The close-knit group of 39 primary dealers in Treasury securities was shaken to the core not too long ago by revelations that Salomon Brothers Inc., the club's most influential member, had fabricated bids at several Treasury auctions. The disclosure set off a barrage of efforts to reform the largely unregulated $2.1 trillion market in Treasury securities. Legislation was expected to sail through Congress and undermine the primary dealers' powerful grip on the Treasury market.
Three months later, it isn't working out that way. The regulatory juggernaut has been stalled -- in all likelihood, for good. True, the Salomon scandal has accelerated efforts to improve information disclosure in the Treasury market and to automate antiquated auction procedures. But such moves, which began before the Salomon affair, are unlikely to have much effect on the primary dealers or investors. Squabbling among the Treasury Dept., the Federal Reserve, and the Securities & Exchange Commission, meanwhile, has kept regulators from forging a united front. And moves for change on Capitol Hill have been derailed by internecine quarrels.
'TREMENDOUS' EXPENSE. Also acting as a brake on reform are fears that fiddling with the system could add billions to the budget deficit. If new rules raise the cost to bidders by, say, a tenth of a point, and they pass that on to the government, that would amount to $1.6 billion a year for the $1.6 trillion in annual sales of Treasury notes and bonds. "The cost of passing improper legislation is tremendous," says bond consultant Leonard Santow, managing partner of New York-based Griggs & Santow.Even rival government-securities firms that for years have railed against the privileges of primary dealers have lost some of their zeal for reform. Many fear that too much tinkering too quickly could create new and unexpected market inefficiencies. "You can rock the boat, but you run the risk of turning it over if you do too much at one time," says James T. Kinsella, senior vice-president of The Chicago Corp.
The dour outlook for reform would only change if an eagerly awaited joint study by the Fed, Treasury, and SEC on Treasury auctions due in mid-December reports a broad pattern of wrongdoing far beyond previous disclosures. But the betting is that the report won't be that incendiary. Furthermore, lawmakers, facing an election year, may be too preoccupied to consider a complex reform package.
SMALL CHANGE. Treasury has already introduced some modest reforms in the auction process. They make it easier for all registered securities firms and institutional investors to enter bids without going though primary dealers. In the past, only primary dealers could submit competitive bids for themselves and their customers, in exchange for the obligation to participate in auctions even when the market was sour.
At the first auctions under the new regulations on Nov. 5-6, bidding was thin, leading some Washington officials to wonder whether the primary dealers were boycotting the offering to protest the changes. But analysts say the real factor was uncertainty over whether the Fed would cut rates. Few customers took advantage of the option to bypass the primary dealers. "We're still sticking with primary dealers because we need to be assured of the creditworthiness of the people we're dealing with," says Roland M. Machold, director of New Jersey's Investment Div.
Congress isn't likely to step in to make broader changes anytime soon. The Senate passed a measure in September that makes false bids in Treasury auctions -- the kind of conduct Salomon admitted -- a violation of the securities laws. But the Senate doesn't want to consider anything else until it receives the study from regulators.
The most vocal critic of the auction process is Representative Edward J. Markey (D-Mass.) chairman of the telecommunications and finance subcommittee, who raised a ruckus with a bill that he hasn't yet introduced. It would give the government authority to oversee development of a system for disclosing bond-price information, which now is closely held by primary dealers. This has outraged the Fed and Treasury, which currently regulate the market, because Markey would give the SEC these powers. Says Markey: "We need a cop on the beat every day, not just an emergency-only SWAT team."
The SEC argues that it has far more experience than Treasury and the Fed in handling disclosure and surveillance issues. It could monitor the government market the way it now oversees securities of publicly held companies. "Should we reinvent the wheel?" asks SEC Chairman Richard C. Breeden.
But Markey's legislation, which would have to get through the Banking, Ways & Means, and Energy & Commerce committees, faces fierce opposition from the Fed and Treasury. The Fed, which relies on primary dealers to regulate the money supply, and Treasury, whose reform package was intended to preempt broader congressional reforms, bristle at Markey's suggestions of laxity. They claim that they have intensified efforts at enforcement and say Markey's proposals are fraught with peril for the government's debt financing. They argue that imposing a layer of bureaucratic rules on dealers might discourage bidding. And both agencies, which are loath to give up any of their power, worry that the SEC does not understand the government securities market. "Sweeping changes are, I believe, premature," Fed Vice-Chairman David W. Mullins Jr. told Markey's committee on Oct. 25.
AUTOMATION. The fighting on Capitol Hill won't slow the onslaught of technology. But technology, in turn, is not likely to unseat the primary dealers either. The Treasury and the Fed have accelerated plans to automate the Treasury markets. The first phase is set to begin in mid-1992, when small financial institutions that are not primary dealers will be able to bid electronically. The New York Fed is designing a similar plan for large bidders. The primary dealers launched a voluntary quotation system of their own -- called GOVPX -- in June. But some intended beneficiaries say that this is a largely halfhearted effort, noting that users cannot manipulate or save the data, and that it is not a trading system. "I view GOVPX as an attempt by the primary dealers to give as little data as possible to other people," says Robert Pozen, general counsel and managing director of Fidelity Investments.
But even if more price information becomes available and direct bidding becomes easier, investors may still have ways of bucking the system and bypassing primary dealers. Institutions worry that if they don't give primary dealers their buy orders, "when it comes time to sell, I might not get as good a bid," says Barbara Kenworthy, portfolio manager at Dreyfus Corp. With many other big investors sharing her concerns, and with reform efforts in Washington pretty much dead in the water, the primary dealers' hold on the market won't be loosened any time soon.