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.”
POW Issues 30-Year Debs at 8.577%
April 17th, 2009Power Corporation has announced:
IIROC has not yet issued a ruling regarding whether or not this price is fair, so investors of all kinds will just have to guess … if they’re allowed to buy it at all.
At the close last night, Power’s PerpetualDiscounts were quoted at:
Quotations for 2009-4-16 Close
So let’s say that the indicative bid-side YTW for a generic POW PerpetualDiscount is 7% … at the standard equivalency factor of 1.4x, this is equivalent to 9.80% as interest, implying a pre-tax interest-equivalent spread of a mere 122bp. These bonds look cheap to me. Relative to the Preferreds, anyway, even after giving the Prefs a bonus for their capital gains potential!
Update, 2009-4-19: Note that this issue has a Canada Call:
There is also Change of Control protection:
There is also credit rating protection:
Update, 2009-4-20: Closed on schedule.
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