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4.3 Trading Treasury Securities

T

here are both primary and secondary markets in Treasury securities. In this topic we focus mainly on the primary market.

The Primary Market

The U.S. Treasury auctions securities at regular intervals. The most frequent auctions are the 13- and 26-week T-bill auctions, which are held every Monday, with securities issued the following Thursday. Auction participants are a network of primary dealers granted special status by the Federal Reserve Bank of New York.

Primary dealers participate in every auction and also are expected to be active market makers in the secondary markets. In return, they receive certain privileges, such as the right to submit bids on behalf of clients without depositing funds upfront.

Nonprimary dealers who submit tenders for Treasuries must deposit the amount in cash or in an "acceptable" value equivalent (e.g., maturing Treasuries) with the Federal Reserve Bank. Nonprimary dealers also must submit in advance an amount equal to the full face value of the securities bid; if their bid is successful, the Treasury issues them a discount check three to five days after the auction.

For example, in the case of T-bills, the full face value of the T-bill must accompany the tender. This can be in the form of cash deposited in person at any Federal Reserve Bank, or in the form of maturing Treasuries, certified checks, direct deposit or even automatic reinvestment. Because T-bills are sold at discount to their face value, the dealer must overpay. Successful bidders receive discount checks three to five days after the auction.

Position Limits at Auctions

To guard against dealer corners on the market, the Treasury confines primary dealers (but not nonprimary dealers) to positions not exceeding 35% (directly and indirectly) in any one auction. This limit is imposed in an attempt to eliminate dealer manipulation of prices.

Before the Treasury auction takes place, but after its announcement, an active "when issued" market opens. This market trades Treasury securities that have been announced but not yet auctioned. Prices in this market are reported by the financial press with the secondary Treasury markets. The abbreviation "WI" distinguishes it from the secondary markets.

The when-issued market has attracted the attention of short sellers who perceive a systematic price discrepancy. Treasury prices may be higher prior to the auction than immediately after the auction, in the secondary markets. Short traders therefore aim to sell prior to the auction and cover immediately after the auction.

In an illegal exercise of market power, in May 1991, traders at Salomon Brothers took a majority position in the auction in an attempt to "squeeze" these short sellers. Salomon’s significant position allowed its traders to influence supply in the secondary Treasury market for this security. As yields were driven down (and prices up) after the auction, the positions of the short traders were squeezed. When the behavior of this market attracted attention, the Government identified major violations of the 35% requirement and imposed large fines on Salomon Brothers.

Bidding in the Auction

Two types of acceptable bids can be submitted to the Treasury auction:

1. Competitive.

2. Noncompetitive, and for up to $1 million of Treasuries.

Once all bids are received, they are ranked from highest to lowest. The supply of Treasury securities is then allocated first to the highest bidder, then to the second highest, and so on. This goes on until the supply remaining equals the total volume of noncompetitive bids. The noncompetitive bids are then allocated, with these bidders paying the average price established in the competitive auction.

Therefore, noncompetitive bids provide guaranteed purchase at the average winning price. Winners of competitive bids pay more or less than the average price.

For some irregular issues, the Treasury will accept only competitive bids. One example is that on some occasions, the Treasury will issue very short term bills known as "Cash Management Bills" in minimum denominations of $1 million with very short maturities, such as 10 to 20 days.

After completion of each auction, the Treasury discloses the results. Among these results are the "bid cover," which is the ratio of total bids submitted to bids accepted, and the "stop-out rate" or "stop-out price," which is the lowest accepted bid.

The Secondary Markets

Secondary markets operate after the initial auction. With the assistance of the primary dealers as market makers, these markets have become some of the most liquid security markets in the world. The four largest secondary Treasury markets are for Treasury Bills, Treasury Notes, Treasury Bonds, and Strips.