SECONDARY MARKET

The secondary market for Treasury securities is an over-the-counter market in which a group of U.S. government securities dealers offer continuous bid and ask prices on outstanding issues. There is virtual 24-hour trading of Treasury securities. The three primary trading locations are New York, London, and Tokyo. Trading begins at 8:30 a.m. Tokyo time (7:30 p.m. New York time) and continues to about 4:00 p.m. Tokyo time (3:00 a.m. New York time).7 Trading then moves to London where trading commences at 8:00 a.m. London time and then on to New York at 12:30 p.m. London time (7:30 a.m. New York time). In New York, trading starts at 7:30 a.m. and continues until 5:30 p.m.8

The most recently auctioned Treasury bill for a particular maturity is referred to as the on-the-run issue. Issues auctioned prior to the on-the-run issue are typically referred to as off-the-run issues. These issues are not as liquid as an on-the-run issue for a particular maturity. This difference in liquidity manifests itself in wider bid-ask spreads and lower size quotes for off-the-run issues relative to an on-the-run issue.

While the secondary market for Treasury bills is one of the most liquid segment of the global money market, most of the trading activity occurs during New York trading hours. In a 1997 study, Michael J. Fleming finds that while bills represent approximately 27% of trading volume of on-the-run Treasury trading volume in New York, bills comprise only about 1% of the trading volume in London and Tokyo. In fact, on many trading days, not a single bill trade is brokered during overseas hours.9 One possible explanation for this result is put forward in a study by Michael J. Fleming and Jose A. Lopez. They suggest that a disproportionate share of speculative trading in Treasury securities occurs overseas. Accordingly, longer-term coupon Treasuries (as opposed to bills) are suitable vehicles for this type of trading.10

Treasury Dealers and Interdealer Brokers

Any firm can deal in government securities, but when the Federal Reserve engages in trades of Treasuries in order to implement monetary policy, the New York Fed’s Open Market Desk will deal directly only with dealers that it designates as primary or recognized dealers. The primary dealer system was established in 1960 and is designed to ensure that firms requesting status as primary dealers have adequate capital relative to positions assumed in Treasury securities and that their trading volume in Treasury securities is at a reasonable level. The Federal Reserve requires primary dealers to participate in both open market operations and Treasury auctions. In addition, primary dealers provide market information and analysis which may be useful to the Open Market Desk in the implementation of monetary policy. Exhibit 3.5 lists the primary dealers as of October 31, 2001. Primary dealers include diversified and specialized firms, money center banks, and foreign-owned financial entities.

Primary dealers trade with the secure investing public and with other dealer firms. When they trade with each other, it is through intermediaries known as interdealer brokers. Dealers leave firm bids and offers with interdealer brokers who display the highest bid and the lowest offer in a computer network tied to each trading desk and displayed on a monitor. The dealer responding to a bid or offer by “hitting” or “taking” pays a commission to the interdealer broker. The size and prices of these transactions are visible to all dealers at once. The fees charged are negotiable and vary depending on transaction volume.

Six interdealer brokers handle the bulk of daily trading volume. They include Cantor, Fitzgerald Securities, Inc.; Garban Ltd.; Liberty Broker- age Inc.; RMJ Securities Corp.; Hilliard Farber & Co. Inc.; and Tullett & Tokyo Securities Inc. These six firms serve the primary government deal- ers and approximately a dozen other large government dealers aspiring to be primary dealers.

Dealers use interdealer brokers because of the speed and efficiency with which trades can be accomplished. With the exception of Cantor, Fitzgerald Securities Inc., interdealer brokers do not trade for their own account, and they keep the names of the dealers involved in trades confidential. The quotes provided on the government dealer screens represent prices in the “inside” or “interdealer” market. Historically, primary dealers have discouraged attempts to allow the general public to have access to them. However, as a result of government pressure, GovPX is a joint venture of five of the six interdealer brokers and the primary dealers in which information on best bids and offers, size, and trade price are distributed via Bloomberg, Reuters and Knight-Ridder. In addition, some dealers have developed an electronic trading system that allows trading between them and investors via Bloomberg. One example is Deutsche Morgan Grenfell’s AutoBond System.