- Excessive markups estimated in the billions of dollars
- Markup disclosure could diminish liquidity, dealer says
At 2:26 p.m. one day in April, an investor bought $30,000 of bonds issued to finance a new stadium for the New York Mets at 106 cents on the dollar. Six minutes earlier, a broker paid 101 cents for the same securities.
Chances are, if the buyer was one of the individual investors who dominate the $3.7 trillion municipal market, he or she was unaware that the total markup on his or her bond could have been as high as $1,500. That will change if regulators adopt a new rule requiring brokers to disclose their profits on trade confirmations.
“A year’s of worth interest can be wiped away simply by buying or selling a bond,” Securities and Exchange Commission commissioner Michael Piwowar said in a telephone interview. “People should know what they’re paying.”
The proposal by the Municipal Securities Rulemaking Board, which is soliciting comments on it through Dec. 11, follows a push by the SEC to inject more transparency into the market for state and city debt to protect mom and pop customers. Such buyers own about 42 percent of the securities, according to the Federal Reserve’s figures. That’s six times more than their share of the Treasury market.
By requiring brokers to disclose how much they earn, regulators want to foster more competitive pricing among dealers and drive down trading costs. A study by the Securities Litigation & Consulting Group, a firm that advises on lawsuits, estimated that customers paid more than $10 billion in excessive markups and markdowns on municipal bonds between 2005 and 2013.
Little Guys Pay
That’s mostly borne by small investors. Those who bought $100,000 or less of investment-grade muni debt in December 2013 paid brokers an average transaction cost of 1.73 percent, twice that of corporate bonds, according to a report by Standard & Poor’s.
The MSRB proposal has drawn criticism from some securities dealers, which said it would add costs and harm liquidity by driving brokers out of the market. Investors can also already find out what the markup was if they want: Since 2005 all trades have been reported within 15 minutes to a website run by the board.
“How about we spend more effort and time on other things that aren’t so transparent,” like the markup on a carton of milk at the gas station, said Matt Dalton, chief executive officer of Rye Brook, New York-based Belle Haven Investments, a broker that also manages accounts on behalf of customers. “Should that have a label on it that says that this owner operator has marked up this gallon of milk by X amount?”
Many investors don’t know that trading prices are now disclosed, according to Piwowar, whose said the fee disclosure “is the next natural step” and won’t be costly for firms to implement. He said the same arguments were once made against the same-day trade reporting, which lowered customer costs without affecting the market’s liquidity.
“It’s the little guys who we’re talking about here,” he said. “If the argument is the information is already out there, what’s the argument against providing it?"
The MSRB proposal -- similar to one the Financial Industry Regulatory Authority has proposed for the corporate market -- applies to “riskless principal” transactions, which make up a large portion of muni trades. That’s when a broker buys a security only after locking in an order to resell it, instead of acquiring a bond and holding it in the hopes of selling it later. Dealers embed their fees in the purchase price but aren’t required to disclose them.
That arrangement is essentially the same as an agency trade, in which a dealer acts as matchmaker between customers but doesn’t use its capital to purchase the bond. Brokers must disclose commissions from those.
The MSRB proposal, as currently drafted, would require dealers to disclose the markup or markdown for principal transactions if the dealer trades the same security within a two-hour window of the customer’s transaction. The dealer’s trade also has to equal or exceed the size of the customer trade to trigger disclosure.
Jessica Giroux, senior counsel at the Bond Dealers of America, said the group supports making the muni and corporate bond markets more transparent.
“We’d like to see coordination and harmonization between the two regulators,” said Giroux, whose Washington-based group represents regional firms. “What we don’t want to have is a whole other system being required, costing the dealer more -- and then in turn, perhaps, passed onto the client.”
The regulators have already rolled back the scope of the proposal. When it was first introduced last year, the MSRB recommended disclosing markups for bonds that a firm traded on the same day as its client, instead of just two hours.
SEC Commissioner Piwowar said he would be “extremely disappointed,” if the MSRB keeps the narrower time frame in place. If so, he said, dealers could skirt the disclosure requirement by delaying trades. The MSRB’s rules have to be approved by the SEC.
“The two hour window is easily game-able,” he said. “The MSRB will ultimately get it right.”