Remarks at the Bond Market Association
President, NASD Regulation, Inc.
I’d like to start by thanking the other organizers of this conference for the invitation. I have always had great respect for this organization, even if I don’t know what to call it anymore. Perhaps we could avoid confusion by adopting the formal name, "the Association Formerly Known as the PSA." If it’s good enough for the rock star Prince, it should be good enough for Paul Saltzman, but I’ll leave that question up to you.
Whatever the name, this organization has always been at the forefront of helping to shape the dialogue on important issues. Although it has not always embraced every new regulatory initiative with open arms, in my experience it has consistently provided thoughtful comments, respected the regulatory process, offered alternatives when it disagrees with the approach being advocated, and generally strived to uphold high standards of conduct. So I am not just being polite to my hosts when I say that you are well represented.
My objective today is to talk about some long-term trends in the marketplace, and in particular in the debt markets. Against that backdrop, I want to describe for you how from my perspective those trends have affected and may continue to affect regulatory policy, and how we can hopefully be better at anticipating and responding to change.
Finally, I will spend some time talking about some current issues with which you are no doubt very familiar, and which I think are good illustrators of how our ability as self-regulators and as market participants to adapt is constantly being challenged.
I have heard there was a time when the world of bond traders and salesmen was a satisfying, safe and predictable one -- a pretty good, secure way to make a living as those things go, but perhaps not very…exhilarating. Of course, one had to keep a close eye on interest rates, and an occasional default by a public issuer could create some excitement for a while, but on the whole it was a steady, you could even say relaxing, existence.
That’s what I’ve been told. I don’t remember witnessing a world like that during my career, and I couldn’t begin to tell you when it changed, or whether it was a pre- or post-Colombian event. In any event, the change is real, and it impacts real people in immediate ways.
For example, even a fairly savvy, sophisticated investor could easily fail to appreciate the potential volatility associated with interest only or principal only strip securities. This can be especially true if they are heavily used by a fund that is marketed in a way that implies safety and stability.
It doesn’t take much more to make you realize that this is not your grandfather’s bond market. And imagine how much more puzzling this market must seem to truly unsophisticated investors, for whom "IO," if it means anything at all, refers to one of Jupiter’s moons, and who think "SEC" stands for "Southeast Conference."
As this example demonstrates, one of the most significant trends is the enormous divergence and increased complexity of the products that bond firms trade and sell. A huge portion of the growth in derivatives markets has been oriented around bets or hedges on interest rates.
In addition, otherwise ordinary-looking bonds have been transformed by adding a little (or in some cases, a lot) of spice in the form of inverse bets on rate movements, commodity or equity market components, and on and on. As everyone knows, a little spice makes things interesting; a lot can lead to headaches and nausea.
There have been especially remarkable developments in the asset-backed markets. In addition to an explosion of variety in CMO offerings, there are interests in all kinds of assets -- credit card receivables, auto loans, and commercial real estate. Even the gas pumps and teller machines we use every day may well be financed by leases that have been securitized.
Changes in product development, of course, have not happened in a vacuum at the sales end of the market. They have been primarily driven by buyers’ demand for instruments that meet their own idiosyncratic needs. They have been aided enormously by systems and software development, along with the introduction of academic risk management and modeling concepts, and people who know how to apply them, into the securities industry. Together, they represent a marvelous example of the industry’s ingenuity and flexibility, which is a big part of the reason for its success.
Debt markets also have changed in terms of the roles played by dealers and their counterparties. The buy side of the market has become in some cases extraordinarily sophisticated in understanding how to manage risk and in structuring portfolios to that end. I should add that this statement stops just short of reality in some cases. I think it stops somewhere just east of Orange County..….
Notwithstanding the celebrated failures, a lot of institutional buyers have gotten smarter. And, they have the aid of new systems and software that can allow them in many cases to plan or at least propose their own strategies.
Maybe just as important, the way that institutions are participating in the markets has changed. In some cases, buy-side institutions may possess as much market savvy as do many dealers. Some may in fact enter markets in an aggressive way, and have comparable influence over the pricing of particular securities.
An overarching implication of this change is that the line between the sellers and buyers has become blurred, and that may itself have meaning for how we regulators look at the respective rights and obligations of participants.
Dealers themselves have assumed non-traditional roles, and this is as true in both debt and equity sectors. In particular, dealers often act to bring buyers and sellers of securities together in a way that was not contemplated at the time that the basic regulatory structure was put in place; screen-based systems run by a dealer or group of dealers today perform many of the functions that physical stock markets traditionally performed.
Increasing transparency is a trend that has affected all capital markets over the long term, and invariably for the better. This is one area where change has been more incremental in the bond markets than elsewhere. In the government markets, a great deal more information is available than was once the case, but it continues to be fragmented among competing dealers and vendors.
Hopefully, we will continue to see more and wider dissemination of price information in all debt markets. When the private sector is successful in fulfilling this need, it serves investors well, and it incidentally helps to stave off regulatory mandates.
All of these developments are noteworthy. None of them are news to any of you, but I have described them because I want to talk about how these kinds of changes in the market place can and should affect the approaches that regulators adopt in creating new standards, or refining old ones. Having a clear understanding of trends and changes also helps us to better tailor regulatory tools to individual markets, recognizing that they can serve very different functions and constituencies.
After suggesting some general principles in crafting and applying regulation, I want to spend a few minutes discussing how those principles may impact some current regulatory issues that heavily affect the bond markets.
As a general thesis, there is much value in trying to keep rules streamlined, with a lot of flexibility to meet new conditions and circumstances, rather than attempt to address and anticipate each one by specific language. At the same time, obviously it is important to make standards objective enough that people can tell in advance of taking a particular action whether or not that action would be permitted. That is often a hard balance to strike, and we are faced with the challenge all the time.
It is impossible to predict the changes that will take place in such a dynamic environment, but the inability to do so should not impede effective regulation so long as we can clearly define the ultimate objective that regulation is seeking to accomplish, and write standards that relate particular market behavior to those objectives.
Even when we are successful in striking the balance, we need to constantly reevaluate the application of existing rules to markets that may begin to look very different from those that existed when the rules were first written. In some cases, for example, rules that were written to apply to activities by dealers across different markets need to be reevaluated to the extent that the character of individual markets changes over time.
Rules that were written primarily with the equity markets in mind may not apply equally to debt markets, or may not apply in the same way. Conversely, rules that were written only for equity or debt might need to be given greater application in other sectors as those sectors evolve. These were questions that we had to consider in a comprehensive way last year when we amended our rules to apply the authority we gained from the Government Securities Act amendments to transactions in non-municipal debt securities.
On a broader scale, it is a process that we go through continuously in trying to be responsible and responsive, to investors and our members.
These ideas are easy enough to state in the abstract. As you know all too well, they are anything but simple to apply. One of the areas where I think they have been applied successfully is institutional suitability. Our efforts to address it grew out of the legislative authority we got in 1993, and it was especially important to the highly institutionalized debt markets.
Members have always had an obligation to assure that their recommended transactions are suitable, but this principle has not been clearly understood when institutions are receiving the recommendations. Some have contended that no suitability obligation should be recognized when a firm is dealing with a corporate entity of any size, shape, or dimension.
We rejected that view. We were true to the general principle but said that in determining whether it has been satisfied members can look to an institution’s ability to make its own judgments about investment risk, and whether the institution is in fact exercising independent judgment in a given situation.
This approach doesn’t create a convenient blueprint or checklist. It does recognize the enormous diversity in experience and sophistication among institutional investors, and I think it creates a flexible way of making reasonable determinations before the fact about the degree of care that members need to exercise.
It is true that the suitability standards we adopt, as in other areas, are tougher in some respects than those that apply to other types of financial service firms. I don’t think that means we should abandon the things that have helped to make our industry strong.
If there are legitimate concerns that competition is impeded by different standards -- and there are, let there be no doubt about that -- I firmly believe they should be resolved not by rushing to endorse lower standards but by pushing for better ones for everyone selling similar products. Functional regulation has always made so much sense that, even in Washington, it may yet win the day.
I want to touch on debt mark-ups, because I know that is a topic of interest to you, but I won’t say much, because our efforts to provide guidance are ongoing and will still take some work to complete. We start from the fundamental premise that dealers have an obligation to charge their customers prices and mark-ups that are fair, and that this obligation applies to every kind of firm, every customer, and every market.
We are trying to provide more guidance on what this standard means for the debt markets, in a way that makes sense to members and regulators; specifically, more guidance on how one determines the market price from which the mark-up is figured. Often, this is not hard, where the market is deep and liquid; in other situations, it will be far more difficult.
In many cases, the analysis will lead to the dealer’s contemporaneous cost because that number is often the most reliable. We think that firms should be able to justify a different price in appropriate cases, but the burden of doing so should be theirs.
We are not trying to create some kind of grid or schedule of permissible percentage mark-ups for different types of securities. The debt markets are far too complex and diverse for such an effort to be very successful.
For equities, the five percent standard has always been a very loose guideline, and my friend Steve Wallman, for example, has questioned whether it continues to be valid, even as a general benchmark. It has never been an appropriate standard for the debt markets.
We have filed a proposed interpretation with the Commission, and hopefully it will be published soon and we will be able to start receiving public comments on it. I can’t promise you when this will be resolved, only that we will continue working hard to do so.
Another topic that has gotten a great deal of attention lately -- including an awful lot of mine -- is whether to permit members to use in their sales literature risk ratings for bond funds published by rating agencies. This is an issue that regulators have been dodging for a long time; for our part, we hope to have an answer in the near future, notwithstanding tremendous disagreement among the industry and investor groups.
The fundamental goal of risk ratings is to provide more useful information about market risk to investors in bond funds. As we all know, many bond funds are subject to much more volatile price swings than has been the case before, but the information about the potential for such price swings, to the extent that it exists at all, may be buried in prospectus language that is opaque at best. Ordinary people could clearly benefit from having this information distilled into more understandable form if -- and let me emphasize, that is an important if -- the information can be presented in a way that is not misleading and makes clear its limitations.
One point of view holds that this information should be permitted without limitation, and the market should decide its value. At the opposite extreme, some in the fund industry believe the information is inherently misleading and predictive and should always be prohibited.
In many contexts, the SEC is expressly permitting and encouraging companies to provide forward-looking information, and there is plenty of information that we now permit to be used that is in some sense predictive. Even a rating based solely on past performance, for example, is predictive in the sense that good past performance may say something about the likelihood of good future performance; at least, we have to acknowledge that many people will see it that way.
Another area in which we are trying to adapt existing rules to the reality of the modern marketplace is the prohibition on free-riding or withholding "hot" issues. This prohibition has been a mainstay for many years of NASD’s efforts to promote market integrity. It is based on the assumption that new issues that trade at a premium should not be retained in the hands of member firms and insiders, who could make a quick profit in the period immediately after issuance.
This standard is based on notions of fairness as well as concerns about the potential for price manipulation. We have recently proposed several amendments to update our current interpretation.
One of these would eliminate the application of the interpretation to offerings of investment rated debt, whether or not it’s convertible into equity. Our experience has been that this type of debt does not usually trade at a premium, and in any event tends to trade in relation to interest rates rather than other factors. This may be one way the interpretation could be modernized.
Beyond the current proposals, we need to look at the free-riding and withholding interpretation from the top down, starting with the title, and rewrite it to make it more understandable. It continues to serve a good purpose, but it is needlessly complex and arcane -- a result that often occurs when changes meant to address one specific problem have slowly aggregated over time, until the rule starts to look like the regulatory creature from the black lagoon. When that happens, it’s time to go back to basics and, again, ask ourselves, what is the purpose, how are we trying to achieve it, how can that be accomplished in the current marketplace in the simplest and most effective way?
Before I finish, I don’t want to ignore happenings in the municipal securities market. We certainly don’t ignore it at NASD Regulation; it constitutes a major and growing part of our responsibility. I suppose I should say a few words about Rule G-37, although I do that with some anxiety, considering the popularity of that rule.
The NASD has always been in a bit of an odd position with regard to this rule; namely, it is not ours, but we have been given responsibility to enforce it and the authority to exempt firms from its provisions. Normally, the agency or organization that writes and interprets the substantive provisions of a regulation is in the best position to do that.
In any event, it is part of our mandate, and we take it seriously. In performing this function, we are bound by the MSRB’s interpretations. Where the MSRB has not directly addressed a particular circumstance, we do our best to apply the general public interest and other standards of the rule, while keeping in mind that the MSRB and the SEC have both made it clear that exemptions should be rare.
We have recently granted two partial exemptions, that is, a reduction from two years to one year in the prohibition on conducting business following a prohibited contribution. Both situations involved fairly unique fact patterns. One involved the mailing of a duplicate check that, because of unusual circumstances, the firm’s compliance procedures failed to detect. The other concerned an individual who backed into a position as a municipal officer as the result of a merger and who had previously made a contribution that became a prohibited contribution by virtue of his new position in the merged entity.
I want to make clear that these actions do not signal a willingness to grant exemptions freely or in any but truly exceptional situations. In fact, we have made clear in a Notice to Members that firms should review the circumstances in the two cases where exemptions were granted to make sure their procedures are designed to prevent even such clearly inadvertent violations.
In other words, our door is open to considering requests, but the opening is not wide, and the best advice is to make sure your procedures are as tight and thorough as possible.
We are further concentrating our focus on municipal securities compliance generally, with the help of Mac Northam, who is directing our fixed-income compliance efforts.
We are looking to see that firms conducting municipal securities business have the right qualifications for their employees who engage in that activity. Where firms are reporting municipal securities income, there ought to be someone at the firm who is qualified as a municipal securities principal to manage and supervise that business.
There has been a great deal of press attention lately to compliance with Rule G-36, and this is obviously an area where a lot of our attention is focused. In the absence of the mandated registration and disclosure scheme required for corporate securities, it is important that we assure compliance with those filing and disclosure obligations that do exist.
I hope I’ve given you some sense today of how we attempt to keep pace with change in refining our regulatory approach, and this principle applies particularly to the markets in which you work. We do this on a daily basis when considering new initiatives, and we also try periodically to take a broader view and look at whether old approaches need to be reconsidered in more than an incremental way. We may not always hit the mark, but I can promise you we try very hard to aim for it.
Thank you for your invitation and your attention.