Open Platform - Prepare for Even More Scrutiny

The fixed-income industry is in the middle of a transformation that began as early as 1997, and for the most part, has succeeded in migrating much of the previous order flow from traditional phone-based methods to more efficient technology-based Alternative Trading Systems (ATS). It’s been an exciting time for our industry. In many ways it’s not only surprising that these changes would be embraced, but also that they are now ushering in new possibilities.

One of those possibilities will come to fruition next year when Trade Reporting and Compliance Engine (Trace), the corporate bond reporting system required and operated by the National Association of Securities Dealers (NASD), and Real-Time Transaction Reporting System (RTRS), the Municipal Securities Rulemaking Board’s real-time reporting module, begin publishing the majority of their trade data in real-time. This will bring transparency to the once opaque bond market. Some may wonder how much efficiency the new Trace and RTRS systems will really bring.

We won’t be the only ones keeping a close eye on the data. The fixed-income industry must prepare itself for the environment in which the New York State Attorney General’s office, the Securities and Exchange Commission (SEC), and other regulatory bodies have teamed up to enforce the letter of the laws governing the financial services industry. These regulators are now striving for deeper ethical standards in judging the once acceptable practices of the financial services industry.

This was made clear this year when New York Attorney General Eliot Spitzer, shortly after securing a landmark $1.4 billion settlement with 10 major investment banks for research practices once widely tolerated, took Wall Street by surprise with a new initiative against the mutual fund industry. Now more in sync with the SEC than ever, Spitzer was recently asked in an interview with SmartMoney if he thinks the regulatory body can ever be proactive. Spitzer answered, "It’s always a question of balance. You react to scandals that emerge, but you are proactive where you diagnose a problem before scandals emerge and try to remedy it."

A question on the fixed income industry’s mind should be whether any of our own practices might be the next "problem" Spitzer and the SEC try to diagnose and remedy. What will really happen when Trace and RTRS start publishing fixed income trade data in real-time? One obvious risk that everyone in fixed income faces is that this real-time data pulls back the curtain for regulators to possibly expose imbalances in pricing practices from firm to firm. This could provide the fundamental impetus for greater scrutiny over the entire industry’s order handling practices.

Times like these call on all broker-dealers to take a hard and honest look in the mirror and cast a sharp light on their fixed income order handling practices especially within their retail channels. When one of your clients asks one of your Financial Advisors to sell their bonds, what then happens to that order? Does your firm keep a trade history including proof of every bid-wanted that was solicited on her behalf? Do you document the fact that someone in your firm reached out either electronically or telephonically to search for the best price for your client?

Today many firms still hold their clients and financial advisors hostage to shopping only out of their own proprietary fixed income inventory, while other firms put every trade in competition between their fixed income trading desks and an electronic communication network (ECN) or alternative trading system (ATS). If you are keeping your clients captive to your proprietary fixed income inventory, how will you justify that your order handling practices promoted competition and best price execution when Spitzer and the SEC come to "diagnose" and "remedy" your practices? You may be saving money now by not installing the technology needed to insure your compliance with the highest ethical standards, but is it really worth risking your firm’s reputation on the day Trace and RTRS turn its lights on? The time is at hand to ask ourselves some bracing questions. Are we ready and do we have the technology in place to withstand this level of regulatory scrutiny that will be precipitated by Trace and RTRS?

When Trace and RTRS real-time data shine a spotlight on pricing discrepancies and other trading practices, a question of legality may no longer be the issue. Spitzer has made it clear in his actions and words that legal or not, if a financial institution’s trading practices are ethically questionable, they will be targeted. "The question is, are we making overall progress in restoring core ethics to the Street?" he told Smartmoney.com. "We’ll continue as prosecutors to do our best to find the wrongdoers. But, there is work to be done, obviously."

Not even the strictest regulator would believe it’s cost effective or even realistic to prove best execution on every single trade when there are over 4 million fixed income CUSIPS, and only 20,000 of them are traded on any given day. Instead, the industry should promote a "Best Execution Practice" in which a sustainable methodology brings the highest likelihood of an overall best execution built into the process. This would give each firm’s clients a fair shot at consistent and competitive prices.

While everyone’s idea of "Best Execution Practice" may differ, there are essential elements that are needed to build a valid and sound practice capable of sustaining regulatory scrutiny, and giving a fair shot at competitive pricing to the individual investor. The essential elements to a Best Execution Practice would include competition, recording, reporting, and freedom from conflicts of interest. Let’s take a look at them one by one.

First, pricing must be derived from within a competitive framework. Any process must have clearly demonstrable elements of competitiveness built into each trade. For example, firms should require that every bid-wanted sent to a firm would be electronically documented and routed, either to an ATS or a significant list of competing dealers.

In terms of recording, current regulatory guidelines require a transaction history going back at least three years for every completed trade. However a "Best Execution Practice" should go further than this because a fixed income trade often has many steps prior to the actual trade completion. For example, requirements should include an electronic trail of each of these steps that let to an order execution. To use the previous example, this would begin as early as the bid-wanted stage on a sell order. Where you should be able to go into your three-year history and pull sell trades showing the preceding multiple bid-wanted’s, who they were sent to, what price was received for each one, and what time they were received.

Finally, in order to avoid conflicts of interest, in the coming regulatory environment we will need to ensure that all our order-handling processes are free of conflicts of interest and that we are striving for best execution for our clients.

Charles Almond is CEO of The BondDesk Group, which is based in Mill Valley, Calif.