Saturday, May 5, 2012

Corporate bonds are marked up excessively more than 10,000 times per month. Fines would run into the billions if FINRA enforced them automatically.

My country of birth and country of residence differ in their approach to speeding fines. In the U.S. an officer must pick the worst offender, literally chase them down and finally present a ticket. In Australia things are a little more streamlined. A camera registers the license plate of every speeding car, whether or not it is merely going with the flow.

In the corporate bond market the equivalent of speeding is selling a bond to a customer with a markup that is judged excessive. The line appears to be drawn somewhere around 3%. To be clear, that means charging the customer more than $3000 when they go in for $100,000, say, or a whopping $30,000 when they buy a million. You might think these violations are rare, given the wide spread and reluctance (you would think) of investors to pay real estate level commissions. But they are not and FINRA regularly fines market participants quite heavily.

For example FINRA fined Morgan Stanley last year and although 5% used to be the guideline, the language around a more recent Citibank case is not so clear.  Citibank was found guilty of marking up bonds by "2.73 percent to over 10 percent" and this was "excessive given market conditions, the cost of executing the transactions and the value of the services rendered to the customers, among other factors". FINRA's press release quotes Thomas Gira appearing to discard the 5% precedent.
"FINRA is committed to ensuring that customers who purchase and sell securities, including corporate and agency bonds, receive fair prices. The markups and markdowns charged by Citi International were outside of appropriate standards for fair pricing in debt transactions, and FINRA will continue to identify and address transactions that violate fair pricing standards, regardless of whether a markup or markdown is above or below 5 percent."
Back in 2001 FINRA wrote in this letter that they would not provide interpretive guidance on the appropriateness of a commission or mark-up schedule under Rule 2400 (NASD). But as noted by Eckert and Newman that didn't stop the heat being turned up somewhere around 2007. Firms were reminded of their obligations, including the need to consider the following:
  1. Prices of contemporaneous inter-dealer transactions in the security
  2. Prices of contemporaneous dealer transactions in the same security with institutional accounts with which any dealer regularly effects transactions in the security
  3. For actively traded securities, contemporaneous bid or offer quotations in the security through any inter-dealer mechanism through which transactions generally occur at displayed quotations
Furthermore, as also noted by Eckert and Newman, firms are obligated to consider similar securities and specifically:
  1. Prices of contemporaneous inter-dealer transactions in a similar security, or prices of contemporaneous dealer transactions in a similar security with institutional accounts with which any dealer regularly effects transactions in the similar security
  2. Yields calculated from prices of contemporaneous inter-dealer transactions in similar securities
  3. Yields calculated from prices of contemporaneous dealer transactions in a similar security with institutional accounts with which any dealer regularly effects transactions in the similar security
  4. Yields calculated from validated contemporaneous inter-dealer quotations in similar securities
It is unlikely that FINRA envisaged the automation of all these criteria in real time. And wherever the line is to be drawn, it is clear that FINRA has adopted the U.S. version of enforcement - the officer chasing down the speeding driver and issuing one fine at a time by hand.

Have you ever wondered, however, what might happen if they had a speeding camera? Until recently that was not possible because there was no independent, real-time indicative mid price to compare the reported trades to - one that is not easily fooled by pairs of dealer-dealer and dealer-customer trades well off market (to pick one technique for "moving" the mid). How many non-compliant trades would the Magenta Line catch?

The answer is astonishing. A colleague ran the numbers last night on 9000 corporate bonds tracked for approximately the last four months. Of the 1,090,898 reported investment grade trades there were 29,825 examples where the customer was at least 3% off market. That number rises to around 50,000 when you include high yield bonds and, while it would never happen, if FINRA was to levy a $30,000 fine for each and every violation it would bring in $4.5 billion annually! 

We are not likely to see punitive numbers on that order but more realistically, FINRA could demand restitution for many, many trades. Customers paid an excess of $866,801,894 to dealers over the last four months alone, by buying investment grade bonds far above the mid.

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