Should rule G-43 call for 3rd party reference prices?

The Bond Buyer covered the new MSRB rule G-43 intended to protect retail muni investors from predatory broker's brokers' practices. Broker's brokers are one of several intermediaries in the muni bond industry characterized, in part, by the so called bid-wanted auctions. Rule G-43, in part, is intended to police this activity and not dis-similarly to the corporate market involves a somewhat arbitrary notion of a roughly reasonable price.

That is because in sourcing interest for bonds broker's brokers will sometimes contact individuals who bid prior to the conclusion of the auction, even without informing the seller of this contact. To limit the nefarious possibilities arising from this sort of communication, rule G-43 lays down criteria under which this communication may take place. Incidentally it also makes other demands, including reasonable dissemination of the bid-wanted lists:

Unless otherwise directed by the seller, a broker’s broker must make a reasonable effort to disseminate a bid-wanted widely (including, but not limited to, the underwriter of the issue and prior known bidders on the issue) to obtain exposure to multiple dealers with possible interest in the block of securities, although no fixed number of bids is required.

Here, however, is where the notion of a roughly reasonable bid enters:

If the high bid received in a bid-wanted is above or below the predetermined parameters of the broker’s broker and the broker’s broker believes that the bid may have been submitted in error, the broker’s broker may contact the bidder prior to the deadline for bids to determine whether its bid was submitted in error, without having to obtain the consent of the seller.  If the high bid is within the predetermined parameters but the broker’s broker believes that the bid may have been submitted in error, the broker’s broker must receive the oral or written permission of the seller before it may contact the bidder to determine whether its bid was submitted in error.

If the high bid received in a bid-wanted is below the predetermined parameters of the broker’s broker, the broker’s broker must disclose that fact to the seller, in which case the broker’s broker may still effect the trade, if the seller acknowledges such disclosure either orally or in writing.

Thus the rules related to communication with bidders come down to an internal determination of whether bids were above or below a given threshold. It would seem that an independent, third party estimate may be the preferable criteria.

A Few Statistics from the GAO Report on Municipal Bond Market

The U.S. Government Accountability Office issued a congressional report on the municipal bond market a while back. A few notes:

• One percent of muni's trade once a day or more
• There are 46,000 issuers and between 1-1.5m securities in play
• FINRA oversees 98% of 1,800 MSRB-registered broker-dealers
• FINRA investigated 5,764 times resulting in 51 occasions where G-30 violations were pursued, of these 37 resulted in cautionary action, 11 resulted in a compliance conference. (The Office of Compliance, Inspections and Examinations - part of the SEC - oversees FINRA's oversight of MSRB rules, albeit infrequently)
• Average markup for $10,000-$20,000 trade is 1.8 points
• Average markup for $50,000-$100,000 trade is 0.9 points
• Average markup for $250,000+ trades is on the order of 10-30 bps
• Markdowns are smaller

The GAO report also mentions ongoing studies by the SEC and MSRB, also due this year and distinct from the regular statistical summaries from the MSRB (such as this one, for example).

On crossing at the Magenta Line versus paying the bid-offer

More bond market participants are considering guided crossing networks as an alternative to paying the bulge bracket bid-offer spread. The idea is very simple, at least in theory. An independent third party real-time price is computed in real-time, and anonymous parties can cross there. Of course they could also modify their desired price or allow it to float with the reference price (or reference spread). In 99.9% of cases this sort of crossing appears to be a no-brainer, since the typical bid offer in U.S. corporates is quite wide. It is visually obvious that buy side participants will save a lot - arguably on the order of several billions per year.

Because the development costs are very high, the only real-time reference price for U.S. corporates is currently provided by Benchmark Solutions. It is known as the Magenta Line. Crossing at the Magenta Line is a real, dare I say imminent possibility. For years the available reference prices have been inaccurate and produced no more than a few times a day. Needless to say new technology brings new commercial opportunities.  

This short note preempts a possible objection: the quality of the reference price in fast markets. Market participants can see the sort of display shown below and can easily make their own judgement, at least for liquid bonds (and they may exercise prudence by waiting for the market to settle down, of course). But what about illiquid bonds, that must be priced off "the" curve (or really two curves - credit and basis, plus idiosyncratic estimates)? Fortunately the Magenta Line is really a Magenta Curve, so the performance can be assessed by looking at relatively liquid bonds.

The other day we saw a big move in NAV that occurred in the space of twenty minutes, thus providing an opportunity to test whether the Magenta Line is suitable for crossing in fast markets. In fact the Magenta Line performs extremely well - a couple of years of research helps. Below you see the result of a recent code cut and the curve response. The even mildly technical reader will correctly infer that non-gaussian price dynamics are being modeled (together with numerous micro-structure devices that are less obvious in this particular example).

There are two things worthy of note here. First, this is actually an intermediate result in the sense that there is additional post-filtering applied after the fact - which in practice would improve the performance further (particularly in the period 3pm-4pm where I think there is a little room for improvement).

But at the risk of repetition, I am showing the response for one particular bond on the curve which is liquid. The point is that the entire term structure of credit and basis (as well as interest rates, of course) will also be moving. That how customers crossing at the Magenta Line on a far less liquid bond can still receive a fair price, no matter when they choose to trade.

Dealers and investors call summit to discuss ... something

I can't resist a plug here for a couple of new blogs of interest to corporate bond market participants. The first is The New New Issue Report hosted by Eric Schmalzbauer. Erik will provide a concise daily commentary on new issues hitting the corporate bond market.

The second is Hosker's Hoot a two or three minute commentary from former Goldman strat Jim Hosker providing a summary of buying and moves in the bond and CDS markets, and broader color on economic events.

In his first hoot, Jim drew attention to the unusual summit held between some major broker dealers and buy side firms outside of Boston called to discuss concerns over liquidity and changes in the credit markets. They certainly have a lot to discuss.

Anecdotally, this is not the only high level offsite in recent times on the same topic. One bank revealed to us that they had held a similar meeting, and that a certain provider of real-time corporate bond and CDS pricing (ahem, Benchmark Solutions) was mentioned many times during their meeting.