Price Transparency in the Fixed Income Markets

Price Transparency in the Fixed Income Markets

Background

Further advancing its long stated goal of price transparency in the fixed income markets, the Securities & Exchange Commission (SEC) recently approved rule amendments from FINRA and the Municipal Securities Rulemaking Board (MSRB) that require members and dealers to disclose pricing information on customer confirmations on certain fixed-income securities transactions.

MSRB and FINRA worked together and with the industry on their amendments and honored their commitment to achieve consistency among their rule requirements to lessen the compliance and implementation burden on the industry.  The final regulations closely mirror each other’s as it relates to the actual confirmation disclosure requirements.

The MSRB, in amending its Rule G-30 and the related G-30 Supplemental Material, adds to its rules the manner in which dealers are to determine the prevailing market price of a given municipal security.  FINRA currently has rules related to the mark-up policy and practices for corporate and agency debt securities for its members to follow.

Securities Subject to the Rule

The covered securities subject to the rule are:

  • Municipal securities, except municipal fund securities
  • Corporate debt[1]
  • Agency debt[2]

Transaction Subject to the Rule

Several events need to occur to trigger the disclosure rule.  The dealer effects a transaction on a principal basis in a covered security with a non-institutional customer.[3]  The dealer then effects one or more offsetting transactions in the security in the aggregate trading size that meets or exceeds the size of the transaction with non-institutional customer on the same trading day.

When a dealer executes the offsetting transaction with an affiliate, it will be required to determine whether the transaction was conducted on an “arms-length[4]” basis or not.  In the circumstance of a non-arms-length transaction, the dealer will be required to “look through” to the time and terms of the affiliate’s transaction with a third party to make the determination as to whether the confirmation disclosure requirement is triggered.

bondsTwo types of transactions are exempted from the disclosure rule.  The first is when a dealer’s offsetting same-day principal trade was executed by a trading desk that is functionally separate from the trading desk handling the customer order.  To illustrate this condition, consider an Institutional Trading Desk that is separate from the Retail Trading Desk.  When both Desks execute transaction in the same security, the disclosure requirement is not triggered if the Desks are functionally separated and have no knowledge of each other’s orders or trades.

The second exception is when the dealer participates in a fixed-price offering and sold the security to a retail customer at the fixed-priced offering price on the day the dealer acquired the securities.

Specifics of the Disclosure

The dealer’s mark-up or mark-down on the customer’s transaction must be displayed as a total dollar amount and as a percentage of the prevailing market price, calculated in compliance with FINRA Rule 2121 or MSRB Rule G-30.

Included in the final rulemaking are additional confirmation disclosures that are required regardless if the transaction is one where the mark-up mark-down disclosures is triggered.   In other words, the disclosures are required on all covered fixed income securities transactions.   These disclosure are:

  • For municipal securities, the time of execution expressed to the minute (HH:MM)
  • For corporate and agency securities, the time of execution expressed to the second (HH:MM:SS)
  • A reference to a webpage hosted by either FINRA (for corporate and agency securities) to its TRACE trading data for that security or MSRB (for municipal securities) to its EMMA trading data for that security
  • If the confirmation is electronic in form, the reference must be presented as a hyperlink
  • A brief description of the information available on these webpages

Determination of Prevailing Market Price

Current FINRA Rule 2121 and its associated Supplemental Material .02 address how a member is to determine the prevailing market price for corporate and agency bonds and the calculation of a mark-up or mark-down, that include the presumption of the use of the contemporaneous cost or proceeds.  Members are expected to have policies and procedures in place for the determination of the prevailing market price and mark-up or mark-down.  It is also understood that these policies and procedures are to be applied consistently to all types of customers.

FINRA noted in its rulemaking that the mark-up or mark-down is established at the time of the trade and further states that members may generate customer confirmations, including the disclosures, on an intra-day basis.  Clarifying their position, FINRA states that “members may determine prevailing market price, as a final matter for disclosure purposes, based on the information the dealer has available to it as a result of reasonable diligence at the time the dealer inputs the prevailing market price and associated mark-up information into its system to generate a confirmation” which is generally at the time of the trade.  FINRA confirmed that it will not expect members to send a corrected confirmation in cases of subsequent transactions or other events that impact its prevailing market price calculation.

The MSRB, during this rulemaking, adopted amendments and Supplementary Material to its Rule G-30 to provide guidance to the industry on the determination of prevailing market price and mark-ups and mark-downs for municipal securities.  This guidance lists a set sequence of criteria and procedures dealers are to use in their determination of prevailing market price.  The guidance codifies the presumption that the prevailing market price of a security is the contemporaneous cost or proceeds.  MSRB acknowledges that there are instances in which contemporaneous cost or proceeds does not equate to a prevailing market price.

Stated in the guidance, a dealer can overcome the presumption in instances where a) interest rate changes impact fixed-income securities pricing, b) credit quality of the security has changed significantly or c) news has been distributed and known to the marketplace that impact the value of the security.waterfall3

When the presumption is overcome or not applicable because the dealer’s cost or proceeds are not contemporaneous, MSRB developed a series of factors that are required or permitted to be considered, in consecutive order, to determine the security’s prevailing market price.  This series of factors is referred to as a “waterfall.

The first set of factors the dealer is required to consider, in successive order, are:

  • Prices of any contemporaneous inter-dealer transactions in the municipal security
  • Prices of contemporaneous dealer purchases or sales in the municipal security from or to institutional account with which the dealer regularly effects transactions in the same municipal security or
  • If an actively traded security, contemporaneous bid or offer quotation for the municipal security made through an inter-dealer mechanism through which transaction generally occur at the displayed quotation

A dealer may turn to other lists of factors if none of the three hierarchy of pricing factors listed above are available for the determination of the prevailing market price.  These factors are similar to those in the pricing hierarchy but apply to prices and yields of specifically defined “similar” securities.   The factors may be considered in any order or in any combination:

  • Prices or yields calculated from prices of contemporaneous inter-dealer transactions in a specifically defined “similar” municipal security
  • Prices or yields calculated from prices of a contemporaneous dealer purchase or sale transaction in a “similar” municipal security with institutional accounts with which the dealer regularly effects transactions, in the similar security with respect to customer mark-ups or mark-downs
  • Yields calculated from validated contemporaneous interdealer bid or offer quotations in “similar” municipal securities for customer mark-ups or mark-downs

The criteria for determination of what constitutes a similar security include the following:

  • Credit quality
  • The spread of the “similar” security is comparable to the spread at which the subject security trades
  • General structural characteristics and provisions of the issue
  • Technical factors such as the size of the issues, the float and any legal restrictions
  • The federal and/or state tax treatment of the “similar” security closely matches to that of the subject security
  • MSRB notes that it expects that in order for a security to qualify as a similar security, it must be highly similar to the subject security with respect to almost all of the listed “similar” factors relevant to the subject security at issue.

Finally, if all the actions listed above fail to provide for a determination of a prevailing market price, MSRB allows a dealer to consider as a factor the prices or yields derived from economic models.  The economic models should take into account factors such as reported trade prices, credit quality, interest rates, industry sector, time to maturity, call provisions, other embedded options, coupon rate and face value.

MSRB clarifies that when using a third-party pricing model, the dealer must have a reasonable basis for the belief that the third-party pricing model’s prices reflect actual prevailing market prices.  The dealer has a responsibility to use due diligence when utilizing a third-party economic model.

Further, MSRB distinguishes the use of third-party vendors versus internally developed economic-based pricing models.  When using an internally developed economic models, the dealer must be able to provide the information that was used on the day of the transaction that determined the prevailing market price.

Effective Date     

The MSRB announced an effective date of May 14, 2018.  FINRA has not announced an effective date as of this writing, but it is expected to be the same date.

Source Documents

Securities & Exchange Commission (Release No. 34-78573; File No. SR-FINRA-2016-032) August 15, 2016 Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Notice of Filing of a Proposed Rule Change Relating to FINRA Rule 2232 (Customer Confirmations) to Require Members to Disclose Additional Pricing Information on Retail Customer Confirmations Relating to Transactions in Fixed Income Securities

SR-FINRA-2016-032 Amendment No. 1 Proposed Rule Change Relating to FINRA Rule 2232 (Customer Confirmations) to Require Members to Disclose Additional Pricing Information on Retail Customer Confirmations Relating to Transactions in Fixed Income Securities

Notice of Filing of Amendment No. 1 and Order Granting Accelerated Approval of a Proposed Rule Change, as Modified by Amendment No. 1, Relating to FINRA Rule 2232 (Customer Confirmations) to Require Members to Disclose Additional Pricing Information on Retail Customer Confirmations Relating to Transactions in Certain Fixed Income Securities

SR-MSRB-2016-12 Proposed Rule Change to MSRB Rules G-15 and G-30 to Require Disclosure of Mark-Ups and Mark-Downs to Retail Customers on Certain Principal Transactions and to Provide Guidance on Prevailing Market Price

SRSR-MSRB-2016-12 Amendment No. 1 Proposed Rule Change to MSRB Rules G-15 and G-30 to Require Disclosure of Mark-Ups and Mark-Downs to Retail Customers on Certain Principal Transactions and to Provide Guidance on Prevailing Market Price

Notice of Filing of Amendment No. 1 and Order Granting Accelerated Approval of a Proposed Rule Change, as Modified by Amendment No. 1, to MSRB Rules G-15 and G-30 to Require Disclosure of Mark-ups and Mark-Downs to Retail Customers on Certain Principal Transactions and to Provide Guidance on Prevailing Market Price

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Prepared by Jane Young

December 7, 2016

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[1] Corporate debt is defined in FINRA Rule 2232(f)(2) as a debt security in U.S. dollar-denominated and issued by a U.S. or foreign issuer and, if a restricted security as defined in SEC Rule 144(a)(3), sold pursuant to Rule 144A, but does not include a money-market instrument or an asset-backed security.

[2] Agency debt is defined as a debt security i) issued or guaranteed by an Agency defined in paragraph (k) of FINRA Rule 6710 or (ii) issued or guaranteed by a Government Sponsored Enterprise defined in paragraph (n). The term excludes a U.S. Treasury security.

[3] FINRA defines a non-institutional customer as a customer that does not have an institutional account as defined in its Rule 4512(c).  Rule 4512(c) defines an institutional account as an account of a bank, savings and loan, insurance company or registered investment company; an investment adviser registered either with the SEC under Section 203 of the Investment Advisers Act or with a state securities commission (or any agency or office performing like functions); or any person (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million.

[4] The rule defines arms-length as a “transaction that was conducted through a competitive process in which non-affiliate firms could also participate, and where the affiliate relationship did not influence the price paid or the proceeds received by the member

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