Chapter 2 Organization and Conduct of Debt Markets

1. Chapter 2Organization and Conduct of Debt Markets

2. Overview • This purpose of this chapter is to provide you with an introduction to the general organization of the debt markets. • Because of its size and importance, the organization of the Treasury market has tended to influence greatly the organization of the other debt markets. • Thus, this chapter deals heavily with the Treasury markets.

3. Market Organization • There are many ways markets can be organized, but some of the most common are: • Direct search – participants look for each other without intermediaries. Examples include Bank CD markets, many labor markets, marriage markets, etc. Search costs tend to be high. • Brokered markets – Intermediaries (brokers) search on behalf of clients, and execute orders on behalf of clients, but do not take positions in the market themselves. Examples include real estate sellers, some securities markets. • Dealer markets – Intermediaries (dealers) take positions in the securities they sell. (Car dealers). Note that the US Treasury secondary market (and many other debt markets) are organized this way. • Auction markets – Some US Treasury primary markets use auctions.

4. Market Organization • Transparency – It is generally agree that the more information that buyers and sellers have, the more efficient a market will be. A transparent market is one in which information about trade prices, quotes, volumes, and other information is readily available. This information should also be relatively inexpensive. • Adverse selection – Usually a result of an information asymmetry. One party to a trade may have information about the trade that is not available to the other party. If this is common in a market (such as the “market of lemons”, i.e. the used car market) market participants will compensate by widening the bid-ask spread. Signalling then becomes an important issue for particpants.

5. Government Securities Markets • The principal players in government securities markets are: • The U.S. Treasury • The Federal Reserve System • Banking regulators • Government Agencies • Primary Dealers • Other Dealers • Inter-dealer Brokers • Investors

6. Government Securities Markets • US Treasury • Responsible for borrowing money in the capital markets for the US government. • Responsible for setting the mechanism through which the Treasury sells securities to the public. This includes the primary and secondary markets. • Federal Reserve • The Fed has a number of important functions that bring it into the debt markets. • Implementation of economic policy. • Implementation and development of banking policy. • Maintaining the “Fed. Funds” system • Maintaining the wire transfer system.

7. Government Securities Markets • How the Fed implements monetary policy • Cutting the discount rate – Depository institutions can borrow directly from the Fed at the “discount window”, and the discount rate is the rate they are charged for borrowing this way. • Changing reserve requirements – The Fed gets to mandate the amount of funds that banks must put into reserve accounts at the Fed. These funds are not available for investment and represent a cost to the banks. As a result banks try to minimize the money the keep in Fed funds accounts, as a result they borrow Fed. Funds back and forth in a very active market. • The Fed. buy or sell in the Treasury market directly. • The Fed. can enter into repos and reverse repos. • Notice this is almost exclusively on shorter-term instruments.

8. Government Securities Markets • Mechanics of the Treasury Market • Treasury instruments are issued in book-entry form, meaning that the owner of record is maintained via a series of custodians. • It is a tiered custodial system • The Treasury tracks how much of each issue is held in each Federal Reserve Bank district. • Each Federal Reserve Bank will track how much each depository institution holds of each issue. • The depository institutions track how much each dealer holds. • The dealers record how much each individual owns. • The primary government securities dealers are responsible for maintaining an orderly secondary market system. To do so they must maintain large inventories of bonds, and they must finance this inventory.

9. Repo Markets • Repurchase agreements are a form of highly collateralized borrowing. This is the primary method through which government securities dealers finance their inventory. • Size of this market is about $600 Billion. • In a repurchase agreement, Party A buys securities from Party B, and simultaneously agrees to sell them back to Party B at a later time. • Reverse Repurchases are opposite – note that for every repo there must be a reverse repo. • Repo’s are used by a number of investors, not just securities dealers funding inventory.

10. Repo Markets • One important issue is that repo’s settle on the trade date, not three days later like most other trades. • The price at which the security will be sold back to the original owner will be higher than the price at which it was sold, with the difference representing the cost of financing. • The original owner of the security, however, continues to receive the coupon payments on the instrument.

11. Repo Example From Book • June 10, 1986 • Securities dealer purchases a bond for a price of 94.03 and accrued interest. The invoice price works out to be 94.5422 (you don’t have enough information to calculate that here). Since the face amount is $10 million, this means they must deliver $9,454,220 to the seller. • To finance this, the dealer turns to the repo market. A repo dealer agrees to finance the deal, they will charge a repo rate of 6%. • To protect against the dealer defaulting, the dealer will take a 0.5% “haircut”, meaning that they will only provide the dealer with 99.5% of the value of the bond (in this case $9,406,948), the dealer must fund the rest. (note error in book!)

12. Repo Example • On June 13, the Securities Dealer re-takes possession of the bond from the Repo Broker. The Securities dealer must now pay the Repo Broker the original amount of the deal plus the interest earned at the repo rate: 9,406,948.90 * 0.06* (3/360) = 4,703.47So the total amount that must be paid is: 9,411,652.37 • Remember that the Securities Dealer continues to earn the coupon on the bond, so they actually made $5,910 during this time. • This is called a positive cost of carry.

13. Interdealer Brokers • The inner market in the government securities market is the trading done through interdealer brokers. This is how the primary brokers trade with each other. • Cantor Fitzgerald opened the screens to non-brokers as well, effectively opening the inner market to a wider audience.

14. Other Markets • The Treasury market has probably the best transparency and is, in many ways, the simplest market. • The other fixed income markets have credit risk, liquidity risk, etc. • There is a very strong push at this time for the corporate markets to increase their transparency in the wake of Enron, WorldCom, and the other scandals. (Although the markets figured out something was fishy WAY before anybody else did.)