Treasury auctions By Justin O’Donnell

Topics to be Covered What treasuries are auctioned The process of treasury auctions Participants involved Worked through example

Introduction Treasury securities are issued by the U.S Department of the Treasury to fund U.S Government expenditure. Treasury securities include Treasury Bills, Notes and Bonds. On an annual basis, more then 200 public auctions occur raising more then 4.2 trillion dollars in securities every year. From 1980 through to 2006, the public debt of the United States grew from $930 billion to $8.68 trillion. Approximately half of this debt was raised through treasuries via the treasury auction system.

Bills, Notes and Bonds Treasury bill- are sold in terms ranging from a few days to 52 weeks. Bills are typically sold at a discount from the par amount Treasury note- earn a fixed rate of interest every six months until maturity. Notes are issued in terms of 2, 3, 5, 7, and 10 years. Treasury bond- earn a fixed rate of interest every six months until maturity. Maturity of more than 10 years.

How often are auctions held? Over the years, depending on the economic climate and the U.S Governments requirements for funds, there have been changes in the amount, maturities and frequency with which treasuries are to be auctioned. However, auctions are usually held as follows: 13-week and 26-week bills held weekly (Mondays) 2-year notes held monthly 5-year notes held monthly 10-year notes held in the months of Feb, Mar, May, Jun, Aug, Sept, Nov, Dec

3 stages to the auction process 1) Announcement 2) Bidding 3) Issuance.

Announcement The process begins by the U.S Department of the Treasury announcing that an issue will occur. The U.S Treasury will make an announcement that it will filter through mediums such as the media, including the financial press and television. Also, when an announcement is made, an official document is made that fully details all the required information, including: Amount of the security Treasury is selling Auction date Maturity date Terms and conditions of the offering Customers eligible to participate Noncompetitive and competitive bidding close times

Bidding The second step of the Treasury Auction process is referred to as the ‘bidding’ stage. Most treasuries are purchased by the ‘primary dealers’, those being financial institutions that are active in buying and selling U.S. government securities and have established business relationships with the New York Fed. It is important to note that individual investors too can bid for treasury securities, although they do so in much smaller quantities.

How can a financial institution become a ‘primary dealer’? – In order to gain status as a primary dealer, the firm must comply with an array of capital requirements set forward by the New York Fed. – For example, bank-related primary dealers must be in compliance with Tier I and Tier II capital standards under the Basel Capital Accord. – This is done to ensure that the Fed is dealing with only firms that have appropriate amounts of capital to their treasury positions. – If these requirements are met, status is given as a reporting dealer. After some period of time, if the firm has continued to meet the requirements, then it will be given status as a primary dealer.

Current primary dealers 1. BNP Paribas Securities Corp. 2. Banc of America Securities LLC 3. Barclays Capital Inc. 4. Cantor Fitzgerald & Co. 5. Citigroup Global Markets Inc. 6. Credit Suisse Securities LLC 7. Daiwa Securities America Inc. 8. Deutsche Bank Securities Inc. 10. Dresdner Kleinwort Securities LLC 11. Goldman, Sachs & Co. 12. HSBC Securities (USA) Inc. 13. J. P. Morgan Securities Inc. 14. Mizuho Securities USA Inc. 15. Morgan Stanley & Co. Incorporated 16. RBS Securities Inc. 17. UBS Securities LLC.

How can individuals purchase treasuries in the auction process? An individual investor can bid and purchase for U.S. treasuries through the ‘TreasuryDirect Accounts’ or the ‘Legacy Treasury Direct Accounts’ programs, both of which are administered by the Treasury. These are both systems that have been set up to allow individuals to purchase, reinvest, sell securities, and perform account maintenance online with no maintenance fees. Thus, this allows individuals to directly participate in the auction process. Alternatively, an individual could purchase treasury securities through a dealer, but this would entail a fee.

The actual bidding process All auctions are performed on a competitive bidding basis and all bids entered by participants must be submitted on a yield basis. Bids may be submitted no more then 30 days in advance, all bids are kept confidential and are not released until auction time and bids can be submitted electronically through the Treasury Automated Auction Processing System (TAAPS). There is not necessarily a physical location for the bidding process. Two types of bids can be entered: Competitive and non- competitive.

Non-competitive bids Are small bids by individual investors of a face value of up to $1 million for treasury securities. They are entered on a quantity basis, not on a yield basis. They are guaranteed to receive securities in the auction. It is for this reason that non competitive bids are deducted from the total amount of securities being auctioned by the treasury. Eg. If total government securities being auctioned by the U.S Treasury was $5 billion, and non-competitive bids by individuals totaled $0.52 billion, then the amount of $4.48billion would be left over for the auction process.

Competitive bids After non-competitve bids have been deducted, the remainder is to be auctioned to competitive bidders. Primary dealers then bid yields that they are willing to pay for the security and the quantity that they want, submitting their bids literally seconds before the deadline passes via TAAPS. The lower the yield bid by the primary dealer, the higher the price they are willing to pay for the treasury. Theoretically, primary dealers are not allowed to discuss among themselves what yield they will be bidding. Once the deadline passes, the Federal Reserves in New York, Chicago, and San Francisco consolidate the bids to ensure compliance with appropriate regulations ie Soloman Brothers Bids are then arranged by the treasury in Washington from lowest yield (highest price) to highest yield (lowest price).

Bidding process continued… For example, a bid schedule would look like the following. Using our example from earlier, there would now be $4.48billion to auction to competitive bidders. Why? But, primary dealers have bid for a total of 7.98 billion. How does the Treasury determine who to allocate securities to and who misses out? Amount bid (billions)Bid yield BNP Paribas Securities Corp % Banc of America Securities LLC % Barclays Capital Inc.15.67% Cantor Fitzgerald & Co.15.68% Citigroup Global Markets Inc % J. P. Morgan Securities Inc % Mizuho Securities USA Inc.25.80%

Bidding process continued… The Treasury will then work its way down the list, accepting the lowest yields until the auction amount has been filled. The Treasury wants to accept the low yields first, because this means that it will receive the most revenue (ie will have to pay out less returns). The BNP bid will be accepted, as will the Bank of America, Barclays Capital, Cantor Fitzgerald and co, and Citigroup bids. Amount bid (billions)Bid yield BNP Paribas Securities Corp % Banc of America Securities LLC % Barclays Capital Inc.15.67% Cantor Fitzgerald & Co.15.68% Citigroup Global Markets Inc % J. P. Morgan Securities Inc % Mizuho Securities USA Inc.25.80%

Bidding process continued… Once the Citigroup bid has been accepted, the total amount of bids been accepted is $4.48bn ( ). This equals the amount on auction, and therefore the treasury does not need to go any further down the list. J.P Morgan and Mizuho securities are said to be ‘shut out’ of the auction, as their bids are not accepted. Amount bid (billions)Bid yield BNP Paribas Securities Corp % Banc of America Securities LLC % Barclays Capital Inc.15.67% Cantor Fitzgerald & Co.15.68% Citigroup Global Markets Inc % J. P. Morgan Securities Inc % Mizuho Securities USA Inc.25.80%

Stop yield The highest yield accepted by the treasury is referred to as the stop yield. The stop yield is calculated as the yield with which the Treasury does not need to exceed as it is the yield that results in the auction amount being completely filled. So, in our example before, what is the stop yield? Any competitive bids above this stop yield are ‘shut out’ and do not receive any treasuries.

A single price auction The U.S Treasury uses a single priced auction system, also known as a ‘Dutch auction’. A multi priced auction system was used prior to This means that all competitors are allocated securities at the highest yield accepted by the treasury (stop yield). That is, all successful competitors are allocated securities at the same yield, regardless of what yield they bid. The yield that non-competitors receive is also equal to the stop yield. So, from our example before, all successful bidders (BNP, BOA, Barclays, Cantor Fitzgerald, Citigroup) were all allocated the quantity of treasuries they bid for, but at the stop yield, not the yield they bid for.

A single price auction Therefore the bid yield put forward by the primary dealers ultimately determines your position in the line. Ie the lower the yield you bid, the more chance you have of your entire order being filled. But that yield is not the yield you will be allocated; you will be allocated the yield that was the highest one accepted by the Treasury ie the price that just clears the market. The reason that the U.S Treasury employs such a system, is because empirical studies have shown that this is the most efficient method that allows the treasury to raise the most amount of funds.

Final result Amount bid (billions) Amount issued (bilions)Bid yieldIssued yield (stop) BNP Paribas Securities Corp %5.69% Banc of America Securities LLC %5.69% Barclays Capital Inc %5.69% Cantor Fitzgerald & Co %5.69% Citigroup Global Markets Inc % J. P. Morgan Securities Inc % N/A Mizuho Securities USA Inc % N/A Non-Competitive bidders0.52 N/A 5.69% Total8.55

Taking it one step further What happens if there is more then one bidder at the stop yield? How does the Treasury then divide up the remaining treasuries between these primary dealers who have bid the exact same yield?

Example 2 continued Assume that the bid schedule now looks like this and assume that there is still $4.48bn to be auctioned. Note that 5.69% is still the stop yield, because the Treasury does not need to exceed this yield to fill its auction amount. Amount bid (billions)Bid yield BNP Paribas Securities Corp % Banc of America Securities LLC % Barclays Capital Inc.15.67% Cantor Fitzgerald & Co.15.68% Citigroup Global Markets Inc % HSBC Securities (USA)25.69% UBS Securities LLC.35.69% J. P. Morgan Securities Inc % Mizuho Securities USA Inc.25.80%

Example 2 continued Once the Cantor Fitzgerald bid has been accepted, there is only $1.38bn ( ) to be auctioned off. But at the next yield of 5.69%, dealers have bid a total of $6.38bn ( ). Therefore we need to proportion out $1.38bn worth of treasuries over dealers with bids of $6.38bn. This is to be done on a pro rata basis ie each bidder will be issued 22% of what they bid (1.38/6.38). Amount bid (billions)Bid yield BNP Paribas Securities Corp % Banc of America Securities LLC % Barclays Capital Inc.15.67% Cantor Fitzgerald & Co.15.68% Citigroup Global Markets Inc % HSBC Securities (USA)25.69% UBS Securities LLC.35.69% J. P. Morgan Securities Inc % Mizuho Securities USA Inc.25.80%

Example 2 continued Citigroup: $1.38bn x 22%= $.276bn HSBC: $2bn x 22%= $.44bn UBS: 3bn x 22%= $.66bn Note: The total here is $1.38bn ( ), which was the remaining amount to be auctioned. All treasuries are still issued at the stop yield of 5.69%, as per before. J.P Morgan and Mizhuo are shut out as per before. Amount bid (billions)Bid yield BNP Paribas Securities Corp % Banc of America Securities LLC % Barclays Capital Inc.15.67% Cantor Fitzgerald & Co.15.68% Citigroup Global Markets Inc % HSBC Securities (USA)25.69% UBS Securities LLC.35.69% J. P. Morgan Securities Inc % Mizuho Securities USA Inc.25.80%

Final result Amount bid (billions) Amount issued (bilions)Bid yieldIssued yield (stop) BNP Paribas Securities Corp %5.69% Banc of America Securities LLC %5.69% Barclays Capital Inc %5.69% Cantor Fitzgerald & Co %5.69% Citigroup Global Markets Inc % HSBC Securities (USA) % UBS Securities LLC % J. P. Morgan Securities Inc % N/A Mizuho Securities USA Inc % N/A Non-Competitive bidders0.52 N/A 5.69% Total

Issuance Third and final stage of the process In this stage, The U.S Treasury issues the treasuries to the winning bidders. In exchange, The Treasury charges the accounts of the bidders. Once the securities have been issued, the results are detailed in an official document by the Treasury.

Questions?