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Fed to Test Using Smaller Broker-Dealers as Counterparties

The Federal Reserve Bank of New York said it will test allowing “small broker-dealers” to act as counterparties in sales and purchases of Treasuries for the central bank’s portfolio.

The New York Fed will conduct a one-year pilot program that will let as many as five companies participate, the regional reserve bank said in a statement today. Firms will only be able to partake in permanent open-market operations for Treasuries.

“The Treasury Operations Counterparty Pilot Program is being launched as a way for the New York Fed to continue to explore the effectiveness and feasibility of expanding operations to a broader range of counterparties,” the statement said. “The length of the program should not be viewed as providing any information about the stance of monetary policy.”

Firms eligible for the program announced today would have to possess net regulatory capital of $1 million to $50 million, and a minimum total owners’ equity of $1 million, according to the Fed statement. The dealers selected will be listed on the New York Fed’s website.

“In theory there is nothing wrong with it,” said Jim Bianco, president of Bianco Research in Chicago. “The positives are more liquidity and a deeper pool to deal with in the Treasury market.”

Open-Market Operations

The Fed has bought more than $2.3 trillion of debt since 2008 through several rounds of quantitative easing aimed at keeping long-term interest rates low to stimulate the economy. Currently, in what has been dubbed QE3, the central bank is buying $85 billion of Treasuries and mortgage debt a month. The Fed holds more than $1.7 trillion in Treasuries in its System Open Market Account.

Firms in the pilot program won’t be guaranteed participation in any future permanent open-market operations, which the purchases of Treasuries through its QE3 are considered a part of, according to the statement. At this time, only primary dealers are offering Treasuries to the Fed during its regular debt purchases. The Fed is expected by analysts at some point to sell securities, which would be though a permanent open market operation, as a way to reduce the size of its balance sheet.

Minutes from the Fed’s January policy meeting released today showed several policy makers said the central bank should be ready to vary the pace of monthly bond purchases amid a debate over the risks and benefits of further QE.

Fed Unwind

Even with the continued monetary expansion, Fed policy makers led by Fed Chairman Ben S. Bernanke have also been considering how to withdraw the unprecedented amounts of cash they have pumped into the financial system to combat the deepest recession since the 1930s. Along with raising their benchmark overnight bank lending rate, Fed officials have said they may use tools including reverse repos and increasing the interest rates it pays on banks’ excess reserves, and debt sales to eventually withdraw or neutralize cash in the banking system.

The Fed has since 2010 been expanding its tri-party reverse repo counterparties, to shore up its ability to drain liquidity from the banking sector when it reverses course on monetary easing. The Fed’s tri-party reverse repo counterparties, which historically were solely primary dealers, now includes firms such as money market mutual funds, government sponsored agencies, banks and savings institutions. Reverse repos are considered temporary open-market operations.

The Fed’s debt purchases since 2008 triggered a surge in the excess bank reserves held by the central bank to $1.58 trillion from $2.4 billion at the end of 2007. The Fed pays banks 0.25 percent interest on these excess reserves.

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