Regulation cracking down on the practice of "pennying" appears imminent, though it is difficult to say how pervasive or harmful the behavior is.
Some dealers say pennying is not a widespread enough problem to warrant regulation, while other dealers say it happens enough to hurt the integrity of the municipal market. Pennying, sometimes called “last look,” happens when a dealer places a retail client’s bid-wanted out to the market and determines the winning bid, but rather than executing the trade with the winning bidder marginally outbids the high bid and buys the bonds for its own account.
One firm estimates that as much as 30% of bid auctions are affected by pennying, making it a systemic issue.
“It calls into question the fairness of the auction process itself because of this practice,” said Martin Mannion, Co-CEO of Headlands Tech Global Markets, LLC. “It could deter participation in the auction and or deter how aggressive people bid in certain auctions if they have the belief no matter how aggressive their bid price is, they don’t have a chance of winning the auction because of the process of last look.”
Some broker-dealers have said increased attention by regulators has discouraged the practice of pennying, but Mannion disagreed.
“We still think it’s happening a meaningful amount,” Mannion said. “It’s always hard to get exact data, but we would say we’ve not seen a meaningful or noticeable change in the practice and so our best bet is that it is happening at a comparable level that we’ve seen in the past.”
The Municipal Securities Rulemaking Board put out a request for comment on its Rule G-18 on best execution in 2018 on the topic and has discussed it consistently at quarterly board meetings. The MSRB has been concerned that widespread pennying could disincentivize participation in the bid-wanted process and discourage bidders from giving their best price in a bid-wanted process.
In HTGM’s 2018 comment letter, the company said over a two-week period on one of the largest alternative trading system platforms it received an execution on only 35% of auctions where it submitted the winning bid. For another 30% of those auctions won by HTGM, it appeared that no trade took place. Mannion said he has no reason to think things have changed since that letter was written.
In late January, the MSRB discussed pennying again at a quarterly board meeting.
The MSRB has not reached a conclusion that pennying is a systemic problem, said Gail Marshall, MSRB’s chief regulatory officer.
“That’s really the goal of trying to determine the extent to which this happens and the impact it has,” Marshall said. The MSRB is also coordinating with the Financial Industry Regulatory Authority on the issue. Marshall wouldn’t comment on whether regulation would be upcoming, emphasizing that the MSRB is still gathering information.
In October 2020, the Financial Industry Regulatory Authority put out a request for comment on pennying in the corporate bond market. That followed a
FIMSAC views last look and pennying separately. It considers last look to refer to a valid process of a dealer reviewing auction responses as part of its best execution process before executing that order.
“The SEC should consider setting the clear expectation that the use of last-look to provide nominal price improvement should occur only in the rare situation, such as when the dealer needs to use the practice to conform with its best execution responsibilities,” FIMSAC said in 2019. “Furthermore, the SEC should encourage dealers to have clear policies and procedures in place delineating when last-look may be used.”
Put all together, broker-dealers see this heightened attention to pennying leading to some form of regulation this year.
FINRA is continuing to coordinate with the MSRB as it reviews its comments from October, a FINRA spokesperson said.
FINRA and MSRB are not finished yet with their pennying inquires, said Michael Decker, senior vice president of policy and research at Bond Dealers of America.
“So I wouldn’t be surprised if I saw rulemaking from FINRA and the MSRB in the next year on pennying,” Decker added.
Pennying is not a systemic issue in the municipal market and regulation is not necessary, Decker said.
“We make a distinction with pennying which would be sort of a systemic issue where firms are on a consistent basis pennying a bid or internalizing a trade with little benefit to the customer versus last look which is necessary to ensure that the customer is getting the best price,” Decker said.
Dealers need to be able to see the auction prices, but it’s also important that dealers don’t undercut prices to the extent it would threaten the integrity of the auction process, Decker added.
Last year, BDA informally surveyed its members to see if pennying was a systemic issue. The consensus was that it was not and was not being conducted to an extent that threatens the ability of customers to get good pricing through auctions or offers, Decker said.
“I know that others feel differently, so it’s not inappropriate for regulators to look at this issue,” Decker said. “We just don’t feel like rulemaking is necessary at this point, but if it moves forward we want to be involved in the process.”
MSRB rules that could change or expand to prevent systemic pennying are MSRB Rule G-18 and Rule G-43 on broker’s brokers. In Rule G-43, the MSRB prohibits brokers acting on behalf of other brokers from giving preferential treatment, including last look.
The issue of systemic pennying has died down in the municipal market over the past five to 10 years, said Ron Bernardi, CEO of Bernardi Securities.
“Technology has advanced,” Bernardi said. “The regulatory agencies’ focus, notices, requests for comment puts people on notice that it’s on their radar as it should be. Overall the muni market, market transparency is a lot better.”
Broker-dealers know pennying when they see it, Bernardi said.
“In terms of issues facing our industry, there are other issues that are more important, frankly,” Bernardi said. “I’m not dismissing it, but I think between the increased efficiency in our market and the lion’s share of dealers that when they’re soliciting bids, they’re out there trying to sell them.”
“The regulatory focus on the issue has taken care of itself.”
