Primary Dealers in the Digital Age

TBAC recommends U.S. Treasury stop selling bonds directly to investors, as primary dealers see roles diminished and fear disorder in markets if investor demand declines.

The Masters of the Universe immortalized by Tom Wolfe in his 1987 novel “The Bonfire of the Vanities” are feeling like mere mortals.

The Wall Street banks known as primary dealers because they get to trade with the Federal Reserve and raise the money that the U.S. government needs to operate are concerned they are being marginalized because of advances in technology. So worried are they that the group wants the Treasury Department to curb the increasingly popular practice by investors of buying bonds directly from the government without their involvement.

In many ways, the request underscores the changing nature of the business, where greater access to information has leveled the playing field between banks and investors, and turned telephones into little more than paperweights. 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. The number of primary dealers has shrunk to 22 from the peak of 46 in 1988.

“The Treasury needed the dealer community for its information, for its distribution,” said E. Craig Coats Jr., who was the co-head of the government bond trading desk at Salomon Brothers in the 1980s, when the partnership was Wall Street’s biggest bond trading firm. “Today there’s so many different sources of liquidity and information and distribution that the dealers become less important to the Treasury.”022414_Bloomberg_PQ3

Primary dealers—which include JPMorgan Chase & Co., Goldman Sachs Group Inc., Bank of America Corp., and Citigroup Inc.—are seeing their roles diminished just as the Fed begins to unwind the extraordinary monetary stimulus measures put in place after the 2008 financial crisis. That includes bond purchases that swelled the assets on the central bank’s balance sheet to a record $4.15 trillion from less than $1 trillion.

At the same time, government borrowing has more than doubled the amount of tradable U.S. government debt to $11.8 trillion. That combination has dealers concerned there’s an increased chance of disorder in markets if demand for Treasuries declines. Forecasters predict higher yields, which would reduce the value of existing bonds.

“This is an oligopoly that’s breaking down, and the oligopolists are concerned,” said Robert Eisenbeis, a former director of research at the Fed Bank of Atlanta and vice chairman and chief monetary economist for money-management firm Cumberland Advisors in Sarasota, Florida.

 

Influential Membership

The request by the dealers was revealed on page 58 of a 74-page chart presentation accompanying the report that the Treasury Borrowing Advisory Committee, or TBAC, presented to the government this month and made public. The 15-member group is made up of the world’s most powerful and influential banks and investment firms.

The committee, which makes recommendations to the Treasury on its borrowings and briefs it on market conditions, suggested setting curbs on investors’ ability to circumvent the dealers and buy bonds directly from the government because the unpredictable nature of that demand “could potentially lead to increased debt funding costs” for the government.

They also suggested the U.S. consider the potential for syndicated sales of securities such as ultra-long maturity bonds due in more than 30 years and granting underwriters the option to buy additional debt at the Treasury offerings. Those measures would tighten their grip on the sales process.

TBAC Chairwoman Dana Emery, the chief executive officer of mutual-fund firm Dodge & Cox Inc. in San Francisco, declined to comment, said her spokesman, Steve Gorski. All of the 14 other members either declined to comment or didn’t return calls.

“We’re always trying to take stock of where we’re at and make sure we understand how new developments in the marketplace are impacting our ability to finance ourselves,” Matthew Rutherford, the Treasury’s assistant secretary for financial markets, said in a Feb. 20 telephone interview.

Ensuring the government is getting the best rates possible on its borrowings is no small matter with the Treasury selling more than $2 trillion of notes and bonds a year. That’s up from an average of $659 billion in the five years before the 2008 financial crisis.022414_Bloomberg_PQ4

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.

 

Rising Share

Direct bidders submitted $829.2 billion in bids last year, and were awarded $351.1 billion, or 17.7 percent of the $1.99 trillion in competitively sold U.S. debt, according to Treasury data compiled by Bloomberg. All were record amounts.

In 2008, direct bidders tendered $25.4 billion and were awarded $20.2 billion, or 2.5 percent, while dealers submitted $1.47 trillion of bids for $809 billion of competitively sold securities, winning $554.7 billion, or 68.6 percent.

The increased availability of data and the advancements in trading technology have leveled the playing field, giving investors access once enjoyed only by the dealers.

“I can enjoy a primary-dealer level of access to both the primary and secondary markets,” Jason Evans, co-founder of hedge fund NineAlpha Capital LP in New York and the former head of U.S. government bond trading at Deutsche Bank AG, said in a telephone interview.

Trading in fixed-income, currencies, and commodities at the 10 largest global investment banks declined 19.4 percent in 2013 to $73.9 billion, according to research firm Coalition Ltd. The “anticipation of rising interest rates, tougher capital adequacy regulations, and concerns over the U.S. Fed ‘tapering’ weighed on the business,” Coalition said in a report last week.

Increased regulations after the financial crisis to limit banks’ risk taking “is increasingly stifling for the dealers,” Evans said last week. “Primary dealers have seen the true value proposition in being a primary dealer eroded over time.”

Even though the amount of U.S. government debt has expanded, trading activity is stagnant, with $544 billion of Treasuries on average changing hands each day in 2013, down from $553 billion in 2008, Fed data show. Electronic trading has increased from 31 percent in 2012, according to a survey of institutional money managers by Greenwich Associates.

Coats, who worked at Salomon when its influence was caricatured in “Bonfire of the Vanities,” said he trades Treasuries via exchange-traded funds. The 66-year-old retired in 2009 as co-head of fixed income at Keefe, Bruyette & Woods Inc.

Treasuries in 2013 suffered their first losing year since 2009, dropping 3.35 percent in value as yields rose, according to Bank of America Merrill Lynch index data.

Yields on 10-year notes are forecast to climb again this year, to 3.37 percent, according to the weighted average in a Bloomberg survey of 74 participants. The yield on the benchmark 2.75 percent security due in February 2024 was 2.75 percent as of 1:49 p.m. in New York, Bloomberg Bond Trader prices show.

Banks began to exit the dealership business in the 1990s as the large number of firms and the increased transparency of electronic trading cut the spread between offers to buy and sell debt, making activity less profitable.

“It’s a tricky balancing act about keeping costs as low as you can but at the same time not disenfranchising dealers,” said John Fath, a former head Treasury trader at Zurich-based primary dealer UBS AG. He’s now a principal at investment firm BTG Pactual in New York, which manages $2.5 billion.

 

‘Meaningful Intermediary’

Treasury officials understand the difficulty posed for dealers by the erosion of their dominance at the auctions and as new regulations limit their ability to commit capital to their bond businesses, according to Karthik Ramanathan, a former Treasury debt management director.

Dealers still “offer a meaningful intermediary” between the market and the Treasury, Ramanathan, who is now a senior vice president at Fidelity Investments, said in a telephone interview from Merrimack, New Hampshire. “I do not believe at this point direct bidding or technology is going to completely disintermediate the primary dealer structure.”

A primary dealership still carries some allure. Toronto-Dominion Bank’s TD Securities was named one by the Fed on Feb. 12, the first new dealer in more than two years. Stamford, Connecticut-based Pierpont Securities LLC is interested in becoming one, according to its chief executive officer Mark Werner.

“Typically, central banks and sovereign funds, the biggest holders of U.S. Treasuries, will only deal with primary dealers,” Werner said in a telephone interview. “There’s a certain distinction that comes with being a primary dealer.”

Werner, who worked at JPMorgan Chase for 22 years, where he rose to vice chairman before co-founding Pierpont in 2009, and in 2010 was a member of the TBAC, acknowledges the challenges.

“You’re in a low-rate environment, with relatively low volatility and low turnover in the asset class,” he said. “The result is a somewhat less profitable environment for dealers.”

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 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.”

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