ATLANTA — Dealers are calling for the Municipal Securities Rulemaking Board to revise and clarify several aspects of draft interpretive guidance that outlines the steps they must take to ensure the prices they charge customers when buying and selling municipal securities are fair and reasonable.
The guidance is designed to harmonize the method in which the prevailing market prices for munis are determined with rules implemented by the Financial Industry Regulatory Authority in 2007 for other types of debt. But dealers complained in comment letters filed with the board that the proposed guidance is too inflexible and would not fit the eccentricities of the muni market.
“To a trader, this process is a rigid construct that does not reflect the way the debt markets operate or the manner in which dealers and institutional investors determine pricing,” wrote Leslie Norwood, managing director and associate general counsel at the Securities Industry and Financial Markets Association.
“While the factors specified by the MSRB are important, it would be inappropriate to limit dealers to the factors listed and in a hierarchical manner,” she said. “We are concerned that asking dealers to ignore relevant information is not only unrealistic, it also exposes them to increased risk and results in increased bid-offer spreads, worse prices for customers, and less liquidity in the market.”
The MSRB does not define what constitutes a fair and reasonable markup or markdown, which represents the compensation dealers receive for trades in which they act as a principal for their customers.
Markups represent the difference between the price paid by a customer for a security and the lower market price that the dealer paid to buy the debt. Markdowns are the opposite — the difference between the price paid to the customer for securities and the higher prevailing market price.
While SIFMA and the Regional Bond Dealers Association were mixed on certain aspects of the proposed guidance — and generally called for a more flexible approach in determining prevailing market prices by dismissing a rigid hierarchy -—some dealers who commented on it were practically fuming.
“The steps set forth for determining prevailing market price offends and confuses municipal market professionals who have been providing not only funding for issuers for decades but who have also provided liquidity to investors and institutions throughout their careers,” wrote Ronald Dieckman, director of municipal bonds at J.J.B. Hilliard, W.L. Lyons, LLC.
“The directives are tantamount to a group of traders and underwriters opining upon how political science should be taught at the university level so that every college or university student would receive the same, identical education on the topic whether they attend an Ivy League school or a local community college.”
Under the proposal, which was floated in late April and is the first update of pricing guidance from the board since 2004, the MSRB examines several different scenarios designed to illustrate how a dealer would determine a fair-market price.
The guidance begins with “riskless principal transactions,” in which a dealer has an order for securities from a customer, buys the bonds in the market, and immediately sells them to the customer without the securities ever going into inventory. In this scenario, the market price would be the same as the dealers’ contemporaneous cost for purchasing the securities in the market.
Under the guidance, a dealer’s cost is considered contemporaneous if its customer transaction is so close enough in time to the transaction in which it bought or sold the security from another dealer that the prevailing market price would “reasonably be expected to reflect the current market price for the municipal security.”
SIFMA called for more flexibility in documenting transactions, an expansion of an exemption from the guidance to include all transactions by dealers with sophisticated municipal market professionals — institutional investors with at least $100 million of munis — and an expansion of the discussion of situations in which a bond dealer may consider itself a market marker.
The RBDA, which made many of the same arguments, also asked for specifics in the final guidance regarding what records dealers would need to produce to demonstrate the facts and circumstances that led them to conclude a transaction was not indicative of the prevailing market price and what records would need to be produced to show how the prevailing market price was ultimately determined.
Such records should be retained for not less than six years, RBDA recommended.
For a non-riskless principal trade, a dealer would have to determine the market price first by looking at the contemporaneous cost of recently buying the same security from another dealer. The dealer would have to use that price unless interest rates had subsequently moved, the credit quality of the paper had changed or a material event occurred — all news factors that have an effect on the perceived value of the security.
SIFMA asked the MSRB to clarify that such news may not be limited to information that has been broadly disseminated or made widely available to the marketplace, and that the distribution of information through narrower channels may affect the price of bonds.
RBDA asked for the MSRB to provide guidance to determine how much time needs to pass to automatically make trades not contemporaneous and, similarly, how much time needs to pass to create “a rebuttable presumption that trades are not contemporaneous.”
Much of the general concerns about the guidance being too rigid apparently stem from the so-called waterfall analysis that dealers would have to conduct to determine the market price of the security if any of the previous scenarios do not reflect the situation in which a trader is buying or selling a security.
Specifically, if the dealer has not recently purchased the security from another dealer, he would have to try to find a market price by looking at contemporaneous trades of the securities between two other dealers. If that proves unfruitful, the dealer would have to look for trades of the security between institutional investors and another dealer. The next step in the waterfall would be for dealers to compare interdealer trades on similar securities.
And if none of these steps was successful, especially for securities that are not frequently traded, the dealer would have to create an economic model to determine the price.
Even though firms said this type of analysis would be impossible to conduct given the fast pace and high-pressure nature of most bond trading desks, in crafting the draft guidance the MSRB was seeking to accommodate the unique characteristics of the muni market that make it difficult for dealers to determine prevailing market prices. These include the enormity of the market, that most investors “buy and hold” munis, and that there is infrequent secondary market trading of most securities.
SIFMA also requested that the MSRB recognize the differences in pricing of different sized transactions, noting that demand is higher for institutional-sized trades and executing a small trade often requires at least as much time and operational resources for a dealer as executing an institutional-size trade.
Even if the dealer’s mark-up or mark-down is taken out of the equation, the prevailing market price will be different for small trades versus institutional-size trades, SIFMA said.
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