SEC Fixed Income Market Structure Advisory Committee Meeting

Securities and Exchange Commission

Meeting of the Fixed Income Market Structure

Advisory Committee (FIMSAC)

Monday, April 9, 2018

Key Topics & Takeaways

  • Block Trade Dissemination Pilot: The Fixed Income Market Structure Advisory Committee (FIMSAC) voted to advance a proposal for a pilot program to test the impact of changes to corporate bond trade reporting requirements. The proposed one-year program would study delaying public dissemination of some details of block trades to 48 hours, while requiring reporting trade data to regulators within 15 minutes. The pilot would also raise the threshold for block trades immediately reported to the public to $10 million for investment-grade bonds and $5 million for high-yield bonds from their current levels.

Opening Statements

Securities and Exchange Commission (SEC) Chairman Jay Clayton
In his opening statement, Chairman Clayton gave an overview of the three FIMSAC subcommittees: (1) Transparency Subcommittee, which considers pre- and post-trade transparency; (2) Exchange-Traded Funds (ETFs) and Bond Funds Subcommittee, which considers the impacts of the growing number of registered funds; and (3) Technology and Electronic Trading Subcommittee, which considers the impact of the growth of electronic trading platforms.

Clayton stated that pre- and post-trade transparency can substantially affect market participants’ behavior and thus the overall markets. He continued that while the panelists recognize this, many do not understand the linkages between trade reporting, liquidity, volatility, efficiency, risk, cost of capital and fairness. Clayton asked the members of the FIMSAC and the panelists to consider whether the SEC’s reporting rules serve the interests of Main Street investors and to continue identifying emerging risks and issues.

Additional Opening Statements
SEC Commissioners Kara Stein, Mike Piwowar, and Hester Peirce also gave opening statements that generally thanked members of FIMSAC and the panelists for their time and efforts to improve the fixed income markets.

FIMSAC Committee Discussion

Block Trade Dissemination Draft Recommendation
SEC staff opened by giving an overview of the preliminary recommendation concerning the block trade dissemination pilot from the Transparency Subcommittee. They explained that transparency was a key part of the discussion in the previous FIMSAC meeting and is important to calibrate transparency risk. Staff also gave an overview of the process, in that a full recommendation will require a vote of approval from the full FIMSAC.

The panel participating in this portion of the meeting consisted of:

  • Brian Archer, Managing Director, Head of Global Credit Trading, Citigroup
  • Scott Krohn, Treasurer, Verizon
  • Mihir Worah, Managing Director, Chief Investment Officer, Asset Allocation and Real Return, PIMCO

Worah began by explaining that today the subcommittee is proposing a pilot to study the effects of modifying Trade Reporting and Compliance Engine (TRACE) dissemination rules and see whether these changes will increase liquidity and transparency in the U.S. corporate bond markets.

Before going into the pilot, Worah gave an overview of the other topics the Transparency Subcommittee is considering, to include long-term considerations such as implementing a pre-trade reporting regime and complementing academic studies.

Worah presented the subcommittee’s recommendation of a one-year pilot to improve transparency and liquidity in the corporate bond markets, which may be hindered by the TRACE reporting requirements. He explained that the pilot recommends no changes to the requirement that every trade must be reported to FINRA within 15 minutes of pricing, and recommends increasing the block size dissemination caps from $5 million to $10 million for investment grade corporate bonds and from $1 million to $5 million for high yield bonds. Worah continued that all trades at or below the thresholds will continue to be disseminated within 15 minutes of execution, and all trades above the respective dissemination cap will be disseminated 48 hours after execution time, with FINRA continuing to report each trading day’s full trading volume. As for the information given to the market after the 48-hour period, it will only provide the trade amount and whether each party was a dealer or customer. Worah continued that the subcommittee’s proposal initially recommended increasing the dissemination cap for high yield bonds to $3 million, but after significant debate among the FIMSAC, the subcommittee ultimately recommended increasing the cap to $5 million. He added that the subcommittee also recommends reducing the dissemination of the actual trade size for capped transactions from six months to three months.

In the spirited debate among the FIMSAC and panelists, some benefits of amending the TRACE reporting requirement were stated by asset managers, issuers, and broker-dealers. It was argued that the pilot improves price transparency and increases the 2017 trading volume of investment grade bonds that would have been captured by the caps from 43.1% to 65.6% and increases the ticket count from 96.9% to 98.9%. Archer stated that he participated on SIFMA calls and saw that most sell-side firms would support a similarly constructed proposal to aid the firms in addressing risk by promoting price transparency. Krohn voiced support for the proposal as a as an investment grade issuer and pension plan sponsor because the proposal will likely reduce the bid-ask spreads on the increasingly in demand investment grade bonds. Worah expressed the general support from the buy-side to reduce transaction costs and improve liquidity, which ultimately helps Main Street investors. Some other benefits given by FIMSAC members in support of this pilot included reducing the information leakage on large illiquid transactions and giving the sell-side more time to assess the risk, which will re-incentivize capital market making.

Some FIMSAC members opposed the pilot, with one arguing that the pilot should be designed with a control group rather than applying the new dissemination cap sizes and changes to all corporate bonds. Another FIMSAC member argued that this proposal reduces transparency by delaying the dissemination for 48 hours and that several bonds will move above the new thresholds, with any reduction in TRACE reporting harming the customer.

While the Transparency Subcommittee considered making a corresponding change to the municipal bond market, it was ultimately decided that the pilot would not be necessary. The subcommittee’s working group reached out to several municipal bond market participants and found that most participants were comfortable with the current TRACE reporting requirements, and the subcommittee believes changes to the transparency rules are not necessary at this time primarily because there is no large block trading in the municipal bond market.

After this spirited debate, the subcommittee recommended increasing the dissemination caps from $5 million to $10 million for investment grade bonds and $1 million to $5 million for high yield bonds. With 15 FIMSAC members in favor of the proposal, the recommendation was made, which will be considered by FINRA and be subject to a notice and comment period, if proposed.

Liquidity Considerations for Bond ETFs

SEC staff opened the Bond ETF portion of the meeting by providing an overview of the current state of bond ETFs. Redfearn noted that there has been much written about the liquidity mismatch between the securities underlying bond ETFs and the shares of the ETFs themselves (which are far more liquid). Redfearn noted the “significant growth” in bond ETFs in recent years, though he added that bond ETFs underlying securities account for a very small percent of total outstanding issuance.

The panel participating in this portion of the meeting consisted of:

  • Joe Arcadi, Head of North America Credit Index Trading, JPMorgan Chase
  • Matt Berger, Global Head of Fixed Income and Commodities, Jane Street
  • Sean Collins, Chief Economist, Investment Company Institute (ICI)
  • Krishna Memani, Chief Investment Officer, Head of Fixed Income, OppenheimerFunds
  • Gregory Peters, Managing Director, Senior Portfolio Manager, PGIM Fixed Income

Each panelist spoke briefly after Redfearn, providing information about their experience in the bond ETF space. Redfearn then asked the panel about liquidity mismatch, noting that fixed-income securities can be difficult to trade or price. He asked if the panel had concerns about a supply and demand mismatch. Berger said that some of these risks can be ameliorated with client education, saying that clients should be aware that owning bond ETFs is equivalent to owning the underlying securities, and that in the high-yield space, clients will carry that liquidity risk. Berger noted that in “good times” ETFs can improve liquidity, but the assets themselves may remain relatively illiquid. Collins praised ETFs for providing liquidity and improving price discovery. Memani argued that with ETFs, it can be easier to find someone to take the other side of the risk, as with ETFs you do not need counterparties for individual Committee on Uniform Security Identification Procedures (CUSIPs). Memani compared ETFs to the depth and liquidity of derivatives markets and praised the ability of ETFs to improve liquidity because prices of ETF shares can provide real-time pricing information, albeit on an aggregated basis.

Redfearn pointed out that most of the trading in bond ETFs is focused in a mere handful of funds. Redfearn asked the panel if they focus their activities in these funds or if they take a broader view of all 164 bond ETF funds in the marketplace today. Memani said that funds with different liquidity profiles can meet different needs, and that some investors may be interested in thinly-traded ETFs for different reasons. Collins said that he was not worried about market or systemic risk despite the presence of thinly traded bond ETFs, noting that they function similarly to small cap stocks.

Redfearn said that arbitrage is crucial to ensure that prices remain aligned, and asked how the market ensures prices remained aligned in times of stress, and that investors get the right prices in stressed times? The panel mainly pushed back that the August 24th ‘flash crash’ was related to bond ETF market and noted that the volatility spikes and trading halts resulted from delayed openings. Peters also said he believes that the environment for bond ETF is better today than it was in 2015.

Redfearn then asked the panel for their views on the future of the bond ETF market. Arcadi noted that bond ETFs have captured a larger slice of the high-yield market compared to the investment grade market and praised high-yield bond ETFs for solving liquidity problems in those markets by aggregating risk for investors. Memani said that he expects the market will grow, in part because of their similarities to mutual funds as an investment vehicle.

There were a handful of questions from other members of the FIMSAC, and then Redfearn closed the panel by asking for their thoughts on how to improve the regulatory framework for bond ETFs. Memani said that anything that brings mutual funds and ETFs closer to one another in terms of regulatory requirements would improve liquidity and draw other investors into bond ETFs. Collins also said that streamlining the approval process for bond ETFs could provide more variety in the market and would be a good next step for regulations. Collins also said that there is a rumor that the SEC is working on an ETF rule.

Later in the meeting, SEC staff provided an update on the FIMSAC’s Bond ETF and Bond Fund Subcommittee meetings to date. The subcommittee identified three key areas of focus, which are: 1) issues with retail investors particularly around education and disclosure; 2) volatility in bond funds and liquidity risk management and redemption risk; and 3) the bond ETF ecosystem generally. Staff said that the subcommittee has had four meetings thus far on the first two topics.

Retail Investor Disclosure and Education

After lunch, the FIMSAC resumed the meeting and the third panel spoke on investor protection and investor education in the fixed-income space. The participants were:

  • Robert Colby, Chief Legal Officer, FINRA
  • Melissa Gainor, Senior Special Counsel, Division of Investment Management, U.S. Securities & Exchange Commission
  • Nick Goetze, Managing Director, Fixed Income Services, Raymond James
  • Gary Mottola, Research Director, FINRA Investor Education Foundation

The first question for the panel dealt broadly with investor education and asked the panel to describe the depth of investor knowledge of fixed-income markets. The panel was also asked to assess the usefulness of retail investor education initiatives. Goetze described the exhaustive procedures that Raymond James goes through to educate investors about different products, as well as the company’s efforts to provide basic financial information to investors generally.

The panel’s FINRA representatives provided an overview of FINRA’s view of investor education and said that in equities and fixed-income markets, FINRA wants to make sure that customers are getting advice that meets their needs, and that the products they buy fall within a “zone” of what products would work for the customer. Colby said that materials given to investors need to be “fair and balanced” and not one-sided advertisements and stressed the importance of firms developing internal controls to monitor the broker-client relationship. Colby also said that FINRA looks to see if customers are being sold complex, expensive products when simpler and cheaper products could meet their needs instead.

Mottola provided an overview of FINRA’s investor education surveys and found that that most investors do not have a good knowledge of fixed-income products. Mottola outlined survey results that found that large percentages of investors did not understand basic fixed-income market terms, like “markup,” “markdown” and “maturity date.” Mottola also noted that one-third of fixed-income investors could not define the term “credit quality.” Mottola argued that low levels of investor education do not make disclosure unhelpful and said that while there are inherent limitations to investors knowledge, it is critical that good information be distributed to them at the time that they make purchases.

Gainor also outlined the importance of accuracy in fund naming conventions and the rules governing fund names. Gainor pointed out that regulations are geared towards preventing funds from using misleading and deceptive names, as the names of funds are used by investors as a shorthand way of comparing financial products. Gainor also walked through the rules governing fund and ETF exposure to assets and sectors mentioned in their name.

One FIMSAC member asked the panel for thoughts on how to improve investor education. Mottola conceded that “moving the dial is hard” and said that investors need to have concise, accurate information presented to them at the time decisions are made. Another question dealt with whether investors understood the difference between brokers and dealers, and the mechanics of broker-dealer operations. Mottola said that most investors do not understand these topics at all, and that FINRA focuses on providing information to investors about ow their relationship with any financial advisor should be structured.

Electronic Trading in the Retail Market

The final panel focused on ways to improve market liquidity and ways to improve industry standards for all electronic trading. The panelists were:

  • Matthew Andresen, CEO, Headlands Technologies
  • Robert Colby, Chief Legal Officer, FINRA
  • Renzo Iturrino, Vice President, Fixed Income Product, Fidelity Capital Markets
  • Kristin Maher, Managing Director, Head of Fixed Income Services, Wells Fargo Advisors
  • Thomas Vales, Chairman and CEO, TMC Bonds

Maher kicked off the panel discussion be describing the ways that electronic trading has improved markets and ways that Wells Fargo aggregates data. Maher stated that TRACE and Municipal Securities Rulemaking Board (MSRB) data is essential to help clients determining whether the price of a municipal security is fair. Wells Fargo proved the ATS data to retail advisors desk to show the investor the full display of offerings and the financial advisors use this to help in assessing which of the over 40,000 offerings to purchase, explaining that the improvements in technology helps firms access liquidity and provide retail investors with a full range of investment options. Iturrino agreed that technology helps with aggregation and Fidelity similarly presents the complete market to retail investors as they see it. Iturrino also stated that electronic trading increased competition because Fidelity operates under an “open architecture model” so that 200 or more dealers have access to Fidelity’s retail order flow.

Vales stated that when the transparency measures went live, there was a transition period before most broker-dealers made all the TRACE and MSRB data available to retail investment advisors. Now, Vales stated that over 60 firms with a private labeled application makes real time or delayed price feed available to retail clients. Vales clearly sees most broker-dealers pass the information down to retail investors.

As both TRACE and MSRB required ATS indicator to be included for trade reporting, Vales saw that ATSs fill the void of exchange fragmentation, adding that now it looks like 25-30% municipal bond trades executing through ATSs with approximately 60% execution in ATSs for inter-dealer trades. Andresen agreed that ATSs contributed to a vibrant market by providing a platform for people to trade municipal bonds. Due to the large number of issuers, it was explained that there are up to one million offerings a day but only 40,000 trades a day, and that ATSs provide transparency for the end customer, allowing retail investors to trade by appointment which promotes competition and leads to better prices for individual auctions.

Andresen further described the auction process and raised a problem with some orders that do not trade, and that because there are no standing bids in municipal securities, the broker will set out an auction and will collect bids for about four hours before determining a “winner.” It was explained that a firm typically only trades one-third of the time after winning an auction due to the price, trade-away, and price fishing. Maher agreed this is a problem as customers only sell 40% of the time after the bidding process.

The panelists then discussed the complications with limit orders on securities that trade infrequently. Maher stated that Wells Fargo does not allow limit orders to be placed in the system. Colby stated that while limit orders are common in the equity world, there are additional obligations in the municipal bond market, and that if a firm recommends a limit order to a customer, it must explain the recommendation, the mechanics of the limit order, and limit orders also have additional agency duties. Iturrino stated that Fidelity offers its customers limit orders with specific time constraints.

All panelists stated that they will be ready for the market disclosure rules coming up in May, but there are several complications including coordinating among vendors, and need for a fully-developed solution that firms can test. Colby gave an overview of the disclosure rules which will give link to TRACE and time for the trade and the equivalent so that allow retail customers see the mark-ups.

Considering that most retail electronic trading venues are ATSs, the panelists considered whether the ATS rules work for this market. Andresen and Vales both agree the SEC ATS guidelines are very helpful and provide new entrants the flexibility and opportunity to try different things. Vales cautioned that extra burdens, such as Reg SCI and CAT, will be a detriment to the market because the annual trading volume in the municipal market is equivalent to one day of trading in the equity market.


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