Remarks from the Bond Dealers Association Annual Conference
Chairman and Chief Executive Officer
As prepared for delivery
Good afternoon and thank you for that introduction.
I'm pleased to be talking to you today, particularly because the fixed income market is at the center of the changes in the overall markets. While the housing market triggered the credit crisis four years ago, the crisis was first observed in the securitized products segment of the fixed income market. We've continued to see changes since then, starting with the dramatic loss of liquidity and visibility to quality quote information. We're also seeing a rush by many retail investors—including baby boomers approaching retirement—away from equities and into fixed income as they search for yield.
These trends are reflected in the dramatic growth in retail trading in the fixed income markets. For example, the average daily number of retail transactions in corporate bonds has grown by fifty percent in just four short years. We have also seen a significant retail presence in not only the mortgage-backed securities specified pool market, but also in the CMO market. Even in the traditionally retail dominated municipal market, the retail presence has grown by twelve percent during the last six years. So while the shift to fixed income investments has helped the market recovery, we may face new problems if rates rise and prices plummet in the coming years. Knowingly or unknowingly, investors may actually be taking on more risk when they move to more complex and fixed income products in an attempt to avoid losing money on their investments.
In addition, the fixed income market structure is undergoing a shift thanks in part to federal regulatory activity. Dodd Frank and the Volker rule have increased firms' focus on risk management and on the structure and mechanisms of the municipal bond market. We're hearing from many market participants that dealers' capital commitment is significantly reduced and firms' margins are being squeezed. As a result, firms are rethinking their traditional roles and market mechanisms. For example, we are seeing proprietary alternative trading systems created on both the buy- and sell-side. These forces are at the beginning of what may become a very innovative period for the fixed income market structure. On the other hand, it isn't clear whether this is the beginning or a momentary inflection point.
Today, I want to reflect on what these changes in the fixed income market mean for our regulatory programs, including TRACE and our exam and surveillance programs, and investor protection.
TRACE Expansion and Transparency Update
Since the introduction of TRACE ten years ago, we have continued to increase our regulatory activity in the fixed income markets. As you know, we expanded TRACE in May 2011 to include transactions in asset-backed and mortgage-backed securities. This expansion of TRACE means that market participants are better able to negotiate fair prices and it has improved our ability to understand and regulate the fixed income markets.
We are taking steps to make all securitized products more transparent. We recognize that securitized products are different from corporate and agency securities and have tailored our approach to reflect those differences. For example, we studied the transaction data we collected before proposing a transparency regime for securitized products. Nearly a year ago, we partnered with Interactive Data Services to provide daily aggregate trading information, including activity and price levels, as a means of providing the marketplace with valuable insight while we continue to study the data. We have engaged four academic teams to help us study the data, and we are focusing on liquidity and fungibility issues. Based on our observations and the academic research, we will begin disseminating mortgage-backed securities traded to-be-announced starting on November 5th of this year. This market segment represents 87 percent of volume traded and over half of all transactions in securitized products. We have also submitted a proposal to the SEC to disseminate mortgage-backed securities traded in specified pool transactions. This segment represents 6 percent of volume traded and 22 percent of trades.
These initiatives are the result of constructive and productive dialogue between FINRA and the industry, both on the buy side and sell side. With both proposals, we adjusted our rule filings to reflect comments we received from market participants. For instance, with the mortgage-backed proposal, we initially proposed to disseminate specified pool trades by the security's CUSIP. Comments from market participants, including BDA, highlighted that disseminating the CUSIP could potentially divulge trading strategies and thereby jeopardize participants' ability to remain anonymous, as many pools are relatively small and held by one investor. As a result, FINRA is proposing to disseminate trading information using data elements that describe the characteristics of the pool.
As we look to bring transparency to asset-backed and CMO securities, we plan to continue this dialogue with market participants, especially given the generally more complex nature of these instruments. If we find that transparency for these securities will add value to the marketplace, we will propose an approach for these segments that takes into account their complex nature and different market dynamics.
FINRA also periodically evaluates current practices and modifications that may be beneficial to firms and the market. As part of that broad review, we are looking at the TRACE volume dissemination caps, which have been in place since TRACE began operating. Recently, we published a request for comment1 on dissemination caps and 144A securities. We are reviewing the comments and are aware of your concerns about raising volume caps. On the other hand, we also recognize that some segments of the market support the effort to make 144A transactions transparent. We recently extended the deadline for submitting comments to November 9th and look forward to receiving more of your feedback.
Another area that we continue to look at is the regulatory gap in the reporting of exempt securities. Bank dealers that are not FINRA member firms are not required to report their transactions to TRACE. We have discussed this issue with BDA, as well as other organizations, on several occasions. I wish I could announce that we have identified a solution, but unfortunately that is not the case. Although it is difficult to gauge the share of the market not being reported, we continue to talk with other regulators about this issue.
The transparency brought about by TRACE has not only transformed many aspects of the fixed income markets, it has allowed us to enhance our ability to detect potential schemes seeking to take advantage of a robust post-trade transparency regime. As a result, we have developed automated surveillance patterns to spot areas of potentially problematic behavior common to transparent markets, such as wash sales and marking the close. We have already sent a number of inquiry letters to firms following up on alerts generated from these patterns, and will take appropriate actions as necessary if we find violations. Of course, more traditional trading issues such as best execution, inter-positioning, and fair pricing will remain a high priority for our surveillance teams.
Following the expansion of TRACE to include asset-backed and mortgage-backed securities, we launched our data integrity reviews to ensure complete and accurate reporting and followed up with patterns focusing on fair pricing and best execution. It's worth mentioning that we have seen substantial improvements in firms' reporting practices, even as the reporting requirements were shortened from T+1 to end of day reporting, and firms should be complimented for their efforts here.
We are now focusing on fair pricing in products such as CMOs and mortgage-backed securities, where we have observed retail activity. We are still in the early stages of these reviews, having recently received firms' responses to our initial inquiry letters. We are aware of the complexity of these products, the differences in their trading behavior and their liquidity relative to other TRACE-eligible securities. Going forward, we will continue to evaluate the effectiveness of our surveillance to ensure that our resources are allocated to areas with the greatest risk to market integrity and investor protection.
I've talked about TRACE and our market surveillance programs. Now I want to talk about enhancements to our broader firm examination program from the fixed income perspective. First, let me take a step back and talk about how we have enhanced our exam program to focus our resources on those areas where we believe the risk to investors is greatest. Part of that focus includes transforming the technology we use to conduct exams. Among other things, we are now collecting more information from firms electronically before an exam. This means our examiners can better understand the activities and risks at firms before they arrive onsite, and we can tailor our exams accordingly.
Another way that we are collecting more and better data from firms is through the new risk control assessment survey we sent to firms in February. We are using the data we collected through the survey—in combination with data we are collecting through other means—to help us tailor our exams to your firm's unique risks. This is another important step toward our goal of better understanding what's happening at your firm and focusing on the areas that pose the greatest risk to investors. Next year we expect to improve the survey in a number of ways, including streamlining the questionnaire and reducing the number of questions. If firms complete it again, they should not have to re-enter information they have already entered.
Our risk-based approach is resulting in exams that are narrower in scope, but produce more in-depth reviews of identified risk areas. Firms have generally provided us with positive feedback on this approach. Our exam teams have greater flexibility to address risk areas—and this goes for MSRB exams as well. As you know, last December, thanks to changes in MSRB rules, we were able to make our municipal examination program more risk-based. Now, you will begin to see that our exams are tailored to your firm's business and risk profile, such as the size of transaction, type of municipal security, type of customer, volume, your firm's past compliance history, and whether your firm is involved in public finance or advisory activity. We expect to review approximately 600 municipal dealers this year with a specific emphasis on their retail sales and requisite disclosure, suitability and pricing determinations and public finance work.
Due to the heavy concentration of retail investors in the fixed income segment of the market, we are particularly interested in firms whose business activity is weighted in retail-sized fixed income transactions. By retail sized, we mean transactions in dollar amounts less than $100,000. In the municipal market, for example, retail sized transactions account for 70 percent of the daily average of $13 billion—based on the par value—of municipal bonds traded in more than 40,000 transactions. While it is too soon to draw conclusions about the total results of these changes, firms have told us they appreciate the sharper focus of the on-site exams.
So, what are some other regulatory priorities and concerns from a fixed income perspective? FINRA and the MSRB expect municipal dealers to understand the municipal securities they sell in order to meet their disclosure, suitability and pricing obligations. Let's start with disclosure, which remains high on the list of priorities. A dealer must disclose to its customer, at or prior to the transaction, all material facts about the transaction that are known to the dealer and all material facts about the security that are reasonably accessible to the market.
Dealers are also required to assess whether a product is suitable for a customer based upon information available from the municipal issuer and facts disclosed by the customer. To meet this obligation, firms need to take into account material information that is available through "established industry sources" which might include issuer official statements, issuer continuing disclosures, press release, trade information available through EMMA, research reports and other data provided by independent sources. Firms need to have procedures that are "reasonably designed" to access material information from varying sources.
Firms are also obligated to ascertain a municipal bond's credit risk. Published credit ratings are not the only factor to consider in making these determinations. Firms are also required to be aware of additional information, such as redemption features, non-standard features that may affect price or yield, and other matters that may be of importance to a retail investor.
Firms should also be looking at how they participate in bond ballot campaigns. FINRA is looking into recent media reports regarding bond ballot campaign contributions and assistance by FINRA member firms that subsequently obtained municipal underwriting business related to those campaigns. This is a murky area involving, in some instances, local and state law regarding prohibitions of issuers engaging in bond ballot campaigns. Generally municipal dealer contributions to bond ballot campaigns do not violate MSRB's rule G-37 on political contributions. However, FINRA staff is concerned about the perception of influence created by bond ballot campaign contributions, and whether some firms may be helping a municipal issuer do what it is prohibited itself from doing. We will continue to work with MSRB staff as they consider any changes to Rule G-37 addressing bond ballot campaigns.
Compliance with so-called new issue retail order periods is another issue firms should focus on. Many municipal issuers mandate that their new issue of bonds be made available first to retail investors, sometimes mandating order priority and priority pricing for the retail investors before making the new issue available for the general market. While we have not found significant non-compliance to date, we are working collaboratively with the MSRB on this subject and have asked them to provide additional tools to help us examine for problems in this area. For example, requiring new issue syndicate managers to keep and produce additional records and reports as an aid for monitoring compliance with issuer retail order mandates.
Another area of concern for municipal securities dealers is pay-to-play. I am sure you saw the recent case involving Goldman Sachs, in which the SEC charged the firm and one of former investment bankers with "pay-to-play" violations involving undisclosed campaign contributions to then-Massachusetts state treasurer Timothy Cahill while he was a candidate for governor.
Related to this, firms should be paying attention to excessive gift-giving and entertainment, which can create a perception of inappropriate and unfair influence and conflict in the new issue municipal market. FINRA continues to look into instances where firms apparently sought to influence issuer officials through these means. The perception of wrongdoing that these activities foster dampens investor confidence and ultimately harms the market for all participants.
What else should firms be concerned about? Making a good-faith effort to comply with recent MSRB interpretive guidance regarding underwriter responsibilities to state and local government issuers. The guidance, which reflects MSRB Rule G-17 on fair dealing and the MSRB's expanded authorities under Dodd-Frank, requires underwriters to make certain disclosures regarding the nature of and material risks associated with certain municipal securities transactions.
Staying in the realm of what we're looking at from an examination standpoint, another area of focus for our regulatory programs is complex products, which is a growing segment of the market because of investors' continued search for yield. While numerous products that fall under the complex products umbrella, we've been particularly focused on structured retail products. These products are typically fixed income instruments and are often linked to reference assets that the average investor may not fully understand. For example, market volatility products can be misperceived. Instead of tracking actual price fluctuation, these products may invest in volatility index futures that reflect the market's expectation of future volatility. We continue to look at range accrual notes that track multiple assets, such as a stock index and an interest rate. These notes may offer an attractive return if both reference assets behave in a certain way, but may also result in a low or zero yield if those conditions are not met. We're also concerned about products with "worst-of" payoffs that are also linked to the performance of multiple reference assets, but in this case the worst-performing asset determines investors' return. And dual-directional notes promise positive returns in both bull and bear markets—subject to strict conditions that can limit an investor's upside while placing principal at risk.
Other fixed income products that give us concern include firm disclosure to investors about so-called "conduit bonds" and unrated munis. While these bonds are sold by municipalities to fund local projects by non-government third parties, the fact that a third-party is solely responsible for repayment means there is potential for investors to misunderstand who the ultimate obligor actually is. And while conduit bonds account for only about 20 percent of the market, they are responsible for about 70 percent of all defaults. If you are going to offer these types of products to retail investors, you must be sure you disclose to investors all the risks and the rewards inherent in these issues.
We're also looking at collateralized loan obligations—complex securitized debt instruments issued pursuant to 144A that invest in corporate loans of lower credit quality. The issuance of new CLOs evaporated during the financial crisis, after peaking at $100 billion in 2007. But CLO activity has been ticking up over the past year. Some market watchers project new issuance could be as high as $35 billion in 2012—almost triple what it was in 2011. We are concerned that the underlying loans in CLOs are being underwritten with weaker covenants and, therefore fewer investor protections.
Another product that has become popular with retail investors is floating rate loan funds or "levered loan" funds. These levered loan mutual funds and closed-end funds, which invest in floating-rate loans extended by financial institutions to companies of lower credit quality, are sometimes marketed inappropriately. We have seen instances where these funds have been sold with inadequate disclosures about the funds' credit quality. In some instances the funds have been misrepresented as high-yielding, money market-like instruments.
These types of products merit heightened supervision. And firms should ensure their practices are in the best interests of their customers. This may require firms to reassess the ways in which they vet products and sell them to customers. Among other things, firms should be asking how will products designed to produce enhanced yield in a low-rate environment perform if, as many expect, rates begin to rise? And how might your firm change its practices with regard to rate-sensitive products it may currently be selling?
Given the increased retail presence in debt securities, we are also taking steps to provide retail debt research recipients with most of the same protections provided to recipients of equity research. As you may know, in February we published a Regulatory Notice requesting comment on a debt research proposal that reflected changes on a previously issued concept proposal and subsequent discussions with the industry. We will soon publish an amended proposal based on the comments and additional industry feedback. The revised debt research proposal will maintain the same overall tiered approach—treating retail investors and institutional investors as customers and counterparties, respectively. Retail debt research would receive essentially the same protections as equity research, while institutional debt research would be exempt from many of the structural provisions and would require only a warning as opposed to the prescriptive disclosures in retail debt research.
The previous proposal required otherwise eligible institutions (those meeting the 4512(c) definition) to say in writing that that they want to receive the less-protected institutional debt research. We listened to your comments about the requirements being unnecessarily burdensome. We will propose a higher tier of institutions that combines the qualified institutional buyer standards with the institutional suitability requirements. Those that meet the higher tier could receive institutional debt research by negative consent; other 4512(c) institutions could still affirmatively elect to receive such research.
We will also ask for comment on possible alternatives, including one that combines 4512(c) with the institutional suitability requirements. We are looking for a standard that will protect more vulnerable institutions, but also will allow firms to leverage their existing compliance systems and procedures and permit sophisticated institutions to continue to receive the type of debt research they receive today. Firms that qualify for the exemption will still be subject to certain prohibitions, including pre-publication review by investment banking personnel and participation in road shows and other marketing on behalf of issuers related to an investment banking transaction.
We will also propose an exemption for firms with limited principal trading activity and look forward to receiving your comments on the right parameters for these exemptions.
The second rulemaking item of note is our proposed amendments to the front-running policy. As you know, we filed the proposed rule change with the SEC in May. The SEC approved the proposal last month, and we will soon publish a Regulatory Notice announcing the implementation date.
The primary change is the extension of the prohibitions in the rule—which currently apply only to certain options and securities futures—to all securities and "related financial instruments." Since we expanded the rule, we made two other notable revisions. First, because some trades in related financial instruments are not reported or publicly disseminated, the trading restrictions would be in place until the material, non-public market information is either publicly available or otherwise becomes stale or obsolete. And we revised the existing exceptions to address the types of trading that are permitted under the rule.
I want to leave you with a few thoughts. The fixed income market continues to undergo change—both in its structure and the demography of investors. The health and efficiency of the fixed income market depends on FINRA and the industry anticipating and being prepared to respond to future changes in the market. I am confident FINRA and the industry can work together in a way that fosters more effective regulation and greater investor protections.
Thanks for listening. I will now take your questions.
1 Regulatory Notice 12-39