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Securities and Exchange Commission Fixed Income Market Structure Advisory Committee Meeting

Securities and Exchange Commission

“Fixed Income Market Structure Advisory Committee Meeting”

Monday, April 15, 2019

 

Discussion Panels

Opening Statements

Jay Clayton, Chairman, Securities and Exchange Commission

In his opening statement, Clayton said that he believes the five recommendations put forward by the committee are pragmatic, thoughtful and actionable. He said the Securities and Exchange Commission (SEC) should look further at these recommendations in its decision-making process, and the vision for the Commission is to continue prioritizing these recommendations. Clayton said moving forward he would like to set an appropriate date to conclude the recommendation process in mid-2020 and move towards rulemaking and implementation.

Commissioner Elad Roisman

Roisman said he wanted to focus on the major themes of the agenda that promote clear transparency for all markets, including for fixed income markets. He said competition in markets is important, and he wants to encourage confidence, new entrants, and participation. Roisman said he wanted to focus on incentivizing market and investor participation while avoiding the creation of “impractical” solutions. He also would like U.S. markets to align with the global ecosystem and ensure diverse voices, stability, and continuity across domestic and global markets.

Michael Heaney, Chairman, Fixed Income Market Structure Advisory Committee

Heaney noted this meeting was the first since October 2018, and he would like to recall prior sentiments describing market functions and efficiencies moving forward. He said the Fixed Income Market Structure Advisory Committee (FIMSAC) is tasked with finding solutions for liquidity, transparency, and efficiency, encouraging the re-doubling of efforts to identify issues for fixed income markets, and use the Committee’s recommendations to better influence change within firms and the U.S. markets.

Panel I: Presentation on TRACE Block Pilot and Reference Data Service Proposal

Panel Presentations

Alex Ellenberg, Financial Industry Regulatory Authority (FINRA), said FINRA filed a rule proposal to create a centralized corporate bond reference data service, in a manner substantively the same at the FIMSAC recommendation. He said under the proposal underwriters must include additional information about newly issued bonds. Ellenberg said FINRA’s proposal would promote broad distribution of bonds information and would require the submission of 26  data fields, with data calculation type being the only field recommended by the FIMSAC that was not included. 13 of these fields are new, in that they are neither required nor voluntary fields on the current TRACE new issue form.  Ellenberg said these fields are important for liquidity and risk assessment and further the collection and use of broad and uniform data. Ellenberg also noted that FINRA has proposed a fee structure where fees would be paid by users of the data service.

Jonathan Sokobin, FINRA, said that at the request of the SEC, FINRA published a request for comments on a proposed corporate bond TRACE pilot program. The proposal outlines a 1-year pilot whereby TRACE trade information dissemination protocols would be changed for a subset of corporate securities.

FIMSAC had recommended that the pilot increase the current dissemination caps from $5 million to $10 million for investment grade corporate bonds, and from $1 million to $5 million for non-investment grade corporate bonds, and delay dissemination of any information about trades above the proposed $10 and $5 million caps for at least 48 hours.  The dissemination caps are transactions sizes above which the actual size of the trade is not disseminated (e.g. a $17MM IG corporate trade would show as $5MM+)

FINRA’s proposal would create three test groups:

–        Group 1, where securities would see dissemination delayed 48-hours with no change to the caps;

–        Group 2, where securities would see changes to the caps but no change to the dissemination timeframe; and

–        Group 3, where securities would see changes to both the caps and the timeframe.

He said the design, implementation and interpretation should describe impacts on various participants including individual investors, and ETFs. The pilot would select from all TRACE eligible securities, including 144a bonds, but not church bonds. Sokobin said the difference between the FIMSAC proposal and FINRA’s publication is the inclusion of a control group and multiple samples so that effects of the changes can be isolated and examined. Sokobin referenced SIFMA’s alternative assignment proposal that would select bonds for inclusion in the groups by reference to the last digit of their CUSIP.  He said to ensure consistency of the pilot program, the pilot would rotate test and control groups halfway through the pilot.  In addition, he indicated FINRA would seek input from academics, as well as the industry, in order to improve the approach and design, for assessing the economic impacts to investors and the industry.

Question & Answer

Sokobin addressed concerns about handling new issues, saying that bonds would, from the first day of secondary trading, be randomly assigned to control and test groups. He added that to address the curve there would be many factors included in the experiment. Sokobin said the goal is to have a good distribution of different types of issuers across groups and avoid complexity, so that reasonable comparisons and conclusions from the impacts of the pilot could be drawn. Sokobin also said FINRA would publish what CUSIP numbers are included in each group.

Panel II: Draft Recommendation on Pennying in the Corporate Bond and Municipal Securities Market

Panel Presentations

Matthew Anderson, Headlands Technologies, said the market structure currently works, especially for municipal markets, but price transparency and best execution standards for dealers need to be improved. He said dealer options in trades determine winners based on best bid price and trading is typically very competitive, but often trades do not occur due to dealers stepping in front of trades, ultimately hurting customers. He also said the recommendation would help maximize function and value for ETF auctions.

Jude Arena, Bank of America Merrill Lynch, said the recommendation will be helpful to parcel through confusion of pennying for municipal securities. He said pennying helps increase bid options incrementally and ending the practice would be damaging. Arena suggested that differentiating between pennying and the last look option would provide clarity for the best bidding process.

John Bagley, Municipal Securities Rulemaking Board (MSRB), said after significant outreach to broker dealers and alternative trading systems (ATSs), he believes pennying as it exists today is a problem for markets. He said by using FINRA’s data and through policies and procedures, the use of pennying should be addressed to prevent harm to liquidity and ensure best execution standards. Bagley also suggested differentiating between the term last look and pennying, and their systematic process for dealers to responsibly provide transparency and execute the best bid. He said pennying platforms should be used less frequently and less aggressively.

John Cahalane, Tradeweb, suggested that pennying and last look are not synonymous and should have clear definitions. Cahalane said given the municipal market’s limited liquidity, last look provides a valuable protocol and he supports correcting the abuse of pennying, although last look usage can be mistaken for pennying, such as through the crossing of bonds. Cahalane also recommended the use of venues, brokers, and participants to establish correct pricing, and said cross bond trades should be studied in the proposal.

Peg Henry, Stifel Financial, said she strongly agreed with Arena and it is “unfortunate” to have so much emphasis on last look options. She suggested using MSRB guidance to extend the definition to include use under ATF’s. Henry said the “devil is in the details” and dealers’ intent and use of pennying versus use of last look should be measured. She also said market makers need data to determine fair pricing.

Justin Land, Wasmer Schroeder, said there has been a lot of “short change” in the municipal securities and ATS algorithmic bidding process. He said he would like to see the fixed income market look more like the equity market. Land also suggested distinguishing pennying from last look for customers to maintain confidence in the best execution process.

Question & Answer

Anderson responded to a question about systematic pennying, saying most pennying occurs at auctions and bidders only win a third of these auctions. He said other times when pennying occurs it is through nominal value, leading to a worse price becoming the winning bid. Jude added that the difference between last look and pennying during the bidding process should be better define, and that pennying should a violation of the bidding process.

Henry addressed the timeline of the 2012 MSRB process for broker’s broker guidance, speaking on Rule 243. She said the common theme under the rule was to internalize trade at a nominal amount and diligent use of last look. Henry said the National Association of Securities Dealers (NASD) addressed fair pricing and the committee should consider defining last look and pennying.

Bagley said prescriptive language in any rule could be harmful, and that the rule can be effective without inclusion of dollar amounts or quantities, to eliminate the consistent behavior of pennying in order to improve the marketplace. Bagley recommended FINRA, the MSRB, and the SEC should collaborate on addressing the use of pennying and unintended consequences of not properly defining the term.

When asked how the use of pennying versus last look could be differentiated, Cahalane said although the systemic use of pennying hurts liquidity, there is a need to look at the potential benefits of it.

When asked about cross bond trading, Land said the cash raised versus bonds put out need to be looked at in terms of volatility. Bagley added that often 25 to 40 percent of bonds put out are actually sold, and Cahalane said there is need for more transparency in the municipal marketplace.

When asked about markups and unbundling, Henry said due to disclosure rules, much of mark ups on trades are not necessarily known to customers, and the process depends on time of trade. Arena added that there is no difference from these disclosures, and he is not sure if clients are aware during markups of trades.

Panel III: Draft Recommendation on Certain Principal Transactions with Advisory Clients

Panel Presentations Part 1: Municipal Underwritings

Horace Carter, Raymond Jones, said the result of underwriting in initial offerings for negotiated municipal bonds should follow the recommendation to meet broker dealer requirements of Section 206 of the Investor Advisor Act.

Chris Kendall, Charles Schwab, said fixed income trading for secondary and new issue markets should be explored by the committee. He said from the adviser perspective there is clear fiduciary duty to the client, and not a difference in compensation.

Anthony Liotti, UBS, said the recommendation benefits retail clients through best execution standards and ensures all retail clients have access to a full continuum of products and best execution standards, as well as liquidity.

Brad Winges, Hilltop Securities, said large municipal underwriting firms have a fiduciary obligation for brokerage accounts and following best execution standards.

Question & Answer

When asked how the subcommittee recommendations would prevent double dipping, Liotti responded that clients in trade by trade model are migrating to a holistic approach, which allows for discretionary trades to occur. He said financial advisor models and fee-based models allow advisors unadulterated access to product continuum, without any impediment on client securities received. Liotti added that best execution is advantageous for clients to buy bonds. Winges said the recommendation allows for issuers price to be accessed in the market for all retail investors and that could be prevented double dipping used by underwriters by removing fees and charge by commission. He discussed credit to managed account or alternative to carve out fee-based security charges, by allowing commission based or fee-based bonds. Carter expressed double dipping as his biggest concern, needing to be addressed.

When asked about the through put into the underwriting process, Winges said the subcommittee negotiated the process to provide the most opportunity for retail investor to compete in the market.

When asked the importance of principal trading in initial offer period and the benefit to investors, Liotti responded by suggesting enabling the ability to look across the entire landscape for best interest of client, through blanket client attestation, and clearly defining what client is being signed up for. He said pricing of municipal securities are typically preferred for clients to secure the best price in the marketplace.

Kendall responded to a question about improving fiduciary obligations by stating that the structure for advisors is to protect client best interests and should continue to be aligned with client priorities.

A question about the impact on retail orders was asked, to which Liotti responded there would be a greater amount of orders received, under a fee-based structure, which would lead to a better issue price. Winges “totally” agreed, adding that this would significantly increase large asset orders.

When asked about underwriting being pushed onto clients, and how to ensure confidence in pricing, Liotti said the vast majority of clients are buying high grade paper which are priced very well and often oversubscribed. He said the recommendation should alleviate concerns of lack of demand for pricing, except for sole underwriting deals through aggressive bond “dumping.”

Liotti and Carter responded to a question about how often small tranches are part of deals. Liotti said very little, as the traditional market is more active in marketplace of larger degree of liquidity.

Carter responded to a concern about primary offerings, to which he said retail orders are the highest priorities of order and after they are filled before other orders are addressed. He said the sale of negotiated retail deals being completely sold would be rare and on the brokerage side of deals.

Winges added that the proposal allowing managed accounts to participate in new issue order periods and should protect against dumping of managed accounts to avoid underwriters not having the best deal sold.

Recommendation passed with a vote of 18 to 0.

Panel Presentations Part 2: Liquidation of Bonds

Carter said, broker dealers are required to trade bonds away, and that clients should be provided with a best execution process without harming the overall process. He said the subcommittee recommends broker dealers be able to meet the Section 206(3) standard by allowing blind bid submissions on principal basis. Horace added that the risk associated is general market structure risk, which does not apply on trade by trade basis.

Liotti said markets have been acting quite well, but in the event of advisor based sell-offs a ripple effect could occur. He said when liquidity dries up traders back off and don’t bid on particular bonds.

Marshall Nicholson, Intercontinental Exchanges (ICE) Bonds, said during volatile periods municipal bond executions should be driven by retail activity, and incremental liquidity and best execution practices are ideal goals to set. He said the ATS platform should be used as the foundation for best execution standards to provide clarity and consistency for credible market participants. He said the reform to the system needs to provide liquidity and maximum dissemination of bids, allowing for auctions to be properly regulated and open to retail investors for structured protocols and consistent trades. He said the impact on bids wanted versus received should be consistent for volatile and nonvolatile times, rather than the current gap for volatile periods. He said it is difficult to make observation of how periods would be impacted in quality of bids received by investors, and should be measured.

Peter Sirbu, Ameriprise Financial, suggested to create a blind bidding system to offer retail clients quality of bids. He also recommended a fee-based trading system for best execution standard increase. Sirbu said to ensure bids are made at fair prices and the proposal only addresses the bid side of the market place. Sirbu added that without access to capital the fee-based structure would the best approach.

Question & Answer

A number of panelists addressed concerns about blind bidding and the best execution process. Sirbu said in order to get to blind bidding, the process would require desks to have big operational changes and determine whether prices are fair and reasonable. He said small firms distinction between fees and desk operations would provide clarity for a less difficult approach. Nicholson said to create a better process, there should be elimination of certain intricacies around pennying and creation of fair and diverse markets. Liotti said any proposal should include last look and pennying definitions without regulating process too much and losing liquidity. Winges said blind bidding would help set prices and prevent firms from stepping in front and changing the price during the bidding process. Carter said the implementation of a new work flow would be very expensive and unnecessary. He said when markets become illiquid, distressed, or dislocated, predatory behaviors become prevalent and need to be protected against, and this would not occur in a blind process. He added that clients can choose to opt out if the bidding is not in their best interest.

When asked about distressed markets and predatory behavior, Nicholson said in times of stress firms are willing to step up for clients under rules-based systems, especially when the process is blind. He added establishing a price formation during blind bidding would prevent predatory behavior in distressed periods.

The committee determined to reconvene on this matter in July, after further discussing blind biding and last look.

Panel IV: Updates from the Credit Ratings, ETFs and Bond Funds, and Corporate Bond Transparency Subcommittee

Panel Presentations

Amy McGarrity, Colorado Public Employees Retirement Association, said the credit rating subcommittee has discussed both the use of the ratings and potential rating changes as well as the costs and benefits of the current rating system. She spoke about the issuance by nationally recognized statistical rating organization (NRSRO) of unsolicited ratings, and working to understand what conflicts of interest are created through the issuer paid model. McGarrity discussed the possibility of oversight for the rating process and compliance for NRSRO’s. She said the goal is to mitigate conflicts and control structure in order to provide transparency, accountability, and good governance. McGarrity said the subcommittee also examined the roles of NRSRO’s, the Triple A credit structure, and the potential creation of an oversight board. She said the subcommittee is also examining the SEC rule 17G-5 program for increasing competition and improve the credit rating quality, and how the rules could create a regime that is more accessible to smaller firms. McGarrity said from the issuers’ perspective this rule is unnecessarily burdensome, and even though it seems the rule is increasing transparency and improving research, some argue it is decreasing competition and could cause risk. McGarrity said the overall take away is the rule may not be working as intended and adapting it to municipal and corporate markets is not recommended. Further, she said the subcommittee will continue to discuss rules regarding selective rating disclosures, alternative payment models, and explore the possibility of hosting an issuer panel to discuss the current ratings model.

Ananth Madhavean, BlackRock, said the ETF and Bond Funds subcommittee has focused on developing a report which synthesizes a “complex” topic, and that their report is not meant to be overwhelmingly comprehensive or broad on systemic risk. He provided a “high level” tour, discussing the report’s topics of the structure of mutual funds and their difference from ETF’s, how they are redeemed, as well as understanding how they flow and affect market quality. Madhaven said the report is purely event based, and studies ETF behavior is stressed markets. He recommended incorporating feedback from academics to provide comprehensive, empirical fact finding, to address and understand the gaps from their report.

Mihir Worah, PIMCO, said the corporate bond transparency subcommittee looked at individual investments and individual retail investors. He said the issue revolves around markups and disclosures and whether there should be pre- and post-trade transparency inclusion. Worah said brokerage statements for bond buying and selling markups are reported higher than what bonds are sold at, and expressed the possibility of moving towards a more centralized system, like TRACE or pennying for pre-trade transparency. Worah also spoke on internotes, and their small share of corporate markets. He said one billion in internotes are issued yearly and are attractive to individual investors.

Panel V: LIBOR Transition: Implications for the Corporate Bond and Municipal Securities Markets

Panel Presentations

Ed Fitzpatrick, JP Morgan Asset Management, said there are many challenges with the transition from the London Interbank Offered Rate (LIBOR) to the Secured Overnight Financing Rate (SOFR), and the first issues to address is the legacy structures. He said there should be a migration phase that includes dual reference rates, under the new rate regime of SOFR. Fitzpatrick said it is important for investor awareness and market preparedness to be increased, and he believes the Alternative Reference Rate Committee (AARC) has done a good job in these areas. Fitzpatrick said the timeliness of the process is paramount, and needs to address industry standard language on credit spread, trigger events, and the fallback process to create a more robust SOFR market. He said principle issues are cash market concerns and term reference rates, as floating rate issuers have become accustomed to payments known in advance. In addition, he mentioned the need for a robust SOFR swap market, which should be clear and improve depth. Fitzpatrick said the future of the reference rate regime is not isolated to the U.S. alone.

David Knutson, Schroeders, said the credit roundtable proposed standard rate language, which ARRC is working to document. He said data shows 30 to 40 firms have begun to purchase SOFR notes, and are beginning to experiment in these markets to prepare for the transition. Knutson said hedge accounting is also an area that needs to be addressed. He recommended hard triggers in documentation for clear and consistent change to the SOFR regime, as well as addressing concerns over a “zombie” LIBOR structure. Knutson also referenced minimizing value transfer to avoid enriching one party at the expense of another during this transition. He included thoughts about adjusting existing payment structures through legal safe harbors to eliminate confusion and uncertainty from an abrupt cessation of LIBOR, and recommended a clear understanding of the transition, to better sync markets.

Julian Potenza, Fidelity Management & Research Co., said the transition to SOFR is “volatile” and it is hard to predict all concerns, but the committee has discussed areas to smooth out the volatility in the transition. He said overnight volatility in SOFR is not unique to this rate and the rate methodology is comparable to current reference rate structure. Potenza said repo market dynamics should be significantly important in the adoption of SOFR, as well as include fallback language. Potenza recommended clear, consistent, investor friendly language for fallback language, as well as clear triggers and minimal agent or issuer discretion to avoid creation of winners and losers. He said the committee is actively engaged in the development of SOFR markets in the bond and money market portfolio.

Tom Wipf, Morgan Stanley, said AARC began with 15 G-SIB banks to solve for a replacement rate for LIBOR and to determine an exit & entry plan into a new rate, which was ultimately determined to be SOFR. Wipf said AARC 1.0 made the determination to recommend SOFR because it is derived from 750 billion to one trillion dollars of daily transaction activity. Further, he said AARC 2.0 is focused on successfully implementing the pace transition plan of the new rates, and address the risk and legacy contracts, such as derivatives, deal with robust fallback language. Wipf pointed out two key areas to address: 1) the need to bridge LIBOR to SOFR derivatives markets series of protocols, and 2) for the cash market conversion from of floating notes to fixed rates.

Question & Answer

Knutson addressed questions about state versus federal legislation, saying Delaware and New York legislation could help establish precedent and get the markets moving in the right way.

Addressing questions about fallback, Wipf said there will need to be language for fallbacks and protocols in place to navigate the transition. Fitzpatrick said once more formalized fallback language is in place, it will help standardize a smooth transition. Wipf warned of a possible “zombie” LIBOR existing, post transition, due to specific definitions in transaction documents and this demands clear fallback language to be included in a proposal.

Wipf addressed questions about legacy transition and interbank lending, saying the problem is banks do not currently do interbank lending. He said the repo market adoption to the SOFR market would help resolve this concern as the LIBOR legal definitions are very specific. Wipf added that outreach and getting information out there to bring awareness to this risk is important.

Chairman Clayton requested an update from the panel in six months.

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