I was recently contracted to help a small firm develop additional wording for its Written Supervisory Procedures (WSPs). The firm had recently received a FINRA cautionary letter due to a failure to include wording in its WSPs regarding “bonds of limited quotation”. The MSRB, in its Rule G-18, Supplementary Material .06, states “Each dealer must have written policies and procedures in place that address how the dealer will make its best-execution determinations with respect to such a security in the absence of pricing information or multiple quotations and must document its compliance with those policies and procedures.”
When I reached out to other firms that I’ve worked with, to ask what sort of policies they have in place to show compliance with the Rule, I was surprised (perhaps I shouldn’t have been) to find that examiners had also asked them about this topic during recent exams. Perhaps it’s on FINRA’s radar and being used as a common exam focus.
Discussion about limited quotation bonds becomes even more timely as the MSRB re-implements its practice of sending “off market” alerts to firms. While the MSRB had discontinued the alerts during the early stage of the pandemic shutdown, as prices of bonds moved wildly and firms invoked their business continuity “extreme market condition” policies, the resumption of these alerts (September 1, 2020) may bring renewed scrutiny of prices at which dealers transact trades. Dealers should be ready to defend the methods by which they reviewed and approved trade prices. Notice that I said, defend their methods. It’s important to remember during this process the Rule requires that a firm engages in “reasonable diligence”, not necessarily that a firm discovers the perfect price for a bond.
Determining the fair price of a bond with limited quotations depends upon, as one of my compliance acquaintances describes it, a sort of “mosaic” approach to that determination. A description of the ingredients of this mosaic should be included in a firm’s WSPs, listing the multitude of factors used in order to show that a reasonable attempt has been made to ensure fair execution. Wording in the WSPs should describe the firm’s attempt to gain a total picture for the value of the bonds, employing various checklists to compare the price of the bond with other available data. Items on the checklist would obviously include matching dealer, institutional, or retail trades, but for bonds with limited quotations, these may be difficult to produce. Still, the lack of such trade information can be used to show that these sources were considered and sought. Other items on the checklist could be:
- Recent bid and asked levels (by contacting broker’s brokers and asking if they have a history on the bond),
- The historic spread to a curve at which the bond has traded in the past, and using that same spread. (Curves are published on the MSRB’s EMMA site.)
- BVAL, other Pricing Services, and Third Party Vendors
- Trade levels of similar bonds.
- Trade levels of bonds from the same (or other) series of the same issuer.
- Economic models.
One might note that this is all similar to the “waterfall” method of determining the prevailing market price (PMP) of a bond for mark-up purposes. However, unlike determining most PMPs, which usually have a starting point and go down the waterfall, there may be no “starting point” in the case of a limited quotation bond. The starting point is anywhere and everywhere, using all possible items on the list.
Always glad to chat about compliance and hear others’ thoughts- especially any other methods by which firms are ensuring compliance with G-18.