WASHINGTON — Issuers and dealers are criticizing as incompatible with the municipal bond market the Municipal Securities Rulemaking Board's proposed rule changes to establish a process for determining markups and markdowns that may have to be disclosed to retail investors.
The Securities and Exchange Commission's Investor Advocate likes the rule changes, but wants a perceived loophole to be closed to prevent possible market manipulation.
The comments respond to proposed changes to Rule G-30 on price and commissions to determine the prevailing market price that MSRB released on Feb. 18. The guidance is designed to harmonize MSRB standards with an already established Financial Industry Regulatory Authority process that requires dealers to consider a "waterfall" of factors in determining the prevailing market price and markups or markdowns.
Ben Watkins, director of bond finance for Florida had the harshest critique of the FINRA-like standards, saying "such stringent definitions and interpretations of rules only burden the market rather than improve it."
"As an issuer and routine market participant, our concerns are whether there is a need for this regulation and the specificity used in defining 'prevailing market price' in the absence of some abuse or clear benefit to the market, neither of which is present," he wrote. "Because of how municipal bonds price and trade, the administrative burden imposed on dealers by this method … outweighs any potential efficiency in developing pricing guidelines consistent with those for other fixed income securities."
The Government Finance Officers Association did not submit a comment letter. But Dustin McDonald, the director of its federal liaison center, said Watkins' comments are consistent with GFOA's position.
The increased burden on dealers was one of multiple issues cited by Mike Nicholas, Bond Dealers of America's chief executive officer. The guidance as written would cause "significant market disruption" and should be amended to reflect how municipal bonds actually trade instead of using FINRA's inapplicable corporate bond template, he said.
In its current form, the proposal's waterfall approach outlines a required process and order where dealer must first look at their contemporaneous trades of the same muni with other dealers or customers. If the dealer does not believe contemporaneous trades are representative of the security, it can rebut the presumption that the trades determine the prevailing market price by showing changes in factors like interest rates, the credit quality of the debt, or news about the security or issuer that has changed the market's perception of the market value of the security.
If the dealer does not have contemporaneous trades of the muni, it must follow a specific order of steps. The first is to look at contemporaneous trades of the muni among other dealers. If the dealer cannot find any, it can then look at trades of the security between other dealers and institutional investors with which the dealers regularly trade that same security. If there are no trades that fit that qualification, the dealer can then look at electronic platforms where trades occur at displayed quotations.
If there are no contemporaneous trades in the muni security or quotes, the dealer may look at contemporaneous trades of similar securities, which at a minimum would have a comparable yield. If none of the prescribed methods work, dealers could base their prevailing market price calculations on economic models that apply the "waterfall" concept and take into account such things as credit quality, interest rates, industry sector, maturities, and call provisions.
"BDA recommends allowing dealers to use one or more of the concepts outlined in the waterfall to identify contemporaneous cost as opposed to requiring rote step-by-step, robotic policies and procedures," Nicholas wrote. "The proposed guidance is entirely too prescriptive and does not take account of the legitimate different methods that various dealers use to establish prevailing market price."
BDA also asked the MSRB to not have the rule cover sophisticated municipal market participants and to consider the significant costs dealers would have to bear.
Leslie Norwood, managing director and co-head of munis for the Securities Industry and Financial Markets Association also argued the waterfall methodology cannot be applied in a "mechanical fashion" but maintained the group's request for a rule that is closely aligned with FINRA's.
In a letter co-authored by Sean Davy, SIFMA's managing director of the capital markets division, she instead recommended the MSRB allow firms to rely on reasonably designed policies and procedures to determine an estimated prevailing market price for confirmation disclosure using the waterfall factors as a non-exhaustive list of things to consider.
The changes should also recognize that the subjectively determined price should not necessarily be used to test if there is a fair and reasonable markup and that the fact the price is an estimate should be disclosed to the customer on the confirmation, Norwood and Davy said.
"Regulators should acknowledge that two firms looking at the same set of facts may reasonably come to two different determinations of the prevailing market price for a particular security," they wrote.
Norwood and Davy also requested that the MSRB, among other things, allow firms to consider the size of transactions and side of the market as relevant determinant factors and make clearer the definitions of "similar securities," "isolated transactions," and "isolated quotations" in the rule.
Additionally, SIFMA requested the MSRB conduct a thorough cost-benefit analysis that considers any other, less burdensome options to achieve the same goals, only apply the guidance to transactions involving retail investors, provide several walkthroughs of how to determine prevailing market price in situations firms may face, and allow for a three-year implementation period if the changes are approved.
SEC Investor Advocate Rick Fleming told the MSRB that his office supports the goal of using prevailing market price to expand markup disclosure and added the harmonization with FINRA's existing process "appears reasonable."
But he worried that the rule changes do not properly cover prevailing market price in non-arm's length affiliate transactions, where two dealers doing business with one another are part of the same company.
"The MSRB's guidance may lend itself to loopholes and slippage when applied to transactions between affiliates, thereby resulting in misleading and inconsistent pricing disclosures to retail customers," he wrote.
Fleming cited an example of two dealers, A1 and A2, working for Company A. A1 purchases a bond from an unaffiliated third-party for $90 and then displays the bond for sale at $93. A2 purchases the bond from A1 at $93 and then sells it to a retail customer for $93 and a $1 trading fee. Fleming said he is concerned that the changes as written would allow dealer A2 to determine that $93 was the contemporaneous cost, which is used to determine prevailing market price, and that the markup is only $1. Instead, the Investor Advocate said dealer A2 should have to "look through" its transaction with A1 to the first transaction, leading to a markup of $4.
The MSRB could make the needed tweaks through textual changes to the guidance, adjustments to the harmonized markup rule expected to be filed with the SEC, or a clarification in the text of the notice the MSRB submits to the commission, Fleming said. But he added the MSRB would best address the issue through a combination of guidance and changes to the rule text.
