Testimony of Jason Lehman to the SEC Field Hearing on Municipal Securites Markets
San Francisco, CA, September 21, 2010
I would like to thank Commissioner Walter, Director Hu, and Director Cross for holding this important and timely hearing on the Municipal Securities markets.
My name is Jason Lehman, and I am the founder and co-CEO of Headlands Technologies LLC. Headlands is a quantitative proprietary trading firm based in San Francisco and Chicago. Prior to founding Headlands, I spent 12 years in various positions at Citadel Investment Group in Chicago. I spent time in several fixed-income businesses, then started the options market making business for Citadel, which we grew to be one of the largest in the world.
For the past decade I have been an investor in the municipal securities markets. During that time I have devoted substantial time to understanding the crucial differences between municipal security prospectuses, financial information, brokerage platforms, and trading environments.
Today I would like to focus my remarks on three main areas. First, I would like to share my observations on the current market structure. Second, I will outline the importance of more rigorous financial reporting by municipal issuers. Third, I will discuss the critical need for the creation of a mechanism for the municipal securities investor to display interest in the marketplace.
Market Structure Observations:
The municipal securities marketplace has made some significant improvements over the last few years, but still lags far behind other retail marketplaces in transparency, efficiency, and fairness. The market structure is that of a dealer market, where dealer intermediaries control price discovery and access. The dealer community is strongly incented to maintain control over prices and orders, and this control creates significant low-risk profits. The investor does not have the opportunity to see other investors’ potential interest, nor the ability to transact directly without dealer intermediation.
There have been several positive steps toward improving this environment in recent years. First, the creation of the EMMA (Electronic Municipal Market Access) System on June 1, 2009 allowed retail investors to have access to last sale information. Second, innovative platform enhancements by online brokers such as Ameritrade, Charles Schwab and Fidelity have greatly improved the process of sourcing and analyzing securities. Third, market platforms such as BondDesk and MuniCenter have improved the price discovery process for retail investors.
Despite these advancements, however, major shortcomings remain. The most significant failures of market structure result when a retail investor is forced to sell a security. There are many reasons that an investor could decide to sell a particular security, such as unexpected liquidity needs in an uncertain economy or the deterioration in fundamentals for that particular security. When a municipal investor tries to sell that security, however, they will suffer a punitively expensive and opaque process. The implicit execution costs of selling are measured in *points*, not basis points. Considering that the average AAA-rated 5-year GO bond yields 1.4%, the prospect of a 2% or more hit on execution price is simply outrageous.
Thanks to decades of incremental regulatory improvements by the SEC, the retail stock investor has access to a wealth of timely financial information about corporate issuers. Corporations of all sizes produce regular and detailed reports on their financial state. There are severe penalties levied on corporations and their managers for failure to produce these reports, or failure to produce accurate reports. Amazingly, there are little to no such obligations for the issuers of municipal debt.
The arguments against financial reporting obligations are old and tired. Complaints about supposedly excessive burdens created by reform do not stand up to the compelling benefits for the major stakeholders in municipal finance. Taxpayers, investors, and regulators would all benefit from access to timely and accurate information. Additionally, the completeness and accuracy of this information should be certified by the relevant officials, as is the case for corporate officers. Justice Louis Brandeis famously remarked in Harper’s Weekly nearly a hundred years ago, “Sunshine is the best disinfectant.” The ready availability of financial information is a long-overdue necessity for municipal markets that will improve accountability to investors and taxpayers.
The investor in municipal securities must also confront a dizzying degree of complexity to make a sound investment choice. Unlike stocks, municipal bonds do not have standardized terms. To properly differentiate between securities, it is absolutely necessary to read the entire prospectus of each issue. Even then, one must know what key terms to look for, and what warning flags to be wary of. I am an experienced professional investor in complex financial areas such as credit and equity options, yet I still feel challenged by the task of picking apart a municipal prospectus. It is questionable whether the average retail investor is equipped to wade through these complex documents.
Limit Order Display Mechanism:
In 1996, the SEC passed the most important regulation in the history of retail stock investing: The Order Handling Rules. Effective January 17, 1997, these rules fundamentally realigned the balance of power in US stock markets towards the retail investing public. For the first time, a retail investor could place a limit order to buy or sell a security, and have that order set the best price in the marketplace. By doing so, the investor can advertise his or her interest to the entire world, attracting other investors to their price. This has allowed investors to transact directly with each other without a dealer in the middle of the trade. Spreads between buyers and sellers have sharply tightened, and therefore the costs of investing for the US public have plummeted.
Unfortunately, no such mechanism exists for the municipal securities market. There is a critical need for a mechanism whereby a retail investor can place a limit order that is displayed to the entire marketplace. Allowing retail investors the ability to set the best price will narrow spreads, improve price discovery, and drastically lower execution costs. The most important benefit will be measured in investors’ increased confidence in the efficiency and fairness of the municipal securities market.
I would like to thank the Commission once again for the opportunity to appear today and share my thoughts, and I look forward to a productive discussion of these important topics.