Speech by SEC Commissioner:
Remarks Before the TBMA Legal and Compliance Conference
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
New York, New York
February 7, 2006
Good morning. It is always such a pleasure to be among so many old friends at The Bond Market Association. The danger, of course, is that with friends, such as Martha Solinger introducing me, it is difficult to maintain the dignified demeanor expected of an SEC Commissioner. Before I begin, however, I must remind you that my remarks represent my own views, and not necessarily those of the Commission, my fellow Commissioners, or the staff.1
I would like to address three topics today - price transparency in the bond markets, markups, and complex structured finance transactions.
Today, we are at the end of a long process of implementing timely trade reporting and dissemination of price information in the corporate bond and municipal bond markets. Early in January of this year, the Commission's approval of the immediate dissemination by the NASD of TRACE trade data became effective. TRACE, short for the Trade Reporting and Compliance Engine, is the NASD's system for reporting and disseminating last sale information on corporate bonds not traded on an exchange. First approved in January 2001 and launched in July 2002, TRACE began by reporting only a subset of all corporate bonds, mostly investment-grade bonds with an initial issue of more than $1 billion and the FIPS 50 high yield bonds. In the beginning, TRACE required reporting within 75 minutes of trade execution. Now, the NASD immediately disseminates price and transaction data within 15 minutes after execution. This represents 100 percent of all TRACE-eligible transactions in corporate bonds. On an average day TRACE provides information on approximately 22,000 transactions representing $18 billion in volume. TRACE data is broadly available to institutions via market data vendors, to newspapers and through the NASD and TBMA (through its website www.investinginbonds.com). The good news is that investors appear to be using these TRACE data sources. The NASD estimates that its investor website gets approximately 55,000 visits per month.2 The TBMA website permits searches of individual bonds and access to historical bond data, along with rating information and disclosure documents.
Similarly for municipal securities, the move toward timely reporting of trades and transparency has been deliberate and incremental. The MSRB technically initiated a trade reporting system in 1995, but it was a daily summary report of interdealer municipal bond trades. Implementation of its Real-time Transaction Reporting System, called RTRS, which requires transaction reports within 15 minutes of trade execution, did not begin until January 2005. While there are limited exceptions to the reporting requirement, such as for new issues and variable rate instruments, the vast majority of the 1.5 million municipal securities issues are reported timely and immediately disseminated by the MSRB's RTRS system.3 Municipal security pricing data is also widely available through the TBMA website and is available to market professionals via several data vendors (e.g., Bloomberg, BondDesk, and MuniCenter).
For regulators, consistent data on TRACE-eligible securities and municipals reported to RTRS are available to study and to surveil. This ability to review the trading in corporate and municipals has led to new insights about these markets and should, in turn, lead to better-informed regulatory surveillance and policy decisions. In the short time we have had access to such data, we have learned that retail investors, that is, trades of less than $100,000, represent approximately two-thirds of all reported trades in corporate bonds.4 Surveillance for various abusive practices, such as insider trading, manipulation, and compliance with best execution and suitability obligations have been greatly enhanced by TRACE and RTRS. Computer programs can screen for evidence of daisy chains, wash trades, and even patterns of violating fair pricing obligations.
It is fair to say that price transparency in the bond markets was achieved despite a fair amount of industry reluctance. Some portended disruption to the fixed income markets and loss of liquidity. Some dealers cautioned that immediate dissemination of transaction data on any but the most liquid bonds would tip the market about a dealer's position. As a result, so the argument went, transparency would discourage dealers from committing capital, assuming risk, and ultimately providing liquidity. Our experience shows, however, that these prophecies have not come to pass. Of note, the Commission has shown a willingness to accommodate the concerns of market participants who asserted that complete and immediate transparency was not practical. For example, dissemination of reports of the very largest trades are made with the volume capped, thus recognizing the sensitivity of this market information. Moreover, notwithstanding the fact that TRACE disseminates transaction data immediately upon receipt, members still have 15 minutes in which to report the transaction, so there is still some latency in the transparency regime.5
I think we have learned some important lessons from this experience with debt transaction reporting. In the earlier discussions regarding price transparency for debt, the dialogue centered on the "trade off" between transparency and liquidity. To date, we have not seen evidence of a trade off. The widespread availability of timely price information, whether the security is equity or debt, promotes fair and efficient pricing. Real-time price information aids investors and dealers in evaluating the current bid or ask for that security and furthers efficient price discovery. The fundamental knowledge that all market participants are subject to the same reporting rules and see the same price information, creates certainty, fosters investor confidence, and promotes participation in the markets.
Over the last few years, Commission staff in the Office of Economic Analysis, as well as academics, have analyzed the transaction data for corporate and municipal securities, with a view to understanding the impact of trade reporting and transparency on transaction costs and liquidity. These studies consistently observe that increased transparency reduces transaction costs and does not negatively impact liquidity.
OEA staff has studied the effect of the introduction of transaction price transparency to the OTC secondary corporate bond market and its findings will be published in a future issue of the Journal of Finance.6 Using corporate bond transaction data, OEA estimated average transaction costs as they related to trade size for each bond that traded at least nine times from January 2003 to January 2005. OEA found costs are lower for bonds with transparent trade prices. Because OEA could observe transaction costs in bonds before and after transaction reporting, they were able to estimate the change in transaction costs when the TRACE system started to publicly disseminate their transaction prices. Not surprisingly, transaction costs dropped. Specifically, OEA estimated transaction costs decreased by about five basis points. When you consider that approximately 2 trillion dollars in bonds trades were not transparent in 2003, investors might have saved an additional 1 billion dollars annually were there transparency in these bonds.7
Academics have independently looked at the impact of transaction reporting on execution costs and liquidity. One soon to be published study8 analyzed a sample of institutional trades in corporate bonds before and after the initiation of public transaction reporting through TRACE. The study indicates that trade execution costs for TRACE-eligible bonds dropped by 50 percent. The study also observed a spillover liquidity benefit for bonds not eligible for TRACE which caused execution costs in these securities to decline by 20 percent. This study also shows that the market share of the largest dealers has decreased suggesting that the corporate bond market has become more competitive following the rollout of TRACE. Another study also evaluated the impact of trade reporting on the liquidity of corporate bonds rated BBB.9 This study shows that transparency either has a neutral or positive effect on liquidity, depending on trade size. Notably, for all but the smallest trades, bond spreads declined for bonds whose prices became more transparent relative to bonds that had no transparency change, although I note that this did not occur for infrequently traded bonds.
OEA has also conducted a major study on municipal bond liquidity examining secondary trading costs for one year (1999-2000) of municipal bond trades. Using econometric analysis, the study concludes that effective spreads for a retail municipal bond trade were significantly more expensive than for a comparable sized equity trade - approximately 2 percent versus 0.8 percent for equities. Also, municipal bond transaction costs decrease with trade size and do not depend significantly on trade frequency. OEA attributes this differential to a lack of transparency in the municipal bond market and related to this, institutions having better price information than retail investors. The authors note that retail investors must be made aware that recent prices are available, in order to refer to them in evaluating a potential purchase or sale.
All this evidence of the salutary effects of transparency on transaction costs and liquidity is heartening indeed. These studies should put to rest the doubts that more sunshine on the activities of fixed income dealers would disrupt or impede the activities of dealers in these markets. Rather, greater transparency has improved efficiency and investor confidence. As in the equity world, it is entirely possible that lower spreads will be followed by greater investor participation in the markets, making it a win-win for investors and dealers alike.
Last week while reading my TBMA Action Line Update, I noted that others at the Commission have expressed an interest in the topic of pre-trade price transparency in the bond markets. In my view, if the bond markets evolve naturally into more order-driven electronic markets, pre-trade transparency might develop over time. Early efforts in the area of electronic bond trading on ECNs has not taken hold as rapidly as some may have expected, however. In the absence of a shift in bond market microstructure, it would seem quite premature to suggest that there might be regulatory efforts toward more continuous price quotations in the bond markets. Indeed, today it would seem to be economically wasteful under our current bond market structure to force dealers to continuously quote.
I'd like to turn now to markups. One area that I think deserves continued focus and energy is markup practices by fixed income dealers. I urge the industry to comprehensively review your practices and consider improving transparency concerning dealer mark-up policies and providing more useful disclosure to customers. Investors should understand what they are paying, whether the broker is acting as agent or principal, and whether the price paid includes compensation to the broker-dealer, and if so, how much. Unfortunately, we have found in many instances that retail bond investors do not understand these essential facts.
Last year, the MSRB noted several instances in which retail customers were charged prices for municipal securities that were not reasonably related to current market value. The MSRB identified a particular practice involving a series of transactions, or chains, where a block of securities bought from one retail investor, passes through a series of interdealer trades, and ultimately gets sold to another retail investor, often within a single day. No individual dealer made an excessive profit, but the large intra-day price differential, ultimately paid by a retail customer, is troubling. As a result of this practice and others, OCIE and the NASD have undertaken a review of municipal brokers.
In March 2005, the NASD also issued a proposed interpretation of its rules for transactions in non-municipal debt securities. The proposal provides guidance to bond dealers as to when a security's prevailing market price may be determined and how to calculate markups consistent with NASD fair pricing rules and Commission decisions interpreting the Exchange Act. The proposal established a base standard for the prevailing market price, which would be applicable to market-making and non-market making dealers alike - the dealer's contemporaneous cost. The proposal also set forth other measures of the prevailing market price, such as referring to bonds with similar characteristics, such as credit quality. The SEC staff is currently working with the industry and evaluating comments in order to refine the proposal in light of the practical realities of fixed income trading. This is not an easy task, but I do think it important that there be consistent standards for, and accountability of, dealers when setting prices and charging mark-ups to customers for fixed income products.
There have been other notable efforts to address bond market issues. In the fall of 2004, the NASD's Corporate Debt Market Panel issued a report making several useful recommendations that I encourage you to consider and implement. This panel of industry participants and academics, who were knowledgeable about the interests of individual investors, institutions, and broker-dealers, explored ways to improve market integrity and investor protection in the corporate bond market. The panel considered both institutional and retail issues, but its recommendations focused on the retail aspects of the debt markets.
The panel determined that many individual investors do not understand key characteristics of bonds, or the significance of the terms of the transaction they are engaging in. As a result, many investors have difficulty assessing the quality of the execution they receive. The report recommended that broker-dealers provide better information to individual investors, both at the time the investor indicates interest and then at the time of sale or purchase, that would allow investors to determine if the bond is an appropriate investment for their objectives, what execution quality they receive, and the bond's overall risk and return. The report identified specific information that the panel believed retail investors should be made aware of at these critical junctures. At the time an investor indicates interest in a bond investment, the Panel believed broker-dealers should make general disclosures about bonds, such as: the basic types of bonds, their structure, and special features; the relationship between price and yield; payment terms, credit risk and ratings, other risks, such as call and interest rate risk; and how brokers are compensated for bond transactions.10 Immediately prior to buying or selling a bond, the panel recommended broker-dealers provide more specific information, including data regarding: the bond's price, maturity, coupon, and unique features; indicators of marketability; applicable yield after broker compensation; and credit rating.
The panel also noted that disclosure of compensation for principal trades should be explicitly disclosed on trade confirmations, similar to the way commissions now appear on confirmations. Specifically, the panel recommended including on a trade confirmation an additional field for brokerage charges that would contain a description "commission" when a broker acts as agent; or a description saying "a payment to your brokerage firm may have deducted from [or incorporated in] the price you received [or paid]."11 Also, the panel recommended that credit rating, cash flow information and yield to worst be included on the trade confirmation. To improve investor education, the panel called for the NASD and industry to intensify their efforts to broadly distribute bond information through popular media channels and increase availability of TRACE data generally. Finally, the panel urged development of industry benchmarks such as indices so that retail investors, when contemplating a bond transaction, may refer to such benchmarks as a means to compare price, yield, and return information. Last year, the NASD prepared a rule proposal to enhance corporate debt confirmation disclosure that incorporates many of the panel's recommendations and which should be published for comment shortly. I hope you consider these recommendations seriously and support initiatives in these areas.
Finally, the recent press on the Enron proceedings in Houston serves as a reminder that the industry must be vigilant in adopting prudent policies and practices with respect to complex structured financial transactions. Difficult lessons were learned concerning the abusive use of complex structured finance transactions, as well as the substantial legal and reputational risks that financial institutions face when they design or use such transactions for improper purposes. After conducting investigations, the OCC, Federal Reserve System, and the SEC took strong and coordinated civil and administrative enforcement actions against certain financial institutions that participated in complex structured finance transactions with Enron. These transactions appeared to have been designed or used to shield the company's true financial health from the public. The enforcement actions involved significant financial penalties and required the institutions to undertake measures to strengthen their risk management practices for complex structured finance activities.
As you know, the Commission, along with several banking regulators, proposed an interagency statement concerning complex structured finance transactions. The Statement describes the types of internal controls and risk management procedures that the Agencies believe are particularly effective in assisting financial institutions to identify and address the reputational, legal, and other risks associated with complex structured finance transactions. The Statement provides that financial institutions should have effective policies and procedures in place to identify those complex structured finance transactions that present heightened reputational and legal risk, to ensure that these transactions receive enhanced scrutiny by the institution, and to ensure that the institution does not participate in illegal or inappropriate transactions. We received very thoughtful comments on the proposal and have continued to meet to discuss these critical issues. It is fair to say that the Agencies were sympathetic to the criticism that the Statement as originally proposed was too prescriptive and not flexible enough to accommodate the various business models to which it would apply. I anticipate that we shall be publishing a revised proposal with a brief comment period shortly.
In conclusion, I note that transparency in all its forms, whether regarding trade reporting and dissemination, mark-up policies, or complex structured products, increases investor confidence and is an essential component of efficient and fair markets. The Commission has long been a proponent of transparency in the fixed income markets, and I look forward to working with all of you as we continue to refine and improve fixed income market practices. Thank you.