September 29, 2014
Secretary Murphy:
I know of no one that has not accepted the concept of a best execution standard for municipal transactions. However, proposed amendments to Rule G-18 that create a best ex standard in the municipal market remain deeply flawed. I will focus on the two most significant issues. First, the proposal erroneously presumes retail customers turn in market orders to purchase specific municipal bonds in the secondary market and, consequently, imposes unnecessary regulatory burdens on selling dealers. Secondly, the definition of market intended to demonstrate the uniqueness of the municipal market instead identifies every single market participant as a market, bizarrely identifying what heretofore has been understood as a single market as thousands of them.
When the question was posed as to what activity would the proposed amendments regulate that is not currently regulated, the Commission noted that the Board identified the best execution standard as an order handling and execution standard, not a pricing standard. Exactly. Customers do not call municipal bond dealers and ask them to buy 500 Shreveport, Louisiana Water and Sewer 4.75 due 5/15/2033 at market. A municipal salesperson offers securities at a price, often out of inventory. Furthermore, any orders that could be considered limit orders (you are offering these at a 3.95, I will take them if you can get the bonds at 4.00) are almost always fill or kill. The fact of the matter is that bonds are always offered based upon the price quoted by the party that owns them and any order is in response to an offering at a specific price. I recently polled several dealers and asked the following questions. Have you received any market orders for specific bonds in the last ten years? Have you received any limit orders for bonds you did not offer at a specific price? And have you ever offered bonds from another dealers inventory at prices cheaper than the dealer that owned them? The responses ranged from never to less than once a year, if that. In other words, on the sell side, there are no orders to speak of that would benefit from requiring a dealer to complete a process demonstrating best execution. Execution quality is not an issue. When addressing this issue, the Commission, without denying the veracity of the Comment related to selling a unique security out of inventory, stated in its release that the proposed Rule is flexible enough to take into account the nature of each transaction. If, however, the proposal is truly flexible enough to take into account each transaction, why then did the Board impose additional burdens on dealers where no quotations are available knowing full well that the owner is the only market for many secondary market customer transactions and a considerable majority of those on the sell side? How difficult would it have been to include an acknowledgement that unique securities sold out of inventory are by nature the only market for that security? Why adopt a Rule that would appear to apply to an entire class of transactions where the Rule would have no practical application whatsoever? Why maintain the illusion that a Rule applies to a transaction and require dealers to create a procedural regime for the extremely rare exception rather than the rule?
Part of the problem with crafting a best execution standard for fixed income markets is the requirement that one has to ignore the nature of the market. The Board attempts to tackle this conundrum by declaring each market participant a market unto themselves. This creates the specter of requiring a firm to obtain the best bid (the conflict between the stated absence of an obligation to obtain the best bid and the definition of each potential bidder as a market is irreconcilable), no matter where that bid resides when one considers each dealer to be a market. The municipal market is unique in that customers do not turn in orders on the secondary market, there are over one million CUSIPs, meaning that the vast majority of the market is not quoted, and securities are almost always sold out of inventory or sold based upon an offering from anothers inventory. It is not unique in that everyone with a telephone is a market. An undue burden not required by FINRA Rules is placed on dealers by defining each dealer as a market. A significant portion of the taxable fixed income market is structured like the municipal market: thinly traded issues offered by the owners of the bonds. FINRA, however, chose not to define each dealer as a market choosing instead to define markets as a variety of venues, including market centers. The FINRA Rule retains the vestiges of the idea that a market is a place where quotes are collected and displayed, not just a location where one might be able to obtain one quote. FINRA addresses the debt market in its supplemental material and immediately thereafter addresses the general absence of quote accessibility that is likely to occur in the debt market. In the absence of quote accessibility, FINRA requires dealers to take reasonable steps and utilize their market expertise to obtain best execution for their clients.
The FINRA language related to the absence of quote accessibility is another area where the Board diverged from FINRA and placed additional burdens on municipal dealers. In place of the reasonable steps requirement are a special procedures requirement and a recommendation that dealers seek out other information and liquidity sources, including calling other dealers (which could already be inferred by the fact that dealers are defined as markets). Absent an exception for a dealer offering bonds out of inventory, in order to comply with the proposed Rule, a dealer may be required to call other dealers and inquire as to what is a fair price for their own inventory.
Regulation should be designed to address situations that actually occur. Dealers are not markets and the price of a bond sold out of inventory at a price offered by the dealer does not represent an order that can be executed. Simply wording the proposal more in line with existing FINRA rules would go a long way toward addressing these issues.
Thank you for the opportunity to comment on the proposal.