The Municipal Securities Rulemaking Board is seeking public comment on draft interpretive guidance it released yesterday that outlines steps dealers must take to ensure the prices they charge customers to buy and sell municipal securities are fair and reasonable.
The lengthy guidance would provide additional structure to the manner in which dealers must determine that the prices they offer their customers are “reasonably related” to the market value of the securities and that the markups or markdowns on a security do not exceed a fair and reasonable amount.
The MSRB is accepting comments on the interpretive guidance through June 4.
The draft is the first update of pricing guidance from the board since 2004 and is designed to harmonize the method in which the prevailing market prices for munis are determined with guidance that was implemented by the Financial Industry Regulatory Authority in 2007.
“We think that the current guidance is strong in terms of protecting investors regarding fair pricing of municipal securities .... But we’re trying to establish a similar structure to pricing that exists for other debt securities in order to provide greater consistency,” said MSRB executive director Lynnette Hotchkiss.
The board 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 principle 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.
The board noted that the guidance is important in part because of the unique characteristics of the municipal market that make it difficult for dealers to determine prevailing market prices. These factors include: the enormity of the market, with more than 1.3 million Cusip numbers; that most investors “buy and hold” munis; and that there is infrequent secondary market trading of most maturities.
The MSRB examines several different scenarios designed to illustrate how a dealer would determine a fair-market price, beginning 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 occurs 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.”
Meanwhile, for a non-riskless principal trade, a dealer would have to determine the market price first by looking at the contemporaneous cost of buying the same security from another dealer recently. 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.
If these initial scenarios do not reflect the situation, the draft guidance would establish a “waterfall” analysis that dealers would have to conduct to determine the market price of the security.
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 were to 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.
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.
Dealer groups were mixed on the proposal.
In a statement, the Securities Industry and Financial Markets Association expressed concerns about the draft and said that the existing fair-pricing rules for municipal securities are “well understood and flexible enough to accommodate rapidly changing market conditions.”
“SIFMA has concerns that the MSRB’s proposed interpretive guidance on markups for municipal securities may have implications on the willingness of firms to make markets and hold inventory,” the industry group said. “We will be reviewing the proposal in detail with our members and look forward to working with the MSRB on this issue.”
But the Regional Bond Dealers Association, said only that the draft is “a significant proposal” and that it intends to look at it closely, especially the question of the use and definition of “contemporaneous cost.”
Christopher Taylor, former executive director of the MSRB, took a different approach, saying the complex draft guidance is more reason all muni market transactions should be traded on a central exchange for increased transparency.
“This is trying to support a dealer market, and that always works to the detriment of customers, as we found out particularly in this financial crisis,” he said.
