WASHINGTON — The Securities and Exchange Commission’s recently-issued report on the municipal securities market should serve as a “starting point for comprehensive dialogue” with Congress and market participants on improving fairness and efficiency of the market, SEC Commissioner Daniel M. Gallagher said last week.

Speaking to business students at Georgetown University, Gallagher acknowledged the SEC “has not devoted sufficient attention and resources” to the municipal and corporate debt markets and “has traditionally focused more on equities.”

He said that over the summer he had re-read Michael Lewis’ book, Liar’s Poker, Lewis’ account of his experiences as a bond trader at Salomon Brothers in the 1980s, and “was struck by just how much the underlying structure of today’s corporate and municipal bond markets look the same as they did when the book was first published in 1989.”

In most of Lewis’ book, the greed and deceit of bond salesmen and traders prevailed over any concerns about investors.

Gallagher noted that in the early 1900s “there was an active market in corporate and municipal bonds on the New York Stock Exchange but said that by the late 1940s, these bonds “had largely migrated to opaque, over-the-count dealer markets, where most bond trading still takes place.”

The SEC Commissioner seemed surprised at the relative lack of attention to the bond markets, given that there was a total of more than $1.3 trillion of corporate and muni issuance in 2011, compared to only about $198 billion of U.S. common and preferred stock underwriting activity during the same period, and that retail investors are “highly active” in the debt markets.

Price transparency in the muni and corporate debt markets “warrant the commission’s further attention,” he said.

Significant steps have been taken to improve post-trade price transparency in the muni market, such as the development of the Municipal Securities Rulemaking Board’s EMMA system, through which dealers report near-real time price and other trade data.

But retail investors “continue to face significant head winds in the bond markets,” he said. “They simply cannot be sure that they receive best execution and a fair price. The bond markets are still relatively opaque for retail investors.”

While some post-trade price information is widely available, it is not useful for retail investors attempting to buy or sell illiquid bonds, and pre-trade price transparency is lacking, he said.

Pre-trade price transparency is hampered by the fact that there is little or no centralized collection and dissemination of bid/ask quotes, he said. Retail investors cannot tap into large dealer networks for quotes or shop around for the best prices. And because dealers act as principal in most bond trades, they are not required to disclose their markups or markdowns on customer confirmations, he added.

Retail investors “tend to be ‘price takers,’ often relying on a single broker-dealer to obtain a quote with limited insight into whether it is fair and accurate,”  Gallagher told the students.

Retail investors generally face higher costs when trading bonds than similarly-sized trades of common stock, he said. In fact, unlike in the equities market where trading costs generally rise with the size of the trade, costs tend to be higher in the bond markets for smaller trades, he said.

This “suggest[s] that the retail investor’s position in the corporate and municipal bond markets demands additional attention from regulators and market participants alike,” he said. 

At the same time, regulators must keep in mind that wider spreads in the bond markets may be caused by a variety of factors, Gallagher said, adding, the SEC also must monitor whether increased price transparency causes a reduction in market liquidity.

He stressed, too, that by calling for the SEC to devote more attention and resources to the bond markets, he is not implying there is a need for more regulation.

“Whether the proliferation of electronic trading in the bond markets will improve the quality of [the bond] markets remains to be seen, he told the students. “The move from humans to computers could well mean leaner ... bond desks, but more efficient and cost-effective trading, at least for those with access to the platforms.”

Gallagher said he is looking forward to the completion of an MSRB study of trade data, led by Erik Sirri, a professor at Babson College who formerly headed the market regulation, now trading and markets, division of the SEC.

He also said he hopes that as the SEC creates an independent Office of Municipal Securities that reports directly to the commission chairman to satisfy a mandate under the Dodd-Frank Act, it “leverage[s] the creation of the muni office into a new era of sophistication and understanding of the fixed income markets at the commission.”

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