By Michael S. Derby

The Federal Reserve Bank of New York said Tuesday it is launching a test program to find small financial firms with whom it can trade mortgage bonds.

The new effort, known as the Mortgage Operations Counterparty Pilot Program, is another chapter in the Fed's long-running effort to broaden the universe of firms it can trade with. It follows in the footsteps of a recently completed test effort that employed similarly small firms to trade Treasury bonds with the central bank.

Firms eligible to participate in the mortgage program are smaller than the Wall Street giants that comprise the Fed's primary dealer roster. The Fed has long relied on these mega-banks to serve as its main trading partners when it buys, borrows and sells Treasury and mortgage bonds. The securities purchases affect borrowing costs in the U.S. economy, and are the primary way in which the central bank influences the economy's trajectory.

The Fed says it is looking for a "small number" of participants for the mortgage program. Eligible firms must be a registered U.S. broker-dealer or chartered bank with capital levels between $1 million and $150 million. The firm must stand ready to buy and sell mortgage bonds. The New York Fed said it expects to announce the names of the firms no later than the first quarter of 2015.

The Fed is looking beyond the 22 primary dealers largely due to the radical changes seen in monetary policy over the course of the financial crisis. Waves of Treasury and mortgage bond buying have lifted the size of the central bank's securities holdings from just over $800 billion in late 2007 to the current near-$4.5 trillion mark. Some $1.7 trillion of those securities are mortgage bonds.

At some point, the Fed will move toward ending its ultra-easy monetary policy stance, and it will begin moving to withdraw or sideline the massive level of liquidity it has injected into the economy. The size of the job may be too large for traditional primary dealers to accommodate, so the central bank has been looking at other firms it can do business with. Looking to smaller banks and other financial firms could assist the Fed in returning monetary policy back to a more normal level, even in a financial system still awash in money.

In its press release, the Fed said its mortgage program exists to "explore ways to broaden access to open market operations, and to determine the extent to which firms beyond the Primary Dealer community can augment the New York Fed's operational capacity and resiliency in its monetary policy operations."

The effort announced Tuesday isnot the only place where the Fed is looking beyond primary dealers. Notably, there is the Fed's overnight reverse-repurchase agreement facility, which it hopes will provide enhanced control over short-term interest rates. It counts as counterparties large money funds, nondealer banks as well as the primary dealers.

Write to Michael S. Derby at michael.derby@wsj.com

(END) Dow Jones Newswires

August 05, 2014 13:33 ET (17:33 GMT)

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