SEC Reviews Controversial Bond Pricing Disclosure for Retail Clients
Almost two years after proposing a controversial rule that would require firms to disclose bond markups to retail customers on trade confirmations, regulators are nearing the final leg of the process.
The Securities and Exchange Commission on Monday said it will accept comment on the proposed Financial Industry Regulatory Authority for 21 days. Finra has already made revisions in its initial proposal of November 2014 in response to claims that additional disclosure could confuse investors and potentially drive some firms from retail bond sales.
The proposed rule would require firms to disclose in dollars-and-cents and percentages the markups and markdowns they charge relative to prevailing market prices on bonds bought and sold to retail customers. The disclosure would be required on bonds that firms buy or sell as principal on the same day that they fill similar-sized retail orders.
The Finra rule applies to corporate bonds and agency securities. The MSRB expects to file an almost identical rule regarding municipal bond transactions within the next two weeks, according to MSRB Executive Director Lynnette Kelly. The SEC has final authority over Finra and MSRB rule proposals, and Chairman Mary Jo White and several commissioners have already expressed support for the markup disclosures.
The rules will encompass a wide swathe of bond trade transactions that, unlike equity securities, cannot be priced easily by retail investors because there are so many publicly traded bonds that are priced differently by different dealers.
About 59% of retail-size customer trades in corporate debt securities made in the third quarter of 2015 would have been subject to the disclosure requirement if the proposed rule had been in place, the Finra rule said.
“Finra believes that some customers pay materially higher mark-ups or mark-downs in retail size trades than other customers for the same fixed-income security,” the self-regulatory organization wrote in an explanation of its rule proposal. “[T]he proposal will better enable customers to evaluate the cost and quality of the execution service that member [firms] provide [and] will promote transparency into firms’ pricing practices.”
The rule proposal does not prescribe how firms should determine a “prevailing market price” but suggested that the same-day pricing provision would provide a close proxy. In their initial proposals, Finra and the MSRB proposed requiring markups or markdowns from a so-called reference price based on bonds bought or sold out of inventory, a calculation that industry commenters said would be difficult, if not impossible, to determine and lead some firms to game the system by waiting more than 24 hours to fill a trade order.
The final proposal also eliminated a definition of a retail trade as one involving 100 or fewer bonds, or involving bonds with a face amount of $100,000 or less. That definition could have excluded retail customer transactions above that amount or subjected some low-volume institutional transactions to the rule, commenters said.
Using standard industry distinctions between retail and institutional should simplify the procedure, regulators said.
The Finra proposal acknowledges that the prevailing market price of a particular security may not be identical across firms. However, it said firms will be required to have “reasonable policies and procedures in place to calculate the prevailing market price and that such policies and procedures are applied consistently across customers.”
Finra’s initial rule proposal drew sharp criticism, with only six of 31 commenters supporting it, and most of those from outside the industry, the SEC said. The Securities Industry and Financial Markets Association, the principal trade group of the industry, said additional disclosure could confuse investors, raise pricing because of expensive systems changes that firms would have to implement and even drive smaller bond dealers out of the business.
In response to some comments on the original proposals suggesting that firms merely provide links to Finra’s bond-pricing database known as TRACE and disclose the time of the trade on customer confirmations, the SEC said in a footnote that Finra “intends to submit a rule filing in the near future that proposes these requirements.”