Bond dealers weigh in against rigid 'pennying' regulation

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WASHINGTON — Bond dealers responded to regulatory concerns over "pennying" in bond pricing, telling the Municipal Securities Rulemaking Board that the seller's intent is important in deciding if a firm is being abusive.

Dealer groups and some individual firms weighed in on the subject in comment letters submitted to the MSRB this week. The board had asked for comment in September when it released draft guidance on pennying and best execution. Pennying occurs when a dealer places a retail client’s bid-wanted out to the market and determines the winning bid, but then rather than executing the trade with the winning bidder marginally outbids the high bid and buys the bonds for its own account.

The practice can appear beneficial in isolation because the dealer technically provides the customer a price equal to or better than the best bid, but the MSRB is concerned that widespread pennying disincentivizes participation in the bid-wanted process, discourages bidders from giving their best price in a bid-wanted and “may impact the efficiency of the market.”

The draft guidance stated that using the bid-wanted process solely for the purposes of price discovery, whether via a brokers’ broker or an alternative trading system, could be a violation of the board’s Rule G-17 on fair dealing.

Leslie Norwood, managing director, associate general counsel, and co-head of munis at the Securities Industry and Financial Markets Association told the MSRB that it was important to define terms clearly.

“SIFMA and its members believe pennying should be defined as the persistent or pattern of internalization of orders by the dealer, at bid prices that are only nominally better than the cover bids,” Norwood wrote. “The determination of what is ‘nominal’ should be based on the facts and circumstances of the credit and the order.”

Norwood worried that the MSRB might not clearly be distinguishing between “pennying,” “internalization,” and “last look,” which Norwood said may mean different things. The term “last look,” according to SIFMA’s letter, carries with it for many the connection to muni bond criminal bid-rigging cases of nearly 10 years ago.

“We agree that the use of bid-wanteds solely for price discovery purposes by a dealer without any intention to trade if a favorable bid is received may be a violation of a dealer’s fair-dealing obligations under MSRB Rule G-17,” Norwood wrote. “However, there are instances in which the use of a bid-wanted solely for price discovery should not be deemed an unfair practice within the meaning of Rule G-17. For example, a client may not wish to decide whether to place an order until they know the bonds can be sold at a reasonable price.”

Mike Nicholas, chief executive officer of Bond Dealers of America, said BDA members encounter pennying regularly. Nicholas urged the MSRB not to adopt a rule against pennying because defining it would be too difficult. Interpretive guidance, he told the board, would be the best vehicle.

“We believe that the combination of the bid data and the MSRB trade data clearly identifies which dealers are engaged in this abusive practice as some dealers engage in ‘pennying’ on a daily basis,” wrote Nicholas. “Thus, the intention of the dealer is inherent to the definition of ‘pennying’ and it is this practice that is concerning for the market place.”

Both groups also provided positive feedback on draft amendments to the MSRB’s Rule G-18 on best execution. Those draft amendments provided a clarification that dealers may not need to put a bid-wanted out on many alternative trading systems to fulfill their obligations to use “reasonable diligence” in seeking the best deal for their customer.

Norwood suggested making the amendment stronger by going beyond “may not” to “does not” need to. Nicholas wrote that while some dealers may post bids on multiple ATS platforms for good reason, others do it out of regulatory concern.

“Accordingly, the BDA believes that it is important for the MSRB to be very clear that a dealer does not need to post bids wanted on multiple platforms,” he told the MSRB.

An amendment to G-18 would require approval from the Securities and Exchange Commission.

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MSRB rules Securities law Munis Secondary bond market MSRB SIFMA BDA SEC Washington DC
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