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Bates Research  |  10-23-15

Municipal Bond Mark-Ups

Guest Post by Expert Pamela Peterson

The MSRB has recently extended the time frame for comments on its current proposal to enhance disclosure to retail customers about a certain class of secondary transactions. Comments are now due by December 11, 2015.

As noted in the release (MSRB Notice 2015-16, published September 24, 2015):

Under the draft amendments, dealers generally would be required to disclose the mark-up (or mark-down) on retail customer confirmations for principal transactions when they transact on the same side of the market as the customer in the customer’s municipal security in one or more transactions that in the aggregate meet or exceed the size of the customer transaction. The disclosure of the mark-up would be required only where the dealer’s same-side of the market transaction occurs within the two hours preceding or following the customer transaction. The MSRB is not proposing to use this timeframe to define a “riskless principal” transaction; rather, the MSRB believes this timeframe would be sufficient to cover transactions that could be considered “riskless principal” transactions under any current market understanding of the term.

The “current market understanding” of the term is that a riskless principal transaction occurs when a dealer has an order in hand that offsets the order it is about to execute. In plain English, at the time it buys a security from its customer (with a mark-down), it has in hand an executable order from another customer to whom it can sell that security (presumably with a mark-up). The MSRB itself defines it this way:

A matching pair of purchase and sale transactions in a municipal security executed by a municipal securities dealer as principal under circumstances where such matched transactions effectively eliminate principal risk to the municipal securities dealer. (MSRB Glossary)

Thus, the dealer has no chance of being “stuck” with the security, and exposed to market risk.

The proposal to disclose some transactions in a four-hour window has major operational implications and will capture some transactions that cannot be riskless principal transactions. Further, disclosure of mark-ups and mark-downs from a prevailing market price (even if only for some transactions) may have unintended consequences. The MSRB notes that among the likely results are: “. . . if an investor believes that a disclosed mark-up is higher than he or she might have received from another dealer, the investor may be incentivized to seek out other dealers offering lower transaction costs for future trades.” Lower prices sound appealing, but there are unintended consequences here. Full service brokerages that provide personalized, human assistance and guidance to investors will be better suited to assist customers who genuinely need help in navigating the million-plus available municipal CUSIPs. Many of these brokerages already feel threatened by internet brokerages, whose automated service models don’t usually require the same level of human involvement—allowing them to charge lower mark-ups. The risk here is that some customers will simply seek the lowest mark-ups, when they really need more assistance and insight. Alas, these are also the same investors who don’t quite realize that “high yield” means “higher risk." The lesson “you get what you pay for” may be painful for muni bond buyers who learn too late that they are in over their heads at a beach with no lifeguards.

One reason why the SEC and the MSRB are so focused on riskless principal transactions is because of their belief that mark-ups and mark-downs are compensation to the dealer for its risk in market-making (no risk should therefore equal very small mark-ups, they believe). Dealers may well wish to question that assumption, as they see the largest component of mark-ups and mark-downs as being compensation to salespersons and profit to the firm. Given the regulators’ expansion of required risk and material events disclosure, their imposition of the requirement to redo full diligence for suitability purposes when an explicit “hold” recommendation is made, and the whopping increase in penalties for ordinary human errors under the SEC’s current “broken windows” theory of regulation, it’s hard to see why regulators are so focused on reasonable mark-ups.

The focus on outrageous mark-ups via enforcement actions is a different—and wholly commendable—thing. The best feature about the various disclosure proposals is that they should lower the number of times when bad actor dealers can conceal predatory pricing.

NOTE: Ms. Peterson has a forthcoming publication titled "Fair Pricing for Municipal Bonds" that offers an authoritative look at the complicated practice of determining fair prices for municipal securities, and touches on many of the issues raised in the post above. For more information, please contact or call 503-670-7772.