[Senate Hearing 108-888]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 108-888
 
                       OVERVIEW OF THE REGULATION
                          OF THE BOND MARKETS

=======================================================================

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED EIGHTH CONGRESS

                             SECOND SESSION

                                   ON

         THE REGULATION OF THE BOND MARKETS, FOCUSING ON FIXED
   INCOME MARKET TRANSPARENCY, TRADE REPORTING AND COMPLIANCE ENGINE 
(TRACE) ENABLING INVESTORS TO ACCESS CURRENT PRICE INFORMATION FOR U.S. 
    CORPORATE BONDS, AND STATE, LOCAL, AND INTERNAL REVENUE SERVICE 
                    REGULATION OF MUNICIPAL ISSUERS

                               __________

                             JUNE 17, 2004

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


      Available at: http://www.access.gpo.gov/congress/senate/ 
                            senate05sh.html


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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire        DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina       ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida

             Kathleen L. Casey, Staff Director and Counsel
     Steven B. Harris, Democratic Staff Director and Chief Counsel
                       Bryan N. Corbett, Counsel
                 Dean V. Shahinian, Democratic Counsel
   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
                       George E. Whittle, Editor

                                  (ii)
















                            C O N T E N T S

                              ----------                              

                        THURSDAY, JUNE 17, 2004

                                                                   Page

Opening statement of Chairman Shelby.............................     1

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................     2

                               WITNESSES

Annette L. Nazareth, Director, Division of Market Regulation, 
  U.S. Securites and Exchange Commission.........................     4
    Prepared statement...........................................    26
Douglas Shulman, President, Markets, Services and Information, 
  National Association of Securities Dealers.....................     6
    Prepared statement...........................................    30
Christopher A. Taylor, Executive Director, Municipal Securities 
  Rulemaking Board...............................................     8
    Prepared statement...........................................    34
Micah S. Green, President, The Bond Market Association...........    17
    Prepared statement...........................................    41
Christopher M. Ryon, Principal and Senior Municipal Bond 
  Portfolio Manager, The Vanguard Group..........................    19
    Prepared statement...........................................    63
Arthur D. Warga, Dean, C.T. Bauer College of Business............    20
    Prepared statement...........................................    75

                                 (iii)










           AN OVERVIEW OF THE REGULATION OF THE BOND MARKETS

                              ----------                              


                        THURSDAY, JUNE 17, 2004

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met, pursuant to notice, at 10:10 a.m., in 
room SD-538, Dirksen Senate Office Building, Senator Richard C. 
Shelby (Chairman of the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order. This 
morning the Committee will examine the regulation of the 
corporate and municipal bond markets. This is an opportunity 
for the Committee to learn about current trends in the industry 
and to examine the market structure and regulatory framework.
    It has been a number of years since this Committee held an 
oversight hearing on the regulation of the bond markets, and I 
look forward to today's testimony.
    Although the bond markets have long been associated with 
large institutional investors, retail investors are a growing 
component of the debt markets, either through individual 
holdings or indirectly through mutual funds and pension 
accounts. Individual households now hold approximately 10 
percent of the $4.6 trillion invested in the corporate bond 
market. Municipal individual households hold approximately 35 
percent of all outstanding issues which equals about $670 
billion. Mutual funds hold another 35 percent of the $1.8 
trillion municipal bond market.
    This expansion of retail investment in bonds makes it 
incumbent upon this Committee and the regulators to ensure that 
the bond markets operate efficiently and fairly. Many have 
criticized the lack of price transparency in the bond markets 
which may result in price swings and markups. I understand that 
the regulators have recently implemented trade and price 
reporting systems to better facilitate the flow of information 
to investors.
    I look forward to hearing more about these programs and 
other efforts by the regulators to improve transparency.
    On the first panel this morning we will hear from the 
regulators. Annette Nazareth is the Director of Market 
Regulation at the Securities and Exchange Commission. Doug 
Shulman is the President, Markets, Services and Information at 
the National Association of Securities Dealers. Finally, 
Christopher Taylor is the Executive Director of the Municipal 
Securities Rulemaking Board. Individually, each of these 
agencies plays a distinct role in the bond markets, but 
collectively they work to ensure transparency and fairness to 
all investors in the markets. In addition to questions 
concerning price transparency, I look forward to exploring the 
questions regrading the structure of the bond markets, 
disclosure practices, compliance programs and enforcement 
activities.
    On the second panel we will hear from several witnesses 
representing different perspectives on the markets. Micah Green 
is the President of the Bond Market Association, which 
represents the broker/dealers involved in the bond markets. 
Chris Ryon is the Senior Municipal Bond Portfolio Manager at 
the Vanguard Group, finally in the second panel we will hear 
from Mr. Arthur Warga, Dean of University of Houston Business 
School and Finance Professor. Professor Warga has done 
extensive research on price transparency in the bond markets. I 
look forward to hearing from all of you at the proper time.
    Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Mr. Chairman. I 
guess we are fighting to get a quorum.
    Chairman Shelby. We are trying to get a quorum. We have a 
few nominations, all of them very important, however, one is 
especially important to this Committee.
    Senator Sarbanes. Two more would do it.
    Chairman Shelby. Need two more.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Mr. Chairman, I want to commend you for 
holding this hearing with respect to the bond markets. It is 
another instance of where this Committee, under your 
leadership, continues its comprehensive oversight of the 
securities industry.
    Today there is more than $20 trillion of outstanding bond 
market debt, and more than a million outstanding bond issues. 
The daily average trading volume of bonds exceeds $800 billion, 
several times the volume of stocks.
    This morning the Committee will focus on the municipal and 
corporate bond markets in which an important issue is price 
transparency. In my view, transparency plays a very important 
role in inspiring investor confidence and promoting the 
fairness and the efficiency of the U.S. capital markets. 
Historically, price transparency in the bond markets has been 
an issue. As recently as 1998, an SEC staff study concluded 
that price transparency in the municipal bond markets was 
``difficult'' and in the high-yield corporate bond market, 
relatively poor.
    In recent years, many positive steps have enhanced 
transparency. The Municipal Securities Rulemaking Board moved 
so that municipal bond trades are now reported the next day, 
and the NASD's Trade Reporting and Compliance Engine System now 
reports trades in the most frequently corporate bonds within 45 
minutes of execution.
    While these are major steps forward many people argue that 
more is needed. An article in Forbes Magazine only a couple of 
months ago stated that: ``transparency is the mantra of the 
day'' from corporate accounting to executive compensation, yet 
it has skipped over the corporate bond market. And The Bond 
Buyer, back in December in an article, quoted a brokerage 
executive who said: ``In terms of liquidity and price 
transparency, the municipal bond market is halfway between the 
New York Stock Exchange and the Oriental rug market.'' It is my 
understanding that the SEC has a task force looking at 
transparency and markups, and the regulators plan to increase 
transparency in the near future. The Municipal Securities 
Rulemaking Board intends to report trades in real time--within 
15 minutes of the time of execution--by next January, and NASD 
plans to report corporate bond trades within 15 minutes of 
execution by next year with certain exceptions.
    These plans need to move forward on schedule. Further study 
may be needed to determine whether additional transparency is 
in the public interest.
    I look forward to the testimony of the witnesses this 
morning, and I thank the Chairman of the Committee once again 
for focusing on this very important matter.
    Chairman Shelby. Thank you. We have established a quorum, 
and I would like to move the Committee to Executive Session and 
ask for a vote on the nomination of Alan Greenspan and two 
commemorative coin bills which are pending before the 
Committee. The Committee will first vote on the nomination of 
Alan Greenspan, who has been nominated for a fifth term as 
Chairman of the Board of Governors of the Federal Reserve 
System.
    As we all know, Dr. Alan Greenspan appeared before the 
Committee earlier this week. Is there any discussion or debate 
at this time on the nomination?
    [No response.]
    Chairman Shelby. All those in favor of reporting out the 
Greenspan nomination signify by saying aye.
    [Chorus of ayes.]
    Chairman Shelby. All opposed, nay?
    [Chorus of nays.]
    Chairman Shelby. In the opinion of the Chair, the ayes have 
it and the nomination will be reported to the floor.
    The second item on the Committee's agenda this morning is 
two commemorative coin bills, S. 894, The Marine Corps 230th 
Anniversary Commemorative Coin Act, and S. 976, The Jamestown 
400th Anniversary Commemorative Coin Act. Each bill has more 
than 67 cosponsors.
    Is there any comment or debate on either of the bills, coin 
bills?
    [No response.]
    Chairman Shelby. I ask unanimous consent that we consider 
the bills en bloc. Hearing no objection, it is so ordered. All 
those in favor--
    Senator Sarbanes. Mr. Chairman, could I just make the 
observation, on both of these bills, that the Committee rule 
requiring 67 cosponsors was met in both instances of this bill. 
That is a rule that was put in place. We have held to that rule 
and I think it serves an important purpose.
    Chairman Shelby. Thank you.
    All those in favor of reporting out the two coin bills, 
signify by saying aye.
    [Chorus of ayes.]
    Chairman Shelby. All those opposed, nay.
    In the opinion of the Chair, the ayes have it and both 
bills will be reported to the full Senate.
    The Executive Session is now adjourned and at this time we 
will resume the hearing.
    If no one else has an opening statement, we will go 
directly to the panel. We will start with you, Ms. Nazareth.

                STATEMENT OF ANNETTE L. NAZARETH

            DIRECTOR, DIVISION OF MARKET REGULATION

            U.S. SECURITIES AND EXCHANGE COMMISSION

    Ms. Nazareth. Good morning, Senator Shelby, Ranking Member 
Sarbanes and Members of the Committee. I am delighted to be 
here today to discuss some of the significant issues and 
developments that the Securities and Exchange Commission are 
currently addressing with respect to the fixed income markets. 
Specifically, I plan to discuss the Fixed Income Market 
Transparency Joint Task Force, which was recently commissioned 
by Chairman Donaldson. I will also talk about other issues that 
the task force is currently considering.
    In March 2004 Chairman Donaldson commissioned a joint task 
force to consider issues relating to bond market transparency 
and mark-up regulation. The task force consists of 
representatives of the Divisions of Market Regulation and 
Enforcement, the Office of Compliance, Inspections and 
Examinations, the Office of Economic Analysis and the Office of 
the General Counsel.
    The task force was organized to summarize fixed income 
market transparency developments, identify current problems and 
generate potential solutions.
    Preliminarily, the task force has found that transparency 
has improved to varying degrees in each of the fixed income 
markets over the last 20 years because of a continued focus on 
this issue by both Congress and the Commission.
    To implement transparency in the corporate bond markets, 
the Securities and Exchange Commission persuaded the NASD to 
create systems to collect transaction reports and disseminate 
price information. Specifically, on January 23, 2001, the 
Commission approved the NASD's proposal to establish the Trade 
Reporting and Compliance Engine system known as TRACE for 
reporting and dissemination of last sale information on 
corporate bonds. On July 1, 2002, TRACE was officially 
launched. Under the current TRACE rules, dealers must report 
trades on U.S. corporate bonds to the NASD within 45 minutes.
    Prior to TRACE real time transparency of investment grade 
corporate bonds was limited to those traded on exchanges, which 
was a very narrow segment of the market. TRACE currently 
disseminates transaction information on more than 4,200 
securities, representing about 75 percent of the dollar value 
of trading activity in investment grade bonds. The NASD makes 
this information available at no cost to investors on a delayed 
basis with a minimum four-hour time lag.
    It is important to note that the NASD is in the process of 
expanding price transparency in the corporate bond market in a 
new phase of the TRACE rollout, which will reflect the NASD's 
experience with earlier phases. The NASD plans to reduce the 
reporting period from 45 minutes to 30 minutes in 2004, and 
ultimately to 15 minutes in 2005. In addition, the NASD Board 
recently approved the recommendations of its advisory Bond 
Transaction Reporting Committee. Our understanding is that the 
NASD intends to file a proposed rule change with the Commission 
shortly. The NASD plan would make public, in near real time, 99 
percent of all transactions and 95 percent of the par value in 
TRACE eligible securities with delayed publication of trades in 
certain new issues and of large transactions in infrequently 
traded high-yield securities. I understand the NASD intends to 
reconsider the need for the remaining restrictions in the near 
term.
    With respect to the municipal bond market, the MSRB, with 
the Commission's active encouragement, first implemented a 
Municipal Securities Trade Reporting System in 1995, and 
proceeded thereafter in measured steps. The implementation date 
of real-time transaction reporting, which is currently 
scheduled to begin in January of 2005, has been delayed by the 
MSRB several times to ensure that dealers have sufficient time 
to make necessary changes in their bond processing systems. 
Real-time transaction reporting in the municipal market is 
defined as the requirement to report transactions within 15 
minutes of the time of the trade.
    In the Government securities market impetus for change 
began in the late 1980's when the GAO published a report 
recommending increased price transparency in this market. In 
1990 the GAO recommended legislation to require inter-dealer/ 
brokers to make transaction prices available to the public. The 
Commission supported the GAO recommendation and recommended 
that legislation require quotation information to be made 
available as well.
    Partially in response to these calls for congressional 
action, a variety of data network providers have emerged that 
publicly disseminate quotation and transaction information on 
Treasury bonds and Federal agency securities. One of these 
providers is GovPX, a vendor created by a group of primary 
dealers in Government securities that publicly disseminates 
information regarding the U.S. Treasury market.
    With respect to the markets for foreign, sovereign and 
mortgage-backed securities, the amount of transparency has not 
changed significantly in recent years. Dollar-denominated 
foreign sovereign bonds are largely traded through inter-
dealer/brokers who post quotation and transaction information 
on their brokerage screens. This information is not generally 
disseminated outside of the dealer network. Pricing information 
on mortgage-backed securities is widely available through a 
variety of commercial vendors. Some vendors also offer 
analytical tools to value these securities. Dealers and some 
institutional investors have in-house analytical models in 
place as well.
    Generally speaking, transparency plays a fundamental role 
in promoting fair and efficient pricing in the fixed income 
markets, thereby fostering investor confidence in those markets 
and encouraging greater participation. Transparency also 
contributes to efficient price discovery and aids investors in 
assessing the quality of prices being offered in the 
marketplace. In addition, transaction reporting has 
supplemented the ability of regulators to surveil the bond 
markets for unfair pricing and abusive mark-ups and mark-downs. 
Finally, a soon-to-be-released study by the Commission's Office 
of Economic Analysis confirms that transaction costs decline 
with added transparency.
    For any type of bond, mark-ups must be reasonable. While 
NASD has a maximum 5 percent guideline for equity securities, 
mark-ups are expected to be significantly lower for bonds. For 
different types of debt, what is recognized as reasonable 
depends on such factors as liquidity, credit rating and yield, 
and can range from less than one half of 1 percent for 
Government debt to higher amounts for high-yield bonds. For 
investors as well as regulators the difficulty lies in 
establishing the prevailing market price for a bond. This 
generally is the baseline that is used to assess whether a 
mark-up is reasonable. We believe that increased transparency 
should enhance the Commission's and the SROs' ability to 
determine the prevailing market for a bond, and thereby 
ascertain that investors are not being charged unfair prices or 
abusive markups.
    Improved transparency will enable investors to better 
determine the fair price of a bond. This will make them better 
able to protect themselves against unfair pricing in the first 
instance.
    In closing, I would like to note that we believe that 
transparency is an essential component of an efficient and fair 
market. In that regard the Commission has supported increased 
transparency in the fixed income markets and will work with 
market participants and regulators in the future to ensure that 
we can continue the trend of increasing transparency in the 
fixed income markets.
    Thank you.
    Chairman Shelby. Mr. Shulman.

                  STATEMENT OF DOUGLAS SHULMAN

          PRESIDENT, MARKETS, SERVICES AND INFORMATION

           NATIONAL ASSOCIATION OF SECURITIES DEALERS

    Mr. Shulman. Thank you. Chairman Shelby, Senator Sarbanes, 
Members of the Committee, my name is Doug Shulman. I am NASD's 
President in charge of Markets, Services and Information, and I 
appreciate the opportunity to address the Committee.
    As you know, NASD's mission is to protect investors and 
ensure the integrity of markets. We have statutory authority 
over the 5,200 broker/dealers operating in the United States, 
as well as authority over the 660,000 individual brokers 
operating in the United States. We have the authority to take 
action against people who have broken our rules, Federal 
securities laws, and in the case of municipal bonds, the rules 
of the MSRB. We also run transparency facilities like TRACE, 
our bond reporting system.
    In the case of bonds we are particularly focused on the 
interests of individual investors, in part because we have seen 
substantial growth in the number of those investors investing 
in bonds and bond funds. We believe the reason for this growth 
of individual investors in this market is two-fold. First, as 
baby-boomers reach retirement age, most financial planners and 
brokers are actively moving people out of stocks and into bonds 
for their asset allocation. Second, the major losses in the 
stock market during 2000 and 2001 have led many investors to 
look for places besides stocks to invest their money.
    Measured in dollar volume, transactions in all U.S. bond 
markets in the first hour of any trading day exceeds those on 
the New York Stock Exchange for the entire day. Yet, while the 
stock markets have generally been open and transparent, 
information about bond markets traditionally has been murky and 
inaccessible to less sophisticated investors. Indeed, we have 
seen that many mainstream investors do not understand the basic 
principles of bond investing. A recent NASD survey found that 
60 percent of investors do not understand the basic principle 
that when interest rates rise, the price of a bond declines.
    To address investors' lack of knowledge of the bond markets 
we have several initiatives under way including investor 
education, as well as working with print and online media to 
improve their bond information. We also have a major initiative 
which we launched in July of 2002 at the urging of Congress and 
the SEC called TRACE. It stands for our Trade Reporting and 
Compliance Engine for corporate bonds.
    Under the NASD rules, every transaction in the corporate 
bond market must be reported to TRACE. We receive pricing 
information on investment grade, high yield, and convertible 
debt. This is the first time that comprehensive information on 
corporate bond trades has been available either to regulators 
or investors. The purpose of TRACE is two-fold. First, we 
receive the information and send prices out to the investing 
public so they can do their job of policing their own trades, 
and second, we use this information for our regulatory 
programs, to look at trading behavior that may violate NASD 
rules or Federal securities laws.
    As I mentioned a moment ago, Mr. Chairman, the ranks of 
individual bond investors are large and growing. Before we 
launched TRACE, in the corporate bond market we had only 
anecdotal evidence of this. After TRACE went live, we had a far 
better understanding of the retail activity in this market. Our 
data shows that 65 percent of trades in the corporate bond 
market are retail in size. That only accounts for 2 percent of 
the par value, but it is a lot of the trading activity. So, 
clearly the transparency and access to information that TRACE 
has brought to individual investors is badly needed. All NASD 
regulated firms must report their corporate bond transactions 
to TRACE within 45 minutes of an execution. As Ms. Nazareth 
mentioned, we plan to reduce the reporting time to 30 minutes 
later this year, and to 15 minutes in 2005.
    Since we launched TRACE we have also moved aggressively to 
have a transition plan to get more and more information out 
into the hands of investors. Currently, as of today, we 
disseminate information on about 4,600 of the 23,000 bonds that 
are traded in the corporate bond arena. We recently filed a 
proposal with the SEC to disseminate 100 percent of bond trades 
to the public, with 99 percent of those being disseminated 
immediately upon receipt by the NASD. Under this plan, by the 
end of 2004, price information about all corporate bonds will 
be made available to the public. This means that when investors 
are considering purchasing a bond, they can review recent 
trades or trades in similar bonds and ensure that they are 
receiving a fair price.
    NASD also uses the data submitted to TRACE and the data 
submitted to the MSRB for municipal bonds to review trades on 
these two markets for regulatory infractions. We combine this 
data from the trading systems with the data that we gather in 
our on-site examination process, and this enables us to monitor 
for issues such as commissions, mark-ups and potentially 
fraudulent conduct.
    When NASD finds that firms have engaged in activities that 
violate our rules or rules of the Federal securities laws, we 
have a range of sanctions available to us, including censures, 
fines, suspensions, and expulsion from the industry. We also 
work hard to return money to investors in the form of 
restitution.
    In conclusion, Mr. Chairman, as the retail presence in the 
bond market continues to grow, NASD will continue to champion 
transparency in this market, and we plan later this year to 
release last sale information on all corporate bond trades. We 
will continue to work with the SEC, the MSRB and the securities 
industry to ensure the fairness and integrity of the bond 
market.
    Thank you for this opportunity to testify.
    Chairman Shelby. Mr. Taylor.

               STATEMENT OF CHRISTOPHER A. TAYLOR

                       EXECUTIVE DIRECTOR

             MUNICIPAL SECURITIES RULEMAKING BOARD

    Mr. Taylor. Thank you, Mr. Chairman, Senator Sarbanes, 
other Members of the Committee. We appreciate the opportunity 
to discuss the MSRB and the municipal securities market.
    We are a unique regulator of a unique market, and our 
mission is to protect investors and the integrity of this 
market which provides much of the capital for the 
infrastructure of this Nation.
    The MSRB is a self-regulatory organization, an SRO, but we 
are very different from the other SRO's, such as the NASD and 
the New York Stock Exchange. We were created by Congress and 
given a mission by Congress to write rules for dealer behavior 
in the municipal securities market. Our very creation and 
charter set us apart from the other SRO's. We regulate only the 
municipal securities activities of dealers, and we are the only 
product line SRO. MSRB only sets the standards, which we 
believe are quite high, for dealer behavior.
    We do not have examination and enforcement power. Those 
powers are vested in the NASD, the three Federal bank 
regulators and ultimately the SEC.
    The market we regulate is unlike any other segment of the 
bond market. Allow me to illustrate with some of the 
statistics. There are more than 50,000 separate issuers who 
over time have issued more than a million and a half separately 
tradable securities. This can be contrasted with the corporate 
debt and equity markets where the number of outstanding and 
separately traded securities is less than 50,000.
    There is an exceptionally wide range of deals that come to 
the market. Last month, the State of California sold $7 billion 
worth of bonds at one time. Around the same time, the 
Litchfield Airport Authority in Illinois sold $100,000 worth of 
bonds.
    Trading activity in this market is extraordinarily thin. On 
any given day less than 1 percent of the outstanding issues 
actually trade, and over a whole year only about a third of all 
the outstanding issues trade. In some ways this lack of trading 
activity should not be a surprise. After all, this is a bond 
market, and in our case, one that is dominated by individual 
investors who generally buy and hold bonds until maturity.
    Nonetheless, the MSRB has adopted rules to protect 
investors and the integrity of the market in keeping with the 
objectives laid down by Congress. We continue to modify our 
rules to adapt to this constantly evolving marketplace.
    Several of our recent activities are notable. With regard 
to price transparency and trade reporting, we recognize that 
any market functions more efficiently with better information 
about what is traded and at what price. We have increased price 
transparency in this market in measured steps, and almost 
exactly 1 year ago today, investors in this market could see 
the details on every trade in our transaction reporting system 
on a next-day basis. For example, at 7 a.m. this morning any 
investor could see all the trade information that we collected 
last night.
    We have been working diligently to implement a real-time 
transaction reporting system. We expect to be operational in 
January 2005. We have mandated that all dealers test their 
reporting systems with us beginning next month. Upon 
implementation, dealers will have to report trades to us within 
15 minutes of execution. We will make that information, in its 
entirety, available immediately.
    In another area of concern to us, over the past 3 years we 
have been reviewing our Rule G-37, which is designed to 
eliminate the perceived or real conflict of interest from the 
giving of political contributions and the awarding of municipal 
securities business, so-called pay-to-play. This rule has been 
quite effective in maintaining the integrity of the municipal 
financing process. A companion rule, Rule G-38, addresses the 
role of consultants hired by dealers to solicit municipal 
securities business. Rule G-38 has been effective in 
illuminating this practice.
    But recent trends raise questions about the place for such 
consultants in this industry. We recently proposed for industry 
comment a ban on the hiring of such consultants. We have 
received lots of comment letters on our proposal, both for and 
against. The MSRB will consider those comments at its next 
meeting in mid-July. These proposals with regard to political 
contributions and consultants and our efforts with regard to 
transparency demonstrate the Board's vigilance in seeking to 
maintain the integrity of this industry.
    This concludes my remarks, and I would be glad to take any 
questions you or Members of the Committee might have.
    Chairman Shelby. Thank you.
    Some people have raised concerns that efforts to create 
real-time price disclosure may negatively impact the liquidity 
in the corporate and municipal bond markets, and may cause 
increased volatility. How would each of you respond to this 
assertion? Ms. Nazareth, we will start with your response.
    Ms. Nazareth. I know that position has frequently been 
maintained by the industry. I think because of the manner in 
which this transparency initiative has been rolled out, we have 
actually been able to study the impact on liquidity because of 
the manner, again, in which it was implemented to move toward 
greater transparency. We have not seen the negative impact on 
liquidity that people thought would occur. In fact, we have 
seen very positive benefits in terms of lower transaction 
costs, and I think as Senator Sarbanes mentioned in his 
opening, what you also find is greater investor confidence in a 
market when they know what a fair price is.
    Chairman Shelby. Mr. Shulman.
    Mr. Shulman. Well, as a matter of principle, we believe 
that more transparency in markets is good for markets and 
potentially brings more liquidity into markets. The stock 
markets have seen this. We had this experience when we used to 
own Nasdaq in the early 1970's.
    What we have tried to do is fashion a transition plan that 
allows a market that used to be totally opaque to move to one 
that is totally transparent, but to have steps along the way so 
that we could study this. We started with investment grade 
bonds that were $1 billion or greater. We looked at that, did 
not see any effects on liquidity. We moved to our phase two, 
which now has A-rated bonds, $100 million or greater, and we 
also put a sample of BBB bonds into the market. Again, we 
studied the issue. We are now moving to 100 percent 
transparency which will put, starting by the end of this year, 
a lot of high-yield bonds into the market, and as I mentioned, 
we will hold back 1 percent of the bonds which are the large 
transactions that are infrequently traded less than once a day.
    And, again, as we fashion this transition plan, we are 
going to study the effect of that part of the market, and I 
will tell you the reason. We have heard concerns. It is at that 
very low end of the market where we have heard concerns not 
just of the dealers but also of the buy side.
    Chairman Shelby. Transparency is information to everyone, 
is not it, in a sense, open market.
    Mr. Taylor, do you have a comment?
    Mr. Taylor. Senator, as you may know, today, as I 
mentioned, we are releasing everything we have in our system as 
soon as we have it. And, in fact, we have a next-day system. It 
is providing information on the day after trade date.
    We, too, were concerned about liquidity but did not over 
time find a significant problem with it, and our plans for the 
real-time system call for the release of all information. The 
Board at its February meeting considered possible liquidity 
effects from releasing all of the information available to us 
in the proposed real-time system and concluded that if there 
were liquidity effects, they would be short term and far 
outweighed by the benefits to the market and to investors.
    Chairman Shelby. Could you all address recent allegations 
regarding certain wide price swings and excessive markups in 
both the municipal and corporate bond areas? What are the rules 
concerning fair pricing and the size of markups? And how do the 
regulators monitor compliance? Finally, have you brought 
enforcement actions regarding excessive markups?
    Ms. Nazareth. One of the substantial advantages of this 
transparency is that we also receive this data for regulatory 
purposes, and Doug Shulman can speak more directly to this 
issue because it is the NASD that does the surveillance. But it 
has been a tremendously powerful tool in enabling the 
regulators to monitor for excessive markups. There have been 
cases that have been brought, and I think our ability to 
continue to monitor in this area will be improved, and we 
continue to work with the SROs to ensure that, we are doing a 
vigilant job in ensuring fair pricing to investors.
    Chairman Shelby. Mr. Shulman.
    Mr. Shulman. There are rules on the books now that include 
NASD rules, SEC rules, MSRB rules, as well as case law. The 
basic rule is that investors have to get a fair price. It is a 
fact-and-circumstances analysis.
    We brought cases in the past. Having TRACE data now allows 
us to really see a lot more. We used to bring cases based on 
going in and looking at the books and records of a firm in an 
on-site exam. We now have data, and we have built in 
surveillance alerts, so when there are big swings in prices in 
a given day, it will automatically kick out. We can give it to 
our investigators. They can find out if this is fair or not.
    We have currently ongoing 20 investigations around markups 
in corporate and municipal bonds, and we are working with the 
SEC actively to get some clarification around markup rules, and 
we do anticipate some significant cases--we are in the final 
stages--coming to light, sometime in the near future.
    Chairman Shelby. Mr. Taylor.
    Mr. Taylor. As you know, as Doug pointed out, we do have 
rules on the books for fair and reasonable pricing. The MSRB 
has believed for a long time that providing the tools such as 
the price reporting system to those that enforce our rules--the 
NASD, the bank regulators, and the SEC--is really part of our 
job. So we did believe that putting together the system not 
only provided price transparency but provided a very strong 
tool to the regulators.
    We did publish a notice in January highlighting for dealers 
their responsibilities under our rules and a practice that we 
had observed in the data that suggested that during a single 
day investors might not be getting a fair and reasonable price 
in accordance with our rules. As Doug has pointed out, the NASD 
is currently investigating that.
    Chairman Shelby. In the recent past, we have seen a number 
of instances of conflicts of interest at work in the equity 
markets where insiders benefit at the expense of retail 
investors. The primary example that you are well aware of is 
the global settlement in which research analysts issued glowing 
reports of company-backed issuers while privately criticizing 
the companies.
    What are the conflicts that regulators are examining in the 
bond markets? Could we see a crisis in the bond markets akin to 
events that led to the global settlement? Ms. Nazareth.
    Ms. Nazareth. Well, we are certainly looking at the issue. 
I think that the bond markets in this respect have been quite 
different. There is fixed-income research. Its function is a 
bit different than it is in the equity markets, obviously.
    Chairman Shelby. Well, the equity markets and bond markets 
are fundamentally different, aren't they?
    Ms. Nazareth. Right. In the equity market, the research, as 
you know, was used largely to promote the stocks and it had an 
impact on trading. In the fixed-income markets, there are so 
many other factors involved in the purchase of a bond, 
including, the creditworthiness of the issuer, interest rate 
spreads to Treasuries. It tends not to play quite the same role 
in the sales process. But there, nevertheless, are areas where 
there could be conflicts, for example, where firms' research 
analysts are involved with the trading desk--and the firm has a 
position and is also taking a public position with respect to 
the bonds.
    The Bond Market Association, was very out front in 
recognizing that there were potential conflicts here and has 
recently finalized their guiding principles to promote the 
integrity of the fixed-income research. We really applaud that 
effort. We are eager to see the firms adhere to these voluntary 
principles and we will watch closely what the impact of 
adherence to those principles does.
    Chairman Shelby. Mr. Shulman.
    Mr. Shulman. It is very similar to what Annette said. We 
have been looking at fixed-income research. The Bond Market 
Association has put forward guiding principles. We are talking 
with the people throughout our institution to make sure that we 
believe that there is independence of research.
    We also always look at the firewall issues, especially 
between proprietary desks and desks that serve customers, and 
we will continue to keep a focus on making sure that there is 
appropriate information barriers and that these conflicts do 
not occur. It is an area that we are quite sensitive about and 
are being vigilant in looking really across firms at these 
issues.
    Chairman Shelby. Mr. Taylor.
    Mr. Taylor. I do not think I could add very much to what 
has just been said by both Doug and Annette, but I would point 
out that in our market, we do have some issues that relate to 
the fact that information on such a wide variety of issuers is 
not broadly available to all participants in the market at the 
same time. And that does raise the possibility of people having 
information that should rightfully be in the possession of 
everyone in the market.
    Chairman Shelby. There are some studies indicating that 
small retail trades in municipal bonds are substantially more 
expensive than large institutional trades. What accounts for 
this disparity in trading costs? Also, would greater 
transparency eliminate the difference?
    Ms. Nazareth. You are correct about the studies. We think 
the seminal one in that area was actually done by the staff of 
the Office of Economic Analysis at the SEC. But what was very 
interesting about the findings was that, unlike the equity 
markets, where the costs to investors are less for smaller 
trades, here it is the inverse. The small retail investors have 
higher transaction costs, which we attribute to the lack of 
transparency. That universe of investors is least able to 
understand what a fair price is, and the costs to them are 
higher. And I think that we are very confident and are already 
seeing that in those circumstances where there is a greater 
transparency in the marketplace, the transaction costs are 
reduced.
    Chairman Shelby. Thank you. Do you have any comment on the 
same thing?
    Mr. Shulman. I would agree. It basically changes the 
information dynamic, and someone is now going to be able to see 
where all the trades were and ask their broker, ``Why did not I 
get this price?''
    Chairman Shelby. Why they did not get a better deal, sure.
    Senator Sarbanes, thanks for your indulgence.
    Senator Sarbanes. Thank you, Mr. Chairman.
    I wanted to follow up on the question before the last 
question the Chairman put. The Wall Street Journal in April 
published an article entitled ``Bond Research Facing Probes 
Over Conflicts,'' which identified, and I quote them,

    ``potential conflicts involving bond research have been 
largely ignored, among them whether bond traders or bankers get 
advanced peeks at research before it is published, giving them 
a chance to trade ahead of the public or clients who paid for 
the reports and whether bankers or trades have influence over 
what analysts say in their research reports.''

    How do you respond to this article?
    Ms. Nazareth. I think that there are, as you know, 
conflicts throughout this industry, and this was an area that 
obviously the industry and the regulators rightly should be 
focused on, particularly after the lessons learned in the 
equity research area. Surely there are opportunities for 
conflicts of interest. I think as Doug mentioned, it is 
important to have walls between the proprietary traders and the 
analysts. This is something where, again, the regulators were 
beginning to look at it. The industry decided to take the lead 
and to do a self-assessment. And I think that the guiding 
principles that they have come up with are really very 
rigorous.
    What they did, I believe, was they started with the 
standards that had been put in place for the equity markets and 
decided to point by point determine whether those standards or 
more rigorous standards or similar but somewhat different 
standards were appropriate for the debt markets. And we are 
very interested in seeing what the impact of that will be, but 
I think it was a very important first step.
    Senator Sarbanes. When you say the impact of it, where are 
we on the implementation of the standards?
    Ms. Nazareth. I think the firms who were involved in that, 
which were the largest dealers in the marketplace, I believe 
have voluntarily agreed to comply. I believe that larger number 
of them are implementing those procedures.
    Senator Sarbanes. And who is monitoring their compliance? 
Is that you, Mr. Shulman?
    Mr. Shulman. Yes.
    Senator Sarbanes. Why do not you respond to this article?
    Mr. Shulman. Two issues. One is we get MSRB data. We have 
TRACE data. We have only had that data now for 2 years. What we 
do now is, if we see broad swings or if we see a trading desk--
we can now see when a desk trades ahead of a customer, if they 
do. It is the first time we have been able to see this, and we 
will go do an investigation and enforcement action, if needed.
    We also were actively in discussions with the Bond Market 
Association and NASD is in discussions now about whether these 
guiding principles, which we do look for adherence to, should 
be codified into rules.
    Senator Sarbanes. Was trading ahead of their customer a 
pretty prevalent practice?
    Mr. Shulman. Not that we know of.
    Senator Sarbanes. I mean before or now, or neither?
    Mr. Shulman. It is not something that has come to our 
attention often, but it is also something we did not have the 
data until about a year ago. We have just set up the parameters 
to actually look for that.
    Senator Sarbanes. Do you want to comment on this, Mr. 
Taylor?
    Mr. Taylor. I actually think, Senator, that much of what 
that article was focused on was the corporate bond market and 
corporate research, because in the municipal area most research 
focuses in entirely on the issues that come before the dealers. 
As I noted in my opening remarks, only about 1 percent of the 
bonds trade on a given day, so the ability of a dealer to trade 
ahead of the market is almost an impossibility because you do 
not actually know what is going to flow into the market on that 
particular day from investors around the country. There is not 
an actively traded two-sided market that allows you to go in 
and position yourself ahead of a customer.
    Senator Sarbanes. On the panel that is going to be 
following you, Dr. Warga in his testimony states--and I quote:

    Even if a bond is rated, when the information about a 
change in credit risk is needed most, the rating usually fails 
to reflect it. Rating agencies often do not change ratings 
until several months after the event that triggers the need for 
a rating change.

    And he cites as authority studies that he performed both in 
1993 and in 1997.
    What about this issue of how quickly credit rating agencies 
respond to events that would trigger the need for a rating 
change?
    Ms. Nazareth. Well, it is difficult to speak generally 
about it. It sounds like the professor is comparing the role of 
the research analyst to the role of the credit rating agency. 
He is saying that on a short-term basis they should be making 
an immediate change in the rating, whereas I think generally 
the credit rating agencies have a longer-term perspective on 
their ratings.
    That having been said, obviously there have been 
circumstances where rating agencies have been slow in 
recognizing trends that would have both an immediate and 
longer-term impact. So, again, it is hard to make general 
statements. But I do think that I would not equate the credit 
rating process necessarily with the research process here.
    Senator Sarbanes. Mr. Shulman.
    Mr. Shulman. We have no authority over credit ratings, the 
agencies that do that, so I wouldn't speak about that.
    One thing that NASD does have authority over is to ensure 
that brokers make suitable recommendations to their customers, 
and, one thing that we encourage the brokers to do and monitor 
for is to make sure customers understand all of the risks of a 
bond, which can include the call feature, the term, the risk, 
and the rating. And we recently put a notice to members out 
reminding them of those obligations in bonds because we have 
seen more people in the bond market. And, this is an issue that 
we would be happy to look at.
    Senator Sarbanes. Mr. Taylor.
    Mr. Taylor. Senator, in this regard, in the municipal 
market the issue is really one not so much of default--in the 
municipal area, the credit rating agencies are focused in on 
the probability of default. And default probabilities are very, 
very low in the municipal securities market.
    Again, to echo what Doug said, we have rules, as does the 
NASD, on suitability and fair pricing, and I think what is 
important to dealers in this market and important to investors 
is knowing, for example, when a call on a bond, an outstanding 
bond, is going to take place. That is not something that rating 
agencies would necessarily concern themselves with but does 
affect very quick changes in value of the bonds and is 
affecting pricing.
    I am not really in a position to comment on what changes 
the credit rating agencies have made since 1997, but certainly 
our conversations with them on an informal basis are that they 
are trying to do a much better job than they have done in the 
past.
    Senator Sarbanes. Would each of you describe the investor 
education programs you have for retail bond investors?
    Ms. Nazareth. Well, the SEC does have an Office of Investor 
Education, and I am not the internal expert on that, but we 
have a very active program. As you know, over the years we have 
had town hall meetings with investors. We have a number of very 
useful tools on our website that investors can look to. We 
also, hyperlink to a number of the tools that the industry has 
created for investors with respect to debt markets as well, 
debt securities.
    Senator Sarbanes. So when you talk about these investors, 
you are talking about retail bond investors?
    Ms. Nazareth. Yes, retail investors.
    Senator Sarbanes. Mr. Shulman.
    Mr. Shulman. NASD had an active investor education program. 
We have brochures on bonds. We have our website, which has a 
variety of information just about investing, portfolio 
allocation, et cetera. As I mentioned in my oral testimony, we 
actually have a team of people actively working with popular 
print media and online websites to improve the information they 
have about bonds, and we found them to be quite receptive and 
anticipate some of the data that we have and other materials 
going up soon.
    We hold town hall meetings around the country, and bonds is 
one of the issues we discuss. NASD just recently put $10 
million into an investor education foundation.
    Finally, our experience is that the time investors really 
start to understand something is when they are going to put 
their money to work. And so we have done a lot to work with the 
industry to make sure that brokers give investors the right 
information and all of the factors of a bond when the 
investment happens. And we will continue to try to make the 
TRACE data, the MSRB data, and other data useful to investors 
so they can watch the movement of the market and better 
understand the dynamics of the security they hold.
    Senator Sarbanes. Mr. Taylor.
    Mr. Taylor. Senator, we do not have an active program 
targeted to retail investors. In fact, I think we would be hard 
pressed to improve upon what the NASD does, and, in particular, 
I will make a plug here for what the Bond Market Association 
has done in terms of trying to reach out to the retail investor 
in bonds, in particular municipal bonds.
    One of the first things they did was to take all of our 
transparency data, put it up on their website, make it 
available free, and allow any retail investor to actually go 
in, type in their CUSIP number, which is the identifier, and 
see all of the trading activity over the last 6 months, if 
there was any, in that security.
    We have worked to make our data readily available to 
anyone, not just the Bond Market Association, but any other 
data services that could use those data. But because the 
general education is being done by the NASD and the Bond Market 
Association, anything we would do would probably just duplicate 
what they are already doing.
    Senator Sarbanes. Are there other things you think would be 
helpful for them to do in this area?
    Mr. Taylor. Raising the awareness of people who invest in 
bonds generally to the availability of data sources is probably 
the most difficult thing to do because bond investors, as I 
mentioned earlier, typically are buy and hold. So they buy the 
bond, stick it in their portfolio, expect to see the interest 
flow in, and eventually get their principal back. They are not 
sitting there monitoring the price, hoping the price goes up 
and they can see it and that is how they make their return. 
They are getting their return on interest. And so my 
experience, both personally, family, friends, and the like, is 
they are watching the flow of interest come to them. They are 
not looking at the price.
    So it is at the initial decision point that you really want 
investors to be aware of what prices are in the market, what 
information is there, and what the alternatives are.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. Mr. Taylor, would you briefly discuss how 
MSRB is evaluating the scope and application of Rule G-37 
regarding political contributions and the award of underwriting 
business with respect to political contributions from 
affiliated companies within a holding company structure? I know 
that is a mouthful.
    Mr. Taylor. Well, let me start with the basics. First of 
all, Rule G-37 requires dealers on a quarterly basis to provide 
us with information on their political contributions, the 
consultants they hire, and the business that they do, in a 
nutshell. And it is this information that the Board is 
reviewing constantly. As I mentioned, we have actually had an 
ongoing review of Rule G-37 and various aspects of it for more 
than 3 years.
    With regard to your question about holding company 
organizations, I would point out that the rule presently 
prohibits a dealer from doing indirectly what he is forbidden 
to do directly.
    Chairman Shelby. Okay.
    Mr. Taylor. We have put a notice out on that, and we have 
worked with the NASD and the regulators to highlight our 
concerns in that area so that when they are doing enforcement, 
they are particularly focused in on that.
    Chairman Shelby. We appreciate all three of your appearing 
here and your contribution to the Committee hearing. Thank you 
very much.
    Chairman Shelby. We will go to the second panel now: Mr. 
Micah Green, President, Bond Market Association; Mr. Chris 
Ryon, Principal, The Vanguard Group; Professor Arthur Warga, 
Dean, C.T. Bauer College of Business and Judge James A. Elkins 
Professor of Banking and Finance, University of Houston. We 
welcome all of you on our second panel. Your written testimony 
will be made part of the record in its entirety, and we will 
proceed when you are ready.
    Mr. Green, we will start with you.

                  STATEMENT OF MICAH S. GREEN

             PRESIDENT, THE BOND MARKET ASSOCIATION

    Mr. Green. Thank you, Mr. Chairman, Ranking Member 
Sarbanes, and Members of the Committee, for the opportunity to 
testify. I am Micah Green, President of The Bond Market 
Association. I commend you for holding this hearing at this 
time. While this Committee has looked at many specific issues, 
it has been a while since there has been a broader review of 
the regulations of the bond markets. Much has changed in recent 
years to make the bond markets safer, more transparent, more 
electronic, more efficient for all market participants. In 
fact, much has changed at The Bond Market Association as these 
market and regulatory developments occurred. We have broadened 
to represent the full array of credit, debt, and structured 
capital markets. With our affiliated organizations, the Asset 
Managers Forum, and various securitization forums, we are 
better able to bring together the viewpoint of investors and 
issuers. Through our offices in Washington, New York, and now 
London, we are representing these markets on a global basis. 
The U.S. bond markets alone represent $22.6 trillion, the 
largest sector of the financial markets, or more than $880 
billion of trades seamlessly on an average day.
    From the schools and roads built by municipal bonds to the 
mortgages that are more affordable because of a mortgage-backed 
securities market, to the new jobs created as corporations 
raise investment capital with bonds to invest in new plants, 
the bond markets touch everyone. Unlike stocks, bonds do not 
trade on an exchange but in an over-the-counter, decentralized 
fashion. There are far too many bonds and far too many bond 
issuers, including a majority of bonds that rarely trade, to 
list them on an exchange and expect constant two-way prices. 
For the bond markets to function as they do, dealers must 
purchase bonds and hold them in inventory, an act that puts 
capital at risk. The less liquid a bond or the more difficult 
it is for a dealer to quickly resell it in the market, the less 
likely dealers are to purchase the bonds in the first place.
    Probably the biggest change in the regulatory environment 
affecting the bond markets has been the introduction of rules 
seeking to protect the retail investor. Although most of the 
daily activity in the bond markets is dominated by large 
sophisticated investors since the stock market bubble burst, 
retail investors have sought out more diversity in their 
portfolios, either directly or through conduits like mutual 
funds. This is a welcome change as we always believe that a 
balanced asset allocation is much more responsible than putting 
your eggs in one basket.
    And yet with all of this retail demand, specifically in the 
municipal and corporate securities marketplace, the vast 
majority of the volume of securities that trade every day are 
large institutional transactions. Even the NASD's own study 
that was cited in their testimony showing that 65 percent of 
daily trades of corporate bonds were trades under $100,000 in 
size, their research also indicated that all of those trades 
represented only 1.8 percent of the total dollar volume.
    Having said that, it has been crucial to improve disclosure 
and transparency in the bond markets to give all market 
participants better information. This Committee, your House 
counterparts, the SEC, the NASD, and the MSRB should all be 
acknowledged for the developments of the last several years 
that have helped to make the bond markets safer and more 
transparent for all market participants, particularly the 
retail investor.
    The Bond Market Association has worked hard to partner in 
these efforts in a manner that is supportive of ensuring that 
investors have all the necessary information they need to make 
responsible and informed decisions, but also to ensure that the 
large, more sophisticated institutional market has sufficient 
liquidity to ensure the ability to move capital freely and 
efficiently, regardless of the size or esoteric nature of the 
transaction.
    In the early 1990's, The Bond Market Association and its 
membership created GovPX, which represented the first time some 
light was shone on the transactions in the Government 
securities market. We have also worked closely, as you heard 
earlier, with the MSRB in the municipal market and the NASD 
with the TRACE corporate system.
    We have also tried to improve the knowledge level of the 
retail investor about bonds. Our award-winning retail investor 
website, which Kit Taylor mentioned, investinginbonds.com, gets 
over 3 million hits a month from retail investors, and it has 
understandable information about bonds and the bond markets, 
and it also has the MSRB and TRACE data system in a very usable 
form.
    Additionally, the association's not-for-profit partner, The 
Bond Market Foundation, is reaching out to nontraditional 
investors such as young adults, women, and the Spanish-speaking 
community, with its websites tomorrowsmoney.org, 
unwantedchange.org, and ahorrando.org. The bond markets have 
also fostered the evolution of important and sophisticated 
tools like interest rate swaps and credit derivatives that 
allow market participants to segregate and manage risk more 
efficiently. These derivatives have made an unquestioned 
contribution to the safety of the overall system.
    In the past year, as Ms. Nazareth indicated, we have also 
worked on several initiatives designed to promote safer and 
more efficient markets. In May, we issued the guiding 
principles to promote the integrity of fixed-income research. 
Neither regulators nor the public had called for it, but the 
association took the initiative to develop the principles as a 
way to help member firms manage potential conflicts that could 
arise from their debt research activities. And, Senator 
Sarbanes, I would note that the issue you raised a question on 
is actually on page 30, Section 4.8.1, hitting that point 
directly, and I appreciate your asking that question.
    The SEC and the broader market have welcomed these 
principles, and they were approved by our membership.
    Mr. Chairman, rising and falling interest rates are a 
reality of the bond markets. It is also a reality that as a 
result of the initiatives, both in the regulatory environment 
and in the marketplace, the bond markets are a dynamic, well-
regulated part of the financial markets whose participants 
recognize the need for safety and efficiency and are eager to 
promote that goal.
    I thank you for the opportunity to appear today.
    Chairman Shelby. Mr. Ryon.

                STATEMENT OF CHRISTOPHER M. RYON

              PRINCIPAL AND SENIOR MUNICIPAL BOND

             PORTFOLIO MANAGER, THE VANGUARD GROUP

    Mr. Ryon. Gentleman, Chairman Shelby, Ranking Member 
Sarbanes, Members of the Committee. My name is Christopher 
Ryon. I am a principal and Senior Municipal Bond Portfolio 
Manager at the Vanguard Group, a mutual fund company based in 
Valley Forge, Pennsylvania. Vanguard is one of the world's 
largest mutual fund families, managing over $725 billion for 
nearly 18 million shareholder accounts. Vanguard offers 131 
mutual funds to U.S. investors and over 35 additional funds in 
foreign markets.
    Vanguard's offerings include 12 corporate bond funds with 
over $73 billion in assets and 14 municipal bond funds with 
over $43 billion in assets. Along with three other portfolio 
managers, four traders and a team of municipal bond analysts, I 
oversee the management of over $43 billion in Vanguard 
municipal bond assets. I am pleased to be here representing 
Vanguard to discuss the U.S. bond markets. My testimony will 
highlight the composition and structure of the bond markets. I 
will also provide an update on bond market transparency with 
respect to bond pricing and issuer financial disclosure.
    Ownership in the bond market is diversified. There are 
significant individual institutional and foreign ownership 
across the markets. Unlike other segments of the bond market, 
investment in municipal bonds closely resembles that of the 
stock market. Individual investors and mutual funds own 
substantial portions of the market. In 2003, 36 percent of 
municipal bonds were held by individuals and 15 percent were 
held through mutual funds. These figures parallel the ownership 
of the stock market, where households own 37 percent and mutual 
funds own 20 percent.
    Buyers and sellers in the bond market trade primarily over-
the-counter. Unlike the stock market, there are no organized 
National exchanges for bonds. Over-the-counter trading 
dominates municipal bond markets to a greater extent than other 
segments of the bond market. Traditionally, municipal bond 
markets have existed in localized State and municipal markets, 
where there was a small community of buyers and sellers with 
little National interest.
    Today, municipal bonds are a significant part of the U.S. 
financial markets, but the diverse and decentralized nature of 
the market still discourages development of an organized 
exchange.
    Pricing transparency in the bond market has improved in the 
past 10 years. Unlike the stock market and the Treasury market, 
there is no real-time pricing for most bond markets. However, 
rules imposed by the Municipal Securities Rulemaking Board, the 
MSRB, have greatly enhanced the reporting of municipal bond 
trades much as the trade system has enhanced transparency of 
corporate bond trades.
    As the fiduciary responsible for the investments of 
hundreds of thousands of municipal bond fund investors, 
Vanguard strongly commends the MSRB's efforts to improve 
municipal bond market price transparency. We also commend the 
recent progress at enhancing corporate bond market price 
transparency on the TRACE system.
    There has been a steady effort to improve the disclosure 
relating to the financial condition of bond issuers. Corporate 
bond issuers are subject to the SEC regulation that requires 
registration and current disclosure for the benefit of 
investors. Disclosure of financial market condition of 
municipal bond issuers has been more of a challenge because of 
the diverse nature of the market. However, important steps to 
improve issuer financial transparency have been made.
    We should all support the steps taken by issuers, self-
regulatory organizations, and investors to improve price 
transparency in the corporate and municipal bond markets. 
Again, as a fiduciary responsible for hundreds of thousands of 
municipal bond investors, Vanguard strongly supports the MSRB's 
efforts to improve price transparency in municipal bond markets 
and believes that it is in the best interests of investors for 
these efforts to continue.
    In addition to price transparency, efforts should continue 
to improve issuer financial condition transparency in the 
municipal bond market. The SEC's efforts to improve disclosure 
through rulemaking have been effective and beneficial. However, 
Vanguard recommends that lawmakers, regulators, industry 
participants continue to monitor developments and consider 
whether more may be done to improve issuer financial condition 
transparency.
    Thank you, and I would be happy to respond to your 
questions.
    Chairman Shelby. Professor Warga.

                  STATEMENT OF ARTHUR D. WARGA

              DEAN, C.T. BAUER COLLEGE OF BUSINESS

          JUDGE JAMES A. ELKINS, PROFESSOR OF BANKING

               AND FINANCE, UNIVERSITY OF HOUSTON

    Mr. Warga. Thank you, Chairman Shelby, for inviting me here 
to provide what I hope is a dispassionate outside academic 
perspective on the topic of today.
    Chairman Shelby. We welcome that.
    Mr. Warga. I would agree with previous speakers that, on 
the institutional side, the bond market has evolved into what I 
view is a relatively efficient competitive cost structure. The 
cost structure is such that dealers are able to capture 
implicitly the costs of providing various research and 
portfolio services to the large institutional buyers, and I 
think most institutional buyers, like Mr. Ryon next to me, will 
agree that the cost structure is very competitive and 
competitive even with the highest decile New York Stock 
Exchange transactions.
    Fortunately, the recent transparency initiatives, TRACE, 
and MSRB initiative are providing the institutional market with 
perhaps its biggest--it is helping them solve their biggest 
problem, which was the issue of trying to mark, on a daily 
basis, the net asset values of their bond portfolios. I have 
always viewed the net asset value numbers produced by bond 
mutual funds and other bond portfolios as very problematic. 
Now, at least, there is a richer source of data that they can 
base some models on to improve that situation, which I think 
has been rather bleak in the past.
    However, the transparency initiatives have not changed the 
costly trading environment for retail investors. In particular, 
I will say that in the written report that Mr. Ryon provides, 
he gives an update, 3 years past my own seminal paper on the 
municipal bond market, that confirms that transparency has had 
virtually no effect whatsoever on the costly retail structure, 
cost structure for retail trades and municipal bond market. 
They still remain extremely high, perhaps as much as 200 basis 
points or 2- percent above what an institutional buyer faces.
    My own guess is that this is largely true for the corporate 
retail market. However, data on that market has been very dark, 
and we are anticipating some reports to be released shortly, 
but we still do not really know what the cost structure is in 
the retail corporate market. We have absolutely no idea. Data 
has not been released publicly to researchers like myself.
    The studies that are forthcoming, and particularly the NASD 
study forthcoming on the cost structure for retail trades in 
the corporate bond market, I think need to have a comparison to 
the one exchange-traded retail market for corporate bonds, the 
automated bond system run by the New York Stock Exchange, for 
which we know what the cost structure is. We know that it is 
competitive with the institutional market, absent some 
commission charges, and it is incumbent upon the NASD to make 
that comparison.
    Individuals need to understand the huge risk of buying 
individual bonds. I, personally, would be hard-pressed to 
recommend anybody buying an individual corporate or municipal 
bond in the existing trading structure. The real problem here I 
think has not been touched upon by the participants in these 
panels, and that problem is that the basic structure of this 
market is simply not set up to accommodate retail trades. There 
needs to be a focus and research on setting up a separate 
structure for retail purchases of individual municipal or 
corporate bonds. The structure, as I said before, is geared 
toward institutional buyers, and it is doing a very good job 
and has for many, many years.
    I have a final comment, and that is just to give a brief 
answer to Senator Sarbanes' comment about my talking about 
credit rating changes occurring very slowly. They do, in fact, 
change slowly. They continue to change slowly, but there is a 
structural reason for that. The U.S. Government provides the 
rating agencies legally with the power to let their ratings be 
used in contracts.
    And so if the rating agencies were to immediately change 
their ratings, and sometimes events happen to the bond markets 
where a price drops precipitously, but then it will come back. 
So, in fact, if they were to change their rating immediately, 
they would end up having to change it again. Unfortunately, 
some of those rating changes would, in the extreme, trigger 
events like bankruptcy and corporations and other events. So it 
is actually important that the rating agencies do not change 
their ratings quickly.
    And my comment in the paper was simply to point out that in 
the existing market structure, dealers and institutional buyers 
need to be in touch with each other so they understand that 
something really has happened, in spite of the fact that the 
rating has not changed.
    Those are my comments. Thank you.
    Chairman Shelby. We will start with you, Dr. Warga. Unlike 
trading in equities, bond transactions are not immediately 
reported and publicly disseminated. How would immediate real-
time price reporting impact liquidity in the bond markets.
    Mr. Warga. Liquidity is generally correlated with the 
amount of underlying volatility in a security. For example, 
stock prices change quite often because little changes in 
information can have big effects on their prices because the 
price reflects the present value of all future cashflows to 
eternity for that company.
    That is certainly not the case with highly rated AA-, A-, 
AAA-rated corporate or municipal bonds. However, for high-yield 
bonds, which can be thought of as a blend between equity and 
investment-grade debt, I think there is a real benefit, 
potential benefit, to increasing liquidity by providing that 
transparency, and I think we all look forward to that 
transparency appearing in the near future.
    Chairman Shelby. What are your thoughts, Professor, on the 
NASD's proposed carve-out from public dissemination through 
TRACE for illiquid and inactively traded bonds?
    Mr. Warga. It is certainly true that if I were the holder 
of an illiquid portfolio of bonds, and I received a margin 
call, and had to dispose of them, and that margin call had 
absolutely nothing to do with the underlying fundamentals of 
the company that issued those bonds, I would face a very 
punishing environment trying to sell them, and I would take a 
very steep discount. And on the face of it, transparency would 
not be a good thing. I would like to get rid of those in a 
market where nobody knew I was trying to get rid of them.
    However, I will say that, since we are really talking about 
mostly corporate bonds and institutional situations where it is 
an institutional buyer or seller in that situation, I will say 
that that has occurred plentifully in the past, when there was 
not any transparency. So it is not clear to me that there will 
be any harm created by transparency, even in that circumstance.
    Chairman Shelby. Mr. Ryon, do you have any comments on 
this?
    Mr. Ryon. We believe that if there is any type of 
dislocation or illiquidity problem due to increased price 
transparency, it will be short-lived, that the profit motive 
will smooth that out rather quickly.
    Chairman Shelby. The market will take care of it?
    Mr. Ryon. Yes, sir, and that the market will be stronger 
given better price transparency for both actively and 
inactively traded bonds, that as individuals know that they are 
getting a fair price, they will be willing to commit more 
capital to the market, and therefore it will grow.
    Chairman Shelby. Mr. Green?
    Mr. Green. Mr. Chairman, I will proclaim unequivocally we 
have been the watchdog for liquidity in this equation, and over 
the many years that this issue has been developed, both at the 
NASD and the MSRB, we have wanted to not prejudge whether or 
not transparency would affect the liquidity, but to make sure 
that premature disclosure of illiquid trade information does 
not affect liquidity. And if it does not go forward--and we 
have been supportive of each phase along the way, both in the 
municipal and corporate market--this last little carve-out that 
is in the proposal of the NASD not only affects the most 
illiquid and institutional trade, it is the largest trade that 
trades most infrequently.
    Their proposal provides complete immediate dissemination 
for any smaller trade, any frequently traded or any high-
quality trade. So we just want to make sure that in those 
markets where liquidity is most needed, it is not taken away.
    Chairman Shelby. During the prior panel--I believe all of 
you were here--the regulators discussed ongoing investigations 
into wide price swings and dealer markups. Would you describe 
pricing practices in the industry and whether you perceive any 
issues surrounding dealer markups.
    We will start with you, Mr. Green.
    Mr. Green. Thank you, Mr. Chairman. I think, as the 
previous panel said, one of the benefits of the transaction 
reporting system is that it is arming the regulators with the 
information they need to root out any problems, and we, as The 
Bond Market Association, support that. The fact is enforcement 
of rules is important. Because if rules are enforced, they do 
not necessarily have to be changed, and therefore wind up being 
excessive. So this information will help figure that issue out.
    Chairman Shelby. Mr. Ryon.
    Mr. Ryon. Sir, I believe the market will be the best 
policeman. If I receive trade information on something I have 
just sold, and I see that a dealer has taken what I believe to 
be an excessive markup, I am going to do whatever I can to show 
my displeasure, and I believe those types----
    Chairman Shelby. But you have got to know that to begin 
with, have you not?
    Mr. Ryon. Exactly, sir, and that is why I think price 
transparency is important, that the market will be its best 
policeman and that it will force----
    Chairman Shelby. It could be hurting and not really 
appreciate how much, huh?
    Mr. Ryon. I beg your pardon, sir?
    Chairman Shelby. It could be hurting and not appreciate it, 
but if you are informed, you know something is wrong.
    Mr. Ryon. I am informed, and I can take the appropriate 
actions.
    Chairman Shelby. Professor Warga.
    Mr. Warga. Well, you know, in the retail market for 
especially municipal bonds, it is quite likely that there will 
not be any price for the individual to see. They will have been 
the only purchaser of that bond more often than not, and so 
transparency is not going to provide any help at all.
    And the websites also provide I think, if a retail investor 
really is looking at those websites carefully, a lot of puzzles 
that are not explained and probably need some explaining. Just 
casually looking over municipal bond trades for the previous 
day, 2 days ago I saw a trade in the State of Texas. Being 
xenophobic, I decided to check out Texas, and I saw a bond that 
traded perhaps a dozen times was sold to investors for price of 
par of $100, and there were four trades between dealers for 
$75. Now, I am willing to believe that it is a mistake, but it 
is not uncommon to see things like that. It probably is a 
mistake, but it sure needs explaining, and it would probably be 
helpful if those explanations went up contemporaneously with 
the posting of prices like that.
    Chairman Shelby. A little footnote people would read.
    Mr. Warga. Yes.
    Chairman Shelby. Thank you.
    Mr. Green. Mr. Chairman, could I just supplement something 
Professor Warga said. Because even if a bond does not trade, 
knowing what the price was in that trade and it will be fully 
disclosed under the MSRB data, it would give that investor the 
relative value at the time--relative value as to other 
benchmark securities, like a Treasury security--so it still has 
value to the retail investor.
    Chairman Shelby. Well, all information has value. It 
depends on how much, does it not, and the quality of it.
    The equity markets and bond markets have each developed 
their own trading systems and industry practices. Why should 
not the bond market have to operate under the same market 
structure as the equity market? Does it make sense to bring 
some of the innovations in the equity market, such as 
electronic trading platforms and real-time posting of bid and 
ask to the debt markets?
    We will start with you, Professor.
    Mr. Warga. Well, in my report, I mentioned the ABS system 
only because it is an electronic system that exists and that I 
have been studying for about 15 years. I am not a proponent of 
it over any other electronic system, but it is a system that is 
geared toward the retail investor, and currently there are some 
very serious regulatory constraints to listing, to having a 
broad range of bonds listed there. There are constraints on 
that system that do not exist in the dealer market. So, while 
the dealer market is able to trade any bond it wants, pretty 
much, on the ABS system, the company that issued the bond has 
to be convinced by the underwriter that it is worth registering 
it in the first place, and this creates one impediment to an 
exchange-based system.
    Chairman Shelby. Mr. Ryon.
    Mr. Ryon. In a municipal market, the sheer number of volume 
of securities outstanding make such a move, a change quite 
problematic. We have tried electronic trading systems in the 
municipal market over the last few years, and none of them have 
been successful. They have all failed.
    Whereas, in the corporate market and the treasury market, 
where you have got more of a homogeneous pool of securities, 
you have seen success with systems like TradeWeb.
    Chairman Shelby. Mr. Green.
    Mr. Green. There have been significant developments in 
electronic trading in the fixed-income markets. And as 
Professor Warga's own study showed, the spreads in the over-
the-counter market versus the ABS market are somewhat 
indistinguishable. So we do not, as the bond markets do not sit 
here saying the equity model is wrong, but I think it is also 
safe to say that the over-the-counter model in the bond markets 
is not wrong either because, frankly, as was just said, with 
the number of municipal issuers, there are 88,000 individually 
listed securities in the stock exchanges.
    There are over 50,000 municipal issuers alone. There are 
tens of thousands of corporate issuers. The over-the-counter 
decentralized model provides access to capital to more issuers 
and more types of issues than the four walls of a building 
exchange would provide.
    You need to make sure that California has access and a 
small community in Alabama has access to the same capital, and 
that is why this system actually works very well.
    Chairman Shelby. Mr. Ryon and Mr. Green, I will pose this 
to both of you.
    Would you discuss how the regulators worked to improve the 
disclosure by municipal issuers. Given the Tower amendment, are 
there still ways to improve the uniformity and availability of 
issuer information.
    Mr. Ryon. Well, there have been some very good voluntary 
efforts that have been moving forward, particularly the 
Municipal Council, that is, 19 members, both issuers, buyside, 
and other organizations. Their first efforts are supposed to be 
coming on-line this summer. Things seem to be going very well 
up until this week, where I have read some articles that looks 
like we have hit a little bit of a dust-up. So I would say, if 
that works itself out, I would give those voluntary efforts 
time to succeed. If they do not, then maybe something else will 
have to be done to ensure disclosure of not only prices, but 
issuer financial conditions.
    Chairman Shelby. Mr. Green.
    Mr. Green. Mr. Chairman, the Tower amendment limits the 
regulation of issuers in the municipal marketplace, which are 
States and localities, very much a division of levels of 
Government. I have got to hand it to the MSRB, and the SEC, and 
frankly the industry, too, of finding a way to provide deep 
primary disclosure and deep secondary market disclosure within 
that limitation.
    The way the rules work right now, the imposition of the 
requirement on disclosure is imposed on the dealer. They cannot 
bring an issue to market if they do not do A, B, and C. And, 
ultimately, we have been able to work within that limitation 
under the MSRB's leadership to provide honest-to-goodness great 
disclosure in the primary and secondary market. But deciding 
whether or not to keep the Tower amendment in place or change 
it is not our job.
    Chairman Shelby. It takes legislation.
    Professor, you have a comment on this, the Tower amendment?
    Mr. Warga. Not the Tower amendment, no.
    Chairman Shelby. Do you think it works?
    Mr. Warga. I have no opinion.
    Chairman Shelby. I appreciate all of you. We will keep the 
record open in case some other Senators might want to pose some 
questions to you. We appreciate your appearance here today.
    Thank you. The hearing is adjourned.
    [Whereupon, at 11:35 a.m., the hearing was adjourned.]
    [Prepared statements supplied for the record follow:]
               PREPARED STATEMENT OF ANNETTE L. NAZARETH
                Director, Division of Market Regulation
                   Securities and Exchange Commission
                             June 17, 2004
    Good morning Chairman Shelby, Ranking Member Sarbanes, and Members 
of the Committee. I am delighted to be here to discuss some of the 
significant issues and developments that the Securities and Exchange 
Commission is currently addressing with respect to the fixed income 
markets. Specifically, I plan to discuss the fixed-income market 
transparency joint Task Force, which was recently commissioned by 
Chairman Donaldson, along with a number of issues that the Task Force 
is currently considering, including corporate bond market transparency, 
municipal securities market transparency, government securities 
transparency, and dealer mark-up practices in the fixed-income market. 
Finally, I will briefly touch upon the development of guiding 
principles for the fixed-income industry related to the mitigation of 
research analyst conflicts of interest.
    In March 2004, Chairman Donaldson commissioned a joint Task Force 
to consider issues relating to bond market transparency and mark-up 
regulation. The Task Force consists of representatives of the Divisions 
of Market Regulation and Enforcement, the Office of Compliance 
Inspections and Examinations (``OCIE''), the Office of Economic 
Analysis (``OEA''), and the Office of the General Counsel. The Task 
Force was organized to summarize fixed-income market transparency 
developments, identify current problems, and generate potential 
solutions.
    Preliminarily, the Task Force has found that transparency has 
improved to varying degrees in each of the fixed income markets over 
the last 20 years, because of a continued focus on this issue by both 
Congress and the Commission. Further, recent increases in the 
availability of information from these markets has enhanced the ability 
of regulators to surveil these markets for mark-up violations and other 
illegal activity.
    To implement transparency in the corporate bond markets, the 
Commission persuaded the NASD to create systems to collect transaction 
reports and disseminate price information. On January 23, 2001, the 
Commission approved the NASD's proposal to establish the Trade 
Reporting and Compliance Engine (``TRACE'') system for reporting and 
dissemination of last sale information on corporate bonds not traded on 
an exchange. On July 1, 2002, TRACE was officially launched. It is 
currently being implemented in phases, and has not yet been fully 
implemented. Under the NASD's TRACE rules, dealers must report trades 
on U.S. corporate bonds to the NASD within 45 minutes of trade 
execution, which was reduced from 75 minutes on October 1, 2003. Prior 
to TRACE, real-time transparency of investment-grade corporate bonds 
was limited to those traded on exchanges--a very narrow segment of that 
market.
    Although all trades in TRACE-eligible bonds are reported to the 
NASD, not all TRACE data is disseminated to market users at this time, 
in part because of industry concerns about the adverse effects that 
dissemination might have on market liquidity. Dealers initially 
contended that immediate dissemination of transaction information on 
anything but the most liquid bonds could discourage dealers from 
committing capital and assuming risk positions by exposing their 
intentions to market participants. Thus far, on the basis of available 
evidence, these concerns remain unsubstantiated. In addition, resales 
of securities under Rule 144A of the Securities Act of 1933 are subject 
to reporting, but not dissemination because of the restrictions on 
resale contained in Rule 144A. Moreover, certain bonds, including bonds 
classified as ``asset-backed'', are excluded from TRACE-eligibility and 
transactions in such bonds are not currently reported to the NASD.
    Under TRACE, the NASD currently disseminates transaction 
information on (i) investment grade corporate bonds rated ``A3'' or 
higher by Moody's Investors Service, and ``A-'' or higher by Standard & 
Poor's, with initial issuance size of $100 million or greater, (ii) 
investment grade corporate bonds rated ``Baa/BBB'' with initial 
issuance of $1 billion or greater, (iii) an additional 120 bonds 
designated by the NASD that are rated ``Baa/BBB'' at the time of 
designation and with initial issuance of less than $1 billion, and (iv) 
50 high-yield securities. Transactions eligible for public 
dissemination are distributed to vendors immediately upon receipt by 
TRACE. Transactions larger than $5 million in investment grade bonds 
are reported as ``5MM+;'' transactions larger than $1 million in the 
roughly 50 reported high-yield bonds are reported as ``1MM+.''
    TRACE data currently includes transaction information on more than 
4,200 securities and represents about 75 percent of the dollar value of 
trading activity in investment grade bonds. Real-time price data is 
available from several third-party data vendors for a fee. Delayed data 
(minimum four hour delay) is available free on the NASD website.
    The NASD is in the process of expanding price dissemination to 
cover additional bonds in a new phase of the TRACE rollout, which will 
reflect the NASD's experience with earlier phases. The 120 BBB/Baa 
bonds currently designated by the NASD for dissemination were selected 
in order to obtain empirical data about the impact that dissemination 
may have on the liquidity of such bonds. The 50 noninvestment grade 
bonds designated for price dissemination were also chosen in part to 
obtain information about the impact on liquidity, if any. The NASD 
commissioned two studies to address this issue, both of which have been 
completed. Neither study provided significant evidence that 
transparency harms liquidity. However, neither study was extensive 
enough to address all concerns raised by dealers and other market 
participants.
    The NASD's advisory Bond Transaction Reporting Committee (``BTRC'') 
recently made recommendations to the NASD Board to enhance TRACE based 
on its review of the findings in these two studies. The NASD Board 
approved the BTRC recommendations, and our understanding is that the 
NASD intends to file a proposed rule change with the Commission 
shortly. The NASD plan would make public in near realtime approximately 
99 percent of all transactions (and 95 percent of the par value) in 
TRACEeligible securities. For the remaining transactions in TRACE-
eligible securities--in essence, newly-issued or infrequently traded 
lower-quality bonds--dissemination of transaction data would be 
delayed. I understand the NASD intends to reconsider the need for the 
remaining restrictions in the near term. Once filed with the 
Commission, the NASD's proposal will be published for public comment 
and processed according to statutory procedures. I also should point 
out that the NASD recently filed a proposal to reduce the reporting 
period from 45 minutes to 30 minutes in 2004, and, ultimately, to 15 
minutes in 2005. There are no plans to reduce the reporting period to 
less than 15 minutes.
    In addition, I should note that data for all TRACE-eligible 
securities is now available to regulators for surveillance purposes. 
The NASD is currently implementing a market surveillance plan designed 
to review market-wide and individual firm activity, monitor compliance 
with reporting requirements, and detect possible investor abuse and 
market manipulation. The availability of TRACE information to the NASD 
for surveillance purposes enhances the NASD's ability to protect 
investors by detecting abusive activity.
    With respect to the municipal bond market, the drive for 
transparency began before the corporate debt markets. The Municipal 
Securities Rulemaking Board (``MSRB''), with the Commission's active 
encouragement, first implemented a municipal securities trade reporting 
system in 1995, and proceeded thereafter in measured steps. The MSRB 
started providing daily summary reports of interdealer municipal bond 
trades in 1995, and expanded the reports to include customer-trade data 
in 1998. In January 2000, the MSRB began publishing individual 
transaction data on frequently traded securities in addition to 
summarizing their high, low and average prices. The Bond Market 
Association now posts next-day MSRB municipal bond trading reports on 
its Internet site for all municipal bonds that traded at least once on 
the previous day. The trades reported represent both wholesale (dealer 
to dealer and dealer to institutional customer) and retail (individual 
investor) purchase and sale transactions. Each daily report typically 
includes about 30,000 trades in approximately 11,000 issues out of the 
1.1 million issues that are outstanding. The daily report displays 
exact par value for all trades with a par value of one million dollars 
and under, and displays an indicator of ``>$1,000,000'' for those 
transactions with a par value greater than one million dollars.
    The implementation date of real-time transaction reporting has been 
delayed by the MSRB several times to ensure that dealers have 
sufficient time to make necessary changes in their bond processing 
systems. Real-time transaction reporting in the municipal market--
generally defined as within 15 minutes of the time of trade--is now 
scheduled to begin in January 2005. The MSRB has announced certain 
narrow exceptions to the requirement to report trades within 15 
minutes, however, including an exception related to new issues and 
variable rate instruments. The MSRB intends to disseminate trades 
reported during the business day immediately upon receipt of the trade 
report.
    In the government securities market, impetus for change began in 
the late 1980's, when the General Accounting Office (``GAO'') published 
a report recommending increased price transparency in this market. In 
1990, the GAO recommended legislation to require interdealer brokers to 
make transaction prices available to the public. The Commission 
supported the GAO recommendation, and recommended that legislation 
require quotation information to be made available as well. Partially 
in response to these calls for Congressional action, a variety of data 
network providers have emerged that publicly disseminate quotation and 
transaction information on treasury bonds and Federal agency 
securities. One example of this is GovPX, a vendor created by a group 
of primary dealers in government securities, that publicly disseminates 
information regarding the U.S. Treasury market.
    With respect to the markets for foreign sovereign and mortgage-
backed securities, the amount of transparency has not changed 
significantly in recent years. Dollardenominated foreign sovereign 
bonds are largely traded through interdealer brokers who post quotation 
and transaction information on their brokerage screens. This 
information is not generally disseminated outside of the dealer 
network. Pricing information on mortgage-backed securities is widely 
available through a variety of commercial vendors; some vendors also 
offer analytical tools to help value these securities. Dealers and some 
institutional investors have in-house analytical models as well.
    Generally speaking, transparency plays a fundamental role in 
promoting fair and efficient pricing in the fixed-income markets, 
thereby fostering investor confidence in those markets and encouraging 
greater participation. Transparency also contributes to efficient price 
discovery and aids investors in assessing the quality of the prices 
being offered in the market. In addition, transaction reporting has 
supplemented the ability of regulators to surveil the bond markets for 
unfair pricing and abusive mark-ups and markdowns. The increased 
availability of information has contributed to greater awareness by SEC 
and NASD staff of wide variations in pricing and mark-ups. The Task 
Force, in conjunction with the NASD, is exploring whether these 
variations create the potential for abuse.
    For any type of bond, mark-ups must be reasonable. While NASD has a 
maximum 5 percent guideline for equity securities, mark-ups are 
expected to be significantly lower for bonds. For different types of 
debt, what is recognized as reasonable depends on such factors as 
liquidity, credit rating, and yield, and can range from less than one-
half of one percent for government debt, to higher amounts for high-
yield bonds. For investors as well as regulators, the difficulty lies 
in establishing the prevailing market price for a bond. This generally 
is the base line that is used to assess whether a mark-up is 
reasonable. We believe that increased transparency should enhance the 
Commission's and SROs' ability to determine the prevailing market for a 
bond and thereby ascertain that investors are not being charged abusive 
mark-ups. In addition, improved transparency will enable investors to 
better determine the fair price of a bond. This will make them better 
able to protect themselves against unfair pricing in the first 
instance.
    In the recent past, Commission staff has held joint meetings with 
NASD staff in an effort to focus on mark-up practices in the fixed 
income markets and to develop appropriate surveillance and enforcement 
policies. Moreover, in February 2004, OEA publicly released a major 
study on municipal bond liquidity that used sophisticated econometric 
methods to analyze average transaction costs from a 1 year sample of 
all municipal bond trades that occurred in the 1999-2000 time frame. 
This study concludes that the effective spread for an average retail 
municipal bond trade was almost 2 percent, in comparison to 0.8 percent 
for a similarly sized equity trade. Among other matters, this OEA study 
is part of an ongoing research initiative that constitutes a 
comprehensive effort to measure the size of bond markups. The 
Commission has widely disseminated the findings of this staff study, so 
as to give municipal bond dealers an opportunity to compare for the 
first time the size of the markups they charge their clients to 
historical practices. Initial results on a similar analysis for 
corporate bonds (not yet released) suggest that transaction costs 
decline with added transparency. The magnitude of the results implies 
that making the rest of the bonds transparent has the potential to save 
investors more than $1 billion per year.
    This January, after our review, the MSRB issued a Notice entitled 
``Review of Dealer Pricing Responsibilities.'' The Notice was 
occasioned by NASD's review of transactions with retail customers at 
prices that were not reasonably related to market value. The MSRB 
expressed concern with ``transaction chains'' where a block of 
securities was bought from a retail investor, and then, after a series 
of inter-dealer trades, was sold to another retail customer at a 
substantially higher price. While no single dealer involved may have 
made an excessive profit, the large intra-day price differential was 
absorbed by retail customers at the ends of the chain. Also in January, 
OCIE and the NASD initiated a coordinated review of municipal brokers' 
brokers. The firms selected for examination were based on the above-
referenced NASD transaction review.
    In addition, the NASD has filed a proposal to add a new 
Interpretation to its rules for transactions in nonmunicipal debt 
securities to address two issues. First, it would address how NASD 
members are to determine a debt security's prevailing market price, 
from which the amount of a mark-up is computed. Second, it would speak 
to when and how a debt security's prevailing market price may be 
determined by reference to transactions with institutions, or to 
transactions in ``similar securities.''
    The NASD proposal would establish a rebuttable presumption that, in 
all cases, the prevailing market price for a debt security would be the 
dealer's contemporaneous cost. While this standard is already imposed 
on nonmarket making dealers, its universal application would eliminate 
a more forgiving standard that has been established for market-makers. 
Regulators and industry participants have found that in the bond 
market, where there is no sharp delineation between market making and 
nonmarket-making firms, the separate standard created a lack of clarity 
and was a frequent source of disputes.
    Moreover, the proposal would list a set of default measures of 
prevailing market price in cases where the base standard should not 
apply. NASD's list includes well-established factors, as well as new 
ones that reflect particular attributes of the bond markets. For 
instance, it would recognize that the market price of a debt security 
may often be established by reference to others with similar 
characteristics, such as credit quality. The proposal would also 
acknowledge the significant role of nondealer institutions in the bond 
markets by permitting NASD members to refer to transactions with 
institutions when determining the prevailing market price of a debt 
security. In light of the significance of the filing and the 
Commission's longstanding sensitivity with respect to the regulation of 
mark-ups, the staff has consulted with NASD and is closely reviewing 
the proposal.
    Another important development in the fixed income market was the 
Bond Market Association's recent release of the final version of its 
``Guiding Principles to Promote the Integrity of Fixed Income 
Research,'' which is a comprehensive and detailed set of voluntary 
principles designed to help the BMA's member firms manage potential 
conflicts of interest that arise in their research activities. The 
Commission staff, analysts' groups, and a variety of other market 
participants reviewed drafts of the principles, which are intended to 
promote an independent flow of unbiased information to the global fixed 
income capital markets. The BMA's new principles are intended to 
provide member firms with a common set of standards they can use 
globally and to complement existing requirements both in the United 
States and Europe.
    The final principles reflect that the nature and intensity of 
conflicts of interest affecting fixed income research are different 
than those affecting equity research, but that conflicts are possible 
in the preparation of fixed income research and needed to be addressed. 
Moreover, the guiding principles are intended to ensure research 
analysts are free from internal or external influences that could 
inhibit their ability to produce impartial assessments. For example, 
they recommend that analysts not participate in investment banking 
activities, which could raise questions about their independence. The 
BMA purposefully chose a flexible principles-based approach to ensure 
that differing organizational structures, various types and uses of 
fixed income research, and the unique aspects of different fixed income 
markets could all be encompassed within the framework.
    Many of the guiding principles are designed to foster a firm 
culture that promotes the integrity of fixed income research and the 
ability of fixed income research analysts to express their views 
without inappropriate pressure from issuers, investment bankers and, 
significantly, other nonresearch department personnel, including 
traders and salespeople. In that regard, the BMA has noted its belief 
that the principles go further than the regulations or legal 
settlements covering equity research.
    Specifically, the principles recommend that firms prohibit promises 
of favorable research in exchange for business, prohibit retaliation 
against analysts for publishing unfavorable research and ensure that 
research coverage decisions are made by research personnel. In terms of 
sales and trading activities, the principles recommend firms prevent 
analysts' recommendations from being prejudiced by the firm's trading 
activities. In addition, under the principles, traders should not know 
the content or timing of upcoming reports before they are issued.
    The principles also address potential conflicts of interest that 
arise from the personal interests of analysts. For example, the 
principles recommend analyst compensation be structured to promote 
independence and that firms impose limitations on the personal trading 
activity of research analysts. Similarly, the principles recommend 
disclosures to assist investors in distinguishing fixed income research 
from analyses produced by trading desk personnel as part of their trade 
execution and/or market making functions. The Commission applauds the 
BMA for being proactive in connection with analyst conflicts and 
believes that the implementation of the principles is a positive 
development for market participants, regulators, and investors in the 
fixed-income market. The Commission will continue to consider whether 
further Commission initiatives in this area are needed.
    In closing, I would like to note that we believe that transparency 
is an essential component of an efficient and fair market. In that 
regard, the Commission has supported increased transparency in the 
fixed income markets and will work with market participants and 
regulators in the future to ensure that we continue to increase 
transparency in the fixed-income markets. Thank you again for inviting 
me to speak on behalf of the Commission. I would be happy to answer any 
questions that you may have.
                               ----------
                   PREPARED STATEMENT OF DOUG SHULMAN
              President, Markets, Services and Information
               National Association of Securities Dealers
                             June 17, 2004
Introduction
    Mr. Chairman and Members of the Committee: NASD would like to thank 
the committee for the invitation to submit this written statement for 
the record.
NASD
    NASD is the world's preeminent private sector securities regulator, 
established in 1939 under authority granted by the 1938 Maloney Act 
Amendments to the Securities Exchange Act of 1934. We regulate every 
broker-dealer in the United States that conducts a securities business 
with the public--nearly 5,400 securities firms that operate more than 
92,000 branch offices and employ more than 665,000 registered 
representatives.
    Our rules comprehensively address every aspect of the brokerage 
business. NASD examines broker-dealers for compliance with NASD rules, 
MSRB rules, and the Federal securities laws--and we discipline those 
who fail to comply. Our market integrity and investor protection 
responsibilities include examination, rule writing, professional 
training, licensing and registration, dispute resolution, and investor 
education. NASD runs market transparency facilities, such as its TRACE 
system for corporate bonds, which provide investors with information to 
help them make more informed decisions. NASD monitors all of the over-
the-counter markets in equity and debt securities, including trading on 
the Nasdaq Stock Market--which is more than 100 million orders, quotes, 
and trades per day. NASD has a Nationwide staff of more than 2,000 and 
is governed by a Board of Governors comprising a majority of 
nonindustry and public members.
Increased Retail Participation in the Bond Markets
    Corporate bonds have become an important retail investment vehicle 
as the activity level of individual investors purchasing bonds or bond 
funds has increased dramatically in recent years. According to data 
from the Federal Reserve, the percentage of household assets in 
corporate and foreign bonds grew 70 percent between 1995 and 1999. 
During this time frame, household holdings of corporate and foreign 
bonds eclipsed municipal bond holdings. And contrary to popular belief, 
newly available NASD trading statistics reveal that the bond market has 
substantial retail participation. In fact, approximately 65 percent of 
the transactions in the corporate bond market are in quantities of 
fewer than 100 bonds or amounts less than $100,000 in par value. We 
believe this trend of increasing retail participation in corporate 
bonds will continue as the `baby boomer' generation reaches retirement 
age and shifts portfolios into fixed income investments.
    While bonds and bond funds can play an important role in portfolio 
diversification, neither product is entirely risk-free. Bonds and bond 
funds may be viewed incorrectly as--and in some cases, marketed as--
risk-free alternatives to equity securities. Purchasers of bonds and 
bond funds often believe that their principal is safe and that they are 
guaranteed a particular yield on their investment. Investors may also 
believe that bonds are inexpensive to purchase or sell because they may 
not realize that they pay a commission or other form of broker-dealer 
compensation--mark-ups or mark-downs--on the transaction. Moreover, the 
terms, conditions, risks, and rewards of bonds vary widely, and in some 
cases, such as high-yield bonds, the risks may be substantial.
    As the activity level of individuals investing in bonds and bond 
funds grows, NASD is concerned that many individual investors many not 
fully appreciate the risks and costs associated with these products. A 
recent NASD survey showed that 60 percent of retail investors do not 
understand that, as interest rates rise, bond prices fall. Therefore, 
when interest rates rise, investors who decide to sell their bond fund 
may not recoup their full investment. In the same environment, 
investors who decide to sell bonds prior to a call or the maturity date 
also may not receive the full amount of their principal invested.
TRACE
    Even educated investors cannot make wise investment decisions if 
they cannot access important transaction information such as comparable 
prices for investment products, including bonds. While investors are 
accustomed to having access to current last sale information in the 
equities markets, bond information, historically, has not been 
similarly available.
    On July 1, 2002, NASD launched the first intraday `consolidated 
tape' in the U.S. over-the-counter corporate bond markets. The Trade 
Reporting and Compliance Engine, commonly referred to as TRACE, enables 
investors to access current price information for U.S. corporate bonds. 
All broker-dealers regulated by NASD have an obligation to report 
transactions in TRACE-eligible corporate bonds under rules approved by 
the SEC.
    As with the dissemination of the selling prices of equities, this 
capability provides a new level of information to bond investors who 
now have access to independent bond transaction data that can be used 
to help determine that they are getting a fair market price when they 
are buying or selling bonds. While information on all bond transactions 
that are reported to TRACE is not disseminated under provisions 
currently in place, the program will be expanded in the next phase so 
that prices of all reported transactions will be made available to the 
public. Because TRACE makes a great deal of important price information 
public and accessible, it helps to increase market fairness and 
integrity.
    With this improved availability of market information, NASD now has 
a better view into the U.S. corporate bond market. For example, since 
the launch of TRACE, we have learned that the corporate bond 
marketplace is far more active than originally anticipated. On a 
typical day approximately $20 billion par value of corporate bonds 
``turn over'' in approximately 25,000 transactions. Of the close to 
5,400 broker-dealer firms regulated by NASD, more than 1,900 report 
transactions to TRACE. And of that number, approximately 500 broker-
dealers report at least one trade every day. The top 10 firms account 
for approximately 60percent of the volume and the top 25 firms trade 
approximately 85percent of the volume. In addition, of the 23,000 
publicly traded corporate bond issues, 20 percent trade at least one 
time per day with 5 percent trading more than 5 times per day. As a 
result of TRACE, NASD now possesses the information to identify trading 
patterns, trading volume, and market participation.
    Both individual investors and investment professionals can access 
TRACE information. Most investment professionals access the trade data 
through market data vendors or their firm's proprietary applications. 
Retail investors typically access TRACE data through web sites such as 
NASD's nasdbondinfo.com or Investinginbonds.com, a part of The Bond 
Markets Association's web site. And in an effort to increase 
distribution of the data on a more widespread basis, NASD is actively 
finding additional ways to distribute the information.
TRACE Reporting and Dissemination
    Currently, more than 29,000 corporate debt securities are subject 
to TRACE reporting requirements. Each firm regulated by NASD that is a 
party to a secondary ``over-the-counter'' market transaction in a TRACE 
eligible security has a reporting obligation under TRACE. As a general 
rule, the vast majority of dollar denominated corporate debt 
instruments must be reported to TRACE. Not included under TRACE are 
government debt securities such as U.S. Treasury bonds, municipal 
securities (which are subject to a separate reporting and dissemination 
regime managed by the MSRB), GSE securities, mortgage or asset backed 
securities, and money market instruments.
    More specifically, TRACE eligible securities include the following 
classes:

 Investment grade debt
 High-yield and un-rated debt of U.S. companies and foreign 
    private issuers
 Medium term notes
 Convertible debt not otherwise reported to an exchange
 Capital trust securities
 Equipment trust securities
 Floating rate notes
 Global bonds issued by U.S. and foreign private issuers
TRACE Reporting Time
    During the past 2 years, NASD has worked with the bond trading 
community to expedite public reporting of TRACE data. Upon the 
inception of TRACE in July 2002, bond dealers had 75 minutes to report 
trades into TRACE. Since that time, NASD has moved aggressively to 
reduce the time frame for reporting to TRACE. Currently, broker-dealers 
must report trades to TRACE within 45 minutes. This requirement will be 
reduced to 30 minutes later this year and the reporting time will be 
reduced again to 15 minutes by mid-2005. Notwithstanding this 
requirement, in the first 5 months of 2004, 74 percent of trades were 
submitted within 15 minutes of execution and 85 percent within 30 
minutes of execution.
    NASD has worked hard to ensure that market participants have had 
the time to prepare their processes and systems for this new reporting 
regime, while moving aggressively to reduce reporting times.
Trace Dissemination
    TRACE has gathered every secondary transaction conducted in the 
corporate bond market for regulatory purposes since its inception on 
July 1, 2002. NASD has taken an aggressive phased approach to 
dissemination of this data to investors and professionals. Phase I, 
which was launched at inception, provided for dissemination of all 
transaction data in investment grade bonds greater than $1 billion in 
original issuance and 50 representative high yield bonds. This phase 
gave investors access to approximately 31 percent of all transactions 
(34 percent of par value) and 38 percent of investment grade trades (45 
percent of par value).
    Phase II was introduced in April of 2003 and provided for 
dissemination of data on all investment grade bonds that were rated A 
or better and were at least $100 million in original issuance, as well 
as data on 120 representative Triple B rated bonds and 50 
representative high-yield bonds. This phase, which is currently in 
effect, gives investors access to approximately 43 percent of all 
transactions (45 percent of par value) and 61 percent of investment 
grade trades (68 percent of par value).
    In April 2004, NASD's Board of Governors voted to make all publicly 
traded TRACE eligible issues subject to dissemination. Under this 
proposal, information on 100 percent of TRACE eligible issues would be 
accessible to the public. Trade information on 99 percent of all 
corporate bonds will be disseminated immediately, thereby giving 
investors contemporaneous access to marketplace prices and transaction 
data. The transactions that would be disseminated on a delayed basis 
would be limited to certain transactions in lower rated securities 
executed during a short period after issuance and for trades over $1 
million in par value in noninvestment grade securities that are 
infrequently traded.
    The proposed increase in dissemination of corporate bond 
information previously described continues NASD's efforts to put more 
information in the hands of investors and other market participants. In 
a very short period of time, TRACE has brought unprecedented 
transparency to the corporate bond market. NASD will continue to work 
with the SEC and the industry to sustain this trend.
Sales Practices
    In addition to having increased price information, NASD believes 
that it is imperative that investors understand the various risks, as 
well as the rewards, associated with debt securities. With the growing 
retail participation in bonds and evidence that investors may not fully 
understand the products (and particularly given that interest rates are 
likely to rise from their current and historically low rates), NASD 
recently issued a notice to the firms it regulates to remind them of 
their sales practice obligations in connection with bonds and bond 
funds.
    These sales practice obligations include:

 Understanding the terms, conditions, risks, and rewards of 
    bonds and bond funds they sell (performing a reasonable-basis 
    suitability analysis);
 Making certain that a particular bond or bond fund is 
    appropriate for a particular customer before recommending it to 
    that customer (performing a customer-specific suitability 
    analysis);
 Providing a balanced disclosure of the risks, costs, and 
    rewards associated with a particular bond or bond fund, especially 
    when selling to retail investors;
 Adequately training and supervising employees who sell bonds 
    and bond funds;
 Implementing adequate supervisory controls to reasonably 
    ensure compliance with NASD and SEC sales practice rules in 
    connection with bonds and bond funds;
 Informing customers that brokers receive compensation for bond 
    trades--that when a firm buys or sells a bond, the customer is 
    charged for the service, in the form of either a commission, or a 
    mark-up or mark-down.

    NASD also regularly reminds firms that they need to take 
appropriate steps to ensure that their employees understand and inform 
customers about the risks as well as the rewards of the products they 
offer and recommend, including corporate bonds.
    Investor education is another important tool. As part of our 
Investor Brochure series, NASD offers information on investing in 
bonds, the different types of bonds, and understanding bond prices, 
quotations, and ratings. This information can be found on the NASD Web 
site. We are also developing additional ways to help investors 
understand investing in bonds--along the lines of explaining what 
``junk'' bonds are, how to use NASD BondInfo, and the importance of 
asset allocation and diversification within a bond portfolio.
NASD Regulatory Functions Regarding Corporate and Municipal
Bond Markets
    While TRACE applies to the corporate debt market, NASD's regulatory 
responsibilities extend to both the corporate and municipal bond 
markets. The MSRB imposes requirements on firms for reporting municipal 
bond transactions and NASD, as discussed above, imposes TRACE 
requirements for reporting corporate bonds transactions. These sources 
of data provide NASD with a comprehensive picture of these two markets 
with more than 50,000 daily transactions.
    TRACE and the MSRB's transaction information enable NASD to create 
an audit trail of the activity in these markets and undertake 
comprehensive automated surveillance. NASD market surveillance systems 
utilize the TRACE and MSRB data to check for compliance with applicable 
rules and to detect potential violations. Compliance checks focus on 
the timeliness, completeness, and accuracy of the required reports. 
Ensuring timely, correct and complete reporting by the firms is a top 
priority because accurate reporting is essential to ensure the 
integrity of the information disseminated to the public and for 
effective automated market surveillance.
    Automated detection patterns are used to address customer 
protection concerns such as the levels of commissions and markups or 
markdowns charged to investors. NASD and MSRB rules prohibit firms from 
charging customers prices that are not reasonably related to the 
current market price of a security. With the increasing level of retail 
participation in the fixed income market, this is clearly a high-
priority concern.
    The NASD surveillance systems are also used to detect potential 
market manipulation. Unlike equities, there is no centralized market 
structure for debt securities where quotes are published or 
transactions may be executed (or facilitated). Accordingly, the 
challenges when policing for potential market manipulation are somewhat 
different from those in the equity markets. Nonetheless, there are 
certain types of conduct that can result in prices that are manipulated 
or artificial market activity. We try to detect that type of activity 
through automated surveillance.
    NASD's Nationwide staff performs routine examinations of each 
broker-dealer registered with NASD. For those firms participating in 
the corporate and municipal bond markets, the exams seek to determine 
whether such firms are complying with NASD and MSRB rules as well as 
applicable Federal securities laws. Examinations begin with a detailed 
review of data that is available through NASD systems, such as 
securities industry registrations, firm financial data, and firm 
trading data. The examiners review the firm's books and records, such 
as financial computation work papers and subsidiary ledgers, order 
tickets and confirmations, and complaint and correspondence files. 
Examiners check to see that the firm's records support the regulatory 
reports that the firm has made to NASD in the case of trade reporting 
and other filings.
    NASD is also committed to supporting securities firms' compliance 
efforts by providing firms specific feedback in the form of performance 
statistics to enable firms to monitor their transaction reporting 
compliance on an individual and industry-wide basis. With a glance at 
the statistics, a firm can quickly see its actual rate of compliance 
with the reporting requirements. This is another way that NASD is 
working to ensure that there is integrity in the bond markets.
    When NASD finds that broker-dealers have violated any of the 
applicable rules, it may take informal or formal action against firms 
and individuals, as appropriate. NASD rules provide for a range of 
formal sanctions including fines, disgorgement, suspension, and 
expulsion from the industry. NASD may also order restitution to 
investors.
Conclusion
    NASD is committed to fulfilling its regulatory responsibility of 
ensuring that broker-dealers engaged in the bond markets comply with 
the Federal securities laws and regulations, including NASD's TRACE and 
other NASD rules and the rules of the Municipal Securities Rulemaking 
Board. We will continue to work with the SEC and the securities 
industry to increase access by the public and professionals alike to 
vital bond market data. This commitment is a vital part of our mission 
to protect investors and ensure market integrity.
                               ----------
              PREPARED STATEMENT OF CHRISTOPHER A. TAYLOR
       Executive Director, Municipal Securities Rulemaking Board
                             June 17, 2004
    Chairman Shelby, Ranking Member Sarbanes and Members of the 
Committee:
    As Executive Director of the Municipal Securities Rulemaking Board, 
I appreciate the opportunity to testify before the Committee concerning 
the municipal securities market and the MSRB's role in this market.
Introduction
    On June 9, 2004, Chairman Shelby requested that the Municipal 
Securities Rulemaking Board (``MSRB'' or ``Board'') prepare testimony 
before the Committee addressing current issues concerning the municipal 
securities market, including market structure, regulatory framework, 
trade reporting, price transparency and related matters. This testimony 
has been prepared in response to that request. Part I provides a 
summary of the Board's structure, authority and rules. Part II provides 
background on the municipal securities market. Part III is a discussion 
of the MSRB's regulatory priorities and goals.
Background on the MSRB's Structure, Authority and Rules
MSRB Structure
    The MSRB is a self-regulatory organization (``SRO'') established by 
Congress in the Securities Acts Amendments of 1975 to write rules with 
respect to transactions in municipal securities effected by brokers, 
dealers and municipal securities dealers (collectively ``dealers''). 
The MSRB stands as a unique SRO for a variety of reasons. The MSRB was 
the first specifically established by Congress. Also unique is the fact 
that the legislation, now codified in section 15B of the Securities 
Exchange Act (``Exchange Act''), dictates that the Board shall be 
composed of members who are equally divided among public members 
(individuals not associated with any dealer), individuals who are 
associated with and representative of banks that deal in municipal 
securities (``bank dealers''), and individuals who are associated with 
and representative of securities firms.\1\ At least one public member 
serving on the Board must represent investors and at least one must 
represent issuers of municipal securities. Further, the MSRB was 
created as a product-specific regulator, unlike most other securities 
regulatory bodies.
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    \1\ Under Board Rule A-3, the Board is composed of 15 membership 
positions, with five positions each for public, bank dealer and 
securities firm members.
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    Members of the Board meet periodically throughout the year to make 
policy decisions, approve rulemaking and review developments in the 
municipal securities market. Day-to-day operations of the MSRB are 
handled by a full-time professional staff. The operations of the Board 
are funded through assessments made on dealers for initial fees, annual 
fees, fees for underwritings and transaction fees.\2\
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    \2\ These fees are set forth in Board Rules A-12 through A-14.
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MSRB Authority
     The substantive areas of the Board's rulemaking authority are 
described in Section 15B(b)(2) of the Exchange Act, which lists several 
specific purposes to be accomplished by Board rulemaking with respect 
to the municipal securities activities of dealers and provides a broad 
directive for rulemaking designed to:

prevent fraudulent and manipulative acts and practices, to promote just 
and equitable principles of trade, to foster cooperation and 
coordination with persons engaged in regulating, clearing, settling and 
processing information with respect to and facilitating transactions in 
municipal securities, to remove impediments to and perfect the 
mechanism of a free and open market and, in general, to protect 
investors and the public interest.

    Like other SROs, the Board must file its proposed rule changes with 
the Securities and Exchange Commission (``SEC'') for approval prior to 
effectiveness.
    Although the Board was created to write rules that govern dealers' 
conduct in the municipal securities market, the Exchange Act directs 
that inspection of dealers for compliance with, and the enforcement of, 
Board rules be carried out by other agencies. For securities firms, the 
NASD, along with the SEC, perform these functions. For bank dealers, 
the appropriate Federal banking authorities, in coordination with the 
SEC, have this responsibility. \3\ The use of existing enforcement 
authorities for inspection and enforcement of Board rules provides for 
an efficient use of resources. The Board works cooperatively with these 
enforcement agencies and maintains frequent communication to ensure 
both that: (1) the Board's rules and priorities are known to examining 
officials; and (2) general trends and developments in the market 
discovered by field personnel are made known to the Board.
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    \3\ These Federal banking authorities consist of the Federal 
Deposit Insurance Corporation, the U.S. Treasury Department's Office of 
the Comptroller of the Currency, and the Board of Governors of the 
Federal Reserve System, depending upon the specific bank dealer.
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    While Section 15B of the Exchange Act provides the Board with broad 
authority to write rules governing the activities of dealers in the 
municipal securities market, it does not provide the Board with 
authority to write rules governing the activities of other participants 
in the municipal finance market such as issuers and their agents (that 
is, independent financial advisors, trustees, etc.). Municipal 
securities also are exempt from the registration and prospectus 
delivery requirements of the Securities Act of 1933 and are exempt from 
the registration and reporting requirements of the Exchange Act.
    In adopting Section 15B of the Exchange Act, Congress provided in 
subsection (d) specific provisions that restrict the Board and the SEC 
from regulating the disclosure practices of issuers in certain ways. 
Paragraph (1) of subsection (d) prohibits the Board (and the SEC) from 
writing rules that directly or indirectly (for example, through dealer 
regulation) impose a presale-filing requirement for issues of municipal 
securities. Paragraph (2) of subsection (d) prohibits the Board (but 
not the SEC) from adopting rules that directly or indirectly require 
issuers to produce documents or information for delivery to purchasers 
or to the Board. Paragraph (2), however, specifically allows the Board 
to adopt requirements relating to such disclosure documents or 
information as might be available from ``a source other than such 
issuer.'' The provisions of subsection (d) commonly are known as the 
``Tower Amendment.''
MSRB Rules Overview
    The Board has adopted a substantial body of rules that regulate 
dealer conduct in the municipal securities market. These rules address 
all of the subjects enumerated in Section 15B of the Exchange Act by 
Congress for Board action, including recordkeeping, clearance and 
settlement, the establishment of separately identifiable departments 
within bank dealers, quotations, professional qualifications of persons 
in the industry and arbitration of disputes. \4\ The Board also adopted 
a number of rules in furtherance of the broad purposes of ensuring the 
protection of investors and the public interest. Among the most 
important of these are the Board's three primary customer protection 
measures--Rule G-17, on fair dealing, Rule G-19, on suitability, and 
Rule G-30, on fair pricing. These rules require dealers to observe the 
highest professional standards in their activities and relationships 
with customers.
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    \4\ The Board's arbitration program was established in 1978. 
Because of the small number of cases filed with the Board and the 
agreement of NASD to handle arbitration cases relating to municipal 
securities transactions brought by customers involving bank dealers as 
well as existing NASD dealer members, the Board discontinued its 
arbitration program in 1998.
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    Maintaining municipal market integrity is an exceptionally high 
priority for the Board as it seeks to foster a fair and efficient 
municipal securities market through dealer regulation. The Board 
engages in an on-going process of reviewing its rules and market 
practices to ensure that the Board's overriding goal of protecting 
investors and maintaining market integrity is not compromised by 
emerging practices.
    The MSRB adopted Rule G-37 on political contributions in an effort 
to remove the real or perceived conflict of interest created when 
issuers receive political contributions from dealers and then award 
municipal securities business to such dealers in a practice that came 
to be known as ``pay-to-play.'' In general, Rule G-37 prohibits dealers 
from engaging in municipal securities business with issuers if certain 
political contributions have been made to officials of such issuers; 
prohibits dealers and municipal finance professionals (``MFPs'') from 
soliciting or bundling contributions for officials of issuers with 
which the dealer engages in business; and requires dealers to disclose 
certain political contributions to allow public scrutiny of political 
contributions and the municipal securities business of a dealer. The 
rule also requires dealers to disclose certain contributions to state 
and local political parties to ensure that such contributions do not 
represent attempts to make indirect contributions to issuer officials 
in contravention of Rule G-37.
    Further, the MSRB adopted Rule G-38 relating to the use by dealers 
of consultants to solicit municipal securities business from issuers on 
the dealers' behalf. This rule is intended to deter and detect attempts 
by dealers to avoid the limitations placed on dealers by Rule G-37 
through their consultants, as well as to require full disclosure to 
issuers and the public of relationships which could otherwise pose 
potential conflicts-of-interests or could result in potentially 
improper conduct by consultants. The rule currently requires dealers 
who use consultants to disclose to issuers information on consulting 
arrangements relating to such issuer, and to submit to the Board 
quarterly reports of all consultants used by the dealer, amounts paid 
to such consultants, and certain political contribution information 
from the consultant.
    The impact of Rules G-37 and G-38 has been very positive. The rules 
have gone a long way toward severing the real or perceived connection 
between political contributions and the awarding of municipal 
securities business to dealers.
    In its role as regulator for dealer conduct, the Board also 
operates data facilities to help ensure that dealers can comply with 
MSRB rules by improving the flow of information in the market about 
municipal issues, and to ensure that the inspection and enforcement 
agencies have the necessary tools to do their work. The Municipal 
Securities Information Library (``MSIL'') system collects primary 
market disclosure documents from underwriters and makes them available 
to the market and the general public. The MSIL system also accepts and 
disseminates certain secondary market information provided by municipal 
issuers and trustees.
    The MSRB's transaction reporting program for municipal securities 
serves the dual role of providing transaction price transparency to the 
marketplace, as well as supporting market surveillance by the 
enforcement agencies.\5\ The market surveillance function of the MSRB's 
transaction reporting system provides the enforcement agencies with a 
powerful tool in enforcing the Board's fair pricing rules. In recent 
years, the MSRB has introduced increasing levels of transparency into 
the market in measured steps. This process is about to reach its 
ultimate goal in January 2005 with the implementation of the final 
phase of the transparency program, which will result in 15-minute 
reporting by dealers of their sales to and purchases from customers and 
other dealers and the real-time dissemination of transaction 
information to the marketplace.
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    \5\ Surveillance data is made available to regulators with 
authority to enforce MSRB rules, including the NASD and the SEC.
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Background on the Municipal Securities Market
Market Overview
    When Section 15B of the Exchange Act was adopted in 1975, yearly 
issuance of municipal securities was approximately $58 billion. \6\ 
Much of this total represented general obligation debt, which reflected 
the simple, unconditional promise of a state or local government unit 
to pay to the investor a specific rate of interest for a specific 
period of time. The investors in these bonds tended to be commercial 
banks and property/casualty insurers interested in tax-exempt interest.
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    \6\ See The Bond Buyer/Thomson Financial 2004 Yearbook at 10. 
Approximately half of this figure represents short-term debt maturing 
in less than 13 months.
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     The municipal securities market has grown into a much larger and 
more complex market. Total municipal debt outstanding through the first 
quarter of 2004 is approximately $1.9 trillion, or approximately 8.6 
percent of the outstanding U.S. debt market.\7\ Last year, a total of 
14,973 long-term municipal securities issues were issued for a total 
par value of $384.0 billion of long-term bonds, a record figure. 
Approximately 49.5 percent of the par amount of municipal bonds issued 
in 2003 carried municipal bond insurance, which translates to 44 
percent of the overall number of issues.\8\
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    \7\ See The Bond Market Association Research Quarterly (May 2004).
    \8\ See The Bond Buyer/Thomson Financial 2004 Yearbook at 2-5.
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    In the United States, there are approximately 80,000 State and 
local Governments, about 50,000 of which have issued municipal 
securities. The market is unique among the world's major capital 
markets because the number of issuers is so large-no other direct 
capital market encompasses so many borrowers. The issues range from 
multibillion dollar financings of large state and city governments to 
issues less than $100,000 in size, issued by localities, school 
districts, fire districts and various other issuing authorities. The 
purposes for which these securities are issued include not only 
financing for basic government functions, but also a variety of public 
needs such as transportation, utilities, health care, higher education 
and housing as well as some essentially private functions to enhance 
industrial development. In the last two decades debt issuance has 
become an important management tool for many municipalities, allowing 
flexibility in arranging finances and meeting annual budget 
considerations. The terms and features of municipal securities have 
evolved over time to meet a multitude of issuer borrowing and 
investment needs.
    Issuers' budgetary and risk management needs have also lead to 
derivative transactions, especially swaps, becoming an increasingly 
common aspect of municipal finance. These derivative transactions are 
not transactions in municipal securities, and the MSRB does not have 
the authority to regulate dealer conduct in connection with derivative 
transactions. In addition, many nonregulated entities effect derivative 
transactions with municipal issuers, or advise municipal issuers with 
respect to these transactions.\9\
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    \9\ The Commodity Futures Modernization Act of 2000 clarified the 
status of OTC derivatives and hybrid instruments under U.S. commodities 
and securities laws. Among other things, it provides that swap 
agreements are not securities under the Federal securities laws. Swap 
agreements that are based on securities prices, yields or volatilities 
are, however, subject to specific antifraud, antimanipulation and 
antiinsider trading provisions of the Federal securities laws as if 
they were securities. Neither the SEC nor the MSRB may, however, impose 
reporting or record keeping requirements or other prophylactic measures 
against fraud, manipulation or insider trading with respect to 
securities-based swap agreements.
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    The municipal securities market has a significant retail 
orientation, with approximately 35 percent of municipal debt held by 
households.\10\ There is great diversity in the types of municipal 
securities that are issued today. Tax-exempt municipal securities are 
popular investments that offer a wide range of benefits, including 
income free from Federal and, in some cases, state and local taxes; 
relative safety with regard to payment of interest and repayment of 
principal; and a wide range of choices to fit an investor's objectives 
with regard to credit quality, maturity, choice of issuer, type of 
bond, and geographical location.
---------------------------------------------------------------------------
    \10\ See The Bond Buyer/Thomson Financial 2004 Yearbook at 84.
---------------------------------------------------------------------------
    There are over 2,400 dealers registered with the MSRB to engage in 
municipal securities activities. These dealers range from large, 
securities firms with Nationwide presence to small local shops. 
Approximately 500 to 600 of these dealers underwrite new issues.
Trading in Municipal Securities
    Municipal securities are bought and sold in the over-the-counter 
market rather than on an organized exchange. Unlike the experience in 
the over-the-counter market for equity securities, there has been no 
evolution of firm, two-sided quotations or a formal market maker 
structure. In fact, a primary characteristic of the municipal 
securities market is the lack of any core group of issues that trade 
frequently and consistently over sustained periods of time. One reason 
for this is the ``buy and hold'' philosophy of most municipal 
securities investors. Another reason is that, for most issues, there is 
a very small or nonexistent ``float'' of securities available to be the 
subject of trading. Making a market in a conventional sense is 
difficult, if not impossible, for these issues. In addition, the tax 
treatment of borrowing tax-exempt securities effectively prevents the 
``shorting'' of an issue. The inability to manage risk in this fashion 
is a disincentive for making markets even in those issues where 
``float'' might be available.
     Another distinction between the municipal securities and the 
equity markets relates to the frequency of trading. In exchange-listed 
and Nasdaq markets, the continuous daily pattern of frequent trades in 
most stocks means that ``last sale'' transaction prices generally 
provide reliable information on market values for most stocks. However, 
even when the MSRB reaches its ultimate goal of disseminating 
comprehensive and contemporaneous pricing data,\11\ ``last sale'' 
prices generally will not provide reliable indicators of market value 
for most municipal securities. One reason for this is that, even on the 
heaviest trading days, less than 1 percent of all outstanding municipal 
issues trade at all and most of those issues trade only once or twice 
during the day. Furthermore, MSRB transaction reporting data suggests 
that only about one-third of the total issues outstanding during a 
given year are traded even once at any time during that year.
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    \11\ As discussed above, the MSRB will begin disseminating real-
time price transparency for municipal securities in 2005.
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Regulatory Priorities and Goals
Long-Range Plan
    The Board continues to review and refine its rules in light of new 
products, changes in marketing practices and other developments. Apart 
from this fine-tuning process, the Board also has taken a broader look 
at more basic changes in the market and has formed long-range 
regulatory priorities and goals.
    The Board has established under its long-range plan the goal of 
fostering and promoting a fair and efficient municipal capital market. 
To help reach this goal, the Board seeks to exercise market leadership 
through promoting education and responsible behavior among all 
participants; providing mechanisms for information flows; having 
simple, cost effective rules; and adapting to changes in conditions. 
Recently the Board has taken a number of major actions to further its 
goal through these priorities and objectives.
Promoting Education and Responsible Behavior Among All Participants--
        Outreach
    One of the significant challenges that the MSRB faces in working to 
foster and promote a fair and efficient capital market is that the MSRB 
only regulates one participant in the market, the dealers. Therefore, 
the MSRB recognizes that it cannot regulate away all problematic market 
practices and inefficiencies. To address this complexity, the MSRB has 
been very aggressive in the past few years in an outreach program 
designed to promote education and responsible behavior among all market 
participants.
    The MSRB's outreach program has focused on bringing market 
participants together to develop common understanding and voluntary 
solutions to industry issues, even though the MSRB may not have 
regulatory authority over these issues. For example, the MSRB convenes 
on a regular basis a roundtable of the key constituencies in the 
municipal securities markets--representing dealers, issuers, investors, 
indenture trustees, independent financial advisors, lawyers and other 
market participants--to promote open lines of communications among such 
groups and to educate all market participants on issues and concerns 
important to each segment of the industry. The MSRB has also hosted 
numerous marketplace forums to explore disclosure practices where the 
issuer community and other unregulated market participants have played 
a crucial role in the discussions. These and similar outreach efforts 
have often served as the catalyst for different constituencies to come 
together to work on issues of common interest. In many cases, 
significant voluntary initiatives among unregulated market participants 
to improve the efficiency and integrity of the municipal securities 
market have been outgrowths of these open lines of communications.
    The MSRB expects to undertake aggressive outreach in the future on 
issues such as the use of derivatives in public finance to assist in 
the development of responsible practices that protect the integrity of 
the municipal securities industry. This outreach would involve not only 
educating the dealers that the MSRB regulates, but also the issuer 
community and other unregulated market participants. Outreach to the 
industry on issues of great importance to the MSRB that are beyond our 
regulatory reach will continue to be a key tool used by the Board to 
achieve its ultimate statutory calling to protect investors and the 
public interest.
Providing Mechanisms for Information Flows--Disclosure and Real-Time
Transaction Reporting
    Fundamentally, the MSRB believes everyone is better off with more 
information about the market. This includes information about issuers, 
information about their securities, and transaction prices.
    In the area of issuer disclosure in the municipal market, the 
MSRB's focus over the past few years has been on voluntary 
improvements. To this end, the MSRB was instrumental in the formation 
of the Muni Council, a voluntary group comprised of 19 municipal market 
participants representing issuers, investors, dealers, lawyers, 
indenture trustees, independent financial advisors and other market 
participants. The Muni Council has been working over the past several 
years to improve secondary market disclosure in the municipal markets 
and is in the late stages of putting into place a formal structure 
which the Muni Council expects will improve the flow of disclosure 
information to investors.\12\ In addition, a number of the Muni Council 
participants and related organizations have established their own 
initiatives and best practice guidelines on disclosure.
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    \12\ The Muni Council recently announced that the Municipal 
Advisory Council of Texas has opened beta testing of its Central Post 
Office (CPO). The CPO is expected to serve as a one-stop filing place 
for issuers' secondary market disclosure documents and to improve the 
flow of information to the existing Nationally recognized municipal 
securities information repositories (NRMSIR's).
---------------------------------------------------------------------------
    The MSRB has a long-standing policy to increase price transparency 
in the municipal securities market, with the ultimate goal of 
disseminating comprehensive and contemporaneous pricing data. The MSRB 
implemented a limited transaction reporting facility for the municipal 
securities market in 1995 and has since increased price transparency in 
the municipal market in a series of measured steps. By 2000, the MSRB 
was making all trade data public on a delayed basis and was giving out 
T+1 transaction data free. The market's reaction to the increasing 
levels of transparency has been positive. The use of the data in 
reports by market professionals and pricing services indicates its 
value and suggests the additional value that will be derived from real-
time price data.
    On June 1, 2004, the MSRB filed with the SEC a proposed rule change 
that represents the final stage in the evolution of price transparency 
in the municipal securities market, which is a system for 
comprehensive, real-time price dissemination. The gradual change to 
real-time reporting by dealers has eased operational and cost concerns 
on the part of the industry, since it has been possible for dealers to 
plan for the extensive system changes that have been required. In 
particular, it has been possible to include these changes within a 
normal planning cycle, as the securities industry moved toward straight 
through processing.
    This real-time price transparency will offer several benefits to 
the market. Because of the lack of market-makers and a centralized 
exchange, it is not uncommon to see fragmented markets and relatively 
wide intra-day price spreads. Existing transaction data suggests that 
the efficiency of pricing in some cases might be improved substantially 
if prices are made accessible on a real-time basis. In general, real-
time price transparency should benefit the market by helping to ensure 
that information relevant to the value of municipal securities issues 
is incorporated more quickly and reliably into transaction prices. For 
both institutional and retail investors, the availability of market 
prices should instill greater confidence that pricing mechanisms in the 
market are fair and efficient. \13\
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    \13\ InvestingInBonds.com, a retail-oriented web site carrying data 
from the MSRB's existing Transaction Reporting Program, has been very 
successful in attracting users. The Bond Market Association operates 
InvestingInBonds.com.
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    The MSRB recognizes that, because of the unique features of the 
municipal securities market, real-time price transparency for municipal 
securities will not necessarily function in the same manner as in the 
major equity markets or even the moreliquid market for Treasury 
securities. For the majority of municipal securities that are not 
traded daily, an investor will not be able to consider ``last sale'' 
information as a reliable means of obtaining an exact market price, as 
generally can be done for exchange-traded or Nasdaq listed stocks that 
trade frequently throughout the day. This is because such last sale may 
have occurred some time in the past under different market conditions 
and material changes may have occurred since that last sale which might 
affect the value of the security. Nevertheless, real-time prices will 
provide extremely important information on the market conditions for 
individual securities that are trading on a given day, and this 
information often can be extrapolated to assist in the accurate 
valuation of similar municipal issues that are not actively traded that 
day. The continued and increased use of transaction data in this manner 
is another major benefit of transparency that will allow for more 
timely and accurate valuations of municipal securities portfolios.
Having Simple Cost Effective Rules--Review of Rules G-37 and G-38
    In order to have simple, cost effective rules the MSRB works 
diligently to promote understanding of its rules. The MSRB also 
continually engages in a process of reviewing its rules. For example, 
in an effort to ensure that Rule G-37, on political contributions and 
prohibitions on municipal securities business, and Rule G-38, on 
consultants, continue to be effective in promoting a fair and efficient 
capital market, the Board has been engaged in an extensive review of 
these rules.
    As a consequence, the Board has reacted to increasing signs that 
individuals and dealers subject to the rules may be seeking ways around 
Rule G-37 by publishing a notice to dealers reminding them that Rule G-
37, as currently in effect, covers indirect as well as direct 
contributions to issuer officials, and alerting dealers that the MSRB 
has expressed to the enforcement agencies our concern that some of the 
increased political giving may indicate a rise in indirect Rule G-37 
violations.\14\
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    \14\ While Rule G-37 was adopted to deal specifically with 
contributions made to officials of issuers by dealers and municipal 
finance professionals, and PACs controlled by dealers or MFPs, the rule 
also prohibits MFPs and dealers from using conduits-be they political 
parties, PACs, consultants, lawyers, spouses or affiliates-to 
contribute indirectly to an issuer official if such MFP or dealer can 
not give directly to the issuer without triggering the rule's ban on 
business.
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     Similarly, while the MSRB believes that its consultant disclosure 
requirements have been effective in bringing to light many aspects of 
dealer practices with respect to the use of outside consultants to 
solicit municipal securities business, the MSRB believes that some 
consultant practices may present challenges to the integrity of the 
municipal securities market.\15\ As a result, the MSRB is considering 
the possibility of rulemaking that would ensure that the basic 
standards of fair practice and professionalism embodied in MSRB rules 
are applied to the process by which municipal securities business is 
solicited. Thus, the MSRB has recently published for comment a draft 
amendment to Rule G-38 that would repeal existing Rule G-38 relating to 
consultants and replace it with a requirement that paid solicitations 
of municipal securities business on behalf of a dealer be undertaken 
only by persons associated with the dealer. The Board currently is 
considering a broad range of comments received from industry 
participants and remains open to all reasonable alternatives that might 
prove effective at addressing the Board's concerns in this area.
---------------------------------------------------------------------------
    \15\ The MSRB has noted in recent years significant increases in 
the number of consultants being used, the amount these consultants are 
being paid and the level of reported political giving by consultants. 
The MSRB is concerned that some of these political contributions may be 
indirect violations of Rule G-37. The MSRB also is concerned that 
increases in levels of compensation paid to consultants for 
successfully obtaining municipal securities business may be motivating 
consultants to use more aggressive tactics in their contacts with 
issuers. These activities suggest that disclosure may not be sufficient 
to ensure that those who market the dealer's services to issuers act 
fairly.
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Adapting to Changes in Conditions--529 Plans
    An important area in which the MSRB has adapted its rules to ensure 
investor protection in a rapidly evolving market has been the Section 
529 college savings plan market. Although in outward appearance greatly 
resembling mutual funds, 529 plans are municipal securities issued by 
state entities as savings vehicles for paying college costs. Because 
they are not debt instruments--like bonds and notes--but instead are in 
effect shares in a pooled investment fund, many of the MSRB's long-
standing customer protection rules originally crafted for debt 
securities were updated to reflect the new reality of the ever-
diversifying municipal securities market created by the advent of 529 
plans.
     The MSRB has in place a broad array of customer protections under 
its rules for 529 plans marketed by dealers.\16\ These include rules on 
suitability, fair and reasonable commissions and sales loads, 
advertising, disclosure and sales practices. In addition, the Board has 
just published for comment two rulemaking proposals to further 
strengthen customer protections by establishing requirements for 
including standardized performance data in dealer advertisements of 529 
plans and by placing limitations on sales incentives that can be given 
or received by dealers in connection with the sale of 529 plan shares 
and other municipal securities. Since--just as in the case of municipal 
bonds--529 plans operate in a political environment, the MSRB's 
political contribution and consultant rules also apply to dealers 
seeking to engage in the 529 plan business. The Board has also created 
a licensing exam designed to test specifically for a thorough 
understanding of the 529 plan products and relevant MSRB rules.
---------------------------------------------------------------------------
    \16\ However, unlike in the municipal bond market, many state 529 
plans by-pass dealers to directly market to customers using state 
personnel. These state personnel are not subject to the MSRB's investor 
protection rules. In addition, some banks that market 529 plans may, as 
a result of the definitions of ``broker'' and ``dealer'' under the 
Gramm-Leach-Bliley Act, not be subject to our investor protection 
rules.
---------------------------------------------------------------------------
    As in the municipal bond market, the MSRB has worked to provide 
education on 529 plans to the dealer community and to create a dialogue 
with all parties active in the market--not just the regulated dealers--
to help foster an understanding of the fundamental need to ensure 
investor protection in this wholly retail market. The Board has long 
been an advocate for thorough and timely disclosure by state 529 plans. 
The MSRB applauds the College Savings Plan Network's recent effort in 
establishing voluntary disclosure guidelines for state 529 plans. We 
look forward to reviewing their draft guidelines and are hopeful that 
they will greatly increase the quality, comparability and accessibility 
of information available to customers seeking to save for the rising 
costs of college education.
Conclusion
    The MSRB will continue to monitor the municipal securities market 
as it further evolves to include more diversified and complex new 
structures and techniques, as dealers, issuers, investors and others 
increasingly rely on new technologies. As it has in the past, the Board 
will remain vigilant and will not hesitate to modify its rules and 
information systems to deal with the ever-changing marketplace.





               PREPARED STATEMENT OF CHRISTOPHER M. RYON
         Principal and Senior Municipal Bond Portfolio Manager
                           The Vanguard Group
                             June 17, 2004
Introduction
    Chairman Shelby, Ranking Member Sarbanes, Members of the Committee, 
my name is Christopher Ryon. I am a Principal and Senior Municipal Bond 
Portfolio Manager at The Vanguard Group, a mutual fund company based in 
Valley Forge, Pennsylvania.
    Vanguard is one of the world's largest mutual fund families, 
managing more than $725 billion for nearly 18 million shareholder 
accounts. Vanguard offers 131 mutual funds to U.S. investors and over 
35 additional funds in foreign markets. Vanguard's offerings include 12 
corporate bond funds with over $73 billion in assets and 14 municipal 
bond funds with over $43 billion in assets. Appendix A shows the number 
of shareholder accounts, the number and types of mutual funds, and the 
total assets under management at Vanguard.
    Along with three other portfolio managers, four traders, and a team 
of municipal bond analysts, I oversee the management of over $43 
billion in Vanguard municipal bond fund assets. I am pleased to be here 
representing Vanguard to discuss the U.S. bond market. My testimony 
will focus on the following four areas:

    1) Bond ownership: I will review how ownership in the municipal 
bond market closely resembles that in the stock market, with individual 
investors and mutual funds owning substantial portions of the market.

    2) Bond trading: I will discuss briefly how the bond market and, in 
particular, the municipal bond market continues to trade primarily over 
the counter. Unlike the stock market, there are no organized National 
exchanges in the municipal bond market, and there is little prospect of 
change in the future.

    3) Bond pricing transparency: I will briefly review how pricing 
transparency in the bond market has improved in the past 10 years. 
Other than in the Treasury market, there exists no real-time pricing in 
the bond markets as there is in the stock market. However, rules 
proposed by the Municipal Securities Rulemaking Board (MSRB) would 
greatly enhance the reporting of municipal bond trades much as the 
TRACE system has started to enhance transparency of corporate bond 
trades. As a fiduciary responsible for the investments of hundreds of 
thousands of municipal bond fund investors, Vanguard strongly commends 
the MSRB's efforts to improve municipal bond market price transparency. 
We also commend the recent progress in enhancing corporate bond market 
transparency through the TRACE system.

    4) Issuer financial condition transparency. I will explain that 
there have been important and beneficial steps in the past to improve 
municipal issuer financial disclosure (most notably, SEC rule 15c2-12). 
However, Vanguard recommends that lawmakers, regulators and industry 
participants continue to consider whether more may be done to improve 
issuer financial condition transparency in the municipal bond market 
for the protection and benefit of municipal bond investors.
Background
Bond Market Segments
    The bond market can be divided into four market segments: Treasury, 
government agency, corporate/foreign, and municipal.

 The Treasury bond market is a multitrillion dollar market of 
    securities issued by the U.S. government.

 The U.S. government agency market consists of bonds issued by 
    various Federal agencies such as the Government National Mortgage 
    Association or GNMA.

 The corporate/foreign bond market consists of bonds issued by 
    companies seeking to raise capital for plant, equipment, or other 
    types of investments.\1\
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    \1\ For reporting purposes, corporate and foreign bonds are 
categorized together. The category includes debt obligations of U.S. 
financial and nonfinancial corporations and foreign entities.

 The municipal bond market consists of bonds issued by states, 
    municipalities, and state-created taxing authorities. Municipal 
    bond proceeds are used by municipalities to finance projects 
    ranging from school, road and sewer construction to industrial 
    development. In the past, municipal bond buyers and sellers 
    consisted primarily of individuals who were attracted to the tax 
    benefits of municipal bonds (municipal bonds pay interest exempt 
    from Federal and sometimes local taxation).\2\
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    \2\ Because of their tax-exempt status, municipal bonds generally 
carry a lower yield than their taxable counterparts. Institutions and 
wealthy individuals who pay high marginal tax rates have been the 
largest buyers of municipal bonds because the tax benefits outweigh the 
decreased yield.
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Bond Ownership
    Appendix B shows the ownership interests of households, mutual 
funds, and other entities in the corporate equities market and in the 
four segments of the bond market. It underscores the degree to which 
individual investors are significant owners in the municipal bond 
market, both directly and through mutual funds.
    Mutual funds provide investors with a distinct advantage over 
direct investment in the bond market. Mutual funds give investors low-
cost access to the market and give them access to professional 
portfolio management. They also provide investors with diversification 
that will mitigate the risk of loss in the event certain bonds lose 
value. Finally, mutual funds provide investors with liquidity.
    As shown in Appendix B, there are significant differences in the 
ownership makeup of municipal bonds on the one hand and Treasury, 
government agency, and corporate/foreign bonds on the other. For 
instance, the Treasury bond market has substantial foreign ownership, 
with owners outside the U.S. representing 37 percent of the market. And 
the government agency and corporate/foreign bond markets have 
significant institutional ownership, with commercial banks and life 
insurance companies representing 22 percent of the agency market and 30 
percent of the corporate/foreign market.
    In contrast, ownership in the municipal bond market more closely 
resembles that of the stock market, with the majority of the market 
owned by households and mutual funds. In 2003, 51 percent of municipal 
bond holdings was attributable to individuals owning municipal bonds 
either directly (36 percent) or through mutual funds (15 percent). 
These figures parallel ownership in the stock market (where households 
own 37 percent and mutual funds own 20 percent). By comparison, the 
corporate/foreign bond market has only 22 percent individual ownership, 
either directly or through mutual funds, down from 25 percent in 1999.
Bond Trading
    Unlike the stock market, trading in the U.S. bond market is done 
primarily over the counter (OTC). The OTC market is quite different 
from the organized exchanges on which most stocks trade. There is no 
central location or computer network in the OTC market. Rather, the OTC 
market is comprised of a large number of brokers and dealers who deal 
with each other by computer or telephone on behalf of buyers and 
sellers. Over-the-counter trading dominates the municipal bond market 
to a greater extent than other segments of the bond market. 
Traditionally, the municipal bond market has existed in localized state 
and municipal markets, where there was a small community of buyers and 
sellers and little National interest.
    Today, municipal bonds are a significant part of U.S. financial 
markets, but the diverse and decentralized nature of the market still 
discourages development of an organized exchange. Several overriding 
characteristics of the municipal bond market make it likely that OTC 
trading will continue to dominate going forward:

 Market size and trading volumes. Notwithstanding its growth in 
    recent years, the municipal bond market is considerably smaller in 
    value relative to the stock and corporate/foreign bond markets. 
    Appendix B shows that at the end of 2003 the corporate stock market 
    totaled $15.5 trillion; the combined corporate/foreign bond market 
    was $6.8 trillion; and the municipal bond market was $1.9 trillion. 
    The municipal bond market is also considerably smaller in terms of 
    trading volumes. The daily buying and selling of municipal bonds 
    involves less than 1 percent of the market. There are about 30,000 
    daily trades involving 10,000 issues in municipal bonds compared to 
    an average of 4 billion shares traded daily on major equity 
    markets.

 Number of issuers. The municipal bond market is significantly 
    more diverse and larger than the stock and corporate/foreign bond 
    markets in terms of the numbers of issuers. The stock market, for 
    example, consists of approximately 8,500 issues that trade 
    electronically or on the New York, Nasdaq and American Stock 
    Exchanges. The corporate bond market consists of about 7,300 
    issuers. By contrast, the municipal bond market is comprised of 
    over 51,000 issuers and has about 1.3 million different securities 
    outstanding.

 Lack of concentration. The municipal bond market is 
    significantly less concentrated than the corporate bond market in 
    terms of underwriting activities. Appendix C lists the top 10 
    underwriters in the corporate and municipal bond markets. In the 
    corporate bond market, the top 10 underwriters account for 84.85 
    percent of the underwritings, compared to 69.05 percent in the 
    municipal bond market. The average issue size in the corporate bond 
    market ($ 122,938,000) is nearly five times larger than the average 
    issue size in the municipal bond market ($ 26,659,000).

    The diverse and decentralized features of the municipal bond market 
make it difficult to centralize trading at a limited number of trading 
locations, and it is unlikely that an organized National exchange will 
evolve in the municipal bond market in the immediate future.
Bond Pricing Transparency
    Substantial progress has been made with respect to price 
transparency in both the corporate and municipal bond markets.\3\
---------------------------------------------------------------------------
    \3\ Price transparency refers to a buyer's and seller's ability to 
obtain current and accurate valuation information and bid/ask spreads 
on a particular bond.
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Corporate Bond Market Price Transparency
    Price transparency in the corporate bond market has traditionally 
been problematic, particularly for individual investors.\4\ Until 
recent years, corporate bond buyers had to rely on broker/dealer bid/ 
ask spreads to obtain pricing information. Buyers had no way of knowing 
whether the bid/ask spread they were being given was reasonable or if 
they were being asked to overpay. There was no centralized exchange 
where recent trade prices were reported. Large institutional investors 
had a distinct advantage over smaller investors because they had access 
to multiple dealers. They could ``shop'' for bonds by calling on a 
number of dealers and purchasing from the dealer that was offering the 
lowest price.
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    \4\ In contrast, price transparency in the Treasury market has been 
excellent as it is a highly liquid, single issuer market with several 
trillion dollars in frequently traded outstanding debt. All levels of 
investors from institutions to individuals have access to reliable and 
thorough Treasury bond information.
---------------------------------------------------------------------------
    In recent years, price transparency has improved because of the 
central reporting system developed by the National Association of 
Securities Dealers, called the Trade Reporting and Compliance Engine 
(TRACE). Recent improvements to TRACE have resulted in a greater number 
of corporate bond trades being reported to the market in a shorter 
period of time following execution. Brokers and dealers who are members 
of the NASD are required to report corporate bond transactions on a 
same-day basis for both investment grade and a very limited number of 
high-yield securities. Thinly traded corporate bonds remain difficult 
to price as they are not continuously traded and, therefore, not 
frequently reported on TRACE.
Municipal Bond Market Price Transparency
    The MSRB has made important progress on pricing transparency in the 
last 10 years. Efforts by the MSRB to improve reporting began in 1994 
when inter-dealer transactions were first required to be reported. In 
1998, dealers began reporting customer trades, and the MSRB began 
reporting next-day price information on both inter-dealer and customer 
transactions involving bonds that traded four or more times per day. 
Price transparency developed further in 2000 when individual trade data 
was reported. In 2003, the MSRB began T+1 reporting for municipal bond 
transactions and eliminated the threshold that only mandated reporting 
on bonds that traded four or more times per day. And, finally, a new 
MSRB rule (Rule G-14), which is scheduled to become effective in the 
beginning of 2005, would require brokers and dealers to report 
transactions in municipal securities within 15 minutes of the time of 
trade. We believe that increasing municipal bond market price 
transparency and comparability to other over-the-counter fixed income 
markets will improve investor confidence in the municipal market.
    There are many potential benefits to improved price transparency. 
Mutual funds, for example, would be able to use reported bond prices to 
improve pricing of fund portfolios. Also, enhanced price transparency 
would likely narrow bid-ask spreads and give consistency to spreads 
among large and small investors. It would also allow regulators to 
better monitor the market. Data suggests that limited price 
transparency disadvantages small investors because spreads are bigger 
when trades are smaller. Appendix D demonstrates how bid/ask spreads 
narrow as trade sizes increase. As shown on Appendix D, a trade between 
$0 and $50,000 on a randomly selected day in September 2003 was an 
average of 190 basis points wider than trades of over $1 million.
    Some municipal market participants do not support the MSRB in its 
efforts to increase pricing transparency, especially for inactively 
traded securities (which often are of lower quality). They argue that 
the market liquidity of these issues would decrease as dealers become 
concerned about competitors knowing the approximate price of their 
newly acquired positions. We disagree. Any short-term dislocations 
would be inconsequential compared to the long-term benefits offered by 
enhanced pricing transparency. The interests of the millions of mutual 
fund shareholders and individual bondholders are best served with the 
highest degree of price transparency.
    Appendix E summarizes the efforts by the NASD to increase price 
transparency in the corporate bond market through the TRACE central 
reporting system, and the recent MSRB initiative to implement real-time 
reporting of pricing information in the municipal bond market.
Issuer Financial Condition Transparency
Historical Context
    Although considerable progress has been made with respect to 
pricing transparency in recent years, issuer financial condition 
transparency is proceeding slowly in the municipal bond market. The 
cost of mandating issuer financial condition disclosure has been 
considered prohibitive for smaller issuers; however, technology may 
afford new and unprecedented opportunities to provide institutional and 
individual investors with consistent and appropriate financial 
information to make informed investment decisions.
    At the time Congress was enacting sweeping new securities laws in 
the 1930s, municipal bonds were largely exempted from Federal 
regulation. They were made subject to the securities laws' general 
antifraud provisions so that market participants could be disciplined 
for misleading and fraudulent behavior. However, municipal securities 
were not subject to the same registration and reporting requirements 
that applied to equity and corporate issuers. At the time the new 
securities laws were enacted, municipal securities were deemed to be 
local in nature and relatively straightforward general obligation 
bonds. There had been no large-scale municipal securities defaults that 
threatened the integrity of the market, as had happened in other 
segments of the financial markets.
    Since the 1930s, all of the factors that convinced lawmakers to 
impose limited Federal oversight of the municipal bond market have 
changed. The localized nature of the market is gone and municipal bonds 
trade on a Nationwide scale. The market no longer consists solely of 
straightforward general obligation bonds but also is now comprised of 
complex instruments. There are sophisticated varieties of revenue bonds 
that are not backed by governmental full faith and credit. And, 
finally, the municipal bond market was touched by a number of defaults 
that caused legislators and regulators to take action.
The MSRB and the Tower Amendment
    In the 1970's, Congress responded to a large-scale fiscal crisis 
involving municipal debt obligations in New York City. The Securities 
Acts Amendments of 1975 resulted in unprecedented Federal intervention 
into the municipal bond market. The 1975 amendments created the MSRB, a 
self-regulatory agency designed to enhance investor protection subject 
to SEC oversight. However, in order to balance investor protection with 
states' rights, Congress placed restrictions on Federal regulators by 
including the Tower Amendment with the 1975 amendments.
    The Tower Amendment limits the SEC's and MSRB's ability to regulate 
municipal bond issuers in the same way that the SEC regulates stock and 
corporate bond markets. Issuers cannot be required to file with the SEC 
or MSRB "prior to sale" any application, report, or document in 
connection with issuance, sale, or distribution of securities.
SEC Rule 15c2-12
    In the late 1980's, there was another large crisis in the municipal 
bond market, this time resulting in a bond default by the Washington 
Public Power Supply System. In response, the SEC took steps to improve 
municipal bond financial disclosure by mandating certain limited 
disclosures by municipal bond underwriters and dealers under SEC rule 
15c2-12. Because the SEC is restricted by the Tower Amendment from 
directly regulating municipal bond issuers, rule 15c2-12 regulates only 
bond underwriters and dealers.
    SEC rule 15c2-12 requires primary bond offerings over $1 million to 
be accompanied by certain limited financial information. Specifically, 
rule 15c2-12 requires that municipal bond underwriters obtain 
``official statements'' from issuers and review them before the initial 
distribution. Underwriters are obligated to provide investors with the 
``official statement'' so that investors can obtain certain limited 
information about a particular bond before purchasing it.
    Under rule 15c2-12, there is also a unique, albeit limited, 
requirement for secondary market disclosure with respect to long-term 
debt. Underwriters, pursuant to written agreements by issuers, are 
required to obtain limited annual financial information and notice of 
certain material subsequent events. Secondary market information is 
distributed through a private network of information repositories, 
known as Nationally Recognized Municipal Securities Information 
Repositories. An issuer selling directly to investors without 
assistance of underwriters or dealers is not subject to rule 15c2-12.
Conclusion
    Voluntary steps taken by issuers, self-regulatory organizations and 
investors to improve price transparency in the corporate and municipal 
bond markets should be commended. As a fiduciary responsible for the 
investments of hundreds of thousands of municipal bond fund investors, 
Vanguard strongly supports the MSRB's efforts to improve price 
transparency in the municipal bond market, and Vanguard recommends that 
these efforts continue as they have enhanced investor protection.
    In addition to price transparency, efforts should continue to 
improve financial condition transparency in the municipal bond market. 
We commend voluntary efforts by industry participants to enhance 
secondary market disclosure concerning issuer financial conditions, and 
encourage such work to continue. The SEC's previous efforts to improve 
disclosure through rule 15c2-12 have been effective and beneficial. 
However, Vanguard recommends that lawmakers and regulators continue to 
monitor developments and consider whether more may be done to improve 
issuer financial condition transparency in the municipal bond market 
for the protection and benefit of municipal bond investors.




                   PREPARED STATEMENT OF ARTHUR WARGA
                  Dean, C.T. Bauer College of Business
         Judge James A. Elkins Professor of Banking and Finance
                         University of Houston
                             June 17, 2004
    The purpose of this report is to provide the Senate Banking 
committee with my perspective of the domestic corporate and municipal 
bond markets with regard to current issues including market structure, 
regulatory framework, trade reporting and price transparency. My focus 
will be on the potential benefits of greater price transparency, but I 
will also comment briefly on several of the other issues.
Overview
    The bond markets have evolved into an over-the-counter system 
geared to institutional-sized transactions. The cost structure for both 
corporate and municipal securities in this market appears to be 
competitive for institutional-sized trades.\1\ The cost of transacting 
retail-sized trades carried out in this dealer-market can best be 
described as ``punishing'', and are five times the size of those found 
for institutional-sized trades.\2\ In the dealer market, about 65 
percent of corporate bond trades are retail-sized, but these trades 
only generate 1.8 percent of the dollar volume of trade in the market. 
This contrasts with the municipal market, where retail trades also 
comprise the majority of activity, but account for 40-50 percent of the 
dollar volume.
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    \1\ See Hong and Warga (2000) for evidence on cost structure in the 
corporate bond market. There is no formal definition of an 
institutional versus retail trade. For the purpose of this discussion 
we call any trade of less than or equal to 100 bonds ($100,000 par 
value) retail, and any trade equal to or greater than 500 bonds (.5 
million par) institutional. The grey area will go unnamed.
    \2\ The factor 5 refers to median bid/ask spreads. The most 
trustworthy evidence for this claim comes from studies of retail-sized 
trades in the municipal bond market. An article forthcoming in the 
Journal of Fixed Income by Hong and Warga (2004) and a study by the SEC 
(Harris and Piwowar (2004)) both reveal bid-ask spreads (cost of a 
round-trip transaction) for retail-sized transactions averaging well 
over 2 percent of par value. There is no published evidence on retail-
sized bid-ask spreads in the dealer market, but based on my discussions 
with NASD and my involvement with the bond market transparency 
initiatives there I believe the cost structure to be similar to that 
found in municipal securities.
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    Trades carried out on the NYSE's Automated Bond System (ABS) \3\ 
are almost exclusively retail-sized and reveal a cost of trade similar 
to the institutional-sized trade costs in the dealer market \4\, 
although commissions can significantly increase the net cost for very 
small trades (say five bonds or less). It would be helpful if the NASD 
included a comparison of the known trading costs on ABS with the yet-
to-be-revealed (as least publicly) trading costs in the dealer market 
in their current study of the trading environment. This comparison will 
also aid the SEC in determining potential benefits of removing 
obstacles to retail-trade activity on the ABS or like system. \5\
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    \3\ See Appendix A for a description of this market.
    \4\ See Hong and Warga (2000)
    \5\ According to newswire reports I have read recently, 
registration requirements mandated by the ABS's exchange status (and 
that are not imposed on the dealer market) are viewed by the NYSE as a 
significant hurdle to achieving levels of liquidity that would help 
make ABS a more viable market for retail trades.
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The Value of Transparency
    To begin, I believe it is important to understand that in any 
market transparency is of greatest potential value when the underlying 
security is one that the marketplace has a structural need to trade on 
a frequent basis. I believe that even in a transparency-enhancing 
environment in which all bond transactions are reported centrally and 
publicly in a short period of time after they occur, there will always 
be large segments of the bond universe for which a lack of transparency 
and liquidity remains because of the fundamental characteristics of 
bonds.
    Liquidity is the ability to transact over a short period of time 
without adversely affecting the price of a security. It has been 
suggested that liquidity can be enhanced by introducing price 
transparency because the market has pent up demand for trading 
securities and that transparency leads to greater willingness to trade. 
The opposite contention is also likely to be true. That is, a 
fundamental lack of demand to trade can create a lack of transparency 
that is wholly independent of the presence of a transparency-enhancing 
environment. Trade and liquidity in bonds declines rapidly a short 
period after a bond is first issued. This is because bonds are for the 
most part what is referred to as ``buy and hold'' securities.
    Figure 1 provides typical values of volatility for a variety of 
securities. Volatility generally correlates positively with the value 
of adding transparency. If there is an underlying demand to trade 
frequently then transparency can help a market be more liquid. 
Volatility causes portfolio holdings to need readjustment, which in 
turn generates a need to trade.
    There are markets where transparency has the potential to add 
liquidity, but the market is young and hasn't evolved into and 
efficient form. Prime examples are the energy markets. While exchange-
traded products currently exist for oil and gas, there are still many 
nonexchange traded securities for which the markets are virtually 
opaque or dependent on newsletter-like surveys for price discovery 
(that is Platts). At the extreme, the market for power several months 
to several years out into the future lacks any transparency, and yet 
the potential benefits of transparency are (I believe) very large. In 
the very least, the payoff of more credible marked-to market accounting 
calculations in the energy sector would seem to be worth the effort of 
fast-forwarding transparency in this market sector.
    Within the bond markets, the greatest potential benefit of 
transparency is in the high yield sector. It is interesting that the 
NASD's TRACE initiative remains to this day silent in its public 
reporting of high yield transactions,\6\ although I am aware that such 
reporting is inevitable. The NASD is to be commended on their TRACE 
initiative in that they have developed a powerful reporting tool 
capable of providing nearly immediate trade reports for a broad range 
of bonds. This initiative follows in the heels of the MSRB's price 
reporting initiative, and the two projects have created a sea-change in 
terms of the bond markets' ability to provide transparency for actual 
transactions. These price reporting initiatives do not provide 
transparency in terms of supply and demand schedules. That is, unlike a 
system such as ABS, they do not allow potential buyers and sellers to 
view actual firm offers to buy or sell a given quantity of a bond at a 
given price.
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    \6\ I ignore the long-standing FIPS high yield trade reporting 
initiative that has been based on only 50 issues representing the most 
liquid portion of the high yield market because of the small number of 
bonds and representation by issues least likely to have information 
problems in the market.
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     One of the main benefits of TRACE and the MSRB price reporting 
systems is that quality data will be more broadly available for market 
participants to employ in models that help determine estimated prices 
for securities that trade infrequently (the vast majority of bonds fall 
under this category). Net Asset Value (NAV) calculations for bond 
mutual funds have always been (in my mind) a very problematic exercise 
carried out with prices supplied by bond pricing services\7\ that are 
naturally handicapped by the lack of immediate access to actual 
transaction prices.\8\
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    \7\ A partial list of examples are Merrill Lynch Bond Pricing 
Service (for corporates), Mueller and J.J. Kenny (for municipals).
    \8\ Because of liquidity effects, bond price is also properly 
viewed as a function of quantity purchased or sold, and it is not clear 
that adequate information is provided in the current TRACE system to 
add much value to pricing algorithms that account for quantity effects. 
This is more of a problem for high yield than for investment grade 
issues.
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Investment-Grade Bond Trades
    Corporate and municipal bonds, especially investment grade issues, 
are purchased primarily as nonspeculative investments. On the 
institutional buy-side, bonds are purchased because they satisfy 
certain criteria that a bond portfolio manager seeks. Their behavior is 
much more predictable than stocks, and so it is possible to know a lot 
about how they will fit into the manager's portfolio over much of their 
life. Portfolio managers rarely purchase investment-grade corporate 
bonds with the intention of selling them in the near term. As bonds age 
past their issuance date and are absorbed into portfolios, their 
liquidity rapidly disappears.\9\ The fact is most bonds do not trade on 
any given day (or week, or even month) because there is no reason for 
them to trade.
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    \9\ This is documented, for example, by Schultz (2001). This effect 
is also apparent with U.S. Treasury issues. See Sarig and Warga (1989) 
for documentation of this effect.
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     It is worth noting the historical evolution of both stock and bond 
markets in the United States. The New York Stock Exchange, which 
provides a central and immediate reporting system, originally began as 
a bond exchange. The simple fact is that the speculative nature of 
stocks and high demand for frequent trading in them naturally led to a 
market system vastly different from bonds. In the natural evolution of 
markets transparency is a consequence of the type of security being 
traded and investor's demand for frequent trade. If the securities 
being traded do not by their nature require frequent trading, then it 
is perfectly reasonable to find that the market for those securities 
has evolved into a system with less apparent transparency than, say, a 
stock market.
    It is important to reemphasize the point that for corporate bonds, 
institutional buyers account for 98 percent of the dollar volume of 
trade. These buyers are professionals, often with the staff necessary 
to call multiple dealers. Dealers in turn often call upon professional 
staffs to provide additional portfolio services demanded by buyers. 
Indeed, bid-ask spreads often include implicitly costs for services 
required by buyers (such as solving portfolio, research, and strategy 
problems) \10\. Markets have evolved in a manner to permit dealers to 
bundle these portfolio services, which often require near-immediate 
trade execution.\11\ Electronic trade and reporting systems are not 
capable of providing this bundle of services that is demanded by 
institutional investors. This provides at least a partial explanation 
as to why the NYSE's Automated Bond System (ABS) has succeeded only in 
attracting retail-sized trades.\12\
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    \10\ Examples are creating a dedicated portfolio meant to meet 
pension fund obligations, or a portfolio that is immunized against 
adverse interest rate movements.
    \11\ The largest and most sophisticated buy-side firms carry out 
most of their portfolio analysis with proprietary systems built in-
house, and probably would prefer a market structure where broker-
dealers offer as few services as possible.
    \12\ See the Appendix for a description and further discussion of 
ABS.
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     If bid-ask spreads are restricted to institutional sized trades of 
at least 500 bonds (.5 million par value), bid-ask spreads\13\ for 
corporate bonds are in the range of 7 to 15 basis points (100 basis 
points equals 1 percent). The bid-ask spreads for these trades, which 
are in fact typical of corporate bond market activity, rival the bid-
ask spreads of about 10 basis points found for the highest 
capitalization stocks on the New York Stock Exchange.
---------------------------------------------------------------------------
    \13\ Hong and Warga (2000) calculate bid-ask spreads of 13 basis 
points for investment grade, and 20 basis points for noninvestment 
grade issues. Consistent results are found in Schultz (2001) and 
Chakravarty and Sarkar (2003) using the same data base.
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     For investment grade bonds it is usually the case that price can 
be estimated within a narrow range of the correct value. The real 
question of interest to a buyer is what type of bond would his/her 
portfolio optimally require to meet its investment goal, and where 
would an appropriate inventory of that type of bond be found. 
Investment grade debt is characterized by the fact that there are often 
many near-perfect substitutes available. In other words, the demand by 
a portfolio manager is not necessarily for, say, a bond issued and 
backed by Citigroup, but in fact for an issue from an ``A'' corporate 
financial institution. Dealers therefore often play the role of 
providing the service of solving a portfolio strategy-related problem 
for a client, and then having in inventory certain classes of bonds 
(along with information about the covenants and other qualifying 
characteristics) so that the buyer will be assured of carrying out 
their fiduciary responsibility.
Non-investment Grade Bond Trades
    Non-investment grade debt contains a greater level of price risk, 
and this translates into more situations where the owner no longer 
finds that the bond qualifies for his/her portfolio. Also, the 
speculative motive to trade is greater than for investment grade 
issues.\14\ Unlike stock or investment grade bonds, the noninvestment 
grade corporate bond universe contains many issues from companies that 
are private. This means that information is harder to come by, and 
credit analysis becomes critical (this latter point is true even for 
public issues). Dealers maintain research departments to track changes 
in such companies, and this is a function that institutional buyers are 
not always equipped to carry out because of the great expense.
---------------------------------------------------------------------------
    \14\ See Blume, Keim, and Patel (1991).
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    High credit risk is often claimed to be captured in bond ratings. 
However, even if a bond is rated, when the information about a change 
in credit risk is needed most, the rating usually fails to reflect it. 
This is because bond ratings are only confirmatory in nature (and by 
design). Rating agencies often do not change ratings until several 
months after the event that triggers the need for a rating change (see 
Warga and Welch (1993)). Ratings can change 5-6 months after the 
marketplace has already acknowledged a change in credit risk through 
significant price moves (Hite and Warga (1997)).
    The discussion above points to why institutional buyers often have 
established relationships with dealers, and the reason is the ``value-
added''. Dealers can provide important services without charging an 
explicit fee because their costs can be embedded in their bid-ask 
spreads. While some of the services sought by buyers can be unbundled 
and provided by third parties, it is often convenient to have ``one-
stop shopping''. For all of the aforementioned reasons, it is not 
surprising to find that retail trades carried out in the dealer market 
face a cost structure that is much higher than it probably needs to be.
Municipal Bond Trading
    The Municipal Bond market differs greatly from the corporate bond 
market in several respects. The prime differentiator is that a 
significant portion of this market involves retail-sized trades (100 
bonds or less) for individual accounts. According to the Bond Market 
Association (BMA) as of 2 years ago there were 1.4 million Municipal 
issues outstanding (about 10 times the number of corporate issues). The 
tax advantages enjoyed by many munis and their low degree of risk (most 
are ``AAA'', a rating often achieved through ``prerefunding'' or 
insurance) make them an attractive investment for many individuals as a 
hedge against their stock and other investments. There is often little 
speculative motive in their purchase, even less than for high-grade 
corporates. Relatively small issue sizes and obscure details about 
specific revenue projects or taxing authority rights and privileges 
make these securities even less transparent than most corporates.
    The muni market underwent a dramatic change in the level of price 
transparency beginning in 1999. The Municipal Securities Rule Board 
(MSRB) through the Bond Market Association (BMA) has made next-day 
pricing and quantity available through a web site and data service.\15\ 
Aside from price and quantity of each transaction, it is also possible 
now to obtain the time of the transaction and whether the trade was a 
dealer buy, a dealer sale, or dealer-dealer. In a short period of time 
the muni market went from being one of the more opaque markets to one 
of the more transparent ones.
---------------------------------------------------------------------------
    \15\ See www.investinginbonds.com. The service started out 
reporting high-low prices for the day and quickly proceeded to add 
individual trade details. It is my understanding that near real-time 
reporting of municipal bond transactions is imminent.
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    The effects of muni transparency provide a cautionary tale for 
those purporting dramatic changes in the corporate market. Munis remain 
relatively illiquid, as illustrated by the persistence of bid-ask 
spreads to remain at or above their previous levels. In research I have 
conducted based on a complete record of muni transactions in May of 
2000, and for transactions in Texas and Florida in September of 2000, 
it is clear that spreads are at or above the levels cited for 
comparable issues in the study by Chakravarty and Sarkar (2003) that is 
based on transactions from 1995-1997. This observation is also 
confirmed in work described recently in The Wall Street Journal by the 
SEC Chief Economist Lawrence Harris and staff economist Michael Piwowar 
(2004) who also examine data from the year 2000.
    While an update through 2004 is needed to confirm the continued 
high cost of transacting in the muni market (for retail trades), it is 
safe to say that the transparency added by the price reporting system 
put in place by the MSRB is at best having a slow-moving effect on the 
cost structure for municipal trades. This simply reflects the fact that 
the market is geared to institutional trading and/or is dealing with 
complex securities that require a costly trading environment.
Appendix A--The New York Stock Exchange's ABS System
    Since 1976-77 bonds have traded on the NYSE's Automated Bond System 
(ABS), which can be described as a fully automated electronic trading 
and information system whose schedules of bid and ask prices are fully 
transparent. In general, trading on ABS is relatively thin and trades 
on the ABS are typically retail-sized (under one hundred bonds).
     Despite the small size of the ABS market, the most actively traded 
issues not only rival the dealer market in terms of both frequency of 
trade and dollar volume of trade, but in some cases even dominate the 
dealer market. In a recent paper examining hourly trade reports from 
the Nasdaq-based Fixed Income Pricing System (FIPS), Hotchkiss and 
Ronen (2002) find that fourteen ABS-traded bonds have median 
transaction frequency equal to twenty-five percent of the entire dealer 
market, with a high figure of eighty-one percent. Based on actual 
transaction data collected over the 1995-1997 period, Kalimipalli and 
Warga (2002) find more direct evidence that frequently traded bonds on 
ABS often have volume equal to or exceeding the entire dealer market. 
Frequently traded bonds on ABS are almost exclusively noninvestment 
grade.
    Unlike its counterpart stock market, there is no specialist in the 
NYSE bond market. Instead, there are brokers who are subscribing 
members of the ABS. As of 2002, there were 58 ABS member brokers 
operating on about 210 terminals. The member brokers usually trade on 
behalf of their customers, though at times they could trade for their 
own account. Member brokers receive limit orders from the public and 
enter the corresponding bid-ask quotes and the respective quantities 
into the automated system. They also enter their own quotes into the 
system. Liquidity to the ABS market is therefore jointly supplied by 
public limit orders and dealers' own quotes. The ABS matches the orders 
automatically and informs the member brokers once an order is executed. 
The ABS is thus a limit order market with a strict price-time priority. 
The ABS market is also very transparent. All subscribers to the ABS 
market have full access to the complete order schedule, which they can 
divulge to investors upon request.
References
        Bloomfield, R., and M. O'Hara, 1999. ``Can Transparent Markets 
        Survive?'' Journal of Financial Economics.

        Blume, M.,D. Keim, and S. Patel, 1991. ``Returns and Volatility 
        of Low Grade Bonds, 1977-1989.'' Journal of Finance, vol.46, 
        no.1, March.

        Chakravarty, S. , and A. Sarkar, ``Trading Costs in Three U.S. 
        Bond Markets,'' Journal of Fixed Income, 2003 June, Vol.13, 
        No.1.

        Harris, Lawrence and M. Piwowar, ``Municipal Bond Liquidity.'' 
        SEC manuscript. 2004.

        Hite, G., and A. Warga, ``The Effect of Bond Rating Changes on 
        Bond Price Performance'' (with G. Hite), Financial Analysts 
        Journal, Vol. 53, No.3, May/June 1997. . Abstracted in CFA 
        Digest.

        Hong, G. and A. Warga. ``An Empirical Study of Bond Market 
        Transactions,'' Financial Analysts Journal, March/April 2000.

        Hong, G. and A. Warga (2004), ``Municipal Marketability,'' 
        forthcoming, Journal of Fixed Income.

        Hotchkiss, E. and T. Ronen, 2002. ``The Informational 
        Efficiency of the Corporate Bond Market: An Intraday 
        Analysis.'' Review of Financial Studies., Vol. 15, No.5

        Kalimipalli, M. and A. Warga, 2002. ``Bid/Ask Spread and 
        Volatility in the Corporate Bond Market.'' Journal of Fixed 
        Income, March.

        Madhavan, A, 1995. ``Consolidation, Fragmentation, and the 
        Disclosure of Trading Information,'' Review of Financial 
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        Sarig, O. and A. Warga. ``Bond Price Data and Bond Market 
        Liquidity,'' Journal of Financial and Quantitative Analysis; 
        September 1989, Vol.24, No.3.

        Schultz, Paul, ``Corporate Bond Trading Costs: A Peek Behind 
        the Curtain,'' Journal of Finance, 2001, v56(2), 677-698

        Warga, A., and I. Welch. ``Bondholder Losses in Leveraged 
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        1993.


        

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