The Federal Reserve Bank of New York ("FRBNY") has been reviewing the terms and conditions of the program for lending U.S. Treasury securities held in the System Open Market Account ("SOMA") to primary dealers. In July 1998, the FRBNY distributed proposed terms and conditions to the primary dealer community for comment. In response to the comments received, revisions were made to the proposal. The Federal Open Market Committee has now approved changes in the Authorization for Domestic Open Market Operations necessary for the FRBNY to commence lending under the revised securities lending program. The FRBNY will be working with primary dealers to test the necessary systems changes in anticipation of a late April implementation date.
Since release of the original proposal in July, two adjustments have been made to the terms and conditions. First, the fails policy has been modified in order to provide the appropriate incentives to borrowers and to bring the FRBNY's practices more in line with accepted market practices. Second, to maintain the transparency of SOMA operations, a provision has been added for the release of auction results. A summary of the new terms and conditions is available in Attachment I to this announcement. Attachment II provides analysis of the issues raised by the comments received.
Current program. The securities lending facility was established by the FOMC in 1969, in response to dealer requests for a program to improve the physical clearing of U.S. Government securities. Under the program, dealers have been allowed to borrow up to $10 million of a Treasury coupon and $50 million of a Treasury bill from the SOMA portfolio at a fixed fee of 150 basis points. Borrowing has only been permitted for the purpose of covering an expected fail to receive on the part of a dealer. In order to prevent lending activity from affecting reserves, Treasury securities, rather than cash, are posted with the Federal Reserve as collateral.
Impetus for change. The program's static borrowing limits have prevented growth of the program commensurate with increases in Treasury market trading volume and SOMA holdings. Since 1969, the cash market for Treasury securities has experienced an over 80-fold increase in average daily trading volume and the SOMA portfolio has grown from $57billion to over $450 billion. During the same time period, the borrowing limits on Treasury bill and coupon issues have remained fixed.
The prohibition on borrowing against short positions was based on the premise that the program was principally intended to reduce "fails" (failures to settle) without encouraging short selling. Over the years, however, short positions have come to be recognized as being as integral a part of the price discovery process as are long positions. This is reflected in the widespread use of Treasury securities to hedge the full range of interest-rate exposures, including swaps, derivative products, corporate bonds, municipal bonds and other sovereign bonds. The ability of market participants to manage risk by short-selling specific Treasury issues enhances liquidity in all sectors of the dollar-denominated interest rate market.
The current program's fixed 150 basis point fee does not reflect the market price for loans and may hamper appropriate allocation of securities. With fixed-rate borrowing fees, loans can be made at a lower-than-market cost, which inequitably shifts value to those dealers who are granted loans. In addition, the fixed-fee price structure poses an allocation problem when the demand for loans exceeds the available supply.
Purpose of the SOMA lending program. The revised securities lending facility is intended to serve the same objective as the original program: to provide a secondary and temporary source of securities to the Treasury financing market in order to promote smooth clearing of Treasury securities. The process has been updated in order to make the program more effective at fulfilling this objective.
The Federal Reserve's open market operations are a major beneficiary of the liquidity of the government securities market, in general, and the financing market, in particular. Over time, the revised lending program should serve to enhance and sustain the liquidity of the market in which monetary operations are conducted. However, the SOMA securities lending facility will not--and is not intended to--eliminate "specials;" rather, it will provide a means to alleviate severe shortages in the financing market.
Features of the new program. In revising the lending facility to fulfill more effectively the objective of providing a short-term, "last-resort" source of Treasury securities, constraints were imposed to mitigate its direct impact on price discovery, to minimize the impact on competition in the securities lending market, and to limit the risk that firms will use the program to augment their ability to control specific issues.
To revise the lending facility, it was necessary to amend the Authorization for Domestic Open Market Operations. The Federal Open Market Committee approved the following as a replacement to paragraph two of the Authorization:
In order to ensure the effective conduct of open market operations, the Federal Open Market Committee authorizes the Federal Reserve Bank of New York to lend on an overnight basis U.S. Government securities held in the System Open Market Account to dealers at rates that shall be determined by competitive bidding, but that in no event shall be less than 1.0 percent per annum of the market value of the securities lent. The Federal Reserve Bank of New York shall apply reasonable limitations on the total amount of a specific issue that may be auctioned, and on the amount of securities that each dealer may borrow. The Federal Reserve Bank of New York may reject bids which could facilitate a dealer's ability to control a single issue as determined solely by the Federal Reserve Bank of New York.
Auction procedure. Competitive price determination, as required by the Authorization, will occur through bidding in an auction. Auctioning of securities loans assures that SOMA will not become a price-setter in the specials market and allows for an equitable and transparent distribution of loans among interested dealers. A multiple-price auction format is consistent with the Federal Reserve's other domestic open market operations.
Noon auction for overnight borrowing. The noon auction time and the overnight borrowing term are intended to make loans from SOMA less attractive as a primary source of scarce issues than loans normally available in the market between dealers and securities lenders. The most liquid hours in the financing market occur during early and mid-morning. Setting the auction time at mid-day is intended to make SOMA securities a temporal "last resort," while still allowing sufficient time for conducting the auction and settling its outcome before the securities wire closes, usually at 3:00 p.m.
Minimum bid. The Authorization stipulates that a minimum bid must be set at no less than 1 percent of the market value of securities. The minimum bid limits direct competition with private sector securities lenders and restricts SOMA lending to issues that are, in fact, scarce as reflected in their rates. The program will commence with a minimum bid of 150 basis points, which has been deemed suitable for the current market environment. Based on interest rate levels and loan activity, the minimum bid may be adjusted up or down in order to keep SOMA lending activity at an appropriately limited level.
Limits on auction size. The Authorization requires the FRBNY to set reasonable limits on the size of daily auctions. Initially, these limits will be set at 25 percent of the SOMA holdings in each security. Over time, the auction limits may be raised based on evident demand and the FRBNY's assessment of the program's effectiveness. However, it is not expected that this limit will exceed 50 percent, in order to permit roughly similar amounts of securities to be auctioned each day. Because dealers are not required to return borrowed securities until after the auction on the day they are due, if more than 50 percent were lent one day and no securities were returned prior to auction the next day, then the supply available for lending would be diminished.
Per dealer limits. Dealer limits have been set commensurate with the auction size limits to ensure distribution of available securities among several dealers and to provide the appropriate amount of liquidity at the firm level. These limits have been raised from their previous levels in order to offer liquidity consistent with today's larger trade sizes and higher trading volume. They are intended to be high enough to facilitate the clearance of trades, but not so high as to augment individual firms' positions significantly. The program will commence with dealer limits of $100 million per issue and $500 million total. However, if auction size limits are raised, dealer limits may be increased. Dealer limits may also be adjusted periodically based on changes in the depth and liquidity of the market, the number of primary dealers, and Treasury issuance patterns.
Right to reject bids. The Authorization grants the FRBNY the right to reject bids at its sole discretion when it is determined that awarding securities would facilitate a particular dealer's ability to control a specific issue. This authority will likely be used only on rare occasions. However, it has been established to deter borrowing by dealers that already have large long positions in specific issues.