United States: Y2K Standby Financing Facility

The FOMC authorized the SFF on August 24, 1999. The FOMC assigned the administration of the program to the FRBNY, which manages the discount window (FRBNY 1999b).

The purpose of the SFF was to “provide tangible encouragement to primary dealers to continue to make markets and to undertake their normal intermediation activities in securities markets, so as to sustain the liquidity of these markets around the century date change” (FRBNY 2000). Sources at FRBNY indicated that a key purpose of the FRBNY was to provide funding to financial institutions that were ineligible for discount-window loans, through the primary dealers.

At the August 24, 1999, FOMC meeting, committee members highlighted concerns that primary dealers would not be “willing to be on both sides of the market for us in some depth . . . market conditions may frustrate the Desk’s ability to add and drain reserves in the period around the year-end and to keep the funds rate trading around the Committee’s target” (FOMC 1999, 19).

Section 14 of the Federal Reserve Act gives the Federal Reserve its legal authority to conduct domestic open market operations programs. The FOMC annually authorizes the New York Fed to execute open market transactions on the Fed’s behalf. Its directions to the New York Fed are contained in the Authorization for Domestic Open Market Operations. On August 24, 1999, the FOMC voted unanimously on a temporary addition to that document that authorized the SFF. Specifically, the FOMC added language to allow the FRBNY to sell options on repos for exercise no later than January 2000 (Board of Governors 1999b, 820). Unlike the SLF, the Federal Reserve Board did not have to revise its regulations to create the SFF (see Leonard, 2022).

The SFF was part of the Fed’s broad, multi-year preparations for the century date change (Kelley 2000). On August 24, 1999, the FOMC agreed on a number of measures: expanded accepted collateral at the discount window, authorization to execute repurchase agreements with up to 90-day maturities, and the SFF (FRBNY 1999b). In a press release on September 8, 1999, the FRBNY announced these measures. It said their purpose was to facilitate “the smooth functioning of money and financing markets and . . . to manage banking system reserves” with respect to Y2K (FRBNY 1999b). Previously, on July 20, the Federal Reserve Board announced the Special Liquidity Facility to provide collateralized term loans to depository institutions (Board of Governors 1999a).

The FOMC directed the Trading Desk at the Federal Reserve Bank of New York (FRBNY) to administer the SFF (FRBNY 2000, 1). Disclosure and oversight for the SFF were consistent with procedures in place for the discount window and open market operations (FRBNY 2000, 4).

The SFF was administered through a Dutch-style auction, wherein options were auctioned in $50 million increments, and winners of each auction paid the rate on the lowest accepted bid (FRBNY 1999a). Auctions for the three strips were initially to be held at 2:30 p.m. on five Wednesdays, beginning October 20, 1999, and ending November 17, 1999 (FRBNY 1999a). The FRBNY added two additional auction dates on November 23 and December 1 in response to higher than expected uptake for the first five auctions (Drossos and Hilton 2000, 5).

The SFF was funded through the Fed’s balance sheet (FRB 2020).

The SFF was initially authorized to auction up to $32 billion in options at the first auction. The term sheet indicated that for subsequent auctions, the FRBNY would offer similar or larger amounts depending on demand at the first auction (FRBNY 1999a). At the August 24 FOMC meeting, the FOMC anticipated auctioning $200 billion in options in total (FOMC 1999, 31).

In practice, the SFF auctioned options worth $42 billion at the first auction, $49 billion at the second, $95 billion at the third, $120 billion at the fourth, $65 billion at the fifth, $55 billion at the sixth, and $55 billion at the seventh (FRBNY 2000, 31). The increase in the size of the auctions was consistent with the SFF’s term sheet, which said that the FRBNY could increase or decrease the volume of options at auction (FRBNY 1999a). Officials at FRBNY indicated that they preannounced the total auction size, as well as the auction size per strip.

The SFF limited the number of bids an eligible participant could place per strip. Specifically, a primary dealer could place at most two bids for its own account and no more than two bids for each customer per strip (FRBNY 1999a).

The SFF auctioned off overnight repo options in $50 million increments through a Dutch-style auction (FRBNY 1999a). In Dutch auctions, the winners of the auction pay the bid of the lowest successful bidder, determined by accepting bids—starting with the highest rates bid—until the amount of accepted liquidity exhausts the amount offered. Options were sold in three sets, called “strips,” each of five days as shown in Figure 4.

Options bought in a given strip could be exercised on any or all of the days covered by the strip for up to the total amount that the holder was awarded at auctions for that strip. Holders of a strip could exercise all or part of the strip as a term repo, covering two, three, four, or five business days, but had to pre-announce exercise on subsequent days (FRBNY 1999a). For example, a holder of $100 million in Dec. 30 strip options could have exercised $50 million on December 30 and $50 million on December 31 but had to pre-announce the exercise of options on December 31.

The strike price for options was set at 150 basis points above the FOMC’s target federal funds rate as of 10:00 a.m. on the exercise date (FRBNY 1999a). Additionally, options in the December 30 strip could be exercised after 10:00 a.m. and before 11:30 a.m. with a strike price of 250 basis points above the FOMC’s target federal funds rate as of 11:30 a.m. on the exercise date (FRBNY 1999a).

In discussing the proposal at the August 24, 1999, FOMC meeting, committee members highlighted that “a range of 150 basis points is considerably wider than the range in which normal arbitrage takes place” and argued that the facility would offer primary dealers “market disaster insurance to get them more comfortable intermediating within that range” (FOMC 1999, 29). Sources at the FRBNY indicated that they chose an auction format to ensure that options were sold at a market-clearing price rather than as a stigma-limiting measure.

Eligible collateral for the SFF included all collateral typically eligible for repo with the FRBNY, as well as additional collateral that the FOMC approved at its August 24, 1999, meeting. Expanded collateral included pass-through mortgage securities of the Government National Mortgage Association (Ginnie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannie Mae); STRIP (Separate Trading of Registered Interest and Principal of Securities) securities of the US Treasury; and “stripped” securities of other government agencies (FRBNY 1999b). Stripped securities are coupon bonds that have been transformed into zero-coupon bonds.

The FRBNY established triparty settlement agreements with two clearing banks to value and accept delivery of collateral for repo. The FRBNY stated that “as a practical matter, triparty agreements were needed to facilitate the pricing and valuing of mortgage-based securities on” repos (FRBNY 2000, 4).

The SFF sold options on overnight repurchase agreements (repos), that therefore had overnight maturities. However, holders of an option could also exercise the option as a “term repo, covering two, three, four, or five business days, by pre-announcing the exercise of subsequent days” (FRBNY 1999a).

The minimum price a dealer could bid was set at 0.5 basis points (FRBNY 1999a). Minimum increments were set at 0.5 basis points as well (FRBNY 1999a).

In creating the program, the FRBNY developed strategies for offsetting the impact of SFF options on the level of reserves. The Desk planned “to offset the impact of reserves created through the exercise of options…by cutting back on the supply of reserves provided through ordinary RPs…[or entering] the market to drain reserves later in the day” (FRBNY 2000, 30). If strong upward rate pressures triggered a broad exercise of SFF options, the Desk was “prepared to abandon its normal reserve management…and to accept a super-abundance of reserves created by the options as useful for countering market stress” (FRBNY 2000, 30). Sources at the FRBNY indicated that by selling options the Desk could provide liquidity during the century date change without permanently impacting the federal funds rate (FFR).

The Fed also created the SLF, a facility that operated through the discount window to provide liquidity to depository institutions (see Leonard, 2022).

Although some other countries also took special measures in anticipation of the century date change, Sundaresan and Wang (2006, 22) could not find an example of another central bank that sold options like the Fed’s SFF. Other programs undertaken by other central banks varied. The Bank of Canada issued Y2K options to depository institutions without a premium. The Bank of Canada also expanded the range of collateral accepted, like the Fed. The Bank of England issued special Treasury bills that matured on December 31, 1999; expanded the range of repo maturities to 90 days; and expanded the range of accepted collateral (Sundaresan and Wang 2006, 22).

In late 1995, the Fed created the Century Date Change (CDC) project to coordinate Y2K readiness across the Federal Reserve system. As part of this plan, the CDC project reviewed every bank by mid-1998 to assess readiness (Kelley 1997). Between 1997 and 1999, the Fed published contingency planning guides, brochures on bank readiness, and press releases explaining the impact of the century date change (Board of Governors 1999c).

On September 17, 1999, the Fed held a Year 2000 Summit to discuss the century date change event, and the actions that the financial sector and the Fed had taken to prepare for the event. Chairman Greenspan noted that while the financial sector had generally taken the necessary steps to prepare and that “the technical breakdowns that might occur as a consequence of the CDC are readily containable,” there was evidence that borrowers and lenders were building up liquid assets to reduce reliance on credit markets. He said that the SLF and the SFF “should help to ensure an ample supply of liquidity and relieve funding pressures” (Greenspan 1999).

In the original term sheet published October 7, 1999, the FRBNY indicated that the day following each auction it would publish the volume of bids submitted and accepted, the range of prices submitted, and the lowest accepted bid (stop-out rate). It also indicated that it would publish the volume of options exercised shortly after the deadline for notice (FRBNY 1999a).

On October 8, 1999, the FRBNY expanded the information it publicly disclosed to make the SFF “more transparent” (FRBNY 2000, 4). Specifically, the FRBNY additionally published the weighted average rate on accepted propositions (FRBNY 2000, 4).

At the August 24, 1999, meeting wherein selling Y2K options was first proposed, FOMC members did not explicitly discuss stigma associated with the facility. Rather, committee members discussed the price mechanism for the facility so that the price was “low enough so that we are making insurance available to the market to calm it down but high enough to provide some constraint on demand,” indicating that they anticipated primary dealer uptake (FOMC 1999, 32).

Sources at FRBNY indicated that the facility was designed as an auction to ensure that liquidity was offered at market rates, which would destigmatize borrowers. However, the program also charged a penalty rate and a fee to limit overuse.

The SFF held only a few auctions, and all options expired by January 12, 2000 (FRBNY 1999a).