Speech by SEC Commissioner:
The Continuing Evolution of the Bond Market and Other Observations:
Remarks Before the Bond Market Association's 30th Annual Conference
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
New York, New York
May 19, 2006
Thank you, John. It is always a pleasure to address The Bond Market Association, and especially so this year, during your 30th anniversary celebration. I am honored to be included among the distinguished speakers invited to address this conference. As I mentioned the last time I spoke here, my connection with the bond market is personal. My father was a life-long investor in bonds and taught me how to clip coupons at an early age. Given the occasion of your 30th anniversary, which the greeting card industry calls the "Pearl Jubilee," I thought I would offer some "pearls of wisdom" in the form of an historical perspective this morning. I'd like to take note of the sweeping changes that have taken place in the bond market since my father's day and look ahead to changes that may occur as the bond markets continue to evolve. Before I begin, I must make the standard disclaimer that the views I express here this morning are my own and do not necessarily reflect those of the Commission, my fellow Commissioners or our staff.
By the end of 2005, according to Federal Reserve data, outstanding corporate and municipal debt in the United States totaled $5.35 trillion and $1.86 trillion, respectively. This huge market, which has operated over-the-counter for several decades, was originally an exchange market. An interesting paper by Bruno Biais from Toulouse University in France who was a visiting economist at the Exchange, and Richard Green from Carnegie Mellon, points out that, prior to World War II, there was an active market on the New York Stock Exchange in both corporate and municipal bonds.1 Until the late twenties, bond trading took place in the same room as stock trading - organized around three booths in the North East corner of the Exchange. As trading in bonds increased, more space was allocated to it, and in 1928, the "bond room," located at 20 Broad Street was opened, connected directly with the Exchange floor. Actively-traded domestic bond issues were traded on the floor, while domestic bonds that traded less frequently were handled in the "inactive" crowd where orders were written on slips of paper and filed in the bond "cabinets."
In the late 1920s, the trading of municipal securities on the Exchange migrated to the OTC market, and in the mid-1940s, trading in corporate bonds migrated as well. Biais and Green suggest that the shift had nothing to do with anything unique about bonds or bond trading per se, but was the result of the relative importance of different types of traders at different times. Their research indicates that, in the late 1920s, retail investors became more attracted to the higher returns on equities than municipal bonds. As retail interest waned, institutions were left as the major player in the municipal market, and they gravitated towards the OTC market.
As far as corporate bond trading goes, Biais and Green debunk arguments that corporate bond trading declined on the Exchange because of a decline in the supply of bonds outstanding or a drop in listings in response to regulatory requirements under the then newly enacted federal securities laws. Rather, during the 1940s, institutional investors increased their ownership of bonds and their presence in corporate bond trading. The authors suggest that the combined power of dealers and institutional investors tipped the balance away from exchange trading in corporate bonds in favor of trading over-the-counter. The end result was that, by the mid-1940s, bond trading on the Exchange had essentially migrated to the OTC market. One of the underlying lessons of the Biais and Green paper is that the bond markets have evolved in response to a changing investor base.
The bond markets have also evolved through several regulatory changes. Beginning in the 1970s, the regulatory environment for bond trading began to change. 1975 saw the creation of the Municipal Securities Rulemaking Board, and in 1986, with the enactment of the Government Securities Act, government securities dealers were required to register, the Treasury was given certain rulemaking authority over government securities dealers, and the dealers' associated persons became subject to NASD oversight with respect to sales practices.
In the 1990s, the need for greater transparency in the debt markets became the regulatory mantra. The MSRB committed to implementing trade reporting requirements in 1994, and the process culminated in January 2005 with "real-time" trade reporting for municipal securities. In the corporate debt market, the NASD developed its Fixed Income Pricing System in 1994 in response to Congressional concern over market abuses in the high-yield market. Later, in response to urging by former Chairman Levitt, the NASD built TRACE, which began operations in July 2002. Today, the NASD disseminates "real-time" information on transactions in more than 29,000 corporate fixed-income securities, including investment grade and high-yield debt securities.
There is an interesting footnote to this short history that brings us full circle. Last May, the New York Stock Exchange filed an exemptive request to permit its Automated Bond System ("ABS") to offer trading in the unlisted debt securities of Exchange-listed issuers. The ABS was created in 1976, and over 1,000 bonds are listed on the Exchange, but trading on the system has been limited. The current proposal raises a number of interesting regulatory issues. The NYSE and supporters of the proposal argue that requiring bonds that trade in the listed market to be registered, but not imposing that requirement in the over-the-counter market, is anti-competitive, and that there is greater transparency in ABS than TRACE. The NASD argues that trades in unlisted bonds effected through ABS are actually OTC transactions subject to its oversight, and that the Commission's key consideration should be to protect against the fragmentation of information to bond investors.
There is sensitivity to the fact that requiring NYSE member firms to double-report their trades to ABS and TRACE, as TRACE rules currently require, could be an impediment to the potential growth of ABS. It is my understanding that the staff is discussing this issue with the relevant parties. Assuming that the trade reporting issue can be resolved, it is critical that we consider carefully how NYSE trade reports could be added to the mix of information made available to retail bond investors. Given the increased transparency that has been achieved in the bond markets, I am hopeful that we can build on this progress and provide investors with consolidated information.
The purpose of my brief historical overview is to make the point that bond trading has thrived under different market structures at different times and to underscore the likelihood that the bond markets will continue to evolve. As millions of baby boomers retire (the figure I've heard is that a baby boomer will turn 60 every eight seconds for the next 20 years), their appetite for bonds will grow, and they will demand new products and services and maybe even new ways of trading. Will there be new entrants to the bond markets that change the competitive landscape, and spur innovation? Will trading continue to move to electronic venues? According to the 2006 Bond Market Association e-Commerce survey, electronic trading has a toehold, but much of the market still operates over the phone. Will demand create incentives for pre-trade transparency? Will demand lead to the creation of an easier way for investors to compare execution quality across dealers and trading venues? Could a form of "dash 5"- type execution quality disclosure work in the bond market?
One area of continuing concern is the issue of transaction costs. Examining historical trade data for a sample of municipal issues, Biais and Green found that transaction costs for retail muni trades in the mid-1920s were lower than comparable trading today. Studies by SEC staff economists as well as several academics find that increases in transparency reduce transaction costs for trades of all sizes.2 Increased investor demand in the bond market will also lead to innovations that likely will continue to increase transparency and further reduce transaction costs.
We may not be able to predict how the bond market will evolve, but we can be sure that effective compliance practices by bond market participants and effective examination and enforcement by the Commission and the SROs will be an essential component of an expanding bond market. Retail investors are active participants in the bond markets, and their investment in bonds will increase as the population ages. For seniors who may not have adequate savings for retirement, the lure of high-yield products may be irresistible. Yet as investors reach for high yields, two things are inevitable. The unscrupulous will try to take advantage of investors through fraudulent means, and investors will be tempted to invest in high-risk products that may not be suitable for them.
The Commission has stepped up its efforts to combat both of these problems. Our Office of Investor Education and Assistance has developed a new section on the Commission's website, especially for seniors. The webpage has information on how to protect against fraudulent sales practices and high-risk, high-cost products. Last week, we announced a joint initiative with the states to protect senior investors from investment fraud and sales of unsuitable securities. The initiative calls for aggressive enforcement, targeted examinations and investor education and outreach programs. Of course, broker-dealers and investment advisers are the first line of defense against fraud and unsuitable investments. As the population ages, recommendations to customers will come under intense scrutiny from regulators, so it is in your firms' best interests to step up training and compliance in this vital area.
There are other initiatives on the Commission's agenda that may of particular interest to bond market participants. At the top of my personal list are the NRSROs and SRO governance. The proposed definition of NRSRO that we issued for comment in 2005 would not substantially change the status quo. The proposal was designed to impose some discipline on the length of time it takes to process applications, to add transparency to the process, and to make NRSRO status conditional on continued compliance with the terms of the original no-action letter, instead of the status being granted in perpetuity.
In my opinion, however, the rule proposal does not substantially reduce the potentially anti-competitive effects of the Commission's involvement in the NRSRO designation process. The requirement that a credit rating agency demonstrate "national recognition" may be anti-competitive in that it presents a barrier to entry. It is extremely difficult for an agency to gain national recognition without being an NRSRO. As you know, reliance on the NRSRO concept has gone well beyond its original use by broker-dealers calculating haircuts under the net capital rule to other SEC regulations and the regulations of other federal agencies, and state and foreign governments - even to the core of Basel II. From my perspective, what we need to do is refocus our efforts on making our process more competitive, whether through abandoning the "national recognition" concept altogether, allowing for the use of proven empirical techniques to generate ratings, introducing "provisional" NRSRO status that would give rating agencies an opportunity to develop national recognition, or some other alternative.
Our approach to SRO governance needs to be re-visited as well. Our concept release on self-regulation and alternatives to self-regulation was issued in 2004, and the SRO world has changed dramatically since then. Given the trend towards for-profit exchanges, which in my opinion exacerbate conflicts of interest, we need to examine whether the alternatives to self-regulation we asked about in 2004 still make sense. There may be other alternatives that should be considered at this point. Moreover, as U.S. exchanges explore international acquisitions and combinations, we need to be ready to work with our international counterparts to ensure that mutual regulatory goals are met.
One of the issues visitors to my office raise most frequently regarding SROs is the need to reduce duplicative SRO regulation. Although the Commission is not directly involved in the discussions, it is my understanding that constructive talks are going on between the NASD and the NYSE on ways to harmonize the SROs' rule books, streamline the examination process, and, over the longer term, come up with options for a consolidated regulatory structure. Progress on these issues would have a direct beneficial impact on the broker-dealer community. The time, effort and money that would be freed up by reducing duplicative regulation could certainly be used more productively in other ways, including reducing the costs passed on to investors.
Speaking of regulation, I'd like to mention some of the key lessons I have learned from my experiences as a Commissioner. As I look back on my four and a half years on the Commission, I have some views on what works and what doesn't work in terms of the SEC's regulation of the markets. First, the market can be a force for good. The power of competition and the market's capacity for innovation cannot be overestimated. Our rules work best when they harness the market's competitive forces and align those forces with investors' interests.
Second, we should set the standards, let markets and market participants compete on the basis of those standards, and take tough enforcement action when the standards are not met. We should guard against attempts to micromanage through regulation, staff action or enforcement precedent. Regulatory bottlenecks for the approval of new market participants, new market practices and new products have anti-competitive implications that limit investor choice. Micromanagement was, of course, one of my fundamental concerns about Regulation NMS. I was not persuaded that the complicated trade-through rule would be more effective than competitive market forces in helping investors achieve their investment objectives of size and certainty as well as price. The steady stream of requests we see for regulatory approvals and exemptive action needed to comply with Regulation NMS and the additional time needed to comply, as evidenced by yesterday's announcement, confirms my original misgivings.
Third, rules should be clear and objective and attempt to accomplish their goals in a cost-effective manner with minimum disruption to markets. Empirical evidence often helps in formulating good rules. For example, empirical information informed proposed changes to the foreign issuer deregistration requirements and the well-known seasoned issuer threshold. Our recently extended pilot on short sale regulation is another example. The data from the pilot are being analyzed by the economists in our Office of Economic Analysis as well as by outside academics. Whatever the data show, I have no doubt but that the results will lead to a more informed outcome on the ultimate short sale rule.
Fourth, we need to communicate better with investors. In our work on the IA/BD rule and our proposed "point of sale" disclosure form, we have found that our ideas about investors' attitudes and expectations are not always accurate. We conducted focus group interviews of investors on both of these initiatives. In both cases, the disclosure that we believed was clear turned out to be anything but. We should be using techniques like focus groups more often to make sure that we get regulations right.
Fifth, we need to improve our timeliness. Too many of the Commission's projects take too long. While rulemaking, enforcement actions, examinations, inspections and processing of exemptive applications are working their way through the Commission, peoples' lives and businesses are at stake. The last time I spoke to the Bond Market Association, I mentioned that one of my and Chairman Pitt's early goals was to undertake a comprehensive review of the overall structure of the securities laws and regulations to ensure that an approach conceived in the 1930s is still relevant and efficient today. I still think this is an important endeavor, but with the experience I have gained since then, I would expand the overview to include a review of the Commission's processes. We need to find ways to speed up our review.
Summing up, I would like to thank the Bond Market Association for many years of thoughtful comments on Commission and SRO rulemaking. Your insights have been valuable in informing our rulemaking proceedings, and your support for increased transparency has been instrumental in achieving important benefits for investors. As a strong advocate of investor education, I would also like to recognize the Bond Market Association's investor education initiatives. Your website, www.investinginbonds.com, is a valuable tool for retail investors, giving them the knowledge and tools to navigate the bond markets.
As you may know, I will be focusing on new challenges and opportunities when I step down from the Commission in the next few months, and I wish you the best of luck as you face your own new challenges and opportunities, including your proposed merger with the SIA. As I said in my letter to President Bush, my term as SEC Commissioner has been the most exciting and fulfilling position of my 35-year career. I have been honored by the opportunity to serve the investing public.