Ranks of US primary dealers grow once more - Boom in Treasuries trading attracts new entrants

Ranks of US primary dealers grow once more - Boom in Treasuries trading attracts new entrants
By Michael Mackenzie in New York
Copyright The Financial Times Limited 2009
Published: July 15 2009 17:47 | Last updated: July 15 2009 20:27
http://www.ft.com/cms/s/0/09e4f92e-715c-11de-a821-00144feabdc0,s01=1.html


After a steady decline, which accelerated last year, the ranks of primary dealers, which interact with the US Federal Reserve and bid for Treasury debt, are growing again.

The booming business in bond trading – as the US Treasury funds its growing budget deficit – and an investor preference favouring primary dealers are attracting new entrants.

“In this world of risk aversion, there is a seal of approval in being a primary dealer as they meet the requirements of the Treasury and the Federal Reserve,” says John Jay, senior analyst at Aite Group.

The number of primary dealers, which include banks and securities broker-dealers, stands at 17, with the recent additions of RBC Capital Markets and Jefferies & Co.

A year ago there were 20 primary dealers, but the ranks were thinned by a number of high profile departures, thanks to the demise of Bear Stearns (acquired by JP Morgan), Lehman Brothers and Merrill Lynch (acquired by Bank of America).

A decade ago, however, there were more than 40 dealers and the list peaked at 46 in 1988.

The general decline before the financial crisis reflected the consolidation between banks and also the lower profitability associated with transacting Treasury debt.

Those days are a distant memory for bond dealers. With the US Treasury set to issue more than $2,000bn in new debt for the current financial year, trading in bonds has become very profitable for existing primary dealers.

The tight limits on bank balance sheets have restricted liquidity, contributing to wider spreads between bid and offer prices for bonds, which has increased margins for dealers.

The Treasury has also brought back previously discontinued notes, such as the three- and seven-year maturities, which has increased the frequency of debt auctions.

On top of that, there are generally much bigger daily swings in Treasury prices and yields, which has boosted revenues for the big dealers.

“The business has been better in the past two years compared with the prior seven years,” says Rick Klingman, managing director at BNP Paribas.

Meanwhile, the Fed’s policy of quantitative easing, whereby the central bank buys back Treasury debt is also being conducted with the dealers.

That is welcome news for the Treasury Borrowing Advisory Committee.

This year, the industry body said there was a need for more primary dealers in order to prevent “the possibility of an undersubscribed auction.”

To date, that prospect has looked remotely likely. Although debt auctions have grown to record sizes, dealers have been placing enough bids to cover auctions. The US Treasury monitors and grades dealers as to their behaviour in Treasury auctions.

RBC is the first Canadian institution to be a primary dealer since CIBC World Markets surrendered its licence in February 2007.

“Becoming a primary dealer is a logical extension of our efforts in building a fixed income franchise worldwide,” says Jonathan Hunter, co-head, fixed income & currencies at RBC Capital Markets.

RBC began discussions with the Fed last October, with attention focused not only on business strategy but also on infrastructure.

One of the big attractions in becoming a primary dealer is the prestige associated with dealing with the Fed on a daily basis.

That cachet also extends to some investors. “Some clients are mandated to only deal with primary dealers,” Mr Hunter says.

The current environment is so compelling that other firms are also looking at returning to the system.

Nomura Securities, which was a primary dealer until November 2007, applied to the Federal Reserve to become one again back in January.

MF Global is holding discussions with the Federal Reserve Bank of New York.

“These primary dealers face a new world and they need to generate new business,” Mr Jay says.

“Being a primary dealer opens the door to clients and gives you the ability to market other services.”

Dealers expect more entrants with another four firms looking to apply over the next six to 12 months. That will improve liquidity, but also narrow bid-offer spreads, reducing profitability over time.

“Clearly there may be a desire among other dealers to enter this space,” Mr Hunter says.

The Fed established the primary dealer network in 1960 with 18 firms and it is designed to help the central bank manage liquidity within the financial system

The dealers are also required to place bids at debt auctions which are regularly held by the US Treasury. As they interact with the New York Fed’s trading desk, dealers provide the central bank with market information and report weekly about their trading.

That enables the Fed to publish weekly data on positions between dealers, inter-dealer brokers and customers across a range of fixed income securities.

In order to become a primary dealer, a firm notifies the New York Fed and a protracted process begins. The bank or securities firm can be foreign owned and the Fed consults with their main regulator to see if they have enough capital.

Even after an institution is approved as a primary dealer, the Fed maintains a close eye on how they operate in conjunction with the central bank.

On its web site the New York Fed says: “Each dealer is expected to be a meaningful business counterparty over time, both in size and in the competitiveness of its propositions.

“Failure to meet performance standards, for example, failing to participate meaningfully in open market operations, may, over time, result in the Fed’s withdrawal of the primary dealer designation.”