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SEC Fixed Income Market Structure Advisory Committee Meeting

Securities and Exchange Commission

“Fixed Income Market Structure Advisory Committee Meeting”

Monday, February 10, 2020

Discussion Panels

Opening Statements

Commissioner Hester M. Peirce, Securities and Exchange Commission

In her statement, Peirce expressed appreciation for the Fixed Income Market Structure Advisory Committee’s (FIMSAC) discussion about credit ratings and municipal securities. She added that she would like to hear about areas where legislation may be helpful in the municipal securities space.

Michael Heaney, Chairman, Fixed Income Market Structure Advisory Committee

Heaney noted that the FIMSAC has had a productive two years and that it has made ten recommendations on nine different topics. He said that the FIMSAC would consider two additional recommendations today to address conflicts in the current credit rating framework and to consider municipal securities disclosures.

Panel I: Credit Ratings Discussion Concerning Issuer-Pay Conflict of Interest

Panel Presentations

Amy McGarrity, Colorado Public Employee’s Retirement Association, explained that the panel would discuss the reworking of the credit rating random assignment model, specifically about nationally recognized statistical rating organizations (NRSROs), transparency and performance metrics.

Martin Fridson, Lehmann Livian Fridson Advisors, provided a broad view of how credit rating agencies operate and provide feedback to avoid counterproductive regulations. Fridson stated that since 2008 the market has become more enhanced on the commercial side for credit rating, specifically the distribution of the bond universe. Fridson suggested that structured finance and corporate markets could be managed better through more incentives. Fridson stated that surveillance is important for underwriters and suggested that the marketplace should determine a credit rating agency’s credibility.

David Jacob said that structured finance is a unique aspect of the fixed income market. He emphasized that rating agencies are not prohibited from changing their rating criteria, which allows for issuers to apply pressure on the agencies. He recommended that the SEC consider increasing financial penalties for violations. Jacob added that there is a lack of sufficient information in the unsolicited rating market. He also highlighted the importance of surveillance and suggested that the rating criteria process could be more precise. Jacob said that performance metrics are “tricky” and that there should be a metric to determine how often a rating agency is changing its criteria to attract business.

Question & Answer

Heaney asked about surveillance for the protection of “mom and pop” investors. Fridson said he is not “keen” on the SEC managing the rating process. He stated that he agrees on enhanced disclosure requirements but that there are organizations that evaluate ratings.

Brett Redfearn, Division of Trading and Markets, SEC, asked about examples of ratings that were too high and harmed competition. Jacob said the compensation model is tough to follow because analysts get paid based on profitability. He added that disclosures could potentially help address the problem.

Lawrence Harris, FIMSAC, asked about providing market participants a bigger voice to improve the quality of ratings. Fridson said that in principle it makes sense, but the SEC would need to consider who the participant is and added that money managers want static ratings. Jacob added that the rating agencies claim they rate through the economic cycle.

Scott Krohn, FIMSAC, suggested that companies rotate through the three main rating agencies. Jacob said that rotation is good behavior and companies should regularly utilize this practice. Fridson added that this has a similar effect as surveillance.

Panel II: Draft Technology and Electronic Trading Recommendation to Enhance Data Reported to TRACE

Panel Presentations

Sonali Theisen, FIMSAC, stated that the recommendation considers improvements to delayed spot trading and electronic trading. She added that the recommendation aims to increase transparency, clarify definitions and help market participation for investment analysis and risk management. Theisen said the recommendation does not tag a recommendation for the size of electronic trading. She said the recommendation makes delayed spot trading transparent and consistent, addresses passive investing and the rise of electronically traded funds (ETFs), and defines portfolio trades to include a basket of 30 unique issues.

Josh Barrickman, Vanguard, explained that delayed spot trading helps set the interest rate to matchup the redemption of a fund and that this helps prevent trades from having to be reversed. Barrickman suggested that this recommendation is “not much of a lift” on the buy-side and he does not see many downsides. He added that it provides clarity to transaction cost analysis (TCA) and removes noise that might stop trades. He continued that this recommendation creates a more robust and transparent market. Barrickman added that electronic trading is quickly evolving and that the advent of strong data offerings in the pricing space is not in sync with the protocols currently in place.

Horace Carter, Raymond James, said that price action and the corporate bond system are relative and that trading occurs on the retail and private client side. He said the recommendation helps delayed spot trading spread and pricing and added that it does not add a “heavy lift” for dealers and helps with trade execution. Carter said that the committee did not believe it best to tag a definite protocol for electronic trade or ETF qualifications.

Lynn Martin, ICE Data Services, said there are no real-time tools in fixed income markets to address current market trends. She said that knowing the course of trade helps eliminate noise and coalesces with data. She emphasized that the recommendation would increase transparency and reduce complexities. Martin added that liquidity in ETFs has been an area of concern and that the proposal helps market transparency, efficiency and costs. Martin continued that the costs of individual sourcing and synthetic creation of a basket are equal to or worse than the cost of a portfolio basket. She added that there is a need to better understand the best execution practices of a trade and for a consistent regulatory framework.

Ola Persson, Financial Industry Regulatory Authority (FINRA), added that there is a much higher concentration of trading for larger transactions around 3 pm EST. He said that 70 percent of trades happen within a 15-minute window and again around 4 pm EST. He said this committee has had to update downstream systems and compliance tools. He added that two of the four areas in the recommendation could be observed, not including single agreed upon pricing.

Question & Answer

Tom Gira, FIMSAC, asked about implementing benchmarks for the overall price allocation to components of the portfolio basket. Carter recommended that FINRA should consider adding that analysis in their examination process.

Larry Harris, FIMSAC, asked about reducing the basket definition to a two-line item level rather than thirty. Theisen said that portfolio trades of two, three, or ten would be misleading. She added that the recommendation intends to reflect trends in the current market.

The recommendation was approved 17-0.

Panel III: Draft Municipal Securities Transparency Recommendation Regarding Timeliness of Municipal Issuer Disclosures

Panel Presentations

Rebecca Olsen, Office of Municipal Securities, SEC, said that her office has recently worked to improve investor protection. She said the office had improved the enforcement authority of municipal security fraud, implemented registration and regulation requirements for broker-dealers and municipal securities dealers, made amendments to Rule 15 c2-12, and provided interpretative guidance for issuers and investors.

Geidre Ball, Metropolitan Washington Airports Authority, said that issuers understand the seriousness of compliance and have improved access to information in the municipal market. She said that financial obligations and distress add another layer to vigilance reporting and internal due diligence. Ball expressed that the requirements for issuers to be transparent and provide investors with information are already present. She emphasized that the committee must consider if SEC enforcement would cause more harm to issuers than help to investors. Ball expressed support for the safe harbor provision in the recommendation. Ball stated that new disclosure requirements could have a significant impact on the market and recommended that the framework not be a one size fits all model. She emphasized the importance of marketplace education and awareness.

Emily Brock, Government Finance Officers Association, said that the Municipal Securities Rulemaking Board’s (MSRB) electronic municipal market access (EMMA) system has been a helpful outreach tool in the municipal market and noted there is a need for web- and market-based solutions. Brock highlighted the diversity of the municipal bond market and reiterated Ball’s point about issuers having to make tradeoffs for additional disclosure requirements. Brock suggested that Rule 15 c2-12 in the SEC amendments 15 and 16 helped create a workable disclosure environment. She suggested implementing educational requirements to better define the policy problem before implementing new disclosure requirements on issuers.

Hannah Sullivan, Fidelity Management & Research Company, said that the SEC’s enforcement actions and work in 2012 have seriously influenced the municipal market. She said that underwriters and issuers find the Municipal Continuing Disclosure Cooperative initiative helpful for disclosure compliance. Sullivan echoed that EMMA has been a helpful tool for advisors and investors. She added that the 2018 amendments to Rule 15 c2-12 could have gone further, but are a step in the right direction. Sullivan continued that the lack of information in the market can affect liquidity and investor choice. She expressed support for the recommendation, adding that there should be provisions to address interim financial disclosures.

Akiko Mitsui, Vanguard, echoed many of Sullivan’s points about the lack of information and the need to address interim financial disclosures. She added that the demand for tax-exempt bonds has surged while the supply has not kept up, the rise of covenant loans has led to credit deterioration and expressed the importance of timely and easily accessible disclosures. Mitsui recommended considering the secondary market in analysis and highlighted the lack of information in these markets.

Elisse Walter, former SEC Commissioner, said that this is a topic she has been spearheading since the 1990s, most notably during her time as a Commissioner. She stated the importance of the timeliness of disclosures in the municipal market. Walter noted that in 2012, the SEC suggested that Congress consider legislation that would require official statement and disclosure for municipal bonds, establish enforcement authorities, and set formal financial statement content requirements. She added that the SEC should be authorized to require audits of municipal security disclosures and there should be a safe harbor for private liabilities. Walter applauded the work of Olsen to take up interruptive guidance and recommended the SEC take another look at Rule 15 c2-12, without adding more amendments to the rule. Walter said it is time to take action and move past educational tools.

Question & Answer

Kumar Venkataraman, FIMSAC, asked about disclosures and SEC authority. Sullivan said it is hard to measure a big yield impact in the current market. She said these recommendations will help bring change to the municipal market before it is too late. Mitsui added that greater disclosures could help address imperfections in credit quality. Walter said there is both an upside and downside in granting the SEC more authority.

The recommendation was approved 14-2.

Panel IV: Internal Fund Crosses Panel

Panel Presentations

Lance Dial, Wellington Management, said that cross trading provides investors the opportunity to access different liquid pool at lower transaction costs. He said that the concern is that crossing can create the potential for abuse. Dial added that Rule 17 a-7 intends to prevent such abuse. He expressed concern about the three bid and three offer requirements and the lack of consistent pricing services. Dial stated he believes the theory that pricing practices against best execution valuation can provide investors with proper protections.

Kevin Gleason, Voya Investment Management, said that it is important to educate investors about what accounts and securities are eligible for cross trades. He added that fraud can be mitigated through appropriate actions if the right factors and data are observed. Gleason said compliance requirements prevent some firms from cross trading.

Nora Jordan, Davis Polk & Wardell LLP, explained that Rule 17 a-7, the Investment Advisors Act and the Investment Company Act mandate advisers to maintain their fiduciary duty to their client. She said that these rules work well with the equity security structure but not for the fixed income security structure. Jordan suggested the possibility of charging a fee similar to a transfer fee. She added that the customary transfer fee impedes on an advisor’s ability to apply discretion in trading. Jordan added that there should no longer be three bid and three offer requirements.

James Wallin, AllianceBernstein, echoed many of the prior commentaries about the potential cost savings to investors and outdated requirements. He said that regulators should recognize that cross trading helps cut trading costs. He added that the rules for pricing services are outdated and that the use of cross trading could be a mark-to-market mechanism for fixed income securities. He added that this would allow for more market access and create an efficient pricing mechanism. Wallin added that in the European Union, there is no bias for cross trading and that they have established independent pricing mechanisms. Wallin emphasized that it is economical to implement uniform cross trading updates.

Question & Answer

Venkataraman asked about the independence of reflected prices. Wallin stated the importance of differentiating between fixed income and equity markets. Gleason said that interposing price services would eliminate pressure and result in better pricing for cross trades. Jordan said illiquid securities might cost more to price.

Theisen asked about liquidity for cross trading. Wallin said that transaction costs in fixed income markets are higher than equity markets.

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