Statements to the Congress - David W. Mullins Jr. testimony concerning government securities market reform - Transcript

Federal Reserve Bulletin, April, 1992

Thank you for this opportunity to present the Federal Reserve Board's views on reforms to the regulation of the government securities market. Since September, when I last testified before this Committee, staff of the Federal Reserve, the Treasury Department, and the Securities and Exchange Commission (SEC) have conducted an exhaustive examination of this market, the results of which were released two weeks ago. My prepared remarks will touch upon some of the main conclusions of this report from the particular perspective of the Board of Governors of the Federal Reserve System. Our perspective differs somewhat from the perspectives of the other agencies contributing to the report because of differences in legislative mandates. The Board of Governors has little direct regulatory authority for the U.S. government securities market.

Although the Board has general oversight responsibility for all Federal Reserve District Banks, it is the District Banks that act as fiscal agents of the Treasury, thus sharing operating responsibility for the market with the Treasury. The SEC's charge is to enforce the securities laws that seek to foster a high degree of fairness in the marketplace. With neither the direct responsibilities of funding the government nor substantial regulatory oversight, the Board of Governors can view this market from a somewhat different vantage point--a policy perspective that allows it to examine these issues in an economywide context.

When we look to the government securities market, we see a market that works as well as any on earth. U.S. government debt is an ideal trading vehicle because it is all closely substitutable and has none of the default risk or idiosyncratic problems of private issues. As a result, market participants, in the aggregate, willingly commit substantial amounts of risk capital and exchange a large volume of securities each day. Positions are large, yet trading skills are so sharply refined that bid-ask spreads are razor thin, a small fraction of the size of spreads in major equity markets.

The government securities market generates widespread macroeconomic benefits. It efficiently absorbs the large quantity of new issues required to finance the deficit. With real-time quotes on a range of instruments, this market serves as the foundation for private market rates and a haven for ready liquidity. Further, this deep and liquid market gives the Federal Reserve a powerful, reliable mechanism for implementing monetary policy.

Nonetheless, the admission of wrongdoing by Salomon Brothers, episodes of price distortions, and other evidence uncovered in our joint study all suggest that this market has faults. It can be improved. The proposals contained in the joint report, along with other reforms announced earlier, constitute a careful, comprehensive modernization of the mechanisms and practices in the government securities market. In our view, implementing these proposals represents a formidable, though feasible, task.

Over the longer term, the most effective force in enhancing market efficiency and reducing the potential for manipulative abuses is the force of competition. And the effect of these proposals is to open up the government securities market to broad-based participation. Automating Treasury auctions; facilitating direct bidding by customers, including nonprimary dealers; implementing a single-price open-auction technique; and reducing the barriers to primary dealer membership--all will serve, in time, to broaden participation in the primary market and in the secondary market for newly issued securities. More depth and breadth in this end of the market should increase efficiency, reduce Treasury financing costs, and lessen the potential for manipulative trading abuses. In addition, the competitive force of broader participation will be reinforced by proposals targeted at manipulative abuse: tighter enforcement of auction rules and enhanced market surveillance by the Federal Reserve Bank of New York to identify potential manipulative episodes that could trigger SEC investigation and Treasury supply management to reopen offerings.

Taken together, these actions should serve to deter manipulative practices and allow quick detection of abuses should they occur. Moreover, they are relatively low-cost, market-based responses that should achieve these benefits without impairing the efficiency and liquidity of this vital market.

Of course, many other alternatives could be considered to combat the potential for abuses in this market. However, the government securities market is too important a national resource and works too well to be put at risk by regulatory change for the sake of change. From the Board of Governors' perspective, a compelling case must be established that the benefits outweigh the costs.

In our view, such a compelling cost-benefit analysis has not been made with respect to proposals to establish a broad-based apparatus of reporting requirements or audit trails in this market. Although increased reporting would deter manipulation and facilitate the investigation of abuses, such systems would impose substantial potential costs on this market. The reporting burden would fall on all traders--the good and the bad-boosting the cost of every trade. While the direct costs of additional recordkeeping might be kept manageable, an indirect cost looms larger. Rather than risk divulging their finances and trading strategies, participants might withdraw from this market, thereby raising the cost of Treasury finance. And, of course, the stakes are high: A tiny increase in Treasury rates aggregates into a very substantial increase in cost to U.S. taxpayers.