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Remarks Regarding the Fixed Income Markets at the Conference on Financial Markets Quality

Commissioner Daniel M. Gallagher

Georgetown University McDonough School of Business

Washington, D.C.

Sept. 19, 2012

Thank you, Professor [Rohan] Williamson, for your kind introduction and for inviting me to speak here today.  I'm very pleased to be back at Georgetown, where I received my undergraduate degree.  I won't say when that was, other than to note that when I graduated, Coach John Thompson Junior and the Hoyas were eagerly anticipating the arrival of a promising freshman named Allen Iverson.  

Before I begin, I must tell you that my remarks today are my own and do not necessarily reflect the views of the Commission or my fellow Commissioners.

The SEC has a three-fold mission:  to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.  Inherent in the agency's mission is the responsibility to continually analyze the efficiency of the U.S. capital markets to ensure that they are competitive with global markets, and are providing liquidity and transparency to investors.  Today, I'd like to talk about a segment of those markets to which the Commission traditionally has not devoted sufficient attention and resources – the bond markets.

Over the past two decades, the equities markets have undergone a series of significant changes, from the order handling rules and decimalization, to the promulgation of Reg NMS.  If you took a specialist from the 1990s and brought him to an equities  exchange today, that specialist – who would now, of course, be referred to as a designated market maker – would be astonished to see just how much has changed.  The chances of that exchange having a physical trading floor would be very slim, but even if the specialist was brought to a real trading floor, they would be amazed to see that the media and Starbucks occupy as much real estate as traders.

By way of contrast, I recently had the opportunity – during these slow, uneventful summer months at the SEC – to re-read Liar's Poker, Michael Lewis's account of his experiences as a bond trader at Salomon Brothers in the eighties.  And I was struck by just how much the underlying structures of today's corporate and municipal bonds markets look the same as they did when the book was published in 1989. 

For you history buffs out there, it is often forgotten that in the early part of the twentieth century, there was an active market in corporate and municipal bonds on the New York Stock Exchange.  By the late 1940s, however, municipal and corporate bonds had largely migrated to opaque, over-the-counter dealer markets, where most bond trading still takes place.

1  For example, today, of the approximately 80,000 corporate bonds outstanding,2 only about 6,000 trade on the New York Stock Exchange's bond trading platform, which is the largest centralized corporate bond market in the U.S.3  In the OTC markets, it is still common for investors to place corporate and municipal bond trades by calling their broker for a quote, without much insight as to whether they are receiving best execution and a fair price.  Although electronic trading has been taking hold in the bond markets, corporate bond desks at some major Wall Street firms continue to execute trades exactly like they did in the 1980s, with orders literally yelled across the room and information passed from person to person through a "squawk box" or "hoots" system.

To put it simply, the fixed income markets are critical to the U.S. capital markets.  These markets play a central role in the operation and stability of our public and private sectors.  Municipal bonds, for example, allow state and local governments to finance important infrastructure projects and provide a variety of public services.  In the private sector, corporate bonds provide cash for companies to grow their businesses through capital investment as well as to run everyday operations. 

The bond markets in the U.S. are also massive, both individually and in the aggregate.  Let me illustrate with a few statistics: 

  • In 2011, there were over 1 million different bonds outstanding,4 totaling approximately $11.7 trillion in principal, in the corporate and municipal markets alone,5 compared to less than 7,000 equities listed on major U.S. stock exchanges.6   
  • Corporate and municipal bond issuance for 2011 alone totaled over $1.3 trillion, compared to around $198 billion in U.S. common and preferred stock underwriting activity.7 
  • From January through August of this year, over $65 billion flowed out of open-end U.S. stock funds, while over $203 billion flowed into taxable and municipal bond funds.8 

Individual investors are highly active in these markets, both directly as retail investors and indirectly through mutual, money market, closed-end, and exchange-traded funds.  In fact, as of the fourth quarter of 2011, individuals held over 50% of the total outstanding principal value of municipal securities, while funds held an additional 25% on their behalf.9  Individuals held over 15% of the total outstanding principal value of corporate and foreign bonds, while funds held another 15% on their behalf.10  As the volatility of the equities markets has increased in recent years, individual investors have increasingly turned to bonds as a safe haven investment for their retirement savings.11  The recent municipal bankruptcies in Harrisburg, Pennsylvania; Jefferson County, Alabama; and the California cities of Stockton, Mammoth Lakes and, just last month, San Bernardino, remind us, however, that although municipal bonds and other fixed income securities may generally carry less risk than equities, they are by no means risk-free.

The SEC has traditionally focused more on equities markets than debt markets.  The question of whether this is the cause or the effect of the bond markets' slower evolution, or their perceived lack of volatility, is one that I'll leave to philosophers and economists.  I'm encouraged, however, by the Commission's recent focus on increasing our understanding of the bond markets, including the changing ways in which market participants are interacting with each other. 

In July of this year, as a result of tireless effort by my colleague Commissioner Elisse Walter, and tremendous efforts from Commission staff, the Commission issued a Report on the Municipal Securities Market.  The Report, which is available on the Commission's web site, contains a detailed review of the state of the municipal securities market and includes a number of recommendations to improve the efficiency and integrity of this market, including in the areas of municipal disclosure and price transparency.  I view the Report as a tremendous step towards a better understanding the municipal securities market by the Commission, as well as a starting point for a comprehensive dialogue with issuers, investors, and Congress on potential improvements to the fairness and efficiency of that market.  It may be worth considering whether the Commission ought to undertake a similar effort with respect to the corporate bond market given how large and important that market has become.

I've spoken in the past of how important it is for the Commission to focus on its core responsibilities – the basic "blocking and tackling" of securities regulation – even as we are bogged down by scores of congressional mandates involving many new, and perhaps for some, more "exciting" areas of regulation, such as OTC derivatives.  The Dodd-Frank Act mandated that the Commission establish an Office of Municipal Securities, which previously was part of the Division of Trading and Markets, as a stand-alone office with a director reporting directly to the Chairman.  It is my hope that as we continue to implement Dodd-Frank and JOBS Act mandates, we at the same time leverage the creation of the muni office into a new era of sophistication and understanding of the fixed income markets at the Commission.  A big part of that process will be exploring the best ways to tackle basic issues of market quality without disrupting the markets or imposing undue burdens on market participants.  And, as with everything we do at the Commission, the process should be grounded in an understanding and critical analysis of the available data.  As we have seen several times this year in our rulemakings, in particular with our Title VII entity definition rulemaking, data-driven analysis is a critical underpinning to policy decisions.  We will need to identify, procure, and analyze all relevant data about the debt markets before we can proceed down a path that would fundamentally alter these critically important markets.  To that end, I was encouraged to see that the MSRB will soon complete a study of trading data to inform policy decisions there and, I assume, at the SEC, and I expect that our newly mandated consolidated audit trail will eventually provide important information to the Commission about the debt markets. 

There are several specific issues that particularly warrant the Commission's further attention.  One of these is price transparency.  Price transparency – both pre- and post-trade – is one of the hallmarks of any fair and efficient financial market.  In secondary markets, including those for corporate and municipal bonds, widely available and timely price information allows dealers and investors to make more informed judgments about what is an acceptable price for the purchase or sale of a security.  In this way, transparent markets promote more efficient and cost-effective trading and, in turn, higher levels of investor confidence and participation. 

Over the past decade, significant steps have been taken to improve price transparency in the bond markets with the introduction of new systems designed to centralize the collection and dissemination of post-trade price information.  In 2002,  FINRA implemented its Transaction Reporting and Compliance Engine, or "TRACE," which now provides investors with access to bond transaction and price information free of charge and on a near real-time basis (that is, 15 minutes post-trade) for 99% of all U.S. corporate bond market activity.  Similarly, building on its Real-Time Transaction Reporting System, the MSRB launched the Electronic Municipal Market Access, or "EMMA," web site in 2008.  EMMA now provides investors with free access to transaction and price information on a near real-time basis – also 15 minutes post-trade – for the majority of municipal bond trades, as well as important municipal disclosure documentation.

By many accounts, the introduction of post-trade price transparency appears to have improved the efficiency and cost-effectiveness of trading in the municipal and corporate bond markets.  Studies have found that, as a result of increased post-trade price transparency in these markets, bid-ask spreads have narrowed; trading costs for investors have declined, perhaps by billions of dollars; competition among bond dealers has increased; and the ability to value bond portfolios has improved.12  Post-trade price transparency in the municipal bond market also may have helped lower borrowing costs for state and local governments.13  In addition, by providing increased access to price and transaction data, TRACE and EMMA have improved the ability of the SEC to better execute its oversight and investor protection responsibilities in the bond markets. At the same time, however, questions remain about whether this increased post-trade price transparency has caused a reduction in liquidity in the corporate and municipal bond markets, and that is an important issue for the Commission to monitor.14

Notwithstanding these recent initiatives in post-trade price transparency,  retail investors  continue to face significant headwinds in the bond markets.  They simply cannot be sure that they receive best execution and a fair price.  The bond markets are still relatively opaque for retail investors.  Although post-trade price information is now widely available, it may not be as useful for the retail investor attempting to buy or sell illiquid bonds.  Moreover, to date, there is little or no centralized collection and continuous dissemination of bid/ask quotes – that is, pre-trade price transparency – in the corporate and municipal bond markets.  And, unlike their large institutional counterparts, retail investors generally have less expertise in the basics of bond trading and cannot tap into large dealer networks for quotes in order to shop around for the best prices available.  Finally, because dealers act as principal in most bond trades, they are not required to disclose their mark-ups and mark-downs on customer confirmations.  Indeed, according to a recent industry survey, many retail investors don't know how much their trades are marked up, and some are unaware that their broker is being compensated at all for the transaction.15    

As a result of all of these factors, retail investors in the bond markets tend to be "price-takers," often relying on a single broker-dealer to obtain a quote with limited insight into whether it is fair and accurate.  In addition, retail investors generally continue to face higher costs to trade corporate and municipal bonds compared to similarly-sized transactions in common stock, even after the introduction of post-trade price transparency in the bond markets.16  Corporate and municipal bond spreads bear this out.  Spreads have been found to range from around 2–5% in the municipal bond market and 1–2% in the corporate bond market, compared to less than 1% for equities.17  One study found that the average effective spread of a representative retail-sized trade of $20,000 in the corporate bond market in 2003 – post-TRACE – was 1.24% of the price, which would have eliminated over two months of the total annual return for a bond with a 6% yield to maturity – the equivalent of nearly $0.52 per share on a similar-sized trade of a $40 stock.18 

Furthermore, unlike the equities markets where trading costs generally increase with trade size, transaction costs in the municipal and corporate bond markets tend to be higher for smaller trades by retail investors compared to larger trades by institutional investors.19  One study found that retail investors incur 65 basis points more in incremental round-trip trading costs on the average corporate bond transaction than institutional investors.20  Issues of best execution and fair price may be most acute for retail investors seeking to sell bonds in the OTC markets.  Here, "spreads to exit" may be several hundred basis points.  In today's low-rate environment, such wide spreads can effectively wipe out a significant portion of bond yield. 

All of these statistics suggest that the retail investor's position in the corporate and municipal bond markets demands additional attention from regulators and market participants alike, including, for example, an examination of the extent of informational asymmetries between retail investors and their institutional counterparts.  At the same time, regulators must keep in mind that wider spreads in the bond markets may be caused by a variety of factors unique to debt securities and the structure of the markets in which they trade, none of which are inherently nefarious.  For example, spreads may be wider in the bond markets compared to the equities markets in part because corporate and municipal bonds are generally more illiquid than stocks.  Similarly, spreads may be higher for retail bond investors compared to institutional bond investors in part because it may take more effort, time, and risk for dealers to execute smaller versus larger trades.  Ultimately, an incremental, balanced, and, above all, well-informed regulatory approach is the best way to ensure that all market participants benefit from fair, orderly, and efficient bond markets.

Another key issue in the bond markets today is liquidity.  As compared to the markets for equities – as well as for Treasuries and mortgage-backed securities – the markets for corporate and municipal bonds are significantly less liquid.  Moreover, liquidity in these markets is diffuse and fragmented due to the large number and variety of corporate and municipal bonds available, many of which are not regularly traded, and the narrow selection of available venues on which to trade. 

Recently, sell-side firms have raised concerns that more stringent capital requirements under Basel III, coupled with anticipated Volcker Rule prohibitions on proprietary trading, have made – and will continue to make – trading certain bonds more expensive and less profitable.  These changes may already be having the unintended consequence of draining liquidity in the OTC bond markets as the dealer banks are less willing to hold bond inventory, even in the face of rising demand from retail and institutional investors.  Whatever the cause, the amount of corporate bonds that dealers hold on their balance sheets has dropped to about $45 billion from about $235 billion in 2007.21  Some buy-side firms in the corporate bond market are now reporting that they are having difficulty finding dealers to purchase or sell bonds, and traders have indicated that it may now take months to move large volumes of bonds.22   

Some market participants appear to be adapting to reduced liquidity and wide spreads in the bond markets by turning to electronic trading.  Earlier this year, for example, two major Wall Street banks rolled out new or revamped electronic trading platforms in the corporate bond market, joining a number of other platforms already in operation.23  Large money managers are also implementing their own electronic trading platforms, allowing their clients to bypass sell-side firms.24  Some of these platforms aim to provide comprehensive and real-time pre-trade price information to investors.25  There has even been renewed discussion about moving bond trading onto a centralized electronic exchange.26   

Whether the proliferation of electronic trading in the bond markets will improve the quality of these markets remains to be seen.  The move from humans to computers could well mean leaner corporate bond desks, but more efficient and cost-effective trading, at least for those with access to the platforms.  One industry report indicated that the introduction of electronic trading in the corporate bond market reduced trading costs by 64%. This same report found that trading activity increased by 88%.27  So far, the data indicate that, at least in the municipal securities market, alternative trading systems and other similar trading systems account for only a small portion of the total dollar volume of trades taking place.28  Still, following the experience of electronic trading in the equities markets over the past two years, it is incumbent upon regulators to better understand the risks associated with this fundamental shift in the structure of the bond markets.

Before I conclude, let me be absolutely clear that devoting more Commission attention and resources to the bond markets does not necessarily imply a need for more regulation.  There is a risk, and we have seen it come up in the context of Title VII, that regulators will, by default, try to impose the equities markets oversight paradigm onto the bond markets.  Instead, the Commission's regulatory approach toward the bond markets must continue to be based on recognizing and understanding the fundamental differences between bonds and equities, without assuming that what is good for one will automatically be good for the other.  And, ideally, we will reach a point where the Commission, through thoughtful, comprehensive, and data-driven analysis, will understand the differences and interplay among the equities, debt and credit markets so that we can be a more sophisticated regulator of those markets.  I will put aside the futures markets for now, but you never know what a future Congress may decide! 

Thank you for having me here tonight, and thanks  for your kind attention.

1           See Bruno Biais & Richard C. Green, The Microstructure of the Bond Market in the 20th Century 1–2 (Aug. 29, 2007) (unpublished manuscript) (on file with Carnegie Mellon Tepper School of Business).

2           Bloomberg L.P. (2012) Debt Map. Retrieved Sept. 13, 2012 from Bloomberg database.  See also Michael McKenzie, Nicole Bullock, and Trace Alloway, Finance:  Grinding to a Halt, Fin. Times, June 19, 2012,

3           Bloomberg L.P. (2012) Custom Bond Search. Retrieved Sept. 14, 2012 from Bloomberg database.  See also Trading on NYSE Bonds:  Features and Functionality,, (last visited Sept. 18, 2012).           

4           U.S. Securities and Exchange Commission, Report on the Municipal Securities Market (2012), at 5 ("Muni Bond Report"). 

5           Securities Industry and Financial Markets Association ("SIFMA"), "U.S. Bond Market Outstanding,"  See also Muni Bond Report at 5.    

6           Bloomberg L.P. (2012) Actively Traded Primary Security of Company, Exchanges:  U.S., -OTC BB, -OTC US, Retrieved Sept. 17, 2012 from Bloomberg database. 

7           SIFMA, "U.S. Key Statistics,"

8           Morningstar Direct U.S. Open-end Asset Flows Update (Sept. 2012), (last visited Sept. 18, 2012).  See also SIFMA, "U.S. Mutual Fund Assets and Net Cash Flow,"; Bond Inflows Buoy Mutual-Fund Assets, Wall St. J., Aug. 23, 2012, at C5.  

9           See Muni Bond Report at 12.

10          See Federal Reserve Board, "Flow of Funds Accounts of the U.S.," Table L.212 (Fourth Quarter 2011), (last visited Sept. 19, 2012).

11          See, e.g., Michael McKenzie, Finance:  Grinding to a Halt, Fin. Times, June 2012; James Ramage, More Retail Investors Turn to Municipal Bond Funds, The Bond Buyer, Apr. 4, 2012, 

12          See, e.g., N. Ola Persson, Expansion of TRACE in the U.S. Fixed-Income OTC Market, Focus (World Fed'n of Exchanges, Paris, Fr.), Feb. 2010, at 7–9; William F. Maxwell & Hendrik Bessembinder, Markets:  Transparency and the Corporate Bond Market, 22 J. Econ. Persp. 217, 225–27 (2008); Michael S. Piwowar, Corporate and Municipal Bonds (2007) (unpublished manuscript) (on file with Securities Litigation and Consulting Group), at 4–6 .  See also Jonathan Hemmerdinger, Sirri: Investors Benefitting From RTRS, The Bond Buyer, Aug. 3, 2012,

13          See, e.g., Michael McDonald, Wall Street Cuts Muni-Bond Trading Amid Transparency Push, Bloomberg News, Aug. 3, 2012,  

14          See, e.g., id.; William Maxwell et al., Transparency and the Corporate Bond Market, 22 J. Econ. Persp. at 228–29.    

15          See Charles Schwab Bond Investor Study (2011),,

16          See, e.g., Muni Bond Report at 123 & n.738; Amy K. Edwards, Lawrence E. Harris & Michael S. Piwowar, Corporate Bond Market Transaction Costs and Transparency, 62 J. Fin. 1421, 1438 (2007); Michael S. Piwowar, Corporate and Municipal Bonds, at 4; Lawrence E. Harris & Michael S. Piwowar, Secondary Trading Costs in the Municipal Bond Market, 41 Journal of Finance 1361, 1362, 1382, 1393 (2006).   

17          See Muni Bond Report at 123 & n.738; Michael S. Piwowar, Corporate and Municipal Bonds, at 4.  See also Jason Zweig, Will New Rules Stop Brokers from Nibbling Your Returns?  Wall St. J., Mar. 26, 2011,

18          See Amy K. Edwards et al., Corporate Bond Market Transaction Costs and Transparency, 62 J. Fin. at 1449; Michael S. Piwowar, Corporate and Municipal Bonds, at 4.

19          See Muni Bond Report at 123; Amy K. Edwards et al., Corporate Bond Market Transaction Costs and Transparency, 62 J. Fin. at 1438, 1449; Michael S. Piwowar, Corporate and Municipal Bonds, at 4; Lawrence E. Harris et al., Secondary Trading Costs in the Municipal Bond Market, 41 Journal of Finance at 1379, 1393. 

20          See Darrin DeCosta, Robert W. Del Vicario, & Matthew J. Patterson, The Bond Market: Where the Customers Still Have No Yachts; Quantifying the markup paid by retail investors in the bond market (Fall 2011) (unpublished manuscript) (on file with Accretive Asset Management),

21          See Michael McKenzie, Finance:  Grinding to a Halt, Fin. Times, June 2012.  See also Serena Ng and Kristen Grind, Large Institutions Discuss New Marketplace for Bonds, Wall St. J., June 13, 2012,

22          See id.; Nathaniel Popper, Bond Trading, N.Y. Times, July 2012; Michael McKenzie, Finance:  Grinding to a Halt, Fin. Times, June 2012.

23          See Aaron Lucchetti & Brett Philbin, Now, It Is Man vs. Machine, Wall St. J., Aug. 9, 2012; at C1; Mary Childs and Michael J. Moore, Morgan Stanley Follows Goldman With Fixed-Income Call, Bloomberg News, Aug. 9, 2012,; Serena Ng, Goldman Debuts Its Bond Platform, Wall St. J., June 28, 2012, C3.  See also Jonathan Hemmerdinger, As E-Brokerage Expands, MSRB Looks Out for Retail Buyers, The Bond Buyer, Aug. 23, 2012,   

24          See, e.g., Kevin Crowley & Alexis Leondis, Blackrock Plans to Start Bond-Trading System to Bypass Banks, Bloomberg News, Apr. 12, 2012,

25          See Katy Burne, Start-Up Targets Price Transparency in Bonds, Derivatives, Wall St. J., July 18, 2011,

26          See Serena Ng, Large Institutions Discuss New Marketplace, Wall St. J., June 2012; Michael McKenzie, Finance:  Grinding to a Halt, Fin. Times, June 2012.

27          See Aaron Lucchetti, Morgan Stanley's Bond Robots May Lower Investor Costs, Wall St. J., Aug. 9, 2012,

28          See Muni Bond Report at 118 & n.715. 

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