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Remarks at University of South Carolina and UNC-Charlotte 4th Annual Fixed Income Conference

Commissioner Michael S. Piwowar

Charlotte, NC

April 21, 2015

Thank you, Jean [Helwege] and Dolly [King], for inviting me to speak at this great conference. I always enjoy getting back to college campuses and spending time with students and fellow academics. Of course, I am using the term “fellow academics” a bit loosely. Although I spent my early career producing academic research, my intervening years in Washington, DC probably make it more accurate to call me a “reformed academic.” The reality is that I am now strictly a consumer of your scholarly work. In my current role, I am constantly reminded of the value of quality academic research to our financial markets, and more specifically the great insights it can provide to financial regulators. Research is particularly important in the area that is the focus of this conference: fixed income markets.

Before I get too far along, I need to give the standard disclaimer that the views I express today are my own and do not necessarily reflect those of the Commission or my fellow Commissioners.

With that out of the way, let me get back to my prepared remarks, which serve partly as a speech and partly as a call to action. This conference is one stop on a bit of a tour I have been on lately, speaking with academics around the country. In each of those conferences, meetings, and other events I have been encouraging increased dialogue between academic researchers and the SEC. Just last month, I spoke to a group of equity market microstructure researchers at the University of Notre Dame, with a message similar to what I intend to share with you today.[1] That message is simple: your work is vital to helping the SEC accomplish its core mission to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.

Given the talent and collective focus of the people in this room, I do not need to recite statistics about the size of the fixed income markets, the degree to which issuers rely on bonds for debt financing, or the pervasiveness of fixed income products from the largest institutional investor portfolios to the smallest retail investor accounts. Suffice it to say that well-functioning fixed income markets are a concern of nearly all participants in our securities markets.

However, compared to equity markets, the SEC has historically taken a more hands-off approach to the municipal and corporate bond markets. I mention this not to imply that the Commission has been absent from fixed income oversight, or that I am advocating for a more interventionist approach. In fact, over the past few years we have boosted the staffing level in our Office of Municipal Securities, which was created by the Dodd-Frank Act, and now consists of a team of experts handling a variety of issues in that area. And although we have not seen a similar increase in staffing related to the corporate bond market, talented individuals in our Division of Trading and Markets have been focusing on that topic as well.

While the Commission to date has dedicated relatively limited resources and attention to fixed income markets, the same cannot be said about the academic community. Having been involved in fixed income market microstructure research since I started my first tour of duty at the SEC in 2002, I am well aware of the quality work undertaken by academics on fixed income issues, including by many of you in this room. That is why I believe the Commission must leverage the talents of the academic community as we seek to advance our core mission in the fixed income markets.

Recent Progress

Before discussing some of these challenges in greater depth, let me first spend a few minutes addressing the progress that has been made recently in the fixed income space. Shortly after assuming my role as a commissioner at the SEC, I gave a speech calling for common-sense reforms to the municipal and corporate bond markets, including the disclosure of markups and markdowns on riskless principal transactions.[2] In August of last year I reiterated that call and also suggested that a best execution standard, which already exists for corporate bond transactions, also be applied to municipal bond transactions.[3]

Thanks to the hard work of staff in the SEC’s Office of Municipal Securities, as well as at the Municipal Securities Rulemaking Board (“MSRB”) and the Financial Industry Regulatory Authority (“FINRA”), we have made great strides on these issues. After much discussion, the MSRB and FINRA moved forward in November with a proposal to require the disclosure of markups and markdowns on riskless principal transactions on both municipal and corporate bonds.[4] The MSRB also adopted a best execution rule for the municipal securities market in December,[5] and I understand that the MSRB and FINRA are collaborating to develop much-needed guidance for the application of the best execution standard for fixed income securities.

I am pleased about the progress over the past year on these important reforms, but there is much to be done on initiatives to improve the fixed income markets that are already underway. First, I encourage the MSRB and FINRA to keep up their momentum toward adopting a final rule on disclosure of markups and markdowns on riskless principal transactions. Second, we must take steps to incrementally increase pre-trade transparency for municipal bonds. I know that SEC staff is working hard on this project, and I urge them to continue their dialogue with market participants in order to develop an approach that balances the goal of improving pre-trade transparency with the risk of pushing transactions further into the dark by taking overly aggressive or burdensome action.

I also continue to meet with various market participants to discuss issues related to instrument complexity in the municipal securities market. As I noted in August, the high degree of complexity seen in many municipal bond offerings puzzles me.[6] At a time when liquidity and standardization in the fixed income markets generally are frequent topics of conversation, we must keep questioning whether the complex nature of many municipal bonds is truly in the best interests of issuers and investors.

In addition to these developments in the regulation of fixed income markets, our Division of Enforcement has done an excellent job tackling the issue of disclosure in the municipal securities market through the SEC’s Municipalities Continuing Disclosure Cooperation Initiative (“MCDC Initiative”). The MCDC Initiative’s goal is to address potentially widespread violations of the federal securities laws by municipal issuers and underwriters of municipal securities in connection with certain representations about continuing disclosures in bond offering documents. The Commission received a number of voluntary submissions from both issuers and underwriters in response to this program, and it is my understanding that there will be settlements stemming from the MCDC Initiative in the near future. More importantly, however, we are already seeing the fruits of the MCDC Initiative in the area of improved disclosure. The MSRB has recently seen an uptick in submissions of continuing disclosures on its Electronic Municipal Market Access (“EMMA”) system, which is an extremely positive sign for investors.[7]

Current Challenges

Despite these recent developments in the oversight of the fixed income markets, the number of active work streams in this space remains relatively small when compared to the size and importance of these markets, particularly with respect to corporate bonds. This fact may not be all that surprising given the SEC’s staffing limitations that I mentioned earlier. But I do not believe that resource allocation alone, or any sort of regulatory neglect, explains our lack of action in the fixed income space. Instead, the more likely answer is the dearth of straightforward issues to tackle or clear regulatory actions to take with respect to many of the key issues concerning the bond markets.

Both the corporate and municipal bond markets present unique challenges from a regulatory perspective given their overwhelmingly over-the-counter nature, which leaves us with fewer of our traditional regulatory responsibilities than we have for the equity markets. As a result, I must confess that we encounter more questions than solutions when it comes to potential problems in the fixed income markets. This, of course, is where each of you and your colleagues come in.

At this point, I will repeat the message that I have given — and will continue to give — to academic audiences. As someone intimately engaged in the Washington, DC policymaking process, I can assure you that academic research can have real, measurable influence. In order to achieve this influence, however, I urge you to use policy implications as an ex ante motivation for new research ideas, rather than as an ex post justification for an already-completed working paper. This is especially true with respect to the municipal and corporate bond markets, where both market participants and regulators alike have a pressing need for rigorous analysis of current market concerns, possible solutions, and the potential consequences to our financial markets.

Market Concerns

Without a doubt, the primary challenge I hear about from participants in the bond markets is liquidity. Market participants have traditionally sourced bond liquidity directly from dealers in the over-the-counter market. Bond dealers under this traditional model hold inventories of bonds that are used to make markets. When dealer inventories are high, liquid bond markets typically follow and everyone is happy. When dealer inventories are low, market participants get worried and my schedule fills up with meetings and calls from reporters. You can probably guess what my outlook calendar looks like right now.

It is well-documented that bond dealer inventories are down since the financial crisis. This reduction is forcing market participants to rethink where they will find liquidity when they need it, and causing regulators to examine what impact this reduction may have on the markets as a whole.

Lately, the potential for a bond market liquidity crisis has been receiving a lot of attention. Much of the discussion involves market stability issues related to the markets and the issuers that rely on them. At the SEC, we certainly have a strong interest in how a liquidity crisis would affect the functioning of our markets, its effect on capital formation, and its impact on investors. Our interests are particularly heightened with respect to retail investors that could be uniquely harmed by a bond market dislocation, as they may be less able to navigate illiquid markets than more sophisticated participants. The SEC, and other financial regulators, can certainly use your help in better understanding a number of issues related to these key concerns.

The first issue is the proper baseline against which to measure current dealer inventories. Some have suggested using 2006 or 2007 data as the baseline because they provide the most recent pre-crisis data. Others have suggested that those years are not appropriate because there may have been “too much liquidity” in the run-up to the crisis. Unless we know the appropriate baseline to serve as a point of comparison, we will not be able to properly understand the magnitude of the change.

The second issue is the underlying causes of the reduction. Recent actions by prudential regulators have undoubtedly added to the risks and costs of holding large inventories of bonds. For example, Section 619 of the Dodd-Frank Act — the so-called Volcker Rule — prohibits proprietary trading by banks, which makes it riskier for banks to hold less-liquid assets like bonds and increases compliance costs related to justifying legitimate market-making activity for these securities. Basel III’s higher risk-weighted asset requirements and supplementary leverage ratio also have raised costs associated with holding fixed income securities by making certain assets, such as corporate bonds, more expensive than under previous capital rules, and setting a higher threshold for capital to be held against gross assets, respectively.

I share the concerns recently expressed by former Treasury Secretary Larry Summers that prudential regulators have not been properly considering the unintended consequences of their actions when he said, “I thought regulatory authorities made a mistake when they looked at each institution, and said, ‘You’ll be safer if you withdraw from the markets a bit,’ and then forget that if all institutions withdraw from the markets a bit, the markets would be less liquid. The markets themselves would be less safe. That would, in the end, hurt all institutions.… Frankly, a lot of the effort that’s going into macroprudential [regulation] should be into making sure we have liquidity.”[8]

In addition to regulatory pressures, which may make dealers less able to provide bond market liquidity, in the current environment dealers may be less willing to provide it.[9] For example, some have suggested that the Federal Reserve’s current zero interest-rate policy makes dealer market-making less profitable. Others have posited that, in the wake of the financial crisis, many dealers reappraised their risk tolerance and are raising the risk premia they demand in exchange for their services.[10] Unless we fully understand the underlying causes of the reductions in dealer inventories, we cannot assess whether the reductions are likely to be permanent or temporary, or whether dealer market-making capacity is likely to improve, stay the same, or decline in response to changes in regulatory policies, interest rates, etc. As a result, more work needs to be done before we can determine whether a regulatory response is even necessary, and, if so, what type of response may be appropriate. These are the types of issues that merit further study by academic researchers, and which would be of enormous value to the SEC and other financial regulators.

Possible Solutions

One of the strengths of our markets is the ability of participants to adapt to changes in the financial system. This is strikingly evident in the fixed income markets. As market participants reevaluate how they will find stable sources of liquidity in a world of decreasing dealer inventories, a whole host of market-based solutions are being developed.

I have met with numerous groups of talented individuals working on creative solutions to bond market liquidity issues. Some are looking to alleviate the reliance on dealer inventories by creating exchange-like platforms for bonds, while others have been developing alternative trading systems to allow buy-side firms to directly interact with one another to satisfy their liquidity needs. Still others are seeking to improve liquidity in the future by standardizing the terms of bond issuances. Many of these proposed solutions overlap and reinforce one another, and yet each contains its own unique characteristics. As a firm believer in the power of competition and market-based solutions, I applaud this innovation. Some have called for the SEC to “do more” to enhance the market structure of municipal and corporate bonds. However, at this point, given all the innovation that is moving forward, I view my role as quite straightforward: stay out of the way. We should let market participants, not regulators, determine which ideas succeed.

It is interesting to note that while groups are proposing to address the liquidity shortfall in any number of ways, they each face one challenge that is the same: the complexity of the fixed income markets. Although corporate bond issuances for the most part are not as complex as municipal bond issuances, their unique characteristics still present barriers that must be overcome if any new market structure initiatives are going to succeed.

As each of these new approaches to increasing liquidity in the bond markets vies for market share, there will be ample opportunity for academics to examine their strengths and weaknesses — including any knock-on effects of restructuring in this market — as well as broader questions surrounding complexity and standardization.

Potential Consequences

As market participants seek out new ways to operate efficiently in today’s fixed income markets, regulators are still left questioning what could occur if efforts to address liquidity shortfalls are ineffective in a time of severe market stress. Academic research in this area could provide invaluable assistance to the SEC and other financial regulators as we try to better understand the types of events that could cause market instability, as well as the potential magnitude of such events.

Two recent incidents provide excellent case studies for this type of analysis. The first is the October 15, 2014 liquidity event or so-called “flash crash” in the Treasury market.[11] On that day, the yield on the benchmark 10-year U.S. Treasury bond suddenly plunged more than 30 basis points to 1.86 percent. Later that afternoon, yields rebounded to 2.13 percent. I continue to be surprised that so few U.S. market participants have drawn attention to this exceptional event.[12]

I say “U.S.” because I have found that contrary to the somewhat muted response to the event in our country, it drew an enormous amount of scrutiny abroad. On a trip late last year to Australia, New Zealand, and Singapore, I had numerous meetings with international market participants and regulators. Without fail, the topic of the October 15th event in the Treasury market came up in each conversation. Those meetings revealed a great amount of concern that what is viewed as the most liquid market in the world could experience this type of instability. Some wondered aloud whether it reflected the proverbial “canary in the coal mine” and portends future liquidity shocks in the rest of the world’s fixed income markets. While the Treasury market has key differences from the rest of the bond markets, the October 15th liquidity event still seems ripe for study to determine its causes and what it can teach us about liquidity in other debt markets.

The second event seems like the perfect test case for a common narrative regarding potential contagion risks in the bond market. Questions continually arise regarding how the market will react to significant outflows from a single large financial firm, and whether such an event could pose risks to the financial system as a whole. This hypothetical scenario became a reality in September of last year when a well-known fund manager abruptly resigned from one of the world’s largest asset managers.[13] That firm experienced billions of dollars of outflows from multiple fixed-income funds in the days after the announcement, which is precisely the type of event some suggest could cause market-wide impacts. Despite these unprecedented outflows, I have seen no evidence to suggest that they posed any measurable threat to the stability of the bond markets. I look forward to reading analyses of this event to see what we can learn about how our markets function in times of stress at individual financial firms.

Despite its challenges, the fixed income market remains a vital part of our nation’s financial system. I appreciate all of your work in this field, and I encourage you to take up these issues as topics of research and share the results with us at the SEC.

Thank you. Enjoy the rest of this great conference.



[1] See Remarks at the University of Notre Dame, Mendoza College of Business, Center for the Study of Financial Regulation, Speech by Commissioner Michael S. Piwowar (Mar. 13, 2015), available at http://www.sec.gov/news/speech/remarks-at-university-of-notre-dame.html.

[2] See Advancing and Defending the SEC’s Core Mission, Speech by Commissioner Michael S. Piwowar (Jan. 27, 2014), available at http://www.sec.gov/News/Speech/Detail/Speech/1370540671978.

[3] See Remarks at the 2014 Municipal Finance Conference presented by The Bond Buyer and Brandeis International Business School, Speech by Commissioner Michael S. Piwowar (Aug. 1, 2014), available at http://www.sec.gov/News/Speech/Detail/Speech/1370542588006.

[4] See, e.g., FINRA and MSRB Release Proposals to Provide Pricing Reference Information for Investors in Fixed Income Markets, Press Release (Nov. 17, 2014), available at http://www.msrb.org/News-and-Events/Press-Releases/2014/FINRA-and-MSRB-Release-Proposals-to-Provide-Pricing-Reference-Information-for-Investors.aspx.

[5] See MSRB Adopts Best-Execution Rule to Enhance Fairness and Efficiency in the Municipal Securities Market, Press Release (Dec. 8, 2014), available at http://www.msrb.org/News-and-Events/Press-Releases/2014/MSRB-Adopts-Best-Execution-Rule.aspx.

[6] In addition to the numerous complex provisions commonly associated with municipal bonds, complexities surrounding the application of the bankruptcy code to these securities in the event of a municipal default also merit attention, particularly with respect to the potential impact on investors.

[7] See Kyle Glazier, MSRB: Trades Down, Disclosures Up, The Bond Buyer (Feb. 25, 2014), available at http://www.bondbuyer.com/news/washington-securities-law/msrb-trades-down-disclosures-up-1070792-1.html; Municipal Securities Rulemaking Board 2014 Fact Book, available at http://www.msrb.org/msrb1/pdfs/MSRB-Fact-Book-2014.pdf.

[8] See Patti Domm, Summers agrees with Dimon: There’s a liquidity problem, CNBC (Apr. 9, 2015), available at http://www.cnbc.com/id/102572921.

[9] See, e.g., Tobias Adrian, Michael Fleming, Jonathan Goldberg, Morgan Lewis, Fabio Natalucci & Jason Wu, Dealer balance sheet capacity and market liquidity during the 2013 selloff in fixed-income

markets, Liberty Street Economics (Oct. 16, 2013), available at http://www.federalreserve.gov/econresdata/notes/feds-notes/2013/dealer-balance-sheet-capacity-and-market-liquidity-during-the-2013-selloff-in-fixed-income-markets-20131016.html.

[10] See id.; Ingo Fender & Ulf Lewrick, Shifting Tides — Market Liquidity and Market-Making in Fixed Income Instruments, BIS Quarterly Review (Mar. 2015), available at https://www.bis.org/publ/qtrpdf/r_qt1503i.pdf.

[11] See, e.g., Ralph Atkins, Stephen Foley & Vivianne Rodrigues, Bulls Run for the Exit, Financial Times (Oct. 15, 2014), available at http://www.ft.com/intl/cms/s/0/f628980c-547f-11e4-b2ea-00144feab7de.html#axzz3XEZn3Qfk.

[12] The Treasury market flash crash has recently received increased attention from a variety of sources, including a Federal Reserve Bank of New York official warning that the events of October 15th could happen again, and in fact become common. See, e.g., Robin Wigglesworth, Fed Official Warns ‘Flash Crash’ Could be Repeated, Financial Times (Apr. 15, 2015), available at http://www.ft.com/intl/cms/s/0/a2279ffe-e233-11e4-9995-00144feab7de.html#axzz3XEZn3Qfk.

[13] See, e.g., Kirsten Grind, Min Zeng & Gregory Zuckerman, Billions Fly Out the Door at Pimco, The Wall Street Journal (Sept. 28, 2014), available at http://www.wsj.com/articles/billions-fly-out-the-door-at-pimco-1411948188.

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