liquidity begins with the preparation of separate estimates of the demand for and the supply of reserves. The demand for reserves is largely driven by the level of reserve requirements. Under lagged reserve requirements in effect since August 1998, reserve requirement levels are known at the start of a maintenance period, based on deposit information provided by banks to the Federal Reserve. Large depository institutions (those with total deposits of $75 million or more) submit a report each week showing daily data for transactions deposits with a one-week lag. Smaller banks submit less frequent and less detailed reports. A subset of about 120 of the largest banks submit daily reports by telephone on their deposit information from two days previously. All these reports provide the Federal Reserve with data to calculate and assess reserve requirements for the banking system as a whole.

Staff projects the supply of balances that banks will have on deposit with the Federal Reserve. Independent projections are made of all the various asset and liability accounts on the Federal Reserve balance sheet using a combination of econometric models, extension of recent trends, and on the basis of established seasonal patterns. The separate estimates of all the individual balance sheet items are prepared each morning under very tight time constraints. Final projections are pulled together usually between 9:30 and 10:00 a.m. Projections of reserve supply arising from each market factor are made for that day and all remaining days in the maintenance period under way.

The Desk works with the U.S. Treasury to target a stable balance in its Fed account of about $5 billion, using projected daily government receipts and payments to manage the Treasury’s Fed balance. Each morning at 10:00 a.m. the staff’s projections are compared with the Treasury’s own independent forecasts during a conference call. At this time decisions are made whether to transfer funds between the Treasury’s account at the Fed and its accounts at commercial banks, so as to maintain a constant balance at the Fed and to prevent bank reserves from being affected by Treasury receipts and expenditures.

The manager of the SOMA and staff review the latest reserve estimates and monitor the federal funds market by viewing quotes transmitted on information screens and by calling market participants. Each day, the strategy for meeting reserve needs over the remainder of the maintenance period is reviewed and a decision is made about the type and size of any open market operation that might be needed that day. These decisions are based on the latest reserve information, a judgment about the risks to these estimates, and a sense for the market’s appetite for liquidity.

At about 10:20 a.m., the manager or his deputy and a few staff members participate in a telephone conversation with senior staff at the Board of Governors and with one of the presidents of a District Federal Reserve Bank outside of New York who is currently a voting member of the FOMC. During this brief call, the staff reviews reserve conditions and developments in the money markets and presents the manager’s plan for open market operations for comment. Operations to affect reserve supplies are typically executed immediately after the morning conference call is completed, currently around 10:30 a.m.

Organization of Market Operations

Open market operations in the United States are executed using an electronic network linking the Desk to all the primary dealers. To initiate an operation, a message indicating the type of operation, maturity if a temporary operation, and deadline for submission of propositions is sent simultaneously to all the dealers over this network. For temporary operations, about 10 to 15 minutes is provided for submitting propositions, and somewhat more time is allowed for permanent operations.

Propositions from all the dealers are aggregated so that specific dealer information is not reviewed during the selection process. However, data pertaining to individual dealers can be viewed if desired to deal with any problems that may arise during submission.

After the submission deadline, propositions for temporary operations are summarized on a computer terminal screen, with the amount offered at the best price (highest rate on RPs) listed on top and other propositions listed in descending order of price attractiveness. This manner of presentation allows for quick selection. On outright operations, propositions on a range of securities is presented. For each security, propositions are arrayed in descending order of attractiveness (lowest price on purchases).

Selections are made by marking all accepted propositions with a keystroke on the computer screen. Propositions are awarded using a multiple price auction format. When selection is complete, each dealer is informed electronically which of its propositions have been selected, and the dealer can then prepare to deliver or receive securities.

Legal Structure: The Master Open Market Agreement

FRBNY has entered into a Master Open Market Agreement (MOMA) with each primary dealer. The MOMA covers repurchase transactions and matched sale/purchase transactions, and is based on the September 1996 version of a Master Repurchase Agreement (PSA Master) published by the Public Securities Association, a U.S. bond industry trade group.⁸ Consistent with the PSA Master, the MOMA provides both parties with a number of legal protections. These protections include (i) characterizing the transactions as purchases and sales, (ii) establishing margin levels and procedures for the settlement of margin calls, (iii) prescribing the remedies available to a party in the event of a counterparty default, and (iv) ensuring the availability of the protections contained in the United States bankruptcy code applicable to repurchase transactions.⁹ In addition, the MOMA contains a number of provisions required to accommodate the unique characteristics of FRBNY’s open market operations.