The following is an edited version of a speech delivered by Securities and Exchange Commission member Elisse B. Walter on Oct. 1 at the Securities Industry and Financial Markets Association's Municipal Bond Summit in New York.
It was about two years ago that our chairman, Mary Schapiro, asked me to lead the SEC staff in a concerted effort to study the municipal securities market. We commenced that study with our inaugural field hearing in San Francisco to elicit the analyses and opinions of a broad array of participants in the municipal market.
We followed up with similar hearings in Washington, D.C., and Birmingham, Ala., in addition to spending a tremendous amount of time meeting and speaking with interested parties on issues spanning from disclosure to accounting to market dynamics to credit ratings, and beyond.
As you know, the information gathering culminated with a comprehensive report that the commission issued July 31 with the unanimous support from the commissioners. Let me take this opportunity to repeat my heartfelt thanks to my fellow commissioners and all of the commission staff who labored tirelessly on the agencywide, collaborative report. [Staff members'] tireless efforts were undertaken on top of their regular workloads, which included responsibilities under Dodd-Frank and the JOBS Act. I would again like to commend them for their dedication and diligence in preparing this important document.
The commission report discusses in depth two broad issues that affect investors in the municipal securities market: disclosure and market structure. The report includes recommendations for changes in legislation, government and [self-regulatory organization] regulations, and industry practice. Pleased as I am to have completed the report, more work remains to be done — by the commission and its staff, and the [Municipal Securities Rulemaking Board], and I look forward to what I hope will also be a robust dialogue with Congress.
On the issue of disclosure, we have heard consistently that investors need more-timely and accurate information from issuers in order to make better-informed decisions. The commission report recommends, among other things, that Congress consider allowing the SEC to set baseline disclosure standards and require municipal issuers to have audited financial statements as appropriate.
Today, however, I want to focus on the structure of the municipal market. Unlike the commission report recommendations relating to the disclosure arena of the municipal securities market, most of the ideas reflected in the recommendations relating to the market's structure are new and are being publicly vetted by the commission for the first time. In my view, we now have an opportunity to initiate significant improvements in this area to better protect not only today's investors but tomorrow's, as well. By leveraging the dramatic advances in communications and technology that have occurred in recent years, I believe we can work together to improve the transparency, efficiency and fairness of the municipal securities market to the benefit of all investors — and particularly the many retail investors for whom municipal securities are such a significant portion of their investment portfolios.
Let me briefly paint a picture of the municipal securities market that exists today. It is substantial, by any measure. There are over 1 million different municipal bonds outstanding, totaling approximately $3.7 trillion in principal. The average daily trading volume in 2011 was $11.3 billion. By par amount, $3.3 trillion was traded in 2011.
But despite the size of the municipal securities market, we know that municipal securities are relatively illiquid. About 99% of outstanding municipal securities do not trade on any given day. While trading is most active in newly issued bonds, it declines significantly as time passes. For example, only 15% of municipal securities trade in the second month after issuance.
As has been the case for many years and despite considerable technological advancements in the trading of securities in general — including municipal bond trading on alternative trading systems — trading in the municipal market remains decentralized and opaque; investors have preferred dealers, and dealers trade selectively with counterparties. Further, the market share among dealers remains heavily concentrated. In 2011, five dealers accounted for approximately 54% of customer trades by par amount, and the top 10 dealers accounted for approximately 75% of all customer trades by par amount.
Yet despite this concentrated dealer market, individual investors play a key role in providing the capital sought by municipal issuers. Fully 50% of the outstanding principal amount of municipal securities is held by individual investors directly. An additional 25% of the outstanding principal amount is held on behalf of individual investors by mutual, money market, closed-end and exchange-traded funds.
In light of the significant role that individual investors play in the municipal market, we must do much more to protect their interests. Despite its size and obvious importance, the municipal securities market, unfortunately, lacks many of the protections customary in many other sectors of the U.S. capital markets. Investors in municipal securities are, in certain respects, afforded “second-class treatment.” In addition to the specific recommendations to improve municipal securities disclosure that are discussed in the commission report, I believe we need to begin a broad-based initiative to improve the structure of the municipal market so that it is more transparent, efficient and fair for all investors.
PRE-TRADE TRANSPARENCY
As highlighted in the commission report as well as the [Government Accountability Office] report issued this past January regarding the market structure, pricing and regulation of the municipal securities market, [it is clear that this] market could benefit from more- meaningful price transparency, especially pre-trade price transparency. Quotation information is not prevalent, and to the extent it exists, it is not widely disseminated.
Pre-trade price information is almost never available to individual investors. This lack of market transparency can dilute the protections afforded investors by a competitive market structure. It can inhibit robust competition among market participants to provide the best prices. It can make evaluation of execution quality difficult or impossible. And it can create enforcement and other regulatory challenges that may lower investor protection.
Studies show that it is more expensive for investors to trade municipal securities than to trade corporate bonds or equity securities. These studies have attributed the higher transaction costs to the relatively low level of price transparency. Further, studies show that transaction costs in the municipal securities markets are generally higher for the retail investor than they are for institutional investors.COST DISPARITY
There are various reasons identified in the commission report for this disparity in costs for retail and institutional investors. One reason is that individual investors have less access to price information. Because retail investors do not have access to the pricing information that institutional investors obtain, their bargaining power with dealers for a good price is diminished. Another reason is that because the market is decentralized, more levels of intermediation are required for an ultimate buyer and seller to meet, and with multiple intermediaries extracting multiple compensation charges, transaction costs consequently increase. This degree of intermediation appears to be more prevalent in smaller trades, making it even more expensive for those investors to transact.
So why are retail investors in the municipal securities markets at such an informational disadvantage? Many argue that the unique attributes of the municipal bond market — a market with a wide variety of securities and a relatively low volume of secondary-market trading — make this market structure inevitable. Perhaps that was the case in the past, when the costs of aggregating liquidity and disseminating trading interest may have been too great to support a different model. But there have been dramatic advances in communications and technology in recent years. I am concerned that market participants are not taking full advantage of these new tools to improve the transparency and efficiency of the municipal securities markets for the benefit of small investors, as they have in other market segments.GETTING REAL
Technology has changed how all sorts of products are traded. Consider the real estate market as an interesting comparison. It has attributes that are somewhat analogous to the municipal bond market: There are a wide variety of homes for sale, each home is unique and the market is relatively illiquid. Yet technology has revolutionized the transparency of available listings, making it markedly easier for prospective buyers to learn of listings. As you know, a variety of web-based services today provide consumers with access to property information, including offering prices, that once was available only by contacting brokers directly.
It is my view that we must seek ways to use new technology to help investors in the municipal securities markets. So why couldn't similar improvements in pricing information — ones that can be made possible by existing developments in technology — be applied in that marketplace?
Certainly, the municipal securities market has experienced important technological advances. Electronic trading in municipal securities is proliferating, as evidenced by the rise of [alternative trading systems]. Liquidity providers using an ATS can now post available bond inventory and trading interest efficiently. Likewise, they are trading electronically more and more. Indeed, the commission report estimates that trading in these [alternative systems] could account for as much as 50% of the number of trades in municipal securities. Further, the data seem to indicate that such [alternative-system] trades [are] smaller, retail-size trades. All of this suggests that municipal bond dealers have leveraged technology to reduce their distribution costs by using [alternative trading systems] to more efficiently distribute their inventory of municipal securities. Yet it is not clear that the benefits of such improvements in efficiency and market transparency have flowed through to retail investors.
In fact, as the report indicates, the trading interest represented on these [alternative trading systems] is generally available to their participating municipal bond dealers, and perhaps even to institutional investors, but is not directly accessible by, or transparent to, nonparticipants, such as retail investors. We also understand that information about trading interest in an [alternative system] might not even be available to all participating dealers of an ATS. While it may be more efficient for dealers to display their trading interest using [such systems], it appears as if the [alternative systems] have been structured generally to mimic the manner in which these liquidity providers have traded in the past. That is, trading interest is still selectively disclosed, and access to that trading interest is selective. In short, the sharing of pricing information remains limited to a select few.
If a primary justification for the existing structure of the municipal securities market and its resulting opacity is the historical inefficiency of dealers in aggregating and disseminating trading interest broadly in a wide variety of securities, then the very same technology being used by these dealers to reduce their own trading costs justifies change. In my view, it certainly provides us with an opportunity to take a significant step in the municipal market toward creating transparency in this area. It presents the industry with an opportunity to lead.
