I wear two hats- working as CEO of Armstrong Compliance Solutions LLC and also as the CCO of Regional Brokers, Inc. (RBI).
RBI is a Municipal Securities Broker’s Broker (MSBB)- it facilitates liquidity in the municipal market by widely distributing bid-wanted requests received from dealers and SMMPs. It’s RBI’s opinion that the wide net cast by its auction platforms helps the retail accounts of dealers by getting as many eyes on the bonds as possible. And, wide distribution is what the MSRB wants!
Despite the ability of an MSBB to cast that wide net, there’s a type of municipal bond that’s currently limited in its liquidity- that is, any bond whose face value is below the minimum denomination (BMD) stipulated for that bond. For example, a piece of $3000 from an issue where the minimum denomination was $5000.
I won’t get into a long discussion here about “why” there are minimum denominations specified on bond issues- much of it had to do with operational costs, like printing and settlement procedures. In the days of electronic settlement and book entry form, these costs have been minimized. Nevertheless, bonds that are below their minimum denomination have historically had limited liquidity, due to the way registered reps at dealers were paid. If a rep wanted to make a $100 commission on a 5m trade, the rep would work for $20 per bond. To make that same $100 on a 2m bond trade, the rep would have to work for $50 per bond, which could be considered an excessive markup by the regulatory agencies. The limited ability to re-sell these bonds led to a lack of liquidity- no firm wanted to bring into its inventory a bond that none of its reps could re-sell. However, in a world where I get advertisements from firms willing to do a trade for $1 a bond, this seems like less of a hurdle for firms- I’d certainly buy pieces like that if I could pay that low a commission.
This lack of liquidity caused the MSRB to enact MSRB Rule G-15(f), which placed compliance requirements on the trading of these bonds. A firm that purchases a BMD from a customer must ensure that it is “taking out” the entire position of that customer, and a firm selling a BMD to an account must warn that account, in writing, that the bond may be difficult to re-sell in the future.
While adhering to these parts of the Rule are certainly manageable, there is another part of the Rule that has affected liquidity in a more stringent way- the requirement of G-15(f)(iii), that requires a dealer purchasing this type of bond from another dealer to receive a letter from the seller stipulating that it was a takeout. The Rule states, ” In determining whether this is the case, a broker, dealer or municipal securities dealer may rely upon customer account records in its possession or upon a written statement provided by the party from which the securities are purchased.“
RBI, as an MSBB, provides confidentiality to its counter-parties. It can therefore not provide a letter from the seller to the buyer without breaking that confidentiality. And, while RBI is willing to receive a letter from a seller, and write its own letter to the buyer, the selling firms are often unwilling to make the letter available . RBI believes that the biggest reason they don’t want to make the letter available is an age old reluctance to put anything in writing, outside their own firm, that could come back and bite them if it ever turned out to be incorrect. The requirement of the letter means that firms are reluctant to use an MSBB, and therefore may not be getting the breadth and scope (from Rule G-18) that the MSRB would like.
RBI’s opinion is that that the requirement of such a letter is not only an imposition, but also a meaningless imposition. If Dealer A buys bonds from Dealer B, and gets a letter from B that it was a takeout, Dealer A has no way of affirming that it really was a takeout. RBI believes that if the regulatory authorities are concerned about whether compliance with the Rule is being fulfilled, that they need to examine Firm A’s procedures and Firm B’s procedures independently. It makes no sense to make Firm A dependent on the compliance of Firm B.
RBI has written a letter to the MSRB regarding this problem of liquidity. While RBI has not suggested specific changes to the Rule, it would seem that, at least, guidance should be given that a letter is not required as long as each firm can show that it has properly performed and memorialized their internal compliance requirements of the Rule.
RBI has also written a letter to FINRA, in that RBI has anecdotally heard that FINRA is actively examining firms for their compliance with receiving a letter from the selling firm, and has been (at least) issuing cautionary letters, warning firms that they cannot proceed with trades such as this without the letter. These actions by FINRA have further caused a freeze in the market for these bonds.
And, who is hurt by all this? The retail investor, who through no fault of their own ended up with a small piece of a bond, either due to a divorce, or death, or some other life event.
I’d be happy to discuss this with anyone interested in trying to solve the liquidity problem.