8A. Regulation of Participants and Transactions in the U.S. Government Securities Market


In the United States, securities brokers and dealers are subject to detailed regulation and supervision to protect investors.1 The lead agency responsible for the regulation and supervision of brokers and dealers is the Securities and Exchange Commission (SEC). Prior to the enactment of the Government Securities Act of 1986 (GSA),2 however, entities whose sole business involved acting as a government securities broker or dealer, unlike other securities brokers and dealers, were not regulated at the federal level, and transactions in government securities3 were not subject to the federal securities laws except the general anti-fraud provisions of the Securities Exchange Act of 1934 (Exchange Act).4

The GSA was enacted in 1986 in response to the tremendous increase in the size of the government securities market and the failure of two unregulated government securities dealers. The failures of these unregulated government securities dealers resulted in significant losses for investors and involved fraudulent activity in the government securities repurchase market,5 particularly the unauthorized use of customer securities. The GSA established, for the first time, a federal system for regulation of brokers and dealers who transact in government securities.

The second section of this article details the current structure for the regulation of government securities market participants mandated by the GSA and implemented through comprehensive regulations. Recent reforms to this structure, reflecting the experience of the government regulators over the first decade after the passage of the GSA, are addressed in detail in the third section of this article.

The fourth and final section of this article details the ways in which brokers and dealers as well as individual investors can hold and transact in an interest in government securities held in the commercial book-entry system. This discussion examines the rights and obligations of interest holders and the federal and state laws applicable thereto.

Regulation of Market Participants under the GSA

The purpose of the GSA is to provide for the integrity, stability, and efficiency of government securities transactions, to ensure that there is adequate regulation of government securities brokers and government securities dealers generally, and to require appropriate financial responsibility, recordkeeping, reporting, and related practices in order to protect investors and to ensure the maintenance of fair, honest, and liquid markets in government securities.

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.


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.

Regulation of the Market

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


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.

Transfers of Interest in 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.




(Account Holder)



(Beneficial Owner)

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.

Rights and Obligations of Holders of Security Interests

The TRADES regulations address the way in which interests in securities held in TRADES are created and perfected. An interest in a government book-entry security is first created when a Participant purchases a security through an auction, and concurrently perfected when the Federal Reserve Bank credits the securities account of the Participant. As a matter of federal law, an interest in a security entered on the books of a Federal Reserve Bank has priority over all other interests in that security, with the sole exception of an interest of the United States marked on the same books. The TRADES regulations generally defer to state law to provide the rules for creation and perfection of all other interests in a government book-entry security not recorded on the books of a Federal Reserve Bank.

Perhaps the most important aspect of the TRADES regulations is that they make clear that neither the Treasury nor the Federal Reserve Banks have any obligation to a non-Participant beneficial owner of an interest in a government book-entry security. For example, the Treasury discharges its obligation to make principal and interest payments when payment is credited to a participant’s account at a Federal Reserve Bank. The rights of a non-Participant beneficial owner, such as for payment of principal and interest, may only be exercised against that owner’s immediate securities intermediary.25

In addition, the TRADES regulations protect the Treasury and the Federal Reserve Banks from conflicting claims to securities. Specifically, the TRADES regulations provide that the Treasury and a Federal Reserve Bank are only required to recognize the interests of Participants in book-entry securities. For example, only a Participant may issue a “Transfer Message” directing the Federal Reserve Bank to transfer an interest in its account to another Participant.26 Debits and credits in connection with a transfer become final at the time the debits and credits are posted to both the Participant/sender’s and the Participant/receiver’s securities accounts, and if appropriate, their funds’ accounts.27

8B. Organization of Open Market Operations in the United States


Operating Target and Procedures for Implementing Monetary Policy

Open market operations are the primary and most flexible instrument for implementing monetary policy available to the Federal Reserve. These operations are directed by the Federal Open Market Committee (FOMC). The head of the Markets Group of the Federal Reserve Bank of New York (FRBNY) is appointed Manager of the System Open Market Account (SOMA) by the FOMC and is responsible for arranging the open market operations. A number of staff units within the Markets Group, collectively referred to as the “Desk,” have day-to-day responsibility for recommending and executing specific operations.

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

Financial Markets and Counterparties for Open Market Operations

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

Federal Funds Market

The federal funds market is the interbank market for borrowing or lending balances held on deposit at the Federal Reserve. Banks and other depository institutions are the largest participants, but some nonbank institutions that hold accounts at the Fed also may participate. Lending in this market is not collateralized. To limit their risk, lenders of funds typically impose credit limits on each of their counterparties. There may be also some tiering in rate by credit quality as well.

The reserve balances that are exchanged in this market rest at the core of the entire financial payments system in the United States. Most financial transactions, including virtually all wholesale payments, are settled when reserve balances are transferred out of the reserve account of the paying depository into the reserve account of the receiving institution. Such transfers total hundreds of billions of dollars each day. The federal funds market is used by banks to offset the net impact of financial payments that otherwise would leave their reserve balance either overdrawn at the end of the day or at a level too far above or below the amount needed to meet reserve requirements.

Trades in this market are almost always for same-day settlement, and the funds market is the last market to close each day, operating until 6:30 p.m. eastern time. Final settlement of federal funds transactions occurs when the instructions of the bank lending funds are received and processed over Fedwire, the electronic network operated by the Federal Reserve. Generally, trades are executed within seconds after an institution sends instructions to the Fed to debit its reserve balance and to credit the balance of the receiving institution.

Many federal funds transactions are arranged through established brokers, who themselves do not trade in this market.4 Institutions wishing to buy or sell funds will contact a broker, who will attempt to arrange a trade with another bank at a mutually agreeable rate. Upwards of $50 billion in federal funds transactions are arranged each day by the largest brokers. Trades can also be arranged directly between banks. Data is not collected on the volume of transactions arranged directly between institutions, but it is probably comparable in volume to the brokered market. Of the many thousands of depository institutions in the United States, a few hundred or so of the larger ones are active in the brokered market. However, smaller banks typically maintain correspondent relationships with larger banks, and may be regular borrowers or lenders of reserves with bigger banks in direct transactions.

Generally speaking, the level of the federal funds rate will be influenced by the balance between the aggregate demand all banks have for holding balances in their Fed accounts at the end of the day and the aggregate supply of reserves. The federal funds rate can become quite sensitive to a level of reserve supply that is either substantially below or above the quantity needed to meet reserve requirements.

The Market for Repurchase Agreements

The other money market critical in the implementation of policy in the United States is the market for repurchase agreements. Under an RP agreement, a purchaser of funds sells securities, pledging to repurchase the securities on a future date at an agreed upon price. The legal structure of some agreements may take the form of a collateralized borrowing of funds or a lending of securities. One particular market segment of special interest to the Desk is the RP market for Treasury and federal agency securities, because these are the types of securities held in the domestic portfolio of the SOMA. The RP market in government securities is much larger than the federal funds market, and is open to a much broader set of institutions. Most trades are arranged for same-day settlement on an overnight basis, although forward and term trades are also quite common.

Cash investors in this market include mutual funds, investment companies, and pension funds that have available funds to invest overnight or on a longer-term basis and that want a liquid and secure investment. Borrowers of cash typically are government securities dealers that hold large inventories of government debt that must be financed. These institutions are often active dealers in the secondary market for government securities and, as a group, hold substantial amounts of Treasury debt that must be financed, up to $30 billion of government securities a day for some of the larger dealers.

The two most common forms of settlement of RP transactions are delivery-versus-payment (DVP) and triparty. Under a DVP transaction, the Federal Reserve transfers securities recorded in electronic bookkeeping form out of the custody account of the seller’s bank into the custody account of the receiving institution’s correspondent bank. These transfers are initiated by the selling institution. The reserve balances of the two correspondent banks will be adjusted simultaneously with the transfer of securities. The securities wire for settlement of securities transactions closes at 3:00 p.m. Under a triparty settlement arrangement, both the sender and recipient of the securities hold custody accounts at a common bank, and any securities exchanged are transferred between subaccounts at the joint custody bank. Because securities are transferred over the Federal Reserve electronic network, transactions can occur later in the day.

The overnight RP rate is determined by the balance between the amount of cash investors wish to place in short-term secure investments, such as RPs, and the financing needs of holders of securities. Swings in the total supply of securities that dealers have to finance and shifts in the level of liquid funds held by investors can affect the RP rate. The overnight RP and federal funds rates generally move in parallel fashion because some participants, notably banks, are active in both markets. However, as a general rule, the RP rate on government securities collateral is a few basis points below the funds rate because RPs are a more secure form of investment. But the spread between the two rates can diverge substantially for brief periods as a result of events that directly affect participants in one of the markets.

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.

Basic Requirements

In order to serve as a primary dealer, a firm must be a commercial banking organization regulated by one of the U.S. Federal bank supervisors, or must be a securities broker/dealer registered with the U.S. Securities and Exchange Commission. Primary dealers must meet certain minimum capital standards on an ongoing basis. Trading relationships with a firm may be suspended if its capital levels fall below the acceptable threshold.

Primary dealers are expected to provide satisfactory performance in three areas: (i) volume and competitiveness of transactions with the Desk, (ii) auctions of U.S. Treasury securities, and (iii) the provision of market information to the Desk that may be useful in the formulation and implementation of monetary policy. The Markets Group of the FRBNY monitors the performance of all primary dealers in each of these three areas. In addition, the Markets Group also monitors the quality of service provided by each dealer from an operational perspective. Primary dealers also have a limited number of statistical market reporting requirements.5

Evaluating Primary Dealer Performance

Primary dealers are each expected to make reasonably good markets to the Desk in its open market operations. Markets Group staff regularly evaluate the market-making performance of each of the primary dealers on its operations. The primary dealer community also serves as the Desk’s available universe of counterparties in the execution of purchases and sales of Treasury securities for foreign central banks, and the dealers are expected to submit competitively priced propositions on these transactions. Each dealer is evaluated on the competitiveness of its pricing and the volume of transactions it completes with the Desk.

Each primary dealer is expected to provide meaningful support to the issuance of U.S. Treasury securities. Dealers are each expected to provide competitive bids at Treasury auctions and to purchase Treasury securities atauctions from time to time. Though it is not a requirement, primary dealers typically play a role in the distribution of new issues. Members of the Markets Group staff monitor and evaluate the Treasury auction performance of each dealer. The staff tracks and evaluates the competitiveness of each dealer’s bids and volume of awards at auctions of Treasury securities. Each dealer’s market share in the secondary trading of Treasury securities is considered when assessing the volume of a dealer’s bids and awards.

Primary dealers are expected to communicate market information to the Desk that may be useful in assessing conditions in the U.S. Treasury and other domestic markets, which may be valuable in the formulation and implementation of monetary policy. Such information may include, but is not limited to, market participants’ expectations of Federal Reserve policy, trading strategies employed in fixed income markets, and market participants’ perceptions of economic data. The Desk utilizes the information provided by primary dealers in the analyses of market developments that it prepares for officials of the Federal Reserve System and, as necessary, to officials at the Treasury Department and other Federal agencies. Information flows from the primary dealers to the Desk are made through frequent phone calls and through periodic, scheduled meetings with their management. Written research and material provided over electronic sources by the primary dealers are also valuable channels of information.

The Markets Group utilizes data and reports regarding relative dealer performance in order to provide critical feedback to management at each of the primary dealers. If, over time, a primary dealer does not perform adequately in trades with the Desk, at Treasury auctions, or in the provision of market information, the FRBNY may move to suspend or discontinue that firm’s primary dealer designation.

Benefits of the Primary Dealer System

From the perspective of a dealer, the primary dealer designation can diversify a firm’s financing sources. As securities firms, most primary dealers are natural demanders of funds to finance their securities positions. Through its ability to transact with the Desk, a primary dealer has access to direct financing from the Federal Reserve.

The primary dealer designation may also increase a firm’s transaction volume, partly in the form of direct trading activity with the Desk. Separately, the ability of a primary dealer to bid at Treasury auctions and to execute financing transactions with the Desk may attract certain customers looking for these services and not willing to pay the costs necessary to establish permanent communication links that would allow them to bid directly at Treasury auctions. However, an entity need not be a primary dealer to bid directly in Treasury auctions.

Types of Counterparties

Over the past 10 to 15 years, the corporate structure of the majority of the Desk’s counterparties has changed from that of a bank to that of a bank subsidiary. The motivation has been the laws in the United States that restrict banks’ participation in some financial market activities. The current set of counterparty arrangements works well in the United States because the bank subsidiaries (the dealers) are active in the markets in which the Desk intervenes. Moreover, any reserve adjustments made by the Desk will be quickly felt in the federal funds market since the Desk’s counterparties will deposit the reserves received from the Fed in their accounts at banks. For this reason, it is not necessary for banks to be the direct counterparties of the Desk in order for its open market operations to affect the interbank market.

Operations to Control the Federal Fund’s Rate

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

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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.

Day-to-Day Conduct of Open Market Operations

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.

Timing of Market Intervention

The Desk has a regular time for intervening in the market with temporary operations. The current entry time on temporary operations is 10:30 a.m. and was chosen because the Desk typically has a complete set of reserve estimates and the RP market is still active at that time. Having an established entry time enables our dealer counterparties to better prepare for our operations, and it allows market participants to know when any uncertainty about the Desk’s intervention will be removed. But given the relatively small presence the Desk has in the total RP market, on most days this impact is minor.

The Desk is always prepared to depart from its general rule of a normal entry time. When the Desk recognizes that the need to make a reserve adjustment is exceptionally large, an earlier entry will be arranged to take advantage of the greater market depth that exists earlier in the morning. The need to have a complete set of reserve estimates limits how early the entry time can be advanced.

In addition to having a regular entry time, the Desk typically enters the market only once per day, and open market operations are not arranged later in the day even in response to observed rate pressures. No additional reserve data are usually available later in the day upon which to judge the needed size of follow up operations. Furthermore, our counterparties typically would have little collateral left to finance as they normally complete the financing of their securities inventories early each morning, which would limit the potential size on an RP arranged later in the day But the Desk retains flexibility to reenter the market with a second operation if propositions fall short of the intended amount, and the Desk would not rule out arranging an operation later in the day if it were to receive new information that significantly altered the reserve picture available at the normal entry time.

For outright operations, the timing of intervention during the day is less fixed. These operations will be scheduled more at the convenience of the Desk. Operations can be arranged early in the day, even before a complete set of reserve estimates for the day is ready, because outright operations usually are not for same-day settlement and generally are meant only to meet a portion of an estimated need. The secondary market for government debt remains relatively liquid further into the day than the RP market, allowing for a later market entry during the day if desired.

Selection Criteria and Release of Operation Results

The selection of propositions on our temporary operations is determined by the size of the reserve adjustment required to balance the estimates of reserve demand and supply. The average rate and stop-out rate needed to meet this quantity goal are of secondary importance to the Desk and are rarely a factor in selection. For permanent operations, the total value of securities purchased or sold by the Desk is also driven by the size of the estimated reserve needs. Propositions on many issues are received on each operation, and specific selections are based on the relative attractiveness of the offering prices received measured against current market prices, subject to some maximum quantity of a particular security the Desk may wish to hold in the SOMA.

Immediately after each operation, the Desk releases to the market the total volume of accepted propositions on its operations. No other information is released, including the stop-out rate and total volume of propositions submitted. Releasing the amount of accepted propositions provides the market with the Desk’s best estimate of the adjustment to reserves necessary to keep demand and supply of reserves in balance. In practice, the announcement of this result usually has little impact on the market because participants trade largely on the assumption that the Desk will make whatever quantity adjustment is needed for reserve management purposes. Although the Desk does not announce the stop-out rate on RPs, market participants often accurately surmise it. One reason the Desk does not publicly announce this rate is that it does not wish to suggest that the stop-out rate carries any policy meaning.

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.


There is a lack of clarity under U.S. commercial law as to the appropriate classification for repurchase transactions. Repurchase transactions possess many characteristics of outright purchases and sales; they also have many characteristics of secured loans. In order to strengthen the legal characterization, the MOMA includes an explicit acknowledgment by the parties that they intend the transactions under the agreement to be purchases and sales. The MOMA also includes a provision that grants the seller of securities a security interest in the subject securities if the transaction is deemed to be a secured loan rather than a purchase and sale.


The MOMA provides for margin with respect to repurchase transactions in order to protect a party from both changes in value of the securities subject to transactions under the MOMA and a party’s default. Margin is determined at the sole discretion of FRBNY and is based on the market value of the securities subject to the transaction. The margined or “haircutted” price is the price against which the securities are transferred. FRBNY values all securities held by it against transactions involving a particular primary dealer on a daily basis, and it will request that the primary dealer send FRBNY additional securities if such value is less than FRBNY’s required margin. Securities are valued on an aggregate basis in order to minimize margin calls. A primary dealer must transfer to FRBNY additional securities in response to a margin call no later than the close of business on the day such call is made.

Default and Liquidation

The MOMA describes the events that trigger either an automatic default or an option by the nondefaulting party to declare an event of default, and provides for the contractual right of a party to liquidate or replace a transaction. Events of Default include an Act of Insolvency as well as a failure to make any payment or delivery of securities required under the MOMA or any transaction.10 Upon the occurrence of an Event of Default, the repurchase date for each transaction entered into under the MOMA is deemed to occur immediately and the nondefaulting party may exercise its closeout remedies. Generally, closeout under the MOMA involves a netting of aggregate positions between the parties. Specifically, for transactions in which the nondefaulting party acts as buyer of securities (e.g., FRBNY under a repurchase transaction), the nondefaulting party may either (i) sell the securities it holds and credit the proceeds of such sale to the amount due from the seller, or (ii) in lieu of selling securities, give the defaulting party credit for the market price (obtained from a generally recognized source) of such securities. To the extent that the sale price (or market price) of the securities is less than the amount due from the defaulting party, the defaulting party is liable to FRBNY for such deficiency. For transactions in which the nondefaulting party acts as seller (e.g., FRBNY under a matched sale/purchase transaction), the nondefaulting party may either (i) purchase replacement securities, or (ii) in lieu of purchasing replacement securities, be deemed to have purchased such securities at a price obtained from a generally recognized source. To the extent that the purchase price (or deemed purchase price) of replacement securities exceeds the price at which the defaulting party was to have resold the securities to FRBNY, the defaulting party is liable to FRBNY for such excess.

Unique Provisions of MOMA

The MOMA differs from the PSA Master in several areas, primarily as a result of some differences between the way that the Federal Reserve conducts its operations and typical practice between private sector participants. While a MOMA is entered into solely between FRBNY and each primary dealer, MOMA permits dealers to submit bids to FRBNY on behalf of its customers. While this representation is standard in agreements of this kind, the MOMA goes further and contains provisions that while primary dealers may make bids on behalf of customers, FRBNY’s counterparty in all transactions is the primary dealer. The MOMA clearly states that the primary dealer is liable for all obligations under all transactions entered thereunder. This provision assures FRBNY that it takes on only primary dealer risk when it enters into open market operations.

The PSA Master allows a seller under a repurchase transaction to substitute securities subject to the consent of the buyer. The MOMA provides FRBNY with the right to require the seller to substitute new securities for securities subject to a repurchase transaction. The Federal Reserve Bank of New York may choose to exercise this right in instances where there is heightened demand for the purchased securities in either the cash or financing market.



I work for The Bond Market Association. Most of you have probably heard of the Federal Reserve Bank and Goldman Sachs, but not The Bond Market Association. We are a trade association composed of banks and broker-dealers. We are not a government agency. We are a voluntary-membership organization and we represent the interests of our members with respect to their activity in the fixed income markets. We do advocacy work on legislative and regulatory affairs, and we address legal and market practice issues, but everything we do is voluntary. We are a private organization and we are not affiliated with government in any way.

The U.S. Government Securities Market has been described by regulators as the largest and most liquid securities market in the world. Indeed, it is so by several measures. About $200 billion dollars in government securities are transacted every day. That activity far out-shadows trading volume in any other market or in any other type of instrument.

Well over $3.5 trillion of outstanding U.S. Government securities are held by the public. There are $5.5 trillion of total Treasury securities outstanding, and when you add the securities issued by federal government agencies, the total is significantly higher than that. The government securities market is an extremely liquid and efficient market. Trading spreads for government securities—the difference between the bid and the ask prices—are extremely thin and are often measured in fractions of a basis point.

I think this liquidity and efficiency is attributable to several factors: the credit standing of the U.S. Government—Treasury securities are often described as credit risk free; the unique role of the U.S. dollar in the world’s economy; the size of the market—the volume of securities lends itself to very active trading; the breadth of the investor base—almost every investor class holds some U.S. Government securities; and a very efficient and targeted regulatory structure. Ms. Hansen described the regulatory structure of U.S. Government securities.1 We learned that it is a comprehensive and well regulated market. However, its regulation is targeted to the specific nature of the market itself, including the high degree of automation in market processes, especially clearance and settlement operations. The breadth, scope, and liquidity of the market entail several economic and policy benefits to our economy. It provides a cost-efficient way for our government to finance its borrowing. It also provides a well-regarded reference interest market rate by which other borrowers in the economy can gauge their borrowing rates, and that alone is a tremendous benefit.

The fact that it is possible in the United States for a lower-middle class family to borrow money for a fixed-rate term of 30 years, secured, for example, by a home mortgage, is a terrific economic benefit. It is something that is at least in part attributable to the efficiency of the capital markets generally, beginning with the government securities market. Also, of course, the market provides an extremely efficient means for the Federal Reserve to carry out monetary policy operations.

In terms of market regulation, Ms. Hansen raised the fact that the primary rule maker in the government securities market is the Treasury Department, not the Securities and Exchange Commission, which is the principal rule maker for most other types of securities, such as equities, corporate bonds, and commercial paper.2

The Treasury Department, in our government securities market, is both the issuer and rule maker. It is a unique situation, but I think it works well because Treasury has a very strong interest in maintaining both the liquidity and efficiency of the market, and the safety and soundness of the market. It is a system that has lent itself to a strong but targeted regulatory structure. Government securities are exempt from many general regulatory rules that apply to securities in general. Other rules that apply in the government securities market are tailored to the government market itself, including, for example, the record-keeping and reporting requirements that Ms. Hansen described.3

A unique feature of the market, from my perspective, is the primary dealer system, which Mr. Hilton described in detail.4 All 35 primary dealers are members of The Bond Market Association. I think the primary dealer system provides a number of benefits to all market participants, including the Treasury Department, the Federal Reserve System, and investors. It is obvious that the system is necessary for the safe and efficient conduct of monetary policy. The Federal Reserve System needs a group of market participants that it knows well and trusts to act as counterparties in intervention transactions.

The primary dealer system clearly benefits the Treasury because it ensures that there will be an aggressive group of bidders at Treasury auctions, guaranteeing an efficient primary market. Of course, the primary dealer system results in a very active, very heavily traded secondary market.

We heard an interesting presentation this afternoon on the commercial paper market. The commercial paper market is principally an over-the-counter market where a great many transactions take place through inter-dealer brokers. The commercial paper market is an important and key element of our capital markets in general and provides a number of benefits to the economy. It obviously provides an efficient, short-term funding source for corporations in general.

The commercial paper market is used widely in particular among financial and lending companies. We have seen a trend over the past 20 years of moving away from banks as a source of short-term lending and toward a system in which the borrowers can access the short-term capital market directly. For example, GE Capital, which is one of the most prolific issuers of commercial paper, behaves in many ways like a bank. It borrows money in the commercial paper market and through the issuance of other types of securities. It is principally in the business of lending and financing equipment and capital investment at higher rates than their borrowing costs. They really are spread bankers, very much like a commercial bank. In fact, that whole sector of companies, which has grown tremendously in the United States over the last decade or two, is known colloquially as “non-bank banks” because of the kind of activity they are engaged in.

The growth of the commercial paper market was fueled by a number of factors, and the regulatory structure of the markets is one of them. Rule 2(a)-7 has provided a level of consistency and safety among money market mutual funds that has contributed to their popularity among retail investors and to the willingness of investors to commit capital to the money market in general, including the commercial paper market.

We also learned about the Euro-commercial paper market, its limitations up until now, and the fact that it’s been segmented to a great degree by differences in currencies among various countries and differences in regulatory schemes. It will be interesting to see in the coming years to what degree that situation evolves and to what degree the Euro-commercial paper market takes off.


This paper was prepared with the assistance of James H. Freis, Jr., Attorney, and Robert B. Toomey, Counsel, of the Federal Reserve Bank of New York.


Most provisions of the GSA are codified at 15 U.S.C. § 78o–5 (1994). Definitions applicable to the GSA may be found at 15 U.S.C. § 78c(a) (1994).


The term “government securities” refers, generally, to securities that are direct obligations of, or obligations guaranteed as to principal and interest by, the United States. The Bureau of the Public Debt (BPD) of the United States Department of the Treasury issues securities in various maturity ranges that are sold to the public to finance the national debt and pay for the ongoing operations of the U.S. government. Additionally, various U.S. government agencies and government-sponsored enterprises (GSEs) issue securities of their own. These issuers include the Federal Agricultural Mortgage Corporation, Federal Home Loan Banks, Federal Home Loan Mortgage Corporation, Financing Corporation, Resolution Funding Corporation, Student Loan Marketing Association, and Tennessee Valley Authority. Securities issued by the agencies and GSEs are treated identically to those issued by the BPD under the GSA. Distinctions in the methods of holding and transacting in securities issued by the agencies or GSEs as opposed to the BPD are noted in footnotes in the fourth part of this article.


The general anti-fraud provisions of the Exchange Act are applicable to all persons who engage in transactions in any security (including securities otherwise exempt from the provisions of the Exchange Act). 15 U.S.C. § 78j (1994).


A repurchase agreement is a transaction in which the owner of securities agrees to sell them to another party and to repurchase the same (or equivalent) securities on a specified date at a specified price. Repurchase agreements represent a substantial portion of the daily activity of the government securities market.


The federal bank regulatory agencies are the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Deposit Insurance Corporation.


SROs are nongovernmental organizations (national securities exchanges, securities associations, or clearing agencies) registered with the SEC that are given authority by statute to regulate their own members through inspection and enforcement of SEC rules.


Financial institution refers, generally, to a bank.


The capital requirements for government securities brokers and dealers are at 17 C.F.R. Part 402.


Rules concerning the protection of customer assets and requirements with respect to custody of customer securities are at 12 C.F.R. Part 403 and 12 C.F.R. Part 450.


Rules concerning recordkeeping, reporting, and audit are at 12 C.F.R. Parts 404 and 405.


The Treasury’s large-position reporting rules are at 17 C.F.R. Part 420.


Sales practice rules applicable to banks are at 12 C.F.R. § 13.1–13.5.


The Uniform Offering Circular is published at 31 C.F.R. Part 356.


The primary dealers are those institutions with which the FRBNY, in order to implement monetary policy, buys and sells U.S. government securities.


When a definitive security is sold by the issuer, in exchange for the tender of the purchase price, the purchaser receives a paper instrument (a “certificate”) evidencing ownership of the security.


Book-entry securities are not issued with individual certificates. In general, the first purchaser’s interest is noted only by an entry in the accounting records or “books” of the issuer. Subsequent sales may be recorded by the issuer or another entity, such as a securities depository. Some of the GSEs still reserve the right to issue definitive securities, but their current practice is to issue solely book-entry securities.


A “securities intermediary” is an organization such as a bank, clearing agency, broker, or dealer that maintains securities accounts for others. This term includes most Participants.


The GSEs do not offer any holding systems with a direct account relationship comparable to Treasury Direct.


The Treasury has appointed the Federal Reserve Bank of Chicago as the Federal Reserve Bank authorized to perform this service.


See 31 C.F.R. Part 357, Subpart B (promulgated Aug. 23, 1996). The GSEs have adopted virtually identical regulations. See, e.g., 12 C.F.R. Part 912 (“Book-Entry Procedure for Federal Home Loan Bank Securities”); 31 C.F.R. Part 3S4 (“Regulations Governing Book-Entry Securities of the Student Loan Marketing Association (Sallie Mae)”).


Within the United States, a model “Uniform Commercial Code” has been drafted by a nationwide body of legal experts to promote uniformity in the commercial law across the 50 states. The model Code must be adopted into law by the legislatures of the individual states. Article 8 of the Uniform Commercial Code governs “Investment Securities,” including Treasury securities. Every state legislature has adopted some version of Article 8. The latest revision of Article 8, completed in 1994 (“Revised Article 8”), sought specifically to update the law with respect to book-entry securities and to reflect the tiered holding system. At this time, 43 states, including New York (as well as the District of Columbia and Puerto Rico), have adopted Revised Article 8 with only minor variations from the model. Five other states are currently considering such adoption.


In this context, federal law refers to the TRADES regulations, offering circulars and announcements of the Treasury with respect to specific issues of Treasury securities, and the uniform Federal Reserve Bank operating circulars. TRADES sets forth one exception to the exclusivity of federal law. If a Federal Reserve Bank obtains an interest in a book-entry security other than by recording the interest in its books, state law shall govern the creation and perfection of this interest.


See supra note 23. In those seven states where the legislature has not yet adopted Revised Article 8, the TRADES regulations preempt the existing state law and declare that obligations arising from transactions and holdings of Treasury book-entry securities shall be treated as if Revised Article 8 were in full effect within those States. Furthermore, if any state were to adopt a provision of Revised Article 8 that differed materially from the model, the TRADES regulations could preempt the application of that nonconforming provision.


Revised Article 8 protects beneficial holders by stating that all interests in a security held by a Securities Intermediary are held on behalf of the holder of the interest in the security and shall not be considered the property of the securities intermediary.


An exception to this is that a Federal Reserve Bank may become obligated to transfer a security pursuant to a court order.


More details regarding the transfer procedures may be found in a uniform Operating Circular issued by the Federal Reserve Banks entitled, “Book-Entry Securities Account Maintenance and Transfer Services” (Operating Circular No. 7).


Banks may also borrow at the discount window for other purposes under the seasonal and extended credit programs, paying market-based rates.


The level of vault cash available to meet reserve requirements in a maintenance period is known in advance under current accounting rules. Thus, the Desk adjusts the supply of reserve balances held at the Fed to meet the portion of reserve requirements not met with vault cash.


The degree of volatility in the federal funds rate that exists is still occasionally high on some days, but this has not interfered with the FOMC’s ability to influence the economy. Moreover, now that the FOMC announces its desired funds rate, market participants do not attach any policy significance to observed rate volatility.


Each morning, the Desk collects data on the rates and volumes of all federal funds transactions arranged by the largest brokers. This information is used to calculate the weighted average or “effective” federal funds rate that is published by the Federal Reserve each day.


Reports regarding dealer positions and trading volume are used by the FRBNY, the Treasury Department, and other Federal agencies to monitor the auction process and the liquidity and functioning of the secondary market for U.S. Treasury securities.


All but a very small fraction of the domestic securities in the SOMA are Treasury securities; the remainder is debt issued by several government-sponsored agencies.


The Desk has the capacity to sell securities outright, but has had to do so only in very small amounts since 1989, when substantial purchases of foreign exchange created large reserve surpluses.


Outright purchase and sale transactions on behalf of SOMA are not covered by MOMA.


Qualifying repurchase transactions enjoy a number of special benefits under the U.S. bankruptcy code. They are exempt from the automatic stay and the right of the bankruptcy trustee to reclaim amounts set off. As a result, the repurchase participant may immediately liquidate collateral and set off the amount that it owes the debtor against retained margin. The repurchase participant need only pay the trustee the amount that exceeds the debtor’s obligations.


MOMA defines an Act of Insolvency to mean the commencement of a proceeding under any bankruptcy or insolvency statutes, the making by a party of a general assignment for the benefit of creditors, or the admission by a party of such party’s inability to pay its debts as they become due.


See herein Joyce Hansen, Regulation of Participants and Transactions in the U.S. Government Securities Market, Chapter 8A.






See herein Spence Hilton, Organization of Open Market Operations in the United States, Chapter 8B.