Municipal Securities: Overview of Market Structure, Pricing, and Regulation
Published: 2012-01-17T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Municipal securities are debt instruments that state and local governments typically issue to finance diverse projects. Individual investors, through direct purchases or investment funds, own 75 percent of the estimated $3.7 trillion in municipal securities in the U.S. market. In the secondary market, where these securities are bought and sold after issuance, trading largely occurs in over-the-counter markets that are less liquid and less transparent than the exchange-traded equity securities market. The Dodd-Frank Wall Street Reform and Consumer Protection Act required GAO to review several aspects of the municipal securities market, including the mechanisms for trading, price discovery, and price transparency. This report examines (1) municipal security trading in the secondary market and the factors that affect the prices investors receive, and (2) the Securities and Exchange Commissions (SEC) and self-regulatory organizations (SRO) enforcement of rules on fair pricing and timely reporting. For this work, GAO analyzed trade data, reviewed federal regulators programs for enforcing trading rules, and interviewed market participants and federal regulators.
section_title: What GAO Found
paragraphs: In the secondary market for municipal securities, both institutional and individual investors trade through brokers, dealers, and banks (broker-dealers). However, GAO analysis of trade data showed that institutional investors generally trade at more favorable prices than individual investors. Broker-dealers said these differences generally reflected the higher average transaction costs associated with trading individual investors smaller blocks of securities. Market participants added that institutional investors have more resources, including networks of broker-dealers, and the expertise to independently assess prices. In recent years, the Municipal Securities Rulemaking Board (MSRB)an SRO that writes rules regulating the broker-dealers that trade municipal securitieshas required timely and public posting of trade prices in an effort to make post-trade price information more widely available. However, unlike the equities market, the relatively illiquid municipal market lacks centrally posted and continuous quotes, and other sources of pretrade price information are not centralized or publicly available to individual investors. In 2010, SEC began a review of the municipal securities market, in part to examine pretrade price information. MSRB has also begun a study that includes a review of the market structure to determine whether access to additional pretrade price information could improve pricing and liquidity. Both SEC and MSRB plan to complete these studies in 2012.
Several regulators share responsibility for overseeing the municipal securities market. The Financial Industry Regulatory Authority (FINRA)an SRO that regulates 98 percent of the broker-dealers that trade municipal securitiesand federal banking regulators enforce broker-dealer compliance with MSRB rules under their respective jurisdictions through electronic surveillances of trade data and routine examinations. SEC evaluates the quality of FINRA and MSRBs municipal regulatory programs through its SRO inspection program, which has recently evolved to a risk-based approach. SEC last inspected MSRB and FINRAs fixed-income surveillance program, which encompass municipal securities trading, in 2005. SEC staff said that staffing constraints have prevented them from conducting inspections of these SROs sooner, although they have recently begun a new inspection of FINRAs fixed-income surveillance program. SECs limited monitoring of FINRA and MSRB between inspections may not be sufficient to support its new risk-based inspection approach. For example, SECs last inspection of FINRAs fixed-income surveillance program predated the financial crisisand its ensuing volatility in the municipal marketbut SEC had collected limited information since its last inspection that would help it assess the quality of FINRAs broker-dealer oversight. SEC currently receives periodic reports from FINRA that provide statistical information on its regulatory activities related to municipal securities trading. According to SEC staff, while they might be able to use the reports to identify significant deviations in FINRAs efforts, they cannot use them solely to determine the effectiveness of FINRAs municipal securities program. Without ongoing collection and analysis of information to assess the effectiveness of SROs regulatory programs, SEC may be unable to identify and act on regulatory problems in a timely manner.
section_title: What GAO Recommends
paragraphs: GAO recommends that SEC collect and analyze information on SROs fixed-income regulatory programs on an ongoing basis to better inform its risk-based inspection approach. SEC agreed, but noted it would need additional resources to conduct more frequent oversight of the SROs. Such ongoing monitoring, however, could help SEC better leverage its resources for inspections.

section_title: Letter
paragraphs: Municipal securities are debt instruments that state and local  governments issue to finance transportation, housing, hospitals,  education, and diverse other projects. The market for these securities is  worth an estimated $3.7 trillion, with individuals holding 75 percent of the  total outstanding, either indirectly through investment funds or directly  through purchases with broker-dealers. But the size, heterogeneity, and  other characteristics of this market create challenges, especially in terms  of pricing. For example, municipal securities are traded primarily through  decentralized, dealer-mediated, over-the-counter (OTC) markets that  provide less liquidity and less price transparency than other securities  markets, such as the exchange-traded equity market. There is no central  facility that publicly posts quotes on all securities trading, as there is in  some equities markets. The relative lack of pretrade transparency in the  municipal securities market has raised questions about whether individual  investors, that is, those who buy and sell securities for themselves directly  through broker-dealers, have sufficient price information to make well- informed investment decisions regarding the securities they wish to buy  and sell in the secondary market, where municipal securities are traded  after they are issued.
The Municipal Securities Rulemaking Board (MSRB) is a self-regulatory  organization (SRO) that writes rules regulating the brokers, dealers, and  banks (collectively referred to as broker-dealers in this report) that  underwrite, sell, and trade municipal securities. MSRB has also issued a  number of rules governing municipal trades. Among other things, these  rules require broker-dealers to trade municipal securities for their investor  customers at fair and reasonable prices and to report their municipal  trades in a timely and accurate manner. However, MSRB does not have  the authority to enforce these rules and relies instead on the Financial  Industry Regulatory Authority, Inc. (FINRA)—an SRO for broker-dealers,  federal banking regulators, and the Securities and Exchange Commission  (SEC). SEC also provides oversight of MSRB and FINRA.
Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203,  §977, 124 Stat. 1376, 1924 (2010). trends in the enforcement of these rules. We address the potential uses  of derivatives by municipal issuers in appendix I of the report.
To address municipal security trading in the secondary market, we  analyzed MSRB trade data from the Real-Time Transaction Reporting  System (RTRS)—the system to which broker-dealers report their municipal  securities trades—for the period from 2005 to 2010. In so doing, we  reviewed information from MSRB on the policies and procedures it used to  ensure that the data were complete and accurate and determined that the  data were reliable for our purpose. In addition, we reviewed studies and  industry literature. We interviewed members of trade organizations  representing institutional investors (mutual funds and other investment  management companies, insurance companies, and banks that possess or  control considerable assets for large-scale investing), broker-dealers  (including broker’s brokers), and individual investors; officials from  independent municipal market research and advisory firms; and officials  from SEC’s Office of Municipal Securities and MSRB. We attended and  viewed SEC’s field hearings on the state of the municipal securities market.  We also received demonstrations of and interviewed officials from an  alternative trading system (ATS) specializing in the electronic trading of  municipal securities and of Bloomberg, L.P. (Bloomberg), which provides  information and other services related to municipal securities trading.
To address the regulators’ enforcement of rules on fair pricing and timely  reporting, we reviewed MSRB rules and draft rules related to the pricing  of municipal securities, trade reporting, and clearance and settlement of  municipal securities transactions. We reviewed MSRB data from RTRS  on the number of trades that MSRB determined were reported late for  each year from January 2005 to July 2011. We reviewed documentation  related to FINRA’s programs for surveilling RTRS data for potential  violations of MSRB pricing and trade reporting rules and examination  procedures used by FINRA, federal banking regulators, and SEC’s Office  of Compliance Inspections and Examinations (OCIE) to assess broker- dealers’ compliance with these rules. We reviewed samples of municipal  broker-dealer examinations conducted from 2002 to 2010 by OCIE and  from 2006 to 2010 by FINRA and federal banking regulators. In addition,  we reviewed OCIE’s guidance for conducting SRO inspections and  reviewed the most recent inspections of MSRB and FINRA’s fixed-income  program conducted in 2002 and 2005. We also reviewed OCIE’s 2009  inspections of two SROs that clear and settle municipal, corporate, and  equity securities transactions—the Depository Trust Company (DTC) and  the National Securities Clearing Corporation (NSCC). Further, we looked  at relevant documentation pertaining to coordination among the SEC,  FINRA, MSRB, and federal banking regulators—the Board of Governors  of the Federal Reserve System (Federal Reserve), the Federal Deposit  Insurance Corporation (FDIC), and the Office of the Comptroller of the  Currency (OCC)—in conducting oversight of the municipal securities  market and interviewed officials from these entities.
We conducted this performance audit from November 2010 to January  2012 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. Appendix II  provides a more detailed description of our scope and methodology.
subsections: section_title: Background
paragraphs: The municipal securities market comprises both primary and secondary  markets. In the primary market, underwriters buy new securities from  municipal issuers (e.g., local government entities) and subsequently sell  them to investors during the primary offering.trade after the primary offering are said to trade in the secondary market,   Municipal securities that  with both institutions and individuals participating. Institutional investors  typically trade municipal securities in amounts of $1 million or more and  generally are in the market full-time to provide or preserve income as well  as maximize investment returns for their clients or firms. In contrast,  individual investors typically trade municipal securities in amounts of  $100,000 or less and access the market relatively infrequently, with the  intent to buy and hold securities until maturity.
Many individual investors find municipal securities an attractive  investment option because of the tax advantages these intruments offer.  Unlike the dividends on equity securities (which also trade in a market  with considerable individual investor participation), the interest on most  municipal securities is exempt from federal income tax and, in some  cases, from state or local income tax. In addition, as debt instruments municipal securities are generally considered less risky than equity  securities. For example, issuers of debt securities have a contractual  obligation to return the principal value of the security to the holder at  maturity, while issuers of equity securities do not. Further, issuers of debt  securities also have a contractual obligation to pay investors a fixed or  variable rate of interest income. On the other hand, dividend payments to  shareholders of equity securities are decided by the company’s board of  directors.
subsections: section_title: Municipal Securities and Secondary Market Structure
paragraphs: Data on the number of municipal issuers and outstanding municipal  securities are not officially tracked by regulators or the private sector.  Third-party information vendors provide a range of estimates; data we  obtained from one indicated the municipal securities market has over  46,000 municipal issuers, including states, counties, cities, towns, and  state and local government agencies, among others, and at least 1.1  million securities outstanding. In contrast, about 5,700 public companies  list their equity securities for trading on the major U.S. exchanges. Each  municipal issuance is unique, with its own credit structure, terms, and  conditions. Most outstanding municipal securities trade infrequently—for  example, in 2010 about 99 percent of outstanding municipal securities did  not trade on any given day. The heaviest trading of municipal securities  typically occurs immediately following their issuance, after which trading  becomes sporadic.
The municipal securities market is geographically fragmented, with  secondary market trading supported by national and regional broker- dealer firms that serve institutional investors (institutional broker-dealers)  or individual investors (retail broker-dealers), and in some firms, both.  Several national broker-dealer firms have enough capital and geographic  presence to underwrite large new issuances nationwide, trade in large  volume with institutional investors, and offer expertise in virtually every  sector of the market. Some midsized broker-dealer firms also have  nationwide coverage for institutional and individual investors on a smaller  scale. But other broker-dealer firms provide inventory and expertise in  well-defined geographic areas, allowing them to serve individual  investors—many of whom invest in municipal securities to enjoy state or  local income tax benefits—as well as institutional investors who need  access to local markets. Given the heterogeneity and variety of municipal  securities available, the fact that they are traded infrequently, and the  geographic fragmentation of the market, broker-dealers typically work  with their customers to find available securities that fit preferred  parameters (e.g., geographic location, yield, credit quality, or price)  instead of specific securities.
Most broker-dealers execute trades as the principal by trading securities from their  proprietary accounts. other features that allow users to share information on and post offerings,  obtain and provide bids on securities, and conduct research and analysis.
Broker-dealers may also use broker’s brokers and electronic trading  platforms to trade in the secondary market. Currently, about 20 broker’s  brokers promote additional liquidity and facilitate information flow in the  municipal securities markets by specializing in segments of the market (by  region, issuer, or type of security) and helping broker-dealers find buyers  for their securities in their areas of expertise. They do so primarily by  arranging auctions called bid wanted procedures (bids wanted) for broker- dealers that are selling securities, particularly in unfamiliar areas of the  market. Broker-dealers can also buy and sell municipal securities for their  customers through electronic trading platforms that combine inventories  from market participants, typically broker-dealers, into one location, thus  enabling users—mostly broker-dealers and, in some cases, institutional  investors—to search for, buy, and sell municipal securities from a single  site.  Some of these trading platforms focus on trading for the individual  investor market. However, individual investors typically do not have direct  access to these trading platforms, although they may have indirect access  through a retail broker-dealer.
section_title: Municipal Market Regulation
paragraphs: About 1,800 securities firms and banks are registered with MSRB as  broker-dealers of municipal securities. As an SRO, MSRB develops rules  for broker-dealers engaged in underwriting, trading, and selling municipal  securities with the goals of protecting investors and issuers and  promoting a fair and efficient marketplace. To further its mandate to  protect investors, MSRB also operates information systems designed to  promote post-trade price transparency and access to municipal securities  issuers’ disclosure documents. MSRB provides this access free of charge  through its Electronic Municipal Markets Access (EMMA) website. As we  have seen, FINRA and federal banking regulators enforce MSRB rules for  broker-dealers under their respective jurisdictions. FINRA oversees 98  percent of those MSRB-registered broker-dealers that are also registered  members of FINRA, while federal baking regulators oversee the  remaining 2 percent.
SEC has designated FINRA as the entity responsible for conducting  surveillance of trade data from RTRS for potential violations of MSRB  rules. FINRA employs automated surveillance in its compliance  monitoring that is programmed to review RTRS data for potentially  excessive prices and late trading, among other rule violations. FINRA  staff review alerts generated by automated surveillance systems to  identify those that warrant further investigation. When FINRA finds  evidence of potential violations of these rules involving those broker- dealers who are its members, it can take action ranging from informal  warnings to the imposition of monetary fines to expulsion from its  membership, among other sanctions. FINRA refers potential violations  involving bank dealers to the appropriate federal banking regulator.  During the period of our review, FINRA and the federal banking regulators  conducted routine examinations of the firms under their jurisdiction once  every 2 years for compliance with MSRB rules, pursuant to MSRB  requirements.
OCIE administers SEC’s nationwide examination and inspection program.  OCIE oversees the SROs’ compliance with federal securities laws and  the SROs’ enforcement of their members’ compliance with federal  securities laws and SRO rules through inspections. Inspection review  areas include an SRO’s compliance, examination, and enforcement  programs. OCIE also directly assesses broker-dealer compliance with  federal securities laws through examinations such as cause and risk- based examinations. If examiners identify compliance findings during  broker-dealer examinations, they may assess the quality of any recent  FINRA examinations of the broker-dealer and provide oversight  comments to FINRA.
SEC’s Office of Municipal Securities is a separate office within the Division  of Trading and Markets that coordinates SEC’s municipal securities  activities, advises on policy matters relating to the municipal security  market, and provides technical assistance in the development and  implementation of major SEC initiatives in the municipal securities area. In  addition, the Office of Municipal Securities reviews and processes rule  proposals filed by MSRB and acts as SEC’s liaison with MSRB, FINRA,  and a variety of industry groups on municipal securities issues. SEC’s  Division of Enforcement (Enforcement) investigates possible violations of  securities laws, recommends commission action when appropriate, either  in a federal court or before an administrative law judge, and negotiates  settlements. In January 2010, Enforcement created the Municipal  Securities and Public Pensions Unit, which focuses on misconduct in the  municipal securities market and in connection with public pension funds.
section_title: Municipal Securities Are Priced in an Opaque Market That Favors Better- Informed Participants
paragraphs: Because of the heterogeneity of the issuers and the securities they issue,  the large number of securities outstanding, and the infrequency with  which these securities trade, the municipal securities market does not  maintain reliable tradable quotes on all outstanding municipal securities.Consequently, broker-dealers we spoke with said they use a variety of  information to determine the prices at which they are willing to buy and  sell securities. We found that institutional investors traded at more  favorable prices than individual investors and were generally better  equipped to make independent assessments of the value of a security.  SEC, MSRB, and market participants have been considering ways to  improve pretrade price transparency.
subsections: section_title: Among Other Factors, Broker-Dealers Use Information on Similar Securities to Assess the Relative Value of a Security and Determine Its Price
paragraphs: As we have seen, the large municipal securities market, with its many  issuers and infrequent trades for a given security, does not have readily  available, transparent information on the prices of securities. Municipal  broker-dealers generally determine the prices at which they are willing to  trade by making relative assessments of a security’s market value, drawing  on various sources of information and incorporating their compensation for  facilitating the trades.identified as relevant to their pricing determinations included (1) recent  post-trade price information on same or comparable securities, (2)  available pretrade price information on the security or comparable  securities, (3) the characteristics and credit quality of the security, (4)  relevant market information, and (5) the cost of trading the security.
Several factors that broker-dealers we spoke with  First, when determining prices, broker-dealers said they often began by  reviewing recent post-trade information on the same or similar securities. In  2005 MSRB began requiring broker-dealers to report price data on most  municipal securities transactions within 15 minutes to RTRS and, in 2008,  made this post-trade pricing information freely available on the EMMA  website. Broker-dealers we spoke with said that the price of a recently  reported interdealer trade for a security was a particularly good indication of  its value for that segment of the market. However, if a security has not  traded recently, they said they instead look for recent trades in comparable  securities. Broker-dealers we spoke with also said they typically access  MSRB’s trade data through Bloomberg, which makes available tools to  perform advanced searches and analytics on the data.
These broker-dealers also said that they frequently used industry  benchmarks—typically yield curves—-constructed in part from the post- trade prices of selected securities as a reference for pricing similar  securities. Representatives of broker-dealers we interviewed explained  that post-trade information provided them with an understanding of real- time trends in the demand for similar types of securities. For example, a  major electronic trading platform offers several tools for assessing the  prices of its listed offerings using post-trade information. Users can see  recently reported trades for similar securities, compare the offer price with  a widely used benchmark curve, and receive alerts if the offering price  exceeds the most recently reported trade by a specified threshold.
Second, broker-dealers may use available pretrade price information on  the same or similar securities to infer market value. In the absence of  tradable quotes for outstanding securities, pretrade price information in  the municipal securities market includes bids from bids wanted and offer  prices. However, unlike post-trade information, pretrade price information  is not centralized, not publicly available, and not as available to broker- dealers (and to other market participants) as post-trade price information.  To estimate the market value for a security they want to sell, broker- dealers may solicit bids—or may ask a broker’s broker to solicit bids— through a bid wanted. Broker’s brokers may also provide broker-dealers  with otherwise publicly unavailable information on third-party bids and  offers from past bids wanted as well as the highest bid and the lowest  offer available at a given time for securities in their areas of expertise. For  example, a broker’s broker who regularly puts a security out for bid  wanted can provide information to broker-dealers on the bids received  even if the security has not traded in the last 2 months. Additionally,  broker-dealers obtain information about offer prices mainly through their  relationships and daily communications with other broker-dealers or  broker’s brokers, their investors who may inform them of competing  offers, and listed offerings on electronic trading platforms or Bloomberg.
Third, information on the credit quality of a security may affect its market  value, particularly any changes to the credit quality of the security since it  last traded. Broker-dealers can infer the credit quality of a security by  reviewing information from issuers’ financial disclosures posted on the  EMMA website, which they typically access via Bloomberg. Issuer  disclosures that may affect a security’s market value include information  on principal and interest payment delinquencies, changes in credit  ratings, and unscheduled draws on debt service reserves reflecting  financial difficulties, among other factors. Broker-dealers stated that their  ability to understand the credit risk of a particular security rested primarily  on their ability to obtain timely, comprehensive issuer disclosures.  However, they noted that municipal issuers’ disclosures are sometimes  outdated and incomplete. They added that conducting an independent  assessment of the credit quality of municipal securities has become  increasingly important given the decline in the availability and use of bond  insurance following the recent financial crisis.
Fourth, broker-dealers identified overall market conditions and events as  important factors to consider when inferring the market value of a  security. For example, an increase in interest rates since the last time a  security has traded will, other things being equal, reduce its value.  Another important factor broker-dealers consider is overall supply and  demand. For example, broker-dealers we interviewed told us that they  monitored the primary market because investor demand for new issues  affects prices for similar securities in the secondary market. Broker- dealers also told us that by being visible and frequently transacting in the  market, they could maintain continuous dialogue with their customers  about prices, helping to gauge the interest of investors and other broker- dealers in certain securities at given prices. Finally, broker-dealers said  that external factors such as “headline risk”—the risk that a news story  will affect prices in a market—can also affect prices in the municipal  securities market. An example of headline risk cited by broker-dealers we  interviewed was a December 2010 report by a financial markets analyst  predicting widespread defaults among municipal issuers. This report  caused many individual investors to withdraw their money from these  funds, in turn depressing prices.
Fifth, in determining prices, broker-dealers we spoke with said they  typically consider trading costs associated with every municipal securities  trade, such as fees to MSRB, and operational costs. They said that in  general, it is less costly for broker-dealers to trade a given volume of  securities in a few large blocks than in a large number of small blocks.  For example, an institutional broker-dealer with a $2 million block of  securities to sell may have to find only one buyer for the securities, while  a retail broker-dealer with a similar block of securities might have to find  100 individual investors to purchase these securities in smaller blocks of  $20,000. They explained that the higher costs related to the smaller  trades include not only the time and other related costs of finding many  more interested buyers, but also the risk that the broker-dealer incurs in  holding the securities in his inventory during that time. Last, broker- dealers we spoke with told us that they could spend considerable  amounts of time with individual investors explaining the characteristics  and relative risks of the securities, answering questions, and complying  with regulatory requirements that govern broker-dealer transactions with  individual investors. In contrast, they said they do not have to spend as  much time with institutional investors, who are typically more  knowledgeable and experienced market participants. In order to be  profitable, broker-dealers consider these costs when establishing prices.
These broker-dealers also noted that they used their professional  judgment to determine the weight of any factor in determining the price for  a security, given the facts and circumstances surrounding the transaction.  For example, while a recent trade price on a similar security may drive a  security’s trade price in one case, the same information may become less  relevant in the case of a security that has more recently suffered a credit  downgrade.
section_title: Individual Investors Generally Trade at Less Favorable Prices than Institutional Investors
paragraphs: We analyzed MSRB data for secondary market trades involving newly  issued fixed-rate securities during the period from 2005 through 2010.  We found that (1) relative to institutional investors, individual investors  generally paid higher prices when buying—and received lower prices  when selling—municipal securities; (2) broker-dealers received larger  spreads (i.e., the difference between the purchase and selling price of a  security based as a percentage of the purchase price) when trading  smaller blocks of municipal securities; and (3) the prices that individual  investors paid for a given security tended to be more dispersed—that is,  to vary more—than the prices that institutional investors paid.
First, our analysis revealed that for broker-dealer sales to investors, the  relative price declined on average with trade amount, and that the  opposite occurs for broker-dealer purchases from investors. That is,  investors paid higher prices when buying smaller blocks of securities  from broker-dealers—and received lower prices when selling them— than they paid or received for larger trades. Table 1 shows average  relative price for trades involving newly issued fixed-rate securities  issued in 2010. The table shows that as trade size increased, relative  prices that investors paid for municipal securities declined steadily and  relative prices that investors received for selling their securities  increased steadily. For example, on average, investors paid 101.9  percent of a security’s reoffering price and received 99.4 percent of a  security’s reoffering price for $5,000 worth of securities, while they paid  100.1 percent of a security’s reoffering price and received 100.5 percent  of a security’s reoffering price for $2 million worth of securities. As  discussed earlier, individual investors typically trade municipal securities  in amounts of $100,000 or less, and institutional investors typically trade  in amounts of $1 million or more. Consequently, individual investors are  likely paying higher prices than institutional investors when they  purchase municipal securities and receiving lower prices than  institutional investors when they sell municipal securities.
Our analysis also found that broker-dealers received larger spreads when  trading small blocks of municipal securities. Because individual  investors tend to trade smaller amounts than institutional investors,  individual investors tended to pay higher spreads than institutional  investors. For example, our analysis showed that the average spread for  a $20,000 trade of a fixed-rate security in 2010 was around 2 percent and  for a $5 million trade around 0.01 percent. Table 2 shows how these  spreads affect investors’ return as measured by the yield to maturity (the  yield received after the security matures) on two hypothetical trades of  $20,000 and $5 million of the same securities purchased by an individual  investor and an institutional investor, respectively.
In addition, our analysis showed a wider range of prices for smaller trades  than for larger trades from 2005 through 2010. That is, prices for larger  trades tended to be more concentrated, while prices for smaller trades  tended to be more dispersed. To the extent that individual investors trade  smaller amounts than institutional investors, this relationship indicates  that individual investors were more likely to pay a wider spectrum of  prices for a given security than institutional investors. Table 3 shows price  dispersion for trades involving newly issued fixed-rate municipal securities  issued in 2010. The table shows prices that investors paid (and, to a  lesser extent, received) for municipal securities were more dispersed for  smaller trades than for larger trades.
These findings are consistent with previous research on municipal  securities trades. For example, researchers analyzing trades of municipal  securities found that broker-dealers received larger spreads on smaller  trades than they received on larger trades. In addition, researchers  analyzing trades of recently issued municipal securities found that prices  for smaller trades were more dispersed than prices for larger trades.
section_title: Individual Investors Generally Have Less Information and Expertise to Assess Prices than Institutional Investors
paragraphs: Various factors could contribute to the differences in prices that individual  investors receive relative to institutional investors. Some researchers  have suggested that these differences are not entirely accounted for by  differences in dealer costs between large and small trades. One study  suggests the lower spreads that institutional investors pay may also be  due to the lack of price transparency in the market, which allows better  informed investors to obtain more favorable trade prices. Another study  adds that institutional investors’ continuous engagement in the market  and frequent interaction with broker-dealers also provide them with more  bargaining power than individual investors. This study also suggests that  the more dispersed prices that individual investors experience could  indicate that, in the nontransparent municipal securities market, broker- dealers may have more opportunities to charge higher prices when  dealing with less knowledgeable investors. The authors explained that the  wider range of prices individual investors receive when they buy or sell  the same security could reflect broker-dealers’ ability to detect diverse  levels of sophistication among individual investors, with less  knowledgeable individuals potentially more likely to trade at less favorable  prices than more market-savvy individuals.
A third study, however, concludes that differences in prices are not  entirely due to the lack of transparency in this market. The study notes  that municipal securities often pass through a chain of dealers before  being placed with investors and suggests that such interdealer trading  may contribute to differences in prices for individual and institutional  investors. This study finds that the prices investors pay increase with the  amount of interdealer trading that preceded their purchases, and also that  more interdealer trading is associated with greater price dispersion. The  study also finds that successive interdealer trades tend to involve smaller  and smaller trades, thus suggesting that investors trading smaller  amounts—individual investors—are likely to pay higher prices and also  more dispersed prices than investors trading larger amounts—institutional  investors.
We found several factors that likely affected individual investors’ ability to  gain and use information to independently assess offers and bids they  received from their broker-dealers for municipal securities they were  interested in purchasing or selling. While MSRB has increased the  amount of information available to all investors through its EMMA  website—including price information on past trades and issuer  disclosures—institutional investors we spoke with generally had more  resources and expertise to assess prices than individual investors. In  particular, they had (1) access to more sources of pretrade price  information in the form of offerings and bids provided through their large  networks of broker-dealers, (2) access to more user-friendly post-trade  information through third-party vendors and their networks of broker- dealers, and (3) more market expertise to help them incorporate other  available information.
First, institutional investors told us that when buying securities they  accessed the fragmented municipal market through their large networks  of broker-dealers. For the institutional investors we interviewed, these  networks range from 30 to over 100 national and regional broker-dealers  who compete for their business by providing them with a wide range of  municipal securities offerings from the primary and secondary markets.For example, institutional investors typically receive daily secondary  market offerings from their broker-dealers through Bloomberg, which  provides an interface that allows users to pull together and organize these  offerings for easy analysis—an important feature in a large,  heterogeneous market where price discovery depends heavily on relative  assessments of similar securities.
Relative to institutional investors, individual investors typically have  access to fewer sources of pretrade price information. Unlike institutional  investors that have access to and can compare thousands of daily  offerings from their large networks of broker-dealers, individuals typically  have brokerage accounts with a few broker-dealers, perhaps only one,  that may or may not offer online access to their offerings. Individuals  with online access to a brokerage firm’s offerings can search for  securities that meet certain parameters and compare the results. They  may be able to repeat this exercise with other broker-dealers, although  they are unlikely to obtain competing prices for the same security. In  contrast, some investors without access to online offerings told us that  they relied on their broker-dealers. These investors can compare prices of  similar securities only insofar as their brokers share this information with  them. However, some retail broker-dealer firms have taken steps to  attract individual investors by combining offerings from electronic trading  platforms with their own offerings, thus expanding the pool of securities  available to their customers. According to one of the largest municipal  electronic trading platforms, which caters to retail broker-dealers,  individuals can access the platform’s inventory through several major  brokers, most full-service brokers, and many independent financial  advisers.
Similarly, institutional investors wanting to sell municipal securities  generally have multiple ways to obtain pretrade price information in the  form of bids. Their access to large networks of broker-dealers and tools  for obtaining bids from more than one dealer allows them to contact  potential buyers and independently assess the bids they receive for their  securities. Institutional investors we interviewed said that they also  frequently carried out their own bids wanted by using Bloomberg to solicit  bids from broker-dealers in order to gauge demand and potentially  receive a bid at which they were willing to sell. Additionally, these  institutional investors told us that they might offer securities directly to  broker-dealers to find interested parties among the firms or their  customers. Finally, institutional investors can ask a broker-dealer to offer  the security for sale through a broker’s broker or an electronic trading  platform.
By contrast, individual investors typically do not have independent access  to multiple bids and thus may be less able to assess the prices they  receive for securities they want to sell. When individuals sell securities,  they typically rely on the broker-dealer responsible for the account that  houses the securities to find a market. A retail broker-dealer may offer the  securities to other broker-dealers or customers or may solicit bids through  a broker’s broker or an electronic trading platform. However, because  selling small blocks of securities is generally more difficult than selling  larger blocks, broker-dealers we interviewed said that they might be able  to obtain only a few bids for the individual investor. Although the broker- dealer may explain to the individual his process for obtaining bids,  individual investors may have difficulty judging the level of demand for  their securities or the level of effort their broker-dealers made to find  potential buyers.
Similar to broker-dealers, institutional investors we interviewed told us  that they can access MSRB’s historical trade information through the  EMMA website and centrally through Bloomberg, which allows users to  compare post-trade prices for two or more securities that share similar  characteristics using a search function. Institutional investors also said  that their established relationships and continued negotiation with their  broker-dealers often revealed market patterns from post-trade prices that  helped them assess prices. For example, some large institutional  investors told us that broker-dealers typically let them know about large or  otherwise meaningful trades that they believed might affect prices of  similar securities before these trades appeared on RTRS (postings must  occur within 15 minutes of the trade). Some of these investors said that  even though MSRB’s RTRS system did not disclose total transaction  amounts for trades over $1 million—which the system reports as trade  amounts of “$1+ million”—they typically were aware of the amount and  the price of these large transactions through their relationships with  broker-dealers. Market participants have said that this information is  important, because prices in large trades affect prices for many other  similar securities because of the relative nature of pricing in this market.  Institutional investors are also able to benefit from broker-dealers’  commentaries on trades or on demand trends in the market through  Bloomberg.
In contrast, individuals—who are likely to find Bloomberg prohibitively  expensive—can obtain post-trade information on any outstanding security  from the EMMA website but may encounter limitations. While individual  investors may use the EMMA website to look for past trade prices of a  security to assess the current price, this information is likely not useful  unless the latest trade is relatively recent, as we have seen. Currently, the  EMMA website does not have search capabilities designed to allow users  to identify comparable securities. Further, individual investors could  misinterpret post-trade pricing data if they were unaware that reported  prices for investor transactions reflected dealers’ compensation for the  trade as well as the estimated market value of the security. MSRB is  currently evaluating improvements that would make the EMMA website  more meaningful and useful for individual investors.
Institutional investors we spoke with generally employed professional  staff, such as credit analysts and traders, who specialized in evaluating  credit risk and trading municipal securities and maintained models to   Institutional investors we interviewed stated evaluate offering prices. that in general they could form an immediate initial judgment about the  price of a municipal security because they were entrenched in the market  on a daily basis and had accumulated expertise to inform their decision  making. These investors told us that they applied a wealth of market  history to determine a security’s relative value. They said that, for  example, they knew the approximate price at which an A-rated hospital  security in California with a 30-year maturity is trading and could update  prices for the same or similar securities by looking at technical features  (like call features), the issuers’ financial profile, and the market strength  on the day of the trade, among other things.
By contrast, individual investors have access to issuer financial  disclosures through MSRB’s EMMA website and other publicly available  issuer information but may lack the expertise to understand and update  prices using this information. Besides issuer disclosures, individuals have  access to free investor information websites, such as the Securities  Industry and Financial Markets Association’s (SIFMA)  investinginbonds.com, which makes available various market benchmark  yield curves, among other things. Many of these resources may also be  available to individuals through their broker-dealers’ online websites.  However, some institutional investors we spoke with believed that  professional expertise was required to use this information to assess  prices, especially for securities that had not traded recently. For example,  even with timely access to issuer disclosures, it is not clear that individual  investors with relatively limited market expertise would be able to  estimate how a rating downgrade translated into a lower price for a  security.
Additionally, individual investors may undertake varied degrees of  research during the few hours that they typically have to make an  investment decision. For example, some investors we spoke with did not  look at historical trade information or issuer disclosure information when  they bought bonds and instead relied on the recommendation of their  broker-dealer. Others, however, chose a few potential securities from  their broker-dealer’s online offerings and checked historical trade  information and disclosure information for those securities. One of the  more knowledgeable among the individual investors we spoke with stated  that he treated the last interdealer trade price as a benchmark for pricing  and used this information with varying degrees of success to negotiate  prices with brokers. For example, one individual said he had successfully  used the last traded price to bargain for better prices with his broker and  found that if he was buying bonds for a par value of $200,000, for  example, he might be able to save $100 (or 0.05 percent of par value).
Market participants explained that individual investors faced additional  challenges in independently assessing the value of a security since the  decline in the use and availability of bond insurance following the recent  financial crisis. In the past, individual investors could choose to buy an  insured security and rely on the insurer’s guarantee without fully  understanding the security’s underlying value. Individual investors may  review issuer disclosures through the EMMA website to help in  independently assessing risk, but some individual investors have  expressed frustration at their inability to identify and understand the  relevant pieces of information from the typically long and technical issuer  disclosures.
section_title: SEC, MSRB, and Market Participants Are Considering Ways to Improve Pretrade Price Transparency
paragraphs: SEC and MSRB have ongoing studies examining the municipal security  market. In May 2010, SEC announced that it was beginning a review of  the municipal securities markets and intended to examine pretrade price  transparency, among other issues, using a series of field hearings.the conclusion of the review, SEC staff are to prepare a publicly available  report recommending whether specific changes to laws, regulation, or  private sector best practices are needed to better protect municipal  securities investors. SEC staff anticipate that the report will be finalized  and made public in 2012. In December 2010, MSRB also announced that  it was undertaking a study of the municipal securities market, including a  review of market structure and trading patterns. MSRB stated that the  study would include a review of transaction costs, price dispersion, and  other market data and was intended to help MSRB assess whether the  market was operating as efficiently and fairly as possible. It is also  intended to assist MSRB in evaluating whether pricing and liquidity in the  market could be improved with higher levels of pretrade price  transparency. MSRB staff said that the initial phase of the study would  likely be completed in 2012. MSRB said that in considering whether to  recommend potential changes in terms of market structure or disclosures  that would improve price transparency, the costs and benefits would need  to be weighed carefully.
Discussions to improve pretrade price transparency in the municipal  securities market focus on whether and how to make bid and offer  information on municipal securities more widely available and how to  improve individual investors’ access to the market. In an October 2010  speech discussing SEC’s review of the municipal securities markets, one  commissioner noted that post-trade transparency in this market had  improved considerably since MSRB’s implementation of real-time trade  reporting and the EMMA website. However, because of the low liquidity  levels of many municipal securities, these trade data could be weeks or  months old and therefore not helpful to investors. In part for this reason,  the commissioner said, improving pretrade transparency was an  important goal. MSRB staff observed that only a few limited venues  allowed even knowledgeable and experienced market participants such  as broker-dealers to see bid and offer information for municipal trades.  They added that because the municipal securities market operates  through over-the-counter trading, even the broker-dealers could not see  bid and offer information for the entire market.
One challenge to improving pretrade price transparency is determining  whether and how to make this information available to the general public  in a timely manner, particularly for thinly traded securities. That is, given  that most municipal bonds are traded infrequently once they have been  initially distributed, two-sided quotes are not continuously available in this  market. One suggestion that arose was to create a national listing service  where all municipal broker-dealers could list their entire municipal  securities offerings for public viewing and allow investors to search for  securities that fit their investment parameters and to compare prices and  yields. To make selling securities easier for investors, one field hearing  participant suggested allowing investors to place bids on offerings, while  another suggested establishing a limit order mechanism for this market. These suggestions would necessitate creating a centralized trading  venue. However, as of January 2012, market participants had not  developed detailed proposals that describe the feasibility or offer cost- benefit analyses of such changes to the structure of the market.
A limit order is an order to buy or sell a security at a specified price. investors.securities, broker-dealers and investors currently have access to a limited  set of offerings in the market, and that when selling securities, they  currently only have access to a subset of potential bidders for the  securities. This market participant said that an exchange could broaden  both broker-dealers’ and investors’ access to bids and offers for municipal  securities, and that such centralized transparent aggregation of dealer  and individual investor interest would lead to increased liquidity, even in  the absence of two-sided quotes for most bonds. Further, this market  participant said that an exchange would promote pretrade price  transparency through the public dissemination of bid and offer  information. Other market participants agreed that an exchange would  broaden individual investors’ access to the market and noted that an  exchange would allow them to more easily find offerings for comparable  securities with the characteristics they wanted. Furthermore, one market  expert stated that an exchange would provide more liquidity to investors  by taking advantage of existing technology to identify potential interested  buyers for a given security, even in the absence of two-sided quotes.
For example, one market participant noted that when buying  However, broker-dealers and large institutional investors we interviewed  stated that, in this fragmented market driven by supply and demand,  relationships and direct negotiation were the key to making markets and  determining prices. Broker-dealers also pointed to the large number of  heterogeneous and relatively illiquid municipal securities that would make  it difficult to establish ready two-sided markets for a given security.  Additionally, large institutional investors we spoke with stated that a  municipal securities exchange may not be feasible or advisable because  of the costs of developing a central meeting place that could incorporate  these unique attributes of the market. Broker’s brokers also thought the  negotiated nature of the market limited the feasibility of an exchange and  noted that demand for their services had increased greatly with the  decline in the availability and use of bond insurance. They said that  because broker-dealers could no longer rely on the homogenizing effects  of bond insurance, their need for reliable information on, for example,  specialized securities’ credit and sector trends had increased.
section_title: Regulators Oversee Compliance with MSRB Rules and Have Not Found Systemic Violations, but SEC’s Monitoring Is Limited
paragraphs: MSRB has issued rules addressing broker-dealers’ pricing, trade  reporting, and clearance and settlement responsibilities with respect to  municipal securities transactions. However, because MSRB does not  have enforcement authority over broker-dealers, FINRA, federal banking  regulators, and SEC conduct broker-dealer oversight and enforce MSRB  rules. FINRA oversees 98 percent of broker-dealers registered with  MSRB, and the federal banking regulators (OCC, FDIC, and the Federal  Reserve) oversee the remaining 2 percent, which we refer to in this report  as bank dealers. SEC’s OCIE provides oversight of MSRB and FINRA’s  regulatory activities. We found that FINRA and the banking regulators did  not identify many violations of the pricing and trade reporting rules from  2006 through 2010 and that settlement failures on municipal securities  transactions were rare.multiple FINRA district office inspections and broker-dealer examinations  as part of its municipal market oversight, it had not inspected MSRB or  FINRA’s fixed-income program since 2005 and lacked a program for  conducting interim monitoring to assess risks at these SROs.
subsections: section_title: MSRB Rules Govern Municipal Transaction Pricing, Reporting, and Clearance and Settlement
paragraphs: Several MSRB rules govern broker-dealers with regard to municipal trade  pricing, reporting, and clearance and settlement.
Rule G-30: MSRB Rule G-30 requires that broker-dealers charge fair  and reasonable aggregate prices to customers (individual and  institutional investors) for buying and selling securities. In principal  transactions, in which broker-dealers take securities into their own  accounts, the aggregate price reflects not only the market value of the  security, but also the compensation the broker-dealer receives on the  transaction, either a markup or markdown from the security’s  prevailing market price. A markup is compensation for selling a  security to a customer, while a markdown is compensation for buying  a security from a customer. A security’s prevailing market price is its  interdealer market value—or the price at which a broker-dealer would  sell or buy the security to or from another broker-dealer—at the time  of the customer transaction. Most broker-dealers engage in municipal  securities transactions in a principal capacity, and as such are not  required to break out the markup or markdown from their aggregate  prices. Figure 1 shows how markups and markdowns are calculated  and illustrates the markups and markdowns in hypothetical municipal  securities transactions.
MSRB has stated that, in order to be fair and reasonable, the price of a  security must bear a reasonable relationship to its prevailing market price.  Both the price and the markup or markdown must be fair and reasonable  in order to satisfy Rule G-30. In other words, a broker-dealer cannot  charge the prevailing market price but add an excessive markup and still  be in compliance with the rule. Citing the heterogeneous nature of  municipal securities transactions and broker-dealers, MSRB has not set  specific numeric guidelines for acceptable markups or markdowns.  Since the early 1970s, however, several SEC cases and opinions have  addressed instances in which broker-dealers charged excessive  aggregate prices. Appendix V describes the key features of several of  these cases.
Rule G-14: Since 2005, MSRB Rule G-14 has required real-time  reporting of most municipal securities trades for transparency and  regulatory purposes. With few exceptions, Rule G-14 requires broker- dealers to report all trades to an RTRS portal “promptly, accurately,  and completely.” recording transactions and their relevant details within 15 minutes of  the time of trade. In addition, Rule G-14 states that broker-dealers  must have a current Form RTRS on file with MSRB with the  information necessary to ensure that their trade reports can be  processed correctly.
There are three ways for broker-dealers to report their trades to the RTRS. First, NSCC  operates an RTRS portal that may be used for any trade record submission or trade  modification. Second, broker-dealers can report customer transactions (but not most  interdealer transactions) to MSRB’s web-based RTRS portal. Third, broker-dealers must  report most interdealer transactions through NSCC’s Real-Time Trade Matching (RTTM)  portal, which feeds into the RTRS. the third business day following the trade date. Specifically, MSRB  Rule G-15 sets out settlement dates with respect to broker-dealers’  transactions with customers, while Rule G-12 sets out settlement  dates for interdealer municipal transactions.
section_title: Regulators Use Various Methods to Monitor and Enforce Compliance with MSRB Pricing and Trade Reporting Rules
paragraphs: MSRB makes trade data submitted by broker-dealers through the RTRS  available to FINRA, the federal banking regulators, and SEC for their  regulatory activities. In January 2010, MSRB launched Regulator Web, or  RegWeb, a secure web-based portal to municipal securities transaction  data. RegWeb provides regulators with consolidated access to information  including real-time, individual firm transaction data as well as dealer data  quality reports (monthly reports listing each dealer’s late, canceled, and  amended trade statistics); monthly reports on system outages and other  statistics; Forms RTRS that firms have filed with MSRB; a list of broker- dealers registered with MSRB; and other information.
FINRA primarily employs an automated surveillance program and conducts  examinations of broker-dealers to enforce MSRB rules related to pricing  and trade reporting. FINRA uses automated surveillance to monitor all  municipal broker-dealers that are FINRA members for compliance with  MSRB pricing and trade reporting rules. FINRA’s automated surveillance  also includes activity related to the bank dealers under the jurisdiction of  the federal banking regulators. Using programmed parameters, FINRA  assesses RTRS data for potential violations of MSRB rules, including G-30  and G-14. For example, FINRA has surveillance programs that identify  transaction prices that appear to be outliers compared with prices in the  rest of the market. FINRA analysts follow up on alerts generated by these  programs with broker-dealers under its jurisdiction in accordance with  written policies and procedures and, in certain circumstances, will refer  potential violations by bank dealers to the appropriate federal banking  regulator for further investigation. FINRA also assesses compliance with  the MSRB pricing and trade reporting rules through routine and cause  examinations of municipal broker-dealers. Examiners use an electronic  examination module that includes specific instructions for collecting  documentation, selecting samples, and running data reports, and for other  aspects of their examinations. FINRA’s surveillance and examinations can  result in a variety of actions against a firm that violates a rule, such as an  informal warning or a monetary penalty, among other actions.
The federal banking regulators rely primarily on examinations to monitor  bank dealers’ compliance with MSRB pricing and trade reporting rules.  Officials from these agencies explained that they did not have formal  surveillance programs designed to monitor bank dealers’ compliance with  MSRB rules. Rather, they periodically review MSRB reports on data  quality and pricing volatility in RegWeb, often as part of their preparation  for on-site examinations. In addition, although the federal banking  regulators all stated that such instances are rare, FINRA may refer to  them potential violations by bank dealers that it identifies through its  automated surveillance program. During their on-site examinations, bank  examiners generally take samples of bank dealers’ transactions and  review them for compliance with Rules G-30 and G-14. Their  examinations can result in corrective actions, among other responses.
As part of its oversight of FINRA’s regulatory operations, OCIE assesses  broker-dealers’ compliance with MSRB Rules G-30 and G-14 through  broker-dealer examinations. OCIE also may review for compliance with  these rules in other types of examinations, such as cause examinations  and risk-targeted examinations. Because OCIE uses a risk-based  approach to determine areas of focus in these examinations, examiners  might not always check for compliance with Rules G-30 and G-14. When  they do, however, they follow OCIE’s written examination procedures.  OCIE’s examinations can result in actions such as a deficiency letter to  the firm or referral to SEC enforcement staff for a more formal review.  See appendix VI for a more detailed description of how FINRA, the  federal banking regulators, and OCIE examine for compliance with Rules  G-30 and G-14.
MSRB and the other regulators coordinate in various ways to facilitate  effective enforcement of Rules G-30 and G-14, as well as other MSRB  rules. For example, MSRB officials provided agendas demonstrating that  SEC, MSRB, and FINRA have held three semiannual meetings since  December 2010, as mandated by the Dodd-Frank Act, to describe their  work in the municipal securities market and to discuss any issues related  to regulation, including rule interpretation, examinations, and enforcement  of MSRB rules. According to documentation provided by MSRB officials,  MSRB and FINRA also meet regularly and share information in  accordance with a memorandum of understanding, and MSRB meets with  SEC several times a year and with the federal banking regulators twice a  year to discuss various municipal market issues, with a focus on MSRB  rule interpretations, amendments, and guidance.formal meetings, SEC, MSRB, and FINRA staff told us that they  maintained daily or weekly informal communication to discuss rule filings  or interpretations; surveillance, examination, and enforcement issues;  technology issues; and other pertinent matters. As described earlier,  MSRB also shares RTRS data and other information with the regulators  via the RegWeb system. Finally, MSRB officials stated that they provide a  variety of training opportunities to examiners and other staff of SEC,  FINRA, and other regulators to promote consistency in the enforcement  of MSRB rules.
section_title: Regulators’ Surveillance and Examinations Did Not Reveal Systemic Trade Pricing, Reporting, or Clearance and Settlement Issues
paragraphs: According to our review of regulators’ surveillance and examination data,  FINRA, the federal banking regulators, and OCIE have identified few  violations of Rule G-30 by broker-dealers and bank dealers from 2006  through 2010. Regulatory officials told us that they considered a variety of  factors when determining whether a broker-dealer had charged unfair or  unreasonable prices, markups, or markdowns. We also found that  violations of Rule G-14 were not systemic and that the industry average  for late reported trades had decreased substantially since 2005. Finally,  sample data from the agency that oversees clearance and settlement of  municipal trades indicate that municipal transaction settlement failures  are rare.
Regulators cited a small number of violations of Rule G-30 during the  period from 2006 through 2010. Specifically, FINRA opened 416 reviews  based on alerts related to potential G-30 violations occurring during the 5- year review period. FINRA had completed 343 of those reviews by June  2011. Of those 343 reviews:
FINRA determined that 267 (78 percent) warranted no further review.
FINRA officials explained that they had investigated the prices and  markups for the firms in question and found that violations had not  actually occurred or were too minor to warrant further action.
Eleven reviews (3 percent) resulted in a cautionary action (an informal  warning to the broker-dealer that similar violations in the future could  result in formal disciplinary actions).
One review (less than 1 percent) resulted in a cautionary action for a  violation of another MSRB rule.
Sixty-four (19 percent) were referred internally for potential  disciplinary action.
Of the 64 reviews FINRA’s surveillance group referred internally, 22 were  closed as of June 2011. Of those 22 reviews:
Two (9 percent) warranted no further review.
Eight (36 percent) resulted in a cautionary action.
Twelve (55 percent) resulted in a Letter of Acceptance, Waiver and  Consent (a disciplinary action in which the broker-dealer consents to  findings and the imposition of sanctions but neither admits nor denies  the violations).
Likewise, out of 5,764 examinations with a municipal securities  component that FINRA conducted from 2006 through 2010, 51  examinations (less than 1 percent) identified G-30 violations that resulted  in a formal or informal action. Of those 51 examinations:
Thirty-seven (about 73 percent) resulted in a cautionary action.
Eleven (about 22 percent) resulted in a compliance conference (a  more serious type of informal action that involves a meeting between  FINRA management and the broker-dealer firm to discuss the  violations).
Three (about 6 percent) were referred internally for potential  disciplinary action.
We reviewed 25 of the 51 examinations and found that the markups and  markdowns that FINRA questioned in those examinations ranged from  about 2 percent to about 10 percent. The federal banking regulators did  not report any G-30 violations in the 87 total bank dealer examinations  they conducted from 2006 through 2010. OCIE staff also said that, for the  examinations they conducted during this time frame in which they  assessed broker-dealers for G-30 compliance, they observed a relatively  low rate of G-30 violations.
Regulators consider multiple factors in determining broker-dealers’  compliance with Rule G-30. For example, Rule G-30 specifies four factors  that broker-dealers must consider when determining a fair and  reasonable price, including the broker-dealer’s best judgment as to the  fair market value of the securities at the time of the transaction. In  addition, in its interpretive notices, MSRB has identified other factors that  may be relevant to this determination, such as the resulting yield—or  annual rate of return—of the security to a customer. To determine  whether a broker-dealer is in compliance with Rule G-30 on a specific  trade, regulators must consider how well the broker-dealer has applied all  of the relevant factors as well as the facts and circumstances of the  transaction. Table 4 lists the written factors that regulators consider in  enforcing this rule. For instance, as part of their consideration of whether  broker-dealers use their best judgment in pricing securities, OCIE  examiners stated that when they found a potentially excessive markup,  they checked to see whether the market had moved or significant  information about the issuer had become available just before the  transaction.
We observed how examiners assessed broker-dealers’ application of  some of these factors in our review of selected FINRA examinations with  G-30 violations. For example, FINRA examiners identified six potential G- 30 violations—all in the form of excessive markups—at one firm they  examined. When they asked the firm to explain the markups, which  ranged from about 4 percent to nearly 10 percent, the firm stated that all  of the transactions in question involved low-rated or unrated bonds and  occurred in late 2008, when the market was highly volatile.stated that because it had no customers for the bonds at the time it   The firm also  purchased them, it had assumed additional risks, and that no comparable  interdealer trades were available to establish the prevailing market price.  While FINRA examiners concluded that four of the six transactions were  fair and reasonable, they cited G-30 violations on the two remaining  transactions based on the combination of high markups, firm profits, and  the transactions’ proximity in time to interdealer purchases. Illustrating the  importance of reviewing the individual facts and circumstances in each  transaction, examiners deemed one of the highest markups acceptable  because the security had been trading within a wide range of prices  around the time of the trade in question and the transaction resulted in a  high yield to the customer relative to those of comparable securities. In  another examination, FINRA examiners questioned a trade in which a  firm bought 10 bonds from a customer at a price substantially lower than  the last reported trade, which had occurred about a week earlier. The firm  indicated that the security’s credit rating had dropped within that time  period. Given this downgrade and the fact that the bonds in question  continued to trade in the lower range for about a month afterward, FINRA  examiners determined that the firm had set a fair and reasonable  aggregate price and thus had not violated Rule G-30.
In April 2010, MSRB proposed draft guidance that would provide greater  specificity for broker-dealers acting as principals in determining a  security’s prevailing market price. Specifically, MSRB’s Regulatory Notice  2010-10 proposed a hierarchical approach that is intended to harmonize  with FINRA’s approach to pricing nonmunicipal debt securities. The  proposed approach would first have the broker-dealer use as the  prevailing market price his contemporaneous costs or proceeds—in other  words, his costs or proceeds from a transaction recent enough that it  would be expected to reflect the current market price for the security. If a  broker-dealer wished to use a source other than his contemporaneous  costs or proceeds to determine the prevailing market price, he would be  required to search through a hierarchy of relevant transactions to seek  other appropriate comparison prices. In addition, broker-dealers would be  required to document how they determined the prevailing market price in  cases where they did not use contemporaneous costs or proceeds.  MSRB officials told us that the proposed method would likely make it  easier for regulators to conduct surveillance and enforcement for Rule G- 30, because it would provide a relatively mechanical way to determine a  security’s prevailing market price. However, broker-dealers have  expressed concerns about the proposed method, citing, among other  issues, increased burdens and risks to liquidity. As of January 9, 2012,  MSRB had not finalized the proposed guidance.
Although regulators identified G-14 violations during our review period,  these trade reporting issues did not appear to be systemic. According to  data we received from MSRB, from February 2005 (the month after the  15-minute reporting requirement took effect) through July 2011, the  monthly industry average for late trades declined from approximately 7  percent to less than 1 percent. The average rate of late trades during this  time frame was less than 2.5 percent. FINRA officials noted that in 2005  FINRA had assigned a dedicated team to conduct automated surveillance  reviews of the municipal market, with an initial focus on late trade  reporting. FINRA officials believe that these surveillance efforts likely  played a role in the decline of the industry G-14 violation average. FINRA  opened 721 reviews based on alerts related to potential G-14 violations  occurring from 2006 through 2010. FINRA’s surveillance group had  completed 621 of those reviews as of June 2011. Of the 621 reviews:
FINRA determined that 323 (52 percent) required no further review.
As with the reviews stemming from G-30 alerts, FINRA officials  explained that they had investigated the transaction reports for the  firms in question and found that violations had not actually occurred or  were too minor to warrant further action.
Fifty-five (9 percent) resulted in a cautionary action for a G-14  violation.
Ten (about 2 percent) resulted in a cautionary action for violations of  other MSRB rules.
Another 233 (about 38 percent) were referred internally for potential  disciplinary action.
Of the 233 reviews FINRA’s surveillance group referred, 147 had been  completed as of June 2011:
Eight (5 percent) warranted no further review.
Fourteen (about 10 percent) resulted in a cautionary action.
Three (2 percent) resulted in a minor rule violation plan letter (an  informal disciplinary process that allows FINRA to assess fines of less  than $2,500).
The remaining 122 (83 percent) resulted in a Letter of Acceptance,  Waiver and Consent.
Also from 2006 through 2010, out of the 5,764 examinations they  conducted with a municipal securities component, FINRA examiners cited  G-14 violations resulting in a formal or informal action in 910 (about 16  percent). Of those 910 examinations:
Some 699 (about 77 percent) resulted in a cautionary action.
Another 136 (15 percent) resulted in a compliance conference.
Forty-two (about 5 percent) resulted in a Letter of Acceptance, Waiver  and Consent.
The remaining 33 examinations (about 4 percent) resulted in minor  rule violation plans, internal referrals for potential disciplinary action,  or offers of settlement.
In the sample of 32 FINRA examinations we reviewed with G-14  violations, we found that the violations stemmed from a variety of  sources, including human error, deficient procedures, a firm’s failure to  submit or update a Form RTRS, or technical malfunctions, among other  reasons. However, human error and deficient procedures were the most  commonly cited causes. Regulators noted that late or inaccurate trade  reporting was relatively simple to identify through surveillance and  examinations and that broker-dealers could be cited for a G-14 violation  based on as little as one or two late or inaccurately reported trades. For  example, in one of the FINRA examinations we reviewed, examiners took  a sample of 60 trades and found that 2 were reported to MSRB with the  incorrect price. A representative of the broker-dealer firm told examiners  that the firm had corrected the trades the day they were entered but that  an error had led to the suppression of the amended information. FINRA  counts instances like this as G-14 violations and requires broker-dealers  to update MSRB with the correct information if possible.
The federal banking regulators cited G-14 violations in 8 of the 87 bank  dealer examinations they conducted. They generally responded to these  violations with corrective action requirements. On the basis of  examinations they conducted during this time frame in which they  assessed broker-dealers for G-14 compliance, OCIE staff agreed that G- 14 violations appeared to have decreased in recent years and said that  the inadvertent late trades they continued to see were sometimes  attributable to factors such as breakdowns in trade reporting systems.
OCIE staff told us that settlement failures typically appeared to represent  a low percentage of municipal transactions cleared through NSCC.  According to data gathered during a 5-day trading period in June 2011 by  NSCC, municipal trade settlement failures composed approximately 2.1  percent of the total dollar value of all NSCC settlement failures across all  markets for that time period.
section_title: OCIE Has Not Inspected Key SROs’ Municipal Activities since 2005 and Has Conducted Limited Monitoring of SRO Regulatory Efforts
paragraphs: Since 2005, OCIE has not inspected FINRA’s fixed-income surveillance  program or MSRB, both because of staffing limitations and because of  changes to its inspection approach. OCIE’s written inspection guidelines  call for inspections of MSRB and FINRA’s regulatory programs. OCIE  did not have a fixed schedule for examining MSRB, but its SRO  Inspection Guidelines stated that the office generally inspected each SRO  under its jurisdiction every 1-4 years. Until 2010, OCIE conducted routine  inspections of various aspects of FINRA’s operations—including district  office programs, arbitration, customer communication, central review, and  financial operations—every 2 to 4 years in accordance with its SRO  inspection guidelines. Surveillance, examination, and enforcement  programs were typically components of these routine inspections, but  municipal securities were not included in each inspection cycle. From  2000 through 2010, mostly in accordance with a 3-year cycle, OCIE  conducted 49 inspections of FINRA’s district offices, which conduct the  majority of broker-dealer examinations. As part of these inspections, they  assessed whether FINRA examined municipal securities broker-dealers  at least once every 2 years and reviewed a sample of FINRA’s  workpapers to determine whether FINRA examiners thoroughly reviewed  broker-dealers for compliance with all MSRB rules and other applicable  rules and regulations. However, the district office inspections are not  intended to address FINRA’s surveillance activities or policies and  procedures for its municipal market regulatory programs. In 2010, OCIE  began transitioning to a risk-based SRO inspection approach in  conjunction with a comprehensive assessment of OCIE’s structure and  functions. As such, OCIE will no longer conduct inspections according  to a routine schedule but rather based on issues that represent the  greatest risks to investor protection and market integrity.
OCIE has not inspected FINRA’s fixed-income surveillance programs or  MSRB since 2005. OCIE’s inspections of FINRA and MSRB in 2005  produced findings related to their municipal securities oversight  activities. While the two SROs responded to OCIE’s findings and  recommendations with corrective actions or, in a few cases, rebuttals,  OCIE has not yet confirmed through on-site inspections whether they  have adequately addressed these recommendations. OCIE staff only  recently began a new inspection of FINRA that will encompass its fixed- income surveillance program, including the municipal trade reporting and  markup reviews. OCIE has not yet begun another inspection of MSRB.
OCIE staff said that staffing constraints had prevented them from starting  another inspection sooner to review FINRA’s fixed-income surveillance  program and MSRB. According to OCIE data, staffing of OCIE’s Market  Oversight group, which is responsible for inspections of FINRA and  MSRB and other SROs that are not clearing agencies, has declined by 5  employees (about 12 percent) since fiscal year 2007—when we last  reported on staffing of this group—and by 24 employees (nearly 40  percent) since fiscal year 2005.  As shown in table 5, as of September  2011, the Market Oversight group consisted of 38 active staff, including  12 managers, 25 professional staff (examiners), and 1 support staff.  According to OCIE staff, the majority of staff members in the Market  Oversight group have a law degree, and 11 people have prior experience  in fixed-income issues. Furthermore, OCIE staff stated that positions in  the Market Oversight group are a mixture of entry-level and senior  positions, with staff typically staying approximately 4 to 5 years before  going elsewhere within or outside of SEC. As of September 2011,  according to OCIE staff, the Market Oversight group had seven vacant  slots, but an SEC hiring freeze limited OCIE’s ability to fill most of these  positions.
GAO-08-33.  2011 (as of  9/16/2011)
According to the information OCIE provided, there were 27 professional staff in the group as of  September 16, 2011. However, that number includes two people who were detailed to other offices in  the agency and were not actively working in the Market Oversight group. Therefore, we list the  number of available professional staff as 25 rather than 27.
Although OCIE is transitioning to a risk-based approach to SRO  inspections, it lacks sufficient data on the SROs’ fixed-income regulatory  activities that it could use to inform this approach. OCIE’s mission  includes protecting investors and ensuring market integrity through risk- based strategies that, among other things, are designed to improve  compliance and monitor risk. However, OCIE currently engages in limited  monitoring of the SROs between inspections and may not have sufficient  sources of information to allow it to effectively assess the risk level of  SROs’ regulatory programs. OCIE staff told us that they plan to convene  all of the SROs in early 2012 to, among other things, clarify expectations  relating to their activities. One of the objectives of the SRO outreach will  be to share issues that OCIE identified in assessments it conducted of all  equity and options SROs in 2011 that have implications across the SROs.  However, this effort will not provide staff with information on the quality of  ongoing SRO oversight in any particular area—such as fixed-income  surveillance—between inspections. OCIE staff also participate in the  meetings mandated by the Dodd-Frank Act that include SEC, MSRB, and  FINRA. While such communication is essential to helping ensure uniform  interpretation of MSRB rules and discussing recent trends in  enforcement, among other things, it does not provide insight into the  ongoing effectiveness of SRO regulatory programs. We found that OCIE  received and reviewed quarterly reports from FINRA on its regulatory  activities related to municipal securities markups and markdowns.  However, an OCIE staff member told us that the reports, which present  aggregate statistics, reveal little about the effectiveness of FINRA’s  activities in this area.
For a risk-based inspection approach to be effective, it is essential for  OCIE to maintain ongoing monitoring and communication with the SROs  to keep abreast of the current operations and to use this information to  update its supervisory strategies. We note that the review period OCIE  covered in its 2005 FINRA inspection predated the recent financial crisis  and ensuing volatility in the municipal securities market. Although OCIE is  now conducting an inspection of FINRA that encompasses its fixed- income surveillance program, it had not obtained any information since its  last inspection about the quality of FINRA’s market oversight. Further,  MSRB implemented RTRS in 2005 and began making real-time trade  price information freely and publicly available on the EMMA website in  2008, but OCIE has not performed any independent reviews or otherwise  obtained information to establish the quality or reliability of the data in this  system, despite the fact that market participants use it for pricing  purposes and that SEC, FINRA, and the federal banking regulators rely  heavily on the data to carry out their regulatory activities.
SEC Release No. 34-50699, November 18, 2004. The rule was part of a larger package  of proposed rules and amendments related to fair administration and governance of  SROs, which SEC has not finalized. insight into the effectiveness of the SROs’ regulatory activities—it would  provide a mechanism for OCIE to regularly collect and analyze  information from the SROs. Without collecting information on an ongoing  basis that provides insight into the effectiveness of SRO regulatory  programs, OCIE may not be able to identify anomalies or changes in the  operations that warrant more immediate inspections.
section_title: Conclusions
paragraphs: OCIE is transitioning to a risk-based approach for its SRO inspection  program and is convening a meeting with the SROs in 2012 to share  issues staff have already identified that have implications across the SROs.  Among other things, the risk-based approach is intended to improve  compliance and monitor risk. While OCIE’s efforts to implement a risk- based inspection program have the potential to better target scarce  resources to high-risk areas, its limited monitoring of the SROs between  inspections could result in its missing potential new or ongoing issues with  their regulatory programs. For example, OCIE’s last inspection of FINRA’s  fixed-income surveillance program predated the recent financial crisis and  ensuing volatility in the municipal securities markets. Although OCIE  obtained some information on FINRA’s examination program through its  district office inspections and broker-dealer examinations, its lack of a  structured mechanism for monitoring the quality of FINRA’s fixed-income  surveillance during that time means that OCIE will not have a full picture of  how effective FINRA was in surveilling for and detecting violations of MSRB  rules until it finishes its 2011 inspection—more than 3 years after the  financial crisis began and more than 6 years since its last inspection.
Proposed Rule 17a-26 is an example of a mechanism that OCIE could  use to obtain meaningful information for ongoing monitoring of SRO  regulatory programs for the municipal securities market. This proposed  rule would compel the SROs to review, on an annual and a quarterly  basis, the operation and performance of their regulatory programs and  report the results of these reviews to SEC. Finalizing this rule—revised as  necessary to reflect OCIE’s current informational needs—would allow  OCIE examiners to formally collect and analyze interim data on the  operation and effectiveness of SROs’ programs and potentially facilitate  ongoing oversight of SROs between inspections. Such information could  provide regulators with more up-to-date information on the state of the  market and SROs’ regulatory efforts. In addition, it could help OCIE meet  its goal of identifying high-risk areas and leverage its staff resources  appropriately. Unless OCIE takes steps to gather and analyze information  on the SROs’ fixed-income regulatory programs on an ongoing basis, it  may not learn about emerging or recurring issues or risks in a timely  manner and take steps to address them.
section_title: Recommendation for Executive Action
paragraphs: To improve SEC’s ability to monitor the operations and effectiveness of  SRO regulatory programs related to municipal securities trading between  inspections and to help identify areas of high risk, we recommend that the  Chairman of the Securities and Exchange Commission direct OCIE to  take steps to gather and analyze information on the SROs’ fixed-income  regulatory programs on an ongoing basis and use it to inform their risk- based inspection approach.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report for comment to the SEC Chairman for  her review and comment. SEC provided written comments that are  reprinted in appendix VII. SEC also provided technical comments that  were incorporated as appropriate. In addition, we provided a draft of this  report to the Federal Reserve, FDIC, and OCC, for their review and  comment. These agencies did not provide written comments, but we  incorporated their technical comments where appropriate. We also  provided a copy of the draft report to MSRB and FINRA for their review  and incorporated technical comments from them as appropriate.
In its written comments, SEC agreed with our findings. With respect to our  recommendation that SEC improve its ability to monitor the operations  and effectiveness of SRO regulatory programs between inspections by  gathering and analyzing information from the SROs on an ongoing basis,  SEC agreed that more enhanced oversight of the SROs’ fixed-income  regulatory programs is needed and that it has already begun that process  through the transition to a risk-focused approach. SEC noted, however,  that more frequent review and analysis would require additional staff  resources and reiterated that OCIE has been unable to fill several vacant  positions in its Market Oversight group due to limitations on SEC hiring  under a Continuing Resolution. SEC further noted that even if the vacant  positions were filled, OCIE’s Market Oversight group would continue to be  understaffed relative to the number and complexity of entities that it  examines and that it would need additional resources to conduct more  frequent inspections of FINRA and MSRB’s fixed-income programs or to  do interim monitoring of FINRA’s fixed income surveillance program. As  we observed, SEC’s efforts to implement a risk-based inspection program  have the potential to better target its scarce resources to high-risk areas.  Gathering and analyzing data from the SROs on an ongoing basis could  help SEC better meet its goal of identifying high-risk areas and leveraging  its staff resources for inspections.
We are sending this report to the Senate Committee on Banking,  Housing, and Urban Affairs and the House Committee on Financial  Services. We are also sending copies of the report to the Special  Committee on Aging, U.S. Senate; the Committee on Agriculture,  Nutrition, and Forestry, U.S. Senate; the Committee on Agriculture, U.S.  House of Representatives; and the Chairman of the SEC. The report also  is available at no charge on the GAO website at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-8678 or clowersa@gao.gov. Contact points for our  Offices of Public Affairs and Congressional Relations may be found on  the last page of this report. GAO staff who made key contributions to this  report are listed in appendix VIII.
section_title: Appendix I: Potential Uses, Risks, and Oversight of Derivative Products in the Municipal Securities Market
paragraphs: Prior to the financial crisis that began in the summer of 2007, municipal  governments made increasing use of interest rate swaps, a derivative  product. In an interest rate swap, a municipal issuer enters into a contract  with a counterparty (typically an investment bank, commercial bank, or  insurance company), and agrees to exchange periodic interest payments.  Municipal issuers may use interest rate swaps to try to lower their  borrowing costs. For example, by issuing variable-rate securities and  entering into a variable-to-fixed interest rate swap, an issuer may be able to  obtain a lower fixed-rate interest payment than it otherwise could obtain if it  had issued fixed-rate securities directly. In this case, after issuing the  variable-rate securities, the issuer enters into a swap agreement with a  counterparty that agrees to pay the issuer a variable rate based on an  index that is intended to approximate the variable-rate interest payments  that the issuer must make to its investors. In exchange, the issuer agrees  to pay the counterparty a fixed interest rate. As a result, the issuer achieves  a synthetic fixed rate by converting a variable-rate obligation to a fixed-rate  obligation. Payment exchanges between the issuer and the counterparty  reflect differences between the fixed rate and the variable rate during a  specific period of time. The swap does not alter the issuer’s obligations,  including debt servicing, to existing investors.
Municipal issuers incur a number of risks when they enter into interest  rate swaps, including basis risk, termination risk, and counterparty risk  Basis risk is the risk that the variable rate paid by the issuer to its  investors is more than the variable interest rate received under the swap.  If that occurs, the payments the issuer receives from the counterparty are  less than the payments the issuer must make to the investors. The issuer  must cover that difference in addition to paying the fixed rate on the swap  to the counterparty. Termination risk is the risk that the swap may  terminate or be terminated before its expiration. Swap agreements allow  for termination of the swap by either party in the case of certain events,  such as payment defaults on the swap or credit rating downgrades. For  example, if the issuer triggers an early termination, it could owe a  termination payment reflecting the value of the swap under the market  conditions at that time. If market rates have changed to the issuer’s  disadvantage (e.g., the issuer is a fixed-rate payer and interest rates have  declined), the issuer will be “out of the money” on the swap, that is, the  fixed rate that the issuer is paying to the counterparty is higher than the  current market rate, and owe the counterparty a termination payment. A  termination of a swap can result in a substantial unexpected payment  obligation. Counterparty risk is the risk that the counterparty will default  on its payment obligations to the issuer.
The recent financial crisis heightened the exposure of a number of  municipal issuers with interest rate swaps to these risks. For example, a  number of municipal issuers had insured their underlying variable-rate  securities with bond insurance. However, the downgrades in these  insurers’ credit ratings during the financial crisis resulted in some issuers  having to post collateral on the swap agreements they had entered into or  face termination of the swaps. Because interest rates had declined  significantly at that time, these issuers were out of the money—making it  expensive to terminate the contract. However, a number of issuers  refunded their variable rate securities and terminated the swaps to free  themselves from these agreements.
In some cases where municipal issuers have suffered losses because of  swap agreements, issuers allege that the counterparties that sold them  the swaps (swap dealers) misrepresented the risks of the swaps that they  sold to the issuers. In other cases, they have called into question the fees  that the swap dealers made. Questions grew that some of the municipal  issuers that entered into swaps during this period did not understand  these complicated products or their risks.
subsections: section_title: Pursuant to the Dodd- Frank Act, CFTC Has Issued Rules Regulating Swap Dealers’ Transactions with Municipal Issuers
paragraphs: Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection  Act (Dodd-Frank Act) created a comprehensive framework to provide  oversight over the previously unregulated over-the counter derivatives  market. The Dodd-Frank Act provided the Commodities Futures Trading  Commission (CFTC) the authority to regulate swaps, including interest  rate swaps. Section 731 specifically amended the Commodity Exchange  Act (CEA) to provide CFTC with both mandatory and discretionary  rulemaking authority to impose business conduct requirements on swap  dealers and major swap participants in their dealings with counterparties  generally, including municipal issuers, which are among the entities  termed “special entities.” In January 2012, CFTC issued rules to  implement this authority.
Among other things, the rules establish a “know your counterparty”  requirement. This requirement requires a swap dealer (but not a major  swap participant) that acts as an adviser to a special entity to make a  reasonable determination that any swap it recommends is in the special  entity’s best interest and make reasonable efforts to obtain information  necessary to make a reasonable determination that the swap it  recommends is in the special entity’s best interest. The swap dealer will comply with its duty to act in the special entity’s best interest where it  complies with the “reasonable efforts” requirement, acts in good faith and  makes full and fair disclosure of all material facts and conflicts of interest  with respect to the recommended swap, and employs reasonable care  that the swap is designed to further the special entity’s objectives. The  rules also require swap dealers and major swap participants to disclose to  their counterparties material information about swaps, including material  risks, characteristics, incentives, and conflicts of interest. Additionally,  CFTC’s rules establish several duties for swap dealer and major swap  participants, including the duty to verify a counterparty’s eligibility to  transact in the swap markets, provide the daily midmarket value of  uncleared swaps to the counterparty, and ensure all communications to  the counterparty are fair and balanced. A swap dealer who recommends  a swap must conduct reasonable diligence to understand risks and  rewards of the recommendation and have a reasonable basis to believe  that the recommendation is suitable for the counterparty.
The rules also establish a duty for any swap dealer that acts as an  adviser to a special entity to act in its best interests, which includes  recommending a swap or trading strategy involving a swap. The rules  establish a duty for swap dealers and major swap participants to have a  reasonable basis to believe that any special entity counterparty has a  representative that meets the following criteria:  is sufficiently knowledgeable to evaluate the transaction and risks;  is not subject to statutory disqualification;  is independent of the swap dealer or major swap participant; undertakes a duty to act in the best interests of the special entity; makes appropriate and timely disclosures to the special entity; evaluates, consistent with any guidelines provided by the special  entity, fair pricing and appropriateness of the swap;  in the case of a special entity that is an employee benefit plan subject  to the Employee Retirement Income Security Act of 1974 (ERISA), is  a fiduciary as defined in Section 3 of ERISA; and  in the case of a special entity that is a municipal entity, is subject to  restrictions on certain political contributions to certain public officials of  the municipal entity.
For special entities other than employee benefit plans subject to ERISA,  the final rule provides a safe harbor under which the swap dealer will be  deemed to have a reasonable basis to believe that the special entity has  a qualified representative if the certain conditions are met, including the  representative stating in writing that it has policies and procedures  designed to ensure that it satisfies the applicable criteria.
section_title: Appendix II: Scope and Methodology
paragraphs: To analyze how institutional and individual investors trade municipal  securities in the secondary market and the factors affecting the prices  institutional and individual investors receive, we obtained data on all  municipal securities trades that broker-dealers reported to the Municipal  Securities Rulemaking Board’s (MSRB) Real-Time Transaction Reporting  System (RTRS) from January 1, 2005, to December 31, 2010. For each  trade, the data included variables describing characteristics of the  security, including the dated date (the date from which interest starts to  accrue), maturity date, interest rate, principal amount at issuance, and  reoffering price (the price at which underwriters sell newly issued  securities to the public in the primary market), as well as variables  describing the characteristics of the trade (trade date/time, settlement  date, trade price, yield, and trade amount) and trade type (dealer sales to  customer, interdealer trade, or dealer purchases from customer). We  analyzed trade data involving newly issued fixed-rate securities to  understand how trade prices differ for institutional and individual  investors, using trade size (amount) as a proxy for whether the trade  involved institutional or individual investors. We focused on trades that  occurred within the period from 30 days prior to and 120 days after the  dated date on municipal securities. We chose to examine this time frame  because we observed that bonds in our sample trade most frequently  around the time of issuance and that trading activity declines as the  number of days after issuance increases, with trading activity typically  leveling off by about 120 days after issuance. Focusing on a period with  more trading activity improved the precision with which we measured the  relationships described below. We chose to examine only trades of newly  issued bonds to ensure that all the trades we analyzed involved bonds  that had been available to investors for a similar amount of time and to  limit the likelihood that unobserved, time-varying characteristics of bonds  influence our analysis.
First, we analyzed the relationship between the relative trade price (the  trade price as a percentage of the reoffering price) and trade amount by  trade type in order to determine if prices for smaller trades—those more  likely to involve individual investors—are different from prices for larger  trades—those that are more likely to involve institutional investors.  Second, we analyzed the relationships between spreads (the difference  between the price on dealer sales to investors and the price on dealer  purchases from investors as a percentage of the price on dealer  purchases) within $10,000 trade amount increments and trade amount to  determine if spreads on smaller trades are different from spreads on  larger trades. For these regressions, we constructed datasets with one  observation for each security for each $10,000 trade amount increment.  For each security, for each $10,000 trade amount increment, we  calculated the inside spread, mean spread, and outside spread. The  inside spread is the difference between the lowest trade price on a dealer  sale and the highest trade price on a dealer purchase as a percentage of  the highest trade price on a dealer purchase. The mean spread is the  difference between the mean trade price on a dealer sale and the mean  trade price on a dealer purchase as a percentage of the mean trade price  on a dealer purchase. The outside spread is the difference between the  highest trade price on a dealer sale and the lowest trade price on a dealer  purchase as a percentage of the lowest trade price on a dealer purchase.  We only used observations on security-trade amount increment  combinations for which there existed at least one dealer sale and at least  one dealer purchase. Third, we analyzed the relationship between price  dispersion (the difference between the maximum and minimum trade  price as a percentage of average trade price) and trade amount by trade  type to determine if prices on smaller trades are more or less dispersed  than prices on larger trades. For these regressions, we constructed  datasets with one observation for each security, for each trade type, and  for each trade amount in $10,000 increments. We formed groups of  trades for each security, trade type, and trade amount in $10,000  increments. We then calculated price dispersion for that group of trades  as the difference between the maximum trade price and minimum trade  price as a percentage of the average trade price. For all three analyses,  our regressions included indicator variables for each security in the  sample to control for unobserved, time-invariant features of the securities.  We estimated separate regressions for bonds issued in each year from  2005 through 2010. We present the results of our regression analyses in  appendix III.
For illustrative purposes, we also calculated descriptive statistics using the  trade data. First, we calculated the average relative trade price on newly  issued fixed-rate securities by trade amount and trade type for 2010.  Second, we determined the average spreads for a $20,000 trade (an  individual investor-sized trade) and a $5 million trade (a institutional  investor-sized trade) of a fixed-rate security in 2010. We then used these  average spreads to calculate the yield to maturity of two hypothetical trades  of $20,000 and $5 million of the same security. We did this to compare the  effect of the size of the spread on the return received by an individual  investor and an institutional investor. Third, we calculated the average price  dispersion for newly issued fixed-rate securities by trade amount and trade  type for 2010. We presented these descriptive statistics in tables in the  report. In conducting our analyses, we carried out a data reliability  assessment of the MSRB trade data. To do so, we reviewed information on  the processes and procedures MSRB uses to help ensure that trade data  entered into RTRS are accurate and complete. We also reviewed the data  for missing values and outliers and, where we observed instances of such,  solicited explanations from MSRB staff. On the basis of this information, we  determined that these data were reliable for our purposes.
We also obtained statistics on the relative size of the municipal securities  market. We obtained data from the Federal Reserve’s Flow of Funds  Accounts of the United States on the estimated dollar value of municipal  securities outstanding and from Bloomberg L.P. (Bloomberg) on the  number of municipal issuers and outstanding municipal securities that it  tracks. We also collected data on the total number of public companies  listed on the major U.S. exchanges from the annual reports of NYSE  Euronext and NASDAQ OMX. We did not conduct an assessment of the  reliability of these data sources. However, these data are widely used by  regulators, market professionals, and academics and are considered  credible for the purposes for which we used them. In addition, we used  these data solely for descriptive purposes and not for the purpose of  making recommendations or drawing conclusions about causality.
We reviewed studies that analyzed pricing in the municipal securities  market. We limited our survey to those studies using data from 1995 or  later. We did this because prior to 1995, there was no systematic and  comprehensive dissemination of post-trade information for municipal  securities. We identified five relevant studies by searching the EconLit, the  JSTOR, the National Bureau of Economic Research (NBER) Working  Paper Series, and the Social Science Research Network (SSRN)  databases. We identified two additional studies through our interviews with  market participants. Although we did not identify methodological concerns  with these studies, the inclusion of these studies is for research purposes  and does not imply that we deem them to be definitive. In addition, we  attended or viewed the Securities and Exchange Commission’s (SEC) field  hearings on the state of the municipal securities market, reviewed industry  literature, and interviewed members of trade organizations representing  institutional investors, broker-dealers (including broker’s brokers), and  individual investors; academics; SEC Office of Municipal Securities Market  officials; MSRB officials and independent municipal market research and  advisory firms. We also reviewed information from these entities on the  availability of pre- and post-trade pricing information in the marketplace,  and we spoke to market participants interested in forming an exchange for  municipal securities. To understand how electronic systems and trading  platforms are used in the trading of municipal securities, we received a  demonstration from Bloomberg on the services it offers to municipal broker- dealers and other subscribers to facilitate municipal securities trading and  analysis. We also reviewed existing alternative trading systems (ATS)  operating in this market by analyzing their annual Form ATSs submitted to  SEC and other descriptive information and received a demonstration from  one ATS of its electronic platform for trading municipal securities.
To determine how federal regulators enforce MSRB rules to ensure fair  and reasonable prices for investors and the timely and accurate reporting  of municipal trades, we reviewed relevant MSRB rules, guidance, and  proposed rules. We focused on Rules G-30, G-14, G-12, and G-15, which  address pricing, trade reporting, and trade clearance and settlement. We  also reviewed documentation describing RegWeb, the web portal MSRB  makes available to federal regulators to analyze and query RTRS data for  regulatory purposes; the Financial Industry Regulatory Authority’s  (FINRA) policies and procedures for electronically surveilling RTRS data  for potential violations of MSRB pricing and trade reporting rules; and  FINRA and federal banking regulators’ (Office of the Comptroller of the  Currency, or OCC; Federal Deposit Insurance Corporation, or FDIC; and  Board of Governors of the Federal Reserve System, or the Federal  Reserve) examination procedures for assessing broker-dealer  compliance with these rules.
We also identified enforcement trends related to Rules G-14 and G-30.  With respect to FINRA, we reviewed results of the periodic surveillance of  trade data it conducted from 2006 to 2010 to monitor broker-dealers and  bank dealers for potential violations of MSRB Rules G-14 and G-30.  These results included the number of alerts FINRA’s surveillance  programs generated on potential G-14 and G-30 violations, as well as the  resolution (for example, no further review, cautionary action, etc.) of each  alert. We also reviewed data from FINRA’s System for Tracking Activities  for Regulatory Policy and Oversight (STAR), which tracks the life cycle of  FINRA’s regulatory matters, on the number of municipal-related broker- dealer examinations FINRA conducted from 2006 to 2010, the number of  those examinations that identified violations of MSRB Rules G-14 and G- 30, and the resolution of each examination. We conducted a reliability  assessment of the FINRA data and determined they were reliable for our  purpose. Specifically, we reviewed information on the STAR system and  FINRA’s policies and procedures for ensuring the data entered into the  STAR system were accurate and complete.
We reviewed a purposeful sample of 45 examinations FINRA conducted  from 2006 to 2010 in which it identified violations of MSRB Rules G-14 and  G-30. We reviewed these examinations to inform our understanding of how  FINRA examiners applied their policies and procedures for assessing  compliance with Rules G-14 and G-30. First, we selected all 11  examinations that had both G-14 and G-30 violations. Next, we selected an  additional 6 examinations with G-30 violations that were forwarded to other  agencies (such as SEC) for further review or initiated for a specific cause,  as opposed to routine examinations. Third, 8 examinations with G-30  violations were selected systematically by selecting every 4th examination  after ordering the remaining examinations with G-30 violations by the  completion date. Finally, we similarly selected 20 additional examinations  with G-14 violations by selecting every 20th examination from an ordered  listing of remaining examinations with G-14 violations.extrapolate the information in the sample examinations to the universe of  municipal broker-dealer examinations. Rather, we drew examples from  some of the examinations to illustrate concepts in the report.
With respect to federal banking regulators’ enforcement of Rules G-14  and G-30, we reviewed data on the number of bank dealer examinations  each regulator conducted from 2006 to 2010 and the number of those  examinations that identified violations of Rules G-14 and G-30, among  other MSRB rules. We conducted a reliability assessment of the federal  banking regulator data and determined they were reliable for our purpose.  Specifically, we reviewed information from federal banking regulators on  the systems from which they generated the data provided to us and their  policies and procedures for ensuring the data were accurate and  complete. From the examination data, we selected and reviewed  examinations or their relevant excerpts to observe examples of cases in  which the federal banking regulators identified violations of Rule G-14 or   As with the FINRA examinations, we reviewed these  other MSRB rules. examinations to inform our understanding of how federal banking  examiners applied their policies and procedures for assessing compliance  with Rules G-14 and G-30. We did not extrapolate the information to the  universe of bank dealer examinations.
Because OCC, FDIC, and the Federal Reserve identified few examinations with Rule G- 14 violations and no examinations with G-30 violations, we expanded our sample to  examinations with other violations (for example, MSRB Rule G-27 on supervision). This  allowed us to see more examination reports and observe how these regulators conducted  their examinations in general. We reviewed a combined total of 15 examination reports  from these regulators. procedures MSRB uses to identify late trades in RTRS. We determined  these data were reliable for our purposes.
To identify trends in settlement failures in municipal securities transactions,  we reviewed data from the National Securities Clearing Corporation  (NSCC). This self-regulatory organization (SRO) provides clearance and  settlement services for a variety of securities, including equity, corporate,  and municipal securities. Because NSCC typically does not track  settlement failures by security type, we requested that NSCC perform a  specialized query to provide us with this information. NSCC reviewed a 5- day trading period, from June 6 to June 10, 2011, and provided us with the  dollar value of municipal securities settlement failures, as well as the total  dollar value of all settlement failures, for that period. We did not assess the  reliability of these data because we used the data solely for descriptive  purposes and not for the purpose of making recommendations or drawing  conclusions about causality. However, we corroborated the data by asking  regulators and market participants about their experience with municipal  trade failures, and what they told us was consistent with the trends in the  data.
To understand how SEC oversees the municipal market, we reviewed the  SEC Office of Compliance Inspections and Examinations’ (OCIE)  guidance for conducting oversight inspections of FINRA-registered  broker-dealers, focusing on policies and procedures for assessing  compliance with MSRB rules related to pricing and trade reporting, and  we reviewed OCIE’s guidance for conducting inspections of SROs. We  reviewed data from OCIE on broker-dealer examinations it conducted  from 2002 to 2010 that assessed compliance with municipal securities  rules and regulations, including information on the MSRB rule violations  examiners identified. We conducted a reliability assessment of these data  and determined that there were limitations to how we could use them. We  reviewed information on OCIE’s system for tracking examination data (the  Super Tracking and Reporting System, or STARS), reviewed OCIE’s  policies and procedures for ensuring the completeness and accuracy of  the data, and interviewed OCIE officials. Although we determined that  STARS data are reliable, we learned that STARS does not contain a  unique field that allows users to retrieve all examinations with a municipal  component. Rather, OCIE officials ran a report by searching for key  words that, based on their experience with STARS data, were likely to be  included in an examination with a municipal component. This produced a  list of approximately 1,100 examinations conducted from 2002 to 2010.  We determined this was a reasonable way to proceed to identify a  significant portion of the targeted universe of examinations from which we  would draw selected exams for our review.
We reviewed a purposeful sample of 35 examinations that OCIE  conducted from 2002 to 2010 in which it identified violations of MSRB  Rules G-14 and G-30. First, we selected all 13 examinations that had G- 30 violations. Four of these examinations also had G-14 violations. We  then selected an additional 22 examinations with G-14 violations (from a  total of 80 examinations with G-14 violations during the time period). For  the latter group, we attempted to select examinations representing the  entire time period and a variety of recommended actions (from minor  deficiency letters to enforcement referrals). We reviewed the  examinations to understand how OCIE examiners applied OCIE’s  examination policies and procedures to assess broker-dealers for  compliance with MSRB rules. However, we did not cite any OCIE  examination statistics in the report, given that the list of 1,100  examinations may not have included all municipal examinations OCIE  conducted from 2002 to 2010, as well as the fact that OCIE uses a risk- based method and does not necessarily review for broker-dealer  compliance with Rules G-30 and G-14 in every examination. We also  reviewed OCIE’s 2002 and 2005 inspections of MSRB and FINRA’s fixed- income program, focusing on OCIE’s review of FINRA’s surveillance,  examination, and enforcement programs for overseeing municipal  securities trading. In addition, we reviewed MSRB’s and FINRA’s  responses to OCIE’s inspection reports. Finally we reviewed OCIE’s  inspections of FINRA’s district offices from 2000 to 2010 and its 2009  inspections of the Depository Trust Company and NSCC, SROs that clear  and settle municipal securities transactions.
We also reviewed meeting minutes, e-mails, training presentations,  MSRB’s memorandum of understanding with FINRA, and other relevant  documentation from MSRB to understand the coordination among SEC,  MSRB, FINRA, and federal banking regulators in conducting oversight of  the municipal securities market. Finally, we interviewed officials from  OCIE, Office of Municipal Securities, SEC’s Division of Enforcement,  MSRB, FINRA, and federal banking regulators to better understand their  oversight of the municipal securities market and efforts to coordinate their  oversight activities.
We conducted this performance audit from November 2010 to January  2012 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives.
section_title: Appendix III: GAO Analysis of MSRB Trade Data, 2005-2010
paragraphs: To understand how trade prices for individual investors differ from those  for institutional investors, we analyzed trade data on newly issued fixed- rate municipal securities from the Municipal Securities Rulemaking  Board’s Real-Time Trade Reporting System from January 1, 2005,  through December 31, 2010, using trade size as a proxy for whether the  trade involved institutional or individual investors. We focused on trades  that occurred within the period from 30 days prior to and 120 days after  the dated date on municipal securities. We chose to examine this time  frame because we observed that (1) securities in our sample trade most  frequently around the time of issuance, (2) trading activity declines within  days after issuance, and (3) trading activity has typically leveled off by  about 120 days after issuance. Focusing on a period with more trading  activity improves the precision with which we measure the relationships  described below. We chose to examine only trades of newly issued  bonds to ensure that all the trades we analyzed involved bonds that had  been available to investors for a similar amount of time and to limit the  likelihood that unobserved, time-varying characteristics of bonds influence  our analysis.
First, we analyzed how relative prices—defined as trade prices as a  percentage of the reoffering prices (the prices at which the securities  were originally sold to the public by the underwriter)—changed as trade  size increased for different types of trades (dealer sales to investors and  dealer purchases from investors). To do so, we estimated regressions on  security trades. The dependent variables in these regressions are the  relative price of a trade, and the independent variables in these  regressions are trade amount interacted with trade type and indicator  variables for each security in the sample. The security indicators control  for time-invariant features of a security that may affect the relative price at  which it trades. We estimated separate regressions for securities issued  in each year from 2005 through 2010. We present our regression results  in table 6. Our analysis shows that, relative to institutional investors,  individual investors generally pay higher prices when buying—and  receive lower prices when selling—municipal securities.
Relative prices at which broker-dealers sold securities to investors  declined on average with trade amount for all years in the analysis.  For all years, this negative relationship is statistically significant at the  1 percent level.
Relative prices at which broker-dealers purchased securities from  investors increased with trade amount for bonds issued in every year  except 2009. For every year except 2009, this positive relationship is  statistically significant at the 1 percent level. For 2009, this  relationship is negative but it is not statistically significant from zero.
Second, we analyzed how broker-dealers’ spreads—defined as the  difference between the price on dealer sales to investors and the price on  dealer purchases from investors as a percentage of the price on dealer  purchases—changed as trade size increased, using three different  measures of spread. For this analysis, we estimated regressions on  securities. The dependent variables in these regressions are the spread  on a security over a $10,000 trade amount increment, and the  independent variables in these regressions are trade amount and  indicator variables for each security in the sample. The security indicators  control for time-invariant features of a security that may affect its spread.  We estimated separate regressions for securities issued in each year  from 2005 through 2010. We present our regression results in table 7.  Our analysis showed, on average, broker-dealers receive larger spreads  when trading smaller blocks of municipal securities. For all years and for  all three measures of spread, this relationship is statistically significant at  the 1 percent level.
The inside spread, which estimated a lower bound for broker-dealer  spreads, declined as trade size increased for all years in the  analysis.
The mean spread, which estimated average broker-dealer spreads,  declined as trade size increased for all years in the analysis.
The outside spread, which estimated an upper bound for broker- dealer spreads, declined as trade size increased for all years in the  analysis.
The mean spread is the difference between the mean trade price on a dealer sale and  the mean trade price on a dealer purchase as a percentage of the mean trade price on a  dealer purchase.
Inside spread  -0.22%    -0.19%  Brackets contain the absolute values of t-statistics calculated using standard errors that are adjusted  for heteroskedasticity and for within-bond correlation. For all years and for all three measures of  spread, the relationship between spread and trade amount is negative, and the negative relationship  is statistically significant at the 1 percent level.
Third, we analyzed how price dispersion, defined as the difference  between the maximum and minimum trade price as a percentage of  average trade price, changed as trade size increased. For this analysis,  we again estimated regressions on securities. The dependent variables in  these regressions are the price dispersion over a $10,000 trade amount  increment, and the independent variables in these regressions are trade  amount interacted with trade type and indicator variables for each security  in the sample. The security indicators control for time-invariant features of  a security that may affect its price dispersion. We estimated separate  regressions for securities issued in each year from 2005 through 2010.  See table 8 for the regression results. Our analysis showed that prices for  larger trades tended to be more concentrated, while prices for smaller  trades tended to be more dispersed. For all years, this relationship is  statistically significant at the 1 percent level.
For broker-dealer sales to investors, the measure of dispersion  declined as trade amount increased.
For broker-dealer purchases from investors, the measure of  dispersion also declined as trade amount increased.
section_title: Appendix IV: Municipal Securities Rulemaking Board Expenses and Revenues Related to the Market Information Transparency Programs
paragraphs: The Municipal Securities Rulemaking Board intends for its Market  Information Transparency Programs (Transparency Programs) to protect  investors by fostering availabilty and transparency of critical information  about municipal securities and market activity. From fiscal years 2004  through 2010, MSRB spent significant resources developing and  operating these programs. MSRB’s total revenue has fluctuated during  this period. To generate additional revenues to continue to enhance and  maintain these transparency programs, in fiscal year 2010 MSRB  increased transaction fees for broker-dealers and imposed a new  technology fee.
subsections: section_title: MSRB Increased the Transaction Fee and Levied a New Technology Fee to Generate Additional Revenues
paragraphs: To establish a more stable long-term revenue base as well as ensure a  more equitable allocation of assessments among the municipal broker- dealers that fund MSRB’s operations, MSRB authorized changes to its  revenue sources in fiscal year 2011 that it expects will generate  significant new revenues. First, MSRB increased the transaction fee  charged to broker-dealers from $0.005 per $1,000 par value to $0.01 per  $1,000 par value on most municipal securities sales transactions reported  to MSRB. The new fee became effective in January 2011. MSRB expects  the increased transaction fee to generate an estimated $7 million  annually. Second, effective January 2011, dealers in municipal securities  are required to pay a technology fee of $1.00 per transaction for all sales  transactions. MSRB expects the technology fee to generate an estimated  $8.5 million annually. MSRB stated that the technology fee would be  transitional in nature and that it would review the fee periodically to  determine whether it should continue to be assessed.
MSRB said that these new and increased fees are necessary because its  expenses have increased significantly as a consequence of its capital  investments in technology and the regulatory responsibilities it has  assumed under the Dodd-Frank Act. MSRB said it would use the new  technology fee to establish a technology renewal fund, which would be  segregated for accounting purposes. The technology renewal fund is  intended to fund replacement of aging and outdated technology and to  fund new technology initiatives. For example, MSRB noted that certain of  the existing public information systems it operates, including RTRS, now  rely on dated technology and can be expected to need comprehensive  reengineering in the coming years. In addition, MSRB said that it will need  to develop information systems to facilitate its increased regulatory  responsibilities under the Dodd-Frank Act, which, among other things,  broadened its mission to include the protection of municipal issuers and  extended its regulatory authority to include municipal advisers.
The Dodd-Frank Act provided for additional revenue sources for MSRB,  although these revenues are unlikely to represent a significant source of  funding. The Dodd-Frank Act expanded the regulatory jurisdiction of  MSRB to include municipal advisers. MSRB amended its rules in  November 2010 to begin collecting initial fees ($100) and annual  registration fees ($500) for municipal advisers. However, MSRB officials  said that they did not anticipate these fees would provide a revenue  stream comparable to what MSRB receives from all fees on broker-dealer  activities, including the transaction, underwriting, and technology fees  previously discussed. The Dodd-Frank Act also mandated that SEC and  the Financial Industry Regulatory Authority, Inc., remit to MSRB a portion  of the fines collected for violation of MSRB rules. Effective October 2010,  SEC must remit half of the fines it collects to MSRB, and FINRA must  remit one-third, although that amount may be modified by agreement  among SEC, MSRB, and FINRA. MSRB stated that the amounts actually  received will be dependent on the level of enforcement by SEC and  MSRB and is expected to vary considerably from year to year.
section_title: Appendix V: Selected SEC Cases and Opinions Involving Excessive Municipal Securities Markups and Markdowns
paragraphs: Since the early 1970s, several Securities and Exchange Commission  cases and opinions have addressed instances in which broker-dealers  charged excessive markups or markdowns in municipal securities  transactions with customers. Table 11 summarizes the details of a few of  these cases.
section_title: Appendix VI: Regulators’ Policies and Procedures for Monitoring Compliance with MSRB Rules G-30 and G-14
paragraphs: The Financial Industry Regulatory Authority, Inc., the federal banking  regulators, and the Securities and Exchange Commission use a variety of  methods to help ensure broker-dealers’ compliance with rules issued by  the Municipal Securities Rulemaking Board. We reviewed their written  policies and procedures to understand how they assess broker-dealers’  compliance with MSRB Rules G-30 (fair and reasonable pricing) and G- 14 (timely, accurate, and complete trade reporting). FINRA has  established electronic surveillances of data reported to MSRB’s Real- Time Transaction Reporting System, by which it analyzes the data to  generate “alerts” for potential violations of certain MSRB rules. FINRA, in  certain circumstances, refers potential violations by bank dealers to the  appropriate federal banking regulators for further investigation. During the  period of our review, MSRB Rule G-16 required FINRA and the federal  banking regulators to conduct routine examinations of the firms under  their jurisdiction once every 2 years for compliance with all MSRB rules  and other applicable laws. The SEC’s Office of Compliance Inspections  and Examinations also conducts oversight activities through examinations  of selected broker-dealers.
FINRA utilizes parameters to help target its surveillance for fair pricing  and markup violations. For example, a surveillance program established  to identify transactions that were not executed at the prevailing market  price would flag any transactions priced outside of a certain range of  comparable prices. Similarly, a surveillance program established to  identify excessive markups or markdowns would flag any transactions  with markups or markdowns above a specified percentage of the  contemporaneous costs (for markups) or proceeds (for markdowns).  FINRA staff stated that these parameters are merely guidelines to assist  them in identifying transactions for further review. FINRA analysts follow a  series of steps to determine whether alerts generated by the surveillances  represent actual violations of Rule G-30. Specifically:
The analyst uses various data sources, such as Bloomberg, MSRB’s  Electronic Municipal Market Access website, or audit trail data, to  verify the information in the alert and confirm or establish the  prevailing market price for the municipal security at the time of the  trade in question.
If necessary, the analyst asks the firm for documentation and an  explanation of how it determined that its price and markup or  markdown were fair and reasonable.
After reviewing the firm’s documentation, the analyst prepares a  memorandum recommending a particular disposition for review and  approval by FINRA managers.
In their G-30 compliance reviews during broker-dealer examinations,  FINRA examiners check for price manipulation and excessive markups  and markdowns. The manipulation module of FINRA’s examination tool  kit includes several questions and warning signs that help examiners  identify whether broker-dealer firms intentionally tried to manipulate  prices. FINRA’s examination tool kit also contains a module to help  examiners identify excessive markups or markdowns. Examiners follow a  series of steps:
Examiners collect a variety of records from the firm, such as order  tickets and confirmations for a given sample of transactions, as well  as daily transaction reports.
Using MSRB data, they identify a comparison transaction that best  represents the market (i.e., the prevailing market price) for each  sample security at the time of each sample customer transaction.
Using the comparison transaction data and records collected from the  firm, examiners calculate the markups and markdowns that the firm  charged on the sample transactions.
For markups or markdowns outside of specific parameters, examiners  request an explanation from the firm. Again, the parameters are  merely guidelines to assist them in identifying transactions for further  review.
Examiners consider the facts and circumstances of each individual  case and, when necessary, consult with FINRA fixed-income experts  to substantiate violations.
FINRA’s periodic late trade reporting surveillance identifies transactions  reported more than 15 minutes after they occurred, with analysts  following a similar review process as they follow for pricing and markup or  markdown alerts.
FINRA reviews MSRB transaction data and selects firms with higher  levels of potential noncompliance during a given surveillance period.
As with surveillances for pricing and markups, analysts use various  data sources, such as Bloomberg, the EMMA website, or audit trail  information to provide context for each case.
If necessary, the analyst asks the firm for documentation, including an  explanation for the late reporting and any trade memorandums in  support of that explanation, a copy of the firm’s written supervisory  procedures regarding municipal securities transaction reporting, and  any evidence of the firm’s own review of the transactions in question.
The analyst reviews the documentation and prepares a memorandum  recommending a particular disposition for review and approval by  FINRA managers.
In their G-14 compliance reviews conducted during examinations, using a  sample of trades from the firm’s trading blotters, FINRA examiners  conduct a “failure to report” review to detect transactions that the firm  effected but failed to report to MSRB. They also check whether firms have  filed and kept current a Form RTRS with MSRB. This form contains  information that ensures that the firm’s trade reports can be processed  correctly. Finally, examiners look for unreported and inaccurately reported  trades, as well as late reported trades that would not have been detected  by FINRA’s surveillance activities. In doing so, they adhere to the  following procedures:
Examiners review monthly RTRS statistics on trades that the firm  executed or cleared during the review period. They select a time  period for review and run statistical reports related to each broker- dealer firm’s trade reporting for that time period. They also obtain  detailed trade information from MSRB.
Examiners then select a sample of trades from the time period they  chose for review.
For the selected sample, they request and review order tickets and  confirmations from the firm and compare the RTRS information to the  information on those documents, making note of differences between  the two sources. For discrepancies noted, they attempt to determine  the root cause of the apparent violations and, if necessary, expand  their sample to confirm the violation.
subsections: section_title: Federal Banking Regulators
subsections: section_title: Rule G-30
paragraphs: The Office of the Comptroller of the Currency, the Federal Deposit  Insurance Corporation, and the Board of Governors of the Federal  Reserve System constitute the federal banking regulators that oversee  those banks that are registered as dealers of municipal securities. In  general, the three federal banking regulators’ examination policies and  procedures require bank examiners to select a sample of the bank  dealer’s transactions, review the relevant bank documentation and MSRB  data for those transactions, and analyze the data to evaluate whether any  prices appear to be unfair or unreasonable.
Federal banking regulator officials told us that bank examiners obtain and  review MSRB transaction data prior to their on-site examinations. When  conducting on-site bank dealer examinations, federal banking examiners  generally select a sample of the bank dealers’ transactions for a given  review period. They typically request and review copies of the bank’s  transaction records for the review period and compare the bank’s records  with MSRB transaction data to ensure that the bank reported all of its  trades to MSRB accurately and on time.
In checking for G-30 compliance during broker-dealer examinations,  OCIE examiners generally take some or all of the following steps:
Examiners review MSRB data to select a sample of the firm’s  transactions that appear to have higher markups than other reported  transactions in a given review period.
Using order tickets, confirmations, and information on  contemporaneous costs or proceeds, they calculate the markups or  markdowns the firm charged on the sample transactions.
Examiners ask the firm to explain cases that fall outside of certain  parameters.
In checking for G-14 compliance during broker-dealer examinations,  OCIE examiners generally do the following:
Examiners select a population of municipal transactions for a given  review period.
They compare the MSRB trade information with the information on the  firm’s purchase and sales blotter to determine whether all transactions  were reported.
They also select a sample of order tickets and confirmations for the  trades and compare that information with the MSRB report to check  for accuracy of reporting.
section_title: Appendix VII: Comments from the Securities and Exchange Commission
section_title: Appendix VIII: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Karen Tremba, Assistant  Director; Pedro Almoguera; Silvia Arbelaez-Ellis; Ben Bolitzer; Emily  Chalmers; William R. Chatlos; Rachel DeMarcus; Stefanie Jonkman;  Courtney LaFountain; Marc Molino; Edward Nannenhorn; Robert Pollard;  Lisa Reynolds; Jessica Sandler; and Ardith Spence made key  contributions to this report.