A warrior for transparency

April 7, 2011

My fellow Reuters blogger Felix Salmon  wrote about his lunch with the bond fund managers Loomis Sayles yesterday.

Bond fund managers generally are not keen on self directed investors. They believe that they are the best managers of investors’ fixed income assets. And some of Felix’s blog post reflected that.

The darkness and complexity of bond markets has served bond mutual funds well.  Generally retail investors, unless they have high net worth and a knowledgable advisor or broker, tend to allocate the “fixed income” portion of their assets into bond funds.  This is unlike the equity markets, where many investors feel confident buying individual stocks.

I’ll write another day on why bond mutual funds are not necessarily in the best interest of investors. That involves an academic literature search that I’m not up for today.

But I would like to highlight a new effort that will help rationalize the market and make muniland more profitable for retail investors. This effort will help tip the balance of understanding to those who want to play in muniland.

Today the Municipal Securities Rulemaking Board  announced that Erik R. Sirri, professor of finance at Babson College and former director of the U.S. Securities and Exchange Commission Division of Trading and Markets, is leading an MSRB study of the municipal securities market. The study, which the MSRB announced previously, will use municipal market trading data to examine transaction costs, price dispersion and other issues in the municipal bond market.

“Erik’s deep experience in trading activity and the capital markets as a whole will help the MSRB analyze whether pricing mechanisms and liquidity in the market could be improved with higher levels of pre-trade price transparency,” said MSRB Executive Director Lynnette Kelly Hotchkiss. “We are thrilled to be working with Erik and look forward to reviewing with our Board members initial findings from the study later this year.”

This is no milquetoast press release. Sirri co-authored an important paper on corporate bond trade transparency prior to joining the SEC as director of division of trading and markets. This is the same market structure issue that the MSRB has retained him to study. His work is broadly cited in market structure studies.

The municipal bond market has a “trade tape” called RTRS or “Real Time Reporting System”. You can see the prices of individual trades on it if you want to confirm the price to buy or sell a muni bond. This is “post-trade” transparency. It is the backside of the transparency equation and the low hanging fruit in opening up a market.

Sirri’s paper, Transparency and Liquidity: A Controlled Experiment on Corporate Bonds, hones in on the bid/ask spread in over-the-counter corporate bond markets before and after the implementation of TRACE for BBB bonds. TRACE is the corporate bond trade tape.

Dealers report their trades into the system, which is run by FINRA.

Trade tapes aggregate and scrub trade data and then distribute it to the markets so market players and investors know which way prices are trending. Sirri’s study demonstrated the success of TRACE’s price transparency in reducing the premium investors paid for bonds.

Here is the money quote from the paper:

The observed decrease in transaction costs is consistent with investors’ ability to
negotiate better terms of trade once they have access to broader bond-pricing data.

“The observed decrease in transaction costs is consistent with investors’ ability to negotiate better terms of trade once they have access to broader bond-pricing data.”

This is unpleasant news for the dealers because it is their trading margins that are squeezed when markets are lit up with price transparency. Dark markets make for bigger trading margins.

The same battle is being played in the current fight to move all OTC derivatives onto exchange-traded platforms or swap execution facilities (SEFs.) These platforms are where market participants can see pre and post trade data. This is the holy grail of open, transparent and stable financial markets.

But the real basis of fear for dealers is the regulatory and and enforcement knowledge that Sirri brings to the scene.

He was in the room when Lehman failed. He was there when the major investment banks, which dominate the municipal market, experienced runs and nearly collapsed before the Federal Reserve and Treasury lent hundreds of billions of dollars and made cash equity infusions. As head of Trading and Markets he had a view into their trading books and balance sheets. And I imagine his time away from the regulatory cauldron has sharpened his views on the destabilizing role of big, highly levered investment banks.

This man knows financial markets like few others. And now he has joined forces with the muniland overseer, the MSRB, to look at market structure and trading practices.

Over my years working to open up these dark and dealer controlled markets occasionally something will happen that makes my heart sing. And that helps me remember why the struggle for fair and transparent markets is the right work. This MSRB announcement today is one of those times. Investors and issuers have gained a real warrior for their interests.

Welcome back to the battle Dr. Sirri. We’ve long awaited your return.

One comment

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Posted by FT Alphaville » Whistleblowers in muniland | Report as abusive

Great news and excellent article! I learned the art of buying individual munis from my father starting in the 70’s. I would never buy or trust a muni fund to act in my best interest. The analysis time, per issue purchases has increased from 60 seconds in the 80’s to, sometimes, several hours these days, thanks to the changing nature of the environment and owing to the information available through sites like EMMA. Differences in mark-ups between dealers is significant but go away when long term BD’s realize I’m shopping.

Posted by WYmuniguy | Report as abusive