Before the House Subcommittee on Finance and Hazardous Materials,
Arthur Levitt, Chairman
Concerning Hedge Fund Activities in the U.S. Financial Markets
March 18, 1999
The Commission supports enhanced transparency in the U.S. corporate debt market. Our support is motivated by our conviction that transparency benefits the market, investors, and the economy as a whole.
The Commission has long believed that transparency promotes the fairness and efficiency of the U.S. capital markets and fosters investor confidence in those markets. This is as true for debt markets as for equity markets. Investors must have access to recent prices to make informed decisions. In the
debt market, however, recent prices currently are not generally available.
Recent efforts to improve the transparency of the government and municipal securities markets, undertaken with the Commission's encouragement, demonstrate the benefits of price transparency. At the same time, these efforts have also shown that regulatory requirements should be tailored to the specific qualities of each market.
Market surveillance goes hand-in-hand with transparency to protect investors and promote efficient markets. Effective market surveillance requires that regulators have access to comprehensive transaction information. Because no regulator now has routine access to transaction information for all corporate bonds and preferred stocks, there is no organized system for surveillance of that market.
The time has come to increase corporate debt transparency because, although this market has grown in size and importance, it has not grown in openness. The market should use current technology to gather transaction prices, distribute them, and interpret them in a timely, accurate, and efficient way.
As I testified in September, we have therefore asked the NASD to adopt transaction reporting rules for corporate debt, and to develop systems to collect and redistribute transaction prices on an immediate basis. We have also requested that the NASD create a database of transactions and a surveillance program to better detect fraud in the corporate debt market.
Through a committee of market participants, the NASD is working towards an industry-guided solution for corporate bond market transparency that is tailored to the unique features of that market. We expect that the NASD's proposal will improve transparency as pricing information is distributed to the public, and will enhance market surveillance as comprehensive transaction information is made available to regulators.
We expect to see the NASD's proposal before the end of the summer.
Chairman Oxley, Representative Towns, and Members of the Subcommittee:
Thank you for giving the Securities and Exchange Commission ("Commission") the opportunity to present its views on an issue in which we are actively engaged -- enhancing transparency in the United States debt market. Today, I'd like to focus on three topics: (1) how transparency promotes fairness and efficiency in the U.S. capital markets, and how regulatory surveillance bolsters investor confidence in those markets, (2) why we believe this is the right time for improved transparency in the corporate bond market, and (3) the progress that has been made in this area since the Fall of last year, when I testified before you about the need to improve corporate bond transparency.
I. Regulatory Goals of Enhanced Transparency and Market Surveillance
The Commission has long believed that transparency -- the extent to which prices are visible and understandable to market participants -- plays a fundamental role in promoting the fairness and efficiency of U.S. capital markets. Despite differences between the debt and equity markets, the Commission believes that transparency is just as important for bonds as it is for stocks. Indeed, because the value of a bond is usually closely related to the value of other bonds, the price paid for one bond may be important information about the value of many other bonds.
In order to make informed decisions, investors must know the prices recently paid for debt instruments generally, as well as for the specific bonds they hold or that are being offered in the market. Often, there are no recent market prices for the bonds an investor holds, and their value must be imputed from the prices of other bonds.
price transparency is therefore critical to informed investment decisions. Informed investors, armed with accurate information, ensure that market prices represent fair values. And fair market prices, in turn, ensure that the markets perform their economic function of efficiently allocating capital resources.
Because transparency increases the fairness and efficiency of markets and fosters investor confidence in those markets, it has the added benefit of encouraging greater participation by investors. This participation means more trading, more market liquidity, and perhaps even new business for bond dealers. Thus, we believe that a sound and sensible approach to bond market transparency will benefit almost everyone -- investors, dealers, and the economy as a whole.
The Commission has a long history of supporting price transparency. When Congress adopted the 1975 Securities Act Amendments, it gave the Commission substantially greater authority over quotation and transaction reporting. Since then, the Commission has pressed repeatedly for increased transparency in equity markets. Each time opponents have predicted doom, and each time the results have shown that more transparency leads only to more liquid and efficient markets. Recent experience in the debt markets has reinforced the Commission's belief in the benefits of price transparency.
For example, in 1991, with encouragement from the Commission and Congress, the industry created GovPX, an electronic reporting system, to distribute real time quotes and transaction prices for U.S. Treasury securities. Treasury markets today exhibit an extraordinary combination of high liquidity and low transaction costs. Trading volume has increased from $111 billion per day in 1990 to $227 billion per day in 1998, and the spreads for benchmark bonds
are near zero.
In 1995, again with the Commission's encouragement, the Municipal Securities Rulemaking Board ("MSRB") began collecting the details of dealer-to-dealer transactions in the municipal bond market and distributing daily summary reports. In August of last year, with Commission approval, the daily reports were expanded to include customer trades as well as interdealer trades. Most recently, just last November, the Bond Market Association began offering daily summaries on its Internet Web site, making municipal bond prices for the previous day available for the first time to the general public. This new Web page received 17,000 hits in its first three weeks of operation, suggesting a high level of interest by the public.
Although we view the MSRB transparency program as a successful effort, the full impact of transparency in the municipal market will not be clear until trade reporting is done on a real-time basis, which the MSRB has committed to do and which we continue to support.
In retrospect, we believe the government and municipal securities market transparency initiatives demonstrate both the benefits of price transparency in the debt markets, and the wisdom of being sensitive to the specific qualities of each market. The Commission's corporate bond transparency initiative will be carried out in the same spirit, seeking to further transparency goals in a manner uniquely tailored to that market.
Market surveillance, like transparency, is a fundamental means of promoting fairness and confidence in markets. In fact, the two go hand-in-hand. Transparency promotes fairness and efficiency by making essential information available to all market participants, assuring that market decisions are based on appropriate information. Surveillance efforts, in turn, are designed to promote fairness and investor confidence by detecting and preventing fraudulent practices, such as market manipulation, and other potential abuses. Surveillance and transparency efforts, in essence, unite to provide a comprehensive program for protecting investors and promoting the effectiveness of capital markets.
Effective market surveillance systems require that comprehensive trade information be reported to regulators. This reported trade information is subsequently used to produce audit trails and other sophisticated market surveillance tools. The key to meaningful surveillance is regulatory access to comprehensive trading information, essentially the same information that is required for price transparency.
Today, no regulator has routine access to transaction information for the broad universe of corporate bonds and preferred stocks. Consequently, there is no organized system for routine surveillance of trading in that market. Regulators must depend on examinations of broker-dealers, or react to complaints brought by investors, which are cumbersome tools. A system of comprehensive trade reporting will permit the creation of a regulatory database and appropriate tools for proactive supervision of the corporate debt markets.
II. Importance of U.S. Debt Markets
We encourage this focus on the corporate bond market now, because in recent years it has grown in importance, but not in openness. In 1985 the corporate bond market, measured by outstanding debt, was smaller than the municipal bond market. Today, at $2.4 trillion outstanding, it is about $1 trillion larger than municipal debt. It is also about 70% as large as the outstanding Treasury debt. Corporate bond issuance has increased more than four fold since 1990, and for high yield bonds, more than ten fold.
Corporate Bond Transparency
Despite its unprecedented growth, however, the corporate debt market has failed to keep pace with transparency improvements in other markets, including the government and municipal bond markets. Timely and accurate pricing information on the broad spectrum of corporate bonds is not available to the public or even to market participants. Some corporate bonds are traded by interdealer brokers, but transaction prices, even for interdealer transactions, are not displayed or reported in an organized way. As a result, in order to obtain accurate valuations of corporate debt instruments, corporate bond market participants must have a trading desk and a research department with sophisticated analytical tools to gather and interpret market information. Generally these kinds of resources are available only to large broker-dealers and institutional investors.
The time has come to illuminate this needlessly dark corner of the capital markets. The technology now exists to gather transaction prices, distribute them, and interpret them in a timely, accurate, and efficient manner. Developing such a mechanism seems the next logical step.
III. Current Initiative
The initiative started last Fall to improve corporate debt transparency is moving forward. As we testified in September, we have asked the NASD to adopt transaction reporting rules for corporate debt, and to develop systems to collect and redistribute transaction prices on an immediate basis. We also requested that the NASD create a database of transactions and a surveillance program to better detect fraud in the corporate debt market.
The NASD subsequently formed a committee of market participants -- the Bond Market Transparency Committee --to work toward an industry-guided solution that will increase price transparency and oversight for the corporate debt market.
The NASD was asked to take on this initiative for two reasons. First, the NASD is the self-regulatory organization for the over-the-counter market, where almost all corporate debt transactions take place. While the NASD is already responsible for surveillance of this market, it generally lacks access to the market information needed to do so effectively. Second, the NASD already has in place much of the required infrastructure. For example, the NASD has a national network that collects transaction reports in Nasdaq and listed securities traded over-the-counter. It performs on-line comparison and reconciliation of those transactions, and redistributes the reported information to vendors and to the NASD's regulatory subsidiary, NASDR. We believe that much of this technology is adaptable to the corporate debt market and will obviate the need to "reinvent the wheel." Finally, the NASD will be able to create systems that combine trade reporting and comparison that will further the industry's goal of T+1 settlement, which is also supported by the Commission.
The NASD, and the industry committee it formed, are working toward a proposal for market transparency tailored to the unique features of the corporate bond market. We expect to see such a proposal before the end of the summer. We expect that the proposal will lead to transaction reporting for corporate debt that will improve transparency as pricing information is distributed to the public. Similarly, we expect that the NASD's efforts will also lead to improvements in its surveillance of the market.
The Bond Market Association ("TBMA") is also developing a proposal for collecting and disseminating transaction information from interdealer brokers, but only in investment grade corporate debt securities. While the details of that proposal and its relationship with the NASD's initiative are still unclear, we welcome industry support for increased transparency. We believe that TBMA's efforts will, at a minimum, demonstrate the feasibility of immediate price reporting in the corporate debt markets.
In conclusion, the Commission believes that we are making strides toward greater transparency for corporate bonds. Transparency is both feasible and practical, and it will lead to fairer, more efficient and more effective markets. Almost everyone will benefit -- investors, dealers, and the economy as a whole.
Thank you. I would be happy to respond to any questions you may have.
Benchmark Treasury bonds are generally considered to be the most recent issues of two, five and 10 year Treasury notes, and the most recently issued 30 year Treasury bond.