Fixed Income—Fair Pricing
Regulatory Obligations
The fair pricing obligations under FINRA Rule 2121 (Fair Prices and Commissions) apply to transactions in all securities—including fixed income securities—and MSRB Rule G-30 (Prices and Commissions) imposes similar obligations for transactions in municipal securities.
These rules generally require a dealer that is acting in a principal capacity in a debt security transaction with a customer, and charging a mark-up or mark-down, to mark up or mark down the transaction from the prevailing market price (PMP). The PMP is presumptively established by referring to the dealer’s contemporaneous cost as incurred or proceeds as obtained. Where the dealer’s cost is no longer contemporaneous, or the dealer has overcome the contemporaneous cost presumption, firms are required to continue down the “waterfall” within FINRA Rule 2121 or MSRB Rule G-30, as applicable, to determine the PMP.
Findings
- Incorrect Determination of PMP: Not following the contemporaneous cost presumption or the waterfall required by FINRA Rule 2121 and MSRB Rule G-30, but rather:
- using other methods, such as obtaining quotations from a limited number of market participants without considering contemporaneous inter-dealer or institutional transaction prices;
- referring to acquisition costs that are no longer contemporaneous;
- relying on third-party software to determine the PMP, while:
- not understanding how the software determines the PMP, notwithstanding the firm’s ultimate responsibility for ensuring the PMP is determined in accordance with FINRA Rule 2121 and MSRB Rule G-30;
- not ensuring that the software could access all information necessary to properly determine the PMP (e.g., the feed of the firm’s own trading was incomplete); or
- not subsequently considering trades flagged by the software for compliance or supervisory review based on the amount of mark-up or mark-down from the determined PMP;
- permitting registered representatives to determine the PMP through a manual override of the third-party software, while:
- not appropriately supervising how the PMP was determined in manual overrides;
- not maintaining documentation regarding why manual override was necessary or how the PMP was determined in manual overrides; or
- determining the PMP based on the firm’s quotation prices, rather than determining the PMP in accordance with the waterfall (e.g., incorrectly categorizing the firm’s quotation price as the contemporaneous cost/proceeds level of the waterfall when determining the PMP).
- Outdated Mark-Up/Mark-Down Grids: Employing mark-up/mark-down grids without periodically reviewing and updating them as needed.
- Failure to Consider Impact of Mark-Up on Yield to Maturity: Charging substantial mark-ups on short-term, fixed-income securities that may significantly reduce the yield received by the investor.
- Unreasonable Supervision: Solely relying on grids or on fixed mark-up/mark-down thresholds in assessing fair pricing in fixed income securities without performing a facts-and-circumstances analysis as required by FINRA Rule 2121 or MSRB Rule G-30.
Effective Practices
- PMP Documentation: Documenting the PMP for each transaction, even if it does not require a mark-up/mark-down disclosure pursuant to FINRA Rule 2232 (Customer Confirmations) or MSRB Rule G-15 (Confirmation, Clearance, Settlement and Other Uniform Practice Requirements with Respect to Transactions with Customers).
- Mark-Up/Mark-Down Reviews: Conducting periodic reviews of the firm’s mark-ups/mark-downs and comparing them with industry data provided in the TRACE and MSRB Mark-Up/Mark-Down Analysis Reports.
- Exception Reports: Using exception reports or outside third-party vendor software, and periodically reviewing and updating the reports’ parameters so they perform as intended, even as market conditions change.
- Considering the Cumulative Customer Impact of Proceeds Transactions: When using the proceeds from a customer sale of bonds to purchase new bonds for the customer at or near the same time, taking into account both the mark-down on the sale and the mark-up on the purchase in considering the total charges borne by the customer.