Fed rules insufficient to lure new primary dealers

A tough post-financial crisis regulatory climate that has prompted banks to scale back bond-dealing operations has left the US Treasury with a growing headache: the institutions it has traditionally relied on to buy and sell its debt may not be able to provide the same depth of liquidity as they have in the past.

Spurred by those concerns, the Federal Reserve Bank of New York introduced new rules in November intended to expand its pool of primary dealers by lowering the minimum net regulatory capital needed to $50 million from $150 million, theoretically allowing smaller dealers to trade directly with the Fed.

But market participants say the changes are not enough to really boost the number of primary dealers.

“It’s a logical move, but we don’t think it’s going to have much of an impact, it’s not like you’re going to see a whole bunch of non-traditional players jump in and become primary dealers,” says the head of rates trading at a large US bank and one of the Fed’s primary dealers. “We think it will probably be something like one or two new dealers that will enter – there’s not going to be 10 names that are going to show up.” 

Analysts say that is partly because the barrier to entry remains relatively high, but also because there is a limited number of eligible smaller firms that have a big enough footprint in the US treasury market (the New York Fed has also introduced a new rule that means aspirant primary dealers must already have a 0.25% minimum treasury market share).

Josh Galper, Finadium

“To become a primary dealer, it’s not just balance sheet, it’s capacity to do the business,” says Josh Galper, managing principal at Finadium, a research and advisory firm. “I wouldn’t be surprised if it’s just a couple [who apply to become primary dealers]. If you look at the strata of broker-dealers, there are a finite number of large ones and a lot of tiny ones, and if those guys have $5 million in capital they’re happy, so they are way out of the conversation. There are not many broker-dealers with over $50 million of capital who would be interested.” Galper adds: “It would really need to be a smaller player that has a decent distribution in US treasuries but have been buying treasuries from one of the primary dealers, so only a smaller firm that has got a stake in this market and actually wants to skip a middle man is going to be interested in this opportunity with the Fed.”

The rule changes are part of an effort to bolster liquidity amid a long-term decline in primary dealership numbers. There are 23 such dealers today, down from a high of 46 in 1988. Only two new dealers have been added since 2011 – Wells Fargo earlier this year and TD Securities in 2014. The New York Fed declined to comment on how many new dealers it hopes the rule changes will attract.

Market share is also uneven. Some 58% of all US treasury trading was handled by just five dealers in 2016, up from 43% in 2006, according to Greenwich Associates. In total, the top 10 dealers accounted for 85% of market activity.

“There’s not all that many benefits of being a primary dealer now,” says the head of rates trading at the US bank. “It’s just more and more expensive to hold securities. Even if you have a firm that makes a lot of money but it is half of what the biggest guys make, it’s really hard to compete because you still have to hire the same number of compliance people, regulatory experts, technology people, people who do the reporting, so it has become more and more of a scale business where you have to have a lot of revenue to support all these costs.”

Market watchers say that for primary dealing to become more lucrative again, the regulatory burden needs to be eased.

Kevin McPartland, Greenwich Associates

“If the cost of holding positions was reduced back to a point at which making markets becomes more economically attractive, the entire market would benefit,” says Kevin McPartland, head of research for market structure and technology at Greenwich Associates. “A serious scaling back of Volcker via the Trump administration however might be even more impactful.”

Some dealers are not optimistic that a big regulatory pull back is on the cards.

“We’re heading towards this era of more transparency and more reporting, so there doesn’t seem to be anything on the horizon that will make it more attractive,” says the head of rates trading at the US bank.

If that backdrop continues to dampen trading appetite among existing dealers, the New York Fed might need to explore other ways of boosting market liquidity. Galper says if the Fed really wanted to make an impact, it could consider allowing proprietary trading firms to become primary dealers.

“The Fed has choices about how far down it’s going to go in the size of the firm it’s willing to accept as a primary dealer, but really the critical part comes if it enters into conversation with these proprietary trading funds that are driving liquidity,” he says. “That would be significant competition for the biggest primary dealers, but the Fed would have to be exceptionally concerned about liquidity to take on that level of counterparty risk.”