While the Securities and Exchange Commission has cracked down in the past on so-called "flippers" posing as retail investors to win allocations of new issue municipal bonds, regulators seem to have become increasingly curious about activity involving firms commonly referred to as trading accounts.
Though regulator interest suggests a concern regarding trading accounts, the issue is nuanced given the role such firms play in providing liquidity in the municipal securities market, reliably stepping in to buy bonds in primary market deals at times when interest from more traditional buyside investors might be lacking.
Queries to underwriting firms from regulators — which have become more "in-depth" in the last year to year-and-a-half — suggest regulators may be questioning "whether these trading accounts are really institutions or whether they function like an unregistered broker," according to Peg Henry, a municipal securities legal expert.
Typically, issuers prioritize orders from retail and institutional customers over orders from broker-dealers seeking bonds for their own inventories. With broker-dealers generally accorded the lowest priority in terms of order sequence, they can be shut out if retail and institutional customer demand exceeds available allocations.
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"Now there are no charges that I know of that have been brought against anybody based on that theory, but some of the questions that FINRA's asked would lead me to conclude that that's what they're considering," Henry said, referring to the Financial Industry Regulatory Authority.
Still, Henry drew a distinction between trading accounts and flippers, which, she said, "never really had any capital" and bought bonds solely with the intention of selling them immediately via a pre-arranged deal to another firm for a nominal profit.
By contrast, trading accounts, while they are opportunistic investors, have enough capital to own the bonds they buy for a while if it suits their strategies, she said. In addition, both Henry and Jeff Timlin, a managing partner at Sage Advisory Services where he serves as lead portfolio manager of the firm's municipal bond strategies, cited the role trading accounts play in providing liquidity in the municipal market.
Timlin, who started his career in munis in 1999, said the dynamic of participants often referred to in muniland slang generally as "flippers" who buy bonds at a new issue price with the intention of selling them back quickly at richer price to somebody else predated his entry into the business.
"Is it something that I think the buyside likes, probably not," he said, referring to more traditional buyside investors such as Sage. "Everybody is clamoring for bonds … and there's only so much to go around to everybody."
The practice is less prevalent today than when he first started in the business, in part because the industry has grown and he suspects that powerful players like BlackRock, Vanguard and Nuveen don't like seeing bonds taken away from them.
Still, like the same coin with two different sides, trading accounts also have an upside, he said.
"During the best of times they take bonds away, but [in] the worst of times they also provide liquidity for markets," Timlin said. "They tend to be present in every market."
While such "arbitrage type of players" help provide liquidity in the muni market and the industry itself has "kind of self-regulated itself away from" the level of flipping activity seen back when he started his career, Timlin emphasized that he wasn't saying that there was no need for regulators to look into activity by trading accounts to ensure no bad behavior is occurring.
"If it's prearranged, obviously then that's definitely I would say unethical," he said.
For example, if an underwriting firm were to permit an arrangement with a trading account to allocate more new issue bonds to the trading account with an understanding that the trading account would sell them back at a certain price so the underwriting firm can make money not only on the new issue but also in the secondary market, that kind of behavior where "you scratch my back, I scratch yours," would be problematic, Timlin said.
"Nobody would agree with that as a fair practice," he said.
However, if a trading account buys new issue new muni bonds with no plans to hold the bonds long term but is instead looking to sell as soon as spreads tighten, there's nothing inherently wrong with that, according to Timlin.
"They're just flipping bonds … they're active traders," he said, adding that their behavior is similar to equity market day traders. "They're just taking advantage of some of the inefficiencies of the municipal market."
While prearranged trades in new issue muni bonds by trading accounts shouldn't be occurring, a regulatory focus that discourages such arbitrage players from participating the market for new issue municipal securities could have unintended consequences, Timlin said. Less participation by trading accounts would not only disadvantage buyside firms like his who benefit from the liquidity they provide, but would likely disadvantage issuers as well.
"There's a potential that issuers may have to pay higher borrowing costs because there's one less buyer in the market that provides liquidity," he said.
Ultimately, there is "no perfect solution," Timlin said.
"You can fix one area and you cause damage on another," he said.
Henry, who launched Peg Henry PLLC, a municipal securities legal consulting and expert witness services business last year after retiring from her role as head of municipal securities group legal at Stifel Financial Corp., is also a co-author of the fourth edition of The Securities Law of Public Finance.
According to a section of the treatise pertaining to trading accounts, underwriters sometimes rely on trading accounts when they lack enough interest from other investors to purchase all of a primary offering.
"However, the underwriters may accept orders from trading accounts even when other investors express interest in the offering so that trading accounts will be available to invest in other primary offerings with limited interest from other investors," the treatise section said.
An underwriter may announce its willingness to repurchase securities from an offering at the same time that it announces the securities are "free to trade," the section said. Some investors may opt to sell their securities back to the underwriter at that time, especially if they didn't receive the full allocation they requested.
For instance, a trading account that placed an order for $1 million worth of the bonds during the primary offering order period and only received $400,000 worth, might not be interested in owning just $400,000 of the issue, according to the treatise section.
While trading accounts don't always resell bonds to underwriters, "FINRA's Department of Market Regulation has for a number of years queried underwriter firms about sales to and repurchases from trading accounts," the section said. "The FINRA inquiries have identified various firms that the underwriters consider to be trading accounts without using that term."
FINRA has requested "information about times of trade execution and copies of documents relating to communications concerning the trades, including bids, offers, quotes, notes, emails, Bloomberg messages, memoranda, and other correspondence," the treatise section said. FINRA has also asked about post-pricing sales, including prices and the type of investor – retail or institutional – that bought from the underwriter in the secondary market, the treatise section on trading accounts said.
"An underwriting firm cannot engage in prearranged trading," Henry said in a recent interview. "So if the understanding when they allocated bonds to one of the trading accounts was that the underwriter would buy it back right away, that would be pre-arranged trading and that would be a rule violation."
Such pre-arranged trading would violate Municipal Securities Rulemaking Board Rule G-17, Henry said. MSRB Rule G-17 requires dealers in the conduct of their municipal securities activities to deal fairly with all persons and not engage in any deceptive, dishonest or unfair practice.
Repurchases by underwriters from trading accounts could also violate MSRB Rule G-18 on best execution, she said. For example, if an underwriter allocates new issue bonds to a trading account, buys them back right away and then immediately sells them to a retail investor in the secondary market at higher price, that could violate Rule G-18, Henry said.
While there are plenty of legitimate reasons why trading accounts opt to sell bonds back to an underwriting firm, given the concerns that are starting to be raised in more depth by regulators, it makes sense for underwriting firms to be cognizant of situations regulators might be concerned about, such as players classified as trading accounts – and therefore institutions in order priority – who routinely sell back bonds to the underwriter or to another dealer right away, she said.
"When you have somebody who's doing this on a regular basis, it does bear examining what's going on," Henry said. "It doesn't necessarily mean that the underwriter has done anything wrong, … but it does bear looking at."
An SEC spokesperson on Thursday declined to comment.
"We don't comment on investigations or their existence," a FINRA spokesperson said Thursday.
