Open Bids Won't Faze Treasury Dealers
Auctions of government securities are about to see a lot more bidders, now that the U.S. Treasury has agreed to let all securities brokers compete alongside the select handful of primary dealers.
In the short term, however, having more players at the table is not likely to hurt the nine U.S. commercial banks that hold primary dealer status. These banks often do not earn profits from the activity in any event.
At best, trading government securities is a volatile business.
In unaudited reports to the New York Federal Reserve Bank, which monitors the auctions, 70% of the primary dealers said they had turned a pretax profit from the business in 1990. The year before, only 45% did.
"Few banks make money in this business," said Melville Blake, a securities specialist at the MAC Group, a unit of Gemini Consulting in Cambridge, Mass.
Mr. Blake estimated that most commercial banks lose as much as $10 million a year because they handle small percentages of any securities issue, which shuts them out from the biggest investors and keeps them in the dark about market trends.
After five withdrawals since 1986, only nine commercial banks remain active as primary dealers. The most recent dropout was Continental Bank. Security Pacific National Bank left early this year.
The Salomon Lesson
The recent Salomon Brothers scandal, in which the Wall Street investment house illegally cornered the market at certain auctions, has shed a harsh light on this highly competitive business. Salomon's ability to elbow out other dealers underscored what insiders had known for years: Only powerhouses can turn a profit trading U.S. government debt.
Nonetheless, banks shrug off the prospect of increased competition. Chase Manhattan Corp., through a spokesman, said the Treasury announcement had "no immediate impact" on its primary dealer business.
"For most institutions, the government business will become increasingly unattractive," said Mr. Blake. "Underwriters will not be able to make the margins they did in the past."
Instead of splitting the market equally, about 40 primary dealers are either dominant players or small fry. Market share determines profitability because, the bigger the share, the more complete the knowledge of investors and trading. And full knowledge in a trading market translates into big bucks.
Because most commercial have only a sliver of the market, they deal with few, if any, big investors. Small players, thus, are shut out of the market knowledge required for smart trading.
Primary dealers make money by filling customers' orders and investing their own funds. The big investment banks make most of their money by trading for their own accounts.
Without adequate information, marginal bidders can only fare poorly - unless the Treasury turns the bidding process into an electronic auction where all participants share information.
A bank may serve its own customers better by becoming a big customer instead of competing with a powerful government securities dealer.
Profit Data Unreliable
Each primary dealer is left to calculate its own costs, so the reported profits or losses are somewhat suspect, anyway. And primary dealers can find artificial ways to boost revenues, for example, by selling securities to a parent company.
Lacking an economic justification, most banks remain primary dealers mainly for prestige but also to stay in the information loop since many products are priced against Treasury security benchmarks.
This may not be enough to entice new broker dealers to bid on securities, however. As an incentive to newcomers, the new Treasury rules let bidders buy as much as $5 million in securities without competing against large dealers. Previously, such "non-competitive" purchases were limited to $1 million.
