REFILE-Direct bidders a new reality for Treasury auctions

By Emily Flitter

NEW YORK, May 14 (Reuters) - A controversial feature of recent U.S. Treasury auctions is gaining grudging acceptance among the community of banks and other financial institutions charged with linking the U.S. Treasury and the wider market for U.S. government debt.

Primary dealers, the 18 firms authorized to bid on behalf of their customers at Treasury auctions, have seen their takedown share of recent auctions diminished by a growing number of Treasury buyers who have obtained their own bidding terminals.

The subject has made it to the top of lists of issues primary dealers have taken to government officials during regular meetings. When the phenomenon first began, dealers complained bitterly.

'It's a big amount of the demand for the auction that used to go through the dealer community and is now sidestepping the dealer community,' said Rick Klingman, managing director of Treasury trading at BNP Paribas in New York.

Primary dealers have argued that these auction participants, known as direct bidders, were upsetting the auction process and could ultimately raise the U.S. government's cost of borrowing by driving up Treasury yields.

So far, that has not happened.

Primary dealers widely concluded that Wednesday's $24 billion 10-year note auction was a success because the high yield the government had to pay on the 10-year notes auctioned fairly matched the yield at which older 10-year notes were trading at the same time in the open market. At that auction, a quarter of the bids accepted came from direct bidders.

Instead of complaining about the high percentage of directs, however, several dealers who commented immediately following the auction said they represented strong buy-side demand -- a positive for the market.

'Why are the dealers upset? I don't know,' said John Spinello, Treasury bond strategist at Jefferies & Co. in New York, a primary dealer. 'It's more of a level playing field in my opinion for those entities going directly to the Fed and not to primary dealers.'

The Treasury Department does not release information on how many direct bidders participate in each auction or who they are, but data on the allotment of securities distributed at each auction has allowed analysts to make rough guesses about the types of institutions that make up the pool of direct bidders.

Based on Treasury data, which is released on a lag of between two weeks and a month, one set of direct bidders appears to be the institutions that are trying to obtain permission from the Federal Reserve Bank of New York to become primary dealers, such as TD Bank and MF Global. This can be determined by subtracting the percentage of an auction awarded to primary dealers from the percentage awarded to all broker-dealers.

In the shorter maturity issues such as two-year and three-year notes, the direct bid award is nearly identical to the difference between the broker-dealer total and the primary dealer award.

For 10-year notes, the direct bid appears to come from domestic investment funds. While there has been little statistical change in the amount of recent 10-year auctions awarded to foreign participants, the direct bid has increased and there has been a statistically significant increase in the amount awarded to domestic investment funds.

Some of these funds, now flush with cash pulled from other markets amid anxiety over the Greek debt crisis, may in the past have gone to dealers to place their Treasury bids. And dealers have argued that without the customer orders they used to get, they have trouble deciding what to bid at each auction.

But dealers also admit they have not changed their bidding processes. If they did, they would risk garnering criticism from the New York Fed, which keeps track of primary dealers' bidding behavior and makes sure the dealers are living up to their commitment to take down a certain percentage of each auction.

As one Treasury market participant who did not want to be named put it: 'In this environment there's a lot more stick than there is carrot for a primary dealership.'

(Additional reporting by IFR Markets Global Managing Analyst for Rates Kenneth Logan and IFR Markets Fixed Income Analyst Courtney Drake in Boston; Editing by Leslie Adler) Keywords: USA/BONDS AUCTIONS ([e-mail]; [phone]; Reuters messaging; [e-mail]) COPYRIGHT Copyright Thomson Reuters 2010. All rights reserved. The copying, republication or redistribution of Reuters News Content, including by framing or similar means, is expressly prohibited without the prior written consent of Thomson Reuters.