Speech by SEC Commissioner:
Legal & Compliance Conference The Bond Market Association
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
New York, New York
February 3, 2004
Thank you, Micah, for the introduction. I'm honored to be here today. Before I begin my remarks, let me make the standard disclaimer that the views I express here today are my own and do not represent the views of the Commission or the staff.
I've just passed my two-year anniversary on the Commission, but I go way back with bonds. When I was growing up, my birthday present from my parents was always a bond. I can't say I was thrilled about this at the time -- I'm sure I was hoping for something more exciting than the receipt for a municipal bond! A Barbie doll would have been nice! But my parents' birthday present strategy turned out to be a good one, and it may even have had the unintended consequence of setting me on a path towards a career in economics. So there's a very warm place in my heart for bonds.
And I'd like to keep it that way, so I have some advice for you. Take heed of the lessons we've learned from the financial scandals of the past few years. Think about all the underlying ingredients that went into the recipe for these scandals. The main ingredient, of course, was greed. Add to that a large dose of conflicts, a large helping of complacency, and a dash of complicity, sift out the transparency, and the end result was disastrous.
As the financial scandals that led to Sarbanes-Oxley unfolded, we saw example after example of company executives bent on meeting Wall Street expectations and willing to do whatever it took to make that happen. The conflicts that got these companies and their gatekeepers - the analysts, auditors and attorneys - into trouble are all familiar to us now. We've seen analysts write favorable research reports to preserve investment banking relationships with issuers - even when they privately held far less positive views. We've seen auditors look the other way when a client engages in financial fraud because of their fear of losing a lucrative client. And situations in which attorneys appeared to have forgotten that they are representing the shareholders of a corporation - not the officers -- when they represent a corporation were the genesis of our "up the ladder" reporting requirements for attorneys practicing before the Commission.
Additional conflicts have surfaced in our mutual fund investigations. We've seen investment advisers that, notwithstanding prospectus disclosure to the contrary, permitted market timing in mutual funds in exchange for the timers' deposit of "sticky" assets in their funds or related hedge funds, which increased management fees. We've seen portfolio managers market-timing their own funds. We've seen broker-dealers being paid by mutual funds to get their funds placed on the firm's "preferred list" and the firms paying their brokers more to push those funds. Needless to say, the special compensation wasn't adequately disclosed to customers, who never got a real opportunity to gauge its effect on the validity of their brokers' recommendations. I could go on, but you get the picture.
Next, consider how complacent boards of directors contributed to the problems. In too many situations, it appears that boards were of the "potted plant" variety that did little more than rubber-stamp management's decisions. Judging from their actions, many directors failed to comprehend the scope of their responsibility to demand that management act ethically and put investors' interests first.
Complicity was another part of the problem. In addition to our actions against other gatekeepers, our enforcement actions against Merrill Lynch, J.P. Morgan Chase, Citibank and CIBC illustrate situations in which banks assisted Enron in misleading its shareholders by disguising what essentially were loan proceeds as cash from operations.
And finally, transparency. Or should I say, the lack of transparency. Many of the rules we adopted under Sarbanes-Oxley - from the certification by CEOs and CFOs of the financial information in companies' periodic reports, to fuller disclosure of off-balance sheet arrangements, to restrictions on the use of non-GAAP pro forma information, to the requirement for a management report on internal controls over financial reporting -- were rules designed to encourage the integrity and transparency of corporate financial reporting.
So as you - the legal and compliance community - interpret these "lessons learned" for your firms, counsel them to avoid making the same mistakes. The last thing investors or our markets need is another breach of investors' trust. And how will the fixed income market avoid these mistakes? By putting investors first and acting in an ethical way, adhering to high standards of corporate governance. This is critically important to investors and to the markets. And, of course, by giving the compliance and supervision function higher visibility within financial services firms. This is a commitment that requires more than lip service - it calls for the money, the staff, the training and strong backing by senior management to instill the right culture. On this point, given this audience, I know I am preaching to the choir.
What are some of the key issues on the horizon for the bond markets? Accurate information to value companies and securities and efficient secondary markets are critical to debt issuance by corporations and state and local governments. These characteristics are increasingly important to retail investors, broker-dealers and institutions as well. While institutional investors dominate the bond markets, retail investors' participation is on the rise. In terms of direct holdings, retail investors hold about 1/3 of municipal bonds. Approximately 86% of all trades of fixed rate municipal securities are retail, in trade sizes from $5,000 - $100,000, although they only account for about 17% of dollar volume traded.
Data from the U.S. Treasury for the mid- to late 1990s indicate that U.S. households held more corporate debt than municipal bonds. The figure is likely higher today. Recent data from TRACE indicate that approximately 65% of trades in investment grade, high yield and convertible debt are under $100,000 in size, a range we assume to represent retail activity, and there are comparable levels of retail activity across the spectrum of credit quality. What's more, these figures don't include the corporate and municipal bonds that retail investors hold indirectly through mutual funds and bank trust departments.
In preparing for being here today, I took a look at the speeches given by former SEC chairmen, previous SEC commissioners and SEC staff to The Bond Market Association over the last few years. In each of these speeches, the Commission representative has stressed the need for the industry and its regulators to move forward on increasing transparency in the bond markets. So where are we on the transparency timeline?
- The Municipal Securities Rulemaking Board began its transparency initiative in 1994, when it first required municipal securities dealers to report their inter-dealer transactions.
- Three or so years later, in March 1998, dealers began reporting their trades with customers.
- In August 1998, the MSRB began releasing a summary T + 1 report of inter-dealer and customer trades, showing high, low and average prices of bonds that traded four or more times per day, and
- In January 2000, data on individual transactions were released.
- The trading threshold of four trades per day was gradually reduced to two trades, and was eliminated in June 2003.
So now, after a decade of incremental steps, bond dealers report all secondary market trades in municipal securities, but trade data are not yet made available until the next day. The MSRB plans to implement its real-time reporting framework - meaning reporting within 15 minutes from execution - by January 2005. I would like this goal be met - on time -- and the release of data on all trades on as close to a real-time basis as possible. The increased transparency to date has permitted increased regulatory surveillance of the muni market.
The timeline for corporate bond transparency started a little later.
- Former Chairman Levitt first called on the NASD to implement a trade reporting system for corporate bonds in 1998.
- Approved by the Commission in June 2001, TRACE commenced operations in July 2002, and is now in its second year of operation.
- Today, NASD members must report transaction information on transactions in all corporate debt instruments, including both investment grade and high-yield debt securities, within 45 minutes of execution.
- The NASD plans to require trade reporting within 15 minutes after execution sometime next year.
While most corporate bond trades are now reported to the NASD, not all of that data is disseminated to market users. So far, the NASD disseminates transaction information on more than 4,700 securities, including large issue investment-grade bonds, 50 high-yield bonds, and an additional 120 BBB-rated bonds. These bonds account for about 70% of the dollar value of trading activity in investment grade bonds, including the most actively traded bonds.
The NASD's Bond Transaction Reporting Committee ("BRTC") continues to discuss the next phase of dissemination of trade data for all remaining bonds. It is my understanding that the BRTC is reviewing information on transparency from a variety of sources and is moving toward a set of recommendations shortly. The remaining bonds include the smaller investment-grade instruments and high-yield bonds, in which we know there is considerable retail and institutional interest. It is these types of high-yield bonds - offering higher interest, yet lower quality -- where pricing decisions are the most difficult and where real-time information would be most beneficial to investors and dealers as well.
Whatever the technical and systems impediments to more timely dissemination of trade data by the MSRB, and whatever additional information the BTRC may review, there can be no disagreement about the benefits of increased transparency of bond transaction information to the public and to the debt market. Professional and retail interest in bond transaction information is high. The NASD reports that more than 4,200 professionals access TRACE information on a "real time" basis through market data vendors or the TRACE website, and many more access it on a delayed basis. Small to medium-sized broker-dealers have found the TRACE data extremely useful, according to the NASD, as have institutional investors. The NASD also reports that it has been getting over 23,000 hits on its TRACE website every month. So the interest and the demand are there.
Increased transparency enables investors and dealers to make more informed investment decisions, and the increased competition that flows from greater transparency will make the debt markets more efficient. As price transparency has increased in the municipal and corporate bond markets, so has the ability to detect apparent sales practice violations in connection with retail transactions. The NASD's ability to conduct surveillance of the municipal and corporate bond markets using the MSRB data and through TRACE increases investor confidence in these markets.
A soon to be released study by our Office of Economic Analysis on the liquidity of the municipal bond markets contains some very interesting results on the beneficial effect of transparency on transaction costs. The study examines the U.S. municipal bond market from November 1999 through October 2000, a period of relatively little trade price transparency (trade information was publicly available on a one-day lag for bonds that traded four or more times per day). Over one million different municipal securities exist, but very few trade with any regularity in the secondary market. In addition, many have very complex features, which makes valuation difficult, especially for the retail investor. Unlike in equity markets where the unit cost of trading increases with trade size, the OEA study finds that small trades, probably trades of retail investors, are substantially more expensive than large trades. The explanation for this, according to our economists, is the lack of transparency in the municipal securities market.
Both the MSRB and the NASD through TRACE have significant goals to meet -- and it is important that these goals be met. Retail investors are doing more and more investing in municipal and corporate bonds, and, as the baby boomers begin to retire and convert their equity holdings to bonds, they will do so in the coming years in greater and greater numbers. The data are also extremely useful to small to medium-sized broker-dealers, institutions and even pricing services, and increased competition is the result. The clear benefits to investors, broker-dealers and institutions from more complete and timely pricing information on bond transactions make it difficult to justify further delays in getting this information released as quickly as possible -- particularly when, as the OEA study suggests, transparency would reduce transaction costs for bond investors.
An additional benefit of increased transparency will be better pricing in bond funds. The Commission has taken enforcement action recently against mutual funds and hedge funds based on inaccurate pricing of bonds. Just as stale pricing in international funds created opportunities for market timers, the inherent lack of precision in pricing bond portfolios - especially where bonds are non-rated or illiquid - could provide fertile ground for fraudulent activity.
For all these reasons, we need to get to the end of the transparency timeline. It has taken a long time to get to this point, and we're still not quite there. I sincerely hope I will be the last SEC commissioner to have to argue for increased transparency in the bond markets.
In light of the changed environment, it is in your own best interests to proceed with transparency. Further delays in making your markets fully transparent may not be the wisest course in terms of minimizing regulatory and reputational risk. One thing that has become crystal clear to me over the last two years is that practices that take place out of the bright sunlight of transparency are usually the practices that require scrutiny. To the extent that there are any parts of the fixed income markets that do not yet operate in complete sunlight, those are the areas in which problems are likely to develop -- especially when there is a conflict between increasing profits and putting customers' interests first.
In this day of global access and technological innovation, any degree of opaqueness in our bond markets is anachronistic and potentially problematic. I recognize there are differences between the bond markets and the equity markets, but investors and across all markets benefit from the competition and the efficiency that flow from increased transparency.
I also recognize that it's not easy - either for the traders or their firms -- to change the way their business has always been done. But by putting out its shingle, the broker-dealer takes on the obligation to put its customers' interests before its own. The best thing the bond industry can do for investors is to extend real-time transparency to all bond transactions. As an economist, a regulator and, perhaps most important, a bond investor, I say to you: Just do it. In the long run, it will be the best thing for you and your firms too.
Thank you for the opportunity to speak to you today.