Quelle Surprise! Banks Are Opposed to More Liquid Markets When They Don’t Make Enough From Them

Bloomberg has an intriguing story about a bit of lobbying the big dealer banks are engaged in via a group called the Treasury Borrowing Advisory Committee, which represents 15 out of the total of 22 primary dealers (a primary dealer, among other things, gets to bid for its own account at Treasury bond auctions). Of course, the object of their efforts is to improve their profitability, here by putting parties they regard as competitors at more of a disadvantage.

The latest quarterly presentation to Treasury contains a peculiar section in which the group argues that Treasury should have more say in the selection and oversight of primary dealers. That job in theory falls to the Fed, but in fact the Fed dismantled its primary dealer supervision unit in 1992. But what sounds like a request for more regulation (clearly something the dealers don’t want) is just a coded request for the Treasury to shore up their once-cozy oligopoly by getting more stringent with recent entrants that have been eating into the already thin entrants into this market.

As Bloomberg explains, the dealers over time have lost market share to electronic order placement and execution:

A record 49 percent of Treasury trading was done electronically in 2013 and the amount of debt sold directly to investors at auction rose to 17.7 percent of issuance from 2.5 percent in 2008.

Now this sounds like a plus from a taxpayer perspective. More bidders at auctions almost certainly means somewhat better prices for Treasury (as in lower interest rates). Remember, any time regulators threaten to raise capital requirements or (horrors!) impose transaction taxes, dealers howl that it will hurt liquidity. Mind you, what they are talking about there is (nearly always) secondary market liquidity, when investors are buying and selling already-existing securities or instruments. Savvy investors, such as John Maynard Keynes, have argued that too much liquidity is detrimental, because it diverts capital from productive investment into speculation:

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done… The introduction of a substantial government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States.

But no, that isn’t the dealers’ motive. From their presentation:

Primary Dealers are the dominant bidder class in Treasury auctions. The Treasury and the Fed incentivize PDs to support the auctions. Indirect bidders provide information to PDs about the auction process. As more institutions bid Direct, auction uncertainty rises for the PD system which could potentially lead to increased debt funding costs. Should the privilege of Direct bidding come with more requirements and transparency? Requirements should be set that induce consistent Direct Bidder participation over the longer term.

“Indirect bidders” are end customers who place orders for Treasuries at auction through a primary dealer, say a retail customer at Bank of America or a foundation or insurance company making a bid through Goldman or Citigroup. So the dealers don’t like that they aren’t seeing these orders and are trying to claim that maybe they’ll take their marbles home someday.

Cut through the blather, and the dealers are asking Treasury to sacrifice a near-certain current benefit (more bids at auction resulting in better prices) with the vague “maybe we won’t be there when you need us in the future” threat. That’s empty in two ways.

First, any credible international securities firm needs to be a Treasury dealer. It’s the foundation of all dollar bond trading. If you aren’t in that business, it’s well nigh impossible to be in the other fixed income businesses, like corporate bonds and mortgage backed securities. Treasuries are the most quick-trigger market to react to developing events, and dealers who don’t participate in Treasuries are at a substantial disadvantage (and similarly, large accounts prefer to deal across all fixed income instruments because they believe they have a better vantage and can execute orders better by virtue of breadth and depth of relationships). And if you aren’t in or competitive in corporate bond issuance, it puts you at a disadvantage in providing investment banking services to large companies. In other words, there are strong synergies among products on both the trading and investment banking side of the house, and Treasuries are one of the “gotta be there” products if you aspire to be a leading securities firm.

Second, even though primary dealers are required to provide bids when the Fed conducts open market operations, that does not mean the bids will necessarily be all that aggressive.

The document contains various suggestions as to how to make it harder for direct bidders to compete with dealers (see p. 58) as well as suggestions for how Treasury can further enrich primary dealers. For instance:

The Greenshoe Option gives the dealer the ability to add-on a percentage (eg 10%) of their awarded bids, at the original auction price. Other DMO’s allow from 2 hours (UK) to 5 days (Belgium) for PDs to exercise this option. The maximum non-competitive allocation after the auction is 30% of total for new bonds issued by Italy.

Another bright idea was to move from bidding to syndication. Syndication allows dealer to buy Treasuries at an explicit discount. Treasury would well understand that, but the point is included in a long list on a page with smaller print than the rest of the document, p. 60: “Requires a syndicate to be selected by Treasury and compensated for underwriting liability.”

Some of the arguments are strained:

Unlike dealers, direct bidders aren’t required to bid at every Treasury auction. That means their decision to participate makes government debt sales less predictable, the TBAC has said in its reports. As a result, dealers may need to reduce their bids to compensate for the added risk.

The individual dealers are not permitted to collude, so from the perspective of each of the 22 dealers, how much the other dealers will step up is also uncertain. The slide deck does not make a persuasive case that the direct bidders are dangerously or disruptively fickle.

Sadly, the Bloomberg story unwittingly reinforces an industry insinuation, that the fall in the number of primary dealers from 46 in 1988 to the current 22 is the result of increased regulation and lower profits. In fact, banks and businesses take to blaming regulators when they need to retrench for completely different reasons. For instance, a 1989 New York Times article discusses how profits for primary dealers had fallen in 1988 and were continuing to fall in 1989, and would lead to a shakeout because the industry clearly had too much capacity. One expert said the number of primary dealers needed to be closer to 30 than 40. And looking at the 1988 list, many of the firms are gone due to consolidation: First Chicago. Bankers Trust. Manufacturers Hanover. Chemical Bank. Kidder Peabody. Smith Barney. Salomon Brothers. Paine Webber. Security Pacific. Continental Bank. Dean Witter. Kleinwort Benson. Dillon Read. Wertheim Schroeder. SG Warburg. CRT (Chicago Research and Trading) Government Trading. LF Rothschild. DLJ Securities. Harris Securities. Chase Securities. Yamaichi. Need I go on?

And when you get outside the dealer community, the reactions to this document are skeptical:

The Treasury may face “perception issues” if it adopts the TBAC’s recommendations, said Dean Baker, co-director of the Center for Economic and Policy Research, a Washington-based group funded by labor unions and private foundations.

“The idea that somehow the Treasury would get a higher price for its bonds with fewer people bidding, that’s not the economics I learned in school,” Baker said in a telephone interview.

The Treasury’s bailout of the banks during the financial crisis created the notion that the biggest lenders were too big to fail and created “implicit subsidies” for them, according to Cumberland’s [Robert] Eisenbeis.

“It’s no wonder they’re going to say they’re concerned about their profitability,” he said. “That’s pure self-interest and has nothing to do with the efficacy or the functioning of that market.”

Bank whinging, sadly, has proven to be effective in the past. But perhaps the attention Bloomberg has given to this special pleading will constrain the Treasury from propping up bank profits, rather than requiring them to deal with a changing business environment, just like private businesses.

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  1. john jansen

    I wrote about this on Monday and will attach a link to my piece. I think my principal objection to what you have written here is that you have taken the dealer proposal out of context. What is the context? The context is that the value of the primary dealer franchise is eroding and technological change has assaulted the ability of dealers to make money in liquid rates markets. The US Treasury market and those other investment grade markets associated with it are the deepest and most liquid markets on the globe. (As an aside the yahoos who wrote Dodd Frank and the Volcker rule understood that well enough to know that they should not tamper with its efficient functioning and allowed for prop trading of Treasuries.) If dealers are not allowed a reasonable opportunity to profit I believe that liquidity in the Treasury market will decline and the taxpayer will pay for that with higher rates.

  2. diptherio

    I have a few questions:

    Isn’t lowering bond rates, i.e. Treasury getting a better deal, actually bad for retirees and others who rely in part on gov’t bond investment income? Pops told me that other day that he was having to move his portfolio out of bonds and into the stock market because the returns on T-bills were so low. Won’t lowering rates have the unintended consequence of driving more risk-adverse investors into the stock market as they look for returns high enough to allow them to stay retired? This seems like a damned-if-you-do-damned-if-you-don’t situation to me…

    1. F. Beard

      Because the money system is damned – for several reasons including favoritism for the rich, oppession of the poor, theft, the need for government privileges, history and logic.

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