Chairman and CEO, FINRA
FINRA Fixed Income Conference
New York, NY
March 9, 2010
Note: An audio podcast of this speech is available for download at www.finra.org/podcast.
Thank you Steve [Joachim] for that introduction and thank you all for coming to FINRA's Fixed Income Conference. This annual event is an opportunity to examine developments in the fixed income markets and how regulators are responding. Throughout the day, there will be sessions devoted to a range of issues that will be of interest to anyone working in the fixed income industry. And this year's conference is particularly timely—as it comes in the midst of sweeping changes to the fixed income markets.
The credit crisis has forever changed how all of us will operate in the fixed income marketplace. At the peak of the crisis, the core credit markets froze. There was an inability to determine fair and equitable prices, which made trading extremely difficult. Firms were unable to mark positions to market and mutual funds were unable to reliably compute net asset values. Without access to current information in these markets, nobody knew what a fair price was. The results were terrifying risks to the financial system and a profound impact on investors' confidence in the market place, as well as—let's face it—a serious gap in trust as to the industry's and regulators' capability to ensure market integrity. I think we all agree that we must do everything we can to regain that trust, and importantly, that we can no longer continue to operate without visibility into these products.
So as we look ahead to the new world in which fixed income markets exist, there is going to be greater transparency, and you can expect all regulators to take more aggressive action to ensure the integrity of these markets.
With that context, I would like to discuss some developments in the debt markets, highlight what you should expect to see on the regulatory front, and also address some of our concerns.
As you well know, the last five years have been an extremely volatile period in the fixed income markets. From 2005 to mid-2007, there was a remarkable rally with increasing prices, volume and new issues. But the rally ended in late 2007 starting in the securitized markets, quickly spread across all fixed income markets, and ultimately helped to plunge the U.S. and global economy into a recession.
By October 2008, the corporate bond market began its recovery, thanks in part to growing retail activity. With the uncertainty in the equity markets, individual investors moved directly and indirectly into fixed income products. This shift provided a potent reminder that the bond markets reflect economic cycles—the good and the bad—while also playing an integral role in them.
The fixed income markets have been a critical engine of the tremendous economic growth over the last 30 years, yet until recently they have largely been invisible to the public and the global political and governmental infrastructure. That has begun to change.
At FINRA, we have been actively working with the SEC, Treasury and the Federal Reserve to ensure more coordinated reviews of fixed income and related derivative markets. We are also pursuing information-sharing agreements with international regulators and, for the first time, we have conducted a joint examination with our counterparts in the UK and Canada. As a result, you can expect to see greater information flow and cooperation among regulators, both domestically and internationally.
Equally important, however, are efforts to enhance the transparency of fixed income markets. As you know, this sector had traditionally been opaque, given that it was largely a professional marketplace. Professionals had access to quotes but retail investors had no access to pricing information except from the broker-dealer. Spreads were relatively wide and no one had access to post-trade information. Portfolio and position pricing was based on matricies and models, as well as indicative quotes, though only when these quotes were available. No one really understood the macro trends in the market. But with the introduction of TRACE for corporate bonds and MSRB requirements for municipal security transaction reporting coupled with the response to the credit crisis, the approach to regulation has begun to change.
The Regulatory Agenda
From the standpoint of investor protection, which is and always will be FINRA's top priority, we simply must shed more light on "the darker" areas of the fixed income market. Transparency in these markets is central to ensuring best execution as well as fair markups (or markdowns). Without this information, it is difficult for investors to make informed investment decisions and it's impossible for regulators to monitor market activity.
FINRA's experience with reporting for corporate bonds has been positive. One reason why is that we've helped to clear up some misconceptions about the bond markets prior to the launch of TRACE. One of which was that conventional wisdom held that this was purely a professional market, the reality was that 65 percent of its trades were retail. Another concern expressed by market participants was that TRACE would reduce liquidity in the corporate bond market. In fact several studies have shown that implied spreads have narrowed by 50 percent and surveys of institutional portfolio managers consistently show that they believe that transaction reporting has improved the market for corporate fixed income securities. By most accounts this reporting also has not had a materially adverse impact on liquidity. One study also indicated that after the launch of TRACE the marks in mutual funds narrowed significantly. None of this is to suggest that transaction reporting does not require changes in the way firms provide liquidity for extremely large transactions in less liquid bonds but these findings underscore the positive results from transparency.
TRACE Expansion Into New Issues and Agencies
On March 1, we expanded TRACE to cover new issue data as well as agency debentures—an important step to enhance transparency in a critically important market. The expansion has worked well so far, though we experienced some challenges in handling the surge of new offering business in the first couple of days. We have also been reminded that because of the timeliness of the reporting, there is great value in this data for market participants and investors, and for regulatory reviews. Our market surveillance teams will look closely at this data for compliance with FINRA rules, with an initial focus on ensuring all of the data is accurate and timely. While we are aware that minor issues may arise in the early days of new issue and agency reporting, for which we will make appropriate allowances, firms should expect to hear from our staff if we detect serious reporting discrepancies.
We anticipate the addition of primary market data will supplement our existing regulatory audit trail and enhance our ability to detect fraud, unfair pricing and other types of misconduct. At the same time, I assure you that as we implement our surveillance programs we will remain keenly attuned to the differences that exist between the corporate and agency debt markets.
Finally, as part of our continuing effort to assist firms in monitoring their performance against their peers, we are working to publish quality of markets report cards for agency debt securities. These reports will provide firms with statistical summaries of their activity in both new issue and agency transactions and will also facilitate their compliance efforts.
The expansion of TRACE is complemented by the heightened attention we are giving to best execution in corporate bonds. There have been a growing number of best execution alerts and reviews, even after our automated surveillance reviews factored in heightened market volatility. To that end, we continue to investigate where it appears firms have not exercised reasonable diligence to determine the best market on behalf of their customers. It is essential that firms have written policies and procedures to supervise all debt securities execution pricing determinations.
FINRA has settled cases involving best execution in corporate securities and obtained substantial restitution for investors. In particular, we have pursued instances in which firms were unable to demonstrate that they took reasonable steps to determine the prevailing market for a security, particularly with regard to the number of markets checked. Additionally, we have settled matters involving instances in which firms acting in an agency capacity have passed on prices unrelated to the current market to its customers.
Another area of regulatory focus is markups. We continue to carefully review markups on transactions in light of FINRA's markup policy guidelines—both those above 5 percent and certain markups less than 5 percent—to ensure that customers are being charged fair and reasonable prices.
In this regard, FINRA recently has settled a number of cases involving markups less than 5 percent. In each matter, the markups charged were deemed to be excessive as they were significantly higher than the next highest markups charged by other member firms in the same security. The firms were sanctioned and restitution was provided to the customers. In addition, during markup investigations, we have pursued instances of unsuitable recommendations involving distressed fixed income securities and elderly investors. One recently settled matter resulted in a sanction and five month suspension for a registered representative who recommended the purchase of 21 distressed securities to an elderly couple, in addition to charging excessive markups.
TRACE Expansion to Securitized Products
Looking ahead, the SEC has also approved our rule to bring securitized debt products into TRACE. With over 1.2 million CUSIPs, we recognize the complexity of these products and we've heard the comments from some market participants indicating that there are portions of the market that are not fungible and very illiquid. We are still in the information-gathering phase, and once it's complete we will determine the best form of transparency for these products. We are moving forward and it's important for you to be a part of the solution, so we will be reaching out to involve members of the fixed income community.
Of course, we can dramatically enhance the transparency of fixed income securities but that alone will not address the implosion of the credit markets and manipulative concerns arising from the complete darkness of the OTC derivative markets. Congress is debating how to reform and modernize the regulations governing OTC derivatives, and credit default swaps in particular. It is widely believed that these instruments were significant contributors to the credit crisis, and we know they had a severe impact on at least one major financial firm. Many public-policy concerns related to the derivatives markets are awaiting resolution, including the lack of standardization, the absence of clearing houses, the overall lack of transparency and the absence of any clear regulatory jurisdiction and audit trail. Some solutions are being driven by regulators in cooperation with the industry, but there remains a tremendous amount to do. I don't know where the Congressional debate regarding exchange-like trading of CDS swaps will end up, but it seems clear that many securities and many end users will be outside the clearing or at least exchange traded framework. As a result, we have had conversations with policymakers and other regulators regarding these products and whether a TRACE-like vehicle would promote transparency.
Whatever the Congressional resolution ends up being, cross-product issues and the interplay between derivatives, fixed income and equities are of great concern to us, particularly in instances in which the derivative can either serve as a substitute for the underlying product or drive activity in the underlying market. Anyone who has watched the impact of derivative markets generally, and the CDS market in particular, recognizes that effective surveillance requires comprehensive review of all these markets. It is simply critical that all regulators with surveillance responsibilities have access to authoritative information regarding trading in the swaps markets.
Given the increasing importance and complexity of the fixed income market, there are several other issues that FINRA is closely monitoring.
First, as many of you know, we are carefully looking at debt market research and exploring whether fixed income analysts should be covered by the rules that apply to equity analysts. We are acutely aware of the significant differences in how fixed income and equity analysts operate. The best practices that were adopted by the Bond Market Association, prior to the creation of SIFMA, have served the industry well. But through our examination process, we have seen that there hasn't been universal or uniform adoption of those best practices. With all of this as a backdrop, we will be meeting with the industry to be certain that we fully understand the dynamics of this market and the role of the debt market research analyst with respect to the trading desks and its customers before we act.
We will also keep a close eye on technology changes in the fixed income arena. For example, we've seen some firms begin to use tools and techniques like algorithmic trading more actively in fixed income trading. So as trading activities previously reserved for equity trading move into the fixed income market, you can expect FINRA to deploy surveillance tools accordingly.
Finally, FINRA continues to be concerned about the retailization of certain complex, exotic or structured products. Many of these products have complicated terms, features and payout structures that can make it difficult for investors, and registered representatives, to accurately assess their risks and costs.
For example, reverse convertibles combine a short-term, high yield note with what is effectively a put option on an unrelated reference asset. Depending on the terms of the specific product and the performance of the reference asset, investors may end up with a full return of principal, or shares of stock worth considerably less than their initial investment.
Likewise, principal-protected notes are often marketed as combining the relative safety of bonds with a potential for growth not available with traditional fixed income products. But different principal-protected notes offer different degrees of principal protection, and the guarantee is subject to the creditworthiness of the guarantor. And the performance of some of products, such as leveraged and inverse ETFs that reset daily, or commodity-linked products that invest in futures contracts instead of the actual commodity, can deviate significantly and unexpectedly from the performance of the underlying index or asset class.
Firms have a duty to fully understand the products they sell, to ensure that their recommendations to customers are suitable, and that their descriptions of the products are accurate. For example, reverse convertibles are not ordinary debt securities and should not be described in a way that suggests they are.
To meet these obligations, firms should have a formal process for vetting every product they sell that is new to either the marketplace generally, or to the firm. The fact that a product is exchange-listed does not relieve firms of this burden, just as an investor's status as an accredited investor for purposes of Regulation D is not a substitute for a thorough suitability analysis.
But just having a formal process for reviewing new products, by itself, is not enough. The rapid pace of product innovation means that the new products review process cannot be static. Firms should be constantly assessing the adequacy of their new products review process in light of product and market developments.
In some cases, a firm may approve a product for sale to only some customers, or under certain conditions. For example, a firm may conclude that a product that contains an option component should only be sold to customers whose accounts are options-eligible, or that the sale of a particular product to investors over a certain age requires heightened supervisory scrutiny. When firms impose such conditions on the sale of a product, they should have an effective post-approval follow-up process to monitor that those conditions are met. And even after a product has been approved, firms should have procedures for monitoring and responding to market developments that may impact a product's performance or suitability going forward.
Done correctly, the combination of exhaustive front-end analysis and ongoing post-approval monitoring can help to prevent or mitigate problems that can culminate in enforcement actions and civil litigation. Most importantly, it can help prevent harm to the investing public.
Underpinning the reform-oriented principles I've just described has been the recognition among regulators and market participants that we can't afford to repeat the market failures of the past few years. We have the rare opportunity to implement comprehensive reforms that will help to stabilize the fixed income markets and also help to prevent the kind of market freeze that set in during the credit crisis. The success of these reforms will hinge on the actions of both regulators and the industry.
We as regulators must keep pace with the changes in fixed income markets—recognizing the differences across fixed income markets, and respecting those differences, while ensuring investor protection and market integrity. FINRA is committed to meeting these objectives as we move forward with our ambitious agenda for the fixed income markets, focused on transparency. And we will work to ensure these objectives are adhered to as we continue our cooperation with the Administration, Congress, U.S regulatory agencies, and our counterparts in other countries.
But we should keep in mind that new regulations can only achieve so much. For the reforms to trigger lasting market improvements, it is just as important for fixed income leaders to communicate to their industry colleagues that change is underway, and that there is a duty to comply with both the letter of the reforms, as well as the spirit underpinning them. I am hopeful that the industry will embrace the work regulators are doing to shape the future of the fixed income markets, because I believe it will lead to more robust markets. The lesson for both sides is: where there is doubt, err on the side of investors.