Fed's primary dealer expansion seen aiding markets

By Emily Flitter

NEW YORK (Reuters) - The Federal Reserve Bank of New York's designation this week of two Canadian banks as primary dealers comes at a crucial time in which rates markets need all the liquidity they can get, analysts said on Wednesday.

Expanding the number of primary dealers will help keep the Treasury market and other short-term rates markets liquid, and is especially crucial as French banks continue to grapple with the euro zone debt crisis, the analysts said.

Primary dealers are the financial firms authorized to help the Federal Reserve carry out monetary policy and to bid directly at Treasury auctions on behalf of clients. The number of primary dealers once neared 40, but there are currently 22 on the list, counting the newest additions.

Two French banks that have struggled recently, Societe Generale <SOGN.PA> and BNP Paribas <BNPP.PA>, operate securities firms that are designated as primary dealers.

The two French banks are among several European institutions that have had to pay more for dollar funding, have seen their share prices fallen, and have had to arrange to sell assets to raise capital.

While there is no indication that SocGen's and BNP's problems are serious enough to jeopardize their primary dealer status just yet, they would exit the list de facto if they failed and likely also if they had to merge with other banks.

"The deterioration in market confidence is having real consequences, as illustrated by the delivering plans put forward by BNP, SocGen and Credit Agricole," wrote Goldman Sachs analyst Jean-Francois Neuez in a note to clients on Tuesday.

By contrast, the newcomers, Bank of Montreal <BMO.TO> and Bank of Nova Scotia <BNS.TO>, are at least for the moment pictures of stability. Bank of Nova Scotia actually runs its primary dealership directly rather than operating a separate securities dealing subsidiary.

"I see adding the Canadian banks as being favorable because they've had a much more stable environment -- they haven't been affected by the crisis swirling around them," said Marty Mosby, a managing director at Guggenheim Securities in Memphis who covers banks stocks. "You're not in a position of being stressed by the environment."

The New York Fed declined to comment.

SAFETY SOUGHT IN MONEY MARKETS

The money markets contain plenty of sources of stress. Repo rates rose on Wednesday, but demand for Treasury bills as repo collateral remained very high, according to Roseanne Briggen, an analyst at IFR, a unit of Thomson Reuters, in New York.

"People are nervous about French banks and counterparty risk," Briggen said.

"As an investor if you've got cash you may not want to buy a bank CD. So you want it to be in a very safe place so you can put it in the repo market. You get the T-bills versus the cash you've been putting in."

Briggen said losing primary dealers would decrease the liquidity in the repo market, as well as in the Treasury market.

"If you are a primary dealer, you have a bigger repo book, so that adds some liquidity. Your desk is going to be more involved in the auctions. The whole thing is liquidity -- that's what the dealers do -- so the more the merrier," she said.

That's not to say the New York Fed rushed through the primary dealer approval processes for BMO or ScotiaBank specifically because it was worried about France's banks.

"It takes a good 12 to 24 months to become a primary dealer, because it takes a long time for the Fed markets desk to get comfortable with a new firm," said Douglas Landy, a partner at Allen & Overy and a former New York Fed lawyer. They run you through a lot of tests."

But Landy said even though the New York Fed's specific approval timeline might not have changed, adding new primary dealers was still a smart move.

"I do think they're always worried about mergers or failures closing the number of primary dealers down to a few," he said, adding that the two Canadian banks' businesses looked simpler than some of the other securities dealers that have recently joined the primary dealer list.

"They've already let in the unconventional ones like Cantor Fitzgerald, Jefferies & Co and MF Global," he said.

(Editing by Leslie Adler)