The Investment Industry Regulatory Organization of Canada has announced:
a proposed rule and guidance note to address fair pricing of over-the-counter (OTC) traded securities including fixed income securities such as bonds. The proposal would amend existing trade confirmation requirements by mandating yield disclosure for fixed income securities. It will require firms to disclose on confirmations sent to retail clients for OTC transactions if the dealer’s remuneration has been added to the price in the case of a purchase or deducted in the case of a sale. The general purpose of these proposed amendments is to enhance the fairness of pricing and transparency of OTC market transactions.
The text of the proposed rule states that, generally speaking:
the proposed amendments will:
• Require Dealer Members to fairly and reasonably price securities traded in OTC markets;
• Require Dealer Members to disclose yield to maturity on trade confirmations for fixed-income securities and notations for callable and variable rate securities; and
• Require Dealer Members to include on trade confirmations sent to retail clients in respect of OTC transactions a statement indicating that they have earned remuneration on those transactions unless the amount of any mark-up or mark-down, commissions and other service charges is disclosed on the confirmation.
These are rules only a regulator could love. They note, for instance, that:
the pricing mechanisms used for fixed income securities are less understood by retail clients. Specifically, retail clients may not understand the inverse relationship between price and yield or the various factors that can affect yield calculations and the relative risk of a particular fixed income security. All these factors contribute to the difficulty retail investors are faced with when determining whether a particular fixed income security is fairly priced (and therefore offers an appropriate yield) and of appropriate risk. IIROC therefore wishes to underscore the responsibility of Dealer Member firms to use their professional judgment and market expertise to diligently ascertain and provide fair prices to clients in all circumstances, particularly in situations where the Dealer Member must determine inferred market price because the most recent market price does not accurately reflect market value of that security.
If a client does not understand the inverse relationship between price and yield, THE CLIENT SHOULD NOT BE BUYING BONDS. Full stop.
The underlying purpose of the rules may be deduced from:
Market regulators’ surveillance of fixed income market activity will provide the tools to monitor for patterns and trends in prices and will allow regulators to more effectively identify price outliers. IIROC is currently considering how best to implement such a system to monitor our Dealer Members’ OTC security (both fixed income and equity) trading, which would allow IIROC to identify circumstances where trade prices do not correspond with the prevailing market at that time.
In other words, somebody at IIROC wants to expand his empire. Or, maybe, has looked at his career prospects and decided that a good future job title would be “Compliance Manager, Retail Bond Desk, Very Big Brokerage Inc.”
Rules 2 (Yield disclosure) and 3 (Compensation disclosure) are derisory; the latter simply requires a statement that the dealer is making money (or hoping to, anyway), something that most people are able to deduce from the fact that the confirmations already state that it’s a principal transaction.
Rule 1, however, is more complex. IIROC has drafted a Guidance Note:
When executing an OTC trade as agent for a customer, a Dealer Member will have to use diligence to ascertain a fair price. For example, in the context of an illiquid security this “reasonable efforts” requirement may require the Dealer Member to canvass various parties to source the availability and the price of the specific security. Passive acceptance of the first price quoted to a Dealer Member executing an agency transaction will not be sufficient.
This will kill the market, such as it is. Why would they bother, when they can just say “No offer” or “No bid”? If they do bother, and they do go through this canvassing process, and they do charge a fair price for their efforts, is the price still going to be halfway reasonable? I doubt it.
Most insidiously:
It is important to note that the fair pricing responsibility of Dealer Members requires attention both to the market value of the security as well as to the reasonableness of compensation. Excessive commissions, mark-ups or mark-downs obviously may cause a violation of the fair pricing standards described above. However, it is also possible for a Dealer Member to restrict its profit on transactions to reasonable levels and still violate the Rule because of inattention to market value. For example, a Dealer Member may fail to assess the market value of a security when acquiring it from another dealer or customer and in consequence may pay a price well above market value. It would be a violation of fair pricing responsibilities for the Dealer Member to pass on this misjudgment to another customer, as either principal or agent, even if the Dealer Member makes little or no profit on the trade.
So, in other words, you could make a good faith misjudgement of a market price – such as, for instance, a bond market professional makes all the time – and be subject to regulatory action. Not to mention being liable (forever) for the difference between the price at which you offset the client transaction and the price some regulator decides is fair.
Just in case there are some people out their with the belief that these rules might actually result in a net improvement to the retail bond market:
IIROC expects Dealer Members to maintain adequate documentation to support the pricing of OTC securities transactions. In most instances, existing transactions records, including audio recordings, will allow Dealer Members to reconstruct the basis on which an OTC transaction price was determined to be fair, and will therefore suffice for purposes of supporting the fairness of a transaction. IIROC anticipates that hard-to-value transactions, are likely to require additional supporting documentation. Proper documentation of such transactions may be the subject of IIROC trading reviews, and the failure to maintain documentation to support the fairness of pricing of hard-to-value transactions will be a consideration in any potential enforcement actions.
It is rather sweet that IIROC believes we can reach a Nirvana through imposition of more rules, but all this stuff simply betrays total lack of comprehension of how the bond market – retail or institutional – works. These rules are the product of people who have never in their lives got on the ‘phone in a cold sweat and said “Done”; it is the product of people who believe they know everything on the basis of their two-year Ryerson certificate in Boxtickingology.
My brief remarks when the gist of the rules was leaked on April 14 attracted comments, both on the post and in my eMail. One Assiduous Reader writes in and says:
I have a similar observation over the few years for bond with short maturity (1 – 5 years). Could you explain some of the factors why retail brokerages seem to be offering a better deal on GIC? Is the difference between a retail bond offering and a GIC the cost of “liquidity” (ability to sell before maturity) and the markup by the brokerage?
GICs are completely easy for the brokerages to offer. They get a feed from the issuer showing the rates, they can offer all they like at those rates in any wierd quantity desired, they get a commission, click, bang, done. A little bit of profit, no market exposure at any time for the brokerage, and the so-called trader can be any eighteen year old teller with the requisite CSI course.
Best of all, when the issuer runs into difficulties and gets its name in the headlines, they don’t have to deal with thousands of desperate, angry, confused clients who don’t understand why the brokerage doesn’t want to buy back every single piece of paper they’ve ever sold at the original price.
There has also been some discussion on Financial WebRing:
On the other hand, we require all sorts of disclosures for mutual fund investors, presumably targeted at unsophisticated investors. If that holds for mutual funds, why not for bonds?
Because mutual funds are sold on the basis that you are hiring somebody – and paying them – to exercise their best efforts. Bonds are sold on the basis that you don’t want to pay exhorbitant management fees on something so simple as bonds, and are therefore buying them yourself as principal and saving all kinds of money, yay!
Definitely agree that bonds should be on more of a transparent exchange than presently. If more complicated forms of debt such as pref shares and debentures can be exchange-traded, why not plain and simple bonds?
Because there are thousands and thousands and thousands of bonds, all but a few of which trade by appointment only. I don’t want to pay listing fees for something that’s going to trade three times a year; you can if you like.
Update: I was quoted by Bloomberg:
“The net effect of these proposed rules will be to decrease the choice of retail offerings even further,” said James Hymas, a fixed-income and preferred-share specialist at Hymas Investment Management Inc. in Toronto. “There’s a lot of overhead for the brokers. They may simply choose to limit the number of offerings they make.”
Mr. Hymas, there seem to be some inconsistencies, or an underlying unfairness, in your arguments against this. You say retail buyers, unaware of the relationship between yield and price should not be buying bonds. Fine. In the next sentence however you say that professional bond dealers who purchase bonds at too high a price through inattentiveness or sheer stupidity (how this differs from a knowledge challenged retail buyer I don’t know) should be allowed to knowingly pass on their bad call and stupidity to their clients regardless of the actual market value of the bond, in the name of what? Buyer beware? Dog eat dog? If I make a bad choice, I have to live with and or it eat it. Bond desks and brokers apparently don’t in your world, sir? That, in a nutshell, is what transparency and regulation is all about. There’s already way too much difference in pricing of the same bond at the same time between brokers. Never could figure out why? Thanks for the inside info! Apparently bond market “professionals”, (“So, in other words, you could make a good faith misjudgement of a market price – such as, for instance, a bond market professional makes all the time”) if they make “mistakes all the time” should be allowed to continue calling and considering themselves professionals and not have to seek a new line of work – simply pass it on to the next sucker down the food chain eh? Works for you does it Mr. Hymas?
should be allowed to knowingly pass on their bad call and stupidity to their clients regardless of the actual market value of the bond
The point is that it’s not, in fact, knowingly. I addressed a specific situation in which a professional makes a good faith effort to source some bonds and passes on that price in good faith – only to be told six months later that the price was not, in fact, fair.
These rules – and your arguments – tend to make the nature of the transaction one of agency (with rather fierce penalties for errors of judgement made in good faith) rather than principal.
If you don’t want the bond offered to you at the price offered to you, you are not obliged to buy it. If you don’t want to be the next sucker down the food chain, that’s your choice entirely.
If you want a professional to take responsibility for your bond investments, buy a fund.
There’s already way too much difference in pricing of the same bond at the same time between brokers. Never could figure out why?
Inventories and judgements made regarding the future. Judgements differ. Sometimes, judgements differ substantially.
Apparently bond market “professionals”, … if they make “mistakes all the time” should be allowed to continue calling and considering themselves professionals and not have to seek a new line of work – simply pass it on to the next sucker down the food chain eh? Works for you does it Mr. Hymas?
They can call themselves anything they like. I’ll make my own decision regarding whether or not I will make a specific trade with them at a specific price – I’m a grown-up.
[…] PrefBlog Canadian Preferred Shares – Data and Discussion « IIROC Publishes Proposed Retail Bond Rules […]
You mention “Because there are thousands of bonds, all but a few of which trade by appointment only.” as a reason bonds are not exchange traded. In your experience, are there some issues that have enough liquidity to justify being exchange traded? Would you agree that an exchange for bonds would give more transparancy to the transaction and possibly solve the problem the regulators are trying to hamhandedly address? Could this be a backdoor effort by regulators to push bond dealers to establish an exchange rather than try to comply with the new regs.
In your experience, are there some issues that have enough liquidity to justify being exchange traded?
The only ones that come to mind are governments. Govies could be quite easily listed on the exchange; but it would be hard to give a good rationale for that.
That being said, there are already some bond (or near-bond, anyway!) issues that trade on the TSX: for instance, TDD.M, which had no trades today and is rather confusingly quoted on the tmxmoney site as 102.05-100.75, 500×350. Whether the quote is simply inverted or not, I simply don’t know.
What retail investors in general do not understand is that CORPORATE BONDS DON’T TRADE MUCH. For instance, there’s a BAM issue in the US that I use to benchmark – very, very approximately – the BAM.PR.J retractible. have a look at the FINRA report, and tell me what a “fair” price is (actually, today is rather a good day to do this, darn it: pretend it’s actually April 10)
Would you agree that an exchange for bonds would give more transparancy to the transaction
Well, sure. By definition. But the question – in regulation and in investments generally – is not so much “Is this good?” as “Is this worth the money?”. I am quite convinced that the answer is “Not even close.”
Wellington Financial points out that a prior attempt at a bond exchange didn’t get off the ground.
Could this be a backdoor effort by regulators to push bond dealers to establish an exchange rather than try to comply with the new regs.
That particular thought hadn’t occured to me, but oddly enough I had been speculating as to whether it was a backdoor to a clone of the FINRA system.
A FINRA clone is something a lot of people (probably, but not certainly, including me) would like to see, but again, it’s not entirely certain that this would be a good thing.
Say you’re a bond trader and a client wants to sell you a million bucks worth of some tiny little municipality paper, or electricity distributor, or whatever. Issue size is $50-million. What do you bid? As soon as you trade, everybody’s going to know your price and use that information against you when you try to sell it. So … you bid less. The damn thing might be sitting on your books for six months, eating up capital.
I’m just not sure whether such a system would really be a step forward for market efficiency, even if it was all free.
If a few bonds were exchange traded, do you think liquidity in those issues would increase, or are most bond issues long term institutional holds?
My frustration as a retail trader comes from not being able to see what is available at what price to make purchase or sale decisions. Also, its the inability to participate in new issues.
For retail clients trading fixed income at TDW, you are given a bid and ask for bonds. These are usually variable, based on volume traded. Is what TD offering actually their own inventory? If so, isn’t the bid/ask just arbitrarily set by TD and just a measure of their markup?
Thanks for your insight.
“Grown up” though you may be J Hymas, you apparently haven’t yet learned there’s no such thing as “good faith” in the financial industry.
If a few bonds were exchange traded, do you think liquidity in those issues would increase,
I think that the illiquidity would become more visible, frankly.
As for liquidity, it depends a good deal on what you mean by it. If you mean “the ability of Granny Oakum to trade $10,000 and not feel ripped off” … probably increase. If you mean “the ability of Joe Trader to trade $1-million and not feel ripped off” … probably decrease.
Look at the preferred share market as a good example. Something can trade in a tight range in 100-lots for months … then suddenly, somebody trades 100,000 and moves the market a buck-and-a-half.
Is what TD offering actually their own inventory? If so, isn’t the bid/ask just arbitrarily set by TD and just a measure of their markup?
Yes, sort-of, and kinda.
Not entirely arbitrarily. What with one thing and another, I believe that writing a ticket costs $50. If they have to cover their costs on a $5,000 trade, that’s a buck a bond right there.
There were huge spreads on GMAC paper when it was having problems. Everybody in the country who wanted to own it was full up, and everybody else was trying to sell. I suspect that a lot of dealers with retail clients took very big positions – bigger than would normally be considered prudent – for an extended period – more extended than would be considered prudent – servicing their clients. They could afford to do this at that time because there wasn’t a simultaneous banking crisis.
So how much of that spread can be ascribed to fair compensation for risk, and how much to “mark-up”?
One thing about retail is that it shows a very high degree of habitat preference. If GMAC paper is quoted at 90-91 and you want to bring your market back into equilibrium, moving it to 89-90 won’t work. You might slow your intake a little, but you won’t make much difference to your selling volume.
I will suggest that you can only call it mark-up if the dealer is acting as agent and taking no market risk of his own; but that’s not how it works. When you sell your GMAC to the dealer, he’s going to own it until another client buys it.
or are most bond issues long term institutional holds?
Have a look at the most recent Debt Market Report, which I reported in an early April PrefBlog post.
In 2008, trading in Federal bonds was approximately 85x the issuance: 5,483.1 / 64.2.
Trading in Corporates was less than 2x the issuance: 115.9 / 56.9.
‘Nuff said?
Thanks for sharing your experience in this area. I’m finding the further I dig the more complex the situation becomes but it’s nice to have someone shine a tolerant light on the subject. Thanks.
I am not unhappy with the way the TD Waterhouse retail bond purchase and sale system works — at least you get to see both the bid and ask AND the spread narrows for larger orders. I once worked out that they make about $50 on a $5,000 order and $80 on $30,000 (although the spreads vary a bit — narrower for governments and wider for longer term corporates).
This system is quite superior to E-Trade (now i-Trade) where the bid-ask is independent of order size and only a buy price is available. I was especially annoyed with i-Trade earlier this year when I tried to sell a GE strip with a stated yield of 1.8% to a 1-year maturity and the best price they could get me was $93, which is 7+%. Naturally I will hold on to an investment with a 7% 1-year return.
One issue with both TD Waterhouse and i-Trade these days is that their inventory is so tiny — especially in corporates and especially in non-financial corporates, which despite high spreads are quite “popular” so in short supply.
The thing that strikes me about all these IIROC regulations is how vague they are. Instead of simply requiring transparency and a bid-ask a la the TD Waterhouse process, there is a lot of blather and record keeping that I doubt will do squat for public investors at the end of the day.
One issue with both TD Waterhouse and i-Trade these days is that their inventory is so tiny — especially in corporates and especially in non-financial corporates, which despite high spreads are quite “popular” so in short supply.
I suspect that inventories will become even tinier if these rules pass.
simply requiring transparency and a bid-ask a la the TD Waterhouse process
The trouble with that is that frequently a corporate will be bid/no-offer and, less often but still legitimately, offered/no-bid.
[…] fields of research in the financial sector is market design. I’ve posted about Pegged Orders, proposed regulation of the retail bond market and the BoC’s analysis of bond auction formats, among others. So I was highly entertained – […]