SEC Fixed-Income Quotation Rule 15c2-11: Industry impact and unanswered questions

During Bloomberg’s virtual Risk and Reg Week event, Jason Palsgrove, Product Manager, Enterprise Regulatory Content at Bloomberg spoke with Audrey Blater, Senior Analyst, Risk and Financial Markets Regulation at Coalition Greenwich to explore challenges the industry is having applying SEC Rule 15c2-11 to fixed income securities.

What does the SEC Rule 15c2-11 apply to?

SEC Rule 15c2-11 was originally adopted in 1971 and amended in 1999 to address fraudulent behavior in the over-the-counter (OTC) equity market. In September 2020, the Commission further amended the rule to enhance the requirements broker-dealers, as gatekeepers to the OTC market, must satisfy before initiating or resuming a quotation of a security. One of the requirements, for example, is if the issuer or its OTC equity security does not satisfy a specific exemption, then the broker-dealer must locate and review for accuracy 14 fields of data from a publicly available source of current financial information prior to quoting.

The staff of the SEC’s Division of Trading and Markets signaled in the summer of 2021 that they would apply Rule 15c2-11 to the fixed income securities for the first time. In September 2021, the staff issued a no-action letter stating that the staff would not recommend enforcement action to allow for an orderly and good faith transition into compliance with the Amended Rule. In December 2021, the staff issued another no-action letter detailing a phased in approach for compliance.

(22:01) Explore challenges the industry is having applying SEC Rule 15c2-11 to fixed income securities.

SEC Rule 15c2-11

Unintentional noncompliance to SEC Rule 15c2-11 could spell trouble for firms or keep them from the market altogether. Explore what the SEC Fixed-Income Quotation Rule 15c2-11 applies to, who will be affected, and how this change could affect liquidity and portfolio diversification.

Who will be affected?

When it comes to understanding who will be affected, Blater points out that further clarity is needed for which party has the obligation to comply with the Rule. Broker-dealers are making the quote, but it is unknown whether trading platforms principally intermediating trades may also be obliged in some instances. While trading platforms don’t act as market makers, they are the intermediary providing the mechanism to connect buyers and sellers, particularly for anonymous trading.

Although the trading platform isn’t making the quote, it is passing it along, often via its own broker-dealer entity, potentially with a spread attached. Similarly, all trading falls into a grey area because it is not immediately clear who “owns the quote,” Blater said. This has drawn industry attention as fears that unintentional noncompliance could spell trouble for firms or keep them from the market altogether.

While the rule was initially intended to increase transparency in OTC equity markets, many investors are concerned that application of the amended rule would have the opposite effect on liquidity markets and undermine transparency in less frequently traded instruments. If bond dealers are unable to access issuer data on an infrequently traded bond in a timely manner, they might choose to stop quoting the bond all together to avoid regulatory noncompliance.

Blater notes that bonds issued by a U.S. publicly listed company will, by default, have the necessary and up-to-date information because of SEC requirements for listed equities. Bonds issued by private companies and some from emerging markets may be more vulnerable, and the rule changes could affect their liquidity.

Privately placed 144A securities will not be affected by the amended rule until January 2023, when the multiyear rollout moves into its next phase, but they risk becoming completely illiquid if they’re no longer able to be quoted.

For example, some issuers may be disproportionately affected by the regulation should investors demand compensation for illiquidity in the form of lower prices. Some sectors may be affected more than others, including emerging-market bonds, as the only existing rule exceptions are for sovereign and sovereign-guaranteed paper rather than regional governments outside of the U.S.

This is particularly troubling for many, as emerging-markets debt and corporate bonds, including investment-grade high-yield bonds and 144As, have trended higher in recent years as investors look to diversify their portfolios and search for yield amid tight spreads and low rates.

How could this change affect liquidity and portfolio diversification?

“These rules don’t live by themselves,” Blater said, “There is a lot going on right now. We have a plethora of market frictions to worry about, we have higher rates, we have rampant inflation.” Blater argued that the fallout from the Covid-19 pandemic, high commodity prices, geopolitical conflict and other unforeseen factors affecting the global economy can create problems for corporate bond liquidity. In addition, the additional regulatory frictions from these rules may lead severe unintended consequences.

“Imagine owning securities in your portfolio, and you’re stuck with them, if there’s no market for them, right? Imagine a portfolio that’s more difficult to hedge, or maybe it aligns less with ETFs, or CDX or other benchmarks. Imagine a more highly correlated portfolio. These are all serious issues,” she said.

Blater said there needs to be clarification from the SEC about the amended rules and their application. There are concerns a firm may be penalized for breaking a rule that has yet to be clearly interpreted, and she encourages others in the industry to keep an open dialogue going with the SEC so that questions may be answered.

“If you look back in early 2020, when COVID really first started, that COVID-induced volatility spike in trading, that was supported by broker-dealers’ ability to quote and trade these instruments,” Blater said. “Now, without ample liquidity, it would be really difficult to imagine smooth risk transfer, particularly when you’re not in calm markets, regardless of what you have in your portfolio.”

“So it’s really, really important that securities stay liquid, that investors are able to risk transfer in a meaningful way. And that certainly we deal with market frictions that aren’t being amplified by regulatory forces.”

How we can help

Bloomberg offers a Fixed Income Quotation Transparency product that provides broker-dealers with information that can be integrated into their compliance program to help identify the fixed income securities that may be impacted by SEC Rule 15c2-11. This regulatory data solution is available to Bloomberg Data License customers who may need to integrate it into their compliance workflow. For more information, please contact us or visit our website.