SEC must look beyond US borders to reform the fixed income markets

By Cate Long
April 11, 2013

The SEC is holding a Fixed Income Roundtable on April 16 to examine ways to improve the transparency and efficiency of the fixed income markets. This is the first time that I am aware of that the SEC has focused exclusively on the market structure of fixed income. Although fixed income as an asset class is over twice the size of the equity market, and the SEC was given authority in 1975 to oversee this market, almost nothing has been done to regulate it.

All US bond trading is done over the counter or through alternative trading systems (ATS), which are trading platforms registered as dealers. ATS do not have responsibility to oversee the conduct of the other dealers trading on their platform. Think of them as fancy eBay systems for dealers to interact with each other. Rule 300(a) of the SEC’s Regulation ATS provides the following legal definition of an “alternative trading system”:

Any organization, association, person, group of persons, or system:

  • That constitutes, maintains, or provides a marketplace or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange within the meaning of Rule 3b-16 of this chapter; and
  • That does not:

1      Set rules governing the conduct of subscribers other than the conduct of such subscribers’ trading on such organization, association, person, group of persons, or system; or

2      Discipline subscribers other than by exclusion from trading.

Retail investors have access to a number of fixed income ATS like Bonddesk and Municenter through online brokers like eTrade. But the rules regulating ATS do nothing to protect a retail investor who uses an introducing broker via the ATS. Since the retail investor is “self directed,” the introducing broker has no responsibility for “fair dealing” to them either.

As it is set up now, retail-directed bond trading either goes through an ATS where prices are pooled, or the investor must choose a specific bond and call a number a dealers to request a price. They then need to establish an account to purchase the security. Efforts aimed at improving pre-trade transparency might give the retail investor some reference data to make price comparisons, but (page ix) they would require the investor to visit EMMA or rely on their broker to have comparative prices. Having pre-trade data in a different location from an execution venue will likely prove a hurdle for direct investors and make comparison shopping more difficult. The best solution for retail investors is to have pooled trading where real time pricing and investor protections are a part of the structure.

The best way to approach odd-lot trading for retail investors is for the SEC to mandate that dealers who submit pricing to ATS must route the same pricing and liquidity to exchanges. For example, the New York Stock Exchange (NYSE) has been authorized since 2007 to conduct bond trading. This requirement would echo Reg NMS requirements in the equity market and help start the process of a unified market structure for fixed income.

But dealers choose to route minimal activity to the NYSE Bonds Platform. The enhanced transparency of the exchange model reduces the dealers bid/ask spread. In an exchange model, the market is flatter than OTC markets and more dealers than the dominant “Big 5” dealers could participate. It’s easy to see in an exchange model how smaller, regional dealers could become dominant market makers for securities from their region.

America is miles behind other nations in adopting this approach for bond trading. The Australian government recently adopted a new law to make retail trading in its Commonwealth Government Securities on the Australian Securities Exchange more simple:

Consultation Paper 181 Retail trading in Commonwealth Government Securities (CP 181), released in July 2012, indicated ASIC’s likely approach to extending the competition market integrity rules to facilitate the trading of CGS depository interests. Our approach is broadly consistent with earlier consultation in CP 181, meaning that for CGS we have extended the scope of market integrity rules relating to:

  • extreme price movements
  • best execution
  • pre- and post-trade transparency
  • regulatory data for market surveillance
  • market operator obligations in a multi-market environment, and
  • market participant obligations.

The Shanghai Stock Exchange has a ~$200 billion annual turnover of bonds, which accounts for 60% of the total turnover of securities traded on the SSE.

NYSE’s European arm NYSE-Euronext has a bond-trading platform that conforms to EU regulations:

US efforts have focused on improving issuer disclosure and devising a method of providing pre-trade prices to the general public. Dealers have tiered pricing that depends on who their counterparties are and the execution venue, and this presents some barriers to opening the architecture of fixed income markets. Their pricing engines are structured to provide the best pricing to their largest institutional clients, and their worst to widows and orphans. The only way to break this market inefficiency is to require that bids and offers posted on ATS must also be routed to exchanges and be executable rather than indicative.

We must look to other nations for our example. We must have a US fixed income “Big Bang” to remake fixed income market structure. Interest rates will eventually rise and retail investors will need a fair and transparent pathway to buy securities when others no longer want them.

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There are a lot of reasons why munis don’t trade on exchanges. First, while there are maybe around 7000-8000 listed equities in the US, there are literally millions of outstanding municipal CUSIPS, most of which are very small in size. Second, unlike equities, where all listed issues trade actively all day long, the vast majority of outstanding munis go months or even years between trades. Most issuers do not get a lot of dealer coverage because it simply isn’t economical–or even possible–for a dealer to monitor the credits of tens of thousands of small municipal issuers. When a potential odd-lot trade is put out to a brokers’ broker or ATS for bids, it isn’t uncommon to receive no bids whatsoever or for all the bids to be off the market.

These aren’t easy issues to solve. Pricing and trading in the general market is easy. Everybody knows where Cal GOs trade, and bid-ask spreads are small. But what’s the right price for a Blytheville, Arkansas School District 4% coupon due in 2027? Simply pushing the market to an exchange isn’t the answer. Just because you post an offering to the NYSE’s platform doesn’t mean anybody is going to trade there.

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