Fixed Income Conference March 11, 2014 2014 by FINRA. All Rights Reserved. The FINRA Fixed Income Conference Video is reproduced by permission of the Financial Industry Regulatory Authority, Inc. (FINRA) under a non-exclusive license and may not be rebroadcasted, reproduced, or repurposed without the express written consent of FINRA. FINRA is not responsible for any errors in or omissions from the information contained in the FINRA Fixed Income Conference Video. All such information is provided "as is" without warranty of any kind and FINRA makes no representations and disclaims all express, implied and statutory warranties of any kind to the user and/or any third party, including any warranties of accuracy, timeliness, completeness, merchantability and fitness for any particular purpose. FINRA reserves the right to amend the Fixed Income Conference Video at its discretion.
Welcome Remarks and Keynote Address FINRA Fixed Income Conference March 11, 2014 New York, NY
Fixed Income Market Structure: Evolution and Electronic Trading FINRA Fixed Income Conference March 11, 2014 New York, NY
Conference resumes at 10:15 a.m. Market Transparency Emails Subscribe to one or all of the Market Transparency update emails: Fixed Income TRACE Information for Service Bureaus Information for TRACE Reporting FINRA Firms Information for TRACE Data Vendors and Subscribers Equities ADF Information OTC Equities Trade Reporting Information OTC Equities (OTCBB) Quotation Information FINRA TRF Information ATS Transparency Information http://www.finra.org/subscriptions
Examination and Enforcement Updates FINRA Fixed Income Conference March 11, 2014 New York, NY
Member Regulation Examination Update
2014 Fixed Income Examination Priorities and Findings Retail sales of interest rate sensitive products Municipal securities broker-dealer activities Municipal advisor activities SEA Rule 15c3-5 on direct or sponsored market access 6
Retail Sales of Interest Rate Sensitive Products Suitability Disclosure of material risks Concentrations in longer duration instruments Training of registered representatives Policies and procedures 7
Municipal Securities Broker-Dealer Activities Pricing of transactions, including by broker s brokers Disclosure of material risks to investors Pay-to-play Gifts and gratuities Suitability Underwriter disclosures regarding role, compensation and conflicts of interest to issuers Proper identification of instruments as municipal securities Primary offering practices Supervisory and internal controls Electronic trading and brokerage 8
Pricing of Transactions, Including by Broker s Brokers Diligence used to determine the prevailing market price of a security at the time of the transaction, especially for thinly-traded securities Compliance with new MSRB Rule G-43 on broker s brokers and related recordkeeping requirements of MSRB Rule G-8 9
Pay-to-Play and Gifts & Gratuities Supervisory controls to prevent pay-to-play violations Especially when a firm employs politically connected individuals Supervision of branch offices where municipal underwriting activities take place Excessive gifts to encourage or reward repeat business Excessive entertainment, such as on rating trips 10
Underwriter Disclosures to Issuers Timing and content of disclosures regarding role, compensation and actual or potential material conflicts of interest to issuers as required by MSRB Rule G-17 interpretations and FAQs. See MSRB Notices 2012-25, 2012-38 and 2013-08 See also MSRB Rule G-23 and MSRB Notice 2011-65 11
Proper Identification of Municipal Securities Dealers sometimes fail to recognize certain financial instruments are municipal securities: 529 College Savings Plans Bank loans used by issuers to finance capital projects may be munis Certain asset-backed securities that are municipal securities Concerns: Firms may apply FINRA rules inappropriately and / or fail to register with MSRB prior to engaging in a municipal securities business. Trades in municipal securities may be reported to TRACE. 12
Primary Offering Practices Honoring issuer retail order periods Timely and accurate submission of offering documents under Rule G-32(b) Access equals delivery of official statement under Rule G-32(a) Review of issuer s continuing disclosure practices and other underwriter due diligence 13
Electronic Trading and Brokerage Dealers operating electronic brokerages have the same obligations as a dealer conducting a traditional trading business: Suitability obligations for recommended transactions Fair pricing Disclosure of material information to non-sophisticated municipal market professional (SMMP) customers 14
Municipal Advisor Activities Permanent registration under SEA Rule 15Ba1-2 Recordkeeping under SEA Rule 15Ba1-8 Current fiduciary standard under the Dodd-Frank Act MSRB rules potentially effective in 2014 15
Municipal Advisors Registration Understand what constitutes municipal advisor activity under the SEC s final rules and whether your firm needs to register. If you are currently conducting municipal advisory activities, you are required to be registered under the temporary registration rule. Underwriters are exempt, but only in certain circumstances. Understand your obligations as a fiduciary. Stay current on SEC and MSRB rules, guidance and effective dates as they are published. Attend the municipal securities panel! 16
Summary of SEA Rule 15c3-5 on Market Access Requires broker-dealers with access to trading directly on an exchange or alternative trading system (ATS), including those providing sponsored or direct market access to customers or other persons, to implement risk management controls and supervisory procedures reasonably designed to manage the financial, regulatory and other risks of this business activity. If your firm has access to trading on an ATS, whether for customer, proprietary, or principal trades, your firm is subject to the Market Access Rule. 17
What are FINRA Examiners Looking For? Fixed income market access procedures that incorporate all transactions sent to an ATS Reasonably designed capital / credit limits reflective of the relative risks associated with this activity Evidence of supervision Adequate due diligence over the use of third-party service providers Periodic testing of systemic controls Annual CEO certification TIP Once the exam is announced, providing the exam team with a flow chart of your firm s trade flow for each ATS utilized will help facilitate the examination. 18
How Fixed Income is Different An individual, registered rep, or trader may enter the order. The rule applies to the last person / desk who touches the order prior to execution. A bid wanted is not an order. If a posted quote is not executable, orders against that quote are not subject to the rule. While there are almost no limit orders in fixed income, firm quotes must be counted for purposes of decreasing financial limits on a pre-trade / intra-day basis. All fixed income instruments, including municipals and treasuries, are subject to the rule. A BD that would otherwise be required to register as an ATS and that only deals in government securities is exempt from Reg ATS (and thus SEA Rule 15c3-5). 19
Common Rule 15c3-5 Questions and Answers Question Our ATS activity is very limited. Does the rule apply? Can we use post-trade, soft blocks? Can we delegate responsibility to the ATS? What ATS controls can we rely on? Who are the ATSs, anyway? Response Yes. While the controls may differ depending on your business, the need to comply is the same. No. The Rule requires that the controls prevent, on a pre-trade basis, an order that would exceed the financial threshold. No. Your firm is responsible for compliance with the rule. Some ATSs offer technical support of duplicative and erroneous trades, as well as financial thresholds. These may be used with appropriate testing. However, your firm should independently set the limits, not just accept the limit set by the ATS. The SEC periodically publishes a list at: www.sec.gov/foia/docs/atslist.htm. 20
Enforcement Update
Notable FINRA Municipal Securities Enforcement Cases 2013-14 22
L.J. Hart & Company (Disciplinary Proceeding No. 2011027491601) Firm improperly gifted over 2,000 tickets, valued at $183,546, to various sporting events to employees or members of the governing boards of municipal securities issuers (school districts and counties), who were underwriting clients of the firm. On 598 occasions, the firm gifted tickets to sporting events valued in excess of $100 to individual municipal representatives within a one-year period. No firm employee attended the events. Firm censured and fined $200,000. 23
Gardnyr Michael Capital, Inc. & Pfilip Gardnyr Hunt, Jr. (Disciplinary Proceeding No. 2011026664301) Case of first impression: Whether it is a violation of MSRB Rule G-17 for a municipal securities firm to obtain reimbursement for certain costs incurred by municipal officials and firm representatives on bond rating trips? MSRB Rule G-17 requires each broker, dealer, municipal securities dealer and municipal advisor to deal fairly with all persons and not engage in any deceptive, dishonest, or unfair practice. FINRA / MSRB Violation of Rule G-17 to pass along expenses to municipal issuers (taxpayers) where the expenses are not reasonably related to, or necessary costs of, the municipal securities offerings. Three categories of expenses at issue (in three ratings trips to New York City): Extra day of travel Contractual obligations Entertainment expenses 24
EXTRA DAY TRAVEL Willful Violation of G-17 Monday meetings in NY scheduled. Four of seven municipal officials, GMCI President and wife, and officer of co-underwriter flew to NY early Saturday morning. Other three municipal officials traveled to NY on Sunday. None of the Saturday activities in NY were related to the bond underwriting. Activities included shopping, entertainment, dining and one municipal official who engaged in other unrelated business. Panel found that charging an issuer for food and lodging on a day on which there was no activity related to the business purpose of the trip was excessive. Excessive exceeding a normal, usual, reasonable, or proper limit, and being more than is usual, required, or permitted. Approval by municipal officials of excessive, unnecessary expenditures does not render the expenses reasonable or proper. 25
CONTRACTUAL OBLIGATIONS Willful Violation of Ethical Obligations under G-17 Warrant purchase agreements obligated GMCI to pay the cost of transportation and lodging for representatives to attend meetings and all other expenses incurred by [GMCI] in connection with its public offering and the distribution of the [warrants]. Clear and unambiguous purchase agreements drafted by the issuer provided a financial benefit to the issuer. Never amended by the parties. Notwithstanding the language of the agreements, GMCI sought and received reimbursement of its travel expenses incurred in ratings trip. Purpose of Rule G-17 is to establish a minimum standard of fair conduct and to codify basic standards of fair and ethical conduct. disregarding clear contractual obligations is dishonorable and inequitable conduct. 26
ENTERTAINMENT EXPENSES No Violation of Rule G-17 GMCI paid for and received reimbursement from two issuers for Broadway shows and a tour of the Empire State Building. Enforcement contended that entertainment expenses were categorically excessive and lavish it was excessive and lavish to make taxpayers pay for anything that was unrelated to the offering. Panel found that GMCI did not have sufficient notice that incurring and seeking reimbursement for any entertainment costs violated Rule G-17. Held that it was not unreasonable for GMCI to interpret Rule G-17, the relevant Interpretative Notices, and disciplinary actions, as allowing for reimbursement of entertainment expenses that were not excessive or lavish. But Panel refused to endorse the practice of seeking and obtaining reimbursement of entertainment expenses. 27
SANCTIONS GMCI censured, fined $10,000, and ordered to pay restitution ($5,322 plus pre-judgment interest) for Rule G-17 violations. GMCI censured and fined $10,000 for supervisory failures relating to ratings trips. GMCI President suspended in all principal capacities for 3 business days and fined $10,000. 28
Market Regulation Legal Section Update
Legal Section Who We Are Lawyers Located in Maryland, New York, Illinois and Pennsylvania Staff attorneys in Rockville (20), New York (15), Chicago (1), and Philadelphia (1) Staff attorneys report to one of seven chief counsels located in Rockville (4) and New York (3) Head of Legal is Robert Marchman and Deputy is David Rosenstein Bring enforcement cases on behalf of Quality of Markets Department (includes Fixed Income) Enforcement cases relate to customer protection, sales practice and market integrity issues 30
Legal Section What We Do Snapshot of 2013 Issued: 370 Letter of Acceptance, Waiver and Consents (AWCs) 37 Minor Rule Violation Letters (MRVs) 309 Cautionary Action Letters (CALs) 9 Formal Complaints Files Fines for TRACE reporting violations were over $1.6 million Fines for fair pricing and best execution violations for TRACEeligible products were more than $2.47 million Fines for MSRB reporting and pricing violations were over $2.3 million Restitution paid to customers was over $1.2 million 31
Overview of Disciplinary Process Disciplinary Process Milestones Initial Notification to firm that matter referred to Legal Staff attorneys review alleged violations and entire file gathered to date including 8210 correspondence with the firm. Firm offered opportunity to make Wells submission. Staff attorneys recommend outcomes in accordance with FINRA s Sanction Guidelines: Scope and duration of violations Whether firm had reasonable supervisory controls in place Whether misconduct was due to intentional, reckless or negligent acts Other considerations published in FINRA s Sanction Guidelines Recommendations are reviewed by management for reasonableness and consistency. 32
Overview of Disciplinary Process Disciplinary Process Factors Considered Staff attorneys consider all factors put forth by the firm, including: the firm s disciplinary history, the firm s subsequent performance in connection with rule violations being considered, the firm s non-compliance rate, performance as compared to peer group. 33
Investigations Conduct investigations in more egregious matters Many investigations focus on fair pricing and best execution rule compliance. May involve on the record testimony of traders, reps and supervisors. Staff attorneys may also examine the firm s supervisory policies, procedures and systems. 34
Factors Considered in Fixed Income Matters Fair Pricing Matters Factors outlined in NASD Rule 2440 and MSRB Rule G-30 Firm s pricing compared to industry outliers identified Magnitude of difference between firm s markup / markdown and those charged by other market participants Best Execution Matters Reasonableness standard Steps taken by firm to arrive at price to customer Documentation to support such steps are relevant Extent of violations isolated vs. systemic violations Effect and extent of market factors such as market volatility and liquidity 35
Factors Considered in Fixed Income Matters Transaction Reporting Number of violations absolute numbers Non-compliance percentage rates Non-compliance rates compared to peer firms Systemic non-compliance evidenced by poor disciplinary history and subsequent performance Sufficiency of firm s written supervisory procedures (WPSs) Evidence of firm s enforcement of WSPs 36
2013 Significant Matters Oppenheimer & Co. Firm priced 89 municipal securities sold to customers between 5.01 percent to 15.57 percent above firm s contemporaneous cost. One individual responsible with determining prices In 59 transactions, individual purchased bonds from another brokerdealer, held the bonds overnight, and sold to customers the next day with markups of 9.4 percent or more. Firm fined $500,000 for violating MSRB Rules G-17 and G-30. Firm also fined $175,000 for supervision deficiencies because firm s system only looked at markups / markdowns charged on securities purchased and sold within same business day. Individual fined $100,000 and suspended 60 days in all capacities. 37
2013 Significant Matters StateTrust Investments, Inc. StateTrust charged excessive markups / markdowns to customers in 563 customer transactions between May 2007 and June 2010. In 227 instances, the firm s markups / markdowns exceeded 5 percent. In 85 instances, the firm s head trader utilized the firm s bank or insurance affiliate to charge markups / markdowns to customers ranging from 8 percent to 23 percent, which acted as a fraud or deceit. During that time, head trader also served as chairman and largest indirect shareholder of bank and insurance affiliate. Firm fined over $1 million for violating NASD Rule 2440 and related rules and ordered to pay $353,000 in restitution. Head trader fined $75,000 and suspended 6 months in all capacities. 38
2013 Significant Matters Robert Marcus Lane and Jeffrey Griffin Lane Lane brothers owned Greenwich High Yield, LLC In 11 instances, Marcus Lane purchased distressed corporate bonds from a broker-dealer, sold to an entity he controlled, purchased the same bonds back, and sold the bonds to his customers. In each leg, the bonds were marked-up. Each 4-legged trip completed typically within one hour. Jeffrey Lane responsible for supervising Marcus Lane. The aggregate mark-up of the bonds charged to customers ranged from 6.45 percent to 40.95 percent. Marcus Lane ordered to disgorge $218,582, plus interest. Marcus and Jeffrey Lane barred from the financial industry 39
Risk Oversight and Operational Regulation Update
Municipal Short Positions In 2013 FINRA uncovered some clearing firms with short, naked municipal positions Potential net capital impact Customers receiving manufactured interest 1 How does this impact you? FINRA may make this a risk-based exam priority for 2014 If you are examining a clearing firm? If you are examining an introducing broker Relevant MSRB Rules for consideration MSRB G-8 Books and records MSRB G-15 Confirmation MSRB G-17 Conduct of municipal securities business MSRB G-27 Supervision 41
Causes and Issues of Municipal Shorts A member firm may create naked short municipal positions for a variety of reasons: Duplicate transaction Bond in process of redemption or call Branch or trading error A series of MSRB and IRS rule violations may occur if: the firm is unable to cover the short or borrow the bonds, and the bonds are long in the account of a customer who seeks tax exempt income. Characterizing the payment of interest to the clients as tax-exempt represents manufactured interest. 42
Practices and Controls The level of the firm s awareness and supervision of the issue The existence and quality of WSPs Length of time shorts are outstanding Number and dollar amount of shorts relative to firm s size Rigor in attempting to cover the short Effort to reduce customer harm by swapping to a comparable security Corrective action, or lack thereof Willingness to self-report to IRS 43
Correlation between MSRB and SEC/FINRA Rules This table illustrates the relevant MSRB Rules and their comparable FINRA Rules. As reminder, FINRA Rules do not apply to municipal securities. See FINRA Rule 0150. MSRB SEC / FINRA MSRB G-8 Books and records to be made by municipal securities brokers SEA 240.17a-3 Records to be Made by Certain Exchange Members, Brokers & Dealers MSRB G-15 Confirmation, clearance and settlement of transactions with customers SEA 240.10b-10 Confirmation of Transactions MSRB G-17 Conduct of municipal securities business FINRA 2010 Standards of Commercial Honor and Principles of Trade MSRB G-27 Supervision NASD 3010 Supervision SEA 240.15c3-3 (d)(4) Allocation of Customers' Fully Paid and Excess Margin Securities to Short Positions 44
Funding & Liquidity Current Regulation: FINRA Regulatory Notice 10-57 Funding & Liquidity Examinations Proposal: First FINRA stress test for funding & liquidity 45
Conference resumes at 11:45 a.m. Report Center Secure access to data and reports designed to support firms compliance activities MSRB G-32 Report Card Municipal Continuing Disclosure Report Municipal Primary Offering Disclosure Report TRACE Quality of Markets Report Cards www.finra.org/reportcenter
TRACE Nuts and Bolts FINRA Fixed Income Conference March 11, 2014 New York, NY
TRACE: Nuts and Bolts Welcome Justin Tubiolo, moderator Introduction of FINRA panelists Introduction to the topic 48
FINRA Market Operations Overview Micheal Sabag
TRACE - www.finra.org/trace 50
TRACE - www.finra.org/trace 51
TRACE Order Form 52
TRACE Order Form 53
TRACE Order Form 54
TRACE - www.finra.org/trace 55
TRACE - www.finra.org/trace 56
FINRA Market Operations Summary As a participant, you can refer to the following website: www.finra.org/trace. TRACE User Guide Legal Agreements: Participation Agreement; Uniform Service Agreement; and TRACE Order Form FAQs Forward documentation to FINRAOperations@finra.org. To initiate or update reporting relationships, email a completed Uniform Service Agreement to FINRAOperations@finra.org. FINRA Market Operations does not need another participation agreement when changing reporting relationships. 57
FINRA Market Operations Summary To request additions, deletions or changes of users, MPIDs, firm name or billing information, submit a TRACE Order Form through the FINRA Firm Gateway. A user ID will be assigned to new users to gain access to TRAQS. New users will receive an email with instructions to download a digital certificate to their computer. This certificate, once installed, will give them access to TRAQS. For assistance with the certificate or password, contact NASDAQ Subscriber Services at (212) 231-5180. FAQs concerning reporting issues can be found at www.finra.org/trace. If you have any questions, call FINRA Market Operations at 866-776-0800. 58
TRAQS Website Functions and Tools John Magrone
Trade Entry 60
Trade Entry Confirmation 61
Trade Entry with Commission 62
Trade Management Filtering and Data Grid 63
Reviewing Historical Trades 64
Reject Scan 65
Unmatched Trade Reports 66
Matched Trade Reports 67
Security Scan 68
Time and Sales Trades 69
Report Cards and ADDS Noah Egorin
Compliance Tools Real- or Near- Time TRACE Web Site Next Day FINRA Automated Data Delivery System (FINRA ADDS ) Periodic Review TRACE Report Cards Report Card Detail Data 71
FINRA ADDS for TRACE Secure website which allows firms to request transaction data submitted to the FINRA Trade Reporting and Quotation Service http://datadelivery.finra.org Standard access : Web-based access to transactions reported and rejected during the last 30 days (calendar). Optional services: Data Delivery Plus allows web-based access to transactions report and rejected during the last 2 years. Data Delivery SFTP (secure file transfer protocol) allows machine-2-machine access to the transaction and rejected files. 72
TRACE Report Cards The three individual TRACE-related report cards Agency Debt Corporate Bonds Securitized Products Report availability notification 73
Report Card Contents Three sections of the Report Card Activity Totals Late Trades Trade Reporting Analysis Features of the Report Card Views Detail data Help document Peer group lookup 74
Market Regulation Joseph Schwetz
TRACE Transaction Reporting Sweeps Late Reporting (Corporate, Agency and SP) Contra Execution Times (Corporate, Agency and SP) Dealer Mismatch (Corporate, Agency and SP) Negative Yields (Corporate and Agency) Large (Blocks) and Late (Corporate and Agency) Excessive Commissions (Corporate, Agency and SP) 6760-Underwriter Late Notice (Corporate, Agency and SP) 76
TRACE Transaction Reporting Sweeps Late Reporting FINRA Rule 6730(a)(6) Determination of TRACE eligibility Report system issues to bondreporting@finra.org Dealer Mismatch Incorrect reporting of contra-party s MPID P1/S1 trading market indicator discrepancies Failure to report Contra Execution Times FINRA Rule 6710(d) Time of Execution Negative Yields Negative yield to maturity or trades executed after a call announcement 6760-Underwriter Late Notice Written supervisory procedures concerning 6760 obligations 77
TRACE Compliance FINRA Marketplace Rules 6700 Series (TRACE Rules) TRACE Market Transparency (Includes Regulatory Notices, FAQs, Documentation and Fact Book) Trade Reporting Notice- August 2013 FAQs addressing Investment Adviser transactions and CMO reporting Trade Reporting Notice- December 2011 FAQs addressing use of P1 and knowing your counterparty TRACE Report Cards Trade Reporting Analysis Section (Report Side Unmatched and Contra Side Unmatched) Trade Reporting Analysis Section (Execution Time Difference) Late Trades Section 78
TRACE Data Alié Diagne
TRACE Program Status Segment Trade Reporting Approach Current status Scope Corporate Debt July 2002 Phased in dissemination and gradually reduced reporting time Agency Debentures To-Be- Announced Specified Pools Asset Backed Securities* March 2010 May 16, 2011 Subject to immediate dissemination Initially reporting only, FINRA to study the data to propose dissemination policy Reportable within 15 minutes, Realtime dissemination of all publicly traded securities. SEC approved disseminated of Rule 144A transactions, which will be implemented in June 2014. Reportable within 15 minutes, Realtime dissemination Disseminated as of 11/12/2012. GD reportable in 15 minutes. NGD reportable in 1 hour. Dissemination based on pool characteristics as of 7/22/2013. Reportable within 1 hour of execution. Reportable on T (as of 11/18/2011) Trade dissemination approved by FINRA Board. Proposal filed with the SEC and published for Notice and Comment. Over 60,000 CUSIPs Just under 20,000 CUSIPs Over 40,000 CUSIPs Over 1 million CUSIPs Over 30,000 CUSIPs CMO/REMIC / RMBS Reportable on T (as of 11/18/2011). Dissemination TBD Just under 250,000 CUSIPs * Includes Consumer Credit (Credit Cards, Auto Loans, Student Loans, etc.), CMBS (non-agency), Manufactured Housing, CDO, CLO, CBO, other miscellaneous credits (for example time shares, equipment leases). 80
TRACE Dissemination Data is disseminated through market data vendors or directly to market participants Data Feed Vendor Terminal FINRA also publishes market indicators and aggregate information FINRA-Bloomberg Active US Corporate Bond Indices: A family of U.S. corporate bond indices that reflect the most actively traded bonds Daily Market Aggregate Statistics: day s market activity including the number of securities and total dollar volume traded, and advances, declines and 52-week highs and lows of all securities FINRA-Interactive Data Market Activity & Price Level tables for Securitized products: Showing trading activity as well as price levels for various subproducts TRACE Fact Book Released quarterly, the TRACE Fact Book gives a historical perspective of the OTC U.S. corporate bond market. TRACE Enhanced Historical data: consists of transaction-level information including the price, the date and time of execution, transaction size and the yield. FINRA makes historical data available 18 months after the transaction date and publishes the information quarterly 81
TRACE Resources TRACE Data Main Page www.finra.org/licensing/trace/ TRACE Data Services (888) 507-3665 tracedataservices@finra.org 82
Conference resumes at 2:15 p.m. FINRA Annual Conference May 19 21, 2014 Washington, DC Features over 31 sessions on regulatory and compliance topics and includes Office Hours on both TRACE and Fixed Income. www.finra.org/annualconference
Sales Practice Case Study: Fixed Income Products (Retail Focus) FINRA Fixed Income Conference March 11, 2014 New York, NY
Conference resumes at 3:45 p.m. FINRA s Fixed Income Conference sessions will be available on-demand. Access information will be provided via email after the conference.
Firms Practices for Mark-ups, Best Execution and Prevention of Front- Running FINRA Fixed Income Conference March 11, 2014 New York, NY