Overview of Market Structure, Pricing, and Regulation
GAO-12-265: Published: Jan 17, 2012. Publicly Released: Jan 17, 2012.
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What GAO Found
In the secondary market for municipal securities, both institutional and individual investors trade through brokers, dealers, and banks (broker-dealers). However, GAO analysis of trade data showed that institutional investors generally trade at more favorable prices than individual investors. Broker-dealers said these differences generally reflected the higher average transaction costs associated with trading individual investors smaller blocks of securities. Market participants added that institutional investors have more resources, including networks of broker-dealers, and the expertise to independently assess prices. In recent years, the Municipal Securities Rulemaking Board (MSRB)an SRO that writes rules regulating the broker-dealers that trade municipal securitieshas required timely and public posting of trade prices in an effort to make post-trade price information more widely available. However, unlike the equities market, the relatively illiquid municipal market lacks centrally posted and continuous quotes, and other sources of pretrade price information are not centralized or publicly available to individual investors. In 2010, SEC began a review of the municipal securities market, in part to examine pretrade price information. MSRB has also begun a study that includes a review of the market structure to determine whether access to additional pretrade price information could improve pricing and liquidity. Both SEC and MSRB plan to complete these studies in 2012.
Several regulators share responsibility for overseeing the municipal securities market. The Financial Industry Regulatory Authority (FINRA)an SRO that regulates 98 percent of the broker-dealers that trade municipal securitiesand federal banking regulators enforce broker-dealer compliance with MSRB rules under their respective jurisdictions through electronic surveillances of trade data and routine examinations. SEC evaluates the quality of FINRA and MSRBs municipal regulatory programs through its SRO inspection program, which has recently evolved to a risk-based approach. SEC last inspected MSRB and FINRAs fixed-income surveillance program, which encompass municipal securities trading, in 2005. SEC staff said that staffing constraints have prevented them from conducting inspections of these SROs sooner, although they have recently begun a new inspection of FINRAs fixed-income surveillance program. SECs limited monitoring of FINRA and MSRB between inspections may not be sufficient to support its new risk-based inspection approach. For example, SECs last inspection of FINRAs fixed-income surveillance program predated the financial crisisand its ensuing volatility in the municipal marketbut SEC had collected limited information since its last inspection that would help it assess the quality of FINRAs broker-dealer oversight. SEC currently receives periodic reports from FINRA that provide statistical information on its regulatory activities related to municipal securities trading. According to SEC staff, while they might be able to use the reports to identify significant deviations in FINRAs efforts, they cannot use them solely to determine the effectiveness of FINRAs municipal securities program. Without ongoing collection and analysis of information to assess the effectiveness of SROs regulatory programs, SEC may be unable to identify and act on regulatory problems in a timely manner.
Why GAO Did This Study
Municipal securities are debt instruments that state and local governments typically issue to finance diverse projects. Individual investors, through direct purchases or investment funds, own 75 percent of the estimated $3.7 trillion in municipal securities in the U.S. market. In the secondary market, where these securities are bought and sold after issuance, trading largely occurs in over-the-counter markets that are less liquid and less transparent than the exchange-traded equity securities market. The Dodd-Frank Wall Street Reform and Consumer Protection Act required GAO to review several aspects of the municipal securities market, including the mechanisms for trading, price discovery, and price transparency. This report examines (1) municipal security trading in the secondary market and the factors that affect the prices investors receive, and (2) the Securities and Exchange Commissions (SEC) and self-regulatory organizations (SRO) enforcement of rules on fair pricing and timely reporting. For this work, GAO analyzed trade data, reviewed federal regulators programs for enforcing trading rules, and interviewed market participants and federal regulators.
What GAO Recommends
GAO recommends that SEC collect and analyze information on SROs fixed-income regulatory programs on an ongoing basis to better inform its risk-based inspection approach. SEC agreed, but noted it would need additional resources to conduct more frequent oversight of the SROs. Such ongoing monitoring, however, could help SEC better leverage its resources for inspections.
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Recommendation for Executive Action
Status: Closed - Implemented
Comments: In its initial response to this recommendation, SEC noted that it will use its findings from FINRA's fixed-income surveillance program inspection to enhance its risk assessment information in this area. In addition, it will use the inspection process to determine what types of ongoing information, in addition to what was already received, might be helpful to the program. In late December 2016, the Office of Compliance Inspections and Examinations (OCIE) received approval from the Commission to request certain types of information from FINRA on an ongoing basis. Further, OCIE staff completed an examination of FINRA's Fixed-Income Regulatory Program and updated its document request. On May 24, 2017, as part of its FINRA oversight program, OCIE sent FINRA a request to gather periodic information that included a number of items on FINRA's fixed-income security regulatory and compliance programs that would inform its risk-based inspection approach.
Recommendation: 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, the Chairman of the Securities and Exchange Commission should direct the Office of Compliance Inspections and Examinations (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 Affected: United States Securities and Exchange Commission