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Commentary: Not Enough Sun Getting Through TRACE's Shutters
Traders Magazine Online News, December 21, 2009
The famous quote of Supreme Court Justice Louis D. Brandeis, that "sunlight is the best of disinfectants," has long set the tone for securities regulation in the United States. The SEC has followed this guiding principle in creating a system of regulation designed to ensure that the securities markets are transparent. Give investors accurate and complete information and, after that, get out of the way. The problem is, the FINRA TRACE system--which was intended to create a regulatory database and bring transparency to the over-the-counter bond market--has never fully opened its shutters to the public.
In October 2009, FINRA proposed amending its rules in order to define asset-backed securities, including mortgage-backed securities and other similar securities, as TRACE-eligible, which would require the reporting of transactions in such securities to TRACE. In my view, this proposal is a step in the right direction because it broadens the range of securities that are subject to TRACE reporting. However, the proposal falls short because it contemplates that at this time no trade data for asset-backed securities will be disseminated to the public.
FINRA's decision to limit dissemination is not surprising, given that FINRA has limited the public disclosure of all other trade data reported to TRACE by establishing flawed dissemination protocols. These FINRA-conceived protocols violate FINRA's own SEC-approved rules and are inconsistent with the intent of TRACE. For TRACE to provide market transparency and protect investors, FINRA must abandon these poorly conceived protocols and disseminate all trade data information to the public. Otherwise, FINRA's current proposal--and TRACE in general--will continue to be of limited utility to many investors.
All FINRA member firms have an obligation to report transactions in eligible fixed income securities to TRACE pursuant to FINRA Rule 6730. And FINRA is required to disseminate trade data for all TRACE-eligible securities pursuant to FINRA Rule 6750. However, buried in FINRA's TRACE User Guide are protocols pursuant to which FINRA withholds certain trade data from the public. These protocols specify that FINRA will withhold the actual numbers of bonds traded in investment grade debt with a par value above $5 million, and non-investment grade debt securities with a par value greater than $1 million, despite the fact that this information is reported to FINRA under Rule 6730.
FINRA and the SEC have repeatedly acknowledged the benefits to the investing public from the dissemination of real-time trade and volume data during market hours. For example, in 1992, in its comments to the proposed penny stock rules, FINRA indicated that increased dissemination would improve market visibility and price discovery. In 1997, with respect to trade reporting in foreign equity securities, the SEC noted that dissemination of trade reports would likely improve the ability of investors to monitor their executions in foreign securities.
Furnishing a trade report to FINRA so that FINRA may observe patterns of trading and otherwise conduct surveillance of the market is not sufficient to protect the investing public. It is as true now as in 1992 and 1997 that "sunlight is the best of disinfectants." All material information contained on the trade report must be disseminated so that the investing public can monitor the behavior of their brokers.
FINRA Rule 6730 on Transaction Reporting currently requires reporting of transactions in TRACE-eligible securities. The information required to be reported includes, among other things, the actual number of bonds traded. FINRA Rule 6750 on Dissemination of Transaction Information provides that as soon as FINRA receives information on TRACE-eligible securities, it will disseminate that information to the public. The only transactions not required to be disseminated, according to this Rule, are (i) transactions effected pursuant to Rule 144A under the Securities Act, (ii) transfers of certain proprietary positions effected in connection with broker-dealer mergers or consolidations and (iii) List or Fixed Offering Price Transactions and Takedown Transactions.
