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S. HRG. 108–888

OVERVIEW OF THE REGULATION

OF THE BOND MARKETS

HEARING

BEFORE THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

SECOND SESSION

ON

THE REGULATION OF THE BOND MARKETS, FOCUSING ON FIXED

INCOME MARKET TRANSPARENCY, TRADE REPORTING AND COMPLIANCE ENGINE (TRACE) ENABLING INVESTORS TO ACCESS CURRENT

PRICE INFORMATION FOR U.S. CORPORATE BONDS, AND STATE,

LOCAL, AND INTERNAL REVENUE SERVICE REGULATION OF MUNICIPAL ISSUERS

JUNE 17, 2004

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN E. SUNUNU, New Hampshire

ELIZABETH DOLE, North Carolina

MEL MARTINEZ, Florida

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

ROBERT MENENDEZ, New Jersey

KATHLEEN L. CASEY, Staff Director and Counsel

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel

BRYAN N. CORBETT, Counsel

DEAN V. SHAHINIAN, Democratic Counsel

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

(II)

CONTENTS

THURSDAY, JUNE 17, 2004

Page

Opening statement of Chairman Shelby ................................................................ 1

Opening statements, comments, or prepared statements of:

Senator Sarbanes .............................................................................................. 2

WITNESSES

Annette L. Nazareth, Director, Division of Market Regulation, U.S. Securites

and Exchange Commission .................................................................................. 4

Prepared statement .......................................................................................... 26

Douglas Shulman, President, Markets, Services and Information, National

Association of Securities Dealers ........................................................................ 6

Prepared statement .......................................................................................... 30

Christopher A. Taylor, Executive Director, Municipal Securities Rulemaking

Board ..................................................................................................................... 8

Prepared statement .......................................................................................... 34

Micah S. Green, President, The Bond Market Association .................................. 17

Prepared statement .......................................................................................... 41

Christopher M. Ryon, Principal and Senior Municipal Bond Portfolio Manager, The Vanguard Group .................................................................................. 19

Prepared statement .......................................................................................... 63

Arthur D. Warga, Dean, C.T. Bauer College of Business .................................... 20

Prepared statement .......................................................................................... 75

(III)

(1)

AN OVERVIEW OF THE REGULATION OF THE

BOND MARKETS

THURSDAY, JUNE 17, 2004

U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC.

The Committee met, pursuant to notice, at 10:10 a.m., in room

SD–538, Dirksen Senate Office Building, Senator Richard C. Shelby (Chairman of the Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order. This morning

the Committee will examine the regulation of the corporate and

municipal bond markets. This is an opportunity for the Committee

to learn about current trends in the industry and to examine the

market structure and regulatory framework.

It has been a number of years since this Committee held an oversight hearing on the regulation of the bond markets, and I look forward to today’s testimony.

Although the bond markets have long been associated with large

institutional investors, retail investors are a growing component of

the debt markets, either through individual holdings or indirectly

through mutual funds and pension accounts. Individual households

now hold approximately 10 percent of the $4.6 trillion invested in

the corporate bond market. Municipal individual households hold

approximately 35 percent of all outstanding issues which equals

about $670 billion. Mutual funds hold another 35 percent of the

$1.8 trillion municipal bond market.

This expansion of retail investment in bonds makes it incumbent

upon this Committee and the regulators to ensure that the bond

markets operate efficiently and fairly. Many have criticized the

lack of price transparency in the bond markets which may result

in price swings and markups. I understand that the regulators

have recently implemented trade and price reporting systems to

better facilitate the flow of information to investors.

I look forward to hearing more about these programs and other

efforts by the regulators to improve transparency.

On the first panel this morning we will hear from the regulators.

Annette Nazareth is the Director of Market Regulation at the Securities and Exchange Commission. Doug Shulman is the President,

Markets, Services and Information at the National Association of

Securities Dealers. Finally, Christopher Taylor is the Executive Director of the Municipal Securities Rulemaking Board. Individually,

each of these agencies plays a distinct role in the bond markets,

2

but collectively they work to ensure transparency and fairness to

all investors in the markets. In addition to questions concerning

price transparency, I look forward to exploring the questions regrading the structure of the bond markets, disclosure practices,

compliance programs and enforcement activities.

On the second panel we will hear from several witnesses representing different perspectives on the markets. Micah Green is the

President of the Bond Market Association, which represents the

broker/dealers involved in the bond markets. Chris Ryon is the

Senior Municipal Bond Portfolio Manager at the Vanguard Group,

finally in the second panel we will hear from Mr. Arthur Warga,

Dean of University of Houston Business School and Finance Professor. Professor Warga has done extensive research on price transparency in the bond markets. I look forward to hearing from all of

you at the proper time.

Senator Sarbanes.

Senator SARBANES. Thank you very much, Mr. Chairman. I guess

we are fighting to get a quorum.

Chairman SHELBY. We are trying to get a quorum. We have a

few nominations, all of them very important, however, one is especially important to this Committee.

Senator SARBANES. Two more would do it.

Chairman SHELBY. Need two more.

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Mr. Chairman, I want to commend you for

holding this hearing with respect to the bond markets. It is another

instance of where this Committee, under your leadership, continues

its comprehensive oversight of the securities industry. Today there is more than $20 trillion of outstanding bond market

debt, and more than a million outstanding bond issues. The daily

average trading volume of bonds exceeds $800 billion, several times

the volume of stocks.

This morning the Committee will focus on the municipal and corporate bond markets in which an important issue is price transparency. In my view, transparency plays a very important role in

inspiring investor confidence and promoting the fairness and the

efficiency of the U.S. capital markets. Historically, price transparency in the bond markets has been an issue. As recently as

1998, an SEC staff study concluded that price transparency in the

municipal bond markets was ‘‘difficult’’ and in the high-yield corporate bond market, relatively poor.

In recent years, many positive steps have enhanced transparency. The Municipal Securities Rulemaking Board moved so

that municipal bond trades are now reported the next day, and the

NASD’s Trade Reporting and Compliance Engine System now reports trades in the most frequently corporate bonds within 45 minutes of execution.

While these are major steps forward many people argue that

more is needed. An article in Forbes Magazine only a couple of

months ago stated that: ‘‘transparency is the mantra of the day’’

from corporate accounting to executive compensation, yet it has

skipped over the corporate bond market. And The Bond Buyer,

back in December in an article, quoted a brokerage executive who

3

said: ‘‘In terms of liquidity and price transparency, the municipal

bond market is halfway between the New York Stock Exchange

and the Oriental rug market.’’ It is my understanding that the SEC

has a task force looking at transparency and markups, and the regulators plan to increase transparency in the near future. The Municipal Securities Rulemaking Board intends to report trades in

real time—within 15 minutes of the time of execution—by next

January, and NASD plans to report corporate bond trades within

15 minutes of execution by next year with certain exceptions.

These plans need to move forward on schedule. Further study

may be needed to determine whether additional transparency is in

the public interest.

I look forward to the testimony of the witnesses this morning,

and I thank the Chairman of the Committee once again for focusing on this very important matter.

Chairman SHELBY. Thank you. We have established a quorum,

and I would like to move the Committee to Executive Session and

ask for a vote on the nomination of Alan Greenspan and two commemorative coin bills which are pending before the Committee. The

Committee will first vote on the nomination of Alan Greenspan,

who has been nominated for a fifth term as Chairman of the Board

of Governors of the Federal Reserve System.

As we all know, Dr. Alan Greenspan appeared before the Committee earlier this week. Is there any discussion or debate at this

time on the nomination?

[No response.]

Chairman SHELBY. All those in favor of reporting out the Greenspan nomination signify by saying aye.

[Chorus of ayes.]

Chairman SHELBY. All opposed, nay?

[Chorus of nays.]

Chairman SHELBY. In the opinion of the Chair, the ayes have it

and the nomination will be reported to the floor.

The second item on the Committee’s agenda this morning is two

commemorative coin bills, S. 894, The Marine Corps 230th Anniversary Commemorative Coin Act, and S. 976, The Jamestown

400th Anniversary Commemorative Coin Act. Each bill has more

than 67 cosponsors.

Is there any comment or debate on either of the bills, coin bills?

[No response.]

Chairman SHELBY. I ask unanimous consent that we consider the

bills en bloc. Hearing no objection, it is so ordered. All those in

favor—

Senator SARBANES. Mr. Chairman, could I just make the observation, on both of these bills, that the Committee rule requiring 67

cosponsors was met in both instances of this bill. That is a rule

that was put in place. We have held to that rule and I think it

serves an important purpose.

Chairman SHELBY. Thank you.

All those in favor of reporting out the two coin bills, signify by

saying aye.

[Chorus of ayes.]

Chairman SHELBY. All those opposed, nay.

4

In the opinion of the Chair, the ayes have it and both bills will

be reported to the full Senate.

The Executive Session is now adjourned and at this time we will

resume the hearing.

If no one else has an opening statement, we will go directly to

the panel. We will start with you, Ms. Nazareth.

STATEMENT OF ANNETTE L. NAZARETH

DIRECTOR, DIVISION OF MARKET REGULATION

U.S. SECURITIES AND EXCHANGE COMMISSION

Ms. NAZARETH. Good morning, Senator Shelby, Ranking Member

Sarbanes and Members of the Committee. I am delighted to be

here today to discuss some of the significant issues and developments that the Securities and Exchange Commission are currently

addressing with respect to the fixed income markets. Specifically,

I plan to discuss the Fixed Income Market Transparency Joint

Task Force, which was recently commissioned by Chairman Donaldson. I will also talk about other issues that the task force is currently considering.

In March 2004 Chairman Donaldson commissioned a joint task

force to consider issues relating to bond market transparency and

mark-up regulation. The task force consists of representatives of

the Divisions of Market Regulation and Enforcement, the Office of

Compliance, Inspections and Examinations, the Office of Economic

Analysis and the Office of the General Counsel.

The task force was organized to summarize fixed income market

transparency developments, identify current problems and generate

potential solutions.

Preliminarily, the task force has found that transparency has improved to varying degrees in each of the fixed income markets over

the last 20 years because of a continued focus on this issue by both

Congress and the Commission.

To implement transparency in the corporate bond markets, the

Securities and Exchange Commission persuaded the NASD to create systems to collect transaction reports and disseminate price information. Specifically, on January 23, 2001, the Commission approved the NASD’s proposal to establish the Trade Reporting and

Compliance Engine system known as TRACE for reporting and dissemination of last sale information on corporate bonds. On July 1,

2002, TRACE was officially launched. Under the current TRACE

rules, dealers must report trades on U.S. corporate bonds to the

NASD within 45 minutes.

Prior to TRACE real time transparency of investment grade corporate bonds was limited to those traded on exchanges, which was

a very narrow segment of the market. TRACE currently disseminates transaction information on more than 4,200 securities, representing about 75 percent of the dollar value of trading activity in

investment grade bonds. The NASD makes this information available at no cost to investors on a delayed basis with a minimum

four-hour time lag.

It is important to note that the NASD is in the process of expanding price transparency in the corporate bond market in a new

phase of the TRACE rollout, which will reflect the NASD’s experience with earlier phases. The NASD plans to reduce the reporting

5

period from 45 minutes to 30 minutes in 2004, and ultimately to

15 minutes in 2005. In addition, the NASD Board recently approved the recommendations of its advisory Bond Transaction Reporting Committee. Our understanding is that the NASD intends

to file a proposed rule change with the Commission shortly. The

NASD plan would make public, in near real time, 99 percent of all

transactions and 95 percent of the par value in TRACE eligible securities with delayed publication of trades in certain new issues

and of large transactions in infrequently traded high-yield securities. I understand the NASD intends to reconsider the need for the

remaining restrictions in the near term.

With respect to the municipal bond market, the MSRB, with the

Commission’s active encouragement, first implemented a Municipal

Securities Trade Reporting System in 1995, and proceeded thereafter in measured steps. The implementation date of real-time

transaction reporting, which is currently scheduled to begin in January of 2005, has been delayed by the MSRB several times to ensure that dealers have sufficient time to make necessary changes

in their bond processing systems. Real-time transaction reporting

in the municipal market is defined as the requirement to report

transactions within 15 minutes of the time of the trade.

In the Government securities market impetus for change began

in the late 1980’s when the GAO published a report recommending

increased price transparency in this market. In 1990 the GAO recommended legislation to require inter-dealer/brokers to make

transaction prices available to the public. The Commission supported the GAO recommendation and recommended that legislation

require quotation information to be made available as well.

Partially in response to these calls for congressional action, a variety of data network providers have emerged that publicly disseminate quotation and transaction information on Treasury bonds

and Federal agency securities. One of these providers is GovPX, a

vendor created by a group of primary dealers in Government securities that publicly disseminates information regarding the U.S.

Treasury market.

With respect to the markets for foreign, sovereign and mortgagebacked securities, the amount of transparency has not changed significantly in recent years. Dollar-denominated foreign sovereign

bonds are largely traded through inter-dealer/brokers who post

quotation and transaction information on their brokerage screens.

This information is not generally disseminated outside of the dealer

network. Pricing information on mortgage-backed securities is

widely available through a variety of commercial vendors. Some

vendors also offer analytical tools to value these securities. Dealers

and some institutional investors have in-house analytical models in

place as well.

Generally speaking, transparency plays a fundamental role in

promoting fair and efficient pricing in the fixed income markets,

thereby fostering investor confidence in those markets and encouraging greater participation. Transparency also contributes to efficient price discovery and aids investors in assessing the quality of

prices being offered in the marketplace. In addition, transaction reporting has supplemented the ability of regulators to surveil the

bond markets for unfair pricing and abusive mark-ups and markVerDate 11-MAY-2000 20:23 Jun 02, 2006 Jkt 025856 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 26179.TXT SBANK4 PsN: SBANK4
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downs. Finally, a soon-to-be-released study by the Commission’s

Office of Economic Analysis confirms that transaction costs decline

with added transparency.

For any type of bond, mark-ups must be reasonable. While NASD

has a maximum 5 percent guideline for equity securities, mark-ups

are expected to be significantly lower for bonds. For different types

of debt, what is recognized as reasonable depends on such factors

as liquidity, credit rating and yield, and can range from less than

one half of 1 percent for Government debt to higher amounts for

high-yield bonds. For investors as well as regulators the difficulty

lies in establishing the prevailing market price for a bond. This

generally is the baseline that is used to assess whether a mark-up

is reasonable. We believe that increased transparency should enhance the Commission’s and the SROs’ ability to determine the

prevailing market for a bond, and thereby ascertain that investors

are not being charged unfair prices or abusive markups.

Improved transparency will enable investors to better determine

the fair price of a bond. This will make them better able to protect

themselves against unfair pricing in the first instance.

In closing, I would like to note that we believe that transparency

is an essential component of an efficient and fair market. In that

regard the Commission has supported increased transparency in

the fixed income markets and will work with market participants

and regulators in the future to ensure that we can continue the

trend of increasing transparency in the fixed income markets.

Thank you.

Chairman SHELBY. Mr. Shulman.

STATEMENT OF DOUGLAS SHULMAN

PRESIDENT, MARKETS, SERVICES AND INFORMATION

NATIONAL ASSOCIATION OF SECURITIES DEALERS

Mr. SHULMAN. Thank you. Chairman Shelby, Senator Sarbanes,

Members of the Committee, my name is Doug Shulman. I am

NASD’s President in charge of Markets, Services and Information,

and I appreciate the opportunity to address the Committee.

As you know, NASD’s mission is to protect investors and ensure

the integrity of markets. We have statutory authority over the

5,200 broker/dealers operating in the United States, as well as authority over the 660,000 individual brokers operating in the United

States. We have the authority to take action against people who

have broken our rules, Federal securities laws, and in the case of

municipal bonds, the rules of the MSRB. We also run transparency

facilities like TRACE, our bond reporting system.

In the case of bonds we are particularly focused on the interests

of individual investors, in part because we have seen substantial

growth in the number of those investors investing in bonds and

bond funds. We believe the reason for this growth of individual investors in this market is two-fold. First, as baby-boomers reach retirement age, most financial planners and brokers are actively

moving people out of stocks and into bonds for their asset allocation. Second, the major losses in the stock market during 2000 and

2001 have led many investors to look for places besides stocks to

invest their money.

7

Measured in dollar volume, transactions in all U.S. bond markets

in the first hour of any trading day exceeds those on the New York

Stock Exchange for the entire day. Yet, while the stock markets

have generally been open and transparent, information about bond

markets traditionally has been murky and inaccessible to less sophisticated investors. Indeed, we have seen that many mainstream

investors do not understand the basic principles of bond investing.

A recent NASD survey found that 60 percent of investors do not

understand the basic principle that when interest rates rise, the

price of a bond declines.

To address investors’ lack of knowledge of the bond markets we

have several initiatives under way including investor education, as

well as working with print and online media to improve their bond

information. We also have a major initiative which we launched in

July of 2002 at the urging of Congress and the SEC called TRACE.

It stands for our Trade Reporting and Compliance Engine for corporate bonds.

Under the NASD rules, every transaction in the corporate bond

market must be reported to TRACE. We receive pricing information on investment grade, high yield, and convertible debt. This is

the first time that comprehensive information on corporate bond

trades has been available either to regulators or investors. The

purpose of TRACE is two-fold. First, we receive the information

and send prices out to the investing public so they can do their job

of policing their own trades, and second, we use this information

for our regulatory programs, to look at trading behavior that may

violate NASD rules or Federal securities laws.

As I mentioned a moment ago, Mr. Chairman, the ranks of individual bond investors are large and growing. Before we launched

TRACE, in the corporate bond market we had only anecdotal evidence of this. After TRACE went live, we had a far better understanding of the retail activity in this market. Our data shows that

65 percent of trades in the corporate bond market are retail in size.

That only accounts for 2 percent of the par value, but it is a lot

of the trading activity. So, clearly the transparency and access to

information that TRACE has brought to individual investors is

badly needed. All NASD regulated firms must report their corporate bond transactions to TRACE within 45 minutes of an execution. As Ms. Nazareth mentioned, we plan to reduce the reporting

time to 30 minutes later this year, and to 15 minutes in 2005.

Since we launched TRACE we have also moved aggressively to

have a transition plan to get more and more information out into

the hands of investors. Currently, as of today, we disseminate information on about 4,600 of the 23,000 bonds that are traded in the

corporate bond arena. We recently filed a proposal with the SEC

to disseminate 100 percent of bond trades to the public, with 99

percent of those being disseminated immediately upon receipt by

the NASD. Under this plan, by the end of 2004, price information

about all corporate bonds will be made available to the public. This

means that when investors are considering purchasing a bond, they

can review recent trades or trades in similar bonds and ensure that

they are receiving a fair price.

NASD also uses the data submitted to TRACE and the data submitted to the MSRB for municipal bonds to review trades on these

8

two markets for regulatory infractions. We combine this data from

the trading systems with the data that we gather in our on-site examination process, and this enables us to monitor for issues such

as commissions, mark-ups and potentially fraudulent conduct.

When NASD finds that firms have engaged in activities that violate our rules or rules of the Federal securities laws, we have a

range of sanctions available to us, including censures, fines, suspensions, and expulsion from the industry. We also work hard to

return money to investors in the form of restitution.

In conclusion, Mr. Chairman, as the retail presence in the bond

market continues to grow, NASD will continue to champion transparency in this market, and we plan later this year to release last

sale information on all corporate bond trades. We will continue to

work with the SEC, the MSRB and the securities industry to ensure the fairness and integrity of the bond market.

Thank you for this opportunity to testify.

Chairman SHELBY. Mr. Taylor.

STATEMENT OF CHRISTOPHER A. TAYLOR

EXECUTIVE DIRECTOR

MUNICIPAL SECURITIES RULEMAKING BOARD

Mr. TAYLOR. Thank you, Mr. Chairman, Senator Sarbanes, other

Members of the Committee. We appreciate the opportunity to discuss the MSRB and the municipal securities market.

We are a unique regulator of a unique market, and our mission

is to protect investors and the integrity of this market which provides much of the capital for the infrastructure of this Nation.

The MSRB is a self-regulatory organization, an SRO, but we are

very different from the other SRO’s, such as the NASD and the

New York Stock Exchange. We were created by Congress and given

a mission by Congress to write rules for dealer behavior in the municipal securities market. Our very creation and charter set us

apart from the other SRO’s. We regulate only the municipal securities activities of dealers, and we are the only product line SRO.

MSRB only sets the standards, which we believe are quite high, for

dealer behavior.

We do not have examination and enforcement power. Those powers are vested in the NASD, the three Federal bank regulators and

ultimately the SEC.

The market we regulate is unlike any other segment of the bond

market. Allow me to illustrate with some of the statistics. There

are more than 50,000 separate issuers who over time have issued

more than a million and a half separately tradable securities. This

can be contrasted with the corporate debt and equity markets

where the number of outstanding and separately traded securities

is less than 50,000.

There is an exceptionally wide range of deals that come to the

market. Last month, the State of California sold $7 billion worth

of bonds at one time. Around the same time, the Litchfield Airport

Authority in Illinois sold $100,000 worth of bonds.

Trading activity in this market is extraordinarily thin. On any

given day less than 1 percent of the outstanding issues actually

trade, and over a whole year only about a third of all the outstanding issues trade. In some ways this lack of trading activity

9

should not be a surprise. After all, this is a bond market, and in

our case, one that is dominated by individual investors who generally buy and hold bonds until maturity.

Nonetheless, the MSRB has adopted rules to protect investors

and the integrity of the market in keeping with the objectives laid

down by Congress. We continue to modify our rules to adapt to this

constantly evolving marketplace.

Several of our recent activities are notable. With regard to price

transparency and trade reporting, we recognize that any market

functions more efficiently with better information about what is

traded and at what price. We have increased price transparency in

this market in measured steps, and almost exactly 1 year ago

today, investors in this market could see the details on every trade

in our transaction reporting system on a next-day basis. For example, at 7 a.m. this morning any investor could see all the trade information that we collected last night.

We have been working diligently to implement a real-time transaction reporting system. We expect to be operational in January

2005. We have mandated that all dealers test their reporting systems with us beginning next month. Upon implementation, dealers

will have to report trades to us within 15 minutes of execution. We

will make that information, in its entirety, available immediately.

In another area of concern to us, over the past 3 years we have

been reviewing our Rule G–37, which is designed to eliminate the

perceived or real conflict of interest from the giving of political contributions and the awarding of municipal securities business, socalled pay-to-play. This rule has been quite effective in maintaining

the integrity of the municipal financing process. A companion rule,

Rule G–38, addresses the role of consultants hired by dealers to solicit municipal securities business. Rule G–38 has been effective in

illuminating this practice.

But recent trends raise questions about the place for such consultants in this industry. We recently proposed for industry comment a ban on the hiring of such consultants. We have received

lots of comment letters on our proposal, both for and against. The

MSRB will consider those comments at its next meeting in midJuly. These proposals with regard to political contributions and

consultants and our efforts with regard to transparency demonstrate the Board’s vigilance in seeking to maintain the integrity

of this industry.

This concludes my remarks, and I would be glad to take any

questions you or Members of the Committee might have.

Chairman SHELBY. Thank you.

Some people have raised concerns that efforts to create real-time

price disclosure may negatively impact the liquidity in the corporate and municipal bond markets, and may cause increased volatility. How would each of you respond to this assertion? Ms. Nazareth, we will start with your response.

Ms. NAZARETH. I know that position has frequently been maintained by the industry. I think because of the manner in which this

transparency initiative has been rolled out, we have actually been

able to study the impact on liquidity because of the manner, again,

in which it was implemented to move toward greater transparency.

We have not seen the negative impact on liquidity that people

10

thought would occur. In fact, we have seen very positive benefits

in terms of lower transaction costs, and I think as Senator Sarbanes mentioned in his opening, what you also find is greater investor confidence in a market when they know what a fair price is.

Chairman SHELBY. Mr. Shulman.

Mr. SHULMAN. Well, as a matter of principle, we believe that

more transparency in markets is good for markets and potentially

brings more liquidity into markets. The stock markets have seen

this. We had this experience when we used to own Nasdaq in the

early 1970’s.

What we have tried to do is fashion a transition plan that allows

a market that used to be totally opaque to move to one that is totally transparent, but to have steps along the way so that we could

study this. We started with investment grade bonds that were $1

billion or greater. We looked at that, did not see any effects on liquidity. We moved to our phase two, which now has A¥rated

bonds, $100 million or greater, and we also put a sample of BBB

bonds into the market. Again, we studied the issue. We are now

moving to 100 percent transparency which will put, starting by the

end of this year, a lot of high-yield bonds into the market, and as

I mentioned, we will hold back 1 percent of the bonds which are

the large transactions that are infrequently traded less than once

a day.

And, again, as we fashion this transition plan, we are going to

study the effect of that part of the market, and I will tell you the

reason. We have heard concerns. It is at that very low end of the

market where we have heard concerns not just of the dealers but

also of the buy side.

Chairman SHELBY. Transparency is information to everyone, is

not it, in a sense, open market.

Mr. Taylor, do you have a comment?

Mr. TAYLOR. Senator, as you may know, today, as I mentioned,

we are releasing everything we have in our system as soon as we

have it. And, in fact, we have a next-day system. It is providing information on the day after trade date.

We, too, were concerned about liquidity but did not over time

find a significant problem with it, and our plans for the real-time

system call for the release of all information. The Board at its February meeting considered possible liquidity effects from releasing

all of the information available to us in the proposed real-time system and concluded that if there were liquidity effects, they would

be short term and far outweighed by the benefits to the market and

to investors.

Chairman SHELBY. Could you all address recent allegations regarding certain wide price swings and excessive markups in both

the municipal and corporate bond areas? What are the rules concerning fair pricing and the size of markups? And how do the regulators monitor compliance? Finally, have you brought enforcement

actions regarding excessive markups?

Ms. NAZARETH. One of the substantial advantages of this transparency is that we also receive this data for regulatory purposes,

and Doug Shulman can speak more directly to this issue because

it is the NASD that does the surveillance. But it has been a tremendously powerful tool in enabling the regulators to monitor for

11

excessive markups. There have been cases that have been brought,

and I think our ability to continue to monitor in this area will be

improved, and we continue to work with the SROs to ensure that,

we are doing a vigilant job in ensuring fair pricing to investors.

Chairman SHELBY. Mr. Shulman.

Mr. SHULMAN. There are rules on the books now that include

NASD rules, SEC rules, MSRB rules, as well as case law. The basic

rule is that investors have to get a fair price. It is a fact-and-circumstances analysis.

We brought cases in the past. Having TRACE data now allows

us to really see a lot more. We used to bring cases based on going

in and looking at the books and records of a firm in an on-site

exam. We now have data, and we have built in surveillance alerts,

so when there are big swings in prices in a given day, it will automatically kick out. We can give it to our investigators. They can

find out if this is fair or not.

We have currently ongoing 20 investigations around markups in

corporate and municipal bonds, and we are working with the SEC

actively to get some clarification around markup rules, and we do

anticipate some significant cases—we are in the final stages—coming to light, sometime in the near future.

Chairman SHELBY. Mr. Taylor.

Mr. TAYLOR. As you know, as Doug pointed out, we do have rules

on the books for fair and reasonable pricing. The MSRB has believed for a long time that providing the tools such as the price reporting system to those that enforce our rules—the NASD, the

bank regulators, and the SEC—is really part of our job. So we did

believe that putting together the system not only provided price

transparency but provided a very strong tool to the regulators.

We did publish a notice in January highlighting for dealers their

responsibilities under our rules and a practice that we had observed in the data that suggested that during a single day investors might not be getting a fair and reasonable price in accordance

with our rules. As Doug has pointed out, the NASD is currently investigating that.

Chairman SHELBY. In the recent past, we have seen a number

of instances of conflicts of interest at work in the equity markets

where insiders benefit at the expense of retail investors. The primary example that you are well aware of is the global settlement

in which research analysts issued glowing reports of companybacked issuers while privately criticizing the companies.

What are the conflicts that regulators are examining in the bond

markets? Could we see a crisis in the bond markets akin to events

that led to the global settlement? Ms. Nazareth.

Ms. NAZARETH. Well, we are certainly looking at the issue. I

think that the bond markets in this respect have been quite different. There is fixed-income research. Its function is a bit different

than it is in the equity markets, obviously.

Chairman SHELBY. Well, the equity markets and bond markets

are fundamentally different, aren’t they?

Ms. NAZARETH. Right. In the equity market, the research, as you

know, was used largely to promote the stocks and it had an impact

on trading. In the fixed-income markets, there are so many other

factors involved in the purchase of a bond, including, the creditVerDate 11-MAY-2000 20:23 Jun 02, 2006 Jkt 025856 PO 00000 Frm 00015 Fmt 6633 Sfmt 6633 26179.TXT SBANK4 PsN: SBANK4
12

worthiness of the issuer, interest rate spreads to Treasuries. It

tends not to play quite the same role in the sales process. But

there, nevertheless, are areas where there could be conflicts, for example, where firms’ research analysts are involved with the trading desk—and the firm has a position and is also taking a public

position with respect to the bonds.

The Bond Market Association, was very out front in recognizing

that there were potential conflicts here and has recently finalized

their guiding principles to promote the integrity of the fixed-income

research. We really applaud that effort. We are eager to see the

firms adhere to these voluntary principles and we will watch closely what the impact of adherence to those principles does.

Chairman SHELBY. Mr. Shulman.

Mr. SHULMAN. It is very similar to what Annette said. We have

been looking at fixed-income research. The Bond Market Association has put forward guiding principles. We are talking with the

people throughout our institution to make sure that we believe that

there is independence of research.

We also always look at the firewall issues, especially between

proprietary desks and desks that serve customers, and we will continue to keep a focus on making sure that there is appropriate information barriers and that these conflicts do not occur. It is an

area that we are quite sensitive about and are being vigilant in

looking really across firms at these issues.

Chairman SHELBY. Mr. Taylor.

Mr. TAYLOR. I do not think I could add very much to what has

just been said by both Doug and Annette, but I would point out

that in our market, we do have some issues that relate to the fact

that information on such a wide variety of issuers is not broadly

available to all participants in the market at the same time. And

that does raise the possibility of people having information that

should rightfully be in the possession of everyone in the market.

Chairman SHELBY. There are some studies indicating that small

retail trades in municipal bonds are substantially more expensive

than large institutional trades. What accounts for this disparity in

trading costs? Also, would greater transparency eliminate the difference?

Ms. NAZARETH. You are correct about the studies. We think the

seminal one in that area was actually done by the staff of the Office of Economic Analysis at the SEC. But what was very interesting about the findings was that, unlike the equity markets,

where the costs to investors are less for smaller trades, here it is

the inverse. The small retail investors have higher transaction

costs, which we attribute to the lack of transparency. That universe

of investors is least able to understand what a fair price is, and the

costs to them are higher. And I think that we are very confident

and are already seeing that in those circumstances where there is

a greater transparency in the marketplace, the transaction costs

are reduced.

Chairman SHELBY. Thank you. Do you have any comment on the

same thing?

Mr. SHULMAN. I would agree. It basically changes the information dynamic, and someone is now going to be able to see where

13

all the trades were and ask their broker, ‘‘Why did not I get this

price?’’

Chairman SHELBY. Why they did not get a better deal, sure.

Senator Sarbanes, thanks for your indulgence.

Senator SARBANES. Thank you, Mr. Chairman.

I wanted to follow up on the question before the last question the

Chairman put. The Wall Street Journal in April published an article entitled ‘‘Bond Research Facing Probes Over Conflicts,’’ which

identified, and I quote them,

‘‘potential conflicts involving bond research have been largely ignored, among

them whether bond traders or bankers get advanced peeks at research before it is

published, giving them a chance to trade ahead of the public or clients who paid

for the reports and whether bankers or trades have influence over what analysts

say in their research reports.’’

How do you respond to this article?

Ms. NAZARETH. I think that there are, as you know, conflicts

throughout this industry, and this was an area that obviously the

industry and the regulators rightly should be focused on, particularly after the lessons learned in the equity research area. Surely

there are opportunities for conflicts of interest. I think as Doug

mentioned, it is important to have walls between the proprietary

traders and the analysts. This is something where, again, the regulators were beginning to look at it. The industry decided to take the

lead and to do a self-assessment. And I think that the guiding principles that they have come up with are really very rigorous.

What they did, I believe, was they started with the standards

that had been put in place for the equity markets and decided to

point by point determine whether those standards or more rigorous

standards or similar but somewhat different standards were appropriate for the debt markets. And we are very interested in seeing

what the impact of that will be, but I think it was a very important

first step.

Senator SARBANES. When you say the impact of it, where are we

on the implementation of the standards?

Ms. NAZARETH. I think the firms who were involved in that,

which were the largest dealers in the marketplace, I believe have

voluntarily agreed to comply. I believe that larger number of them

are implementing those procedures.

Senator SARBANES. And who is monitoring their compliance? Is

that you, Mr. Shulman?

Mr. SHULMAN. Yes.

Senator SARBANES. Why do not you respond to this article?

Mr. SHULMAN. Two issues. One is we get MSRB data. We have

TRACE data. We have only had that data now for 2 years. What

we do now is, if we see broad swings or if we see a trading desk—

we can now see when a desk trades ahead of a customer, if they

do. It is the first time we have been able to see this, and we will

go do an investigation and enforcement action, if needed.

We also were actively in discussions with the Bond Market Association and NASD is in discussions now about whether these guiding principles, which we do look for adherence to, should be codified into rules.

Senator SARBANES. Was trading ahead of their customer a pretty

prevalent practice?

14

Mr. SHULMAN. Not that we know of.

Senator SARBANES. I mean before or now, or neither?

Mr. SHULMAN. It is not something that has come to our attention

often, but it is also something we did not have the data until about

a year ago. We have just set up the parameters to actually look for

that.

Senator SARBANES. Do you want to comment on this, Mr. Taylor?

Mr. TAYLOR. I actually think, Senator, that much of what that

article was focused on was the corporate bond market and corporate research, because in the municipal area most research focuses in entirely on the issues that come before the dealers. As I

noted in my opening remarks, only about 1 percent of the bonds

trade on a given day, so the ability of a dealer to trade ahead of

the market is almost an impossibility because you do not actually

know what is going to flow into the market on that particular day

from investors around the country. There is not an actively traded

two-sided market that allows you to go in and position yourself

ahead of a customer.

Senator SARBANES. On the panel that is going to be following

you, Dr. Warga in his testimony states—and I quote:

Even if a bond is rated, when the information about a change in credit risk is

needed most, the rating usually fails to reflect it. Rating agencies often do not

change ratings until several months after the event that triggers the need for a rating change.

And he cites as authority studies that he performed both in 1993

and in 1997.

What about this issue of how quickly credit rating agencies respond to events that would trigger the need for a rating change?

Ms. NAZARETH. Well, it is difficult to speak generally about it. It

sounds like the professor is comparing the role of the research analyst to the role of the credit rating agency. He is saying that on a

short-term basis they should be making an immediate change in

the rating, whereas I think generally the credit rating agencies

have a longer-term perspective on their ratings.

That having been said, obviously there have been circumstances

where rating agencies have been slow in recognizing trends that

would have both an immediate and longer-term impact. So, again,

it is hard to make general statements. But I do think that I would

not equate the credit rating process necessarily with the research

process here.

Senator SARBANES. Mr. Shulman.

Mr. SHULMAN. We have no authority over credit ratings, the

agencies that do that, so I wouldn’t speak about that.

One thing that NASD does have authority over is to ensure that

brokers make suitable recommendations to their customers, and,

one thing that we encourage the brokers to do and monitor for is

to make sure customers understand all of the risks of a bond,

which can include the call feature, the term, the risk, and the rating. And we recently put a notice to members out reminding them

of those obligations in bonds because we have seen more people in

the bond market. And, this is an issue that we would be happy to

look at.

Senator SARBANES. Mr. Taylor.

15

Mr. TAYLOR. Senator, in this regard, in the municipal market the

issue is really one not so much of default—in the municipal area,

the credit rating agencies are focused in on the probability of default. And default probabilities are very, very low in the municipal

securities market.

Again, to echo what Doug said, we have rules, as does the NASD,

on suitability and fair pricing, and I think what is important to

dealers in this market and important to investors is knowing, for

example, when a call on a bond, an outstanding bond, is going to

take place. That is not something that rating agencies would necessarily concern themselves with but does affect very quick changes

in value of the bonds and is affecting pricing.

I am not really in a position to comment on what changes the

credit rating agencies have made since 1997, but certainly our conversations with them on an informal basis are that they are trying

to do a much better job than they have done in the past.

Senator SARBANES. Would each of you describe the investor education programs you have for retail bond investors?

Ms. NAZARETH. Well, the SEC does have an Office of Investor

Education, and I am not the internal expert on that, but we have

a very active program. As you know, over the years we have had

town hall meetings with investors. We have a number of very useful tools on our website that investors can look to. We also,

hyperlink to a number of the tools that the industry has created

for investors with respect to debt markets as well, debt securities.

Senator SARBANES. So when you talk about these investors, you

are talking about retail bond investors?

Ms. NAZARETH. Yes, retail investors.

Senator SARBANES. Mr. Shulman.

Mr. SHULMAN. NASD had an active investor education program.

We have brochures on bonds. We have our website, which has a variety of information just about investing, portfolio allocation, et

cetera. As I mentioned in my oral testimony, we actually have a

team of people actively working with popular print media and online websites to improve the information they have about bonds,

and we found them to be quite receptive and anticipate some of the

data that we have and other materials going up soon.

We hold town hall meetings around the country, and bonds is one of the issues we discuss. NASD just recently put $10 million

into an investor education foundation.

Finally, our experience is that the time investors really start to

understand something is when they are going to put their money

to work. And so we have done a lot to work with the industry to

make sure that brokers give investors the right information and all

of the factors of a bond when the investment happens. And we will

continue to try to make the TRACE data, the MSRB data, and

other data useful to investors so they can watch the movement of

the market and better understand the dynamics of the security

they hold.

Senator SARBANES. Mr. Taylor.

Mr. TAYLOR. Senator, we do not have an active program targeted

to retail investors. In fact, I think we would be hard pressed to improve upon what the NASD does, and, in particular, I will make

a plug here for what the Bond Market Association has done in

16

terms of trying to reach out to the retail investor in bonds, in particular municipal bonds.

One of the first things they did was to take all of our transparency data, put it up on their website, make it available free,

and allow any retail investor to actually go in, type in their CUSIP

number, which is the identifier, and see all of the trading activity

over the last 6 months, if there was any, in that security.

We have worked to make our data readily available to anyone,

not just the Bond Market Association, but any other data services

that could use those data. But because the general education is

being done by the NASD and the Bond Market Association, anything we would do would probably just duplicate what they are already doing.

Senator SARBANES. Are there other things you think would be

helpful for them to do in this area?

Mr. TAYLOR. Raising the awareness of people who invest in bonds

generally to the availability of data sources is probably the most

difficult thing to do because bond investors, as I mentioned earlier,

typically are buy and hold. So they buy the bond, stick it in their

portfolio, expect to see the interest flow in, and eventually get their

principal back. They are not sitting there monitoring the price,

hoping the price goes up and they can see it and that is how they

make their return. They are getting their return on interest. And

so my experience, both personally, family, friends, and the like, is

they are watching the flow of interest come to them. They are not

looking at the price.

So it is at the initial decision point that you really want investors

to be aware of what prices are in the market, what information is

there, and what the alternatives are.

Senator SARBANES. Thank you, Mr. Chairman.

Chairman SHELBY. Mr. Taylor, would you briefly discuss how

MSRB is evaluating the scope and application of Rule G–37 regarding political contributions and the award of underwriting business

with respect to political contributions from affiliated companies

within a holding company structure? I know that is a mouthful.

Mr. TAYLOR. Well, let me start with the basics. First of all, Rule

G–37 requires dealers on a quarterly basis to provide us with information on their political contributions, the consultants they hire,

and the business that they do, in a nutshell. And it is this information that the Board is reviewing constantly. As I mentioned, we

have actually had an ongoing review of Rule G–37 and various aspects of it for more than 3 years.

With regard to your question about holding company organizations, I would point out that the rule presently prohibits a dealer

from doing indirectly what he is forbidden to do directly.

Chairman SHELBY. Okay.

Mr. TAYLOR. We have put a notice out on that, and we have

worked with the NASD and the regulators to highlight our concerns in that area so that when they are doing enforcement, they

are particularly focused in on that.

Chairman SHELBY. We appreciate all three of your appearing

here and your contribution to the Committee hearing. Thank you

very much.

17

Chairman SHELBY. We will go to the second panel now: Mr.

Micah Green, President, Bond Market Association; Mr. Chris Ryon,

Principal, The Vanguard Group; Professor Arthur Warga, Dean,

C.T. Bauer College of Business and Judge James A. Elkins Professor of Banking and Finance, University of Houston. We welcome

all of you on our second panel. Your written testimony will be made

part of the record in its entirety, and we will proceed when you are

ready.

Mr. Green, we will start with you.

STATEMENT OF MICAH S. GREEN

PRESIDENT, THE BOND MARKET ASSOCIATION

Mr. GREEN. Thank you, Mr. Chairman, Ranking Member Sarbanes, and Members of the Committee, for the opportunity to testify. I am Micah Green, President of The Bond Market Association.

I commend you for holding this hearing at this time. While this

Committee has looked at many specific issues, it has been a while

since there has been a broader review of the regulations of the

bond markets. Much has changed in recent years to make the bond

markets safer, more transparent, more electronic, more efficient for

all market participants. In fact, much has changed at The Bond

Market Association as these market and regulatory developments

occurred. We have broadened to represent the full array of credit,

debt, and structured capital markets. With our affiliated organizations, the Asset Managers Forum, and various securitization forums, we are better able to bring together the viewpoint of investors and issuers. Through our offices in Washington, New York,

and now London, we are representing these markets on a global

basis. The U.S. bond markets alone represent $22.6 trillion, the

largest sector of the financial markets, or more than $880 billion

of trades seamlessly on an average day.

From the schools and roads built by municipal bonds to the mortgages that are more affordable because of a mortgage-backed securities market, to the new jobs created as corporations raise investment capital with bonds to invest in new plants, the bond markets

touch everyone. Unlike stocks, bonds do not trade on an exchange

but in an over-the-counter, decentralized fashion. There are far too

many bonds and far too many bond issuers, including a majority

of bonds that rarely trade, to list them on an exchange and expect

constant two-way prices. For the bond markets to function as they

do, dealers must purchase bonds and hold them in inventory, an

act that puts capital at risk. The less liquid a bond or the more difficult it is for a dealer to quickly resell it in the market, the less

likely dealers are to purchase the bonds in the first place.

Probably the biggest change in the regulatory environment affecting the bond markets has been the introduction of rules seeking

to protect the retail investor. Although most of the daily activity in

the bond markets is dominated by large sophisticated investors

since the stock market bubble burst, retail investors have sought

out more diversity in their portfolios, either directly or through

conduits like mutual funds. This is a welcome change as we always

believe that a balanced asset allocation is much more responsible

than putting your eggs in one basket.

18

And yet with all of this retail demand, specifically in the municipal and corporate securities marketplace, the vast majority of the

volume of securities that trade every day are large institutional

transactions. Even the NASD’s own study that was cited in their

testimony showing that 65 percent of daily trades of corporate

bonds were trades under $100,000 in size, their research also indicated that all of those trades represented only 1.8 percent of the

total dollar volume.

Having said that, it has been crucial to improve disclosure and

transparency in the bond markets to give all market participants

better information. This Committee, your House counterparts, the

SEC, the NASD, and the MSRB should all be acknowledged for the

developments of the last several years that have helped to make

the bond markets safer and more transparent for all market participants, particularly the retail investor.

The Bond Market Association has worked hard to partner in

these efforts in a manner that is supportive of ensuring that investors have all the necessary information they need to make responsible and informed decisions, but also to ensure that the large,

more sophisticated institutional market has sufficient liquidity to

ensure the ability to move capital freely and efficiently, regardless

of the size or esoteric nature of the transaction.

In the early 1990’s, The Bond Market Association and its membership created GovPX, which represented the first time some light

was shone on the transactions in the Government securities market. We have also worked closely, as you heard earlier, with the

MSRB in the municipal market and the NASD with the TRACE

corporate system.

We have also tried to improve the knowledge level of the retail

investor about bonds. Our award-winning retail investor website,

which Kit Taylor mentioned, investinginbonds.com, gets over 3 million hits a month from retail investors, and it has understandable

information about bonds and the bond markets, and it also has the

MSRB and TRACE data system in a very usable form.

Additionally, the association’s not-for-profit partner, The Bond

Market Foundation, is reaching out to nontraditional investors

such as young adults, women, and the Spanish-speaking community, with its websites tomorrowsmoney.org, unwantedchange.org,

and ahorrando.org. The bond markets have also fostered the evolution of important and sophisticated tools like interest rate swaps

and credit derivatives that allow market participants to segregate

and manage risk more efficiently. These derivatives have made an

unquestioned contribution to the safety of the overall system.

In the past year, as Ms. Nazareth indicated, we have also worked

on several initiatives designed to promote safer and more efficient

markets. In May, we issued the guiding principles to promote the

integrity of fixed-income research. Neither regulators nor the public

had called for it, but the association took the initiative to develop

the principles as a way to help member firms manage potential

conflicts that could arise from their debt research activities. And,

Senator Sarbanes, I would note that the issue you raised a question on is actually on page 30, Section 4.8.1, hitting that point directly, and I appreciate your asking that question.

19

The SEC and the broader market have welcomed these principles, and they were approved by our membership.

Mr. Chairman, rising and falling interest rates are a reality of

the bond markets. It is also a reality that as a result of the initiatives, both in the regulatory environment and in the marketplace,

the bond markets are a dynamic, well-regulated part of the financial markets whose participants recognize the need for safety and

efficiency and are eager to promote that goal.

I thank you for the opportunity to appear today.

Chairman SHELBY. Mr. Ryon.

STATEMENT OF CHRISTOPHER M. RYON

PRINCIPAL AND SENIOR MUNICIPAL BOND

PORTFOLIO MANAGER, THE VANGUARD GROUP

Mr. RYON. Gentleman, Chairman Shelby, Ranking Member Sarbanes, Members of the Committee. My name is Christopher Ryon.

I am a principal and Senior Municipal Bond Portfolio Manager at

the Vanguard Group, a mutual fund company based in Valley

Forge, Pennsylvania. Vanguard is one of the world’s largest mutual

fund families, managing over $725 billion for nearly 18 million

shareholder accounts. Vanguard offers 131 mutual funds to U.S. investors and over 35 additional funds in foreign markets.

Vanguard’s offerings include 12 corporate bond funds with over $73 billion in assets and 14 municipal bond funds with over $43

billion in assets. Along with three other portfolio managers, four

traders and a team of municipal bond analysts, I oversee the management of over $43 billion in Vanguard municipal bond assets. I

am pleased to be here representing Vanguard to discuss the U.S.

bond markets. My testimony will highlight the composition and

structure of the bond markets. I will also provide an update on

bond market transparency with respect to bond pricing and issuer

financial disclosure.

Ownership in the bond market is diversified. There are significant individual institutional and foreign ownership across the markets. Unlike other segments of the bond market, investment in municipal bonds closely resembles that of the stock market. Individual

investors and mutual funds own substantial portions of the market.

In 2003, 36 percent of municipal bonds were held by individuals

and 15 percent were held through mutual funds. These figures parallel the ownership of the stock market, where households own 37

percent and mutual funds own 20 percent.

Buyers and sellers in the bond market trade primarily over-thecounter. Unlike the stock market, there are no organized National

exchanges for bonds. Over-the-counter trading dominates municipal

bond markets to a greater extent than other segments of the bond

market. Traditionally, municipal bond markets have existed in localized State and municipal markets, where there was a small community of buyers and sellers with little National interest.

Today, municipal bonds are a significant part of the U.S. financial markets, but the diverse and decentralized nature of the market still discourages development of an organized exchange.

Pricing transparency in the bond market has improved in the

past 10 years. Unlike the stock market and the Treasury market,

there is no real-time pricing for most bond markets. However, rules

20

imposed by the Municipal Securities Rulemaking Board, the

MSRB, have greatly enhanced the reporting of municipal bond

trades much as the trade system has enhanced transparency of corporate bond trades.

As the fiduciary responsible for the investments of hundreds of

thousands of municipal bond fund investors, Vanguard strongly

commends the MSRB’s efforts to improve municipal bond market

price transparency. We also commend the recent progress at enhancing corporate bond market price transparency on the TRACE

system.

There has been a steady effort to improve the disclosure relating

to the financial condition of bond issuers. Corporate bond issuers

are subject to the SEC regulation that requires registration and

current disclosure for the benefit of investors. Disclosure of financial market condition of municipal bond issuers has been more of

a challenge because of the diverse nature of the market. However,

important steps to improve issuer financial transparency have been

made.

We should all support the steps taken by issuers, self-regulatory

organizations, and investors to improve price transparency in the

corporate and municipal bond markets. Again, as a fiduciary responsible for hundreds of thousands of municipal bond investors,

Vanguard strongly supports the MSRB’s efforts to improve price

transparency in municipal bond markets and believes that it is in

the best interests of investors for these efforts to continue.

In addition to price transparency, efforts should continue to improve issuer financial condition transparency in the municipal bond

market. The SEC’s efforts to improve disclosure through rulemaking have been effective and beneficial. However, Vanguard recommends that lawmakers, regulators, industry participants continue to monitor developments and consider whether more may be

done to improve issuer financial condition transparency.

Thank you, and I would be happy to respond to your questions.

Chairman SHELBY. Professor Warga.

STATEMENT OF ARTHUR D. WARGA

DEAN, C.T. BAUER COLLEGE OF BUSINESS

JUDGE JAMES A. ELKINS, PROFESSOR OF BANKING

AND FINANCE, UNIVERSITY OF HOUSTON

Mr. WARGA. Thank you, Chairman Shelby, for inviting me here

to provide what I hope is a dispassionate outside academic perspective on the topic of today.

Chairman SHELBY. We welcome that.

Mr. WARGA. I would agree with previous speakers that, on the

institutional side, the bond market has evolved into what I view is

a relatively efficient competitive cost structure. The cost structure

is such that dealers are able to capture implicitly the costs of providing various research and portfolio services to the large institutional buyers, and I think most institutional buyers, like Mr. Ryon

next to me, will agree that the cost structure is very competitive

and competitive even with the highest decile New York Stock Exchange transactions.

Fortunately, the recent transparency initiatives, TRACE, and

MSRB initiative are providing the institutional market with perVerDate 11-MAY-2000 20:23 Jun 02, 2006 Jkt 025856 PO 00000 Frm 00024 Fmt 6633 Sfmt 6633 26179.TXT SBANK4 PsN: SBANK4
21

haps its biggest—it is helping them solve their biggest problem,

which was the issue of trying to mark, on a daily basis, the net

asset values of their bond portfolios. I have always viewed the net

asset value numbers produced by bond mutual funds and other

bond portfolios as very problematic. Now, at least, there is a richer

source of data that they can base some models on to improve that

situation, which I think has been rather bleak in the past.

However, the transparency initiatives have not changed the costly trading environment for retail investors. In particular, I will say

that in the written report that Mr. Ryon provides, he gives an update, 3 years past my own seminal paper on the municipal bond

market, that confirms that transparency has had virtually no effect

whatsoever on the costly retail structure, cost structure for retail

trades and municipal bond market. They still remain extremely

high, perhaps as much as 200 basis points or 2- percent above what

an institutional buyer faces.

My own guess is that this is largely true for the corporate retail

market. However, data on that market has been very dark, and we

are anticipating some reports to be released shortly, but we still do

not really know what the cost structure is in the retail corporate

market. We have absolutely no idea. Data has not been released

publicly to researchers like myself.

The studies that are forthcoming, and particularly the NASD

study forthcoming on the cost structure for retail trades in the corporate bond market, I think need to have a comparison to the one

exchange-traded retail market for corporate bonds, the automated

bond system run by the New York Stock Exchange, for which we

know what the cost structure is. We know that it is competitive

with the institutional market, absent some commission charges,

and it is incumbent upon the NASD to make that comparison.

Individuals need to understand the huge risk of buying individual bonds. I, personally, would be hard-pressed to recommend

anybody buying an individual corporate or municipal bond in the

existing trading structure. The real problem here I think has not

been touched upon by the participants in these panels, and that

problem is that the basic structure of this market is simply not set

up to accommodate retail trades. There needs to be a focus and research on setting up a separate structure for retail purchases of individual municipal or corporate bonds. The structure, as I said before, is geared toward institutional buyers, and it is doing a very

good job and has for many, many years.

I have a final comment, and that is just to give a brief answer

to Senator Sarbanes’ comment about my talking about credit rating

changes occurring very slowly. They do, in fact, change slowly.

They continue to change slowly, but there is a structural reason for

that. The U.S. Government provides the rating agencies legally

with the power to let their ratings be used in contracts.

And so if the rating agencies were to immediately change their

ratings, and sometimes events happen to the bond markets where

a price drops precipitously, but then it will come back. So, in fact,

if they were to change their rating immediately, they would end up

having to change it again. Unfortunately, some of those rating

changes would, in the extreme, trigger events like bankruptcy and

22

corporations and other events. So it is actually important that the

rating agencies do not change their ratings quickly.

And my comment in the paper was simply to point out that in

the existing market structure, dealers and institutional buyers

need to be in touch with each other so they understand that something really has happened, in spite of the fact that the rating has

not changed.

Those are my comments. Thank you.

Chairman SHELBY. We will start with you, Dr. Warga. Unlike

trading in equities, bond transactions are not immediately reported

and publicly disseminated. How would immediate real-time price

reporting impact liquidity in the bond markets.

Mr. WARGA. Liquidity is generally correlated with the amount of

underlying volatility in a security. For example, stock prices change

quite often because little changes in information can have big effects on their prices because the price reflects the present value of

all future cashflows to eternity for that company.

That is certainly not the case with highly rated AA-, A-, AAArated corporate or municipal bonds. However, for high-yield bonds,

which can be thought of as a blend between equity and investmentgrade debt, I think there is a real benefit, potential benefit, to increasing liquidity by providing that transparency, and I think we

all look forward to that transparency appearing in the near future.

Chairman SHELBY. What are your thoughts, Professor, on the

NASD’s proposed carve-out from public dissemination through

TRACE for illiquid and inactively traded bonds?

Mr. WARGA. It is certainly true that if I were the holder of an

illiquid portfolio of bonds, and I received a margin call, and had to

dispose of them, and that margin call had absolutely nothing to do

with the underlying fundamentals of the company that issued those

bonds, I would face a very punishing environment trying to sell

them, and I would take a very steep discount. And on the face of

it, transparency would not be a good thing. I would like to get rid

of those in a market where nobody knew I was trying to get rid

of them.

However, I will say that, since we are really talking about mostly

corporate bonds and institutional situations where it is an institutional buyer or seller in that situation, I will say that that has occurred plentifully in the past, when there was not any transparency. So it is not clear to me that there will be any harm created by transparency, even in that circumstance.

Chairman SHELBY. Mr. Ryon, do you have any comments on this?

Mr. RYON. We believe that if there is any type of dislocation or

illiquidity problem due to increased price transparency, it will be

short-lived, that the profit motive will smooth that out rather

quickly.

Chairman SHELBY. The market will take care of it?

Mr. RYON. Yes, sir, and that the market will be stronger given

better price transparency for both actively and inactively traded

bonds, that as individuals know that they are getting a fair price,

they will be willing to commit more capital to the market, and

therefore it will grow.

Chairman SHELBY. Mr. Green?

23

Mr. GREEN. Mr. Chairman, I will proclaim unequivocally we have

been the watchdog for liquidity in this equation, and over the many

years that this issue has been developed, both at the NASD and

the MSRB, we have wanted to not prejudge whether or not transparency would affect the liquidity, but to make sure that premature disclosure of illiquid trade information does not affect liquidity. And if it does not go forward—and we have been supportive of each phase along the way, both in the municipal and corporate market—this last little carve-out that is in the proposal of

the NASD not only affects the most illiquid and institutional trade,

it is the largest trade that trades most infrequently.

Their proposal provides complete immediate dissemination for

any smaller trade, any frequently traded or any high-quality trade.

So we just want to make sure that in those markets where liquidity is most needed, it is not taken away.

Chairman SHELBY. During the prior panel—I believe all of you

were here—the regulators discussed ongoing investigations into

wide price swings and dealer markups. Would you describe pricing

practices in the industry and whether you perceive any issues surrounding dealer markups.

We will start with you, Mr. Green.

Mr. GREEN. Thank you, Mr. Chairman. I think, as the previous

panel said, one of the benefits of the transaction reporting system

is that it is arming the regulators with the information they need

to root out any problems, and we, as The Bond Market Association,

support that. The fact is enforcement of rules is important. Because

if rules are enforced, they do not necessarily have to be changed,

and therefore wind up being excessive. So this information will

help figure that issue out.

Chairman SHELBY. Mr. Ryon.

Mr. RYON. Sir, I believe the market will be the best policeman.

If I receive trade information on something I have just sold, and

I see that a dealer has taken what I believe to be an excessive

markup, I am going to do whatever I can to show my displeasure,

and I believe those types——

Chairman SHELBY. But you have got to know that to begin with,

have you not?

Mr. RYON. Exactly, sir, and that is why I think price transparency is important, that the market will be its best policeman

and that it will force——

Chairman SHELBY. It could be hurting and not really appreciate

how much, huh?

Mr. RYON. I beg your pardon, sir?

Chairman SHELBY. It could be hurting and not appreciate it, but

if you are informed, you know something is wrong.

Mr. RYON. I am informed, and I can take the appropriate actions.

Chairman SHELBY. Professor Warga.

Mr. WARGA. Well, you know, in the retail market for especially

municipal bonds, it is quite likely that there will not be any price

for the individual to see. They will have been the only purchaser

of that bond more often than not, and so transparency is not going

to provide any help at all.

And the websites also provide I think, if a retail investor really

is looking at those websites carefully, a lot of puzzles that are not

24

explained and probably need some explaining. Just casually looking

over municipal bond trades for the previous day, 2 days ago I saw

a trade in the State of Texas. Being xenophobic, I decided to check

out Texas, and I saw a bond that traded perhaps a dozen times

was sold to investors for price of par of $100, and there were four

trades between dealers for $75. Now, I am willing to believe that

it is a mistake, but it is not uncommon to see things like that. It

probably is a mistake, but it sure needs explaining, and it would

probably be helpful if those explanations went up contemporaneously with the posting of prices like that.

Chairman SHELBY. A little footnote people would read.

Mr. WARGA. Yes.

Chairman SHELBY. Thank you.

Mr. GREEN. Mr. Chairman, could I just supplement something

Professor Warga said. Because even if a bond does not trade, knowing what the price was in that trade and it will be fully disclosed

under the MSRB data, it would give that investor the relative

value at the time—relative value as to other benchmark securities,

like a Treasury security—so it still has value to the retail investor.

Chairman SHELBY. Well, all information has value. It depends on

how much, does it not, and the quality of it.

The equity markets and bond markets have each developed their

own trading systems and industry practices. Why should not the

bond market have to operate under the same market structure as

the equity market? Does it make sense to bring some of the innovations in the equity market, such as electronic trading platforms and

real-time posting of bid and ask to the debt markets?

We will start with you, Professor.

Mr. WARGA. Well, in my report, I mentioned the ABS system

only because it is an electronic system that exists and that I have

been studying for about 15 years. I am not a proponent of it over

any other electronic system, but it is a system that is geared toward the retail investor, and currently there are some very serious

regulatory constraints to listing, to having a broad range of bonds

listed there. There are constraints on that system that do not exist

in the dealer market. So, while the dealer market is able to trade

any bond it wants, pretty much, on the ABS system, the company

that issued the bond has to be convinced by the underwriter that

it is worth registering it in the first place, and this creates one impediment to an exchange-based system.

Chairman SHELBY. Mr. Ryon.

Mr. RYON. In a municipal market, the sheer number of volume

of securities outstanding make such a move, a change quite problematic. We have tried electronic trading systems in the municipal

market over the last few years, and none of them have been successful. They have all failed.

Whereas, in the corporate market and the treasury market,

where you have got more of a homogeneous pool of securities, you

have seen success with systems like TradeWeb.

Chairman SHELBY. Mr. Green.

Mr. GREEN. There have been significant developments in electronic trading in the fixed-income markets. And as Professor

Warga’s own study showed, the spreads in the over-the-counter

market versus the ABS market are somewhat indistinguishable. So

25

we do not, as the bond markets do not sit here saying the equity

model is wrong, but I think it is also safe to say that the over-thecounter model in the bond markets is not wrong either because,

frankly, as was just said, with the number of municipal issuers,

there are 88,000 individually listed securities in the stock exchanges.

There are over 50,000 municipal issuers alone. There are tens of

thousands of corporate issuers. The over-the-counter decentralized

model provides access to capital to more issuers and more types of

issues than the four walls of a building exchange would provide.

You need to make sure that California has access and a small

community in Alabama has access to the same capital, and that is

why this system actually works very well.

Chairman SHELBY. Mr. Ryon and Mr. Green, I will pose this to

both of you.

Would you discuss how the regulators worked to improve the disclosure by municipal issuers. Given the Tower amendment, are

there still ways to improve the uniformity and availability of issuer

information.

Mr. RYON. Well, there have been some very good voluntary efforts that have been moving forward, particularly the Municipal

Council, that is, 19 members, both issuers, buyside, and other organizations. Their first efforts are supposed to be coming on-line this

summer. Things seem to be going very well up until this week,

where I have read some articles that looks like we have hit a little

bit of a dust-up. So I would say, if that works itself out, I would

give those voluntary efforts time to succeed. If they do not, then

maybe something else will have to be done to ensure disclosure of

not only prices, but issuer financial conditions.

Chairman SHELBY. Mr. Green.

Mr. GREEN. Mr. Chairman, the Tower amendment limits the regulation of issuers in the municipal marketplace, which are States

and localities, very much a division of levels of Government. I have

got to hand it to the MSRB, and the SEC, and frankly the industry,

too, of finding a way to provide deep primary disclosure and deep

secondary market disclosure within that limitation.

The way the rules work right now, the imposition of the requirement on disclosure is imposed on the dealer. They cannot bring an

issue to market if they do not do A, B, and C. And, ultimately, we

have been able to work within that limitation under the MSRB’s

leadership to provide honest-to-goodness great disclosure in the primary and secondary market. But deciding whether or not to keep

the Tower amendment in place or change it is not our job.

Chairman SHELBY. It takes legislation.

Professor, you have a comment on this, the Tower amendment?

Mr. WARGA. Not the Tower amendment, no.

Chairman SHELBY. Do you think it works?

Mr. WARGA. I have no opinion.

Chairman SHELBY. I appreciate all of you. We will keep the

record open in case some other Senators might want to pose some

questions to you. We appreciate your appearance here today.

Thank you. The hearing is adjourned.

[Whereupon, at 11:35 a.m., the hearing was adjourned.]

[Prepared statements supplied for the record follow:]

26

PREPARED STATEMENT OF ANNETTE L. NAZARETH

DIRECTOR, DIVISION OF MARKET REGULATION

SECURITIES AND EXCHANGE COMMISSION

JUNE 17, 2004

Good morning Chairman Shelby, Ranking Member Sarbanes, and Members of the

Committee. I am delighted to be here to discuss some of the significant issues and

developments that the Securities and Exchange Commission is currently addressing

with respect to the fixed income markets. Specifically, I plan to discuss the fixedincome market transparency joint Task Force, which was recently commissioned by

Chairman Donaldson, along with a number of issues that the Task Force is currently considering, including corporate bond market transparency, municipal securities market transparency, government securities transparency, and dealer mark-up

practices in the fixed-income market. Finally, I will briefly touch upon the development of guiding principles for the fixed-income industry related to the mitigation

of research analyst conflicts of interest.

In March 2004, Chairman Donaldson commissioned a joint Task Force to consider

issues relating to bond market transparency and mark-up regulation. The Task

Force consists of representatives of the Divisions of Market Regulation and Enforcement, the Office of Compliance Inspections and Examinations (‘‘OCIE’’), the Office

of Economic Analysis (‘‘OEA’’), and the Office of the General Counsel. The Task

Force was organized to summarize fixed-income market transparency developments,

identify current problems, and generate potential solutions.

Preliminarily, the Task Force has found that transparency has improved to varying degrees in each of the fixed income markets over the last 20 years, because of

a continued focus on this issue by both Congress and the Commission. Further, recent increases in the availability of information from these markets has enhanced

the ability of regulators to surveil these markets for mark-up violations and other

illegal activity.

To implement transparency in the corporate bond markets, the Commission persuaded the NASD to create systems to collect transaction reports and disseminate

price information. On January 23, 2001, the Commission approved the NASD’s proposal to establish the Trade Reporting and Compliance Engine (‘‘TRACE’’) system

for reporting and dissemination of last sale information on corporate bonds not traded on an exchange. On July 1, 2002, TRACE was officially launched. It is currently

being implemented in phases, and has not yet been fully implemented. Under the

NASD’s TRACE rules, dealers must report trades on U.S. corporate bonds to the

NASD within 45 minutes of trade execution, which was reduced from 75 minutes

on October 1, 2003. Prior to TRACE, real-time transparency of investment-grade

corporate bonds was limited to those traded on exchanges—a very narrow segment

of that market.

Although all trades in TRACE-eligible bonds are reported to the NASD, not all

TRACE data is disseminated to market users at this time, in part because of industry concerns about the adverse effects that dissemination might have on market liquidity. Dealers initially contended that immediate dissemination of transaction information on anything but the most liquid bonds could discourage dealers from committing capital and assuming risk positions by exposing their intentions to market

participants. Thus far, on the basis of available evidence, these concerns remain unsubstantiated. In addition, resales of securities under Rule 144A of the Securities

Act of 1933 are subject to reporting, but not dissemination because of the restrictions on resale contained in Rule 144A. Moreover, certain bonds, including bonds

classified as ‘‘asset-backed’’, are excluded from TRACE-eligibility and transactions

in such bonds are not currently reported to the NASD.

Under TRACE, the NASD currently disseminates transaction information on (i)

investment grade corporate bonds rated ‘‘A3’’ or higher by Moody’s Investors Service, and ‘‘A¥’’ or higher by Standard & Poor’s, with initial issuance size of $100 million or greater, (ii) investment grade corporate bonds rated ‘‘Baa/BBB’’ with initial

issuance of $1 billion or greater, (iii) an additional 120 bonds designated by the

NASD that are rated ‘‘Baa/BBB’’ at the time of designation and with initial issuance

of less than $1 billion, and (iv) 50 high-yield securities. Transactions eligible for

public dissemination are distributed to vendors immediately upon receipt by

TRACE. Transactions larger than $5 million in investment grade bonds are reported

as ‘‘5MM+;’’ transactions larger than $1 million in the roughly 50 reported highyield bonds are reported as ‘‘1MM+.’’

TRACE data currently includes transaction information on more than 4,200 securities and represents about 75 percent of the dollar value of trading activity in investment grade bonds. Real-time price data is available from several third-party

27

data vendors for a fee. Delayed data (minimum four hour delay) is available free

on the NASD website.

The NASD is in the process of expanding price dissemination to cover additional

bonds in a new phase of the TRACE rollout, which will reflect the NASD’s experience with earlier phases. The 120 BBB/Baa bonds currently designated by the

NASD for dissemination were selected in order to obtain empirical data about the

impact that dissemination may have on the liquidity of such bonds. The 50 noninvestment grade bonds designated for price dissemination were also chosen in part

to obtain information about the impact on liquidity, if any. The NASD commissioned

two studies to address this issue, both of which have been completed. Neither study

provided significant evidence that transparency harms liquidity. However, neither

study was extensive enough to address all concerns raised by dealers and other market participants.

The NASD’s advisory Bond Transaction Reporting Committee (‘‘BTRC’’) recently

made recommendations to the NASD Board to enhance TRACE based on its review

of the findings in these two studies. The NASD Board approved the BTRC recommendations, and our understanding is that the NASD intends to file a proposed

rule change with the Commission shortly. The NASD plan would make public in

near realtime approximately 99 percent of all transactions (and 95 percent of the

par value) in TRACEeligible securities. For the remaining transactions in TRACEeligible securities—in essence, newly-issued or infrequently traded lower-quality

bonds—dissemination of transaction data would be delayed. I understand the NASD

intends to reconsider the need for the remaining restrictions in the near term. Once

filed with the Commission, the NASD’s proposal will be published for public comment and processed according to statutory procedures. I also should point out that

the NASD recently filed a proposal to reduce the reporting period from 45 minutes

to 30 minutes in 2004, and, ultimately, to 15 minutes in 2005. There are no plans

to reduce the reporting period to less than 15 minutes.

In addition, I should note that data for all TRACE-eligible securities is now available to regulators for surveillance purposes. The NASD is currently implementing

a market surveillance plan designed to review market-wide and individual firm activity, monitor compliance with reporting requirements, and detect possible investor

abuse and market manipulation. The availability of TRACE information to the

NASD for surveillance purposes enhances the NASD’s ability to protect investors by

detecting abusive activity.

With respect to the municipal bond market, the drive for transparency began before the corporate debt markets. The Municipal Securities Rulemaking Board

(‘‘MSRB’’), with the Commission’s active encouragement, first implemented a municipal securities trade reporting system in 1995, and proceeded thereafter in measured

steps. The MSRB started providing daily summary reports of interdealer municipal

bond trades in 1995, and expanded the reports to include customer-trade data in

1998. In January 2000, the MSRB began publishing individual transaction data on

frequently traded securities in addition to summarizing their high, low and average

prices. The Bond Market Association now posts next-day MSRB municipal bond

trading reports on its Internet site for all municipal bonds that traded at least once

on the previous day. The trades reported represent both wholesale (dealer to dealer

and dealer to institutional customer) and retail (individual investor) purchase and

sale transactions. Each daily report typically includes about 30,000 trades in approximately 11,000 issues out of the 1.1 million issues that are outstanding. The

daily report displays exact par value for all trades with a par value of one million

dollars and under, and displays an indicator of ‘‘>$1,000,000’’ for those transactions

with a par value greater than one million dollars.

The implementation date of real-time transaction reporting has been delayed by

the MSRB several times to ensure that dealers have sufficient time to make necessary changes in their bond processing systems. Real-time transaction reporting in

the municipal market—generally defined as within 15 minutes of the time of

trade—is now scheduled to begin in January 2005. The MSRB has announced certain narrow exceptions to the requirement to report trades within 15 minutes, however, including an exception related to new issues and variable rate instruments.

The MSRB intends to disseminate trades reported during the business day immediately upon receipt of the trade report.

In the government securities market, impetus for change began in the late 1980’s,

when the General Accounting Office (‘‘GAO’’) published a report recommending increased price transparency in this market. In 1990, the GAO recommended legislation to require interdealer brokers to make transaction prices available to the public. The Commission supported the GAO recommendation, and recommended that

legislation require quotation information to be made available as well. Partially in

response to these calls for Congressional action, a variety of data network providers

28

have emerged that publicly disseminate quotation and transaction information on

treasury bonds and Federal agency securities. One example of this is GovPX, a vendor created by a group of primary dealers in government securities, that publicly

disseminates information regarding the U.S. Treasury market.

With respect to the markets for foreign sovereign and mortgage-backed securities,

the amount of transparency has not changed significantly in recent years.

Dollardenominated foreign sovereign bonds are largely traded through interdealer

brokers who post quotation and transaction information on their brokerage screens.

This information is not generally disseminated outside of the dealer network. Pricing information on mortgage-backed securities is widely available through a variety

of commercial vendors; some vendors also offer analytical tools to help value these

securities. Dealers and some institutional investors have in-house analytical models

as well.

Generally speaking, transparency plays a fundamental role in promoting fair and

efficient pricing in the fixed-income markets, thereby fostering investor confidence

in those markets and encouraging greater participation. Transparency also contributes to efficient price discovery and aids investors in assessing the quality of the

prices being offered in the market. In addition, transaction reporting has supplemented the ability of regulators to surveil the bond markets for unfair pricing and

abusive mark-ups and markdowns. The increased availability of information has

contributed to greater awareness by SEC and NASD staff of wide variations in pricing and mark-ups. The Task Force, in conjunction with the NASD, is exploring

whether these variations create the potential for abuse.

For any type of bond, mark-ups must be reasonable. While NASD has a maximum

5 percent guideline for equity securities, mark-ups are expected to be significantly

lower for bonds. For different types of debt, what is recognized as reasonable depends on such factors as liquidity, credit rating, and yield, and can range from less

than one-half of one percent for government debt, to higher amounts for high-yield

bonds. For investors as well as regulators, the difficulty lies in establishing the prevailing market price for a bond. This generally is the base line that is used to assess

whether a mark-up is reasonable. We believe that increased transparency should

enhance the Commission’s and SROs’ ability to determine the prevailing market for

a bond and thereby ascertain that investors are not being charged abusive markups. In addition, improved transparency will enable investors to better determine

the fair price of a bond. This will make them better able to protect themselves

against unfair pricing in the first instance.

In the recent past, Commission staff has held joint meetings with NASD staff in

an effort to focus on mark-up practices in the fixed income markets and to develop

appropriate surveillance and enforcement policies. Moreover, in February 2004,

OEA publicly released a major study on municipal bond liquidity that used sophisticated econometric methods to analyze average transaction costs from a 1 year sample of all municipal bond trades that occurred in the 1999-2000 time frame. This

study concludes that the effective spread for an average retail municipal bond trade

was almost 2 percent, in comparison to 0.8 percent for a similarly sized equity trade.

Among other matters, this OEA study is part of an ongoing research initiative that

constitutes a comprehensive effort to measure the size of bond markups. The Commission has widely disseminated the findings of this staff study, so as to give municipal bond dealers an opportunity to compare for the first time the size of the markups they charge their clients to historical practices. Initial results on a similar analysis for corporate bonds (not yet released) suggest that transaction costs decline

with added transparency. The magnitude of the results implies that making the rest

of the bonds transparent has the potential to save investors more than $1 billion

per year.

This January, after our review, the MSRB issued a Notice entitled ‘‘Review of

Dealer Pricing Responsibilities.’’ The Notice was occasioned by NASD’s review of

transactions with retail customers at prices that were not reasonably related to

market value. The MSRB expressed concern with ‘‘transaction chains’’ where a block

of securities was bought from a retail investor, and then, after a series of inter-dealer trades, was sold to another retail customer at a substantially higher price. While

no single dealer involved may have made an excessive profit, the large intra-day

price differential was absorbed by retail customers at the ends of the chain. Also

in January, OCIE and the NASD initiated a coordinated review of municipal brokers’ brokers. The firms selected for examination were based on the above-referenced NASD transaction review.

In addition, the NASD has filed a proposal to add a new Interpretation to its rules

for transactions in nonmunicipal debt securities to address two issues. First, it

would address how NASD members are to determine a debt security’s prevailing

market price, from which the amount of a mark-up is computed. Second, it would

29

speak to when and how a debt security’s prevailing market price may be determined

by reference to transactions with institutions, or to transactions in ‘‘similar securities.’’

The NASD proposal would establish a rebuttable presumption that, in all cases,

the prevailing market price for a debt security would be the dealer’s contemporaneous cost. While this standard is already imposed on nonmarket making dealers,

its universal application would eliminate a more forgiving standard that has been

established for market-makers. Regulators and industry participants have found

that in the bond market, where there is no sharp delineation between market making and nonmarket-making firms, the separate standard created a lack of clarity

and was a frequent source of disputes.

Moreover, the proposal would list a set of default measures of prevailing market

price in cases where the base standard should not apply. NASD’s list includes wellestablished factors, as well as new ones that reflect particular attributes of the bond

markets. For instance, it would recognize that the market price of a debt security

may often be established by reference to others with similar characteristics, such

as credit quality. The proposal would also acknowledge the significant role of nondealer institutions in the bond markets by permitting NASD members to refer to

transactions with institutions when determining the prevailing market price of a

debt security. In light of the significance of the filing and the Commission’s longstanding sensitivity with respect to the regulation of mark-ups, the staff has consulted with NASD and is closely reviewing the proposal.

Another important development in the fixed income market was the Bond Market

Association’s recent release of the final version of its ‘‘Guiding Principles to Promote

the Integrity of Fixed Income Research,’’ which is a comprehensive and detailed set

of voluntary principles designed to help the BMA’s member firms manage potential

conflicts of interest that arise in their research activities. The Commission staff, analysts’ groups, and a variety of other market participants reviewed drafts of the

principles, which are intended to promote an independent flow of unbiased information to the global fixed income capital markets. The BMA’s new principles are intended to provide member firms with a common set of standards they can use globally and to complement existing requirements both in the United States and Europe.

The final principles reflect that the nature and intensity of conflicts of interest

affecting fixed income research are different than those affecting equity research,

but that conflicts are possible in the preparation of fixed income research and needed to be addressed. Moreover, the guiding principles are intended to ensure research

analysts are free from internal or external influences that could inhibit their ability

to produce impartial assessments. For example, they recommend that analysts not

participate in investment banking activities, which could raise questions about their

independence. The BMA purposefully chose a flexible principles-based approach to

ensure that differing organizational structures, various types and uses of fixed income research, and the unique aspects of different fixed income markets could all

be encompassed within the framework.

Many of the guiding principles are designed to foster a firm culture that promotes

the integrity of fixed income research and the ability of fixed income research analysts to express their views without inappropriate pressure from issuers, investment

bankers and, significantly, other nonresearch department personnel, including traders and salespeople. In that regard, the BMA has noted its belief that the principles

go further than the regulations or legal settlements covering equity research.

Specifically, the principles recommend that firms prohibit promises of favorable

research in exchange for business, prohibit retaliation against analysts for publishing unfavorable research and ensure that research coverage decisions are made

by research personnel. In terms of sales and trading activities, the principles recommend firms prevent analysts’ recommendations from being prejudiced by the

firm’s trading activities. In addition, under the principles, traders should not know

the content or timing of upcoming reports before they are issued.

The principles also address potential conflicts of interest that arise from the personal interests of analysts. For example, the principles recommend analyst compensation be structured to promote independence and that firms impose limitations

on the personal trading activity of research analysts. Similarly, the principles recommend disclosures to assist investors in distinguishing fixed income research from

analyses produced by trading desk personnel as part of their trade execution and/

or market making functions. The Commission applauds the BMA for being proactive

in connection with analyst conflicts and believes that the implementation of the

principles is a positive development for market participants, regulators, and investors in the fixed-income market. The Commission will continue to consider whether

further Commission initiatives in this area are needed.

30

In closing, I would like to note that we believe that transparency is an essential

component of an efficient and fair market. In that regard, the Commission has supported increased transparency in the fixed income markets and will work with market participants and regulators in the future to ensure that we continue to increase

transparency in the fixed-income markets. Thank you again for inviting me to speak

on behalf of the Commission. I would be happy to answer any questions that you

may have.

—————

PREPARED STATEMENT OF DOUG SHULMAN

PRESIDENT, MARKETS, SERVICES AND INFORMATION

NATIONAL ASSOCIATION OF SECURITIES DEALERS

JUNE 17, 2004

Introduction

Mr. Chairman and Members of the Committee: NASD would like to thank the

committee for the invitation to submit this written statement for the record.

NASD

NASD is the world’s preeminent private sector securities regulator, established in

1939 under authority granted by the 1938 Maloney Act Amendments to the Securities Exchange Act of 1934. We regulate every broker-dealer in the United States

that conducts a securities business with the public—nearly 5,400 securities firms

that operate more than 92,000 branch offices and employ more than 665,000 registered representatives.

Our rules comprehensively address every aspect of the brokerage business. NASD

examines broker-dealers for compliance with NASD rules, MSRB rules, and the Federal securities laws—and we discipline those who fail to comply. Our market integrity and investor protection responsibilities include examination, rule writing, professional training, licensing and registration, dispute resolution, and investor education. NASD runs market transparency facilities, such as its TRACE system for

corporate bonds, which provide investors with information to help them make more

informed decisions. NASD monitors all of the over-the-counter markets in equity

and debt securities, including trading on the Nasdaq Stock Market—which is more

than 100 million orders, quotes, and trades per day. NASD has a Nationwide staff

of more than 2,000 and is governed by a Board of Governors comprising a majority

of nonindustry and public members.

Increased Retail Participation in the Bond Markets

Corporate bonds have become an important retail investment vehicle as the activity level of individual investors purchasing bonds or bond funds has increased dramatically in recent years. According to data from the Federal Reserve, the percentage of household assets in corporate and foreign bonds grew 70 percent between

1995 and 1999. During this time frame, household holdings of corporate and foreign

bonds eclipsed municipal bond holdings. And contrary to popular belief, newly available NASD trading statistics reveal that the bond market has substantial retail participation. In fact, approximately 65 percent of the transactions in the corporate

bond market are in quantities of fewer than 100 bonds or amounts less than

$100,000 in par value. We believe this trend of increasing retail participation in corporate bonds will continue as the ‘baby boomer’ generation reaches retirement age

and shifts portfolios into fixed income investments.

While bonds and bond funds can play an important role in portfolio diversification, neither product is entirely risk-free. Bonds and bond funds may be viewed incorrectly as—and in some cases, marketed as—risk-free alternatives to equity securities. Purchasers of bonds and bond funds often believe that their principal is safe

and that they are guaranteed a particular yield on their investment. Investors may

also believe that bonds are inexpensive to purchase or sell because they may not

realize that they pay a commission or other form of broker-dealer compensation—

mark-ups or mark-downs—on the transaction. Moreover, the terms, conditions,

risks, and rewards of bonds vary widely, and in some cases, such as high-yield

bonds, the risks may be substantial.

As the activity level of individuals investing in bonds and bond funds grows,

NASD is concerned that many individual investors many not fully appreciate the

risks and costs associated with these products. A recent NASD survey showed that

60 percent of retail investors do not understand that, as interest rates rise, bond

prices fall. Therefore, when interest rates rise, investors who decide to sell their

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bond fund may not recoup their full investment. In the same environment, investors

who decide to sell bonds prior to a call or the maturity date also may not receive

the full amount of their principal invested.

TRACE

Even educated investors cannot make wise investment decisions if they cannot access important transaction information such as comparable prices for investment

products, including bonds. While investors are accustomed to having access to current last sale information in the equities markets, bond information, historically,

has not been similarly available.

On July 1, 2002, NASD launched the first intraday ‘consolidated tape’ in the U.S.

over-the-counter corporate bond markets. The Trade Reporting and Compliance Engine, commonly referred to as TRACE, enables investors to access current price information for U.S. corporate bonds. All broker-dealers regulated by NASD have an

obligation to report transactions in TRACE-eligible corporate bonds under rules approved by the SEC.

As with the dissemination of the selling prices of equities, this capability provides

a new level of information to bond investors who now have access to independent

bond transaction data that can be used to help determine that they are getting a

fair market price when they are buying or selling bonds. While information on all

bond transactions that are reported to TRACE is not disseminated under provisions

currently in place, the program will be expanded in the next phase so that prices

of all reported transactions will be made available to the public. Because TRACE

makes a great deal of important price information public and accessible, it helps to

increase market fairness and integrity.

With this improved availability of market information, NASD now has a better

view into the U.S. corporate bond market. For example, since the launch of TRACE,

we have learned that the corporate bond marketplace is far more active than originally anticipated. On a typical day approximately $20 billion par value of corporate

bonds ‘‘turn over’’ in approximately 25,000 transactions. Of the close to 5,400

broker-dealer firms regulated by NASD, more than 1,900 report transactions to

TRACE. And of that number, approximately 500 broker-dealers report at least one

trade every day. The top 10 firms account for approximately 60percent of the volume and the top 25 firms trade approximately 85percent of the volume. In addition,

of the 23,000 publicly traded corporate bond issues, 20 percent trade at least one

time per day with 5 percent trading more than 5 times per day. As a result of

TRACE, NASD now possesses the information to identify trading patterns, trading

volume, and market participation.

Both individual investors and investment professionals can access TRACE information. Most investment professionals access the trade data through market data

vendors or their firm’s proprietary applications. Retail investors typically access

TRACE data through web sites such as NASD’s nasdbondinfo.com or

Investinginbonds.com, a part of The Bond Markets Association’s web site. And in

an effort to increase distribution of the data on a more widespread basis, NASD is

actively finding additional ways to distribute the information.

TRACE Reporting and Dissemination

Currently, more than 29,000 corporate debt securities are subject to TRACE reporting requirements. Each firm regulated by NASD that is a party to a secondary

‘‘over-the-counter’’ market transaction in a TRACE eligible security has a reporting

obligation under TRACE. As a general rule, the vast majority of dollar denominated

corporate debt instruments must be reported to TRACE. Not included under TRACE

are government debt securities such as U.S. Treasury bonds, municipal securities

(which are subject to a separate reporting and dissemination regime managed by

the MSRB), GSE securities, mortgage or asset backed securities, and money market

instruments.

More specifically, TRACE eligible securities include the following classes:

• Investment grade debt

• High-yield and un-rated debt of U.S. companies and foreign private issuers

• Medium term notes

• Convertible debt not otherwise reported to an exchange

• Capital trust securities

• Equipment trust securities

• Floating rate notes

• Global bonds issued by U.S. and foreign private issuers

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TRACE Reporting Time

During the past 2 years, NASD has worked with the bond trading community to

expedite public reporting of TRACE data. Upon the inception of TRACE in July

2002, bond dealers had 75 minutes to report trades into TRACE. Since that time,

NASD has moved aggressively to reduce the time frame for reporting to TRACE.

Currently, broker-dealers must report trades to TRACE within 45 minutes. This requirement will be reduced to 30 minutes later this year and the reporting time will

be reduced again to 15 minutes by mid-2005. Notwithstanding this requirement, in

the first 5 months of 2004, 74 percent of trades were submitted within 15 minutes

of execution and 85 percent within 30 minutes of execution.

NASD has worked hard to ensure that market participants have had the time to

prepare their processes and systems for this new reporting regime, while moving aggressively to reduce reporting times.

Trace Dissemination

TRACE has gathered every secondary transaction conducted in the corporate bond

market for regulatory purposes since its inception on July 1, 2002. NASD has taken

an aggressive phased approach to dissemination of this data to investors and professionals. Phase I, which was launched at inception, provided for dissemination of all

transaction data in investment grade bonds greater than $1 billion in original

issuance and 50 representative high yield bonds. This phase gave investors access

to approximately 31 percent of all transactions (34 percent of par value) and 38 percent of investment grade trades (45 percent of par value).

Phase II was introduced in April of 2003 and provided for dissemination of data on all investment grade bonds that were rated A or better and were at least $100

million in original issuance, as well as data on 120 representative Triple B rated

bonds and 50 representative high-yield bonds. This phase, which is currently in effect, gives investors access to approximately 43 percent of all transactions (45 percent of par value) and 61 percent of investment grade trades (68 percent of par

value).

In April 2004, NASD’s Board of Governors voted to make all publicly traded

TRACE eligible issues subject to dissemination. Under this proposal, information on

100 percent of TRACE eligible issues would be accessible to the public. Trade information on 99 percent of all corporate bonds will be disseminated immediately, thereby giving investors contemporaneous access to marketplace prices and transaction

data. The transactions that would be disseminated on a delayed basis would be limited to certain transactions in lower rated securities executed during a short period

after issuance and for trades over $1 million in par value in noninvestment grade

securities that are infrequently traded.

The proposed increase in dissemination of corporate bond information previously

described continues NASD’s efforts to put more information in the hands of investors and other market participants. In a very short period of time, TRACE has

brought unprecedented transparency to the corporate bond market. NASD will continue to work with the SEC and the industry to sustain this trend.

Sales Practices

In addition to having increased price information, NASD believes that it is imperative that investors understand the various risks, as well as the rewards, associated

with debt securities. With the growing retail participation in bonds and evidence

that investors may not fully understand the products (and particularly given that

interest rates are likely to rise from their current and historically low rates), NASD

recently issued a notice to the firms it regulates to remind them of their sales practice obligations in connection with bonds and bond funds.

These sales practice obligations include:

• Understanding the terms, conditions, risks, and rewards of bonds and bond funds

they sell (performing a reasonable-basis suitability analysis);

• Making certain that a particular bond or bond fund is appropriate for a particular

customer before recommending it to that customer (performing a customer-specific

suitability analysis);

• Providing a balanced disclosure of the risks, costs, and rewards associated with

a particular bond or bond fund, especially when selling to retail investors;

• Adequately training and supervising employees who sell bonds and bond funds;

• Implementing adequate supervisory controls to reasonably ensure compliance

with NASD and SEC sales practice rules in connection with bonds and bond

funds;

• Informing customers that brokers receive compensation for bond trades—that

when a firm buys or sells a bond, the customer is charged for the service, in the

form of either a commission, or a mark-up or mark-down.

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NASD also regularly reminds firms that they need to take appropriate steps to

ensure that their employees understand and inform customers about the risks as

well as the rewards of the products they offer and recommend, including corporate

bonds.

Investor education is another important tool. As part of our Investor Brochure series, NASD offers information on investing in bonds, the different types of bonds,

and understanding bond prices, quotations, and ratings. This information can be

found on the NASD Web site. We are also developing additional ways to help investors understand investing in bonds—along the lines of explaining what ‘‘junk’’ bonds

are, how to use NASD BondInfo, and the importance of asset allocation and diversification within a bond portfolio.

NASD Regulatory Functions Regarding Corporate and Municipal

Bond Markets

While TRACE applies to the corporate debt market, NASD’s regulatory responsibilities extend to both the corporate and municipal bond markets. The MSRB imposes requirements on firms for reporting municipal bond transactions and NASD,

as discussed above, imposes TRACE requirements for reporting corporate bonds

transactions. These sources of data provide NASD with a comprehensive picture of

these two markets with more than 50,000 daily transactions.

TRACE and the MSRB’s transaction information enable NASD to create an audit

trail of the activity in these markets and undertake comprehensive automated surveillance. NASD market surveillance systems utilize the TRACE and MSRB data

to check for compliance with applicable rules and to detect potential violations.

Compliance checks focus on the timeliness, completeness, and accuracy of the required reports. Ensuring timely, correct and complete reporting by the firms is a

top priority because accurate reporting is essential to ensure the integrity of the information disseminated to the public and for effective automated market surveillance.

Automated detection patterns are used to address customer protection concerns

such as the levels of commissions and markups or markdowns charged to investors.

NASD and MSRB rules prohibit firms from charging customers prices that are not

reasonably related to the current market price of a security. With the increasing

level of retail participation in the fixed income market, this is clearly a high-priority

concern.

The NASD surveillance systems are also used to detect potential market manipulation. Unlike equities, there is no centralized market structure for debt securities

where quotes are published or transactions may be executed (or facilitated). Accordingly, the challenges when policing for potential market manipulation are somewhat

different from those in the equity markets. Nonetheless, there are certain types of

conduct that can result in prices that are manipulated or artificial market activity.

We try to detect that type of activity through automated surveillance.

NASD’s Nationwide staff performs routine examinations of each broker-dealer

registered with NASD. For those firms participating in the corporate and municipal

bond markets, the exams seek to determine whether such firms are complying with

NASD and MSRB rules as well as applicable Federal securities laws. Examinations

begin with a detailed review of data that is available through NASD systems, such

as securities industry registrations, firm financial data, and firm trading data. The

examiners review the firm’s books and records, such as financial computation work

papers and subsidiary ledgers, order tickets and confirmations, and complaint and

correspondence files. Examiners check to see that the firm’s records support the regulatory reports that the firm has made to NASD in the case of trade reporting and

other filings.

NASD is also committed to supporting securities firms’ compliance efforts by providing firms specific feedback in the form of performance statistics to enable firms

to monitor their transaction reporting compliance on an individual and industrywide basis. With a glance at the statistics, a firm can quickly see its actual rate

of compliance with the reporting requirements. This is another way that NASD is

working to ensure that there is integrity in the bond markets.

When NASD finds that broker-dealers have violated any of the applicable rules,

it may take informal or formal action against firms and individuals, as appropriate.

NASD rules provide for a range of formal sanctions including fines, disgorgement,

suspension, and expulsion from the industry. NASD may also order restitution to

investors.

Conclusion

NASD is committed to fulfilling its regulatory responsibility of ensuring that

broker-dealers engaged in the bond markets comply with the Federal securities laws

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1 Under Board Rule A–3, the Board is composed of 15 membership positions, with five positions each for public, bank dealer and securities firm members. 2These fees are set forth in Board Rules A–12 through A–14.

and regulations, including NASD’s TRACE and other NASD rules and the rules of

the Municipal Securities Rulemaking Board. We will continue to work with the SEC

and the securities industry to increase access by the public and professionals alike

to vital bond market data. This commitment is a vital part of our mission to protect

investors and ensure market integrity.

—————

PREPARED STATEMENT OF CHRISTOPHER A. TAYLOR

EXECUTIVE DIRECTOR, MUNICIPAL SECURITIES RULEMAKING BOARD

JUNE 17, 2004

Chairman Shelby, Ranking Member Sarbanes and Members of the Committee:

As Executive Director of the Municipal Securities Rulemaking Board, I appreciate

the opportunity to testify before the Committee concerning the municipal securities

market and the MSRB’s role in this market.

Introduction

On June 9, 2004, Chairman Shelby requested that the Municipal Securities Rulemaking Board (‘‘MSRB’’ or ‘‘Board’’) prepare testimony before the Committee addressing current issues concerning the municipal securities market, including market structure, regulatory framework, trade reporting, price transparency and related

matters. This testimony has been prepared in response to that request. Part I provides a summary of the Board’s structure, authority and rules. Part II provides

background on the municipal securities market. Part III is a discussion of the

MSRB’s regulatory priorities and goals.

Background on the MSRB’s Structure, Authority and Rules

MSRB Structure

The MSRB is a self-regulatory organization (‘‘SRO’’) established by Congress in

the Securities Acts Amendments of 1975 to write rules with respect to transactions

in municipal securities effected by brokers, dealers and municipal securities dealers

(collectively ‘‘dealers’’). The MSRB stands as a unique SRO for a variety of reasons.

The MSRB was the first specifically established by Congress. Also unique is the fact

that the legislation, now codified in section 15B of the Securities Exchange Act (‘‘Exchange Act’’), dictates that the Board shall be composed of members who are equally

divided among public members (individuals not associated with any dealer), individuals who are associated with and representative of banks that deal in municipal securities (‘‘bank dealers’’), and individuals who are associated with and representative of securities firms.1 At least one public member serving on the Board must represent investors and at least one must represent issuers of municipal securities.

Further, the MSRB was created as a product-specific regulator, unlike most other

securities regulatory bodies.

Members of the Board meet periodically throughout the year to make policy decisions, approve rulemaking and review developments in the municipal securities

market. Day-to-day operations of the MSRB are handled by a full-time professional

staff. The operations of the Board are funded through assessments made on dealers

for initial fees, annual fees, fees for underwritings and transaction fees.2

MSRB Authority

The substantive areas of the Board’s rulemaking authority are described in Section 15B(b)(2) of the Exchange Act, which lists several specific purposes to be accomplished by Board rulemaking with respect to the municipal securities activities of

dealers and provides a broad directive for rulemaking designed to:

prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling and processing information with respect to

and facilitating transactions in municipal securities, to remove impediments to and

perfect the mechanism of a free and open market and, in general, to protect investors and the public interest.

Like other SROs, the Board must file its proposed rule changes with the Securities and Exchange Commission (‘‘SEC’’) for approval prior to effectiveness.

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3These Federal banking authorities consist of the Federal Deposit Insurance Corporation, the

U.S. Treasury Department’s Office of the Comptroller of the Currency, and the Board of Governors of the Federal Reserve System, depending upon the specific bank dealer. 4The Board’s arbitration program was established in 1978. Because of the small number of

cases filed with the Board and the agreement of NASD to handle arbitration cases relating to

municipal securities transactions brought by customers involving bank dealers as well as existing NASD dealer members, the Board discontinued its arbitration program in 1998.

Although the Board was created to write rules that govern dealers’ conduct in the

municipal securities market, the Exchange Act directs that inspection of dealers for

compliance with, and the enforcement of, Board rules be carried out by other agencies. For securities firms, the NASD, along with the SEC, perform these functions.

For bank dealers, the appropriate Federal banking authorities, in coordination with

the SEC, have this responsibility. 3 The use of existing enforcement authorities for

inspection and enforcement of Board rules provides for an efficient use of resources.

The Board works cooperatively with these enforcement agencies and maintains frequent communication to ensure both that: (1) the Board’s rules and priorities are

known to examining officials; and (2) general trends and developments in the market discovered by field personnel are made known to the Board.

While Section 15B of the Exchange Act provides the Board with broad authority

to write rules governing the activities of dealers in the municipal securities market,

it does not provide the Board with authority to write rules governing the activities

of other participants in the municipal finance market such as issuers and their

agents (that is, independent financial advisors, trustees, etc.). Municipal securities

also are exempt from the registration and prospectus delivery requirements of the

Securities Act of 1933 and are exempt from the registration and reporting requirements of the Exchange Act.

In adopting Section 15B of the Exchange Act, Congress provided in subsection (d)

specific provisions that restrict the Board and the SEC from regulating the disclosure practices of issuers in certain ways. Paragraph (1) of subsection (d) prohibits

the Board (and the SEC) from writing rules that directly or indirectly (for example,

through dealer regulation) impose a presale-filing requirement for issues of municipal securities. Paragraph (2) of subsection (d) prohibits the Board (but not the SEC)

from adopting rules that directly or indirectly require issuers to produce documents

or information for delivery to purchasers or to the Board. Paragraph (2), however,

specifically allows the Board to adopt requirements relating to such disclosure documents or information as might be available from ‘‘a source other than such issuer.’’

The provisions of subsection (d) commonly are known as the ‘‘Tower Amendment.’’

MSRB Rules Overview

The Board has adopted a substantial body of rules that regulate dealer conduct

in the municipal securities market. These rules address all of the subjects enumerated in Section 15B of the Exchange Act by Congress for Board action, including

recordkeeping, clearance and settlement, the establishment of separately identifiable departments within bank dealers, quotations, professional qualifications of persons in the industry and arbitration of disputes. 4 The Board also adopted a number

of rules in furtherance of the broad purposes of ensuring the protection of investors

and the public interest. Among the most important of these are the Board’s three

primary customer protection measures—Rule G–17, on fair dealing, Rule G–19, on

suitability, and Rule G–30, on fair pricing. These rules require dealers to observe

the highest professional standards in their activities and relationships with customers.

Maintaining municipal market integrity is an exceptionally high priority for the

Board as it seeks to foster a fair and efficient municipal securities market through

dealer regulation. The Board engages in an on-going process of reviewing its rules

and market practices to ensure that the Board’s overriding goal of protecting investors and maintaining market integrity is not compromised by emerging practices.

The MSRB adopted Rule G–37 on political contributions in an effort to remove

the real or perceived conflict of interest created when issuers receive political contributions from dealers and then award municipal securities business to such dealers in a practice that came to be known as ‘‘pay-to-play.’’ In general, Rule G–37 prohibits dealers from engaging in municipal securities business with issuers if certain

political contributions have been made to officials of such issuers; prohibits dealers

and municipal finance professionals (‘‘MFPs’’) from soliciting or bundling contributions for officials of issuers with which the dealer engages in business; and requires

dealers to disclose certain political contributions to allow public scrutiny of political

contributions and the municipal securities business of a dealer. The rule also requires dealers to disclose certain contributions to state and local political parties to

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5Surveillance data is made available to regulators with authority to enforce MSRB rules, including the NASD and the SEC. 6See The Bond Buyer/Thomson Financial 2004 Yearbook at 10. Approximately half of this figure represents short-term debt maturing in less than 13 months. 7See The Bond Market Association Research Quarterly (May 2004).

8See The Bond Buyer/Thomson Financial 2004 Yearbook at 2–5.

ensure that such contributions do not represent attempts to make indirect contributions to issuer officials in contravention of Rule G–37.

Further, the MSRB adopted Rule G–38 relating to the use by dealers of consultants to solicit municipal securities business from issuers on the dealers’ behalf. This

rule is intended to deter and detect attempts by dealers to avoid the limitations

placed on dealers by Rule G–37 through their consultants, as well as to require full

disclosure to issuers and the public of relationships which could otherwise pose potential conflicts-of-interests or could result in potentially improper conduct by consultants. The rule currently requires dealers who use consultants to disclose to

issuers information on consulting arrangements relating to such issuer, and to submit to the Board quarterly reports of all consultants used by the dealer, amounts

paid to such consultants, and certain political contribution information from the consultant.

The impact of Rules G–37 and G–38 has been very positive. The rules have gone

a long way toward severing the real or perceived connection between political contributions and the awarding of municipal securities business to dealers.

In its role as regulator for dealer conduct, the Board also operates data facilities

to help ensure that dealers can comply with MSRB rules by improving the flow of

information in the market about municipal issues, and to ensure that the inspection

and enforcement agencies have the necessary tools to do their work. The Municipal

Securities Information Library (‘‘MSIL’’) system collects primary market disclosure

documents from underwriters and makes them available to the market and the general public. The MSIL system also accepts and disseminates certain secondary market information provided by municipal issuers and trustees.

The MSRB’s transaction reporting program for municipal securities serves the

dual role of providing transaction price transparency to the marketplace, as well as

supporting market surveillance by the enforcement agencies.5 The market surveillance function of the MSRB’s transaction reporting system provides the enforcement

agencies with a powerful tool in enforcing the Board’s fair pricing rules. In recent

years, the MSRB has introduced increasing levels of transparency into the market

in measured steps. This process is about to reach its ultimate goal in January 2005

with the implementation of the final phase of the transparency program, which will

result in 15-minute reporting by dealers of their sales to and purchases from customers and other dealers and the real-time dissemination of transaction information

to the marketplace.

Background on the Municipal Securities Market

Market Overview

When Section 15B of the Exchange Act was adopted in 1975, yearly issuance of municipal securities was approximately $58 billion. 6 Much of this total represented

general obligation debt, which reflected the simple, unconditional promise of a state

or local government unit to pay to the investor a specific rate of interest for a specific period of time. The investors in these bonds tended to be commercial banks and

property/casualty insurers interested in tax-exempt interest.

The municipal securities market has grown into a much larger and more complex

market. Total municipal debt outstanding through the first quarter of 2004 is approximately $1.9 trillion, or approximately 8.6 percent of the outstanding U.S. debt

market.7 Last year, a total of 14,973 long-term municipal securities issues were

issued for a total par value of $384.0 billion of long-term bonds, a record figure. Approximately 49.5 percent of the par amount of municipal bonds issued in 2003 carried municipal bond insurance, which translates to 44 percent of the overall number

of issues.8

In the United States, there are approximately 80,000 State and local Governments, about 50,000 of which have issued municipal securities. The market is

unique among the world’s major capital markets because the number of issuers is

so large-no other direct capital market encompasses so many borrowers. The issues

range from multibillion dollar financings of large state and city governments to

issues less than $100,000 in size, issued by localities, school districts, fire districts

and various other issuing authorities. The purposes for which these securities are

issued include not only financing for basic government functions, but also a variety

of public needs such as transportation, utilities, health care, higher education and

37

9The Commodity Futures Modernization Act of 2000 clarified the status of OTC derivatives

and hybrid instruments under U.S. commodities and securities laws. Among other things, it provides that swap agreements are not securities under the Federal securities laws. Swap agreements that are based on securities prices, yields or volatilities are, however, subject to specific

antifraud, antimanipulation and antiinsider trading provisions of the Federal securities laws as

if they were securities. Neither the SEC nor the MSRB may, however, impose reporting or

record keeping requirements or other prophylactic measures against fraud, manipulation or insider trading with respect to securities-based swap agreements. 10See The Bond Buyer/Thomson Financial 2004 Yearbook at 84. 11 As discussed above, the MSRB will begin disseminating real-time price transparency for

municipal securities in 2005.

housing as well as some essentially private functions to enhance industrial development. In the last two decades debt issuance has become an important management

tool for many municipalities, allowing flexibility in arranging finances and meeting

annual budget considerations. The terms and features of municipal securities have

evolved over time to meet a multitude of issuer borrowing and investment needs.

Issuers’ budgetary and risk management needs have also lead to derivative transactions, especially swaps, becoming an increasingly common aspect of municipal finance. These derivative transactions are not transactions in municipal securities,

and the MSRB does not have the authority to regulate dealer conduct in connection

with derivative transactions. In addition, many nonregulated entities effect derivative transactions with municipal issuers, or advise municipal issuers with respect

to these transactions.9

The municipal securities market has a significant retail orientation, with approximately 35 percent of municipal debt held by households.10 There is great diversity

in the types of municipal securities that are issued today. Tax-exempt municipal securities are popular investments that offer a wide range of benefits, including income free from Federal and, in some cases, state and local taxes; relative safety

with regard to payment of interest and repayment of principal; and a wide range

of choices to fit an investor’s objectives with regard to credit quality, maturity,

choice of issuer, type of bond, and geographical location.

There are over 2,400 dealers registered with the MSRB to engage in municipal

securities activities. These dealers range from large, securities firms with Nationwide presence to small local shops. Approximately 500 to 600 of these dealers underwrite new issues.

Trading in Municipal Securities

Municipal securities are bought and sold in the over-the-counter market rather

than on an organized exchange. Unlike the experience in the over-the-counter market for equity securities, there has been no evolution of firm, two-sided quotations

or a formal market maker structure. In fact, a primary characteristic of the municipal securities market is the lack of any core group of issues that trade frequently

and consistently over sustained periods of time. One reason for this is the ‘‘buy and

hold’’ philosophy of most municipal securities investors. Another reason is that, for

most issues, there is a very small or nonexistent ‘‘float’’ of securities available to be

the subject of trading. Making a market in a conventional sense is difficult, if not

impossible, for these issues. In addition, the tax treatment of borrowing tax-exempt

securities effectively prevents the ‘‘shorting’’ of an issue. The inability to manage

risk in this fashion is a disincentive for making markets even in those issues where

‘‘float’’ might be available.

Another distinction between the municipal securities and the equity markets relates to the frequency of trading. In exchange-listed and Nasdaq markets, the continuous daily pattern of frequent trades in most stocks means that ‘‘last sale’’ transaction prices generally provide reliable information on market values for most

stocks. However, even when the MSRB reaches its ultimate goal of disseminating

comprehensive and contemporaneous pricing data,11 ‘‘last sale’’ prices generally will

not provide reliable indicators of market value for most municipal securities. One

reason for this is that, even on the heaviest trading days, less than 1 percent of

all outstanding municipal issues trade at all and most of those issues trade only

once or twice during the day. Furthermore, MSRB transaction reporting data suggests that only about one-third of the total issues outstanding during a given year

are traded even once at any time during that year.

Regulatory Priorities and Goals

Long-Range Plan

The Board continues to review and refine its rules in light of new products,

changes in marketing practices and other developments. Apart from this fine-tuning

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12The Muni Council recently announced that the Municipal Advisory Council of Texas has

opened beta testing of its Central Post Office (CPO). The CPO is expected to serve as a onestop filing place for issuers’ secondary market disclosure documents and to improve the flow of

information to the existing Nationally recognized municipal securities information repositories

(NRMSIR’s).

process, the Board also has taken a broader look at more basic changes in the market and has formed long-range regulatory priorities and goals.

The Board has established under its long-range plan the goal of fostering and promoting a fair and efficient municipal capital market. To help reach this goal, the

Board seeks to exercise market leadership through promoting education and responsible behavior among all participants; providing mechanisms for information flows;

having simple, cost effective rules; and adapting to changes in conditions. Recently

the Board has taken a number of major actions to further its goal through these

priorities and objectives.

Promoting Education and Responsible Behavior Among All Participants—Outreach

One of the significant challenges that the MSRB faces in working to foster and

promote a fair and efficient capital market is that the MSRB only regulates one participant in the market, the dealers. Therefore, the MSRB recognizes that it cannot

regulate away all problematic market practices and inefficiencies. To address this

complexity, the MSRB has been very aggressive in the past few years in an outreach

program designed to promote education and responsible behavior among all market

participants.

The MSRB’s outreach program has focused on bringing market participants together to develop common understanding and voluntary solutions to industry issues,

even though the MSRB may not have regulatory authority over these issues. For

example, the MSRB convenes on a regular basis a roundtable of the key constituencies in the municipal securities markets—representing dealers, issuers, investors,

indenture trustees, independent financial advisors, lawyers and other market participants—to promote open lines of communications among such groups and to educate all market participants on issues and concerns important to each segment of

the industry. The MSRB has also hosted numerous marketplace forums to explore

disclosure practices where the issuer community and other unregulated market participants have played a crucial role in the discussions. These and similar outreach

efforts have often served as the catalyst for different constituencies to come together

to work on issues of common interest. In many cases, significant voluntary initiatives among unregulated market participants to improve the efficiency and integrity

of the municipal securities market have been outgrowths of these open lines of communications.

The MSRB expects to undertake aggressive outreach in the future on issues such

as the use of derivatives in public finance to assist in the development of responsible

practices that protect the integrity of the municipal securities industry. This outreach would involve not only educating the dealers that the MSRB regulates, but

also the issuer community and other unregulated market participants. Outreach to

the industry on issues of great importance to the MSRB that are beyond our regulatory reach will continue to be a key tool used by the Board to achieve its ultimate

statutory calling to protect investors and the public interest.

Providing Mechanisms for Information Flows—Disclosure and Real-Time

Transaction Reporting

Fundamentally, the MSRB believes everyone is better off with more information

about the market. This includes information about issuers, information about their

securities, and transaction prices.

In the area of issuer disclosure in the municipal market, the MSRB’s focus over

the past few years has been on voluntary improvements. To this end, the MSRB was

instrumental in the formation of the Muni Council, a voluntary group comprised of

19 municipal market participants representing issuers, investors, dealers, lawyers,

indenture trustees, independent financial advisors and other market participants.

The Muni Council has been working over the past several years to improve secondary market disclosure in the municipal markets and is in the late stages of putting into place a formal structure which the Muni Council expects will improve the

flow of disclosure information to investors.12 In addition, a number of the Muni

Council participants and related organizations have established their own initiatives

and best practice guidelines on disclosure.

The MSRB has a long-standing policy to increase price transparency in the municipal securities market, with the ultimate goal of disseminating comprehensive and

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13 InvestingInBonds.com, a retail-oriented web site carrying data from the MSRB’s existing

Transaction Reporting Program, has been very successful in attracting users. The Bond Market

Association operates InvestingInBonds.com. 14While Rule G–37 was adopted to deal specifically with contributions made to officials of

issuers by dealers and municipal finance professionals, and PACs controlled by dealers or MFPs,

the rule also prohibits MFPs and dealers from using conduits-be they political parties, PACs,

consultants, lawyers, spouses or affiliates-to contribute indirectly to an issuer official if such

MFP or dealer can not give directly to the issuer without triggering the rule’s ban on business.

porting facility for the municipal securities market in 1995 and has since increased

price transparency in the municipal market in a series of measured steps. By 2000,

the MSRB was making all trade data public on a delayed basis and was giving out

T+1 transaction data free. The market’s reaction to the increasing levels of transparency has been positive. The use of the data in reports by market professionals

and pricing services indicates its value and suggests the additional value that will

be derived from real-time price data.

On June 1, 2004, the MSRB filed with the SEC a proposed rule change that represents the final stage in the evolution of price transparency in the municipal securities market, which is a system for comprehensive, real-time price dissemination.

The gradual change to real-time reporting by dealers has eased operational and cost

concerns on the part of the industry, since it has been possible for dealers to plan

for the extensive system changes that have been required. In particular, it has been

possible to include these changes within a normal planning cycle, as the securities

industry moved toward straight through processing.

This real-time price transparency will offer several benefits to the market. Because of the lack of market-makers and a centralized exchange, it is not uncommon

to see fragmented markets and relatively wide intra-day price spreads. Existing

transaction data suggests that the efficiency of pricing in some cases might be improved substantially if prices are made accessible on a real-time basis. In general,

real-time price transparency should benefit the market by helping to ensure that information relevant to the value of municipal securities issues is incorporated more

quickly and reliably into transaction prices. For both institutional and retail investors, the availability of market prices should instill greater confidence that pricing

mechanisms in the market are fair and efficient. 13

The MSRB recognizes that, because of the unique features of the municipal securities market, real-time price transparency for municipal securities will not necessarily function in the same manner as in the major equity markets or even the

moreliquid market for Treasury securities. For the majority of municipal securities

that are not traded daily, an investor will not be able to consider ‘‘last sale’’ information as a reliable means of obtaining an exact market price, as generally can be

done for exchange-traded or Nasdaq listed stocks that trade frequently throughout

the day. This is because such last sale may have occurred some time in the past

under different market conditions and material changes may have occurred since

that last sale which might affect the value of the security. Nevertheless, real-time

prices will provide extremely important information on the market conditions for individual securities that are trading on a given day, and this information often can

be extrapolated to assist in the accurate valuation of similar municipal issues that

are not actively traded that day. The continued and increased use of transaction

data in this manner is another major benefit of transparency that will allow for

more timely and accurate valuations of municipal securities portfolios.

Having Simple Cost Effective Rules—Review of Rules G–37 and G–38

In order to have simple, cost effective rules the MSRB works diligently to promote

understanding of its rules. The MSRB also continually engages in a process of reviewing its rules. For example, in an effort to ensure that Rule G–37, on political

contributions and prohibitions on municipal securities business, and Rule G–38, on

consultants, continue to be effective in promoting a fair and efficient capital market,

the Board has been engaged in an extensive review of these rules.

As a consequence, the Board has reacted to increasing signs that individuals and

dealers subject to the rules may be seeking ways around Rule G–37 by publishing

a notice to dealers reminding them that Rule G–37, as currently in effect, covers

indirect as well as direct contributions to issuer officials, and alerting dealers that

the MSRB has expressed to the enforcement agencies our concern that some of the

increased political giving may indicate a rise in indirect Rule G–37 violations.14

Similarly, while the MSRB believes that its consultant disclosure requirements

have been effective in bringing to light many aspects of dealer practices with respect

to the use of outside consultants to solicit municipal securities business, the MSRB

believes that some consultant practices may present challenges to the integrity of

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15The MSRB has noted in recent years significant increases in the number of consultants

being used, the amount these consultants are being paid and the level of reported political giving by consultants. The MSRB is concerned that some of these political contributions may be

indirect violations of Rule G–37. The MSRB also is concerned that increases in levels of compensation paid to consultants for successfully obtaining municipal securities business may be

motivating consultants to use more aggressive tactics in their contacts with issuers. These activities suggest that disclosure may not be sufficient to ensure that those who market the dealer’s services to issuers act fairly. 16 However, unlike in the municipal bond market, many state 529 plans by-pass dealers to

directly market to customers using state personnel. These state personnel are not subject to the

MSRB’s investor protection rules. In addition, some banks that market 529 plans may, as a result of the definitions of ‘‘broker’’ and ‘‘dealer’’ under the Gramm-Leach-Bliley Act, not be subject

to our investor protection rules.

the municipal securities market.15 As a result, the MSRB is considering the possibility of rulemaking that would ensure that the basic standards of fair practice and

professionalism embodied in MSRB rules are applied to the process by which municipal securities business is solicited. Thus, the MSRB has recently published for comment a draft amendment to Rule G–38 that would repeal existing Rule G–38 relating to consultants and replace it with a requirement that paid solicitations of municipal securities business on behalf of a dealer be undertaken only by persons associated with the dealer. The Board currently is considering a broad range of comments

received from industry participants and remains open to all reasonable alternatives

that might prove effective at addressing the Board’s concerns in this area.

Adapting to Changes in Conditions—529 Plans

An important area in which the MSRB has adapted its rules to ensure investor

protection in a rapidly evolving market has been the Section 529 college savings

plan market. Although in outward appearance greatly resembling mutual funds, 529

plans are municipal securities issued by state entities as savings vehicles for paying

college costs. Because they are not debt instruments—like bonds and notes—but instead are in effect shares in a pooled investment fund, many of the MSRB’s longstanding customer protection rules originally crafted for debt securities were updated to reflect the new reality of the ever-diversifying municipal securities market

created by the advent of 529 plans.

The MSRB has in place a broad array of customer protections under its rules for

529 plans marketed by dealers.16 These include rules on suitability, fair and reasonable commissions and sales loads, advertising, disclosure and sales practices. In addition, the Board has just published for comment two rulemaking proposals to further strengthen customer protections by establishing requirements for including

standardized performance data in dealer advertisements of 529 plans and by placing

limitations on sales incentives that can be given or received by dealers in connection

with the sale of 529 plan shares and other municipal securities. Since—just as in

the case of municipal bonds—529 plans operate in a political environment, the

MSRB’s political contribution and consultant rules also apply to dealers seeking to

engage in the 529 plan business. The Board has also created a licensing exam designed to test specifically for a thorough understanding of the 529 plan products and

relevant MSRB rules.

As in the municipal bond market, the MSRB has worked to provide education on

529 plans to the dealer community and to create a dialogue with all parties active

in the market—not just the regulated dealers—to help foster an understanding of

the fundamental need to ensure investor protection in this wholly retail market. The

Board has long been an advocate for thorough and timely disclosure by state 529

plans. The MSRB applauds the College Savings Plan Network’s recent effort in establishing voluntary disclosure guidelines for state 529 plans. We look forward to

reviewing their draft guidelines and are hopeful that they will greatly increase the

quality, comparability and accessibility of information available to customers seeking to save for the rising costs of college education.

Conclusion

The MSRB will continue to monitor the municipal securities market as it further

evolves to include more diversified and complex new structures and techniques, as

dealers, issuers, investors and others increasingly rely on new technologies. As it

has in the past, the Board will remain vigilant and will not hesitate to modify its

rules and information systems to deal with the ever-changing marketplace.

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1For reporting purposes, corporate and foreign bonds are categorized together. The category

includes debt obligations of U.S. financial and nonfinancial corporations and foreign entities.

PREPARED STATEMENT OF CHRISTOPHER M. RYON

PRINCIPAL AND SENIOR MUNICIPAL BOND PORTFOLIO MANAGER

THE VANGUARD GROUP

JUNE 17, 2004

Introduction

Chairman Shelby, Ranking Member Sarbanes, Members of the Committee, my

name is Christopher Ryon. I am a Principal and Senior Municipal Bond Portfolio

Manager at The Vanguard Group, a mutual fund company based in Valley Forge,

Pennsylvania.

Vanguard is one of the world’s largest mutual fund families, managing more than

$725 billion for nearly 18 million shareholder accounts. Vanguard offers 131 mutual

funds to U.S. investors and over 35 additional funds in foreign markets. Vanguard’s

offerings include 12 corporate bond funds with over $73 billion in assets and 14 municipal bond funds with over $43 billion in assets. Appendix A shows the number

of shareholder accounts, the number and types of mutual funds, and the total assets

under management at Vanguard.

Along with three other portfolio managers, four traders, and a team of municipal

bond analysts, I oversee the management of over $43 billion in Vanguard municipal

bond fund assets. I am pleased to be here representing Vanguard to discuss the U.S.

bond market. My testimony will focus on the following four areas:

1) Bond ownership: I will review how ownership in the municipal bond market

closely resembles that in the stock market, with individual investors and mutual

funds owning substantial portions of the market.

2) Bond trading: I will discuss briefly how the bond market and, in particular,

the municipal bond market continues to trade primarily over the counter. Unlike

the stock market, there are no organized National exchanges in the municipal bond

market, and there is little prospect of change in the future.

3) Bond pricing transparency: I will briefly review how pricing transparency

in the bond market has improved in the past 10 years. Other than in the Treasury

market, there exists no real-time pricing in the bond markets as there is in the

stock market. However, rules proposed by the Municipal Securities Rulemaking

Board (MSRB) would greatly enhance the reporting of municipal bond trades much

as the TRACE system has started to enhance transparency of corporate bond trades.

As a fiduciary responsible for the investments of hundreds of thousands of municipal bond fund investors, Vanguard strongly commends the MSRB’s efforts to improve municipal bond market price transparency. We also commend the recent

progress in enhancing corporate bond market transparency through the TRACE system.

4) Issuer financial condition transparency. I will explain that there have

been important and beneficial steps in the past to improve municipal issuer financial disclosure (most notably, SEC rule 15c2-12). However, Vanguard recommends

that lawmakers, regulators and industry participants continue to consider whether

more may be done to improve issuer financial condition transparency in the municipal bond market for the protection and benefit of municipal bond investors.

Background

Bond Market Segments

The bond market can be divided into four market segments: Treasury, government agency, corporate/foreign, and municipal.

• The Treasury bond market is a multitrillion dollar market of securities issued by

the U.S. government.

• The U.S. government agency market consists of bonds issued by various Federal

agencies such as the Government National Mortgage Association or GNMA.

• The corporate/foreign bond market consists of bonds issued by companies seeking

to raise capital for plant, equipment, or other types of investments.1

• The municipal bond market consists of bonds issued by states, municipalities, and

state-created taxing authorities. Municipal bond proceeds are used by municipalities to finance projects ranging from school, road and sewer construction to industrial development. In the past, municipal bond buyers and sellers consisted primarily of individuals who were attracted to the tax benefits of municipal bonds

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2 Because of their tax-exempt status, municipal bonds generally carry a lower yield than their

taxable counterparts. Institutions and wealthy individuals who pay high marginal tax rates

have been the largest buyers of municipal bonds because the tax benefits outweigh the decreased yield.

(municipal bonds pay interest exempt from Federal and sometimes local taxation).2

Bond Ownership

Appendix B shows the ownership interests of households, mutual funds, and other

entities in the corporate equities market and in the four segments of the bond market. It underscores the degree to which individual investors are significant owners

in the municipal bond market, both directly and through mutual funds.

Mutual funds provide investors with a distinct advantage over direct investment

in the bond market. Mutual funds give investors low-cost access to the market and

give them access to professional portfolio management. They also provide investors

with diversification that will mitigate the risk of loss in the event certain bonds lose

value. Finally, mutual funds provide investors with liquidity.

As shown in Appendix B, there are significant differences in the ownership makeup of municipal bonds on the one hand and Treasury, government agency, and corporate/foreign bonds on the other. For instance, the Treasury bond market has substantial foreign ownership, with owners outside the U.S. representing 37 percent of

the market. And the government agency and corporate/foreign bond markets have

significant institutional ownership, with commercial banks and life insurance companies representing 22 percent of the agency market and 30 percent of the corporate/foreign market.

In contrast, ownership in the municipal bond market more closely resembles that

of the stock market, with the majority of the market owned by households and mutual funds. In 2003, 51 percent of municipal bond holdings was attributable to individuals owning municipal bonds either directly (36 percent) or through mutual

funds (15 percent). These figures parallel ownership in the stock market (where

households own 37 percent and mutual funds own 20 percent). By comparison, the

corporate/foreign bond market has only 22 percent individual ownership, either directly or through mutual funds, down from 25 percent in 1999.

Bond Trading

Unlike the stock market, trading in the U.S. bond market is done primarily over

the counter (OTC). The OTC market is quite different from the organized exchanges

on which most stocks trade. There is no central location or computer network in the

OTC market. Rather, the OTC market is comprised of a large number of brokers

and dealers who deal with each other by computer or telephone on behalf of buyers

and sellers. Over-the-counter trading dominates the municipal bond market to a

greater extent than other segments of the bond market. Traditionally, the municipal

bond market has existed in localized state and municipal markets, where there was

a small community of buyers and sellers and little National interest.

Today, municipal bonds are a significant part of U.S. financial markets, but the

diverse and decentralized nature of the market still discourages development of an

organized exchange. Several overriding characteristics of the municipal bond market

make it likely that OTC trading will continue to dominate going forward:

• Market size and trading volumes. Notwithstanding its growth in recent years,

the municipal bond market is considerably smaller in value relative to the stock

and corporate/foreign bond markets. Appendix B shows that at the end of 2003

the corporate stock market totaled $15.5 trillion; the combined corporate/foreign

bond market was $6.8 trillion; and the municipal bond market was $1.9 trillion.

The municipal bond market is also considerably smaller in terms of trading volumes. The daily buying and selling of municipal bonds involves less than 1 percent of the market. There are about 30,000 daily trades involving 10,000 issues

in municipal bonds compared to an average of 4 billion shares traded daily on

major equity markets.

• Number of issuers. The municipal bond market is significantly more diverse and

larger than the stock and corporate/foreign bond markets in terms of the numbers

of issuers. The stock market, for example, consists of approximately 8,500 issues

that trade electronically or on the New York, Nasdaq and American Stock Exchanges. The corporate bond market consists of about 7,300 issuers. By contrast,

the municipal bond market is comprised of over 51,000 issuers and has about 1.3

million different securities outstanding.

• Lack of concentration. The municipal bond market is significantly less concentrated than the corporate bond market in terms of underwriting activities. ApVerDate 11-MAY-2000 20:23 Jun 02, 2006 Jkt 025856 PO 00000 Frm 00068 Fmt 6633 Sfmt 6621 26179.TXT SBANK4 PsN: SBANK4
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3Price transparency refers to a buyer’s and seller’s ability to obtain current and accurate valuation information and bid/ask spreads on a particular bond. 4 In contrast, price transparency in the Treasury market has been excellent as it is a highly

liquid, single issuer market with several trillion dollars in frequently traded outstanding debt.

All levels of investors from institutions to individuals have access to reliable and thorough

Treasury bond information.

pendix C lists the top 10 underwriters in the corporate and municipal bond markets. In the corporate bond market, the top 10 underwriters account for 84.85 percent of the underwritings, compared to 69.05 percent in the municipal bond market. The average issue size in the corporate bond market ($ 122,938,000) is nearly

five times larger than the average issue size in the municipal bond market ($

26,659,000).

The diverse and decentralized features of the municipal bond market make it difficult to centralize trading at a limited number of trading locations, and it is unlikely that an organized National exchange will evolve in the municipal bond market in the immediate future.

Bond Pricing Transparency

Substantial progress has been made with respect to price transparency in both

the corporate and municipal bond markets.3

Corporate Bond Market Price Transparency

Price transparency in the corporate bond market has traditionally been problematic, particularly for individual investors.4 Until recent years, corporate bond buyers

had to rely on broker/dealer bid/ask spreads to obtain pricing information. Buyers

had no way of knowing whether the bid/ask spread they were being given was reasonable or if they were being asked to overpay. There was no centralized exchange

where recent trade prices were reported. Large institutional investors had a distinct

advantage over smaller investors because they had access to multiple dealers. They

could ‘‘shop’’ for bonds by calling on a number of dealers and purchasing from the

dealer that was offering the lowest price.

In recent years, price transparency has improved because of the central reporting

system developed by the National Association of Securities Dealers, called the Trade

Reporting and Compliance Engine (TRACE). Recent improvements to TRACE have

resulted in a greater number of corporate bond trades being reported to the market

in a shorter period of time following execution. Brokers and dealers who are members of the NASD are required to report corporate bond transactions on a same-day

basis for both investment grade and a very limited number of high-yield securities.

Thinly traded corporate bonds remain difficult to price as they are not continuously

traded and, therefore, not frequently reported on TRACE.

Municipal Bond Market Price Transparency

The MSRB has made important progress on pricing transparency in the last 10

years. Efforts by the MSRB to improve reporting began in 1994 when inter-dealer

transactions were first required to be reported. In 1998, dealers began reporting customer trades, and the MSRB began reporting next-day price information on both

inter-dealer and customer transactions involving bonds that traded four or more

times per day. Price transparency developed further in 2000 when individual trade

data was reported. In 2003, the MSRB began T+1 reporting for municipal bond

transactions and eliminated the threshold that only mandated reporting on bonds

that traded four or more times per day. And, finally, a new MSRB rule (Rule G–

14), which is scheduled to become effective in the beginning of 2005, would require

brokers and dealers to report transactions in municipal securities within 15 minutes

of the time of trade. We believe that increasing municipal bond market price transparency and comparability to other over-the-counter fixed income markets will improve investor confidence in the municipal market.

There are many potential benefits to improved price transparency. Mutual funds,

for example, would be able to use reported bond prices to improve pricing of fund

portfolios. Also, enhanced price transparency would likely narrow bid-ask spreads

and give consistency to spreads among large and small investors. It would also allow

regulators to better monitor the market. Data suggests that limited price transparency disadvantages small investors because spreads are bigger when trades are

smaller. Appendix D demonstrates how bid/ask spreads narrow as trade sizes increase. As shown on Appendix D, a trade between $0 and $50,000 on a randomly

selected day in September 2003 was an average of 190 basis points wider than

trades of over $1 million.

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Some municipal market participants do not support the MSRB in its efforts to increase pricing transparency, especially for inactively traded securities (which often

are of lower quality). They argue that the market liquidity of these issues would

decrease as dealers become concerned about competitors knowing the approximate

price of their newly acquired positions. We disagree. Any short-term dislocations

would be inconsequential compared to the long-term benefits offered by enhanced

pricing transparency. The interests of the millions of mutual fund shareholders and

individual bondholders are best served with the highest degree of price transparency.

Appendix E summarizes the efforts by the NASD to increase price transparency

in the corporate bond market through the TRACE central reporting system, and the

recent MSRB initiative to implement real-time reporting of pricing information in

the municipal bond market.

Issuer Financial Condition Transparency

Historical Context

Although considerable progress has been made with respect to pricing transparency in recent years, issuer financial condition transparency is proceeding slowly

in the municipal bond market. The cost of mandating issuer financial condition disclosure has been considered prohibitive for smaller issuers; however, technology may

afford new and unprecedented opportunities to provide institutional and individual

investors with consistent and appropriate financial information to make informed

investment decisions.

At the time Congress was enacting sweeping new securities laws in the 1930s,

municipal bonds were largely exempted from Federal regulation. They were made

subject to the securities laws’ general antifraud provisions so that market participants could be disciplined for misleading and fraudulent behavior. However, municipal securities were not subject to the same registration and reporting requirements

that applied to equity and corporate issuers. At the time the new securities laws

were enacted, municipal securities were deemed to be local in nature and relatively

straightforward general obligation bonds. There had been no large-scale municipal

securities defaults that threatened the integrity of the market, as had happened in

other segments of the financial markets.

Since the 1930s, all of the factors that convinced lawmakers to impose limited

Federal oversight of the municipal bond market have changed. The localized nature

of the market is gone and municipal bonds trade on a Nationwide scale. The market

no longer consists solely of straightforward general obligation bonds but also is now

comprised of complex instruments. There are sophisticated varieties of revenue

bonds that are not backed by governmental full faith and credit. And, finally, the

municipal bond market was touched by a number of defaults that caused legislators

and regulators to take action.

The MSRB and the Tower Amendment

In the 1970’s, Congress responded to a large-scale fiscal crisis involving municipal

debt obligations in New York City. The Securities Acts Amendments of 1975 resulted in unprecedented Federal intervention into the municipal bond market. The

1975 amendments created the MSRB, a self-regulatory agency designed to enhance

investor protection subject to SEC oversight. However, in order to balance investor

protection with states’ rights, Congress placed restrictions on Federal regulators by

including the Tower Amendment with the 1975 amendments.

The Tower Amendment limits the SEC’s and MSRB’s ability to regulate municipal

bond issuers in the same way that the SEC regulates stock and corporate bond markets. Issuers cannot be required to file with the SEC or MSRB ′′prior to sale′′ any

application, report, or document in connection with issuance, sale, or distribution of

securities.

SEC Rule 15c2–12

In the late 1980’s, there was another large crisis in the municipal bond market,

this time resulting in a bond default by the Washington Public Power Supply System. In response, the SEC took steps to improve municipal bond financial disclosure

by mandating certain limited disclosures by municipal bond underwriters and dealers under SEC rule 15c2–12. Because the SEC is restricted by the Tower Amendment from directly regulating municipal bond issuers, rule 15c2–12 regulates only

bond underwriters and dealers.

SEC rule 15c2–12 requires primary bond offerings over $1 million to be accompanied by certain limited financial information. Specifically, rule 15c2–12 requires

that municipal bond underwriters obtain ‘‘official statements’’ from issuers and review them before the initial distribution. Underwriters are obligated to provide inVerDate 11-MAY-2000 20:23 Jun 02, 2006 Jkt 025856 PO 00000 Frm 00070 Fmt 6633 Sfmt 6621 26179.TXT SBANK4 PsN: SBANK4
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vestors with the ‘‘official statement’’ so that investors can obtain certain limited information about a particular bond before purchasing it.

Under rule 15c2–12, there is also a unique, albeit limited, requirement for secondary market disclosure with respect to long-term debt. Underwriters, pursuant to

written agreements by issuers, are required to obtain limited annual financial information and notice of certain material subsequent events. Secondary market information is distributed through a private network of information repositories, known

as Nationally Recognized Municipal Securities Information Repositories. An issuer

selling directly to investors without assistance of underwriters or dealers is not subject to rule 15c2–12.

Conclusion

Voluntary steps taken by issuers, self-regulatory organizations and investors to

improve price transparency in the corporate and municipal bond markets should be

commended. As a fiduciary responsible for the investments of hundreds of thousands of municipal bond fund investors, Vanguard strongly supports the MSRB’s efforts to improve price transparency in the municipal bond market, and Vanguard

recommends that these efforts continue as they have enhanced investor protection.

In addition to price transparency, efforts should continue to improve financial condition transparency in the municipal bond market. We commend voluntary efforts

by industry participants to enhance secondary market disclosure concerning issuer

financial conditions, and encourage such work to continue. The SEC’s previous efforts to improve disclosure through rule 15c2–12 have been effective and beneficial.

However, Vanguard recommends that lawmakers and regulators continue to monitor developments and consider whether more may be done to improve issuer financial condition transparency in the municipal bond market for the protection and

benefit of municipal bond investors.

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1See Hong and Warga (2000) for evidence on cost structure in the corporate bond market.

There is no formal definition of an institutional versus retail trade. For the purpose of this discussion we call any trade of less than or equal to 100 bonds ($100,000 par value) retail, and

any trade equal to or greater than 500 bonds (.5 million par) institutional. The grey area will

go unnamed. 2The factor 5 refers to median bid/ask spreads. The most trustworthy evidence for this claim

comes from studies of retail-sized trades in the municipal bond market. An article forthcoming

in the Journal of Fixed Income by Hong and Warga (2004) and a study by the SEC (Harris and

Piwowar (2004)) both reveal bid-ask spreads (cost of a round-trip transaction) for retail-sized

transactions averaging well over 2 percent of par value. There is no published evidence on retailsized bid-ask spreads in the dealer market, but based on my discussions with NASD and my

involvement with the bond market transparency initiatives there I believe the cost structure to

be similar to that found in municipal securities. 3See Appendix A for a description of this market.

4See Hong and Warga (2000)

5 According to newswire reports I have read recently, registration requirements mandated by

the ABS’s exchange status (and that are not imposed on the dealer market) are viewed by the

NYSE as a significant hurdle to achieving levels of liquidity that would help make ABS a more

viable market for retail trades.

PREPARED STATEMENT OF ARTHUR WARGA

DEAN, C.T. BAUER COLLEGE OF BUSINESS

JUDGE JAMES A. ELKINS PROFESSOR OF BANKING AND FINANCE

UNIVERSITY OF HOUSTON

JUNE 17, 2004

The purpose of this report is to provide the Senate Banking committee with my

perspective of the domestic corporate and municipal bond markets with regard to

current issues including market structure, regulatory framework, trade reporting

and price transparency. My focus will be on the potential benefits of greater price

transparency, but I will also comment briefly on several of the other issues.

Overview

The bond markets have evolved into an over-the-counter system geared to institutional-sized transactions. The cost structure for both corporate and municipal securities in this market appears to be competitive for institutional-sized trades.1 The cost

of transacting retail-sized trades carried out in this dealer-market can best be described as ‘‘punishing’’, and are five times the size of those found for institutionalsized trades.2 In the dealer market, about 65 percent of corporate bond trades are

retail-sized, but these trades only generate 1.8 percent of the dollar volume of trade

in the market. This contrasts with the municipal market, where retail trades also

comprise the majority of activity, but account for 40-50 percent of the dollar volume.

Trades carried out on the NYSE’s Automated Bond System (ABS) 3 are almost exclusively retail-sized and reveal a cost of trade similar to the institutional-sized

trade costs in the dealer market 4, although commissions can significantly increase

the net cost for very small trades (say five bonds or less). It would be helpful if the

NASD included a comparison of the known trading costs on ABS with the yet-tobe-revealed (as least publicly) trading costs in the dealer market in their current

study of the trading environment. This comparison will also aid the SEC in determining potential benefits of removing obstacles to retail-trade activity on the ABS

or like system. 5

The Value of Transparency

To begin, I believe it is important to understand that in any market transparency

is of greatest potential value when the underlying security is one that the marketplace has a structural need to trade on a frequent basis. I believe that even in a

transparency-enhancing environment in which all bond transactions are reported

centrally and publicly in a short period of time after they occur, there will always

be large segments of the bond universe for which a lack of transparency and liquidity remains because of the fundamental characteristics of bonds.

Liquidity is the ability to transact over a short period of time without adversely

affecting the price of a security. It has been suggested that liquidity can be enhanced by introducing price transparency because the market has pent up demand

for trading securities and that transparency leads to greater willingness to trade.

The opposite contention is also likely to be true. That is, a fundamental lack of demand to trade can create a lack of transparency that is wholly independent of the

presence of a transparency-enhancing environment. Trade and liquidity in bonds declines rapidly a short period after a bond is first issued. This is because bonds are

for the most part what is referred to as ‘‘buy and hold’’ securities.

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6 I ignore the long-standing FIPS high yield trade reporting initiative that has been based on

only 50 issues representing the most liquid portion of the high yield market because of the small

number of bonds and representation by issues least likely to have information problems in the

market. 7 A partial list of examples are Merrill Lynch Bond Pricing Service (for corporates), Mueller

and J.J. Kenny (for municipals). 8 Because of liquidity effects, bond price is also properly viewed as a function of quantity purchased or sold, and it is not clear that adequate information is provided in the current TRACE

system to add much value to pricing algorithms that account for quantity effects. This is more

of a problem for high yield than for investment grade issues. 9This is documented, for example, by Schultz (2001). This effect is also apparent with U.S.

Treasury issues. See Sarig and Warga (1989) for documentation of this effect.

Figure 1 provides typical values of volatility for a variety of securities. Volatility

generally correlates positively with the value of adding transparency. If there is an

underlying demand to trade frequently then transparency can help a market be

more liquid. Volatility causes portfolio holdings to need readjustment, which in turn

generates a need to trade.

There are markets where transparency has the potential to add liquidity, but the

market is young and hasn’t evolved into and efficient form. Prime examples are the

energy markets. While exchange-traded products currently exist for oil and gas,

there are still many nonexchange traded securities for which the markets are virtually opaque or dependent on newsletter-like surveys for price discovery (that is

Platts). At the extreme, the market for power several months to several years out

into the future lacks any transparency, and yet the potential benefits of transparency are (I believe) very large. In the very least, the payoff of more credible

marked-to market accounting calculations in the energy sector would seem to be

worth the effort of fast-forwarding transparency in this market sector.

Within the bond markets, the greatest potential benefit of transparency is in the

high yield sector. It is interesting that the NASD’s TRACE initiative remains to this

day silent in its public reporting of high yield transactions,6 although I am aware

that such reporting is inevitable. The NASD is to be commended on their TRACE

initiative in that they have developed a powerful reporting tool capable of providing

nearly immediate trade reports for a broad range of bonds. This initiative follows

in the heels of the MSRB’s price reporting initiative, and the two projects have created a sea-change in terms of the bond markets’ ability to provide transparency for

actual transactions. These price reporting initiatives do not provide transparency in

terms of supply and demand schedules. That is, unlike a system such as ABS, they

do not allow potential buyers and sellers to view actual firm offers to buy or sell

a given quantity of a bond at a given price.

One of the main benefits of TRACE and the MSRB price reporting systems is that

quality data will be more broadly available for market participants to employ in

models that help determine estimated prices for securities that trade infrequently

(the vast majority of bonds fall under this category). Net Asset Value (NAV) calculations for bond mutual funds have always been (in my mind) a very problematic exercise carried out with prices supplied by bond pricing services7 that are naturally

handicapped by the lack of immediate access to actual transaction prices.8

Investment-Grade Bond Trades

Corporate and municipal bonds, especially investment grade issues, are purchased

primarily as nonspeculative investments. On the institutional buy-side, bonds are

purchased because they satisfy certain criteria that a bond portfolio manager seeks.

Their behavior is much more predictable than stocks, and so it is possible to know

a lot about how they will fit into the manager’s portfolio over much of their life.

Portfolio managers rarely purchase investment-grade corporate bonds with the intention of selling them in the near term. As bonds age past their issuance date and

are absorbed into portfolios, their liquidity rapidly disappears.9 The fact is most

bonds do not trade on any given day (or week, or even month) because there is no

reason for them to trade.

It is worth noting the historical evolution of both stock and bond markets in the

United States. The New York Stock Exchange, which provides a central and immediate reporting system, originally began as a bond exchange. The simple fact is that

the speculative nature of stocks and high demand for frequent trading in them naturally led to a market system vastly different from bonds. In the natural evolution

of markets transparency is a consequence of the type of security being traded and

investor’s demand for frequent trade. If the securities being traded do not by their

nature require frequent trading, then it is perfectly reasonable to find that the market for those securities has evolved into a system with less apparent transparency

than, say, a stock market.

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10 Examples are creating a dedicated portfolio meant to meet pension fund obligations, or a

portfolio that is immunized against adverse interest rate movements. 11The largest and most sophisticated buy-side firms carry out most of their portfolio analysis

with proprietary systems built in-house, and probably would prefer a market structure where

broker-dealers offer as few services as possible. 12See the Appendix for a description and further discussion of ABS. 13 Hong and Warga (2000) calculate bid-ask spreads of 13 basis points for investment grade,

and 20 basis points for noninvestment grade issues. Consistent results are found in Schultz

(2001) and Chakravarty and Sarkar (2003) using the same data base. 14See Blume, Keim, and Patel (1991).

It is important to reemphasize the point that for corporate bonds, institutional

buyers account for 98 percent of the dollar volume of trade. These buyers are professionals, often with the staff necessary to call multiple dealers. Dealers in turn often

call upon professional staffs to provide additional portfolio services demanded by

buyers. Indeed, bid-ask spreads often include implicitly costs for services required

by buyers (such as solving portfolio, research, and strategy problems) 10. Markets

have evolved in a manner to permit dealers to bundle these portfolio services, which

often require near-immediate trade execution.11 Electronic trade and reporting systems are not capable of providing this bundle of services that is demanded by institutional investors. This provides at least a partial explanation as to why the NYSE’s

Automated Bond System (ABS) has succeeded only in attracting retail-sized

trades.12

If bid-ask spreads are restricted to institutional sized trades of at least 500 bonds

(.5 million par value), bid-ask spreads13 for corporate bonds are in the range of 7

to 15 basis points (100 basis points equals 1 percent). The bid-ask spreads for these

trades, which are in fact typical of corporate bond market activity, rival the bid-ask

spreads of about 10 basis points found for the highest capitalization stocks on the

New York Stock Exchange.

For investment grade bonds it is usually the case that price can be estimated

within a narrow range of the correct value. The real question of interest to a buyer

is what type of bond would his/her portfolio optimally require to meet its investment

goal, and where would an appropriate inventory of that type of bond be found. Investment grade debt is characterized by the fact that there are often many nearperfect substitutes available. In other words, the demand by a portfolio manager is

not necessarily for, say, a bond issued and backed by Citigroup, but in fact for an

issue from an ‘‘A’’ corporate financial institution. Dealers therefore often play the

role of providing the service of solving a portfolio strategy-related problem for a client, and then having in inventory certain classes of bonds (along with information

about the covenants and other qualifying characteristics) so that the buyer will be

assured of carrying out their fiduciary responsibility.

Non-investment Grade Bond Trades

Non-investment grade debt contains a greater level of price risk, and this translates into more situations where the owner no longer finds that the bond qualifies

for his/her portfolio. Also, the speculative motive to trade is greater than for investment grade issues.14 Unlike stock or investment grade bonds, the noninvestment

grade corporate bond universe contains many issues from companies that are private. This means that information is harder to come by, and credit analysis becomes

critical (this latter point is true even for public issues). Dealers maintain research

departments to track changes in such companies, and this is a function that institutional buyers are not always equipped to carry out because of the great expense.

High credit risk is often claimed to be captured in bond ratings. However, even

if a bond is rated, when the information about a change in credit risk is needed

most, the rating usually fails to reflect it. This is because bond ratings are only confirmatory in nature (and by design). Rating agencies often do not change ratings

until several months after the event that triggers the need for a rating change (see

Warga and Welch (1993)). Ratings can change 5–6 months after the marketplace

has already acknowledged a change in credit risk through significant price moves

(Hite and Warga (1997)).

The discussion above points to why institutional buyers often have established relationships with dealers, and the reason is the ‘‘value-added’’. Dealers can provide

important services without charging an explicit fee because their costs can be embedded in their bid-ask spreads. While some of the services sought by buyers can

be unbundled and provided by third parties, it is often convenient to have ‘‘one-stop

shopping’’. For all of the aforementioned reasons, it is not surprising to find that

retail trades carried out in the dealer market face a cost structure that is much

higher than it probably needs to be.

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15See www.investinginbonds.com. The service started out reporting high-low prices for the day

and quickly proceeded to add individual trade details. It is my understanding that near realtime reporting of municipal bond transactions is imminent.

Municipal Bond Trading

The Municipal Bond market differs greatly from the corporate bond market in

several respects. The prime differentiator is that a significant portion of this market

involves retail-sized trades (100 bonds or less) for individual accounts. According to

the Bond Market Association (BMA) as of 2 years ago there were 1.4 million Municipal issues outstanding (about 10 times the number of corporate issues). The tax advantages enjoyed by many munis and their low degree of risk (most are ‘‘AAA’’, a

rating often achieved through ‘‘prerefunding’’ or insurance) make them an attractive

investment for many individuals as a hedge against their stock and other investments. There is often little speculative motive in their purchase, even less than for

high-grade corporates. Relatively small issue sizes and obscure details about specific

revenue projects or taxing authority rights and privileges make these securities

even less transparent than most corporates.

The muni market underwent a dramatic change in the level of price transparency

beginning in 1999. The Municipal Securities Rule Board (MSRB) through the Bond

Market Association (BMA) has made next-day pricing and quantity available

through a web site and data service.15 Aside from price and quantity of each transaction, it is also possible now to obtain the time of the transaction and whether the

trade was a dealer buy, a dealer sale, or dealer-dealer. In a short period of time

the muni market went from being one of the more opaque markets to one of the

more transparent ones.

The effects of muni transparency provide a cautionary tale for those purporting

dramatic changes in the corporate market. Munis remain relatively illiquid, as illustrated by the persistence of bid-ask spreads to remain at or above their previous

levels. In research I have conducted based on a complete record of muni transactions in May of 2000, and for transactions in Texas and Florida in September of

2000, it is clear that spreads are at or above the levels cited for comparable issues

in the study by Chakravarty and Sarkar (2003) that is based on transactions from

1995–1997. This observation is also confirmed in work described recently in The

Wall Street Journal by the SEC Chief Economist Lawrence Harris and staff economist Michael Piwowar (2004) who also examine data from the year 2000.

While an update through 2004 is needed to confirm the continued high cost of

transacting in the muni market (for retail trades), it is safe to say that the transparency added by the price reporting system put in place by the MSRB is at best

having a slow-moving effect on the cost structure for municipal trades. This simply

reflects the fact that the market is geared to institutional trading and/or is dealing

with complex securities that require a costly trading environment.

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APPENDIX A—THE NEW YORK STOCK EXCHANGE’S ABS SYSTEM

Since 1976–77 bonds have traded on the NYSE’s Automated Bond System (ABS),

which can be described as a fully automated electronic trading and information system whose schedules of bid and ask prices are fully transparent. In general, trading

on ABS is relatively thin and trades on the ABS are typically retail-sized (under

one hundred bonds).

Despite the small size of the ABS market, the most actively traded issues not only

rival the dealer market in terms of both frequency of trade and dollar volume of

trade, but in some cases even dominate the dealer market. In a recent paper examining hourly trade reports from the Nasdaq-based Fixed Income Pricing System

(FIPS), Hotchkiss and Ronen (2002) find that fourteen ABS-traded bonds have median transaction frequency equal to twenty-five percent of the entire dealer market,

with a high figure of eighty-one percent. Based on actual transaction data collected

over the 1995–1997 period, Kalimipalli and Warga (2002) find more direct evidence

that frequently traded bonds on ABS often have volume equal to or exceeding the

entire dealer market. Frequently traded bonds on ABS are almost exclusively noninvestment grade.

Unlike its counterpart stock market, there is no specialist in the NYSE bond market. Instead, there are brokers who are subscribing members of the ABS. As of 2002,

there were 58 ABS member brokers operating on about 210 terminals. The member

brokers usually trade on behalf of their customers, though at times they could trade

for their own account. Member brokers receive limit orders from the public and

enter the corresponding bid-ask quotes and the respective quantities into the automated system. They also enter their own quotes into the system. Liquidity to the

ABS market is therefore jointly supplied by public limit orders and dealers’ own

quotes. The ABS matches the orders automatically and informs the member brokers

once an order is executed. The ABS is thus a limit order market with a strict pricetime priority. The ABS market is also very transparent. All subscribers to the ABS

market have full access to the complete order schedule, which they can divulge to

investors upon request.

REFERENCES

Bloomfield, R., and M. O’Hara, 1999. ‘‘Can Transparent Markets Survive?’’

Journal of Financial Economics.

Blume, M.,D. Keim, and S. Patel, 1991. ‘‘Returns and Volatility of Low Grade

Bonds, 1977-1989.’’ Journal of Finance, vol.46, no.1, March.

Chakravarty, S. , and A. Sarkar, ‘‘Trading Costs in Three U.S. Bond Markets,’’

Journal of Fixed Income, 2003 June, Vol.13, No.1.

Harris, Lawrence and M. Piwowar, ‘‘Municipal Bond Liquidity.’’ SEC manuscript. 2004.

Hite, G., and A. Warga, ‘‘The Effect of Bond Rating Changes on Bond Price Performance’’ (with G. Hite), Financial Analysts Journal, Vol. 53, No.3, May/June

1997. . Abstracted in CFA Digest.

Hong, G. and A. Warga. ‘‘An Empirical Study of Bond Market Transactions,’’

Financial Analysts Journal, March/April 2000.

Hong, G. and A. Warga (2004), ‘‘Municipal Marketability,’’ forthcoming, Journal

of Fixed Income.

Hotchkiss, E. and T. Ronen, 2002. ‘‘The Informational Efficiency of the Corporate Bond Market: An Intraday Analysis.’’ Review of Financial Studies., Vol.

15, No.5

Kalimipalli, M. and A. Warga, 2002. ‘‘Bid/Ask Spread and Volatility in the Corporate Bond Market.’’ Journal of Fixed Income, March.

Madhavan, A, 1995. ‘‘Consolidation, Fragmentation, and the Disclosure of Trading Information,’’ Review of Financial Studies, Vol. 8, No. 3; Fall.

Sarig, O. and A. Warga. ‘‘Bond Price Data and Bond Market Liquidity,’’ Journal

of Financial and Quantitative Analysis; September 1989, Vol.24, No.3.

Schultz, Paul, ‘‘Corporate Bond Trading Costs: A Peek Behind the Curtain,’’

Journal of Finance, 2001, v56(2), 677–698

Warga, A., and I. Welch. ‘‘Bondholder Losses in Leveraged Buyouts,’’ Review of

Financial Studies, Vol. 6, No. 4; December 1993.

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