Forbes Online, November 25, 2009
Becoming one of the handful of firms on Wall Street who can trade directly with the Federal Reserve has proven a double-edged sword. Dealers who clamored to become the Federal Reserve’s trading partners have found it an expensive venture.
"You’re going to lose money," said Howard Lutnick, chief executive officer of Cantor Fitzgerald, speaking at the Reuters Global Finance Summit. But being a primary dealer helps firms attract attention from potential clients who may then choose to use a wide range of the dealers’ other services.
Primary dealers interact directly with the Federal Reserve Bank of New York’s open markets desk and are charged with bidding on each new auction of Treasury securities. With the Treasury selling an estimated $1.5 trillion to $2 trillion debt in 2010, the viability of primary dealers and their ability to find homes for government bonds is of utmost importance as the Obama administration works to pull the economy out of the worst downturn since the Great Depression.
Primary dealers can either sell the Treasuries from an auction into the secondary market or place specific bids on behalf of their clients. This was a lucrative activity during the financial crisis, as the spread between buyers’ bids and sellers’ offers rose. "If you’re a new entrant or a smaller player, it was kind of okay last year because bid-offers were wide. You actually had a reasonable chance to make money on a trade," said a senior executive at a large primary dealer. "This year we’ve seen bid/offer (spreads) come back in."
Last year, Bear Stearns, Countrywide Financial, Lehman Brothers and Merrill Lynch all exited the list of primary dealers. This year three new firms have joined — Nomura Securities, Jefferies & Co., and Royal Bank of Canada.
"There was a brief time just when Bear and Lehman went out when it looked like it was a big money-maker, but that was just sort of like someone left the window open and then your mother walked over and shut the window," Lutnick said. The cost of becoming a primary dealer, which includes hiring new traders and gearing up technologically, is high. Smaller boutiques may never gain enough market share to cross into the top tier of the market’s participants, who take on a significantly larger portion of the bids at each auction.
And since primary dealers’ overall market share has fallen as some foreign central banks and large institutional investors have begun buying Treasuries directly from the government, the informational advantage, too, has changed.
In an earlier era, "if you had a large enough market share you got tremendous market insight, which made you an effective proprietary risk taker," said David Weinberg, who ran the Treasury trading desks at Citibank and Eastbridge Capital until 1994.
But in November’s $16 billion 30-year bond auction, for example, primary dealers were credited with a total of just 44 percent of the bids’ dollar volume. Direct and indirect bidders took the other 56 percent.
Still, primary dealers say their status helps them gain access to new clients, who give them business in areas of the market such as derivatives trading and other fee-generating activities. Two more firms, MF Global and Toronto Dominion Bank, are awaiting Fed approval to become primary dealers.
"This is a way to get introduced to the big players," said Adam Schneider, a principal at Deloitte Consulting. He added that working directly with the New York Fed was seen as "a kind of a stamp of approval" by the government.
The volume of Treasury purchases through primary dealers could also be attractive to firms looking for market insight.
"These sets of purchases re] denominated literally in the trillions," Schneider said.
Each primary dealer has specific reasons for getting into the business.
"It’s the most liquid, most well-traded instrument globally," said Takeo Sumino, chief operating officer of Nomura Holding ( NMR – news – people) America, of U.S. government debt. "We have seen a lot of welcoming messages from the clients…It has been a very well-rewarded exercise for us."
Lutnick, meanwhile, said Cantor had joined the group in 2006 out of a sense of duty.
"I think, for us, there was a decision that…we were becoming bigger and it was part of our responsibility of playing in the government securities market at the size and scale that we do," he said.