Primary Dealers

Primary dealers are banks and securities broker-dealers that trade in U.S. Government securities with the Federal Reserve Bank of New York. On behalf of the Federal Reserve System, the New York Fed’s Open Market Desk engages in the trades in order to implement monetary policy. The purchase of Government securities in the secondary market by the Open Market Desk adds reserves to the banking system; the sale of securities drains reserves.

  • Primary dealers are banks and securities brokerages that trade in U.S. Government securities with the Federal Reserve System.
  • As of December 2007, there were 20 primary dealers.
  • Primary dealers’ daily average trading volume in U.S. Government securities approximately $531 billion during 2006.

 

Primary dealers are banks and securities broker-dealers that trade in U.S. Government securities with the Federal Reserve Bank of New York. On behalf of the Federal Reserve System, the New York Fed’s Open Market Desk engages in the trades in order to implement monetary policy. The purchase of Government securities in the secondary market by the Open Market Desk adds reserves to the banking system; the sale of securities drains reserves.

The primary dealer system was established by the New York Fed in 1960 and began with 18 primary dealers. In 1988, the number of dealers grew to a peak of 46. From the mid 1990s to 2007, it declined to 20. The most important reason for the decreasing number of dealers is consolidation, as Government securities trading firms have merged or refocused their core lines of business. A current list of primary dealers can be found at the Bank’s website.

Amended Procedures for Primary Dealers

In January 1992, in order to address certain shortcomings that had arisen in the primary dealer arrangements, the Federal Reserve amended its procedures for selecting primary dealers. One problem was the widespread misconception that the Fed regulated the primary dealer firms. Also, the primary dealer designation by the Fed had come to be viewed as giving special status to the firms.

Responding to these issues, the New York Fed changed its criteria for administering its counterparty (primary dealer) relationships. One change eliminated a standard for trading volume with customers. Another disbanded the Bank’s dealer surveillance unit and shifted its focus to market surveillance, reflecting more accurately the nature of its work. This change reiterated the point that the Bank does not have—nor did it ever have—regulatory authority over the primary dealers. At the same time, the Bank strengthened its market-monitoring capability. Bank staff members involved in market surveillance communicate market developments to an interagency working group consisting of the Federal Reserve Bank of New York, the Federal Reserve Board of Governors, the Securities and Exchange Commission, the U.S. Treasury and the Commodity Futures Trading Commission.

The Bank also accelerated its efforts to automate Treasury auctions and open market operations with a view toward increasing the efficiency of these activities. An automated Treasury auction system was begun in April 1993 and the open market operations were automated in 1994.

Becoming a Primary Dealer

A firm wishing to become a primary dealer must notify the New York Fed in writing. The Bank then consults with the applicant’s principal regulator to verify that the firm complies with relevant capital standards. Applicants must be either commercial banking organizations that are subject to official supervision by federal bank supervisors or broker-dealers registered with the Securities and Exchange Commission. They may be foreign owned.

According to the New York Fed’s current criteria, bank-related primary dealers must be in compliance with Tier I and Tier II capital standards under the Basel Capital Accord, with at least $100 million of Tier I capital. Registered broker-dealers must have at least $50 million in regulatory capital and must not be in violation of the regulatory "warning levels" for capital set by the Securities and Exchange Commission and the Treasury, the two regulatory bodies that oversee non-bank securities trading organizations. These specified minimum levels of capital are designed to help ensure that primary dealers are able to enter into transactions with the Fed in sufficient size to maintain the efficiency of trading desk operations.

The Fed requires primary dealers to participate meaningfully in both the Fed’s open market operations and Treasury auctions and to provide the Fed’s trading desk with market information and analysis that are helpful in the formulation and implementation of monetary policy.

Dealers report weekly on their trading activities, as well as on cash, futures, and financing market positions in Treasury and other securities. Such reports supply additional information important to market surveillance efforts. Primary dealers’ daily average trading volume was approximately $550 billion during 2005. See primary dealers’ statistical releases for current trading volumes.

Open market transactions occur through a competitive bidding process in which the Open Market Desk invites all primary dealers to submit propositions in response to its announced operations, that is, purchases, sales, repurchase agreements, or matched-sale purchase transactions. Dealers submit propositions and receive results electronically. The open market desk uses software programs to facilitate the selection process for the transactions. The total volume of transactions is reported back to the dealers.

Review Procedures

The New York Fed continually reviews the designation of each primary dealer and evaluates its role as a trading partner with the Bank. Each dealer is expected to be a meaningful business counterparty over time, both in size and in the competitiveness of its propositions. Failure to meet performance standards—for example, failing to participate meaningfully in open market operations—may, over time, result in the Fed’s withdrawal of the primary dealer designation. In addition, if a primary dealer fails to meet required capital standards, the Fed may suspend its trading relationship until the firm’s capital position is restored to the appropriate level. Decisions by the Fed in this regard carry no implication as to the creditworthiness, financial strength or managerial competence of the firm.

December 2007

This article has been reprinted with the authorization of the Federal Reserve