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

Letter

Background

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.

Municipal Securities and Secondary Market Structure

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.

Municipal Market Regulation

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.

Municipal Securities Are Priced in an Opaque Market That Favors Better- Informed Participants

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.

Among Other Factors, Broker-Dealers Use Information on Similar Securities to Assess the Relative Value of a Security and Determine Its Price

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.

Individual Investors Generally Trade at Less Favorable Prices than Institutional Investors

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.

Individual Investors Generally Have Less Information and Expertise to Assess Prices than Institutional Investors

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.

SEC, MSRB, and Market Participants Are Considering Ways to Improve Pretrade Price Transparency

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.

Regulators Oversee Compliance with MSRB Rules and Have Not Found Systemic Violations, but SEC’s Monitoring Is Limited

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.

MSRB Rules Govern Municipal Transaction Pricing, Reporting, and Clearance and Settlement

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.

Regulators Use Various Methods to Monitor and Enforce Compliance with MSRB Pricing and Trade Reporting Rules

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.

Regulators’ Surveillance and Examinations Did Not Reveal Systemic Trade Pricing, Reporting, or Clearance and Settlement Issues

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.

OCIE Has Not Inspected Key SROs’ Municipal Activities since 2005 and Has Conducted Limited Monitoring of SRO Regulatory Efforts

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.

Conclusions

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.

Recommendation for Executive Action

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.

Agency Comments and Our Evaluation

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.

Appendix I: Potential Uses, Risks, and Oversight of Derivative Products in the Municipal Securities Market

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.

Pursuant to the Dodd- Frank Act, CFTC Has Issued Rules Regulating Swap Dealers’ Transactions with Municipal Issuers

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.

Appendix II: Scope and Methodology

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.

Appendix III: GAO Analysis of MSRB Trade Data, 2005-2010

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.

Appendix IV: Municipal Securities Rulemaking Board Expenses and Revenues Related to the Market Information Transparency Programs

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.

MSRB Increased the Transaction Fee and Levied a New Technology Fee to Generate Additional Revenues

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.

Appendix V: Selected SEC Cases and Opinions Involving Excessive Municipal Securities Markups and Markdowns

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.

Appendix VI: Regulators’ Policies and Procedures for Monitoring Compliance with MSRB Rules G-30 and G-14

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.

Federal Banking Regulators

Rule G-30

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.

Appendix VII: Comments from the Securities and Exchange Commission

Appendix VIII: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

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.