The MSRB's treatise on minimum denominations

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WASHINGTON – After backing off further rulemaking on minimum denominations, the Municipal Securities Rulemaking Board has published a report on the topic to be used as a resource for any future regulatory efforts.

“While the MSRB does not plan to propose changes to its minimum denomination rule, it is providing this resource to support any efforts by market stakeholders to evaluate market practices regarding the use of minimum denominations, particularly in light of developments in technology, a growing interest in small-denomination municipal bonds and the allocation practices of investment advisers,” the board said in its executive summary to the report.

The 19-page report provides the history and purpose of minimum denominations, the MSRB’s adoption of Rule G-15(f)’s prohibition on trading in lower amounts, investor and enforcement issues, the board’s attempts to proceed with rule changes or a stand-alone rule, and the concerns that were raised by market participants.

The MSRB said it reached out to stakeholders, including issuers, dealers and regulators, and obtained their views.
Minimum denominations of muni securities are sometimes set by issuers to target their sale to sophisticated investors and have been used since at least the 1970s, according to the report.

For example, if munis are deemed risky, an issuer might put provisions in the bond documents saying they can only be sold in denominations of 100,000, which typically is a high amount than what retail investors would purchase.

In some cases, the use of minimum denominations may be set by state or local laws, the board said.

In January 2002, the MSRB added a section “f” to its Rule G-15 on confirmation, clearance and settlement that generally prohibits a dealer from trading bonds with customers in amounts less than the minimum denomination set by an issuer.

Two exceptions from the prohibition were added to protect customers who already held positions in bonds below the required minimum denomination.

The first exception permits a dealer to buy a muni below the minimum denomination from a customer if the customer’s position is below the minimum denomination and the purchase would liquidate its position in the munis.

The second exception permits a dealer to sell a customer a muni below the required minimum denomination if the sale would allow the seller to liquidate its position in the muni and if the dealer disclosed the situation to the customer and warned the customer of possible liquidity problems with trying to sell the muni in the future.

Over the years observers reported situations where a dealer couldn’t assist a customer with a purchase or sale because of the rule.

In addition, regulators found several dealers violated the rule. From 2006 through 2017 the Financial Industry Regulatory Authority took more than two dozen disciplinary actions against multiple dealers, the MSRB said. From 2014 through 2017, the Securities and Exchange Commission instituted 14 administrative proceedings against dealers who violated the rule.

The MSRB said it began a review of Rule G-15(f) in 2016 to see if it could address the liquidity problems for customers holding munis in below-minimum denominations amounts.

From January 2016 to May 2017 it the board developed and considered three versions of proposals to amend the rule. The board solicited comments and muni groups complained they would hurt investors.

The third version proposed a stand-alone rule G-49 on minimum denominations, which would include G-15(f) and amendments. The MSRB filed it with the SEC, but withdrew it after dealers complained it would have limited interdealer transactions and harmed market liquidity.

The MSRB reached out for input from dealers, issuers, bond counsel and even regulators. The board asked the stakeholders a broad range of questions, including how minimum denominations were started, what they mean, what are the costs and benefits of establishing minimum denominations and whether Rule G-15(f) should be amended.

The last part of the paper contains a series of questions the MSRB says should be considered if market participants decide in the future that changes to the existing Rule G-15(f) on minimum denominations are warranted.

Several of these questions are similar to the ones the MSRB asked stakeholders in its outreach efforts.

The board asked, among other things, if issuers should consider establishing minimum denominations of less than $5,000.

“Are larger minimum denominations effective in limiting investment in securities, or should another mechanism be used, such as restricting purchases to qualified institutional buyers (QIBs), or accredited investors?” the board asked.

Noting that the current regulatory framework does not apply to interdealer transactions, the MSRB asked, “Is there any data available to assist in determining if interdealer transactions contribute to the creation of additional below-minimum denomination positions?”

The board also asked if more can be done in this area. For example, it asked if its Real-time Transaction Reporting System should be modified to “flag” transactions executed below the minimum denomination of a muni?

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