Speech by SEC Staff:
Keynote Address before the NASD Conference on Fixed Income Markets
Annette L. Nazareth
Director, Division of Market Regulation
U.S. Securities and Exchange Commission
New York City, NY
October 1, 2004
Thank you, Doug, for that kind introduction. I am delighted to be here to discuss some of the important issues that the Commission is currently addressing with respect to the fixed income markets. In addition, I would like to commend NASD for organizing this conference and giving us all the opportunity to share our thoughts on the current state of the fixed-income markets. Before I begin my talk let me remind you that my remarks represent my own views and do not necessarily reflect the views of the Commission or my colleagues on the staff.1
The U.S. securities markets are some of the most vibrant and liquid in the world and, as such, drive the U.S. economy forward. Our markets facilitate the growth of public companies by giving them the ability to raise financing through the capital markets and expand their businesses. In addition, our markets provide investors with a host of options as to the securities in which they can invest their savings. Moreover, efficient secondary markets provide investors with confidence that they will be able to buy and sell securities when their financial needs dictate. I do not think anyone would argue with the contention that our securities markets play a critical role in the nation's financial welfare.
By following the mainstream financial media, you could be led to believe that our securities markets are built solely upon equity securities. Particularly in recent years, as retail investor interest in the stock market surged, the equity market became a cultural phenomenon of sorts. The equity securities market is indeed one of the primary pillars of our financial markets and it gives investors the opportunity to - in effect - become business owners. As with all business owners, shareholders accept a heightened degree of risk, but also have the opportunity to share in the future profits of the business. The other side of the coin and one of the other major pillars of our financial markets is the fixed-income market. The fixed-income market provides investors with the opportunity to - in effect - become lenders. As with all lenders, bond holders expect a more predictable return on their investment than business owners, but also are exposed to limited risk. Together the equity and fixed-income markets provide investors with a broad range of investment options that they need to diversify their holdings and achieve their financial goals.
I believe that the fixed-income market, as one of the primary pillars of our financial markets, deserves to share the spotlight with the equity market. The way to do this is simple - make individual investors feel at home in your market. Give them some of the same tools that they have come to expect on the equity side. To become active participants in your market, investors need an understanding of how the debt market works and sufficient transparency to see what a bond costs at any given time. By providing tools to investors and increasing transparency, the integrity of the fixed-income markets will be enhanced. Ultimately, the result will be increased investor confidence and an even stronger and more vibrant market.
There have been significant developments in the fixed income markets since I testified before the Senate Banking Committee on June 17th of this year, which demonstrate the Commission's and NASD's continuing commitment to improving the transparency of the fixed income markets. Let me begin by addressing Chairman Donaldson's Task Force on Bond Market Transparency. In June, I reported that Chairman Donaldson had commissioned the Task Force to consider issues relating to fixed-income market transparency, identify current problems, and generate potential solutions. I am pleased to report that the Task Force has presented its Work Plan to the Chairman for consideration. In its Plan, the Task Force discusses possible ways to maximize the benefits of transparency in the bond markets and identifies specific areas it believes the Commission should consider in order to determine whether or not additional action is needed. While it is premature to discuss any recommendations, the Task Force's work to-date demonstrates the vitality of the Commission's commitment to continued improvement toward transparency of the fixed income markets.
The recent expansion of the TRACE system is a case in point. As most of you are aware, the Commission recently approved NASD's proposal to expand TRACE dissemination to make public, in near real-time, roughly 99 percent of all transactions (and 95 percent of par value) in TRACE-eligible securities other than Rule 144A securities. Under the proposal, TRACE will disseminate transaction information on non-investment grade bonds (other than the FIPS 50, which have been disseminated since the beginning of TRACE) for the first time, significantly enhancing the transparency of this important segment of the corporate bond market. The proposal also provides for dissemination delays for bonds rated BBB or lower in the new issue aftermarket, and for larger transactions in infrequently traded non-investment grade bonds in the secondary market other than the new issue aftermarket. Since Doug just described the implementation schedule for the proposal, I will not repeat it. I will say, however, that I look forward to working with the industry as we move ahead in making the fixed income markets more transparent and more user-friendly for investors.
In addition to the recent expansion of the system, today marks another impressive milestone for TRACE. Effective today, transaction reporting times have been reduced to 30 minutes and, effective July 1, 2005, they will be further reduced to 15 minutes. This dissemination time compression represents a significant incremental improvement in the transparency of the corporate bond market. At the same time, I think there is always room for improvement and I am hopeful that all unnecessary restrictions on the availability of beneficial transaction information will be lifted.
NASD has proceeded at a deliberate pace in expanding TRACE dissemination, in part because of concerns expressed by some dealers that dissemination of last sale information could adversely affect market liquidity, especially in more thinly traded bonds. In that regard, NASD commissioned two studies to address the relationship between transparency and liquidity and found no conclusive evidence that TRACE transparency has adversely affected liquidity. Based in part on these findings, in approving the most recent TRACE proposal concerning transaction reporting times, the Commission noted that it expects NASD to submit a proposed rule change eliminating the delays in TRACE information dissemination not later than November 1, 2005. My staff intends to closely monitor the rollout of the TRACE expansion proposal, as well as the impact of the dissemination delays on investors' access to pricing information. While some in the industry are concerned about the coming changes, I fully expect that the increased transparency will make the corporate fixed-income market even more robust than it already is today.
Another development of critical importance to the corporate bond market is the recent release of an independent study by three economists associated with the Office of Economic Analysis on corporate bond market transparency and transaction costs. This study by Amy Edwards and Michael Piwowar, who are currently financial economists in our Office of Economic Analysis, and Larry Harris, until recently our Chief Economist, considered every trade reported to TRACE in 2003 and focused specifically on the relationship between increased transparency and transaction costs. Using sophisticated econometric methods, the study found that "trading costs are lower for transparent bonds than for similar opaque bonds, and … these costs fall when a bond's prices are made transparent." The study concluded that "transparency has improved liquidity in corporate bond markets."
The study breaks new ground in the ongoing dialogue regarding the effects of increased transparency on market liquidity, by specifically linking increased transparency with improved liquidity. It makes major strides in addressing and resolving the concerns that these dealers have expressed on this important issue. Equally important, it provides additional support for the Commission's continued call for the removal of barriers to complete transparency, particularly the elimination of TRACE dissemination delays.
Having discussed some of the mechanics of TRACE enhancements and some of the analysis that has been done regarding the impact of increased pricing transparency, I would now like to step back and focus on some of the more general efforts that have been made to increase fixed-income market integrity and investor participation in the fixed-income markets. NASD should be commended for making significant progress in exploring ways to improve the quality of information available to investors in the corporate bond markets. Earlier this year, NASD convened a panel of twelve market participants and academics to make recommendations regarding market integrity and investor protection in the corporate bond market. Although the panel reviewed both individual and institutional investor aspects of the market, its emphasis was primarily on individual investors.
The NASD Panel Report, which as Doug mentioned has just been released, finds that individual investors often do not understand key aspects of bonds and need more information to determine whether corporate bonds are appropriate for their investment objectives and to assess the quality of the executions they receive. Accordingly, the report recommends that broker-dealers ensure that individual investors have better information regarding their investment, both at the time of indicating an interest in a corporate bond investment, and immediately prior to buying or selling a corporate bond. The Report goes on to list the types of information that individual investors should understand at these two points in the investment process. The Report recommends a variety of other steps that could be taken to enhance the corporate fixed income market, including various improvements to debt trade confirmations, the intensification of efforts to achieve wider distribution of bond information through media channels, an increase in the distribution and availability of TRACE information, and the development of industry benchmarks against which investors could compare the price and yield they receive for a bond. Overall, these appear to be sound recommendations for ways to make investors more comfortable with participating in the corporate fixed income market.
To implement these recommendations, the Report states that the NASD staff, working closely with the Commission, should work to organize appropriate education, possible rule filings, Notices to Members, and other activities as necessary. I applaud NASD's proactive efforts to enhance investor protection in this market, and I look forward to working with the industry on developing the Panel's recommendations further. Moreover, to leverage the benefits of the NASD Panel's work, I believe it may be appropriate for the MSRB to review its rules to determine whether it is appropriate to adopt disclosure requirements for municipal bond investors similar to the ones that the NASD Panel has recommended. It is my belief that, as transparency increases and investors become more familiar with the fixed-income market, volume and investor participation will increase along with it.
Turning to the municipal bond market, we have seen significant recent improvements regarding real-time trade reporting as well. On August 31, 2004, the Commission approved an MSRB proposal to require reporting of transactions in municipal securities within 15 minutes of the time of trade execution instead of by midnight on trade date. The MSRB expects that a proposed facility for real-time collection and dissemination of transaction prices will become operational in January 2005, at which time MSRB will begin to disseminate transaction data electronically in real time. We understand that testing of the MSRB's facility is currently underway. I applaud the MSRB's efforts in facilitating real-time trade reporting in the municipal bond market.
The recent increase in transparency in the fixed-income markets has already yielded a number of benefits. Notably, increased transaction reporting has enhanced the ability of regulators to surveil the bond markets for unfair pricing, illegitimate mark-ups and mark-downs, and other abusive practices. The amount of a mark-up for a dealer transaction in bonds - indeed for a transaction in any security - must be reasonable. While NASD has a maximum 5% guideline for equity securities, mark-ups are expected to be significantly lower for bonds. For different types of debt, what is recognized as reasonable depends on such factors as liquidity, credit rating, and yield, and can range from less than one-half of one percent for government debt, to higher amounts for high-yield bonds.
Historically, for investors, dealers, and regulators, the difficulty has been in assessing a bond's current market value. The TRACE and MSRB reporting systems now permit the comparison of transactions, so that the current market value for a particular debt security is becoming increasingly discernable. Consequently, increased transparency has improved the Commission's and the SROs' abilities to observe market prices of a bond and thereby explore whether investors are being charged excessive prices, or whether other abusive practices may be occurring.
For example, in January the MSRB issued a Notice entitled "Review of Dealer Pricing Responsibilities." The Notice was occasioned by NASD's review of transactions with retail customers at prices that were not reasonably related to market value. The MSRB expressed concern with "transaction chains" where a block of securities was bought from a retail investor, and then, after a series of inter-dealer trades, was sold to another retail customer at a substantially higher price, thus causing large intra-day price differentials to be absorbed by retail customers. Additionally, based on the same transaction review, the Commission's Office of Compliance Inspections and Examinations and NASD selected a number of municipal brokers' brokers for examination in a coordinated review.
Another development in the debt market involves NASD's proposal to add a new Interpretation to its rules for transactions in non-municipal debt securities. One version or another of this proposal has been in the works since I began at the Commission. The current proposal would address how, for purposes of calculating a mark-up, the NASD members should determine a debt security's prevailing market price. In brief, the NASD proposal would provide a base standard that the prevailing market price for a debt security would be the dealer's contemporaneous cost. While this standard already applies to non-market making dealers, the Interpretation would use the standard as a baseline for all dealers, avoiding confusion and disputes in a market that does not have a sharp delineation between market making and non-market making firms.
Moreover, NASD's proposed new Interpretation would take advantage of increased price reporting and recognize certain well-established attributes of the bond markets by defining additional measures of prevailing market price in cases where the base standard should not apply. The new Interpretation would also address when and how a bond's prevailing market price may be determined by reference to transactions with institutions, or to transactions in similar debt securities. For instance, the proposal recognizes that the market price of a debt security may be established in certain circumstances by reference to other bonds with similar characteristics, such as credit quality. The proposal would also acknowledge the significant role of non-dealer institutions in the bond markets by permitting the NASD members to refer to transactions with institutions at times when determining the prevailing market price of a debt security. The staff is carefully reviewing the proposal, and anticipates publishing it for notice and comment within the next few weeks.
The increased flow of information in the debt markets represents a great step forward for investors. Transparency promotes fair and efficient pricing, educates investors about the cost of investment, allows for better surveillance, and deters misconduct. Ultimately, the growth of transparent debt markets will further foster investor confidence and encourage investment.
A final area of critical importance that I would like to touch upon is the area of fixed income research. The Commission continues to consider whether further regulatory action in the area of fixed income research is appropriate. Last year, the Commission adopted Regulation Analyst Certification, which applies to both equity and fixed income research and, among other things, requires firms issuing research reports to include clear and prominent certifications by analysts that the report accurately reflects his or her personal views about the subject securities and issuers, and to disclose whether analysts received compensation for the views or specific recommendations in the research report.
I note that the industry has also been proactive in seeking to manage conflicts of interest in fixed income research. Recently, The Bond Market Association released a set of "Guiding Principles to Promote the Integrity of Fixed Income Research," which is a comprehensive and detailed set of voluntary principles designed to help the TBMA's member firms manage potential conflicts of interest that arise in their research activities.
The Principles reflect that the nature and intensity of conflicts of interest affecting fixed income research are different than those that may affect equity research, but that conflicts are indeed possible in the preparation of fixed income research reports. I note that the TBMA chose a flexible principles-based approach to ensure that differing organizational structures, various types and uses of fixed income research, and the unique aspects of different fixed income markets could all be encompassed within the framework.
Many of the Principles address issues that are also addressed by the self-regulatory organization rules governing equity research, such as the potential conflicts of interest that arise from the personal interests of analysts. For example, the Principles recommend analyst compensation be structured to promote independence and that firms impose limitations on the personal trading activity of research analysts. I applaud the TBMA for being proactive in connection with analyst conflicts and believe that the implementation of the Principles is a positive development for market participants, regulators, and investors in the fixed-income market. The Commission will continue to consider whether further initiatives in this area are needed.
In closing, I would like to note my belief that transparency is an essential component of an efficient and fair market. In that regard, the Commission has supported increased transparency in the fixed income markets and I expect it to continue working with market participants and regulators in the future to ensure that the fixed-income markets are sufficiently transparent. Earlier in my remarks, I noted that the debt markets deserve to share the spotlight with the equity markets. I think this can be done by increasing transparency and giving individual investors the tools they need to become active participants in your market. As an industry, I believe you are well on your way in this respect through your efforts in increasing transparency, tightening rules related to abusive trading practices, and establishing principles for independent research in the fixed income market. I believe that further increasing transparency should reinforce fixed-income market integrity and, ultimately, result in increased investor confidence and ensure that the fixed-income market remains strong and vibrant. Thank you.