WASHINGTON – The Municipal Securities Rulemaking Board is cautioning broker-dealers trading through alternative trading systems or broker’s brokers against “filtering” or screening out bids and offers in a way that adversely impacts retail investors and market efficiency.

“The MSRB reminds firms that filters are to be used only for legitimate purposes and that dealers should have in place, and periodically review, policies and procedures to govern when and how the firm uses filters,” the board said in a notice published Wednesday.

The notice comes almost a week before the Securities and Exchange Commission holds its first Fixed Income Market Structure Advisory Committee meeting, which is scheduled to be held on Jan. 11 and to focus on liquidity issues. The advisory committee includes several muni market participants, including MSRB chief market structure officer John Bagley.

The MSRB notice urged broker-dealers to determine what processes and what criteria or factors should be used when establishing, modifying, and removing filters.

Firms also should decide whether authorization must be required to establish filters and, if so, who should give it, the board said. In addition, broker-dealers should decide how often filters are reviewed, who should do the reviews, and what those reviews should entail.

The MSRB stressed that the notice “does not create new legal or regulatory requirements” but rather summarizes existing guidance on filtering or screening in Rule-43 for broker’s brokers, Rule G-30 on prices and commissions, as well as guidance issued in 2015 on Rule G-18 on best execution.

Lynnette Kelly
MSRB Executive Director Lynnette Kelly

“Dealers have had almost two years to implement and comply with the best execution rules, which has been an examination priority for enforcement agencies,” said MSRB Executive Director Lynnette Kelly. “Given the developments in the use of ATSs,

it makes sense to remind dealers of the guidance about the appropriate use of filters to help support their compliance with the best-ex rule.”

Filtering occurs when a dealer handling a customer’s order uses automated tools on an ATS to screen out bids received from and offers made available by certain dealers. It also occurs when a selling dealer directs a broker’s broker to limit the participants for a bid-wanted.

In its notice, the MSRB said it “recognizes that there are legitimate purposes that justify the use of filters.” However, the board said it’s “concerned that their use otherwise may limit access to and competition in the market, which could reduce liquidity and have a negative impact on the quality of executions and, ultimately, the prices paid or received by customers.”

One impetus for the notice was the increased use of ATSs and the role of broker’s brokers.

The MSRB released statistics in November 2017 showing that for the 12 months from September 2016 to 2017, an average of about 59% of trades between dealers, and 29% of the par volume traded, were executed on an ATS.
About 90% of the ATS trades involved transactions of $100,000 or less – typically the size of trades associated with retail investors. The MSRB found that 25% of all retail-sized trades in the muni market were conducted on ATSs.

The data indicated that 7% of interdealer trades occurred through a broker’s broker, the board said.

The MSRB raised concerns about filtering last year in an Oct. 17 letter to SEC Investor Advocate Rick Fleming. Fleming had asked the board to identify products and practices in the municipal securities market that may have an adverse impact on retail investors.

In January of last year, the Financial Industry Regulatory Authority listed best execution among its regulatory and examination priorities for the year in a letter to market participants. It said firms should consider how “recent advances in trading technology and communications in the fixed income markets affect their order handling decisions and factor those changes into the review of the execution quality they provide customers.”