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SEC FIMSAC Meeting

Wesley Althoff | [email protected] | 212-313-1129

Securities and Exchange Commission

Meeting of the Fixed Income Market Structure Advisory Committee (FIMSAC)

Monday, October 29, 2018

Key Topics & Takeaways

  • The FIMSAC Members unanimously approved all the proposals.
    • The Draft Recommendations on exchange-traded fund (ETF) classification provides different classification choices for investors to make the distinction between exchange-traded products (ETPs) and recommends making distinguishing the products as ETF, exchange-traded note (ETN), exchange-traded commodity (ETC) or exchange-traded instrument (ETI), based on the underlying securities.
    • The education proposal recommends the Commission encourage the formation of an industry-wide group to promote educations with specific recommendations, including a training module for financial advisors and ways to improve investor education.
    • The Draft Recommendation on Collection and Dissemination of Reference Data recommends developing a single central source of new issue reference data like that available in the municipal bond market.
  • The Municipal Securities Rulemaking Board (MSRB) presented its Analysis of Municipal Securities Pre-Trade Data from Alternative Trading Systems paper.
  • A panel discussed the role of credit ratings in a higher leveraged world:
    • Companies have higher leverage from mergers and acquisitions and using debt to pay shareholders, but all the credit ratings incorporate leverage in their ratings as the ratings are forward looking statements based on the company’s risk of default.
    • The key factor on the liquidity of distressed bonds after a potential downgrade to below investment grade will depend on the investment requirements of the increased number of foreign investors.

Opening Statements

SEC Chairman Jay Clayton, Commissioner Kara Stein, Commissioner Robert Jackson, Commissioner Elad Roisman and Division of Trading and Markets Director Brett Redfearn gave welcoming remarks that thanked the FIMSAC members and noted the productive first year. Clayton also gave remarks on the importance of pricing in the marketplace and that with a dynamic economy the model should be reviewed and improved. Stein added that she is most interested in hearing what should be the right classifications of ETFs and how collection and reference data will facilitate electronic trading. Roisman looked forward to making improvements to the fixed income market and the importance of reliable pre- and post-trade transparency. Redfearn gave an overview of the plans for the day, including the consideration of three recommendations. Additionally, FIMSAC Chairman Michael Heaney stated the 2019 FIMSAC meetings will be on January 28, May 6, July 29 and October 28.

FIMSAC Committee Discussion

Draft Recommendations on ETF classification and Education and Data

The FIMSAC Subcommittee on ETFs and Bond Funds made the following recommendations regarding education and data due to the increased presence of fixed income ETFs and investor’ interest in them. The subcommittee worked through these three workstreams: (1) draft comment letter on the Commission’s proposal on the classification and appropriation of ETFs; (2) study and make recommendations on ways to promote investor education and create an accessible database with key documents; and (3) in the January meeting, the subcommittee will present its findings on how ETFs will operate in stressed markets. The draft comment letter is available here and the findings and recommendations regarding education and data is located here.

ETF Classification Preliminary Recommendation

Lynn Martin discussed the draft of the comment letter to support the Commission’s ETF proposal.  Martin stated that as ETFs’ complexity increased, the risk characteristics are deviating from traditional ETFs. Therefore, the letter discusses different classification choices discussed to make the distinction between ETFs, such as passive versus active investing strategies, but recognizes that some of the proposed classifications may be blurred, such as smart beta strategies. The subcommittee stated that the distinguishing factors should not be based on the structure, e.g., Undertakings for the Collective Investment of Transferable Securities (UCITS) and ’40 Act funds and that funds with the same underlying holdings should be treated the same. The letter suggested the Commission should focus on establishing greater clarity on the term ETF.

Martin described the different potential classifications of ETPs that the subcommittee recommended, which include: ETF, ETN, ETC and ETI. An ETF would comply with Rule 6c-11 with the underlying securities being liquid but not include leverage or inverse features. ETNs would not be subject to Rule 6c-11 and include debt instruments that provide an index-based return. ETCs would not comply with Rule 6c-11 and the underlying securities would consist of physical or derivative commodities. ETIs would include features that provide leverage and inverse features.

Questions About the Comment Letter

The subcommittee then fielded questions by all FIMSAC members on the comment letter recommendation. Elisse Walter asked the subcommittee members about the difficulty in determining what category each product it will fall in and how much will require interpretive advice by the Commission. Mihir Worah followed up with a similar question and asked whether there would be any percentage limits. Ananth Madhavan thought there may be some funds that will cross the classification and may require additional Commission guidance. Madhavan also stated that the main goal is to have truth in labeling with a focus on trading, leverage and the holdings or goals of return. However, Madhavan continued that drawing a line between active and an index may prove to be too difficult, and that there can be fine tuning and interpretation done at a later stage.

Larry Harris stated the importance of classifying between active and passive funds, particularly because most ETFs are associated with indexes. Madhavan stated this distinction is increasingly harder to make as a blurring of the lines is seen in the market where some passive funds have some features that are considered active. Martin agreed and added the goal of ensuring the future can accommodate the regulatory structure. However, Harris defined passive funds as one with any well-defined criteria, regardless of complexity, whereas any human or machine judgments should be considered active. Harris also thought this could be addressed in the education section but possibly put something in the title to at least give trigger that more education should may be needed. Madhavan similarly recommended some fine-tuning of the recommendation and maybe consider including some percentages.

Amy McGarrity asked more about the mandated IAV and the impact from market failures. Martin stated that IAVs are good for retail because it constitutes a value the investor can point to throughout the day. Madhavan stated that the challenge was how to produce meaningful numbers and wanted to balance with the helpful and misleading. Kumar Venkataraman stated that the IAV is useful when the underlying securities trade frequently, so the education recommendation should include information on use of IAV with the caveat that prices may be stale. Harris stated that the IAV should be published every day but equally important for someone to publicize the calculation of the correlation of the IAV to the underlying securities prices. Tom Gira added that FINRA looks to see if IAV diverges from the market to see if there is a disconnect in the market.

The comment letter recommendation was approved unanimously by the FIMSAC members.

Education and Data Preliminary Recommendation

Venkataraman discussed the subcommittee’s education proposal and how many participants felt investors should be educated, aiming at retail investors in distinct plain language provided by academics and trade groups. As such, the subcommittee recommended the Commission encourage the formation of an industry-wide group to promote education. This group will address the following: develop a trading module within the existing certifications for financial advisors that ensure correct usage of terms, recognize that ETF premiums and discounts may be misleading when the net asset value (NAV) is still and the like; improve investor education; and identify key standard information regarding ETFs.

Questions from FIMSAC Members

The subcommittee then fielded questions from the FIMSAC members. Sonali Theisen asked whether the education should include more than ETF products and how the subcommittee imagines how the participation measures under section h would work. Madhavan stated that the subcommittee was initially focused on ETFs and bond funds but could see the education platform expanding to the rest of the ecosystem. Venkataraman stated that based on a survey, there was a shortage of useful data on whether the process works well and suggested to collect this information. Venkataraman stated that the information would be collected from the issuer and provided to the regulators with a possible publication delay of a year to eighteen months.

The FIMSAC members and Chair Clayton then discussed the importance of keeping this information simple and easily understandable. They also discussed including the expertise of those experienced in designing effective educational products, conduct testing and refer to the options education done for really complex products.

The education recommendation was approved unanimously by the FIMSAC members.

Draft Recommendation on Collection and Dissemination of Reference Data

Rick McVey discussed the Technology and Electronic Trading subcommittee’s recommendation, available here, to make improvements to fixed income reference data. He explained that the group is still considering market structure changes to electronic trading as there are gaps in timing and accuracy of reference data. McVey also highlighted the problems with getting new issue information into systems, noting that a central database exists for municipal bonds that has solved some of these issues for muni bonds, but these problems still exist in corporates.

Spencer Gallagher of ICE Data Services discussed their work providing better access to accurate reference data and how the reference data on a new bond issue is typically made available about half the time at the pricing of the deal. He continued that the current system is inconsistent and inefficient as the new issue reference data is disseminated via emails from the underwriters. Unlike the muni market, he explained, there is no central source of information, so buyers must piece together information from various sources with some relying on getting the information from the prospectus off Edgar; the recommendation gives minimum required uniform information that will provide better and consistent disclosure.

Fred Demesy of Refinity stated that with the electronification of bond trading, there is increased importance of having equal access to information to avoid information asymmetry across platforms. Currently, he explained, investors must source data from three avenues: (1) contribution from customers/sell desks; (2) teams that source the information from websites and sell side; and (3) third-party vendors. Demesy noted that now that market participants need to know the price of the bond at pricing, with intra-day updates, the distribution of data needs to be uniform and timely.

Bob LoBue of JP Morgan discussed the underwriting process, highlighting the importance of accurate information and their sensitives to sharing the information with constituents or vendors to ensure the information is consistent and accurate. He added that all this is very ad-hoc and not a great process. LoBue continued that the deals are typically priced between 3 and 5pm, and underwriters have 15 minutes to get key information to FINRA and will need to ensure trading is set-up. LoBue stated that once they have a legal term sheet, typically one hour after pricing, they will send it to all investor clients.

Alex Sedgwick of T. Rowe Price shared his thoughts on how investors collect new issue information. Sedgwick discussed their proprietary software that shares the price information with the trading desk, portfolio managers and research. However, this still requires a key manual process of entering that information, which typically involves someone from the trading desk gets the information from Bloomberg. He explained that there is a delay in a new issue being set up in electronic trading, as electronic market makers need this information to provide accurate pricing and evaluation, adding that a significant delay may affect best execution analysis when calculating the NAVs and evaluating executions against benchmarks.

Ola Persson of FINRA discussed FINRA’s role in improving this process. For trading to begin, the security needs to be set up in TRACE and the underwriter must give basic details on that security prior to first transaction. Some key information includes: identifying firm; specifying how to disseminate the information; and providing information on the bond. There are approximately ten fields, with more optional, but the main focus is to get the information out to the TRACE reporting firm and the subscribers of the data feeds. Persson explained that FINRA could build a database with some technology advancements and require underwriters to provide the information.

The panelists then fielded questions from the FIMSAC members. LoBue stated that as a first step, the accuracy of the price must be ensured, decide who should receive the information and determine when the confidentiality requirements are released. Demesy and Gallagher stated some of the key fields include the issue amount and some sort of debt ranking (senior, second lien, etc.) but at this time they do not need prospectus level content or the full terms of conditions. Persson and LoBue stated that increasing the number of required fields will affect timeliness, so the list needs to balance time with information. Persson can ask for a credit rating but cannot send it to a third part, and that FINRA can only create obligations on their members—the underwriters. LoBue stated that exchanges would have to add rules to obligate the issuers. LoBue added that the burden should be on the underwriter community to ensure there is a standardized process that works universally, and the list of criteria can be amended with further input from more stakeholders.

The FIMSAC Members voted to approve the recommendation.

Corporate Bond Transparency Subcommittee Update

Worah gave an update on the considerations of the Corporate Bond Transparency Subcommittee and stated the subcommittees overlap with the other recommendations today. The subcommittee has primarily focused on improving pre-trade transparency and reviewed the European method under MiFID II and found it to be onerous, expensive and less transparent than in the U.S. Worah continued that the subcommittee looked into the retail corporate bond market and found that while there were a few minor issues, the subcommittee generally found that liquidity and transparency exists. The subcommittee also considered whether market markets should post levels on Securities Information Processors (SIPs) and whether market-makers should be mandated to stick to those levels, but the subcommittee did not think that would be best either. They also considered requiring reporting on monthly basis, but this did not seem appropriate because of evolvement of electronic trading. The subcommittee is still considering ways to improve transparency and looks forward to discussing more at the next FIMSAC meeting.

Municipal Securities Transparency Subcommittee Update and Presentation of the Pre-Trade Transparency Analysis

Simon Wu of the MSRB presented its Analysis of Municipal Securities Pre-Trade Data from Alternative Trading Systems, available here. The MSRB has been collecting and disseminating post-trade information and provided yield curve and pricing scale information. This report was focused on quote data accessible only to ATS participants. The data was collected from two ATS systems for 4-month period in 2015. Wu stated that the Muni market is large and primary retail investors—holding 40 percent directly and as much as 66 percent directly and indirectly—and predominately with a long investment horizon. Wu noted that trading is initially frequent and then sporadic, and that the illiquid nature of the muni market makes it more difficult to find a counter-party and muni bonds cannot be shorted.

The MSRB paper treated like quotes and request for bids separately and found that about 60 percent of inter-dealer trades occurred on ATS. Additionally, the paper found that the majority of trades have less than $100,000 par value—suggesting retail investors. Of the request for quote data, 99 percent are request for bids and only 25 percent of these requests ended at execution, but over 99 percent traded at the highest bid price. The paper found that interdealer trades were symmetrical around the best bid and offers quotes. When there was a request for bids, the offeror typically received 20 responses, but execution only happened approximately 40 percent of the time. This infrequent trading could be caused by clients trying to figure out the price of bonds, and had no intention of execution, or the execution helped elsewhere.

MSRB took a snap shot of the market each day at 10am and found that 90 percent of muni bonds only had one or two quoting. In part, this is from the market structure where an investor must own the bond to trade. The 2016 MSRB best execution rules and the increased use of ATSs may show more quotes and responses today.

Corporate Credit Markets: The Role of Credit Ratings in a Higher Leverage World

Committee Chair Heaney gave an overview of the focus for this panel discussion and highlighted the critical role of credit ratings in the bond market. Heaney discussed the potential implications of increased mergers and acquisitions activity with leverage and increase in corporate debt overall in a potential economic downturn. Heaney was interested in hearing ideas for improving the application and reliability of ratings and the distinguishing factors between investment and non-investment grade.

Jessica Kane, Director of the SEC’s Office of Credit Ratings from SEC provided an overview of the regulatory structure of credit rating agencies, explaining that the Dodd-Frank Act mandated the creation of the Office of Credit Ratings. Credit rating agencies must manage the conflicts of interest by separating the marketing side that gathers business from the analytical side that rates the bonds. The credit rating agency’s boards have independent directors and approve procedures for rating a bond. The rating agencies must disclose a description of the data relied on in the analysis and an explanation on the rating’s potential volatility. The Commission conducts annual exams of each nationally recognized statistical rating organization (NRSRO) to ensure it complies with its policies and procedures for determining ratings and for compliance with the regulations.

The panelists began by discussing their view of the economic cycle. Adam Richmond from Morgan Stanley began by stating he has a cautious view on the credit markets and while the vulnerabilities are hard to spot until after the fact, the problem areas usually involve leverage. Richmond identified some potential riskier ratings for companies that have high leverage from high business profiles, promises to decrease leverage over time, and those with low borrowing costs. Eric Beinstein from JP Morgan stated that leverage in mergers and acquisitions deals has increased to 1.6 times, and based on a sample of deals, most companies have not de-levered post transactions. Most companies are using the debt markets to pay shareholders and any economic downturn we show the impact of about one fourth of high-grade companies being over levered. Murphy stated that the downgrades will not be from companies with A ratings, and leverage from companies with a BBB rating have decreased even though the leverage for A rated companies has increased. Kennedy did not see an economic downturn soon but is watching out for a small subset of companies, some of which are smaller issuers.

The representatives from rating agencies discussed the ratings signifying an ability to handle an economic downturn. Craig Parmalee from S&P Global discussed the changes made since the financial crises and that ratings are forward looking on how companies can handle economic stress and their likelihood of defaulting. Additionally, Parmalee stated that they created credit and sector level committees to talk about risk and pass that information to the analytical teams. Daniel Gates from Moody’s Investors Service agreed that ratings are forward looking about the companies’ risk of default and that the ratings cannot be reduced to one number, such as debt to EBITDA. Van Hesser from Kroll Bond Rating Agency stated that the BBB firms will be more durable in the next downturn and any market shocks will depend on the investor base. Hesser also recommended that corporate managers, boards, and policy makers should all learn from each cycle to better understand how a company will perform going forward.

Heaney asked whether the rating process for a post-merger company is the same as a new company. Gates stated that these are both events that need a new assessment that will use the same process and methods. Gates added that the forward-looking assessment may not be twelve months and the corresponding press release will cover the factors considered in the rating. Hesser stated that a rating has some flexibility and the agencies re-asses for material changes to ensure the ratings can be durable throughout the economic cycle.

Heaney then asked about the process of handling a downgrade to high-yield. John Bender from Legal and General Investment Management America stated that the majority will sell when a bond is downgraded to high-yield and they have approximately 120 days to liquidate those securities. Brian Kennedy from Loomis Sayles stated that he tries avoiding selling right after a downgrade and has a bucket to cover any downgrades, particularly those investment grade securities that already have a down grade priced in. Kennedy also stated that they will have a specified time before selling. Tom Murphy from Columbia Threadneedle Investments also referenced a 5-10 percent bucket to handle any downgrades.

Heaney asked more about the ratings process and relationship between the issuer and rating analysis and whether they provide any unsolicited credit rating agencies. Parmalee stated that he is on the analytical side and is not part of the relationship or commercial side and that his involvement begins with a presentation of the company to the analytical team with lots of follow up questions and continue the dialogue, which continues after the rating is issued. Hesser and Gates agreed this was a very similar process and all three generally will not do unsolicited ratings, unless there is a market interest and there is a large outstanding issuance.

Garcia asked about credit trends, market disruptions and liquidity and anything to signals for the next crisis. Murphy stated the sell-sides knowledge is pretty good and tracking economic trends is key. As to liquidity, Murphy stated that with the large number of foreign investors, it’s more difficult to understand their perspectives and investment criteria for buying and selling a security. Kennedy stated that he is concerned with liquidity in the market, particularly depending on how markets will react post a downgrade. Bender recommended keeping track of the Federal Reserve rating which could result in a flat or inverted curve. Beinstein stated there is a more diverse base of issuers so market is more stable overall.

Harris asked if there is anything the SEC is doing that it should or should not do to mitigate the risk, and Chair Clayton followed up that he is worried about forced selling. Beinstein stated that the TRACE pilot is important to provide more information. Kennedy stated that once the buckets are full, they will be forced to sell, which will create a run. Beinstein also stated that passive high-yield bond ETFs may cause problems in the future, but they are currently still too small of a market.

Future Topics for Committee Consideration

The FIMSAC then discussed potential future topics for the Committee to discuss. Harris recommended the committee: (1) explore the establishment and growth in state municipal bond banks; (2) review riskless principle trades that are marked up and conflate the compensation; (3) consider how information is provided to retail clients on a pre-trade basis; and (4) explore any potential problems with counter-party risk. Venkataraman would like the committee to better understand how index providers construct their products in an optimal way. Winges suggested the committee look into any declines in small bond issues, smaller underwriters and less ATS quotes.  Worah suggested the committee help ensure there is appropriate fall back language for replacing LIBOR for cash bonds. Gira recommended the committee review trade reporting including compensation and consider whether the current mark-up disclosure construct is still appropriate. Carter would like to see more price inputs and recommended the committee consider including prices on ATSs.

For more information on this meeting, please click here.