Speech by SEC Commissioner:
Developing Bond Markets in APEC: Key Lessons from the U.S. Experience: Remarks before the ABAC/ADBI/PECC Conference
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
June 21, 2005
Thank you, Mr. Toyoo Gyohten (President, Institute for International Monetary Affairs, Japan) for the introduction. It is my pleasure to be here today at the Asian Development Bank Institute's Conference on Developing Bond Markets in Asia. Before I start, I must issue the standard Securities and Exchange Commission (SEC) disclaimer: The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses my personal views, and does not necessarily reflect those of the Commission, other Commissioners, or members of the staff.
As all of you know, a series of financial scandals in the United States over the past three years have proven to be something of a watershed for U.S. markets. The collapse of Enron and other financial improprieties in the issuer, investment banking, and mutual fund industries have led to the most significant revamping of U.S. securities laws in 70 years. Asia, too, had its watershed financial crisis in 1997. As the saying goes, with crisis comes opportunity, and just as Enron led to many positive changes in U.S. markets, the 1997 Asian crisis, while highly disruptive on many fronts, also led to many positive developments. For example, several regional development and regulatory initiatives, emphasizing such things as strong corporate governance and market transparency, were a direct result of the events of the 1997 crisis.
As a policy matter, the United States has long supported Asian trade and financial integration and the creation of more efficient, transparent, and well-governed financial markets. Successful Asian companies need capital to keep being successful, and we have long believed that American investors should be able to pursue legitimate investment opportunities wherever they may be. Efficient, transparent and well-governed financial markets are the lynchpin that produces a win-win situation for everyone.
Lessons from the Crisis
One key lesson coming from the crisis was the need for additional forms of capital formation and financial intermediation away from the dependence on bank intermediation. Just as a smart business has more than one source for a critical component, financial markets are stronger when they are not dependent on just one form of capital financing. As Federal Reserve Board Chairman Alan Greenspan said, it's always good for markets to have a "spare tire." In this regard, local capital markets are an important "spare tire," and since the Asian financial crisis, many countries have taken steps to strengthen securities regulation and bank supervision.
I understand that the regional initiatives discussed today were spurred not only by the weaknesses uncovered in the financial system, but also by a desire to reduce East Asian dependence on external capital, and to create internal mechanisms for dealing with liquidity crises. As a result, since 1997, Asian bond markets have experienced significant growth. Capitalization of domestic bond markets has roughly doubled since 1997 from 25% to approximately 50% of GDP. In terms of outstanding credit, bond markets have grown from 10% of outstanding in 1995 to over 20% in 2002.
Of the many regional initiatives, APEC and the Asian Development Bank have been active, with proposals such as the Asian Bond Fund and Asian securitization project. These initiatives are producing several benefits in Asia, including a focused attention on financial market development and institutional strengthening. In addition, bringing the various countries in the region together and dealing with issues like standardization helps bring the weaker players along.
Notwithstanding the initiatives and developments described above, it is important to keep some perspective. Ideas for securitization and credit enhancement are sound in theory, but such sophisticated derivatives require high-quality market institutions and infrastructure, together with a well-functioning legal and supervisory framework in the underlying local bond market. Clearly, the initial focus should be on developing these basic institutions and laws - a process that could include opening up to foreign intermediaries.
Summary of the Current U.S. Situation
As history and current practice shows, rather than using official interventions to create demand in the U.S., the key is to create a market environment in which private investors are better able to assess and price risk. This will lead to capital market efficiency and economic growth.
Bond markets in the United States have had a long, illustrious, and sometimes questionable history. For example, early bond markets financed our country's westward expansion, including construction of the trans-continental railroad and the Erie Canal. They were vital to the country's development in more ways than one, but it was not always a pretty picture. Many early investors in the railroads and Erie Canal - including many foreign investors - lost large sums of money as these companies went bankrupt due to fraud or mismanagement. There was no SEC at the time, so an entire private industry developed designed to give investors more information about these companies and the likelihood that they would repay their debts. Accordingly, Standard & Poor's, Moody's and the Wall Street Journal all got their start as private-sector bond market "watchdogs."
The SEC subsequently was created as a government response to financial scandals in our bond markets, as well as our equity markets. And since then, our bond markets have grown enormously.
Today, bond markets in the U.S. remain large and economically significant by any measure. The U.S. corporate market has over 37,000 bonds outstanding and more than 3,000 registered market participants. The municipal market has well over 1 million bonds outstanding and more than 2,000 registered dealers. The average daily trading volume in long-term corporate and municipal securities for the first five months of this year was about $37 billion U.S. dollars - compared to about $56 billion for the New York Stock Exchange (NYSE). Individual bond transactions range in size from a few hundred dollars to over $100 million. Bond investors include individual retail investors with small portfolios, as well as the largest institutional investors.
Today, in the United States, major reforms are currently underway in both the equity and fixed income markets. On the equity side, much has been reported about the SEC's new rule, Regulation NMS, which will affect the equity markets, as well as the proposed changes involving the NYSE and NASDAQ, respectively. But on the fixed income side, there also has been considerable reform taking place, particularly relating to price transparency in the corporate and municipal bond markets.
The U.S. moves on corporate bond transparency emanated from two requests from the SEC to the National Association of Securities Dealers (NASD). In 1991, former SEC Chairman Breeden asked the NASD to create a system to promote transparency in liquid high-yield corporate bonds following insider trading and price manipulation scandals in the bond markets in the late 1980's. The Commission sought to avoid another scandal such as the one that lead to the demise of Drexel Burnham Lambert. As a result, the NASD created the Fixed Income Pricing System (FIPS), which provided transparency for 50 liquid high-yield bonds.
In 1998, former Chairman Levitt noted that the FIPS initiative did not go far enough, remarking that "[t]he sad truth is that investors in the corporate bond market do not enjoy the same access to information as a car buyer or a homebuyer or, dare I say, a fruit buyer." To address the lack of price transparency in the corporate debt market, Chairman Levitt called on the NASD to do three things: (1) Adopt rules requiring dealers to report all transactions in U.S. corporate bonds and preferred stocks to the NASD and to develop systems to receive and redistribute transaction prices on an immediate basis; (2) Create a database of transactions in corporate bonds and preferred stocks. This would enable regulators to take a proactive role in supervising the corporate debt market, rather than only reacting to complaints brought by investors; and (3) In conjunction with the development of a database, create a surveillance program to better detect fraud in order to foster investor confidence in the fairness of these markets. As a result, broker-dealers must now report all Over-the-Counter (OTC) corporate bond transactions to the NASD's Transaction Reporting and Compliance Engine (TRACE) System.
In relation to the overall theme of this conference - public-private sector partnership - I note that with respect to both FIPS and TRACE, the SEC asked the industry's self-regulatory organization, the NASD, to develop the systems. In addition, throughout the various phases of TRACE implementation, the SEC actively engaged in dialogue with, and responded to comments made by, bond market participants.
This public-private sector partnership clearly has resulted in greater transparency. As of February 7, 2005, trade information from most trades (99%) in all 29,000 corporate bonds is publicly available within 30 minutes after trade execution. On July 1, 2005, the 30 minute reporting window will narrow to 15 minutes. The remaining 1% of transactions are transparent with a delay of up to 10 business days. These trades occur in inactive high-yield bonds and in new issues. This delay in near-real time price transparency was a response to industry concerns that price transparency might somehow discourage the willingness of dealers to commit capital and adversely affect market liquidity. The Commission expects the NASD to eliminate these delays by November 1, 2005.
The public-private partnership model was similarly used by the SEC to bring transparency to the municipal bond market. The SEC oversaw the development of the Real-Time Transaction Reporting System (RTRS) by the Municipal Securities Rulemaking Board (MSRB), the self-regulatory organization (SRO) for municipal debt securities. Currently, broker-dealers must report all municipal bond transactions to RTRS. As of January 31, 2005, all trades in municipal bonds are available with a 15-minute lag.
Another potential development that may increase transparency in the U.S. bond markets is that the NYSE has petitioned the Commission to grant exemptive relief to allow it to provide a market for trading more bonds. Currently, the NYSE's Automated Bond System (ABS) provides a market for less than 1% of corporate bond trading due to a prohibition in the Exchange Act that limits NYSE members to quote only the bonds of issuers that are registered with the Commission. In contrast, debt securities may trade in the OTC market absent Exchange Act registration. According to the NYSE, 92% of the par value of all debt traded in the U.S. capital markets is traded OTC due, in part, to this disparate regulatory treatment. The NYSE recently submitted a request for exemptive relief from this prohibition. If this request is granted, I believe there may be even greater transparency in the U.S. bond markets. Bond trades through the ABS are reported instantaneously. In addition, investors can see bid and ask quotations and last sale prices, exclusive of any mark-ups, mark-downs, or other charges.
In addition to the advantages of greater transparency and disclosure if the exemptive relief is granted, investors also may benefit from the increased competition among bond markets in the United States. The key in reviewing the NYSE's request will be to balance the proposed relief with the potential loss of the comprehensive public information that an issuer must provide under Exchange Act registration. I look forward to examining this request more closely in the approaching days.
As one of our greatest Supreme Court justices, Justice Brandeis, once wrote, when arguing for the creation of financial disclosure laws "[i]t is said that sunlight is the best disinfectant, electric light the best policeman." Rather than second-guess the market's judgment on a bond issuance, our new initiatives are designed to provide the market with the information it needs to make these judgments. With more and better information, we fully expect that bond market liquidity will improve, transaction costs will lower, and issuers will be able to access capital at lower cost.
I believe we are already seeing results. A recent study by SEC economists found that transaction costs decline when corporate bond prices become transparent. The magnitude of the decline suggests that an additional $1 billion U.S. dollars in additional savings would have been realized by investors in 2003 if all corporate bond prices had been transparent throughout the entire year. This finding and results from other empirical studies are important because they dispel previous concerns from market participants that adding price transparency to the bond markets would somehow harm liquidity.
The long-run benefits from transparency for all market participants are probably even greater. Most of the long-run benefits of transparency come from the adaptation of the market and the accessibility of the data. Note that these benefits are largely out of the control of regulators. For transparency to really work, market participants have to use the new information to improve the markets.
Everyone wins with price transparency. Information that is timely, accurate, and easily accessible - which the regulators can ensure - allows investors to make more informed decisions. Broker-dealers have the opportunity to adapt to meet the new investor demands for bond market products and services facilitated by price transparency. Significant improvements in the fair valuation of bond mutual funds are now possible. Issuers benefit from a lower cost of capital due to the improvements in the secondary market liquidity of their bonds - a link that has long been asserted in finance theory and has been increasingly supported by empirical evidence.
There are also important collateral implications for regulators. It is important to distinguish the reporting of trade information from the dissemination of this information to the public. Even if not all of the transaction information is made available to market participants, the public can benefit from central trade reporting because regulators will have better information and will not need to rely on anecdotal evidence. The problems with anecdotal evidence are illustrated by The Story of the Blind Men and the Elephant. Each of the blind men had a different description of the elephant depending on which part of the beast they came in contact with - the hide, trunk, or the tusk. None of the blind men was lying about the elephant nor were they trying to mislead, but none gave an accurate description either. The trouble with anecdotal evidence is that regulators cannot tell how complete or accurate the information is.
Central trade reporting gives regulators the ability to learn more about the markets than they can from anecdotal evidence alone. For example, prior to central trade reporting to TRACE, a widely held view among market participants and regulators was that there was not much retail interest in trading corporate bonds. However, once we started collecting and analyzing trade reports from the entire OTC corporate bond market through TRACE, it became evident that there was substantial retail interest in corporate bonds - 2 out of every 3 transactions reported to TRACE are "retail-size" (less than $100,000).
Regulators also can more effectively and efficiently police and enforce rules and standards. The data from central reporting gives regulators a greater ability to conduct low cost monitoring. As a result, regulators can more efficiently focus on specific targets that are most likely to be violating securities laws. Regulators can also appropriately revise rules and standards. Armed with a better understanding of the markets and a better ability to monitor, regulators can write better rules to maintain or improve the integrity of the markets.
Financial crises everywhere tend to expose weaknesses in a financial system, but they also offer the opportunity to fix those weaknesses and strengthen our markets long-term. Of course, while learning from one's own painful experiences is good, learning from another's painful experiences is even better. Recent events in the U.S., Europe, and Asia demonstrate not only how important bond markets are, but how important transparency is to the health of these markets. Transparency equals efficiency and liquidity. It means a lower costs of capital for issuers, better opportunities for investors, and lower transaction costs for everyone. But ultimately, transparent, efficient, and liquid bond markets are not built solely on regional initiatives. The theory has to be put into practice, and this means strengthening markets and institutions at home.
The type of disclosures and regulatory oversight needed for healthy capital markets can be intimidating, particularly where this level of disclosure and oversight has not been the rule in the past. There is a degree of uncertainty in transparency - the fear that one is giving up something very tangible (such as information about one's own intentions or condition) in return for something that seems intangible (better information about the market). But this is not a blind leap of faith. The evidence is in, and $1 billion is not pocket change. It is money that I'm sure investors and issuers everywhere could find a way to put to good use.