[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
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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
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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.
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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.
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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.
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\10\ See The Bond Buyer/Thomson Financial 2004 Yearbook at 84.
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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).
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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.
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\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.
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\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.
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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\
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\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.
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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.
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\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.
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\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.
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\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
Studies, Vol. 8, No. 3; Fall.
Sarig, O. and A. Warga. ``Bond Price Data and Bond Market
Liquidity,'' Journal of Financial and Quantitative Analysis;
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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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