The SEC Takes Aim At The Corporate and Municipal Bond Markets
“Sunlight is the best disinfectant” – U.S. Supreme Court Justice Louis Brandeis
Last week, SEC Chair Mary Jo White gave a speech about adding more transparency to the US corporate and municipal bond markets:
“I am therefore concerned that in the fixed income markets, technology is being leveraged simply to make the old, decentralized method of trading more efficient for market intermediaries, and its potential to achieve more widespread benefits for investors, including the broad availability of pre-trade pricing information, lower search costs, and greater price competition – especially for retail investors – is not being realized.”
Chair White said she will be working on a best execution rule for the fixed income markets and a rule which would require disclosure of “mark ups” in riskless principal transactions. We believe that both of these suggestions should increase transparency and should help institutional and retail investors.
Chair White then went further and said:
“I have asked the staff to focus on a regulatory initiative to enhance the public availability of pre-trade pricing information in the fixed income markets, particularly with respect to smaller retail-size orders.
“This initiative would require the public dissemination of the best prices generated by alternative trading systems and other electronic dealer networks in the corporate and municipal bond markets.”
Whoa!! We just got a Reg ATS flashback. You will recall that Reg ATS was implemented in 1997 and essentially forced all orders on an ECN’s (electronic communications network) book to be displayed to the public quote. These included the block sized “I-only” orders that institutional investors frequently used to attract other block sized orders. Reg ATS essentially shut down a major source of liquidity that institutions were supplying to each other and ended up fragmenting the market and shrinking the average trade size. At the time, then SEC Chairman Arthur Levitt, tried to justify the rule by saying : “Today, is there “fragmentation” in the sense that there are separate, isolated markets with reduced liquidity in normal trading hours? I think not. But is there “fragmentation” in terms of multiple pools of liquidity competing for orders based on transparent quotes and prices? Absolutely.”
After reading that part of Chair White’s speech, we immediately became fearful that the SEC was about to embark on the same journey in the fixed income markets that they did over the past 15 years in the equity market. We had visions of all those HFT’s licking their chops and getting ready to invade the corporate and municipal bond markets. However, before blasting off a blog post about how the SEC was doomed to repeat their sins of the past, we decided to finish reading Chair White’s speech and found comfort in these words:
“In particular, the goal of competition among trading venues can lead to what we generally call “fragmentation,” where orders may be spread among competing venues. Too much fragmentation may in turn detract from efficient execution and an opportunity for investor orders to meet directly by creating opportunities for excessive intermediation.”
“I am, however, also acutely aware of the need to carefully calibrate any regulatory proposal in this area to best achieve its goals and minimize unintended consequences. In particular, we must be mindful to strike the right balance of compelling the disclosure of meaningful pre-trade pricing information without discouraging market participants from producing it because of concerns that it will compromise trading positions.”
Whew!! Chair White has calmed our nerves somewhat. She clearly understands the difference between competition and fragmentation (unlike one of her predecessors, Arthur Levitt). And she clearly understands that there may be unintended consequences of new regulations. The goal is to add transparency without reducing liquidity by creating artificial arbitrage situations. Clearly, the SEC has a noble goal and we wish them well. However, when crafting these new fixed income rules, we hope they call on some of us who have experienced firsthand the unintended consequences that SEC regulations have had on the equity market.