Oct. 19 (Bloomberg) -- The Federal Reserve Bank of New York said it’s working with market participants on how it would use reverse repurchase agreements to help drain the record amount of cash it has added to the financial system.

At the same time, the central bank is considering expanding the counterparties for reverse repo operations beyond the 18 primary dealers that trade with the Federal Reserve, according to a statement today from the New York Fed. No such operations have been conducted so far, the bank said.

“This work is a matter of prudent advance planning by the Federal Reserve, and no inference should be drawn about the timing of monetary-policy tightening,” the statement said.

Fed Chairman Ben S. Bernanke and his fellow policy makers are considering how to withdraw the unprecedented amount of cash they have pumped into the financial system to avoid sparking inflation once the economy recovers. The Fed purchased $1.36 trillion in mortgage, government-housing agency and Treasury debt through Oct. 13 to battle the worst slump since the Great Depression.

“The Fed is making sure they have the tools in place when and if they go to implement the exit strategy, but it’s not a signal that it’s any time soon,” said Michael Pond, an interest-rate strategist in New York at Barclays Capital Inc., one of the primary dealers that trades with the Fed. “There have been some who have taken the Fed’s inquiry into the repo market as a signal they would be tightening policy in the near term. That’s not likely.”

Other Tools

Reverse repos are among the tools Fed officials have said they could use to begin withdrawing the money they have added to the system. Along with raising the overnight bank lending rate, Bernanke has said the Fed may also pay interest on excess bank reserves and sell securities directly to investors.

In a reverse repo, the Fed loans securities for a set period, temporarily decreasing the amount of money available in the banking system. At maturity, the securities are returned to the Fed, and the cash to the dealers.

The focus of the tests is to expand the Fed’s ability to conduct reverse repos with primary dealers using so-called triparty settlement, the bank said.

In such an arrangement, a third party known as a clearing bank functions as the agent for the transaction and holds the security as collateral.

JPMorgan Chase & Co. and Bank of New York Mellon Corp., both based in New York, are the only banks that serve in a trade-clearing capacity in the tri-party repo market. When dealers use repos to borrow money from institutional investors, it is through tri-party repo.

‘Testing’ the System

“We have recently begun testing this capability with all involved parties and systems, and it is likely that the Federal Reserve will engage in additional tests in the future,” the statement said.

Bernanke told Congress in July that the Fed may step beyond primary dealers and conduct the reverse repurchase agreements with government-sponsored enterprises or a “range of other counterparties.”

Raymond Stone, managing director at Stone & McCarthy Research in Skillman, New Jersey, said today’s statement by the New York Fed was probably prompted by speculation about the discussions that has been circulating in financial markets.

Information Leaked

“The New York Fed was likely concerned because they have been discussing with the dealer community these reverse repo operations and that that information was leaked out,” said Raymond Stone. “It is good that they did this. What was wrong was to have the conversations with dealers and not share it with all of us.”

Primary dealers might face constraints on capital if they were the sole counterparties on all the reverse repurchase transactions while they’re still repairing balance sheets after booking losses and writedowns in the aftermath of the financial crisis.

The yield on the 10-year note rose 1 basis point, or 0.01 percentage point, to 3.42 percent at 11:30 a.m. in New York, according to BGCantor Market Data. The yield on the two-year note was little changed at 0.96 percent, after climbing to 0.99 percent, the highest this month.

The dollar declined 0.2 percent to $1.4942 per euro at 11:12 a.m. in New York, from $1.4905 at the end of last week. The yen advanced 0.2 percent to 90.68 per dollar, from 90.89.

No Decision Made

So far, no decision has been made on expanding transactions beyond primary dealers, the New York Fed said.

Reverse repos have typically been settled through a delivery versus payment, or DVP, method where the central bank sends the securities to the dealers’ clearing banks, which causes a simultaneous movement of money, according to the New York Fed’s Web site.

Central bankers are unlikely to drain cash from the banking system until at least late 2010, according to the median forecast of 47 economists surveyed by Bloomberg News from Oct. 1 to Oct. 8.

The consensus is the Fed won’t begin raising interest rates until its Aug. 10, 2010, meeting.

To contact the reporters on this story: Michael McKee in New York at mmckee@bloomberg.net.

Last Updated: October 19, 2009 12:18 EDT