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

Federal Reserve Bulletin, April, 1992

Because it might be difficult to resist implementing, even backup authority risks sending a chilling message about the U.S. market to all participants choosing a trading arena in the global marketplace. Moreover, in view of the extensive nature of the other changes proposed in this report, one might question the capacity of this market to absorb, at an acceptable cost, this additional change--the imposition of broad-based reporting requirements for this market. The agencies agree that large position reporting requirements should not be implemented at this time. Rather than risk slipping into this fundamental change through backup authority, the Board of Governors feels it would be a wiser course of action to return to the Congress in the future should such authority appear necessary.

The interagency report provides an alternative to burdensome regulation--a low-cost, marketbased solution to the problem that targets manipulative behavior without impairing the liquidity of this important market. This overall strategy has three basic elements: improved auction mechanisms, enhanced market surveillance, and active supply management.

Although many aspects of the Salomon Brothers admission of wrongdoing and the results of the subsequent investigation cause concern, one is particularly unsettling: Because of the falsification of bids at auctions, the Treasury was the direct counterparty in attempts to manipulate the market. Immediate steps were taken to reduce the risk of a reoccurrence, including tightening the enforcement of auction rules and implementing measures to encourage more direct bidding. Looking forward, automation of the auction process, already under way and expected to be completed by year-end, should efficiently snare any infraction of the rules.

More important still, automation will facilitate consideration of alternative auction techniques. At a minimum, switching to single-price awards from the current multiple-price format should foster greater participation and likely reduce gaming behavior at the auction. But more can be done. Linking bidders directly by a computer network and conducting the auction in real time will expose any would-be manipulator to public scrutiny in time for the competition to react. With the element of surprise gone, the potential return to manipulation should disappear. Thus, the auction of the near future may well be played in the open, on a level field, with sharply defined and easily policed foul lines.

The report also finds that the benefits of enhanced monitoring extend to when-issued and secondary market trading. Manipulative behavior leaves its footprints in market quotes because a shortage of an issue will be evidenced by a yield below that of similar securities and by depressed financing rates. The agencies agreed that the Federal Reserve Bank of New York, with its substantial experience as the operating arm of the Federal Open Market Committee and (along with the other Reserve Banks) as one of the fiscal agents of the Treasury, should have primary responsibility for market surveillance; the Bank, in turn, will provide information to the Treasury, the SEC, and the Board of Governors. The view of the Board of Governors is that rigorous monitoring of the behavior of market rates will expose manipulative behavior without the need to gather the positions of large traders routinely.