WASHINGTON – The Municipal Securities Rulemaking Board is concerned that market practices such as “pennying” and “filtering” may be hurting retail investors in the municipal bond market.

In a five-page letter to Securities and Exchange Commission Investor Advocate Rick Fleming, the MSRB said it also worries about the risk to retail investors of holding a position of munis in an amount below the minimum denomination set by the issuer, as well as certain disclosure practices and price transparency.

Rick Fleming
SEC Investor Advocate Rick Fleming

The MSRB letter, signed by executive director Lynnette Kelly, was written in response to a request by the SEC Office of Investor Advocate for the board to identify products and practices that may have an adverse impact on retail investors of munis.

The first concern described by the MSRB was the market practice of “pennying” or “last look.” According to the board, a dealer will often place a retail client’s bid-wanted out to the market and then compile the bids received to determine the winning bid. But instead of executing the trade with the highest bidder, the dealer may nominally exceed the high bid to the client and then buy the bonds for its own account.

“While a dealer’s willingness to improve the highest bid, even nominally, is beneficial to the particular retail client in the short term, the MSRB is concerned that it can be harmful to investors over the long-term if the practiced discourages broad market participation in the bidding process and renders the market less efficient,” the board told Fleming.

The MSRB said it also concerned with the practice of “filtering” or “screening,” when a dealer uses automated tools on an alternative trading system (ATS) to filter or screen out bids and offers received from certain dealers. In some cases, a selling dealer may direct a broker’s broker to limit the audience for a bid-wanted.

“The MSRB recognizes that there are credit, legal, regulatory and other legitimate concerns that justify filtering of certain counterparties or bond characteristics,” the board wrote. “However, dealers should have policies and procedures in place to govern when and how to: reasonably use filters; periodically review any established filters; and consider lifting them upon request. In addition, they may only be used for a legitimate purpose consistent with obtaining the most favorable executions for retail customers.”

The board said it has raised questions about these issues in the past and “plan to continue to raise awareness” about them in the coming year as issues that may affect the prices received by retail investors.

Another concern for the MSRB is the risk that retail investors will end up holding positions in munis in amounts below the minimum denominations set by issuers, possibly rendering the munis illiquid.

The board noted that it has no jurisdiction over the conduct of investment advisers and their allocation practices, but said its Rule G-15(f) generally prohibits dealers from trading munis in amounts less than their minimum denominations.

Disclosure practices are of “ongoing concern” for the MSRB, the letter said. The board said it received “considerable feedback” on its advisory guidance about selective disclosure practices, and added, “We plan to continue raising awareness about this issue in the coming year.”

MSRB also said it continues to be concerned about the lack of disclosure of bank loans. At present, there are just over 1,100 bank loan disclosures on its EMMA website.

“Given estimations of the size of the bank loan market, we believe that this represents only a small fraction of bank loan transactions by municipal issuers,” the MSRB wrote, adding that bank loan information is “imperative for retail investors to make informed decisions when buying or selling municipal securities.”

The board also told the SEC Investor Advocate that improving price transparency in the muni market “is essential to ensuring a fair market for retail investors.”

The MSRB noted that it has worked on a best execution rule and, more recently, a markup disclosure rule. It said it is planning “an extensive education campaign for retail investors” this year as the effective date of the markup disclosure rule nears “to ensure a complete understanding of this new trade disclosure.”

The board also described the changes it has made to its EMMA system to help ensure retail investors are better informed about the muni market.

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