A revolution in muniland

June 23, 2014

Goldman Sachs

In a speech last week at the Economic Club of New York, SEC Chairman Mary Jo White set out three new initiatives that will reorder the way fixed income markets serve retail investors.

Congress gave the SEC the authority to regulate fixed income markets in 1975. The initiatives that White announced make up the first broad extension of the SEC’s authority over the murky, cost ridden, over-the-counter bond market. The combined firepower of the SEC, FINRA and the MSRB will likely topple any resistance that dealers will use to protect one of the last remaining profit centers.

In her speech, White pointed out that securities markets operate within a “structure” of regulator rules, technology and market practices. Bond trading information for retail-size trades is often locked in trading venues and available only to select market participants. Transparency for investors is mostly an illusion. White said:

It is striking that the dramatic technological advances that have transformed the equity markets over the past decade have had only a modest impact on the trading of fixed income securities. While today there are a number of electronic systems that facilitate trading in fixed income securities, they tend to be ‘inventory-based,’ providing information primarily on the bonds their participating dealers would like to sell.

The vast majority of small trades are executed through alternative trading systems (ATS) like Bonddesk and The MuniCenter.

In addition, information about the trading interest reflected on these systems often is restricted to participating dealers and select customers. So, although new technologies are gradually being incorporated into the trading of fixed income securities, producing efficiencies and some pre-trade pricing information, it appears they are being used primarily to support the traditional dealer model.

White is describing the already deep and abundant price discovery that is going in some ATS platforms like Thomson Reuters majority-owned Bonddesk. You can see the depth of bids and offers for a corporate bond issued by Goldman Sachs on Bonddesk’s Bookviewer at the top of this post. It shows a number of broker-dealers willing to “make a market” and show prices at which they are willing to buy and sell the bonds (bids and offers). It looks very much like an equity traders “depth of book.” Note the minimum trade size of 2 bonds, which is a retail-sized trade lot (typically the market considers a trade of less than $100,000 to be retail-size or an “odd-lot”).

Although pre-trade bid and offer information is robust, it is not available to all market participants. Disseminating pre-trade information is one of the three goals that White outlined for bond transparency, but she did not suggest how this would be done. There has been ongoing discussion that the MSRB would aggregate and host pre-trade information from all market venues on the EMMA website.

The second initiative is to require brokers to disclose how much they have marked up a bond that they are selling to a retail customer on a “riskless principal” basis. Riskless principal trades happen when a dealer buys a bond in the market and immediately resells it to a client. There is no price risk for the dealer because there is no holding period.

There are currently no rules for how a dealer can mark up a bond he purchases on behalf of a client. Generally a dealer looks at a similar transaction and uses the reported price as a baseline to calculate how much to mark up (or mark down) the trade he is making to a retail customer. You can see this at “Broker-dealer 3” on the right side of the visual from a 2012 GAO report below:


A year ago the SEC held a fixed income roundtable and mark-ups were discussed by several leading market participants. Craig Noble, Managing Director and Head of Retail Fixed Income at Wells Fargo Advisors, said that for mark-ups they don’t distinguish between bonds that the firm owns in inventory and bonds that are purchased in the marketplace. From the roundtable transcript:

[SEC official] MR. DIMITRIOUS:  Further to this point John [Ramsey former acting director of the SEC Division of Trading and Markets] was bringing up about the prevailing market value and how you guys determined prices, regarding the mark-ups themselves, do you distinguish between mark-ups on riskless principal versus trading out of inventory when calculating your mark- ups?

MR. [Craig] NOBLE [Wells Fargo]:  Similar, riskless principal or principal.  Since we are in a marketplace where especially with price dissemination, when you look at EMMA, you can’t tell if it’s riskless principal or principal. It’s what the yield was. So if a bond is supposed to be yielding a five percent, to get to a customer, you may have a small mark, you may have a little larger mark, it’s trying to get to a yield, and that’s the end result, if I have riskless principal or principal.

MR. EADY:  To what extent do you currently disclose to the customer what the mark-up is on the trade, whether it’s out of inventory or on an agency basis or riskless principal basis, if you want to define a non-inventory trade? [Agency trades happen when a dealer facilitates a trade between parties and never takes actual possession of the security. Dealers charge fixed commissions on agency trades.

MR. NOBLE:  Agencies would be disclosed because as such it would be disclosed on the confirm.  Any principal transaction, the mark-up is not disclosed. [Confirm or confirmation is the verification a customer receives when a trade is made on his behalf]

The amount of mark-up is flexible. Noble said that Wells Fargo follows this practice for bonds that it buys in the market to resell to clients and on bonds that it is holding in inventory.

Chairman White is not saying mark-ups shouldn’t exist, she just wants the amount of the markup (or markdown if a customer is selling a bond) to be disclosed to the investor. Seeing the mark-up would allow an investor to judge if selling the bond would benefit him or if it would be best to wait and continue to collect interest. Also, an investor who knows how much his bonds are marked up could comparison shop among broker-dealers to see who is providing the best service and fees.

In today’s low interest rate environment, mark-ups can take a huge bite out of an investor’s returns. Mark-ups vary tremendously depending on the size of the trade. On retail $10,000 trades, mark-ups average 2.7 percent. They drop to 0.10 percent for $5,000,000 trades. This explains the SEC’s focus on retail investors. (Burton Hollifield presentation):

Burton Hollifield

White’s third initiative is “best execution” for retail bond trades. In May the MSRB proposed a new rule to the SEC for approval:

The MSRB agreed to seek approval from the Securities and Exchange Commission (SEC) to implement a ‘best-execution’ standard for transactions in the municipal market. The rule would establish for the first time an explicit obligation for dealers to use ‘reasonable diligence’ when handling and executing municipal security trades for retail investors to achieve a price that is as favorable as possible under prevailing market conditions.

I discussed some implications of best execution for Reuters Insider:

Chairman White’s announcement is audacious, but she has the full backing of the other members of the SEC on this complex effort. Dealers will try to delay and weaken these new rules. The four and half million retail investors who own municipal bonds or bond funds will be the real winners if White succeeds.

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