By John M. Jascob, J.D., LL.M.
The House Subcommittee on Capital Markets, Securities, and Investment held a hearing on July 14 to review the state of the U.S. fixed income markets and the need for reform of the current market structure. Aimed at providing lawmakers with the background to examine the optimal design of the fixed income market based on today’s conditions, the hearing explored the importance of liquidity and data transparency for various fixed income asset classes and the increasing use of technology and electronic trading platforms, among other topics.
Unique characteristics. Chairman Bill Huizenga (R-Mich) began by making a point emphasized by several witnesses, namely, that fixed income markets are different than equity markets. As such, the fixed income market should have a regulatory structure that appropriately reflects its unique characteristics. Accordingly, Huizenga applauded SEC Chair Jay Clayton’s recent call for the creation of a Fixed Income Market Structure Advisory Committee that would be asked to give advice to the Commission on the regulatory issues impacting fixed income markets.
Ranking Member Carolyn B. Maloney (D-NY) echoed Huizenga’s comments about the unique characteristics of the fixed income market, noting the fragmentation and lack of standardization in the corporate bond market. For example, Maloney observed that General Electric currently has 900 bond issues outstanding. Maloney suggested that even with reforms the corporate bond market will still remain relatively illiquid, and we should not fool ourselves into thinking that corporate bonds will ever approach the liquidity of stocks or even Treasury bonds.
While the market for U.S. Treasury securities has become increasingly more standardized and electronic over the past decade, Maloney observed that most dealers still trade with their customers over the telephone. Maloney cautioned that lawmakers need to be careful when making changes to the Treasury market, which remains the largest and most liquid bond market in the world, because taxpayers will end up footing the bill in the form of higher interest rates if Congress gets it wrong.
Municipal bond market reforms. Matthew Andresen, CEO of Headlands Technologies LLC, focused his remarks on suggested improvements to the municipal bond market. Andresen noted that the secondary market for municipal bonds has historically been a dealer market. Despite advances made by the MSRB in making available post-trade data information, retail investors are often dependent on dealers for pricing information the abundance and diversity of municipal bonds and the infrequency of trading of certain issues.
Andresen highlighted several anticompetitive practices that he believes limit the advantages of the existing market structure and exert detrimental effects on retail investors. For example, “filtering” occurs when a broker-dealer handling its own retail customer’s order requests a quote or starts an auction on an alternative trading system (ATS), but uses automated tools on the ATS to filter out responses from specified dealers. Although these restrictions may harm investors’ execution quality, the practices benefit the retail broker-dealers whom these investors depend on for pricing information. Accordingly, a focus on whether the continued use of filters constitutes a “legitimate purpose” under MSRB Rule G-18 may be in order, Andresen stated.
Another practice questioned by Andresen is the "trade through," in which a retail broker-dealer obtains prices for a customer via a bid wanted auction, but then internalizes the order by purchasing the bond from its customer for its own account at a lower price than the winning bid in the auction. This practice of internalizing orders and allowing for a trade through is harmful to customers because it results in bonds selling at inferior prices to those that were available at the time of the trade, Andresen stated. Andresen also believes that municipal bond investors would benefit from enforcement against the use of the "last-look" practice, in which a dealer observes the prices submitted to a completed auction and decides to purchase the bond from the customer at a price slightly better than the winning bid. Dealers continue to use this practice even though it appears to be prohibited by MSRB Rule G-43, Andresen said.
Transparency and standardization of regulatory standards. John Shay, Global Head of Fixed Income and Commodities at Nasdaq, also applauded SEC Chair Clayton’s request for the creation of a Fixed Income Market Structure Advisory Committee. With regard to the Treasury market, Nasdaq believes that transparency benefits all market participants because widespread availability of the best available prices ensures that market participants make informed investment decisions and receive high quality, low cost service. Shay said that TRACE reporting to FINRA was a positive step, but further evolution towards a comprehensive, centralized reporting mechanism is critical.
Nasdaq also advocates the standardization of regulatory standards and surveillance practices across all U.S. Treasury venues, whether electronic multiparty trading platforms or bi-lateral dealer-to-customer arrangements. Shay noted that rules similar to the SEC's Regulation SCI would ensure that participants in the U.S. Treasury markets develop systems with sufficient capacity, resiliency, availability, and security to minimize the occurrence of disruptive systems issues.
Non-linear evolution. Alex Sedgwick, Head of Fixed Income Market Structure & Electronic Trading for T. Rowe Price, stressed that fixed income products can, and historically have, traded in a variety of ways, and that the evolution of market structure has never been linear. The fixed income market represents a collection of several diverse markets, which differ in terms of the drivers of returns, liquidity characteristics, and the amount of electronic trading that takes place.
With respect to the Treasury market, Sedgwick said that his firm generally supports the recommendations of the Joint Staff Report on the Treasury flash rally of October 15, 2014, particularly the utility of enhanced regulatory reporting to help the Treasury Department and other stakeholders better ensure an efficient and competitive market for all participants. With regard to the fixed income market as a whole, T. Rowe Price believes that removing obstacles to further electronification will improve price discovery, facilitate best execution, and enhance capital formation.
Impact of post-crisis regulation. SIFMA Executive Vice President Randy Snook said that while SIFMA supports many of the post-crisis regulatory reform efforts in the area of capital and liquidity, now is the time to review how these rules work together. This review should include the Volcker Rule, liquidity requirements, leverage requirements, and other rules and regulations that have impaired market efficiency and capital formation. In SIFMA’s view, regulators must move very cautiously when considering new requirements and restrictions on activities and participants in the fixed income markets.