oversight

Municipal Securities: Overview of Market Structure, Pricing, and Regulation

Published by the Government Accountability Office on 2012-01-17.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

               United States Government Accountability Office

GAO            Report to Congressional Committees




January 2012
               MUNICIPAL
               SECURITIES
               Overview of Market
               Structure, Pricing, and
               Regulation




GAO-12-265
                                                January 2012

                                                MUNICIPAL SECURITIES
                                                Overview of Market Structure, Pricing, and
                                                Regulation
Highlights of GAO-12- 265, a report to
congressional committees




Why GAO Did This Study                          What GAO Found
Municipal securities are debt                   In the secondary market for municipal securities, both institutional and individual
instruments that state and local                investors trade through brokers, dealers, and banks (broker-dealers). However,
governments typically issue to finance          GAO analysis of trade data showed that institutional investors generally trade at
diverse projects. Individual investors,         more favorable prices than individual investors. Broker-dealers said these
through direct purchases or investment          differences generally reflected the higher average transaction costs associated
funds, own 75 percent of the estimated          with trading individual investors’ smaller blocks of securities. Market participants
$3.7 trillion in municipal securities in        added that institutional investors have more resources, including networks of
the U.S. market. In the secondary               broker-dealers, and the expertise to independently assess prices. In recent
market, where these securities are
                                                years, the Municipal Securities Rulemaking Board (MSRB)—an SRO that writes
bought and sold after issuance, trading
                                                rules regulating the broker-dealers that trade municipal securities—has required
largely occurs in over-the-counter
markets that are less liquid and less
                                                timely and public posting of trade prices in an effort to make post-trade price
transparent than the exchange-traded            information more widely available. However, unlike the equities market, the
equity securities market. The Dodd-             relatively illiquid municipal market lacks centrally posted and continuous quotes,
Frank Wall Street Reform and                    and other sources of pretrade price information are not centralized or publicly
Consumer Protection Act required                available to individual investors. In 2010, SEC began a review of the municipal
GAO to review several aspects of the            securities market, in part to examine pretrade price information. MSRB has also
municipal securities market, including          begun a study that includes a review of the market structure to determine
the mechanisms for trading, price               whether access to additional pretrade price information could improve pricing and
discovery, and price transparency. This         liquidity. Both SEC and MSRB plan to complete these studies in 2012.
report examines (1) municipal security
trading in the secondary market and             Several regulators share responsibility for overseeing the municipal securities
the factors that affect the prices              market. The Financial Industry Regulatory Authority (FINRA)—an SRO that
investors receive, and (2) the                  regulates 98 percent of the broker-dealers that trade municipal securities—and
Securities and Exchange                         federal banking regulators enforce broker-dealer compliance with MSRB rules
Commission’s (SEC) and self-                    under their respective jurisdictions through electronic surveillances of trade data
regulatory organizations’ (SRO)                 and routine examinations. SEC evaluates the quality of FINRA and MSRB’s
enforcement of rules on fair pricing and        municipal regulatory programs through its SRO inspection program, which has
timely reporting. For this work, GAO            recently evolved to a risk-based approach. SEC last inspected MSRB and
analyzed trade data, reviewed federal           FINRA’s fixed-income surveillance program, which encompass municipal
regulators’ programs for enforcing              securities trading, in 2005. SEC staff said that staffing constraints have
trading rules, and interviewed market           prevented them from conducting inspections of these SROs sooner, although
participants and federal regulators.            they have recently begun a new inspection of FINRA’s fixed-income surveillance
                                                program. SEC’s limited monitoring of FINRA and MSRB between inspections
What GAO Recommends                             may not be sufficient to support its new risk-based inspection approach. For
                                                example, SEC’s last inspection of FINRA’s fixed-income surveillance program
GAO recommends that SEC collect
                                                predated the financial crisis—and its ensuing volatility in the municipal market—
and analyze information on SROs’
                                                but SEC had collected limited information since its last inspection that would help
fixed-income regulatory programs on
an ongoing basis to better inform its
                                                it assess the quality of FINRA’s broker-dealer oversight. SEC currently receives
risk-based inspection approach. SEC             periodic reports from FINRA that provide statistical information on its regulatory
agreed, but noted it would need                 activities related to municipal securities trading. According to SEC staff, while
additional resources to conduct more            they might be able to use the reports to identify significant deviations in FINRA’s
frequent oversight of the SROs. Such            efforts, they cannot use them solely to determine the effectiveness of FINRA’s
ongoing monitoring, however, could              municipal securities program. Without ongoing collection and analysis of
help SEC better leverage its resources          information to assess the effectiveness of SROs’ regulatory programs, SEC may
for inspections.                                be unable to identify and act on regulatory problems in a timely manner.
View GAO-12-265 For more information,
contact A.Nicole Clowers at (202) 512-8678 or
clowersa@gao.gov.

                                                                                         United States Government Accountability Office
Contents


Letter                                                                                      1
               Background                                                                   4
               Municipal Securities Are Priced in an Opaque Market That Favors
                 Better-Informed Participants                                             11
               Regulators Oversee Compliance with MSRB Rules and Have Not
                 Found Systemic Violations, but SEC’s Monitoring Is Limited               30
               Conclusions                                                                48
               Recommendation for Executive Action                                        49
               Agency Comments and Our Evaluation                                         49

Appendix I     Potential Uses, Risks, and Oversight of Derivative Products in the
               Municipal Securities Market                                                51



Appendix II    Scope and Methodology                                                      56



Appendix III   GAO Analysis of MSRB Trade Data, 2005-2010                                 65



Appendix IV    Municipal Securities Rulemaking Board Expenses and Revenues
               Related to the Market Information Transparency Programs                    70

               MSRB Increased the Transaction Fee and Levied a New
                 Technology Fee to Generate Additional Revenues                           74


Appendix V     Selected SEC Cases and Opinions Involving Excessive Municipal
               Securities Markups and Markdowns                                           77



Appendix VI    Regulators’ Policies and Procedures for Monitoring Compliance with
               MSRB Rules G-30 and G-14                                                   78



Appendix VII   Comments from the Securities and Exchange Commission                       83




               Page i                                          GAO-12-265 Municipal Securities
Appendix VIII   GAO Contact and Staff Acknowledgments                                      85



Tables
                Table 1: Average Relative Prices on Newly Issued Fixed-Rate
                         Municipal Securities, by Trade Amount, 2010                       17
                Table 2: Example of Broker-Dealer Spreads’ Effects on the Yields
                         to Maturity Received by an Individual and an Institutional
                         Investor                                                          18
                Table 3: Average Price Dispersion for Newly Issued Fixed-Rate
                         Municipal Securities, 2010                                        19
                Table 4: Factors That Regulators Consider in Determining Broker-
                         Dealers’ Compliance with MSRB Rule G-30                           39
                Table 5: Number of OCIE Market Oversight Staff, Fiscal Years
                         2005-2011                                                         46
                Table 6: Percentage Change in Relative Price per 1 Percent Change
                         in Trade Amount, by Trade Type and Year, 2005-2010                66
                Table 7: Percentage Change in Spread per $10,000 Increase in
                         Trade Amount, by Year, 2005-2010                                  68
                Table 8: Change in Price Dispersion per $10,000 Increase in Trade
                         Amount (in Basis Points), by Trade Type and Year, 2005-
                         2010                                                              69
                Table 9: MSRB Expenses, Fiscal Years 2004-2010                             72
                Table 10: MSRB Revenues, Fiscal Years 2004-2010                            73
                Table 11: Selected SEC Cases and Opinions Involving Excessive
                         Municipal Securities Markups and Markdowns, 1970-2011             77


Figures
                Figure 1: Hypothetical Broker-Dealer Markups and Markdowns in
                         Municipal Securities Transactions                                 32
                Figure 2: MSRB Revenues and Expenses, Fiscal Years 2004 through
                         2010                                                              74




                Page ii                                         GAO-12-265 Municipal Securities
Abbreviations
ATS         alternative trading system
CEA         Commodity Exchange Act
CFTC        Commodities Futures Trading Commission
CUSIP       Committee on Uniform Security Identification Procedures
DTC         Depository Trust Company
DTTC        Depository Trust and Clearing Corporation
EMMA        Electronic Municipal Markets Access
ERISA       Employee Retirement Income Security Act of 1974
FDIC        Federal Deposit Insurance Corporation
FINRA       Financial Industry Regulatory Authority
MSIL        Municipal Securities Information Library
MSRB        Municipal Securities Rulemaking Board
NASD        National Association of Securities Dealers
NBBO        National Best Bid and Offer
NBER        National Bureau of Economic Research
NSCC        National Securities Clearing Corporation
OCC         Office of the Comptroller of the Currency
OCIE        Office of Compliance Inspections and Examinations
OTC         over-the-counter
RTRS        Real-Time Transaction Reporting System
RTTM        Real-Time Trade Matching
SEC         Securities and Exchange Commission
SIFMA       Securities Industry and Financial Markets Association
SMMP        Sophisticated Municipal Market Professional
SRO         self-regulatory organization
SSRN        Social Science Research Network
STAR        System for Tracking Activities for Regulatory Policy and
            Oversight
STARS       Super Tracking and Reporting System
YTM         yield to maturity


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Page iii                                                   GAO-12-265 Municipal Securities
United States Government Accountability Office
Washington, DC 20548




                                   January 17, 2012

                                   The Honorable Tim Johnson
                                   Chairman
                                   The Honorable Richard C. Shelby
                                   Ranking Member
                                   Committee on Banking, Housing,
                                     and Urban Affairs
                                   United States Senate

                                   The Honorable Spencer Bachus
                                   Chairman
                                   The Honorable Barney Frank
                                   Ranking Member
                                   Committee on Financial Services
                                   House of Representatives

                                   Municipal securities are debt instruments that state and local
                                   governments issue to finance transportation, housing, hospitals,
                                   education, and diverse other projects. The market for these securities is
                                   worth an estimated $3.7 trillion, with individuals holding 75 percent of the
                                   total outstanding, either indirectly through investment funds or directly
                                   through purchases with broker-dealers. 1 But the size, heterogeneity, and
                                   other characteristics of this market create challenges, especially in terms
                                   of pricing. For example, municipal securities are traded primarily through
                                   decentralized, dealer-mediated, over-the-counter (OTC) markets that
                                   provide less liquidity and less price transparency than other securities
                                   markets, such as the exchange-traded equity market. 2 There is no central
                                   facility that publicly posts quotes on all securities trading, as there is in
                                   some equities markets. The relative lack of pretrade transparency in the


                                   1
                                    Federal Reserve Flow of Funds Accounts of the United States, December 8, 2011. This
                                   figure comprises securities held directly by individual investors (51 percent) or through
                                   investment management companies such as mutual funds, money market mutual funds,
                                   closed-end funds, and exchange-traded funds (24 percent). Insurance companies and
                                   commercial banks hold most of the remaining securities
                                   2
                                    Liquidity refers to the relative ability of a security to be readily convertible into cash
                                   without substantial transaction costs or reduction of value. Price transparency refers to the
                                   degree to which information regarding quotations for securities (pretrade transparency)
                                   and the prices and volume of transactions (post-trade transparency) is made publicly
                                   available in the securities market.




                                   Page 1                                                      GAO-12-265 Municipal Securities
municipal securities market has raised questions about whether individual
investors, that is, those who buy and sell securities for themselves directly
through broker-dealers, have sufficient price information to make well-
informed investment decisions regarding the securities they wish to buy
and sell in the secondary market, where municipal securities are traded
after they are issued.

The Municipal Securities Rulemaking Board (MSRB) is a self-regulatory
organization (SRO) that writes rules regulating the brokers, dealers, and
banks (collectively referred to as broker-dealers in this report) that
underwrite, sell, and trade municipal securities. 3 MSRB has also issued a
number of rules governing municipal trades. Among other things, these
rules require broker-dealers to trade municipal securities for their investor
customers at fair and reasonable prices and to report their municipal
trades in a timely and accurate manner. However, MSRB does not have
the authority to enforce these rules and relies instead on the Financial
Industry Regulatory Authority, Inc. (FINRA)—an SRO for broker-dealers,
federal banking regulators, and the Securities and Exchange Commission
(SEC). SEC also provides oversight of MSRB and FINRA. 4

Title IX of the Dodd-Frank Wall Street Reform and Consumer Protection
Act (Dodd-Frank Act) required us to review several aspects of the
municipal securities market, including the mechanisms for trading, trade
reporting, price discovery, clearance and settlement, and transparency,
as well as the potential uses of derivatives in this market. 5 Accordingly,
the objectives of this report are to (1) analyze how investors trade
municipal securities in the secondary market and the factors affecting the
prices they receive, and (2) determine how federal regulators enforce
MSRB rules to help ensure fair and reasonable prices for investors and
the timely and accurate reporting of municipal trades, including recent



3
 SROs are exchanges and associations that operate and govern the markets, and that are
subject to oversight by the Securities and Exchange Commission.
4
 Section 977 of the Dodd-Frank Act contains a provision that requires MSRB, FINRA, and
SEC to meet at least twice a year to discuss their respective work in the regulation of
municipal securities trading and to share information about their respective rules and
examination and enforcement activities related to municipal securities. Pub. L. No.111-
203, § 975(b)(5), 124 Stat. 1376, 1920 (2010).
5
 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203,
§977, 124 Stat. 1376, 1924 (2010).




Page 2                                                  GAO-12-265 Municipal Securities
trends in the enforcement of these rules. We address the potential uses
of derivatives by municipal issuers in appendix I of the report.

To address municipal security trading in the secondary market, we
analyzed MSRB trade data from the Real-Time Transaction Reporting
System (RTRS)—the system to which broker-dealers report their municipal
securities trades—for the period from 2005 to 2010. In so doing, we
reviewed information from MSRB on the policies and procedures it used to
ensure that the data were complete and accurate and determined that the
data were reliable for our purpose. In addition, we reviewed studies and
industry literature. We interviewed members of trade organizations
representing institutional investors (mutual funds and other investment
management companies, insurance companies, and banks that possess or
control considerable assets for large-scale investing), broker-dealers
(including broker’s brokers), and individual investors; officials from
independent municipal market research and advisory firms; and officials
from SEC’s Office of Municipal Securities and MSRB. 6 We attended and
viewed SEC’s field hearings on the state of the municipal securities market.
We also received demonstrations of and interviewed officials from an
alternative trading system (ATS) specializing in the electronic trading of
municipal securities and of Bloomberg, L.P. (Bloomberg), which provides
information and other services related to municipal securities trading.

To address the regulators’ enforcement of rules on fair pricing and timely
reporting, we reviewed MSRB rules and draft rules related to the pricing
of municipal securities, trade reporting, and clearance and settlement of
municipal securities transactions. We reviewed MSRB data from RTRS
on the number of trades that MSRB determined were reported late for
each year from January 2005 to July 2011. We reviewed documentation
related to FINRA’s programs for surveilling RTRS data for potential
violations of MSRB pricing and trade reporting rules and examination
procedures used by FINRA, federal banking regulators, and SEC’s Office
of Compliance Inspections and Examinations (OCIE) to assess broker-
dealers’ compliance with these rules. We reviewed samples of municipal
broker-dealer examinations conducted from 2002 to 2010 by OCIE and
from 2006 to 2010 by FINRA and federal banking regulators. In addition,
we reviewed OCIE’s guidance for conducting SRO inspections and



6
 A broker’s broker is a broker-dealer that executes securities transactions exclusively with
other broker-dealers.




Page 3                                                     GAO-12-265 Municipal Securities
             reviewed the most recent inspections of MSRB and FINRA’s fixed-income
             program conducted in 2002 and 2005. 7 We also reviewed OCIE’s 2009
             inspections of two SROs that clear and settle municipal, corporate, and
             equity securities transactions—the Depository Trust Company (DTC) and
             the National Securities Clearing Corporation (NSCC). Further, we looked
             at relevant documentation pertaining to coordination among the SEC,
             FINRA, MSRB, and federal banking regulators—the Board of Governors
             of the Federal Reserve System (Federal Reserve), the Federal Deposit
             Insurance Corporation (FDIC), and the Office of the Comptroller of the
             Currency (OCC)—in conducting oversight of the municipal securities
             market and interviewed officials from these entities.

             We conducted this performance audit from November 2010 to January
             2012 in accordance with generally accepted government auditing
             standards. Those standards require that we plan and perform the audit to
             obtain sufficient, appropriate evidence to provide a reasonable basis for
             our findings and conclusions based on our audit objectives. Appendix II
             provides a more detailed description of our scope and methodology.


             The municipal securities market comprises both primary and secondary
Background   markets. In the primary market, underwriters buy new securities from
             municipal issuers (e.g., local government entities) and subsequently sell
             them to investors during the primary offering. 8 Municipal securities that
             trade after the primary offering are said to trade in the secondary market,




             7
              The fixed-income inspections we reviewed were of the National Association of Securities
             Dealers (NASD), which formerly acted as the SRO for broker-dealers. In July 2007, NASD
             assumed the broker-dealer regulatory functions of the New York Stock Exchange and
             became FINRA.
             8
              An underwriter is a broker-dealer that purchases a new issue of municipal securities for
             resale in a primary offering. Often a group of underwriters, known as an underwriting
             syndicate, forms to purchase new issues. The underwriting spread is the difference
             between the amount underwriters pay an issuer for its securities and the amount they
             receive from selling the securities in the primary offering.




             Page 4                                                     GAO-12-265 Municipal Securities
with both institutions and individuals participating. 9 Institutional investors
typically trade municipal securities in amounts of $1 million or more and
generally are in the market full-time to provide or preserve income as well
as maximize investment returns for their clients or firms. In contrast,
individual investors typically trade municipal securities in amounts of
$100,000 or less and access the market relatively infrequently, with the
intent to buy and hold securities until maturity. 10

Many individual investors find municipal securities an attractive
investment option because of the tax advantages these intruments offer.
Unlike the dividends on equity securities (which also trade in a market
with considerable individual investor participation), the interest on most
municipal securities is exempt from federal income tax and, in some
cases, from state or local income tax. 11 In addition, as debt instruments
municipal securities are generally considered less risky than equity
securities. For example, issuers of debt securities have a contractual
obligation to return the principal value of the security to the holder at
maturity, while issuers of equity securities do not. Further, issuers of debt
securities also have a contractual obligation to pay investors a fixed or



9
 Institutional investors participate in the primary market by buying large blocks of
municipal securities directly from the underwriters. Individual investors may be able to
participate in the primary market, particularly—but not exclusively—if the issuer
establishes a retail order period. During a retail order period, underwriters or the
underwriting syndicate seeks orders only from retail customers. Issuers determine
whether a primary offering will have a retail order period, the length of the retail order
period, and who qualifies as a retail customer. Underwriters told us that some issuers
defined retail customers as individuals but might also include entities that represent
individuals, such as trusts.
10
  Although MSRB trade data do not distinguish between individual and institutional
investors, most broker-dealers we spoke with said that their individual investor clients
trade in amounts of $100,000 or less. Our analysis of MSRB trade data showed that in
2010 about 82 percent of dealer sales to investors of newly issued fixed-rate bonds were
for $100,000 or less and that about 97 percent of all such trades were for $1 million or
less. However, individual investors can make larger trades; for example, one broker-
dealer we interviewed said some of the firm’s individual customers buy $250,000 to $1
million blocks of municipal securities.
11
  For interest on a municipal security to qualify as exempt from the investor’s gross
income for federal income tax purposes, the issuer must meet a number of requirements
in the federal income tax code and regulations. Some taxable municipal securities were
issued in 2009 and 2010 under the Build America Bonds program adopted as part of the
American Recovery and Reinvestment Act of 2009. An issuer may also issue taxable
securities if the purpose of the issuer’s financing does not meet certain public purpose or
public use tests under the federal tax rules, such as in the case of private activity bonds.




Page 5                                                       GAO-12-265 Municipal Securities
                           variable rate of interest income. On the other hand, dividend payments to
                           shareholders of equity securities are decided by the company’s board of
                           directors.


Municipal Securities and   Data on the number of municipal issuers and outstanding municipal
Secondary Market           securities are not officially tracked by regulators or the private sector.
Structure                  Third-party information vendors provide a range of estimates; data we
                           obtained from one indicated the municipal securities market has over
                           46,000 municipal issuers, including states, counties, cities, towns, and
                           state and local government agencies, among others, and at least 1.1
                           million securities outstanding. 12 In contrast, about 5,700 public companies
                           list their equity securities for trading on the major U.S. exchanges. 13 Each
                           municipal issuance is unique, with its own credit structure, terms, and
                           conditions. 14 Most outstanding municipal securities trade infrequently—for
                           example, in 2010 about 99 percent of outstanding municipal securities did
                           not trade on any given day. 15 The heaviest trading of municipal securities
                           typically occurs immediately following their issuance, after which trading
                           becomes sporadic.

                           The municipal securities market is geographically fragmented, with
                           secondary market trading supported by national and regional broker-
                           dealer firms that serve institutional investors (institutional broker-dealers)
                           or individual investors (retail broker-dealers), and in some firms, both.
                           Several national broker-dealer firms have enough capital and geographic



                           12
                             As of October 3, 2011, Bloomberg tracked over 46,000 municipal issuers and obligors
                           as well as 1,138,405 outstanding unique municipal securities, as identified by their
                           Committee on Uniform Security Identification Procedures (CUSIP) numbers. Generally, a
                           CUSIP number uniquely identifies municipal securities in each maturity for a given primary
                           market issuance.
                           13
                             We obtained data on the number of companies listed on the New York Stock Exchange,
                           the NASDAQ Stock Market, and the NYSE Amex as of December 31, 2010, from the 2010
                           annual reports of NYSE Euronext and NASDAQ QMX.
                           14
                             For example, municipal bonds can have a “put,” or “tender,” feature, giving the investor
                           the right to surrender the securities to the issuer at specified dates and at a predetermined
                           price (usually par), or a “call” feature that gives issuers the right to call, or redeem, a
                           security prior to the stated date of maturity.
                           15
                             We derived this statistic by dividing 15,051 (the average daily number of unique
                           municipal securities traded in 2010, according to MSRB) by 1,138,405 (the number of
                           outstanding municipal securities as of October 3, 2011, according to Bloomberg).




                           Page 6                                                      GAO-12-265 Municipal Securities
presence to underwrite large new issuances nationwide, trade in large
volume with institutional investors, and offer expertise in virtually every
sector of the market. 16 Some midsized broker-dealer firms also have
nationwide coverage for institutional and individual investors on a smaller
scale. But other broker-dealer firms provide inventory and expertise in
well-defined geographic areas, allowing them to serve individual
investors—many of whom invest in municipal securities to enjoy state or
local income tax benefits—as well as institutional investors who need
access to local markets. Given the heterogeneity and variety of municipal
securities available, the fact that they are traded infrequently, and the
geographic fragmentation of the market, broker-dealers typically work
with their customers to find available securities that fit preferred
parameters (e.g., geographic location, yield, credit quality, or price)
instead of specific securities.

The fact that the average municipal security is traded infrequently
indicates that generally ready buyers and sellers are not available. Thus,
some broker-dealers provide liquidity for their investors by committing
capital to maintain their own inventories. In doing so, these broker-dealers
can offer investors securities when they want to buy and buy securities
when investors want to sell. Broker-dealers may also facilitate trades
taking little or no risk on their own capital by purchasing or selling
securities in order to fulfill prearranged orders. 17 In addition to trading
securities from their own inventories, broker-dealers communicate and
trade securities with other broker-dealers directly to expand the pool of
securities that they may offer investors and to find potential buyers for
their securities. Such communication can also help them identify market
supply and demand trends on particular securities. Broker-dealers
generally communicate with each other directly by phone or through
Bloomberg, which connects its users through e-mail, instant text, and




16
  According to MSRB, the top 10 underwriting firms underwrote over 70 percent of primary
market issuance volume (by par amount) in 2010 and in 2011. Additionally, the top 10
broker-dealer firms executed about 55 percent of secondary market trades in 2010 and
2011, and the top 200 broker-dealer firms accounted for 98 percent of all municipal trade
volume (by par amount) in 2010 and 2011. The remaining approximately 1,600 firms were
less active in the municipal securities market as they were not primarily engaged in
municipal securities underwriting, research, or trading.
17
  Most broker-dealers execute trades as the principal by trading securities from their
proprietary accounts.




Page 7                                                     GAO-12-265 Municipal Securities
other features that allow users to share information on and post offerings,
obtain and provide bids on securities, and conduct research and analysis.

Broker-dealers may also use broker’s brokers and electronic trading
platforms to trade in the secondary market. Currently, about 20 broker’s
brokers promote additional liquidity and facilitate information flow in the
municipal securities markets by specializing in segments of the market (by
region, issuer, or type of security) and helping broker-dealers find buyers
for their securities in their areas of expertise. 18 They do so primarily by
arranging auctions called bid wanted procedures (bids wanted) for broker-
dealers that are selling securities, particularly in unfamiliar areas of the
market. 19 Broker-dealers can also buy and sell municipal securities for their
customers through electronic trading platforms that combine inventories
from market participants, typically broker-dealers, into one location, thus
enabling users—mostly broker-dealers and, in some cases, institutional
investors—to search for, buy, and sell municipal securities from a single
site. Some of these trading platforms focus on trading for the individual
investor market. However, individual investors typically do not have direct
access to these trading platforms, although they may have indirect access
through a retail broker-dealer. 20




18
  Broker’s brokers execute transactions primarily with broker-dealers for a fee and do not
maintain proprietary inventories of securities. Municipal broker’s brokers are registered as
such through MSRB. Other over-the-counter fixed-income markets also use interdealer
brokers to facilitate transactions in the secondary market.
19
  In a broker’s broker bid wanted, the broker’s broker typically disseminates information
about the securities for sale electronically and then contacts various broker-dealers by
phone to solicit bids (institutional Investors and broker-dealers can also customize their
own bids wanted through Bloomberg). Besides arranging bids wanted, broker’s brokers
told us that they might facilitate situation trading, which is generally used for institutional-
sized trades. In situation trading, broker’s brokers find buyers for a broker-dealer’s
securities at a prespecified price set by the broker-dealer.
20
   The electronic trading platforms that broker-dealers told us they regularly used were
registered with SEC as ATSs under Regulation ATS. The regulation defines an ATS as an
organization, association, person, group of persons, or system that provides a
marketplace or facility that brings together buyers and sellers of securities or otherwise
performs the functions commonly performed by a stock exchange. However, the ATS
does not set rules governing the conduct of the subscribers other than its ATS trading
activities, nor does it discipline subscribers other than by excluding them from trading.




Page 8                                                         GAO-12-265 Municipal Securities
Municipal Market   About 1,800 securities firms and banks are registered with MSRB as
Regulation         broker-dealers of municipal securities. As an SRO, MSRB develops rules
                   for broker-dealers engaged in underwriting, trading, and selling municipal
                   securities with the goals of protecting investors and issuers and
                   promoting a fair and efficient marketplace. 21 To further its mandate to
                   protect investors, MSRB also operates information systems designed to
                   promote post-trade price transparency and access to municipal securities
                   issuers’ disclosure documents. MSRB provides this access free of charge
                   through its Electronic Municipal Markets Access (EMMA) website. As we
                   have seen, FINRA and federal banking regulators enforce MSRB rules for
                   broker-dealers under their respective jurisdictions. FINRA oversees 98
                   percent of those MSRB-registered broker-dealers that are also registered
                   members of FINRA, while federal baking regulators oversee the
                   remaining 2 percent.

                   SEC has designated FINRA as the entity responsible for conducting
                   surveillance of trade data from RTRS for potential violations of MSRB
                   rules. FINRA employs automated surveillance in its compliance
                   monitoring that is programmed to review RTRS data for potentially
                   excessive prices and late trading, among other rule violations. FINRA
                   staff review alerts generated by automated surveillance systems to
                   identify those that warrant further investigation. When FINRA finds
                   evidence of potential violations of these rules involving those broker-
                   dealers who are its members, it can take action ranging from informal
                   warnings to the imposition of monetary fines to expulsion from its
                   membership, among other sanctions. FINRA refers potential violations
                   involving bank dealers to the appropriate federal banking regulator.
                   During the period of our review, FINRA and the federal banking regulators
                   conducted routine examinations of the firms under their jurisdiction once




                   21
                     MSRB also writes rules regulating municipal advisers that provide advice to or on behalf
                   of municipal entities or obligated persons with respect to municipal financial products, the
                   issuance of municipal securities, and certain solicitations of municipal entities and
                   obligated persons. Nearly 200 registered broker-dealers, as well as over 500 other firms,
                   are registered with MSRB as municipal advisers.




                   Page 9                                                     GAO-12-265 Municipal Securities
every 2 years for compliance with MSRB rules, pursuant to MSRB
requirements. 22

OCIE administers SEC’s nationwide examination and inspection program.
OCIE oversees the SROs’ compliance with federal securities laws and
the SROs’ enforcement of their members’ compliance with federal
securities laws and SRO rules through inspections. Inspection review
areas include an SRO’s compliance, examination, and enforcement
programs. OCIE also directly assesses broker-dealer compliance with
federal securities laws through examinations such as cause and risk-
based examinations. If examiners identify compliance findings during
broker-dealer examinations, they may assess the quality of any recent
FINRA examinations of the broker-dealer and provide oversight
comments to FINRA.

SEC’s Office of Municipal Securities is a separate office within the Division
of Trading and Markets that coordinates SEC’s municipal securities
activities, advises on policy matters relating to the municipal security
market, and provides technical assistance in the development and
implementation of major SEC initiatives in the municipal securities area. In
addition, the Office of Municipal Securities reviews and processes rule
proposals filed by MSRB and acts as SEC’s liaison with MSRB, FINRA,
and a variety of industry groups on municipal securities issues. SEC’s
Division of Enforcement (Enforcement) investigates possible violations of
securities laws, recommends commission action when appropriate, either
in a federal court or before an administrative law judge, and negotiates
settlements. In January 2010, Enforcement created the Municipal
Securities and Public Pensions Unit, which focuses on misconduct in the
municipal securities market and in connection with public pension funds.




22
  On December 16, 2011, SEC approved a MSRB proposed rule change that included an
amendment to MSRB Rule G-16, which had required FINRA and the federal banking
regulators to examine broker-dealers at least once every 2 calendar years to determine
their compliance with all applicable MSRB rules, as well as other SEC rules and
regulations. The amended rule allows for up to a 4-year examination cycle for FINRA
member firms, consistent with FINRA’s existing requirement for examinations cycles for all
other FINRA members. According to MSRB, broker-dealer firms that present higher risks
would be likely examined on an annual basis, while other firms would be examined every
2 to 4 years, depending on the risks they presented. Cycle examination frequencies for
FINRA member broker-dealer firms would be reassessed at least on an annual basis.




Page 10                                                   GAO-12-265 Municipal Securities
                           Because of the heterogeneity of the issuers and the securities they issue,
Municipal Securities       the large number of securities outstanding, and the infrequency with
Are Priced in an           which these securities trade, the municipal securities market does not
                           maintain reliable tradable quotes on all outstanding municipal securities. 23
Opaque Market That         Consequently, broker-dealers we spoke with said they use a variety of
Favors Better-             information to determine the prices at which they are willing to buy and
Informed Participants      sell securities. We found that institutional investors traded at more
                           favorable prices than individual investors and were generally better
                           equipped to make independent assessments of the value of a security.
                           SEC, MSRB, and market participants have been considering ways to
                           improve pretrade price transparency.


Among Other Factors,       As we have seen, the large municipal securities market, with its many
Broker-Dealers Use         issuers and infrequent trades for a given security, does not have readily
Information on Similar     available, transparent information on the prices of securities. Municipal
                           broker-dealers generally determine the prices at which they are willing to
Securities to Assess the   trade by making relative assessments of a security’s market value, drawing
Relative Value of a        on various sources of information and incorporating their compensation for
Security and Determine     facilitating the trades. 24 Several factors that broker-dealers we spoke with
Its Price                  identified as relevant to their pricing determinations included (1) recent
                           post-trade price information on same or comparable securities, (2)
                           available pretrade price information on the security or comparable
                           securities, (3) the characteristics and credit quality of the security, (4)
                           relevant market information, and (5) the cost of trading the security.




                           23
                              In contrast, in the equities market, tradable quotes are readily available for all securities
                           listed on the exchanges. Under SEC rules, broker-dealers that sell equity securities to
                           individual or institutional investors must guarantee the National Best Bid and Offer
                           (NBBO)—the best available ask price when the security is purchased and the best
                           available bid price when it is sold. The NBBO is updated throughout the day to show the
                           highest bid and lowest offers for all equity securities on all exchanges and market makers
                           and is publicly available. In the municipal securities market, pricing evaluation services
                           provide daily estimates for most outstanding securities to subscribers. However,
                           participants said that they used these estimates primarily to assign values to municipal
                           securities portfolios and did not generally consider them executable trade prices in the
                           face of alternative sources of reliable and timely information.
                           24
                             MSRB Rule G-30 requires that broker-dealers charge investors fair and reasonable
                           aggregate prices. For most municipal securities trades, these prices reflect the market
                           value of the security, trading costs, and the compensation that the broker-dealer receives
                           on the transaction.




                           Page 11                                                       GAO-12-265 Municipal Securities
First, when determining prices, broker-dealers said they often began by
reviewing recent post-trade information on the same or similar securities. In
2005 MSRB began requiring broker-dealers to report price data on most
municipal securities transactions within 15 minutes to RTRS and, in 2008,
made this post-trade pricing information freely available on the EMMA
website. 25 Broker-dealers we spoke with said that the price of a recently
reported interdealer trade for a security was a particularly good indication of
its value for that segment of the market. 26 However, if a security has not
traded recently, they said they instead look for recent trades in comparable
securities. Broker-dealers we spoke with also said they typically access
MSRB’s trade data through Bloomberg, which makes available tools to
perform advanced searches and analytics on the data.

These broker-dealers also said that they frequently used industry
benchmarks—typically yield curves—-constructed in part from the post-
trade prices of selected securities as a reference for pricing similar
securities. 27 Representatives of broker-dealers we interviewed explained
that post-trade information provided them with an understanding of real-
time trends in the demand for similar types of securities. For example, a
major electronic trading platform offers several tools for assessing the
prices of its listed offerings using post-trade information. Users can see
recently reported trades for similar securities, compare the offer price with
a widely used benchmark curve, and receive alerts if the offering price
exceeds the most recently reported trade by a specified threshold.


25
  MSRB has been taking steps over a number of years to improve post-trade price
transparency in the municipal securities markets. Prior to 1995, there was no systematic
and comprehensive dissemination of either post-trade or pretrade information for
municipal securities. In 1995, MSRB began next-day public dissemination of certain trades
between broker-dealers. By 2003, MSRB was collecting and disseminating price data on
all municipal securities transactions the morning after the trade date, but this information
was not available to the general public. Real-time trade reporting began in 2005 with the
implementation of RTRS and public dissemination of these data in 2008.
26
 Market participants and regulators explained they used these trades because trades
between broker-dealers do not include compensation, which broker-dealers include in the
aggregate price of a security when they trade with investors.
27
  A yield curve is a graph plotting the yields for securities of the same quality with
maturities ranging from the shortest to the longest available. One commonly used
benchmark yield curve plots yields for highly rated state general obligation securities. The
curve allows users to compare bonds with different maturities and characteristics. For
example, if three different securities offer yields below, at, and above the appropriate
benchmark yields, respectively, the broker-dealer can use her judgment to decide whether
or not these differences are warranted.




Page 12                                                    GAO-12-265 Municipal Securities
Second, broker-dealers may use available pretrade price information on
the same or similar securities to infer market value. In the absence of
tradable quotes for outstanding securities, pretrade price information in
the municipal securities market includes bids from bids wanted and offer
prices. However, unlike post-trade information, pretrade price information
is not centralized, not publicly available, and not as available to broker-
dealers (and to other market participants) as post-trade price information.
To estimate the market value for a security they want to sell, broker-
dealers may solicit bids—or may ask a broker’s broker to solicit bids—
through a bid wanted. Broker’s brokers may also provide broker-dealers
with otherwise publicly unavailable information on third-party bids and
offers from past bids wanted as well as the highest bid and the lowest
offer available at a given time for securities in their areas of expertise. For
example, a broker’s broker who regularly puts a security out for bid
wanted can provide information to broker-dealers on the bids received
even if the security has not traded in the last 2 months. Additionally,
broker-dealers obtain information about offer prices mainly through their
relationships and daily communications with other broker-dealers or
broker’s brokers, their investors who may inform them of competing
offers, and listed offerings on electronic trading platforms or Bloomberg.

Third, information on the credit quality of a security may affect its market
value, particularly any changes to the credit quality of the security since it
last traded. Broker-dealers can infer the credit quality of a security by
reviewing information from issuers’ financial disclosures posted on the
EMMA website, which they typically access via Bloomberg. Issuer
disclosures that may affect a security’s market value include information
on principal and interest payment delinquencies, changes in credit
ratings, and unscheduled draws on debt service reserves reflecting
financial difficulties, among other factors. Broker-dealers stated that their
ability to understand the credit risk of a particular security rested primarily
on their ability to obtain timely, comprehensive issuer disclosures.
However, they noted that municipal issuers’ disclosures are sometimes




Page 13                                            GAO-12-265 Municipal Securities
outdated and incomplete. 28 They added that conducting an independent
assessment of the credit quality of municipal securities has become
increasingly important given the decline in the availability and use of bond
insurance following the recent financial crisis. 29

Fourth, broker-dealers identified overall market conditions and events as
important factors to consider when inferring the market value of a
security. For example, an increase in interest rates since the last time a
security has traded will, other things being equal, reduce its value. 30
Another important factor broker-dealers consider is overall supply and
demand. For example, broker-dealers we interviewed told us that they
monitored the primary market because investor demand for new issues
affects prices for similar securities in the secondary market. Broker-
dealers also told us that by being visible and frequently transacting in the
market, they could maintain continuous dialogue with their customers
about prices, helping to gauge the interest of investors and other broker-
dealers in certain securities at given prices. Finally, broker-dealers said
that external factors such as “headline risk”—the risk that a news story


28
  There are no direct federal requirements on municipal issuers to produce or disseminate
specific items of disclosure to the marketplace. Instead, the municipal securities disclosure
regime is based on a combination of indirect disclosure obligations established through
broker-dealers’ role as underwriters in primary market issuances and voluntary issuer
disclosures. Market participants have expressed frustration regarding the resulting lack of
uniformity in the completeness and timeliness of issuer disclosures available in the
municipal market, particularly in the secondary market. Section 976 of the Dodd-Frank Act
also requires us to report on issues related to disclosure requirements for municipal
issuers by July 2012, and this work is ongoing.
29
   Bond insurance provides securities with the rating of the bond insurer and guarantees
investors timely interest payments and, if the issuers default, the return of principal.
Market participants we spoke with agreed that the widespread use of bond insurance prior
to the recent financial crisis significantly simplified the process of determining trade prices.
The homogenization of the credit quality of most municipal securities allowed market
participants to rely primarily on the creditworthiness of these few monoline insurers
instead of assessing the credit quality of the underlying securities. However, during the
recent financial crisis, many of these insurers suffered financial losses brought on by their
exposure to troubled mortgage-backed securities and were subsequently downgraded.
According to Thomson Reuters data in the 2006 and 2011 Bond Buyer Yearbook, in
2005, nine highly rated bond insurers insured about 57.1 percent of new issue volume (or
51 percent of newly issued securities). By 2010, there was only one active bond insurer in
the market, providing insurance to approximately 6.2 percent of new issue volume (or 12
percent of newly issued securities).
30
  Interest rates increases tend to lower a security’s value because its discounted cash
flows (that is, the value of future expected cash receipts at a common date) fall as interest
rates increase.




Page 14                                                       GAO-12-265 Municipal Securities
will affect prices in a market—can also affect prices in the municipal
securities market. An example of headline risk cited by broker-dealers we
interviewed was a December 2010 report by a financial markets analyst
predicting widespread defaults among municipal issuers. This report
caused many individual investors to withdraw their money from these
funds, in turn depressing prices.

Fifth, in determining prices, broker-dealers we spoke with said they
typically consider trading costs associated with every municipal securities
trade, such as fees to MSRB, and operational costs. They said that in
general, it is less costly for broker-dealers to trade a given volume of
securities in a few large blocks than in a large number of small blocks.
For example, an institutional broker-dealer with a $2 million block of
securities to sell may have to find only one buyer for the securities, while
a retail broker-dealer with a similar block of securities might have to find
100 individual investors to purchase these securities in smaller blocks of
$20,000. They explained that the higher costs related to the smaller
trades include not only the time and other related costs of finding many
more interested buyers, but also the risk that the broker-dealer incurs in
holding the securities in his inventory during that time. Last, broker-
dealers we spoke with told us that they could spend considerable
amounts of time with individual investors explaining the characteristics
and relative risks of the securities, answering questions, and complying
with regulatory requirements that govern broker-dealer transactions with
individual investors. In contrast, they said they do not have to spend as
much time with institutional investors, who are typically more
knowledgeable and experienced market participants. In order to be
profitable, broker-dealers consider these costs when establishing prices.

These broker-dealers also noted that they used their professional
judgment to determine the weight of any factor in determining the price for
a security, given the facts and circumstances surrounding the transaction.
For example, while a recent trade price on a similar security may drive a
security’s trade price in one case, the same information may become less
relevant in the case of a security that has more recently suffered a credit
downgrade.




Page 15                                          GAO-12-265 Municipal Securities
Individual Investors      We analyzed MSRB data for secondary market trades involving newly
Generally Trade at Less   issued fixed-rate securities during the period from 2005 through 2010. 31
Favorable Prices than     We found that (1) relative to institutional investors, individual investors
                          generally paid higher prices when buying—and received lower prices
Institutional Investors
                          when selling—municipal securities; (2) broker-dealers received larger
                          spreads (i.e., the difference between the purchase and selling price of a
                          security based as a percentage of the purchase price) when trading
                          smaller blocks of municipal securities; and (3) the prices that individual
                          investors paid for a given security tended to be more dispersed—that is,
                          to vary more—than the prices that institutional investors paid. 32

                          First, our analysis revealed that for broker-dealer sales to investors, the
                          relative price declined on average with trade amount, and that the
                          opposite occurs for broker-dealer purchases from investors. 33 That is,
                          investors paid higher prices when buying smaller blocks of securities
                          from broker-dealers—and received lower prices when selling them—
                          than they paid or received for larger trades. Table 1 shows average
                          relative price for trades involving newly issued fixed-rate securities
                          issued in 2010. The table shows that as trade size increased, relative
                          prices that investors paid for municipal securities declined steadily and
                          relative prices that investors received for selling their securities
                          increased steadily. For example, on average, investors paid 101.9
                          percent of a security’s reoffering price and received 99.4 percent of a
                          security’s reoffering price for $5,000 worth of securities, while they paid
                          100.1 percent of a security’s reoffering price and received 100.5 percent
                          of a security’s reoffering price for $2 million worth of securities. As



                          31
                            MSRB trade prices reflect the aggregate prices that broker-dealers charged or paid
                          when selling or buying securities, respectively. For trades with investors, these aggregate
                          prices include the compensation that broker-dealers charged or paid investors when
                          selling securities to or buying securities from them, respectively.
                          32
                             For more information on our methodology for this analysis, see appendix II. For
                          regression analysis results supporting our findings for all years of analysis (2005-2010),
                          see appendix III.
                          33
                            For each trade, the relative price is the price of the broker-dealer sale or purchase to an
                          investor as a percentage of the reoffering price (the price at which newly issued securities
                          are sold to the public by the underwriter). The results of our analysis of broker-dealer
                          sales to investors were statistically significant at the 1 percent level for all years. The
                          results of our analysis of dealer purchases from customers were statistically significant at
                          the 1 percent level for all years except 2009. For 2009, the relationship between relative
                          trade price and trade amount was negative for dealer purchases from customers but was
                          not statistically significantly different from zero.




                          Page 16                                                     GAO-12-265 Municipal Securities
discussed earlier, individual investors typically trade municipal securities
in amounts of $100,000 or less, and institutional investors typically trade
in amounts of $1 million or more. Consequently, individual investors are
likely paying higher prices than institutional investors when they
purchase municipal securities and receiving lower prices than
institutional investors when they sell municipal securities.

Table 1: Average Relative Prices on Newly Issued Fixed-Rate Municipal Securities,
by Trade Amount, 2010

                                      Average relative prices for     Average relative prices for
                                          broker-dealer sales to       broker-dealer purchases
    Trade amount                                  Investors (%)a             from investors (%)
    $1,000-$10,000                                         101.9                                  99.4
    $10,000-$20,000                                        101.8                                  99.6
    $20,000-$50,000                                        101.4                                  99.7
    $50,000-$100,000                                       100.9                                100.1
    $100,000-$250,000                                      100.4                                100.1
    $250,000-$500,000                                      100.3                                100.3
    $500,000-$1 million                                    100.2                                100.4
    $1 million-$5 million                                  100.1                                100.5
    $5 million and over                                    100.1                                100.5
Source: GAO analysis of MSRB trade data.
a
 The relative price on a municipal security is the trade price expressed as a percentage of the
reoffering price. We analyzed trades that occurred within the period from 30 days prior to 120 days
after the dated date (date from which interests start to accrue) on municipal securities that had dated
dates in 2010. We analyzed trades involving fixed-rate securities and excluded trades involving zero-
coupon or variable-rate securities. The largest trade in 2010 in the sample was for $6.1 million.


Our analysis also found that broker-dealers received larger spreads when
trading small blocks of municipal securities. 34 Because individual


34
   The results were the same for three different measures of spreads—the mean, outside,
and inside spreads. The mean spread is the difference between the mean price on dealer
sales and the mean price on dealer purchases to investors as a percentage of the mean
price on dealer purchases. The outside spread is the difference between the highest price
on dealer sales and the lowest price on dealer purchases to investors as a percentage of
the lowest price on dealer purchases. Last, the inside spread is the difference between the
lowest price on dealer sales and the highest price on a dealer purchases as a percentage
of the highest price on dealer purchases. Mean, inside, and outside spreads were
calculated for each security, for each trade size category (trade size was grouped into
$10,000 increments). Our results were statistically significant at the 1 percent level for all
three measures of spread for all years.




Page 17                                                             GAO-12-265 Municipal Securities
                                          investors tend to trade smaller amounts than institutional investors,
                                          individual investors tended to pay higher spreads than institutional
                                          investors. For example, our analysis showed that the average spread for
                                          a $20,000 trade of a fixed-rate security in 2010 was around 2 percent and
                                          for a $5 million trade around 0.01 percent. Table 2 shows how these
                                          spreads affect investors’ return as measured by the yield to maturity (the
                                          yield received after the security matures) on two hypothetical trades of
                                          $20,000 and $5 million of the same securities purchased by an individual
                                          investor and an institutional investor, respectively.

Table 2: Example of Broker-Dealer Spreads’ Effects on the Yields to Maturity Received by an Individual and an Institutional
Investor

                                      Broker-dealer         Broker-dealer sale          Broker-dealer    Broker-dealer sale to
                                        retail-sized     to individual investor    institutional-sized   institutional investor
                                          purchase             with 2% spread                purchase      with 0.01% spread
Par value                                    $20,000                   $20,000            $5,000,000                $5,000,000
Coupon rate                                    5.00%                    5.00%                  5.00%                    5.00%
Years to maturity                                   10                      10                     10                         10
Par value price                              $100.00                   $102.00               $100.00                   $100.01
Total price                                  $20,000                   $20,400            $5,000,000                $5,000,500
Yield to maturity (YTM)                        5.00%                    4.75%                 5.000%                    4.99%
Percentage change in YTM                                                -5.07%                                          -0.03%
                                          Source: GAO.



                                          In addition, our analysis showed a wider range of prices for smaller trades
                                          than for larger trades from 2005 through 2010. That is, prices for larger
                                          trades tended to be more concentrated, while prices for smaller trades
                                          tended to be more dispersed. To the extent that individual investors trade
                                          smaller amounts than institutional investors, this relationship indicates
                                          that individual investors were more likely to pay a wider spectrum of
                                          prices for a given security than institutional investors. Table 3 shows price
                                          dispersion for trades involving newly issued fixed-rate municipal securities
                                          issued in 2010. The table shows prices that investors paid (and, to a
                                          lesser extent, received) for municipal securities were more dispersed for
                                          smaller trades than for larger trades.




                                          Page 18                                                GAO-12-265 Municipal Securities
Table 3: Average Price Dispersion for Newly Issued Fixed-Rate Municipal
Securities, 2010

                                  Average price dispersion for     Average price dispersion for
                                        broker-dealer sales to        broker-dealer purchases
                                                              a
    Trade amount                                investors (%)               from investors (%)
    $1,000-$10,000                                        1.24                                  0.68
    $10,000-$20,000                                       1.05                                  0.43
    $20,000-$50,000                                       0.88                                  0.46
    $50,000-$100,000                                      0.46                                  0.33
    $100,000-$250,000                                     0.18                                  0.19
    $250,000-$500,000                                     0.13                                  0.19
    $500,000-$1 million                                   0.11                                  0.25
    $1 million-$5 million                                 0.11                                  0.27
    $5 million and over                                   0.07                                  0.07
Source: GAO analysis of MSRB trade data.
a
 Price dispersion is the difference between the maximum and minimum trade price for a security as a
percentage of its average trade price. We analyzed trades that occurred within the period from 30
days prior to 120 days after the dated date on municipal securities with dated dates in 2010. We
analyzed trades involving fixed-rate securities and excluded trades involving zero coupon or variable-
rate securities. The largest trade in 2010 in the sample was for $6.1 million. Our results were
statistically significantly at the 1 percent level for all years.


These findings are consistent with previous research on municipal
securities trades. For example, researchers analyzing trades of municipal
securities found that broker-dealers received larger spreads on smaller
trades than they received on larger trades. 35 In addition, researchers
analyzing trades of recently issued municipal securities found that prices
for smaller trades were more dispersed than prices for larger trades. 36




35
  See Richard C. Green, Burton Hollifield, and Norman Schürhoff, “Financial
Intermediation and the Costs of Trading in an Opaque Market,” Review of Financial
Studies 20(2), March 2007, 275-314; Lawrence E. Harris and Michael S. Piwowar,
“Secondary Trading Costs in the Municipal Bond Market,” Journal of Finance 61(3), June
2006, 1361-97; and Securities and Exchange Commission, Offices of Economic Analysis
and Municipal Securities, Report on Transactions in Municipal Securities, Washington
D.C., July 1, 2004. Available at www.sec.gov/news/studies/munireport2004.pdf.
36
  See Richard C. Green, Burton Hollifield, and Norman Schürhoff, “Dealer Intermediation
and Price Behavior in the Aftermarket for New Bond Issues,” Journal of Financial
Economics 86 (2007), 643-82; and Securities and Exchange Commission, Report on
Transactions in Municipal Securities.




Page 19                                                           GAO-12-265 Municipal Securities
Individual Investors        Various factors could contribute to the differences in prices that individual
Generally Have Less         investors receive relative to institutional investors. Some researchers
Information and Expertise   have suggested that these differences are not entirely accounted for by
                            differences in dealer costs between large and small trades. One study
to Assess Prices than       suggests the lower spreads that institutional investors pay may also be
Institutional Investors     due to the lack of price transparency in the market, which allows better
                            informed investors to obtain more favorable trade prices. 37 Another study
                            adds that institutional investors’ continuous engagement in the market
                            and frequent interaction with broker-dealers also provide them with more
                            bargaining power than individual investors. This study also suggests that
                            the more dispersed prices that individual investors experience could
                            indicate that, in the nontransparent municipal securities market, broker-
                            dealers may have more opportunities to charge higher prices when
                            dealing with less knowledgeable investors. The authors explained that the
                            wider range of prices individual investors receive when they buy or sell
                            the same security could reflect broker-dealers’ ability to detect diverse
                            levels of sophistication among individual investors, with less
                            knowledgeable individuals potentially more likely to trade at less favorable
                            prices than more market-savvy individuals. 38

                            A third study, however, concludes that differences in prices are not
                            entirely due to the lack of transparency in this market. The study notes
                            that municipal securities often pass through a chain of dealers before
                            being placed with investors and suggests that such interdealer trading
                            may contribute to differences in prices for individual and institutional
                            investors. This study finds that the prices investors pay increase with the
                            amount of interdealer trading that preceded their purchases, and also that
                            more interdealer trading is associated with greater price dispersion. The
                            study also finds that successive interdealer trades tend to involve smaller


                            37
                              See Harris and Piwowar, “Secondary Trading Costs in the Municipal Bond Market.”
                            38
                                See Green, Hollifield, and Schürhoff, “Dealer Intermediation and Price Behavior.” Other
                            studies have noted potential evidence of broker-dealers’ ability to use their position in the
                            market to the detriment of investors. For example, one study suggests that broker-dealers
                            exercise their market power by either disregarding crucial disclosure information or
                            withholding it from buyers in order to sell securities at higher prices. (See Peter Schmitt,
                            The Consequences of Poor Disclosure Enforcement in the Municipal Securities Market,
                            DPC Data 2009). Another study suggests that when selling securities, broker-dealers
                            opportunistically delay responses to price drops while immediately recognizing price
                            increases. (See Richard C. Green, Dan Li, and Norman Schurhoff, “Price Discovery in
                            Illiquid Markets: Do Financial Asset Prices Rise Faster Than They Fall?” Journal of
                            Finance, Vol. 65 (5), October 2010).




                            Page 20                                                     GAO-12-265 Municipal Securities
                                and smaller trades, thus suggesting that investors trading smaller
                                amounts—individual investors—are likely to pay higher prices and also
                                more dispersed prices than investors trading larger amounts—institutional
                                investors. 39

                                We found several factors that likely affected individual investors’ ability to
                                gain and use information to independently assess offers and bids they
                                received from their broker-dealers for municipal securities they were
                                interested in purchasing or selling. While MSRB has increased the
                                amount of information available to all investors through its EMMA
                                website—including price information on past trades and issuer
                                disclosures—institutional investors we spoke with generally had more
                                resources and expertise to assess prices than individual investors. In
                                particular, they had (1) access to more sources of pretrade price
                                information in the form of offerings and bids provided through their large
                                networks of broker-dealers, (2) access to more user-friendly post-trade
                                information through third-party vendors and their networks of broker-
                                dealers, and (3) more market expertise to help them incorporate other
                                available information.

Institutional Investors         First, institutional investors told us that when buying securities they
Generally Have Access to More   accessed the fragmented municipal market through their large networks
Sources of Pretrade Price       of broker-dealers. For the institutional investors we interviewed, these
Information                     networks range from 30 to over 100 national and regional broker-dealers
                                who compete for their business by providing them with a wide range of
                                municipal securities offerings from the primary and secondary markets. 40
                                For example, institutional investors typically receive daily secondary
                                market offerings from their broker-dealers through Bloomberg, which
                                provides an interface that allows users to pull together and organize these
                                offerings for easy analysis—an important feature in a large,
                                heterogeneous market where price discovery depends heavily on relative
                                assessments of similar securities.



                                39
                                  See Paul Shultz, The Market for New Issues of Municipal Bonds: The Roles of
                                Transparency and Limited Access to Retail Investors, University of Notre Dame, January
                                2012.
                                40
                                   Institutional investors we spoke with said that it was their standard practice to maintain
                                and trade only through internally approved broker-dealers that were continually reviewed
                                for performance and conduct. A couple of investors noted that while they had relationships
                                with many broker-dealers, they did the bulk of their trades through about 13 to19 percent
                                of them.




                                Page 21                                                     GAO-12-265 Municipal Securities
Relative to institutional investors, individual investors typically have
access to fewer sources of pretrade price information. Unlike institutional
investors that have access to and can compare thousands of daily
offerings from their large networks of broker-dealers, individuals typically
have brokerage accounts with a few broker-dealers, perhaps only one,
that may or may not offer online access to their offerings. 41 Individuals
with online access to a brokerage firm’s offerings can search for
securities that meet certain parameters and compare the results. They
may be able to repeat this exercise with other broker-dealers, although
they are unlikely to obtain competing prices for the same security. 42 In
contrast, some investors without access to online offerings told us that
they relied on their broker-dealers. These investors can compare prices of
similar securities only insofar as their brokers share this information with
them. However, some retail broker-dealer firms have taken steps to
attract individual investors by combining offerings from electronic trading
platforms with their own offerings, thus expanding the pool of securities
available to their customers. 43 According to one of the largest municipal
electronic trading platforms, which caters to retail broker-dealers,
individuals can access the platform’s inventory through several major
brokers, most full-service brokers, and many independent financial
advisers. 44

Similarly, institutional investors wanting to sell municipal securities
generally have multiple ways to obtain pretrade price information in the
form of bids. Their access to large networks of broker-dealers and tools
for obtaining bids from more than one dealer allows them to contact
potential buyers and independently assess the bids they receive for their
securities. Institutional investors we interviewed said that they also


41
  For example, of the nine individual investors we spoke with who traded municipal
securities directly through broker-dealers, four had accounts with one broker, while the
remaining five used two to four brokers to trade municipal securities (we also interviewed
two individuals who invested in municipal securities through mutual funds).
42
 Market participants told us that retail broker-dealers were unlikely to have the same
securities in inventory because of the variety of municipal securities available and the
geographic fragmentation of the market, among other things.
43
  A broker-dealer that combines offerings with an electronic trading platform may also be
able to expand by selling securities through other broker-dealer subscribers that may sell
them to their clients.
44
 Full-service brokers provide personalized service to their investors, including research
and investment advice.




Page 22                                                     GAO-12-265 Municipal Securities
frequently carried out their own bids wanted by using Bloomberg to solicit
bids from broker-dealers in order to gauge demand and potentially
receive a bid at which they were willing to sell. 45 Additionally, these
institutional investors told us that they might offer securities directly to
broker-dealers to find interested parties among the firms or their
customers. Finally, institutional investors can ask a broker-dealer to offer
the security for sale through a broker’s broker or an electronic trading
platform. 46

By contrast, individual investors typically do not have independent access
to multiple bids and thus may be less able to assess the prices they
receive for securities they want to sell. When individuals sell securities,
they typically rely on the broker-dealer responsible for the account that
houses the securities to find a market. A retail broker-dealer may offer the
securities to other broker-dealers or customers or may solicit bids through
a broker’s broker or an electronic trading platform. However, because
selling small blocks of securities is generally more difficult than selling
larger blocks, broker-dealers we interviewed said that they might be able
to obtain only a few bids for the individual investor. Although the broker-
dealer may explain to the individual his process for obtaining bids,
individual investors may have difficulty judging the level of demand for
their securities or the level of effort their broker-dealers made to find
potential buyers.




45
   Through Bloomberg, institutional investors can customize their own bids wanted by
sending out the details of the auction to Bloomberg users of their choice and receiving
bids. Some institutional investors noted they usually solicited bids from their network of
broker-dealers, which in turn solicited bids from their own customers. On the other hand,
institutional investors are not involved in the broker’s brokers’ bids wanted. If a broker-
dealer seeks the services of a broker’s broker to sell an institutional investor’s securities,
the investor receives the anonymous highest bids and can decide to hold or sell the
securities.
46
   Some broker’s brokers offer anonymity by buying the securities from the selling dealer
and then immediately selling them to another dealer that they lined up prior to executing
the trade. For example, an institutional investor selling a large block of securities may ask
a broker’s broker to facilitate the trades and sell the securities in smaller blocks so as to
maintain a stable price and not reveal the investor’s trading strategy. For other
transactions that do not require anonymity, broker’s brokers reveal the names of both
parties at the point of sale.




Page 23                                                       GAO-12-265 Municipal Securities
Institutional Investors Can     Similar to broker-dealers, institutional investors we interviewed told us
Access Post-trade Pricing       that they can access MSRB’s historical trade information through the
Information through the EMMA    EMMA website and centrally through Bloomberg, which allows users to
Website, Bloomberg, and Their   compare post-trade prices for two or more securities that share similar
Broker-Dealers                  characteristics using a search function. Institutional investors also said
                                that their established relationships and continued negotiation with their
                                broker-dealers often revealed market patterns from post-trade prices that
                                helped them assess prices. For example, some large institutional
                                investors told us that broker-dealers typically let them know about large or
                                otherwise meaningful trades that they believed might affect prices of
                                similar securities before these trades appeared on RTRS (postings must
                                occur within 15 minutes of the trade). Some of these investors said that
                                even though MSRB’s RTRS system did not disclose total transaction
                                amounts for trades over $1 million—which the system reports as trade
                                amounts of “$1+ million”—they typically were aware of the amount and
                                the price of these large transactions through their relationships with
                                broker-dealers. Market participants have said that this information is
                                important, because prices in large trades affect prices for many other
                                similar securities because of the relative nature of pricing in this market.
                                Institutional investors are also able to benefit from broker-dealers’
                                commentaries on trades or on demand trends in the market through
                                Bloomberg.

                                In contrast, individuals—who are likely to find Bloomberg prohibitively
                                expensive—can obtain post-trade information on any outstanding security
                                from the EMMA website but may encounter limitations. 47 While individual
                                investors may use the EMMA website to look for past trade prices of a
                                security to assess the current price, this information is likely not useful
                                unless the latest trade is relatively recent, as we have seen. Currently, the
                                EMMA website does not have search capabilities designed to allow users
                                to identify comparable securities. Further, individual investors could
                                misinterpret post-trade pricing data if they were unaware that reported
                                prices for investor transactions reflected dealers’ compensation for the
                                trade as well as the estimated market value of the security. MSRB is




                                47
                                  According to Bloomberg staff, a subscription to Bloomberg services costs about $20,000
                                a year.




                                Page 24                                                 GAO-12-265 Municipal Securities
                                  currently evaluating improvements that would make the EMMA website
                                  more meaningful and useful for individual investors. 48

Institutional Investors’ Market   Institutional investors we spoke with generally employed professional
Expertise Allows Them to          staff, such as credit analysts and traders, who specialized in evaluating
Better Use Available              credit risk and trading municipal securities and maintained models to
Information to Assess Prices      evaluate offering prices. 49 Institutional investors we interviewed stated
                                  that in general they could form an immediate initial judgment about the
                                  price of a municipal security because they were entrenched in the market
                                  on a daily basis and had accumulated expertise to inform their decision
                                  making. These investors told us that they applied a wealth of market
                                  history to determine a security’s relative value. They said that, for
                                  example, they knew the approximate price at which an A-rated hospital
                                  security in California with a 30-year maturity is trading and could update
                                  prices for the same or similar securities by looking at technical features
                                  (like call features), the issuers’ financial profile, and the market strength
                                  on the day of the trade, among other things.

                                  By contrast, individual investors have access to issuer financial
                                  disclosures through MSRB’s EMMA website and other publicly available
                                  issuer information but may lack the expertise to understand and update
                                  prices using this information. Besides issuer disclosures, individuals have
                                  access to free investor information websites, such as the Securities
                                  Industry and Financial Markets Association’s (SIFMA)
                                  investinginbonds.com, which makes available various market benchmark
                                  yield curves, among other things. Many of these resources may also be
                                  available to individuals through their broker-dealers’ online websites.
                                  However, some institutional investors we spoke with believed that
                                  professional expertise was required to use this information to assess
                                  prices, especially for securities that had not traded recently. For example,
                                  even with timely access to issuer disclosures, it is not clear that individual
                                  investors with relatively limited market expertise would be able to




                                  48
                                   See appendix IV for a discussion of MSRB’s ongoing assessment of the EMMA website
                                  and related transparency programs and funding of these programs.
                                  49
                                    These models create benchmark yield curves that allow investors to deem a price
                                  “cheap,” “fair,” or “rich” if it is below, at, or above the model’s estimated market value.




                                  Page 25                                                       GAO-12-265 Municipal Securities
estimate how a rating downgrade translated into a lower price for a
security. 50

Additionally, individual investors may undertake varied degrees of
research during the few hours that they typically have to make an
investment decision. For example, some investors we spoke with did not
look at historical trade information or issuer disclosure information when
they bought bonds and instead relied on the recommendation of their
broker-dealer. Others, however, chose a few potential securities from
their broker-dealer’s online offerings and checked historical trade
information and disclosure information for those securities. One of the
more knowledgeable among the individual investors we spoke with stated
that he treated the last interdealer trade price as a benchmark for pricing
and used this information with varying degrees of success to negotiate
prices with brokers. For example, one individual said he had successfully
used the last traded price to bargain for better prices with his broker and
found that if he was buying bonds for a par value of $200,000, for
example, he might be able to save $100 (or 0.05 percent of par value).

Market participants explained that individual investors faced additional
challenges in independently assessing the value of a security since the
decline in the use and availability of bond insurance following the recent
financial crisis. In the past, individual investors could choose to buy an
insured security and rely on the insurer’s guarantee without fully
understanding the security’s underlying value. Individual investors may
review issuer disclosures through the EMMA website to help in
independently assessing risk, but some individual investors have
expressed frustration at their inability to identify and understand the




50
  Certain disclosure, suitability, and fair pricing obligations of a broker-dealer under MSRB
rules may be deemed fulfilled in connection with a transaction between the broker-dealer
and an investor that constitutes a Sophisticated Municipal Market Professional (SMMP)
with respect to such transaction. MSRB recently proposed changes to its definition of
SMMP to include individuals with at least $50 million invested in municipal assets who
believed and affirmatively attested to their broker-dealers that they could independently
evaluate investment risks and market value both in general and for specific transactions.
The previous definition excluded individual investors and included institutional investors
with at least $100 million invested in municipal securities. The proposal noted that these
changes were the result of investors’ increased access to electronic trading platforms and
issuer disclosure information, among others things, as well as the movement to align
MSRB rules with FINRA rules. See MSRB 2011-63, November 8, 2011.




Page 26                                                     GAO-12-265 Municipal Securities
                         relevant pieces of information from the typically long and technical issuer
                         disclosures. 51


SEC, MSRB, and Market    SEC and MSRB have ongoing studies examining the municipal security
Participants Are         market. In May 2010, SEC announced that it was beginning a review of
Considering Ways to      the municipal securities markets and intended to examine pretrade price
                         transparency, among other issues, using a series of field hearings. 52 At
Improve Pretrade Price
                         the conclusion of the review, SEC staff are to prepare a publicly available
Transparency             report recommending whether specific changes to laws, regulation, or
                         private sector best practices are needed to better protect municipal
                         securities investors. SEC staff anticipate that the report will be finalized
                         and made public in 2012. In December 2010, MSRB also announced that
                         it was undertaking a study of the municipal securities market, including a
                         review of market structure and trading patterns. MSRB stated that the
                         study would include a review of transaction costs, price dispersion, and
                         other market data and was intended to help MSRB assess whether the
                         market was operating as efficiently and fairly as possible. It is also
                         intended to assist MSRB in evaluating whether pricing and liquidity in the
                         market could be improved with higher levels of pretrade price
                         transparency. MSRB staff said that the initial phase of the study would
                         likely be completed in 2012. MSRB said that in considering whether to
                         recommend potential changes in terms of market structure or disclosures
                         that would improve price transparency, the costs and benefits would need
                         to be weighed carefully.

                         Discussions to improve pretrade price transparency in the municipal
                         securities market focus on whether and how to make bid and offer
                         information on municipal securities more widely available and how to
                         improve individual investors’ access to the market. In an October 2010
                         speech discussing SEC’s review of the municipal securities markets, one


                         51
                           As mentioned earlier, while MSRB’s EMMA website provides a central repository of
                         issuer disclosure information, MSRB does not have the authority to regulate the content or
                         timing of these disclosures. For more information on investors’ concerns with issuer
                         disclosures, see the transcript to SEC’s Hearing on the Municipal Securities market,
                         December 2010, available at http://www.sec.gov/spotlight/municipalsecurities.shtml.
                         52
                            SEC held three hearings on the municipal securities market, including one in San
                         Francisco, CA; one in Washington, DC; and one in Birmingham, AL. SEC staff told us that
                         SEC originally planned to hold more hearings but were unable to because of budget
                         constraints. Instead, staff said that they held a number of “mini muni” hearings, meeting
                         with a variety of municipal securities market stakeholders at SEC’s offices.




                         Page 27                                                   GAO-12-265 Municipal Securities
commissioner noted that post-trade transparency in this market had
improved considerably since MSRB’s implementation of real-time trade
reporting and the EMMA website. 53 However, because of the low liquidity
levels of many municipal securities, these trade data could be weeks or
months old and therefore not helpful to investors. In part for this reason,
the commissioner said, improving pretrade transparency was an
important goal. MSRB staff observed that only a few limited venues
allowed even knowledgeable and experienced market participants such
as broker-dealers to see bid and offer information for municipal trades.
They added that because the municipal securities market operates
through over-the-counter trading, even the broker-dealers could not see
bid and offer information for the entire market.

One challenge to improving pretrade price transparency is determining
whether and how to make this information available to the general public
in a timely manner, particularly for thinly traded securities. That is, given
that most municipal bonds are traded infrequently once they have been
initially distributed, two-sided quotes are not continuously available in this
market. One suggestion that arose was to create a national listing service
where all municipal broker-dealers could list their entire municipal
securities offerings for public viewing and allow investors to search for
securities that fit their investment parameters and to compare prices and
yields. To make selling securities easier for investors, one field hearing
participant suggested allowing investors to place bids on offerings, while
another suggested establishing a limit order mechanism for this market. 54
These suggestions would necessitate creating a centralized trading
venue. However, as of January 2012, market participants had not
developed detailed proposals that describe the feasibility or offer cost-
benefit analyses of such changes to the structure of the market.

Market participants and observers we spoke to disagreed on the
feasibility of creating and maintaining a municipal securities exchange.
Some believed that pricing and liquidity in the municipal securities market
could be improved through exchange trading, particularly for individual




53
 Commissioner Elisse B. Walter, U.S. Securities and Exchange Commission, Key Note
Address at the National Association of Bond Lawyers (NABL) 35th Bond Attorneys’
Workshop. San Antonio, TX, October 28, 2010.
54
     A limit order is an order to buy or sell a security at a specified price.




Page 28                                                           GAO-12-265 Municipal Securities
investors. 55 For example, one market participant noted that when buying
securities, broker-dealers and investors currently have access to a limited
set of offerings in the market, and that when selling securities, they
currently only have access to a subset of potential bidders for the
securities. This market participant said that an exchange could broaden
both broker-dealers’ and investors’ access to bids and offers for municipal
securities, and that such centralized transparent aggregation of dealer
and individual investor interest would lead to increased liquidity, even in
the absence of two-sided quotes for most bonds. Further, this market
participant said that an exchange would promote pretrade price
transparency through the public dissemination of bid and offer
information. Other market participants agreed that an exchange would
broaden individual investors’ access to the market and noted that an
exchange would allow them to more easily find offerings for comparable
securities with the characteristics they wanted. Furthermore, one market
expert stated that an exchange would provide more liquidity to investors
by taking advantage of existing technology to identify potential interested
buyers for a given security, even in the absence of two-sided quotes.

However, broker-dealers and large institutional investors we interviewed
stated that, in this fragmented market driven by supply and demand,
relationships and direct negotiation were the key to making markets and
determining prices. Broker-dealers also pointed to the large number of
heterogeneous and relatively illiquid municipal securities that would make
it difficult to establish ready two-sided markets for a given security.
Additionally, large institutional investors we spoke with stated that a
municipal securities exchange may not be feasible or advisable because
of the costs of developing a central meeting place that could incorporate
these unique attributes of the market. Broker’s brokers also thought the
negotiated nature of the market limited the feasibility of an exchange and
noted that demand for their services had increased greatly with the
decline in the availability and use of bond insurance. They said that
because broker-dealers could no longer rely on the homogenizing effects



55
  Academic researchers point out that both municipal and corporate securities were
predominantly traded on the New York Stock Exchange until the 1920s and the 1940s,
respectively. They argue that the switch from an exchange to an over-the-counter trading
venue was most likely the result of the concurrent increase in institutional investors’
participation in the markets. See Bruno Biais and Richard C. Green, “The Microstructure
of the Bond Market in the 20th Century,” Institut d’Economie Industrielle Working Paper
No. 482, August 29, 2007.




Page 29                                                  GAO-12-265 Municipal Securities
                           of bond insurance, their need for reliable information on, for example,
                           specialized securities’ credit and sector trends had increased.


                           MSRB has issued rules addressing broker-dealers’ pricing, trade
Regulators Oversee         reporting, and clearance and settlement responsibilities with respect to
Compliance with            municipal securities transactions. However, because MSRB does not
                           have enforcement authority over broker-dealers, FINRA, federal banking
MSRB Rules and Have        regulators, and SEC conduct broker-dealer oversight and enforce MSRB
Not Found Systemic         rules. FINRA oversees 98 percent of broker-dealers registered with
                           MSRB, and the federal banking regulators (OCC, FDIC, and the Federal
Violations, but SEC’s      Reserve) oversee the remaining 2 percent, which we refer to in this report
Monitoring Is Limited      as bank dealers. 56 SEC’s OCIE provides oversight of MSRB and FINRA’s
                           regulatory activities. We found that FINRA and the banking regulators did
                           not identify many violations of the pricing and trade reporting rules from
                           2006 through 2010 and that settlement failures on municipal securities
                           transactions were rare. 57 We also found that, although OCIE conducted
                           multiple FINRA district office inspections and broker-dealer examinations
                           as part of its municipal market oversight, it had not inspected MSRB or
                           FINRA’s fixed-income program since 2005 and lacked a program for
                           conducting interim monitoring to assess risks at these SROs.


MSRB Rules Govern          Several MSRB rules govern broker-dealers with regard to municipal trade
Municipal Transaction      pricing, reporting, and clearance and settlement.
Pricing, Reporting, and
                           •    Rule G-30: MSRB Rule G-30 requires that broker-dealers charge fair
Clearance and Settlement        and reasonable aggregate prices to customers (individual and
                                institutional investors) for buying and selling securities. In principal



                           56
                             Some banks designate a department or division to engage in municipal securities
                           underwriting, trading, and sales; financial advisory or consultant services for issuers of
                           municipal securities; or processing and clearance activities for municipal securities. These
                           entities must register as municipal securities dealers with SEC and provide a copy of their
                           registration to the appropriate federal banking regulator. As of December 2011, there were
                           11 bank dealers under OCC’s jurisdiction, 8 under FDIC’s, and 11 under the Federal
                           Reserve’s. However, an OCC staff member told us that the number of municipal securities
                           dealers under each banking regulator’s jurisdiction could fluctuate as banks registered and
                           withdrew as municipal securities dealers or switched charters among the three banking
                           regulators.
                           57
                             A settlement failure occurs when delivery or receipt of securities does not take place on
                           the settlement date for a transaction between two broker-dealers.




                           Page 30                                                    GAO-12-265 Municipal Securities
    transactions, in which broker-dealers take securities into their own
    accounts, the aggregate price reflects not only the market value of the
    security, but also the compensation the broker-dealer receives on the
    transaction, either a markup or markdown from the security’s
    prevailing market price. 58 A markup is compensation for selling a
    security to a customer, while a markdown is compensation for buying
    a security from a customer. A security’s prevailing market price is its
    interdealer market value—or the price at which a broker-dealer would
    sell or buy the security to or from another broker-dealer—at the time
    of the customer transaction. Most broker-dealers engage in municipal
    securities transactions in a principal capacity, and as such are not
    required to break out the markup or markdown from their aggregate
    prices. Figure 1 shows how markups and markdowns are calculated
    and illustrates the markups and markdowns in hypothetical municipal
    securities transactions.




58
   MSRB Rule G-18 addresses a broker-dealer’s responsibility to make a reasonable effort
to obtain a fair and reasonable price for customers in agency transactions (those in which
the broker-dealer buys or sells securities on behalf of and under the instruction of another
party—typically the customer—but does not take any securities into his own account).
However, Rule G-18 does not address the broker-dealer’s compensation for agency
transactions, which are in the form of commissions rather than markups or markdowns.
Rule G-30(b) addresses commissions, which differ from markups and markdowns in that
they are typically set fees per security or transaction rather than fees based on the
security’s prevailing market price. A broker-dealer acting in an agency capacity must
disclose the commission charged to customers as a separate item on the transaction
confirmation.




Page 31                                                    GAO-12-265 Municipal Securities
Figure 1: Hypothetical Broker-Dealer Markups and Markdowns in Municipal
Securities Transactions




a
The prevailing market price is not necessarily equivalent to par value, as it is in this example.
b
 This example is based on the assumption that no changes occurred in the market between the
interdealer transaction and broker-dealer 3’s transactions with investors A and B that would affect the
prevailing market price.


MSRB has stated that, in order to be fair and reasonable, the price of a
security must bear a reasonable relationship to its prevailing market price.
Both the price and the markup or markdown must be fair and reasonable
in order to satisfy Rule G-30. In other words, a broker-dealer cannot
charge the prevailing market price but add an excessive markup and still
be in compliance with the rule. Citing the heterogeneous nature of




Page 32                                                             GAO-12-265 Municipal Securities
municipal securities transactions and broker-dealers, MSRB has not set
specific numeric guidelines for acceptable markups or markdowns. 59
Since the early 1970s, however, several SEC cases and opinions have
addressed instances in which broker-dealers charged excessive
aggregate prices. Appendix V describes the key features of several of
these cases.

•    Rule G-14: Since 2005, MSRB Rule G-14 has required real-time
     reporting of most municipal securities trades for transparency and
     regulatory purposes. With few exceptions, Rule G-14 requires broker-
     dealers to report all trades to an RTRS portal “promptly, accurately,
     and completely.” 60 In general, reporting to an RTRS portal entails
     recording transactions and their relevant details within 15 minutes of
     the time of trade. 61 In addition, Rule G-14 states that broker-dealers
     must have a current Form RTRS on file with MSRB with the
     information necessary to ensure that their trade reports can be
     processed correctly.

•    Rules G-15 and G-12: MSRB rules provide for most secondary
     market transactions to settle, or complete delivery and payment, by



59
  For a discussion of numeric guidelines related to Rule G-30, see the MSRB Rule Book
2011, 239 (Report on Pricing, September 26, 1980). Available at
http://www.msrb.org/msrb1/pdfs/MSRBRulebook.pdf. By comparison, guidance issued in
connection with FINRA’s rule on fair commissions and markups (IM-2440-1) includes a
statement that markups and markdowns on securities transactions, which include debt
securities transactions (bond transactions), generally should not exceed 5 percent.
However, this guidance is not definitive and, if factored into a markup analysis
appropriately, is only one of several items considered. IM-2440-1 also states that a higher
percentage of the markup customarily applies to a common stock transaction than to a
bond transaction of the same size.
60
  There are three ways for broker-dealers to report their trades to the RTRS. First, NSCC
operates an RTRS portal that may be used for any trade record submission or trade
modification. Second, broker-dealers can report customer transactions (but not most
interdealer transactions) to MSRB’s web-based RTRS portal. Third, broker-dealers must
report most interdealer transactions through NSCC’s Real-Time Trade Matching (RTTM)
portal, which feeds into the RTRS.
61
  Rule G-14 provides exemptions to this 15-minute window. For example, dealers have
until the end of the RTRS business day to report trades in certain short-term (less than 9
months in maturity) instruments, including variable- rate instruments, auction-rate
products, and commercial paper. RTRS entries for customer trades require a variety of
details, such as the CUSIP number, trade date and time, settlement date, par amount and
dollar price of the trade, the yield (with limited exceptions), and the commission (if
applicable), as well as whether it was a buy or a sell and a principal or agency transaction.




Page 33                                                     GAO-12-265 Municipal Securities
                              the third business day following the trade date. Specifically, MSRB
                              Rule G-15 sets out settlement dates with respect to broker-dealers’
                              transactions with customers, while Rule G-12 sets out settlement
                              dates for interdealer municipal transactions.


Regulators Use Various    MSRB makes trade data submitted by broker-dealers through the RTRS
Methods to Monitor and    available to FINRA, the federal banking regulators, and SEC for their
Enforce Compliance with   regulatory activities. In January 2010, MSRB launched Regulator Web, or
                          RegWeb, a secure web-based portal to municipal securities transaction
MSRB Pricing and Trade    data. RegWeb provides regulators with consolidated access to information
Reporting Rules           including real-time, individual firm transaction data as well as dealer data
                          quality reports (monthly reports listing each dealer’s late, canceled, and
                          amended trade statistics); monthly reports on system outages and other
                          statistics; Forms RTRS that firms have filed with MSRB; a list of broker-
                          dealers registered with MSRB; and other information.

                          FINRA primarily employs an automated surveillance program and conducts
                          examinations of broker-dealers to enforce MSRB rules related to pricing
                          and trade reporting. FINRA uses automated surveillance to monitor all
                          municipal broker-dealers that are FINRA members for compliance with
                          MSRB pricing and trade reporting rules. FINRA’s automated surveillance
                          also includes activity related to the bank dealers under the jurisdiction of
                          the federal banking regulators. Using programmed parameters, FINRA
                          assesses RTRS data for potential violations of MSRB rules, including G-30
                          and G-14. For example, FINRA has surveillance programs that identify
                          transaction prices that appear to be outliers compared with prices in the
                          rest of the market. FINRA analysts follow up on alerts generated by these
                          programs with broker-dealers under its jurisdiction in accordance with
                          written policies and procedures and, in certain circumstances, will refer
                          potential violations by bank dealers to the appropriate federal banking
                          regulator for further investigation. FINRA also assesses compliance with
                          the MSRB pricing and trade reporting rules through routine and cause
                          examinations of municipal broker-dealers. Examiners use an electronic
                          examination module that includes specific instructions for collecting
                          documentation, selecting samples, and running data reports, and for other
                          aspects of their examinations. FINRA’s surveillance and examinations can
                          result in a variety of actions against a firm that violates a rule, such as an
                          informal warning or a monetary penalty, among other actions.

                          The federal banking regulators rely primarily on examinations to monitor
                          bank dealers’ compliance with MSRB pricing and trade reporting rules.
                          Officials from these agencies explained that they did not have formal


                          Page 34                                           GAO-12-265 Municipal Securities
surveillance programs designed to monitor bank dealers’ compliance with
MSRB rules. Rather, they periodically review MSRB reports on data
quality and pricing volatility in RegWeb, often as part of their preparation
for on-site examinations. In addition, although the federal banking
regulators all stated that such instances are rare, FINRA may refer to
them potential violations by bank dealers that it identifies through its
automated surveillance program. During their on-site examinations, bank
examiners generally take samples of bank dealers’ transactions and
review them for compliance with Rules G-30 and G-14. Their
examinations can result in corrective actions, among other responses.

As part of its oversight of FINRA’s regulatory operations, OCIE assesses
broker-dealers’ compliance with MSRB Rules G-30 and G-14 through
broker-dealer examinations. OCIE also may review for compliance with
these rules in other types of examinations, such as cause examinations
and risk-targeted examinations. Because OCIE uses a risk-based
approach to determine areas of focus in these examinations, examiners
might not always check for compliance with Rules G-30 and G-14. When
they do, however, they follow OCIE’s written examination procedures.
OCIE’s examinations can result in actions such as a deficiency letter to
the firm or referral to SEC enforcement staff for a more formal review.
See appendix VI for a more detailed description of how FINRA, the
federal banking regulators, and OCIE examine for compliance with Rules
G-30 and G-14.

MSRB and the other regulators coordinate in various ways to facilitate
effective enforcement of Rules G-30 and G-14, as well as other MSRB
rules. For example, MSRB officials provided agendas demonstrating that
SEC, MSRB, and FINRA have held three semiannual meetings since
December 2010, as mandated by the Dodd-Frank Act, to describe their
work in the municipal securities market and to discuss any issues related
to regulation, including rule interpretation, examinations, and enforcement
of MSRB rules. According to documentation provided by MSRB officials,
MSRB and FINRA also meet regularly and share information in
accordance with a memorandum of understanding, and MSRB meets with
SEC several times a year and with the federal banking regulators twice a
year to discuss various municipal market issues, with a focus on MSRB




Page 35                                          GAO-12-265 Municipal Securities
                           rule interpretations, amendments, and guidance. 62 In addition to holding
                           formal meetings, SEC, MSRB, and FINRA staff told us that they
                           maintained daily or weekly informal communication to discuss rule filings
                           or interpretations; surveillance, examination, and enforcement issues;
                           technology issues; and other pertinent matters. As described earlier,
                           MSRB also shares RTRS data and other information with the regulators
                           via the RegWeb system. Finally, MSRB officials stated that they provide a
                           variety of training opportunities to examiners and other staff of SEC,
                           FINRA, and other regulators to promote consistency in the enforcement
                           of MSRB rules.


Regulators’ Surveillance   According to our review of regulators’ surveillance and examination data,
and Examinations Did Not   FINRA, the federal banking regulators, and OCIE have identified few
Reveal Systemic Trade      violations of Rule G-30 by broker-dealers and bank dealers from 2006
                           through 2010. Regulatory officials told us that they considered a variety of
Pricing, Reporting, or     factors when determining whether a broker-dealer had charged unfair or
Clearance and Settlement   unreasonable prices, markups, or markdowns. We also found that
Issues                     violations of Rule G-14 were not systemic and that the industry average
                           for late reported trades had decreased substantially since 2005. Finally,
                           sample data from the agency that oversees clearance and settlement of
                           municipal trades indicate that municipal transaction settlement failures
                           are rare.

Trade Pricing              Regulators cited a small number of violations of Rule G-30 during the
                           period from 2006 through 2010. Specifically, FINRA opened 416 reviews
                           based on alerts related to potential G-30 violations occurring during the 5-
                           year review period. 63 FINRA had completed 343 of those reviews by June
                           2011. Of those 343 reviews:



                           62
                             The memorandum of understanding between MSRB and FINRA, created in 2006 and
                           substantially broadened under a new memorandum of understanding entered into in
                           September 2011, specifies multiple ways in which the two SROs have agreed to work
                           together to ensure broker-dealer compliance with MSRB rules. For example, the
                           memorandum specifies what kinds of information MSRB will share with FINRA; how
                           MSRB will support FINRA’s surveillance, examination, and enforcement activities,
                           including providing technical support and referring potential rule violations to FINRA; and
                           how often MSRB and FINRA will meet regarding specific regulatory activities.
                           63
                             FINRA officials told us that the number of alerts does not necessarily equate to the
                           number of cases they opened. For instance, FINRA might open a single case in response
                           to hundreds of alerts for a broker-dealer firm.




                           Page 36                                                     GAO-12-265 Municipal Securities
•    FINRA determined that 267 (78 percent) warranted no further review.
     FINRA officials explained that they had investigated the prices and
     markups for the firms in question and found that violations had not
     actually occurred or were too minor to warrant further action. 64

•    Eleven reviews (3 percent) resulted in a cautionary action (an informal
     warning to the broker-dealer that similar violations in the future could
     result in formal disciplinary actions).

•    One review (less than 1 percent) resulted in a cautionary action for a
     violation of another MSRB rule.

•    Sixty-four (19 percent) were referred internally for potential
     disciplinary action.

Of the 64 reviews FINRA’s surveillance group referred internally, 22 were
closed as of June 2011. Of those 22 reviews:

•    Two (9 percent) warranted no further review.

•    Eight (36 percent) resulted in a cautionary action.

•    Twelve (55 percent) resulted in a Letter of Acceptance, Waiver and
     Consent (a disciplinary action in which the broker-dealer consents to
     findings and the imposition of sanctions but neither admits nor denies
     the violations).

Likewise, out of 5,764 examinations with a municipal securities
component that FINRA conducted from 2006 through 2010, 51
examinations (less than 1 percent) identified G-30 violations that resulted
in a formal or informal action. Of those 51 examinations:

•    Thirty-seven (about 73 percent) resulted in a cautionary action.

•    Eleven (about 22 percent) resulted in a compliance conference (a
     more serious type of informal action that involves a meeting between



64
  FINRA officials noted that in cases where broker-dealers that were FINRA members
committed pricing violations that did not warrant further review because of the limited
nature of the violations or mitigating factors, FINRA typically sought restitution on behalf of
customers for any losses the customers incurred in violative transactions.




Page 37                                                      GAO-12-265 Municipal Securities
      FINRA management and the broker-dealer firm to discuss the
      violations).

•     Three (about 6 percent) were referred internally for potential
      disciplinary action. 65

We reviewed 25 of the 51 examinations and found that the markups and
markdowns that FINRA questioned in those examinations ranged from
about 2 percent to about 10 percent. 66 The federal banking regulators did
not report any G-30 violations in the 87 total bank dealer examinations
they conducted from 2006 through 2010. OCIE staff also said that, for the
examinations they conducted during this time frame in which they
assessed broker-dealers for G-30 compliance, they observed a relatively
low rate of G-30 violations. 67

Regulators consider multiple factors in determining broker-dealers’
compliance with Rule G-30. For example, Rule G-30 specifies four factors
that broker-dealers must consider when determining a fair and
reasonable price, including the broker-dealer’s best judgment as to the
fair market value of the securities at the time of the transaction. In
addition, in its interpretive notices, MSRB has identified other factors that
may be relevant to this determination, such as the resulting yield—or
annual rate of return—of the security to a customer. To determine
whether a broker-dealer is in compliance with Rule G-30 on a specific


65
    Percentages total more than 100 percent because of rounding.
66
  Although the markups and markdowns in the examinations we reviewed ranged from
about 2 percent to about 10 percent, FINRA officials noted that there is no upper limit on
markup or markdown percentages that examiners would question.
67
  We obtained information from OCIE on broker-dealer examinations conducted from
2002 through 2010 and on the MSRB rule violations cited. However, the Super Tracking
and Reporting System (STARS), the OCIE database that stores this information, does not
allow users to conduct automatic searches for certain examination components, such as
products reviewed. Therefore, the list of approximately 1,100 examinations and MSRB
violations we received likely did not capture all of the examinations OCIE conducted with a
municipal component from 2002 through 2010. OCIE is aware of the deficiency with the
database, and staff stated that SEC is currently developing new systems with improved
search capabilities. In addition, as noted above, OCIE does not consistently review for
compliance with all MSRB rules in every examination it conducts. For these reasons, we
chose not to present statistics from the broker-dealer examination information we received
from OCIE. However, we did review selected OCIE broker-dealer examinations to observe
how OCIE examiners assessed them for compliance with certain MSRB rules, particularly
G-30 and G-14.




Page 38                                                    GAO-12-265 Municipal Securities
trade, regulators must consider how well the broker-dealer has applied all
of the relevant factors as well as the facts and circumstances of the
transaction. Table 4 lists the written factors that regulators consider in
enforcing this rule. For instance, as part of their consideration of whether
broker-dealers use their best judgment in pricing securities, OCIE
examiners stated that when they found a potentially excessive markup,
they checked to see whether the market had moved or significant
information about the issuer had become available just before the
transaction.

Table 4: Factors That Regulators Consider in Determining Broker-Dealers’
Compliance with MSRB Rule G-30

 Source                       Factors
 Rule G-30                    Broker-dealer’s best judgment as to the fair market value of the
                              securities at the time of the transaction and of any securities
                              exchanged or traded in connection with the transaction
                              Broker-dealer’s expense in effecting the transaction
                              Broker-dealer’s entitlement to a profit
                              Total dollar amount of the transaction
 MSRB Interpretive            Yield comparable to that on other securities of comparable quality,
 Notices                      maturity, coupon rate, and block size then available in the market
                              Maturity of the security
                              Availability of the securities in the market
                              Nature of the broker-dealer’s business
Sources: GAO summary of Rule G-30 and MSRB guidance.



We observed how examiners assessed broker-dealers’ application of
some of these factors in our review of selected FINRA examinations with
G-30 violations. For example, FINRA examiners identified six potential G-
30 violations—all in the form of excessive markups—at one firm they
examined. When they asked the firm to explain the markups, which
ranged from about 4 percent to nearly 10 percent, the firm stated that all
of the transactions in question involved low-rated or unrated bonds and
occurred in late 2008, when the market was highly volatile. 68 The firm also
stated that because it had no customers for the bonds at the time it


68
  Unrated bonds would likely require the broker-dealer to do more research, which could
increase the expense of executing the transaction. Similarly, low-rated bonds may be
more challenging for broker-dealers to market to potential buyers than well-known, highly
rated securities, possibly resulting in higher markups.




Page 39                                                            GAO-12-265 Municipal Securities
purchased them, it had assumed additional risks, and that no comparable
interdealer trades were available to establish the prevailing market price.
While FINRA examiners concluded that four of the six transactions were
fair and reasonable, they cited G-30 violations on the two remaining
transactions based on the combination of high markups, firm profits, and
the transactions’ proximity in time to interdealer purchases. Illustrating the
importance of reviewing the individual facts and circumstances in each
transaction, examiners deemed one of the highest markups acceptable
because the security had been trading within a wide range of prices
around the time of the trade in question and the transaction resulted in a
high yield to the customer relative to those of comparable securities. In
another examination, FINRA examiners questioned a trade in which a
firm bought 10 bonds from a customer at a price substantially lower than
the last reported trade, which had occurred about a week earlier. The firm
indicated that the security’s credit rating had dropped within that time
period. Given this downgrade and the fact that the bonds in question
continued to trade in the lower range for about a month afterward, FINRA
examiners determined that the firm had set a fair and reasonable
aggregate price and thus had not violated Rule G-30.

In April 2010, MSRB proposed draft guidance that would provide greater
specificity for broker-dealers acting as principals in determining a
security’s prevailing market price. Specifically, MSRB’s Regulatory Notice
2010-10 proposed a hierarchical approach that is intended to harmonize
with FINRA’s approach to pricing nonmunicipal debt securities. 69 The
proposed approach would first have the broker-dealer use as the
prevailing market price his contemporaneous costs or proceeds—in other
words, his costs or proceeds from a transaction recent enough that it
would be expected to reflect the current market price for the security. If a
broker-dealer wished to use a source other than his contemporaneous
costs or proceeds to determine the prevailing market price, he would be
required to search through a hierarchy of relevant transactions to seek


69
   FINRA’s IM-2440-2 states that in a debt security transaction with a customer, a broker-
dealer’s markup or markdown must be calculated from the prevailing market price of that
security. This price is typically the broker-dealer’s cost or proceeds from a recent interdealer
purchase or sale in the same CUSIP (contemporaneous cost or proceeds) to which the firm
was a party. To avoid this pricing policy, the broker-dealer must show that, given particular
circumstances, the contemporaneous cost or proceeds were not indicative of the prevailing
market price. In the event that the broker-dealer does not have a recent interdealer
transaction to identify the current prevailing market price of the bond, FINRA (in IM-2440-2)
provides a hierarchy of alternatives for determining its prevailing market price.




Page 40                                                       GAO-12-265 Municipal Securities
                  other appropriate comparison prices. In addition, broker-dealers would be
                  required to document how they determined the prevailing market price in
                  cases where they did not use contemporaneous costs or proceeds.
                  MSRB officials told us that the proposed method would likely make it
                  easier for regulators to conduct surveillance and enforcement for Rule G-
                  30, because it would provide a relatively mechanical way to determine a
                  security’s prevailing market price. However, broker-dealers have
                  expressed concerns about the proposed method, citing, among other
                  issues, increased burdens and risks to liquidity. As of January 9, 2012,
                  MSRB had not finalized the proposed guidance. 70

Trade Reporting   Although regulators identified G-14 violations during our review period,
                  these trade reporting issues did not appear to be systemic. According to
                  data we received from MSRB, from February 2005 (the month after the
                  15-minute reporting requirement took effect) through July 2011, the
                  monthly industry average for late trades declined from approximately 7
                  percent to less than 1 percent. The average rate of late trades during this
                  time frame was less than 2.5 percent. FINRA officials noted that in 2005
                  FINRA had assigned a dedicated team to conduct automated surveillance
                  reviews of the municipal market, with an initial focus on late trade
                  reporting. FINRA officials believe that these surveillance efforts likely
                  played a role in the decline of the industry G-14 violation average. FINRA
                  opened 721 reviews based on alerts related to potential G-14 violations
                  occurring from 2006 through 2010. FINRA’s surveillance group had
                  completed 621 of those reviews as of June 2011. Of the 621 reviews:

                  •    FINRA determined that 323 (52 percent) required no further review.
                       As with the reviews stemming from G-30 alerts, FINRA officials
                       explained that they had investigated the transaction reports for the
                       firms in question and found that violations had not actually occurred or
                       were too minor to warrant further action.

                  •    Fifty-five (9 percent) resulted in a cautionary action for a G-14
                       violation.


                  70
                    The proposed guidance provides several illustrations to explain how broker-dealers
                  would determine the prevailing market price in different situations. However, according to
                  MSRB officials, one of the illustrations conflicts with, and certain principles underlying the
                  proposed guidance may not be entirely consistent with, Draft Rule G-43, a proposed rule
                  addressing the use of broker’s brokers that MSRB has twice issued for comment since
                  February 2011. MSRB officials stated that they were waiting to finalize the guidance on
                  pricing until they had considered all comments on Draft Rule G-43.




                  Page 41                                                      GAO-12-265 Municipal Securities
•   Ten (about 2 percent) resulted in a cautionary action for violations of
    other MSRB rules.

•   Another 233 (about 38 percent) were referred internally for potential
    disciplinary action.

Of the 233 reviews FINRA’s surveillance group referred, 147 had been
completed as of June 2011:

•   Eight (5 percent) warranted no further review.

•   Fourteen (about 10 percent) resulted in a cautionary action.

•   Three (2 percent) resulted in a minor rule violation plan letter (an
    informal disciplinary process that allows FINRA to assess fines of less
    than $2,500).

•   The remaining 122 (83 percent) resulted in a Letter of Acceptance,
    Waiver and Consent.

Also from 2006 through 2010, out of the 5,764 examinations they
conducted with a municipal securities component, FINRA examiners cited
G-14 violations resulting in a formal or informal action in 910 (about 16
percent). Of those 910 examinations:

•   Some 699 (about 77 percent) resulted in a cautionary action.

•   Another 136 (15 percent) resulted in a compliance conference.

•   Forty-two (about 5 percent) resulted in a Letter of Acceptance, Waiver
    and Consent.

•   The remaining 33 examinations (about 4 percent) resulted in minor
    rule violation plans, internal referrals for potential disciplinary action,
    or offers of settlement.

In the sample of 32 FINRA examinations we reviewed with G-14
violations, we found that the violations stemmed from a variety of
sources, including human error, deficient procedures, a firm’s failure to
submit or update a Form RTRS, or technical malfunctions, among other
reasons. However, human error and deficient procedures were the most
commonly cited causes. Regulators noted that late or inaccurate trade
reporting was relatively simple to identify through surveillance and



Page 42                                             GAO-12-265 Municipal Securities
                           examinations and that broker-dealers could be cited for a G-14 violation
                           based on as little as one or two late or inaccurately reported trades. For
                           example, in one of the FINRA examinations we reviewed, examiners took
                           a sample of 60 trades and found that 2 were reported to MSRB with the
                           incorrect price. A representative of the broker-dealer firm told examiners
                           that the firm had corrected the trades the day they were entered but that
                           an error had led to the suppression of the amended information. FINRA
                           counts instances like this as G-14 violations and requires broker-dealers
                           to update MSRB with the correct information if possible.

                           The federal banking regulators cited G-14 violations in 8 of the 87 bank
                           dealer examinations they conducted. They generally responded to these
                           violations with corrective action requirements. On the basis of
                           examinations they conducted during this time frame in which they
                           assessed broker-dealers for G-14 compliance, OCIE staff agreed that G-
                           14 violations appeared to have decreased in recent years and said that
                           the inadvertent late trades they continued to see were sometimes
                           attributable to factors such as breakdowns in trade reporting systems.

Clearance and Settlement   OCIE staff told us that settlement failures typically appeared to represent
                           a low percentage of municipal transactions cleared through NSCC.
                           According to data gathered during a 5-day trading period in June 2011 by
                           NSCC, municipal trade settlement failures composed approximately 2.1
                           percent of the total dollar value of all NSCC settlement failures across all
                           markets for that time period. 71




                           71
                             Officials from the Depository Trust and Clearing Corporation (DTCC), the parent
                           company of DTC and NSCC, stated that NSCC typically did not track settlement failures
                           by type of security (for example, municipal, equity, and so on). However, NSCC analyzed
                           municipal settlement failures in response to our request. DTCC officials also noted that
                           DTC and NSCC did not clear and settle 100 percent of all trades, municipal or otherwise.
                           However, they stated that DTC and NSCC likely handled the majority of municipal trades.




                           Page 43                                                  GAO-12-265 Municipal Securities
OCIE Has Not Inspected      Since 2005, OCIE has not inspected FINRA’s fixed-income surveillance
Key SROs’ Municipal         program or MSRB, both because of staffing limitations and because of
Activities since 2005 and   changes to its inspection approach. OCIE’s written inspection guidelines
                            call for inspections of MSRB and FINRA’s regulatory programs. 72 OCIE
Has Conducted Limited
                            did not have a fixed schedule for examining MSRB, but its SRO
Monitoring of SRO           Inspection Guidelines stated that the office generally inspected each SRO
Regulatory Efforts          under its jurisdiction every 1-4 years. Until 2010, OCIE conducted routine
                            inspections of various aspects of FINRA’s operations—including district
                            office programs, arbitration, customer communication, central review, and
                            financial operations—every 2 to 4 years in accordance with its SRO
                            inspection guidelines. Surveillance, examination, and enforcement
                            programs were typically components of these routine inspections, but
                            municipal securities were not included in each inspection cycle. From
                            2000 through 2010, mostly in accordance with a 3-year cycle, OCIE
                            conducted 49 inspections of FINRA’s district offices, which conduct the
                            majority of broker-dealer examinations. As part of these inspections, they
                            assessed whether FINRA examined municipal securities broker-dealers
                            at least once every 2 years and reviewed a sample of FINRA’s
                            workpapers to determine whether FINRA examiners thoroughly reviewed
                            broker-dealers for compliance with all MSRB rules and other applicable
                            rules and regulations. However, the district office inspections are not
                            intended to address FINRA’s surveillance activities or policies and
                            procedures for its municipal market regulatory programs. In 2010, OCIE
                            began transitioning to a risk-based SRO inspection approach in
                            conjunction with a comprehensive assessment of OCIE’s structure and
                            functions. 73 As such, OCIE will no longer conduct inspections according
                            to a routine schedule but rather based on issues that represent the
                            greatest risks to investor protection and market integrity.

                            OCIE has not inspected FINRA’s fixed-income surveillance programs or
                            MSRB since 2005. OCIE’s inspections of FINRA and MSRB in 2005


                            72
                              OCIE’s Market Oversight group examines SROs that are registered securities
                            exchanges, FINRA (a national securities association), MSRB, the Public Company
                            Accounting Oversight Board, and the Securities Investor Protection Corporation. OCIE’s
                            Clearing and Settlement group examines clearing agency SROs. In 2009, this group
                            conducted inspections of DTC and NSCC, SROs that conduct clearance and settlement of
                            municipal securities trades.
                            73
                               OCIE transitioned several years ago to a risk-based approach to examining broker-
                            dealers and investment advisors. OCIE staff stated that this approach permits the
                            examination program to focus its resources on entities and issues that pose the highest
                            risk for investors.




                            Page 44                                                   GAO-12-265 Municipal Securities
produced findings related to their municipal securities oversight
activities. 74 While the two SROs responded to OCIE’s findings and
recommendations with corrective actions or, in a few cases, rebuttals,
OCIE has not yet confirmed through on-site inspections whether they
have adequately addressed these recommendations. OCIE staff only
recently began a new inspection of FINRA that will encompass its fixed-
income surveillance program, including the municipal trade reporting and
markup reviews. OCIE has not yet begun another inspection of MSRB.

OCIE staff said that staffing constraints had prevented them from starting
another inspection sooner to review FINRA’s fixed-income surveillance
program and MSRB. According to OCIE data, staffing of OCIE’s Market
Oversight group, which is responsible for inspections of FINRA and
MSRB and other SROs that are not clearing agencies, has declined by 5
employees (about 12 percent) since fiscal year 2007—when we last
reported on staffing of this group—and by 24 employees (nearly 40
percent) since fiscal year 2005. 75 As shown in table 5, as of September
2011, the Market Oversight group consisted of 38 active staff, including
12 managers, 25 professional staff (examiners), and 1 support staff.
According to OCIE staff, the majority of staff members in the Market
Oversight group have a law degree, and 11 people have prior experience
in fixed-income issues. Furthermore, OCIE staff stated that positions in
the Market Oversight group are a mixture of entry-level and senior
positions, with staff typically staying approximately 4 to 5 years before
going elsewhere within or outside of SEC. As of September 2011,
according to OCIE staff, the Market Oversight group had seven vacant
slots, but an SEC hiring freeze limited OCIE’s ability to fill most of these
positions.




74
 OCIE’s inspection findings are not public information.
75
 GAO-08-33.




Page 45                                                   GAO-12-265 Municipal Securities
Table 5: Number of OCIE Market Oversight Staff, Fiscal Years 2005-2011

                                        Managers                          Staff
                           Senior        Assistant     Branch                                 Year
                                                                                a
    Fiscal year            officer        director       chief   Professional       Support   total
    2005                            2              4        9              43            4      62
    2006                            2              3        9              29            4      47
    2007                            2              4        8              26            3      43
    2008                            2              4        8              35            2      51
    2009                            2              3        8              34            2      49
    2010                            1              4        8              33            1      47
    2011 (as of                     1              4        7              25            1      38
    9/16/2011)
Source: GAO summary of OCIE data.
a
 According to the information OCIE provided, there were 27 professional staff in the group as of
September 16, 2011. However, that number includes two people who were detailed to other offices in
the agency and were not actively working in the Market Oversight group. Therefore, we list the
number of available professional staff as 25 rather than 27.


Although OCIE is transitioning to a risk-based approach to SRO
inspections, it lacks sufficient data on the SROs’ fixed-income regulatory
activities that it could use to inform this approach. OCIE’s mission
includes protecting investors and ensuring market integrity through risk-
based strategies that, among other things, are designed to improve
compliance and monitor risk. However, OCIE currently engages in limited
monitoring of the SROs between inspections and may not have sufficient
sources of information to allow it to effectively assess the risk level of
SROs’ regulatory programs. OCIE staff told us that they plan to convene
all of the SROs in early 2012 to, among other things, clarify expectations
relating to their activities. One of the objectives of the SRO outreach will
be to share issues that OCIE identified in assessments it conducted of all
equity and options SROs in 2011 that have implications across the SROs.
However, this effort will not provide staff with information on the quality of
ongoing SRO oversight in any particular area—such as fixed-income
surveillance—between inspections. OCIE staff also participate in the
meetings mandated by the Dodd-Frank Act that include SEC, MSRB, and
FINRA. While such communication is essential to helping ensure uniform
interpretation of MSRB rules and discussing recent trends in
enforcement, among other things, it does not provide insight into the
ongoing effectiveness of SRO regulatory programs. We found that OCIE
received and reviewed quarterly reports from FINRA on its regulatory
activities related to municipal securities markups and markdowns.
However, an OCIE staff member told us that the reports, which present


Page 46                                                            GAO-12-265 Municipal Securities
aggregate statistics, reveal little about the effectiveness of FINRA’s
activities in this area.

For a risk-based inspection approach to be effective, it is essential for
OCIE to maintain ongoing monitoring and communication with the SROs
to keep abreast of the current operations and to use this information to
update its supervisory strategies. We note that the review period OCIE
covered in its 2005 FINRA inspection predated the recent financial crisis
and ensuing volatility in the municipal securities market. Although OCIE is
now conducting an inspection of FINRA that encompasses its fixed-
income surveillance program, it had not obtained any information since its
last inspection about the quality of FINRA’s market oversight. Further,
MSRB implemented RTRS in 2005 and began making real-time trade
price information freely and publicly available on the EMMA website in
2008, but OCIE has not performed any independent reviews or otherwise
obtained information to establish the quality or reliability of the data in this
system, despite the fact that market participants use it for pricing
purposes and that SEC, FINRA, and the federal banking regulators rely
heavily on the data to carry out their regulatory activities. 76

SEC proposed a rule (17a-26) in 2004 that would require certain SROs
(specifically, national securities exchanges or registered securities
associations, such as FINRA) to periodically review the operation and
performance of their regulatory programs. This rule was intended to allow
OCIE to monitor the SROs covered by the rule during the periods
between inspections and identify both SRO-specific issues as well as
common issues across multiple SROs. The rule would, among other
things, require SROs it covered to submit quarterly reports to SEC on the
results of their regulatory activities, including surveillance, complaints
received, and investigations, examinations, and enforcement actions. 77
While the proposed rule in its current form may have some limitations—
for example, the quarterly reports might not provide OCIE with much



76
  As noted earlier, we conducted a data reliability assessment of the MSRB trade data
with respect to specific variables for our purpose, which was to understand how prices
differ for institutional and individual investors. However, we did not assess the MSRB
data’s reliability for the transparency or regulatory purposes for which broker-dealers,
investors, and regulators use the system.
77
  SEC Release No. 34-50699, November 18, 2004. The rule was part of a larger package
of proposed rules and amendments related to fair administration and governance of
SROs, which SEC has not finalized.




Page 47                                                    GAO-12-265 Municipal Securities
              insight into the effectiveness of the SROs’ regulatory activities—it would
              provide a mechanism for OCIE to regularly collect and analyze
              information from the SROs. Without collecting information on an ongoing
              basis that provides insight into the effectiveness of SRO regulatory
              programs, OCIE may not be able to identify anomalies or changes in the
              operations that warrant more immediate inspections.


              OCIE is transitioning to a risk-based approach for its SRO inspection
Conclusions   program and is convening a meeting with the SROs in 2012 to share
              issues staff have already identified that have implications across the SROs.
              Among other things, the risk-based approach is intended to improve
              compliance and monitor risk. While OCIE’s efforts to implement a risk-
              based inspection program have the potential to better target scarce
              resources to high-risk areas, its limited monitoring of the SROs between
              inspections could result in its missing potential new or ongoing issues with
              their regulatory programs. For example, OCIE’s last inspection of FINRA’s
              fixed-income surveillance program predated the recent financial crisis and
              ensuing volatility in the municipal securities markets. Although OCIE
              obtained some information on FINRA’s examination program through its
              district office inspections and broker-dealer examinations, its lack of a
              structured mechanism for monitoring the quality of FINRA’s fixed-income
              surveillance during that time means that OCIE will not have a full picture of
              how effective FINRA was in surveilling for and detecting violations of MSRB
              rules until it finishes its 2011 inspection—more than 3 years after the
              financial crisis began and more than 6 years since its last inspection.

              Proposed Rule 17a-26 is an example of a mechanism that OCIE could
              use to obtain meaningful information for ongoing monitoring of SRO
              regulatory programs for the municipal securities market. This proposed
              rule would compel the SROs to review, on an annual and a quarterly
              basis, the operation and performance of their regulatory programs and
              report the results of these reviews to SEC. Finalizing this rule—revised as
              necessary to reflect OCIE’s current informational needs—would allow
              OCIE examiners to formally collect and analyze interim data on the
              operation and effectiveness of SROs’ programs and potentially facilitate
              ongoing oversight of SROs between inspections. Such information could
              provide regulators with more up-to-date information on the state of the
              market and SROs’ regulatory efforts. In addition, it could help OCIE meet
              its goal of identifying high-risk areas and leverage its staff resources
              appropriately. Unless OCIE takes steps to gather and analyze information
              on the SROs’ fixed-income regulatory programs on an ongoing basis, it



              Page 48                                          GAO-12-265 Municipal Securities
                     may not learn about emerging or recurring issues or risks in a timely
                     manner and take steps to address them.


                     To improve SEC’s ability to monitor the operations and effectiveness of
Recommendation for   SRO regulatory programs related to municipal securities trading between
Executive Action     inspections and to help identify areas of high risk, we recommend that the
                     Chairman of the Securities and Exchange Commission direct 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.


                     We provided a draft of this report for comment to the SEC Chairman for
Agency Comments      her review and comment. SEC provided written comments that are
and Our Evaluation   reprinted in appendix VII. SEC also provided technical comments that
                     were incorporated as appropriate. In addition, we provided a draft of this
                     report to the Federal Reserve, FDIC, and OCC, for their review and
                     comment. These agencies did not provide written comments, but we
                     incorporated their technical comments where appropriate. We also
                     provided a copy of the draft report to MSRB and FINRA for their review
                     and incorporated technical comments from them as appropriate.

                     In its written comments, SEC agreed with our findings. With respect to our
                     recommendation that SEC improve its ability to monitor the operations
                     and effectiveness of SRO regulatory programs between inspections by
                     gathering and analyzing information from the SROs on an ongoing basis,
                     SEC agreed that more enhanced oversight of the SROs’ fixed-income
                     regulatory programs is needed and that it has already begun that process
                     through the transition to a risk-focused approach. SEC noted, however,
                     that more frequent review and analysis would require additional staff
                     resources and reiterated that OCIE has been unable to fill several vacant
                     positions in its Market Oversight group due to limitations on SEC hiring
                     under a Continuing Resolution. SEC further noted that even if the vacant
                     positions were filled, OCIE’s Market Oversight group would continue to be
                     understaffed relative to the number and complexity of entities that it
                     examines and that it would need additional resources to conduct more
                     frequent inspections of FINRA and MSRB’s fixed-income programs or to
                     do interim monitoring of FINRA’s fixed income surveillance program. As
                     we observed, SEC’s efforts to implement a risk-based inspection program
                     have the potential to better target its scarce resources to high-risk areas.
                     Gathering and analyzing data from the SROs on an ongoing basis could




                     Page 49                                          GAO-12-265 Municipal Securities
help SEC better meet its goal of identifying high-risk areas and leveraging
its staff resources for inspections.


We are sending this report to the Senate Committee on Banking,
Housing, and Urban Affairs and the House Committee on Financial
Services. We are also sending copies of the report to the Special
Committee on Aging, U.S. Senate; the Committee on Agriculture,
Nutrition, and Forestry, U.S. Senate; the Committee on Agriculture, U.S.
House of Representatives; and the Chairman of the SEC. The report also
is available at no charge on the GAO website at http://www.gao.gov.

If you or your staff have any questions about this report, please contact
me at (202) 512-8678 or clowersa@gao.gov. Contact points for our
Offices of Public Affairs and Congressional Relations may be found on
the last page of this report. GAO staff who made key contributions to this
report are listed in appendix VIII.




A. Nicole Clowers
Director
Financial Markets and Community Investment




Page 50                                         GAO-12-265 Municipal Securities
Appendix I: Potential Uses, Risks, and
               Appendix I: Potential Uses, Risks, and
               Oversight of Derivative Products in the
               Municipal Securities Market


Oversight of Derivative Products in the
Municipal Securities Market
               Prior to the financial crisis that began in the summer of 2007, municipal
               governments made increasing use of interest rate swaps, a derivative
               product. 1 In an interest rate swap, a municipal issuer enters into a contract
               with a counterparty (typically an investment bank, commercial bank, or
               insurance company), and agrees to exchange periodic interest payments.
               Municipal issuers may use interest rate swaps to try to lower their
               borrowing costs. For example, by issuing variable-rate securities and
               entering into a variable-to-fixed interest rate swap, an issuer may be able to
               obtain a lower fixed-rate interest payment than it otherwise could obtain if it
               had issued fixed-rate securities directly. In this case, after issuing the
               variable-rate securities, the issuer enters into a swap agreement with a
               counterparty that agrees to pay the issuer a variable rate based on an
               index that is intended to approximate the variable-rate interest payments
               that the issuer must make to its investors. In exchange, the issuer agrees
               to pay the counterparty a fixed interest rate. As a result, the issuer achieves
               a synthetic fixed rate by converting a variable-rate obligation to a fixed-rate
               obligation. 2 Payment exchanges between the issuer and the counterparty
               reflect differences between the fixed rate and the variable rate during a
               specific period of time. The swap does not alter the issuer’s obligations,
               including debt servicing, to existing investors. 3

               Municipal issuers incur a number of risks when they enter into interest
               rate swaps, including basis risk, termination risk, and counterparty risk
               Basis risk is the risk that the variable rate paid by the issuer to its
               investors is more than the variable interest rate received under the swap.
               If that occurs, the payments the issuer receives from the counterparty are
               less than the payments the issuer must make to the investors. The issuer
               must cover that difference in addition to paying the fixed rate on the swap
               to the counterparty. Termination risk is the risk that the swap may
               terminate or be terminated before its expiration. Swap agreements allow


               1
                A derivative is a financial instrument created from or whose value depends upon the
               value of one or more separate assets or indexes of asset values.
               2
                In an interest rate swap, the principal amount is not actually exchanged between the
               counterparties. The payments on an interest rate swap are a function of the (1) principal
               amount, (2) interest rates, and (3) the time elapsed between payments. The
               counterparties to the swap agree to exchange payments on specific dates, according to a
               predetermined formula.
               3
                Beyond seeking cost savings, issuers may also use interest rate swaps to hedge interest
               rate risk in their debt portfolios, better manage their assets and liabilities, or gain access to
               different markets and their respective investor bases.




               Page 51                                                       GAO-12-265 Municipal Securities
Appendix I: Potential Uses, Risks, and
Oversight of Derivative Products in the
Municipal Securities Market




for termination of the swap by either party in the case of certain events,
such as payment defaults on the swap or credit rating downgrades. For
example, if the issuer triggers an early termination, it could owe a
termination payment reflecting the value of the swap under the market
conditions at that time. If market rates have changed to the issuer’s
disadvantage (e.g., the issuer is a fixed-rate payer and interest rates have
declined), the issuer will be “out of the money” on the swap, that is, the
fixed rate that the issuer is paying to the counterparty is higher than the
current market rate, and owe the counterparty a termination payment. A
termination of a swap can result in a substantial unexpected payment
obligation. Counterparty risk is the risk that the counterparty will default
on its payment obligations to the issuer.

The recent financial crisis heightened the exposure of a number of
municipal issuers with interest rate swaps to these risks. For example, a
number of municipal issuers had insured their underlying variable-rate
securities with bond insurance. However, the downgrades in these
insurers’ credit ratings during the financial crisis resulted in some issuers
having to post collateral on the swap agreements they had entered into or
face termination of the swaps. 4 Because interest rates had declined
significantly at that time, these issuers were out of the money—making it
expensive to terminate the contract. However, a number of issuers
refunded their variable rate securities and terminated the swaps to free
themselves from these agreements.

In some cases where municipal issuers have suffered losses because of
swap agreements, issuers allege that the counterparties that sold them
the swaps (swap dealers) misrepresented the risks of the swaps that they
sold to the issuers. In other cases, they have called into question the fees
that the swap dealers made. Questions grew that some of the municipal
issuers that entered into swaps during this period did not understand
these complicated products or their risks.



4
 Bond insurance guarantees investors timely interest payments and, if the issuers default,
the return of principal. According to Thomson Reuters data in the 2006 and 2011 Bond
Buyer Yearbook, in 2005, nine highly rated bond insurers insured about 57.1 percent of
new issue volume (or 51 percent of newly issued securities). By 2010, there was only one
active bond insurer in the market, providing insurance to approximately 6.2 percent of new
issue volume (or 12 percent of newly issued securities). During the recent financial crisis,
many of these insurers had suffered financial losses brought on by their exposure to
troubled mortgage-backed securities and were subsequently downgraded.




Page 52                                                    GAO-12-265 Municipal Securities
                          Appendix I: Potential Uses, Risks, and
                          Oversight of Derivative Products in the
                          Municipal Securities Market




Pursuant to the Dodd-     Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection
Frank Act, CFTC Has       Act (Dodd-Frank Act) created a comprehensive framework to provide
Issued Rules Regulating   oversight over the previously unregulated over-the counter derivatives
                          market. The Dodd-Frank Act provided the Commodities Futures Trading
Swap Dealers’             Commission (CFTC) the authority to regulate swaps, including interest
Transactions with         rate swaps. 5 Section 731 specifically amended the Commodity Exchange
Municipal Issuers         Act (CEA) to provide CFTC with both mandatory and discretionary
                          rulemaking authority to impose business conduct requirements on swap
                          dealers and major swap participants in their dealings with counterparties
                          generally, including municipal issuers, which are among the entities
                          termed “special entities.” 6 In January 2012, CFTC issued rules to
                          implement this authority. 7

                          Among other things, the rules establish a “know your counterparty”
                          requirement. This requirement requires a swap dealer (but not a major
                          swap participant) that acts as an adviser to a special entity to make a
                          reasonable determination that any swap it recommends is in the special
                          entity’s best interest and make reasonable efforts to obtain information
                          necessary to make a reasonable determination that the swap it
                          recommends is in the special entity’s best interest. 8 The swap dealer will
                          comply with its duty to act in the special entity’s best interest where it
                          complies with the “reasonable efforts” requirement, acts in good faith and
                          makes full and fair disclosure of all material facts and conflicts of interest



                          5
                           The Dodd-Frank Act provided the Securities and Exchange Commission (SEC) the
                          authority to regulate security-based swaps, security-based swap dealers, and major
                          security-based swap participants. SEC has proposed rules to implement this authority.
                          6
                           The Dodd-Frank Act defines a swap dealer as any person that holds itself out as a dealer
                          in swaps, makes a market in swaps, regularly enters into swaps with counterparties in the
                          ordinary course of business for its own account, or engages in any activity causing the
                          person to be commonly known as a dealer or market maker in swaps in connection with
                          CFTC-regulated swaps. It defines a major swap participant as any person that is not a
                          swap dealer and that meets any of the following criteria: maintains a substantial position in
                          swaps, holds outstanding swaps that create substantial counterparty exposure, or is a
                          highly leveraged financial entity. It defines special entities to include states and their
                          political subdivisions (state agencies, cities, and counties and other municipalities).
                          7
                            This description of the final rules is based on a question and answers document and a
                          press release outlining the rule issued by the CFTC on January 12, 2012. A copy of the
                          final rule itself was not available.
                          8
                           A swap dealer acts as an adviser to a special entity when it recommends a swap or
                          trading strategy involving a sway that is tailored to the particular needs of the special
                          entity.




                          Page 53                                                      GAO-12-265 Municipal Securities
Appendix I: Potential Uses, Risks, and
Oversight of Derivative Products in the
Municipal Securities Market




with respect to the recommended swap, and employs reasonable care
that the swap is designed to further the special entity’s objectives. The
rules also require swap dealers and major swap participants to disclose to
their counterparties material information about swaps, including material
risks, characteristics, incentives, and conflicts of interest. Additionally,
CFTC’s rules establish several duties for swap dealer and major swap
participants, including the duty to verify a counterparty’s eligibility to
transact in the swap markets, provide the daily midmarket value of
uncleared swaps to the counterparty, and ensure all communications to
the counterparty are fair and balanced. A swap dealer who recommends
a swap must conduct reasonable diligence to understand risks and
rewards of the recommendation and have a reasonable basis to believe
that the recommendation is suitable for the counterparty.

The rules also establish a duty for any swap dealer that acts as an
adviser to a special entity to act in its best interests, which includes
recommending a swap or trading strategy involving a swap. 9 The rules
establish a duty for swap dealers and major swap participants to have a
reasonable basis to believe that any special entity counterparty has a
representative that meets the following criteria:

•   is sufficiently knowledgeable to evaluate the transaction and risks;

•   is not subject to statutory disqualification;

•   is independent of the swap dealer or major swap participant;

•   undertakes a duty to act in the best interests of the special entity;

•   makes appropriate and timely disclosures to the special entity;

•   evaluates, consistent with any guidelines provided by the special
    entity, fair pricing and appropriateness of the swap;




9
 Section 975 of the Dodd-Frank Act defines “municipal adviser” to include, among others
and subject to certain exclusions, any person that provides advice to or on behalf of a
municipal entity with respect to municipal financial products, including municipal
derivatives. The Municipal Securities Rulemaking Board has begun the rulemaking
process with respect to the fiduciary and other obligations of municipal advisers to their
municipal entity clients.




Page 54                                                    GAO-12-265 Municipal Securities
Appendix I: Potential Uses, Risks, and
Oversight of Derivative Products in the
Municipal Securities Market




•   in the case of a special entity that is an employee benefit plan subject
    to the Employee Retirement Income Security Act of 1974 (ERISA), is
    a fiduciary as defined in Section 3 of ERISA; and

•   in the case of a special entity that is a municipal entity, is subject to
    restrictions on certain political contributions to certain public officials of
    the municipal entity.

For special entities other than employee benefit plans subject to ERISA,
the final rule provides a safe harbor under which the swap dealer will be
deemed to have a reasonable basis to believe that the special entity has
a qualified representative if the certain conditions are met, including the
representative stating in writing that it has policies and procedures
designed to ensure that it satisfies the applicable criteria.




Page 55                                             GAO-12-265 Municipal Securities
Appendix II: Scope and Methodology
              Appendix II: Scope and Methodology




              To analyze how institutional and individual investors trade municipal
              securities in the secondary market and the factors affecting the prices
              institutional and individual investors receive, we obtained data on all
              municipal securities trades that broker-dealers reported to the Municipal
              Securities Rulemaking Board’s (MSRB) Real-Time Transaction Reporting
              System (RTRS) from January 1, 2005, to December 31, 2010. 1 For each
              trade, the data included variables describing characteristics of the
              security, including the dated date (the date from which interest starts to
              accrue), maturity date, interest rate, principal amount at issuance, and
              reoffering price (the price at which underwriters sell newly issued
              securities to the public in the primary market), as well as variables
              describing the characteristics of the trade (trade date/time, settlement
              date, trade price, yield, and trade amount) and trade type (dealer sales to
              customer, interdealer trade, or dealer purchases from customer). We
              analyzed trade data involving newly issued fixed-rate securities to
              understand how trade prices differ for institutional and individual
              investors, using trade size (amount) as a proxy for whether the trade
              involved institutional or individual investors. 2 We focused on trades that
              occurred within the period from 30 days prior to and 120 days after the
              dated date on municipal securities. 3 We chose to examine this time frame
              because we observed that bonds in our sample trade most frequently
              around the time of issuance and that trading activity declines as the
              number of days after issuance increases, with trading activity typically


              1
               MSRB currently collects information on all municipal securities transactions within 15
              minutes of the trade through RTRS, which began operating on January 31, 2005. Data
              from January 1, 2005, through January 30, 2005, were collected by MSRB on all
              municipal securities transactions the day after the trade occurred via the Trade Reporting
              System.
              2
               MSRB data does not identify the kind of investor involved in a trade; we therefore use
              trade size as a proxy to indicate the kind of investor.
              3
               We measured days since issuance as the trade date minus the dated date. The dated
              date is the date of an issue from which interest on the issue usually starts to accrue, even
              though the issue may actually be delivered at some later date. We use the dated date as
              our proxy for the date a bond is issued, because the delivery date—the date that is
              considered the issuance date in a municipal securities primary offering—was not included
              in our dataset. We found that other researchers have used the dated date as a proxy for
              the date a bond is issued. We also found that trades that take place prior to the dated date
              tend to settle on or after the dated date—about 70 percent or more settle on the dated
              date and more than 99 percent settle on or after the dated date. This finding is consistent
              with the practice of trades that occur prior to the date a bond is issued, settling on the date
              a bond is issued. Thus, we believe using the dated date as a proxy for the date a bond is
              issued is reasonable.




              Page 56                                                      GAO-12-265 Municipal Securities
Appendix II: Scope and Methodology




leveling off by about 120 days after issuance. Focusing on a period with
more trading activity improved the precision with which we measured the
relationships described below. We chose to examine only trades of newly
issued bonds to ensure that all the trades we analyzed involved bonds
that had been available to investors for a similar amount of time and to
limit the likelihood that unobserved, time-varying characteristics of bonds
influence our analysis.

First, we analyzed the relationship between the relative trade price (the
trade price as a percentage of the reoffering price) and trade amount by
trade type in order to determine if prices for smaller trades—those more
likely to involve individual investors—are different from prices for larger
trades—those that are more likely to involve institutional investors.
Second, we analyzed the relationships between spreads (the difference
between the price on dealer sales to investors and the price on dealer
purchases from investors as a percentage of the price on dealer
purchases) within $10,000 trade amount increments and trade amount to
determine if spreads on smaller trades are different from spreads on
larger trades. For these regressions, we constructed datasets with one
observation for each security for each $10,000 trade amount increment.
For each security, for each $10,000 trade amount increment, we
calculated the inside spread, mean spread, and outside spread. The
inside spread is the difference between the lowest trade price on a dealer
sale and the highest trade price on a dealer purchase as a percentage of
the highest trade price on a dealer purchase. The mean spread is the
difference between the mean trade price on a dealer sale and the mean
trade price on a dealer purchase as a percentage of the mean trade price
on a dealer purchase. The outside spread is the difference between the
highest trade price on a dealer sale and the lowest trade price on a dealer
purchase as a percentage of the lowest trade price on a dealer purchase.
We only used observations on security-trade amount increment
combinations for which there existed at least one dealer sale and at least
one dealer purchase. Third, we analyzed the relationship between price
dispersion (the difference between the maximum and minimum trade
price as a percentage of average trade price) and trade amount by trade
type to determine if prices on smaller trades are more or less dispersed
than prices on larger trades. For these regressions, we constructed
datasets with one observation for each security, for each trade type, and
for each trade amount in $10,000 increments. We formed groups of
trades for each security, trade type, and trade amount in $10,000
increments. We then calculated price dispersion for that group of trades
as the difference between the maximum trade price and minimum trade
price as a percentage of the average trade price. For all three analyses,


Page 57                                         GAO-12-265 Municipal Securities
Appendix II: Scope and Methodology




our regressions included indicator variables for each security in the
sample to control for unobserved, time-invariant features of the securities.
We estimated separate regressions for bonds issued in each year from
2005 through 2010. We present the results of our regression analyses in
appendix III.

For illustrative purposes, we also calculated descriptive statistics using the
trade data. First, we calculated the average relative trade price on newly
issued fixed-rate securities by trade amount and trade type for 2010.
Second, we determined the average spreads for a $20,000 trade (an
individual investor-sized trade) and a $5 million trade (a institutional
investor-sized trade) of a fixed-rate security in 2010. We then used these
average spreads to calculate the yield to maturity of two hypothetical trades
of $20,000 and $5 million of the same security. We did this to compare the
effect of the size of the spread on the return received by an individual
investor and an institutional investor. Third, we calculated the average price
dispersion for newly issued fixed-rate securities by trade amount and trade
type for 2010. We presented these descriptive statistics in tables in the
report. In conducting our analyses, we carried out a data reliability
assessment of the MSRB trade data. To do so, we reviewed information on
the processes and procedures MSRB uses to help ensure that trade data
entered into RTRS are accurate and complete. We also reviewed the data
for missing values and outliers and, where we observed instances of such,
solicited explanations from MSRB staff. On the basis of this information, we
determined that these data were reliable for our purposes.

We also obtained statistics on the relative size of the municipal securities
market. We obtained data from the Federal Reserve’s Flow of Funds
Accounts of the United States on the estimated dollar value of municipal
securities outstanding and from Bloomberg L.P. (Bloomberg) on the
number of municipal issuers and outstanding municipal securities that it
tracks. We also collected data on the total number of public companies
listed on the major U.S. exchanges from the annual reports of NYSE
Euronext and NASDAQ OMX. We did not conduct an assessment of the
reliability of these data sources. However, these data are widely used by
regulators, market professionals, and academics and are considered
credible for the purposes for which we used them. In addition, we used
these data solely for descriptive purposes and not for the purpose of
making recommendations or drawing conclusions about causality.

We reviewed studies that analyzed pricing in the municipal securities
market. We limited our survey to those studies using data from 1995 or
later. We did this because prior to 1995, there was no systematic and


Page 58                                           GAO-12-265 Municipal Securities
Appendix II: Scope and Methodology




comprehensive dissemination of post-trade information for municipal
securities. We identified five relevant studies by searching the EconLit, the
JSTOR, the National Bureau of Economic Research (NBER) Working
Paper Series, and the Social Science Research Network (SSRN)
databases. 4 We identified two additional studies through our interviews with
market participants. Although we did not identify methodological concerns
with these studies, the inclusion of these studies is for research purposes
and does not imply that we deem them to be definitive. In addition, we
attended or viewed the Securities and Exchange Commission’s (SEC) field
hearings on the state of the municipal securities market, reviewed industry
literature, and interviewed members of trade organizations representing
institutional investors, broker-dealers (including broker’s brokers), and
individual investors; academics; SEC Office of Municipal Securities Market
officials; MSRB officials and independent municipal market research and
advisory firms. We also reviewed information from these entities on the
availability of pre- and post-trade pricing information in the marketplace,
and we spoke to market participants interested in forming an exchange for
municipal securities. To understand how electronic systems and trading
platforms are used in the trading of municipal securities, we received a
demonstration from Bloomberg on the services it offers to municipal broker-
dealers and other subscribers to facilitate municipal securities trading and
analysis. We also reviewed existing alternative trading systems (ATS)
operating in this market by analyzing their annual Form ATSs submitted to
SEC and other descriptive information and received a demonstration from
one ATS of its electronic platform for trading municipal securities.

To determine how federal regulators enforce MSRB rules to ensure fair
and reasonable prices for investors and the timely and accurate reporting
of municipal trades, we reviewed relevant MSRB rules, guidance, and
proposed rules. We focused on Rules G-30, G-14, G-12, and G-15, which
address pricing, trade reporting, and trade clearance and settlement. We
also reviewed documentation describing RegWeb, the web portal MSRB
makes available to federal regulators to analyze and query RTRS data for
regulatory purposes; the Financial Industry Regulatory Authority’s



4
 The American Economic Association provides EconLit, an electronic bibliography of
economics literature, including journal articles and working papers; JSTOR is a nonprofit
service that offers a digital archive of academic journals; the NBER Working Paper Series
is a database of working papers submitted by NBER researchers; and SSRN publishes
abstracts and working papers submitted by researchers, journals, publishers and
institutions.




Page 59                                                   GAO-12-265 Municipal Securities
Appendix II: Scope and Methodology




(FINRA) policies and procedures for electronically surveilling RTRS data
for potential violations of MSRB pricing and trade reporting rules; and
FINRA and federal banking regulators’ (Office of the Comptroller of the
Currency, or OCC; Federal Deposit Insurance Corporation, or FDIC; and
Board of Governors of the Federal Reserve System, or the Federal
Reserve) examination procedures for assessing broker-dealer
compliance with these rules.

We also identified enforcement trends related to Rules G-14 and G-30.
With respect to FINRA, we reviewed results of the periodic surveillance of
trade data it conducted from 2006 to 2010 to monitor broker-dealers and
bank dealers for potential violations of MSRB Rules G-14 and G-30.
These results included the number of alerts FINRA’s surveillance
programs generated on potential G-14 and G-30 violations, as well as the
resolution (for example, no further review, cautionary action, etc.) of each
alert. We also reviewed data from FINRA’s System for Tracking Activities
for Regulatory Policy and Oversight (STAR), which tracks the life cycle of
FINRA’s regulatory matters, on the number of municipal-related broker-
dealer examinations FINRA conducted from 2006 to 2010, the number of
those examinations that identified violations of MSRB Rules G-14 and G-
30, and the resolution of each examination. We conducted a reliability
assessment of the FINRA data and determined they were reliable for our
purpose. Specifically, we reviewed information on the STAR system and
FINRA’s policies and procedures for ensuring the data entered into the
STAR system were accurate and complete.

We reviewed a purposeful sample of 45 examinations FINRA conducted
from 2006 to 2010 in which it identified violations of MSRB Rules G-14 and
G-30. We reviewed these examinations to inform our understanding of how
FINRA examiners applied their policies and procedures for assessing
compliance with Rules G-14 and G-30. First, we selected all 11
examinations that had both G-14 and G-30 violations. Next, we selected an
additional 6 examinations with G-30 violations that were forwarded to other
agencies (such as SEC) for further review or initiated for a specific cause,
as opposed to routine examinations. Third, 8 examinations with G-30
violations were selected systematically by selecting every 4th examination
after ordering the remaining examinations with G-30 violations by the
completion date. Finally, we similarly selected 20 additional examinations
with G-14 violations by selecting every 20th examination from an ordered




Page 60                                          GAO-12-265 Municipal Securities
Appendix II: Scope and Methodology




listing of remaining examinations with G-14 violations. 5 We did not
extrapolate the information in the sample examinations to the universe of
municipal broker-dealer examinations. Rather, we drew examples from
some of the examinations to illustrate concepts in the report.

With respect to federal banking regulators’ enforcement of Rules G-14
and G-30, we reviewed data on the number of bank dealer examinations
each regulator conducted from 2006 to 2010 and the number of those
examinations that identified violations of Rules G-14 and G-30, among
other MSRB rules. We conducted a reliability assessment of the federal
banking regulator data and determined they were reliable for our purpose.
Specifically, we reviewed information from federal banking regulators on
the systems from which they generated the data provided to us and their
policies and procedures for ensuring the data were accurate and
complete. From the examination data, we selected and reviewed
examinations or their relevant excerpts to observe examples of cases in
which the federal banking regulators identified violations of Rule G-14 or
other MSRB rules. 6 As with the FINRA examinations, we reviewed these
examinations to inform our understanding of how federal banking
examiners applied their policies and procedures for assessing compliance
with Rules G-14 and G-30. We did not extrapolate the information to the
universe of bank dealer examinations.

We also identified trends in the incidences of late reporting of transactions
(i.e., reported more than 15 minutes after the time of trade) by broker-
dealers to the RTRS since its implementation in 2005. More specifically,
we analyzed data on the number of late-reported trades MSRB identified
each month from January 2005 to July 2011 and the total trades reported
for those months. In reviewing these data, we carried out a data reliability
assessment. To do so, we reviewed information on the processes and




5
 When we reviewed the FINRA examinations, we discovered that 1 of the examinations
we had selected for a G-30 violation alone also included a G-14 violation. Thus, we
actually reviewed 12 examinations with both a G-14 and a G-30 violation.
6
 Because OCC, FDIC, and the Federal Reserve identified few examinations with Rule G-
14 violations and no examinations with G-30 violations, we expanded our sample to
examinations with other violations (for example, MSRB Rule G-27 on supervision). This
allowed us to see more examination reports and observe how these regulators conducted
their examinations in general. We reviewed a combined total of 15 examination reports
from these regulators.




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Appendix II: Scope and Methodology




procedures MSRB uses to identify late trades in RTRS. We determined
these data were reliable for our purposes.

To identify trends in settlement failures in municipal securities transactions,
we reviewed data from the National Securities Clearing Corporation
(NSCC). This self-regulatory organization (SRO) provides clearance and
settlement services for a variety of securities, including equity, corporate,
and municipal securities. Because NSCC typically does not track
settlement failures by security type, we requested that NSCC perform a
specialized query to provide us with this information. NSCC reviewed a 5-
day trading period, from June 6 to June 10, 2011, and provided us with the
dollar value of municipal securities settlement failures, as well as the total
dollar value of all settlement failures, for that period. We did not assess the
reliability of these data because we used the data solely for descriptive
purposes and not for the purpose of making recommendations or drawing
conclusions about causality. However, we corroborated the data by asking
regulators and market participants about their experience with municipal
trade failures, and what they told us was consistent with the trends in the
data.

To understand how SEC oversees the municipal market, we reviewed the
SEC Office of Compliance Inspections and Examinations’ (OCIE)
guidance for conducting oversight inspections of FINRA-registered
broker-dealers, focusing on policies and procedures for assessing
compliance with MSRB rules related to pricing and trade reporting, and
we reviewed OCIE’s guidance for conducting inspections of SROs. We
reviewed data from OCIE on broker-dealer examinations it conducted
from 2002 to 2010 that assessed compliance with municipal securities
rules and regulations, including information on the MSRB rule violations
examiners identified. We conducted a reliability assessment of these data
and determined that there were limitations to how we could use them. We
reviewed information on OCIE’s system for tracking examination data (the
Super Tracking and Reporting System, or STARS), reviewed OCIE’s
policies and procedures for ensuring the completeness and accuracy of
the data, and interviewed OCIE officials. Although we determined that
STARS data are reliable, we learned that STARS does not contain a
unique field that allows users to retrieve all examinations with a municipal
component. Rather, OCIE officials ran a report by searching for key
words that, based on their experience with STARS data, were likely to be
included in an examination with a municipal component. This produced a
list of approximately 1,100 examinations conducted from 2002 to 2010.
We determined this was a reasonable way to proceed to identify a



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Appendix II: Scope and Methodology




significant portion of the targeted universe of examinations from which we
would draw selected exams for our review.

We reviewed a purposeful sample of 35 examinations that OCIE
conducted from 2002 to 2010 in which it identified violations of MSRB
Rules G-14 and G-30. First, we selected all 13 examinations that had G-
30 violations. Four of these examinations also had G-14 violations. We
then selected an additional 22 examinations with G-14 violations (from a
total of 80 examinations with G-14 violations during the time period). For
the latter group, we attempted to select examinations representing the
entire time period and a variety of recommended actions (from minor
deficiency letters to enforcement referrals). We reviewed the
examinations to understand how OCIE examiners applied OCIE’s
examination policies and procedures to assess broker-dealers for
compliance with MSRB rules. However, we did not cite any OCIE
examination statistics in the report, given that the list of 1,100
examinations may not have included all municipal examinations OCIE
conducted from 2002 to 2010, as well as the fact that OCIE uses a risk-
based method and does not necessarily review for broker-dealer
compliance with Rules G-30 and G-14 in every examination. 7 We also
reviewed OCIE’s 2002 and 2005 inspections of MSRB and FINRA’s fixed-
income program, focusing on OCIE’s review of FINRA’s surveillance,
examination, and enforcement programs for overseeing municipal
securities trading. 8 In addition, we reviewed MSRB’s and FINRA’s
responses to OCIE’s inspection reports. Finally we reviewed OCIE’s
inspections of FINRA’s district offices from 2000 to 2010 and its 2009
inspections of the Depository Trust Company and NSCC, SROs that clear
and settle municipal securities transactions.

We also reviewed meeting minutes, e-mails, training presentations,
MSRB’s memorandum of understanding with FINRA, and other relevant
documentation from MSRB to understand the coordination among SEC,



7
 When we requested the OCIE examinations in March 2011, we had not yet narrowed our
scope to Rules G-30 and G-14. Therefore, we requested and reviewed examinations that
had violations of several other MSRB rules. The number of examinations we reviewed that
involved G-30 or G-14 violations were 13 and 26, respectively.
8
 The fixed-income inspections we reviewed were of the National Association of Securities
Dealers (NASD), which formerly acted as the SRO for broker-dealers. In July 2007, NASD
assumed the broker-dealer regulatory functions of the New York Stock Exchange and
became FINRA.




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Appendix II: Scope and Methodology




MSRB, FINRA, and federal banking regulators in conducting oversight of
the municipal securities market. Finally, we interviewed officials from
OCIE, Office of Municipal Securities, SEC’s Division of Enforcement,
MSRB, FINRA, and federal banking regulators to better understand their
oversight of the municipal securities market and efforts to coordinate their
oversight activities.

We conducted this performance audit from November 2010 to January
2012 in accordance with generally accepted government auditing
standards. Those standards require that we plan and perform the audit to
obtain sufficient, appropriate evidence to provide a reasonable basis for
our findings and conclusions based on our audit objectives.




Page 64                                          GAO-12-265 Municipal Securities
Appendix III: GAO Analysis of MSRB Trade
              Appendix III: GAO Analysis of MSRB Trade
              Data, 2005-2010



Data, 2005-2010

              To understand how trade prices for individual investors differ from those
              for institutional investors, we analyzed trade data on newly issued fixed-
              rate municipal securities from the Municipal Securities Rulemaking
              Board’s Real-Time Trade Reporting System from January 1, 2005,
              through December 31, 2010, using trade size as a proxy for whether the
              trade involved institutional or individual investors. 1 We focused on trades
              that occurred within the period from 30 days prior to and 120 days after
              the dated date on municipal securities. We chose to examine this time
              frame because we observed that (1) securities in our sample trade most
              frequently around the time of issuance, (2) trading activity declines within
              days after issuance, and (3) trading activity has typically leveled off by
              about 120 days after issuance. Focusing on a period with more trading
              activity improves the precision with which we measure the relationships
              described below. 2 We chose to examine only trades of newly issued
              bonds to ensure that all the trades we analyzed involved bonds that had
              been available to investors for a similar amount of time and to limit the
              likelihood that unobserved, time-varying characteristics of bonds influence
              our analysis.

              First, we analyzed how relative prices—defined as trade prices as a
              percentage of the reoffering prices (the prices at which the securities
              were originally sold to the public by the underwriter)—changed as trade
              size increased for different types of trades (dealer sales to investors and
              dealer purchases from investors). To do so, we estimated regressions on
              security trades. The dependent variables in these regressions are the
              relative price of a trade, and the independent variables in these
              regressions are trade amount interacted with trade type and indicator
              variables for each security in the sample. The security indicators control
              for time-invariant features of a security that may affect the relative price at
              which it trades. We estimated separate regressions for securities issued
              in each year from 2005 through 2010. We present our regression results
              in table 6. Our analysis shows that, relative to institutional investors,
              individual investors generally pay higher prices when buying—and
              receive lower prices when selling—municipal securities.


              1
               According to market participants, most trades by individual investors are $100,000 or
              less, while most trades by institutional investors are more than $1 million. MSRB data do
              not identify the kind of investor involved in a trade; therefore, we use trade size as a proxy
              for the kind of investor.
              2
               See appendix II for additional information on our methodology for constructing the data
              used in our analyses.




              Page 65                                                      GAO-12-265 Municipal Securities
Appendix III: GAO Analysis of MSRB Trade
Data, 2005-2010




•     Relative prices at which broker-dealers sold securities to investors
      declined on average with trade amount for all years in the analysis.
      For all years, this negative relationship is statistically significant at the
      1 percent level.

•     Relative prices at which broker-dealers purchased securities from
      investors increased with trade amount for bonds issued in every year
      except 2009. For every year except 2009, this positive relationship is
      statistically significant at the 1 percent level. For 2009, this
      relationship is negative but it is not statistically significant from zero.

Table 6: Percentage Change in Relative Price per 1 Percent Change in Trade
Amount, by Trade Type and Year, 2005-2010

                                          Broker-dealer sales               Broker-dealer purchases
    Year                                         to investors                        from investors
    2005                                            -0.0017%                                     0.0018%
                                                                 a
                                                       [73.64]                                     [24.94]
    2006                                            -0.0020%                                     0.0011%
                                                        [79.39]                                    [18.21]
    2007                                            -0.0018%                                     0.0016%
                                                        [62.49]                                    [21.64]
    2008                                            -0.0015%                                     0.0033%
                                                        [24.09]                                    [14.88]
    2009                                            -0.0022%                                    -0.0003%
                                                        [44.39]                                      [1.60]
    2010                                            -0.0020%                                     0.0010%
                                                        [48.94]                                      [7.99]
Source: GAO analysis of data from MSRB.
a
 Brackets contain t-statistics calculated using standard errors that are adjusted for heteroskedasticity
and for within-bond correlation. For all years, the relationship between relative trade price and trade
amount is negative for dealer sales to customers, and the negative relationship is statistically
significant at the 1 percent level. For every year except 2009, the relationship between relative trade
price and trade amount is positive for dealer purchases from customers, and the positive relationship
is statistically significant at the 1 percent level. For 2009, the relationship between relative trade price
and trade amount is negative for dealer purchases from customers, but it is not statistically
significantly different from zero. For all years and for all trade types, the relationship between price
dispersion and trade amount is negative, and the negative relationship is statistically significant at the
1 percent level.


Second, we analyzed how broker-dealers’ spreads—defined as the
difference between the price on dealer sales to investors and the price on
dealer purchases from investors as a percentage of the price on dealer
purchases—changed as trade size increased, using three different



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Appendix III: GAO Analysis of MSRB Trade
Data, 2005-2010




measures of spread. For this analysis, we estimated regressions on
securities. The dependent variables in these regressions are the spread
on a security over a $10,000 trade amount increment, and the
independent variables in these regressions are trade amount and
indicator variables for each security in the sample. The security indicators
control for time-invariant features of a security that may affect its spread.
We estimated separate regressions for securities issued in each year
from 2005 through 2010. We present our regression results in table 7.
Our analysis showed, on average, broker-dealers receive larger spreads
when trading smaller blocks of municipal securities. For all years and for
all three measures of spread, this relationship is statistically significant at
the 1 percent level.

•   The inside spread, which estimated a lower bound for broker-dealer
    spreads, declined as trade size increased for all years in the
    analysis. 3

•   The mean spread, which estimated average broker-dealer spreads,
    declined as trade size increased for all years in the analysis. 4

•   The outside spread, which estimated an upper bound for broker-
    dealer spreads, declined as trade size increased for all years in the
    analysis. 5




3
 The inside spread is the difference between the lowest trade price on a dealer sale and
the highest trade price on a dealer purchase as a percentage of the highest trade price on
a dealer purchase.
4
 The mean spread is the difference between the mean trade price on a dealer sale and
the mean trade price on a dealer purchase as a percentage of the mean trade price on a
dealer purchase.
5
 The outside spread is the difference between the highest trade price on a dealer sale and
the lowest trade price on a dealer purchase as a percentage of the lowest trade price on a
dealer purchase.




Page 67                                                   GAO-12-265 Municipal Securities
Appendix III: GAO Analysis of MSRB Trade
Data, 2005-2010




Table 7: Percentage Change in Spread per $10,000 Increase in Trade Amount, by
Year, 2005-2010

    Year                      Inside spread           Mean spread                   Outside spread
    2005                                  -0.22%              -0.29%                           -0.33%
                                          [8.73]a             [14.50]                          [17.77]
    2006                                  -0.19%              -0.23%                           -0.25%
                                           [9.71]             [13.43]                          [17.06]
    2007                                  -0.16%              -0.19%                           -0.20%
                                           [9.51]             [13.68]                          [18.31]
    2008                                  -0.23%              -0.33%                           -0.47%
                                           [8.12]             [13.31]                          [22.16]
    2009                                  -0.31%              -0.41%                           -0.53%
                                          [10.45]             [19.52]                          [30.38]
    2010                                  -0.35%              -0.42%                           -0.47%
                                          [14.72]             [20.34]                          [29.26]
Source: GAO analysis of data from MSRB.
a
 Brackets contain the absolute values of t-statistics calculated using standard errors that are adjusted
for heteroskedasticity and for within-bond correlation. For all years and for all three measures of
spread, the relationship between spread and trade amount is negative, and the negative relationship
is statistically significant at the 1 percent level.


Third, we analyzed how price dispersion, defined as the difference
between the maximum and minimum trade price as a percentage of
average trade price, changed as trade size increased. For this analysis,
we again estimated regressions on securities. The dependent variables in
these regressions are the price dispersion over a $10,000 trade amount
increment, and the independent variables in these regressions are trade
amount interacted with trade type and indicator variables for each security
in the sample. The security indicators control for time-invariant features of
a security that may affect its price dispersion. We estimated separate
regressions for securities issued in each year from 2005 through 2010.
See table 8 for the regression results. Our analysis showed that prices for
larger trades tended to be more concentrated, while prices for smaller
trades tended to be more dispersed. For all years, this relationship is
statistically significant at the 1 percent level.

•      For broker-dealer sales to investors, the measure of dispersion
       declined as trade amount increased.

•      For broker-dealer purchases from investors, the measure of
       dispersion also declined as trade amount increased.



Page 68                                                            GAO-12-265 Municipal Securities
Appendix III: GAO Analysis of MSRB Trade
Data, 2005-2010




Table 8: Change in Price Dispersion per $10,000 Increase in Trade Amount (in Basis
Points), by Trade Type and Year, 2005-2010

                                          Broker-dealer sales to      Broker-dealer purchases from
    Year                                              investors                          investors
    2005                                                 -0.14%                                -0.04%
                                                                  a
                                                        [45.64]                                 [11.53]
    2006                                                 -0.11%                                -0.03%
                                                         [47.53]                                [11.11]
    2007                                                 -0.13%                                -0.04%
                                                         [38.02]                                 [9.74]
    2008                                                 -0.41%                                -0.26%
                                                         [52.39]                                [18.54]
    2009                                                 -0.39%                                -0.19%
                                                         [65.81]                                [14.60]
    2010                                                 -0.33%                                -0.15%
                                                         [68.79]                                [17.96]
Source: GAO analysis of data from MSRB.
a
 Brackets contain the absolute values of t-statistics calculated using standard errors that are adjusted
for heteroskedasticity and for within-bond correlation. For all years and for all trade types, the
relationship between price dispersion and trade amount is negative, and the negative relationship is
statistically significant at the 1 percent level.




Page 69                                                               GAO-12-265 Municipal Securities
Appendix IV: Municipal Securities Rulemaking
                          Appendix IV: Municipal Securities Rulemaking
                          Board Expenses and Revenues Related to the
                          Market Information Transparency Programs

Board Expenses and Revenues Related to the
Market Information Transparency Programs
                          The Municipal Securities Rulemaking Board intends for its Market
                          Information Transparency Programs (Transparency Programs) to protect
                          investors by fostering availabilty and transparency of critical information
                          about municipal securities and market activity. From fiscal years 2004
                          through 2010, MSRB spent significant resources developing and
                          operating these programs. MSRB’s total revenue has fluctuated during
                          this period. To generate additional revenues to continue to enhance and
                          maintain these transparency programs, in fiscal year 2010 MSRB
                          increased transaction fees for broker-dealers and imposed a new
                          technology fee.


MSRB’s Transparency       MSRB currently implements five transparency programs that
Programs Make Municipal   coordinate the collection and dissemination of specific market information.
Data and Documents
                          •   Primary Market Disclosure Program: manages official statements
Publicly Available            and other primary market documents about new issues of municipal
                              securities.

                          •   Continuing Disclosure Program: manages ongoing disclosures
                              about existing municipal securities.

                          •   Transaction Data Program: collects and disseminates real-time
                              municipal trade price information.

                          •   Short-Term Disclosure Program: manages interest rate and related
                              information about auction rate securities and variable rate demand
                              obligations.

                          •   Political Contribution Disclosure Program: manages quarterly
                              reports of political contributions and municipal securities business
                              from municipal securities dealers active in the new issue market in
                              connection with MSRB Rule G-37. 1




                          1
                           MSRB Rule G-37 prohibits municipal securities dealers from engaging in municipal
                          securities business with issuers if certain political contributions have been made to
                          officials of such issuers. It also requires them to disclose certain political contributions to
                          MSRB to allow for regulatory and public scrutiny. Political contribution disclosure
                          information is available at www.msrb.org.




                          Page 70                                                        GAO-12-265 Municipal Securities
Appendix IV: Municipal Securities Rulemaking
Board Expenses and Revenues Related to the
Market Information Transparency Programs




MSRB makes available most data and documents it collects to the
public at no charge on its Electronic Municipal Market Access (EMMA)
website. 2 MSRB launched the EMMA website in 2008. 3 The EMMA
website makes trade prices available on a real-time basis along with
historical market trading information dating back to January 31, 2005, and
issuer’s continuing disclosure documents are available for disclosures
posted to the EMMA website beginning in July 2009. New issue
disclosure documents are available for issues dating back to 1990. The
EMMA website also provides information on the market and investor
educational material and offering documents for municipal fund securities.

MSRB staff told us that they are developing a 5-year plan that will guide
future enhancements to the EMMA website. In doing so, they said they
will consider what improvements would make the EMMA website more
meaningful and useful, how MSRB can help individual investors
understand what information they need and acquire that information, and
whether MSRB is in a position to acquire such information in a reliable
manner for posting to the system. They said that the planning will focus
on how data are organized in the system and the parameters by which
different types of users might want to search the data. MSRB staff also
said that as the market in general has increasingly come to rely on the



2
http://emma.msrb.org/.
3
 Prior to the Transparency Programs, MSRB operated the Municipal Securities
Information Library (MSIL), which collected, stored, and provided subscription access to
some municipal securities market information, including issuer official statements,
advance refunding documents, and a limited number of material event notices through a
continuing disclosure subsystem of MSIL (CDINet). MSIL also maintained files for public
access to information about political contributions and municipal securities business
submitted by municipal securities dealers active in the new issue market. In addition,
MSRB operated the Trade Reporting System (TRS), which provided next-day public
dissemination of reported municipal securities trades. In January 2005, MSRB replaced
the TRS system with the Real-Time Transaction Reporting System. The data in that
system were available only to subscribers, although the subscription feed data were made
available to the public through the InvestingInBonds.com website of The Bond Market
Association (now known as the Securities Industry and Financial Markets Association).
When MSRB launched the EMMA website in 2008 as a pilot, MSRB began making its
official statements and advanced refunding documents collected through MSIL and trade
prices collected through RTRS publicly available through the EMMA website. In 2009
MSRB formally initiated the Primary Market Disclosure Program (replacing most elements
of MSIL) and the Transaction Data Program (incorporating RTRS), the Short-Term
Disclosure Program, and the Continuing Disclosure Program (replacing CDINet) and
continued to provide access to information on political contributions through the Political
Contribution Disclosure Program.




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                                        Appendix IV: Municipal Securities Rulemaking
                                        Board Expenses and Revenues Related to the
                                        Market Information Transparency Programs




                                        EMMA website, they will consider the needs of institutional investors and
                                        issuers as well as individual investors. MSRB staff told us that once the
                                        board approves the 5-year plan, they will release a summary version of it
                                        to the public.


Transparency Program                    As table 9 shows, MSRB’s expenses related to developing and operating
Expenses Increased                      its Transparency Programs increased significantly over recent years, from
Significantly from Fiscal               about $4.8 million in fiscal year 2004 to about $11.3 million in fiscal year
                                        2010, or from 35 percent to 49 percent of MSRB’s total expenses. Table 9
Years 2004 through 2010                 also shows MSRB’s total expenses increasing over 70 percent between
                                        fiscal year 2004 and fiscal year 2010, from about $13.6 million to about
                                        $23.1 million.

Table 9: MSRB Expenses, Fiscal Years 2004-2010

Year ended September 30
Expenses                        2004             2005                  2006                 2007           2008              2009           2010
Market Information         $4,769,029    $7,216,980           $7,240,392           $6,844,783         $7,224,140     $10,073,932     $11,319,323
Transparency Programs
and operationsa
Administration and          3,754,430       4,514,109          4,619,281             5,648,682         4,619,132        5,612,560      5,909,092
operations
Rulemaking and policy       2,930,805       3,613,446          3,605,787             3,614,750         4,253,688        2,994,537      3,030,192
development
Board and committee         1,110,212       1,134,080          1,283,029             1,566,723         1,545,968        1,473,049      1,625,522
Professional                 744,469         731,878              736,268               758,473         741,022           616,748        463,133
qualifications
Education and                321,444         212,660              149,601               178,870         177,601           510,434        784,146
communications
Total expenses            $13,630,389   $17,423,153         $17,634,358           $18,612,281        $18,561,551     $ 21,281,260    $23,131,408
                                        Source: GAO analysis of MSRB audited financial statements.
                                        a
                                         In fiscal year 2004, MSRB operated MSIL, which collected, stored, and provided access to certain
                                        municipal securities market information. The data in this system were only available to subscribers. In
                                        fiscal year 2005, MSRB implemented the Real-Time Trade Reporting System, but again the data in
                                        the system were only available to subscribers. During fiscal years 2008 and 2009, MSRB
                                        implemented the EMMA website, which replaced MSIL and offered market disclosures and data,
                                        including RTRS data, to the public.


                                        MSRB stated that its total operating expenses increased to approximately
                                        $26.1 million in fiscal year 2011 (a 13 percent increase over those of
                                        fiscal year 2010), and that it anticipates that its total operating expenses
                                        will increase to approximately $29.4 million in fiscal year 2012 (a 27
                                        percent increase over those of fiscal year 2010). MSRB stated that a



                                        Page 72                                                                    GAO-12-265 Municipal Securities
                                            Appendix IV: Municipal Securities Rulemaking
                                            Board Expenses and Revenues Related to the
                                            Market Information Transparency Programs




                                            significant part of these increases are due to anticipated expenses related
                                            to the Transparency Programs, such as replacing aging and outdated
                                            technology systems and new technology initiatives. Other anticipated
                                            expenses are related to rulemaking activities required under the Dodd-
                                            Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)
                                            and other information systems needed to fulfill MSRB’s mission.

                                            MSRB has relied mostly on the underwriting and transaction fees it collects
                                            from broker-dealers to fund its expenses, including those related to the
                                            Transparency Programs. Table 10 shows that these fees accounted for
                                            between 90 and 92 percent of total revenues for fiscal years 2004-2010.

Table 10: MSRB Revenues, Fiscal Years 2004-2010

Year ended September 30
Revenues                        2004               2005                  2006                   2007           2008             2009            2010
Underwriting               $9,752,383     $11,149,597            $9,852,226          $12,456,134         $12,188,220     $10,837,652    $13,984,780
assessment fees
Transaction fees            5,421,603       5,611,792             6,198,630             6,893, 813         7,723,365        7,150,905      6,940,551
Annual fees                  744,800            712,300              684,800                663,300         644,864          622,700       1,010,321
Data subscriber fees         238,523            466,000              406,295                375,066         390,210          441,392         509,547
                                      b
Professional                    N/A                  N/A                   N/A                    N/A           N/A               N/A         92,220
qualification
examination feesa
Initial fees                  12,900              8,800                  9,600                 8,500           8,800            8,400          8,500
Investment return            107,802            210,043              601,322             1,008,422         1,123,096         533,667          92,715
Publications and other       258,347             22,909                16,067                69,859          72,194            33,268         41,612
Income
Total revenues            $16,536,358     $18,181,441          $17,768,940           $21,475,094         $22,150,749     $19,627,984    $22,680,246
Underwriting                     92%                92%                   90%                    90%            90%              92%            92%
assessment and
transaction fees as a
percentage of total
revenue
                                            Source: GAO analysis of MSRB audited financial statements.
                                            a
                                             In November 2009, MSRB filed a new rule that established an examination fee of $60 assessed on
                                            persons taking certain qualification examinations as of January 4, 2010. These examinations include
                                            the Series 51 (Municipal Fund Securities Limited Principal Qualification Examination), Series 52
                                            (Municipal Securities Representative Qualification Examination), and Series 53 (Municipal Securities
                                            Principal Qualification Examination).
                                            b
                                            Not applicable.


                                            Table 10 also shows that MSRB’s total revenues declined by 11.4 percent
                                            from fiscal year 2008 to fiscal year 2009, which MSRB attributed to the



                                            Page 73                                                                    GAO-12-265 Municipal Securities
                      Appendix IV: Municipal Securities Rulemaking
                      Board Expenses and Revenues Related to the
                      Market Information Transparency Programs




                      economic crisis and consequent decrease in transaction fees and
                      underwriting assessment fees collected. This decline in revenues
                      occurred when expenses were increasing, as shown in figure 2.

                      Figure 2: MSRB Revenues and Expenses, Fiscal Years 2004 through 2010




                      To establish a more stable long-term revenue base as well as ensure a
MSRB Increased the    more equitable allocation of assessments among the municipal broker-
Transaction Fee and   dealers that fund MSRB’s operations, MSRB authorized changes to its
                      revenue sources in fiscal year 2011 that it expects will generate
Levied a New          significant new revenues. First, MSRB increased the transaction fee
Technology Fee to     charged to broker-dealers from $0.005 per $1,000 par value to $0.01 per
Generate Additional   $1,000 par value on most municipal securities sales transactions reported
                      to MSRB. The new fee became effective in January 2011. MSRB expects
Revenues              the increased transaction fee to generate an estimated $7 million
                      annually. Second, effective January 2011, dealers in municipal securities
                      are required to pay a technology fee of $1.00 per transaction for all sales
                      transactions. MSRB expects the technology fee to generate an estimated
                      $8.5 million annually. MSRB stated that the technology fee would be




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Appendix IV: Municipal Securities Rulemaking
Board Expenses and Revenues Related to the
Market Information Transparency Programs




transitional in nature and that it would review the fee periodically to
determine whether it should continue to be assessed. 4

MSRB said that these new and increased fees are necessary because its
expenses have increased significantly as a consequence of its capital
investments in technology and the regulatory responsibilities it has
assumed under the Dodd-Frank Act. MSRB said it would use the new
technology fee to establish a technology renewal fund, which would be
segregated for accounting purposes. The technology renewal fund is
intended to fund replacement of aging and outdated technology and to
fund new technology initiatives. For example, MSRB noted that certain of
the existing public information systems it operates, including RTRS, now
rely on dated technology and can be expected to need comprehensive
reengineering in the coming years. In addition, MSRB said that it will need
to develop information systems to facilitate its increased regulatory
responsibilities under the Dodd-Frank Act, which, among other things,
broadened its mission to include the protection of municipal issuers and
extended its regulatory authority to include municipal advisers.

The Dodd-Frank Act provided for additional revenue sources for MSRB,
although these revenues are unlikely to represent a significant source of
funding. The Dodd-Frank Act expanded the regulatory jurisdiction of
MSRB to include municipal advisers. MSRB amended its rules in
November 2010 to begin collecting initial fees ($100) and annual
registration fees ($500) for municipal advisers. However, MSRB officials
said that they did not anticipate these fees would provide a revenue
stream comparable to what MSRB receives from all fees on broker-dealer
activities, including the transaction, underwriting, and technology fees
previously discussed. The Dodd-Frank Act also mandated that SEC and
the Financial Industry Regulatory Authority, Inc., remit to MSRB a portion
of the fines collected for violation of MSRB rules. Effective October 2010,
SEC must remit half of the fines it collects to MSRB, and FINRA must


4
 MSRB also increased other fees and assessments in fiscal years 2009 and 2010, but
MSRB staff do not anticipate that these will generate significant sources of revenue to
mitigate the costs of the Transparency Programs. These actions included amending its
underwriting assessment to remove certain exemptions and to establish a single uniform
assessment rate of $0.03 per $1,000 par value, increasing its annual registration fee from
$300 to $500 for dealers, adding a new fee to be assessed on individuals taking certain
professional qualifications examinations, and increasing subscription fees to its real-time
feeds of trade data and disclosure documents associated with new and existing municipal
security issues.




Page 75                                                    GAO-12-265 Municipal Securities
Appendix IV: Municipal Securities Rulemaking
Board Expenses and Revenues Related to the
Market Information Transparency Programs




remit one-third, although that amount may be modified by agreement
among SEC, MSRB, and FINRA. MSRB stated that the amounts actually
received will be dependent on the level of enforcement by SEC and
MSRB and is expected to vary considerably from year to year.




Page 76                                        GAO-12-265 Municipal Securities
Appendix V: Selected SEC Cases and
                                         Appendix V: Selected SEC Cases and Opinions
                                         Involving Excessive Municipal Securities
                                         Markups and Markdowns


Opinions Involving Excessive Municipal
Securities Markups and Markdowns
                                         Since the early 1970s, several Securities and Exchange Commission
                                         cases and opinions have addressed instances in which broker-dealers
                                         charged excessive markups or markdowns in municipal securities
                                         transactions with customers. Table 11 summarizes the details of a few of
                                         these cases.

Table 11: Selected SEC Cases and Opinions Involving Excessive Municipal Securities Markups and Markdowns, 1970-2011

Case                                     Year         Findings
SEC v. Charles A. Morris & Associates,   1974         SEC ordered a permanent injunction against the firm. Among other things, the
Inc., et al                                           District Court and SEC found the defendant had been selling bonds at prices
(U.S. District Court)                                 not reasonably related to the prevailing market prices and charging markups
                                                      ranging from 25 percent to 100 percent over the prices at which recent
                                                      interdealer trades occurred.
Staten Securities Corporation            1982         SEC upheld NASD’s findings that the firm’s markups, ranging from 5.1 percent
(SEC Review of NASD Disciplinary                      to 6.7 percent, were excessive. SEC found that the securities were readily
Proceedings)
             a                                        available in the marketplace with easily ascertainable prices, the firm was not at
                                                      risk with respect to any of the transactions, and the firm did not incur any
                                                      unusual expense in effecting the transactions. SEC also stated in this case that
                                                      markups of 5 percent or less are not necessarily fair and reasonable. SEC
                                                      upheld NASD’s penalties, which censured the firm, imposed joint and individual
                                                      fines of $2,000, and prohibited the firm’s president and principal shareholder
                                                      from supervising or effecting principal transactions in municipal securities with
                                                      public customers until he took and passed a municipal securities principal
                                                      qualification examination.
First Honolulu Securities, Inc.          1993         SEC upheld NASD’s findings of violation for markups above 5 percent, but it set
(SEC Review of NASD Disciplinary                      aside NASD’s findings of violations for markups below 5 percent. SEC noted in
Proceedings)                                          its decision that, while it agreed that the markups below 5 percent were likely
                                                      unfair, it may not have been clear when the transactions occurred in 1990 that
                                                      markups between 4 percent and 5 percent usually are unfair, since SEC had
                                                      not dealt with enforcement cases for markups below 5 percent until 1993. SEC
                                                      also noted that it set aside findings of excessive markups that were below 4
                                                      percent because NASD had not introduced any evidence to establish the
                                                      unfairness of markups at those levels, but noted that markups below 4 percent
                                                      may well have been unfair. The firm was censured and fined $7,400.
Mark David Anderson                      2003         SEC imposed substantial monetary sanctions and a cease and desist order
(SEC Opinion)                                         against a broker-dealer who, in the mid-1990s, had charged retail customers
                                                      markups ranging from 1.42 percent to 5 percent and markdowns ranging from
                                                      3.02 percent to 5.64 percent. Most of the transactions in question were
                                                      executed on a “riskless principal” basis, in which the defendant knew he had a
                                                      buyer and a seller in place prior to executing the trade. SEC concluded that the
                                                      markups and markdowns deviated significantly from industry norms. SEC
                                                      rejected the defendant’s argument that his aggregate prices were fair because
                                                      the securities offered competitive yields.
                                         Sources: Lexis, SEC, and Westlaw.
                                         a
                                          The National Association of Securities Dealers (NASD) formerly acted as the self-regulatory
                                         organization for broker-dealers. In July 2007, NASD assumed the broker-dealer regulatory functions
                                         of the New York Stock Exchange and became FINRA.




                                         Page 77                                                         GAO-12-265 Municipal Securities
Appendix VI: Regulators’ Policies and
              Appendix VI: Regulators’ Policies and
              Procedures for Monitoring Compliance with
              MSRB Rules G-30 and G-14


Procedures for Monitoring Compliance with
MSRB Rules G-30 and G-14
              The Financial Industry Regulatory Authority, Inc., the federal banking
              regulators, and the Securities and Exchange Commission use a variety of
              methods to help ensure broker-dealers’ compliance with rules issued by
              the Municipal Securities Rulemaking Board. We reviewed their written
              policies and procedures to understand how they assess broker-dealers’
              compliance with MSRB Rules G-30 (fair and reasonable pricing) and G-
              14 (timely, accurate, and complete trade reporting). FINRA has
              established electronic surveillances of data reported to MSRB’s Real-
              Time Transaction Reporting System, by which it analyzes the data to
              generate “alerts” for potential violations of certain MSRB rules. FINRA, in
              certain circumstances, refers potential violations by bank dealers to the
              appropriate federal banking regulators for further investigation. During the
              period of our review, MSRB Rule G-16 required FINRA and the federal
              banking regulators to conduct routine examinations of the firms under
              their jurisdiction once every 2 years for compliance with all MSRB rules
              and other applicable laws. 1 The SEC’s Office of Compliance Inspections
              and Examinations also conducts oversight activities through examinations
              of selected broker-dealers.


FINRA
Rule G-30     FINRA utilizes parameters to help target its surveillance for fair pricing
              and markup violations. For example, a surveillance program established
              to identify transactions that were not executed at the prevailing market
              price would flag any transactions priced outside of a certain range of
              comparable prices. Similarly, a surveillance program established to
              identify excessive markups or markdowns would flag any transactions
              with markups or markdowns above a specified percentage of the
              contemporaneous costs (for markups) or proceeds (for markdowns).
              FINRA staff stated that these parameters are merely guidelines to assist



              1
               On December 16, 2011, SEC approved a MSRB proposed rule change that included an
              amendment to MSRB Rule G-16, which had required FINRA and the federal banking
              regulators to examine broker-dealers at least once every 2 calendar years to determine
              their compliance with all applicable MSRB rules, as well as other SEC rules and
              regulations. The amended rule allows for up to a 4-year examination cycle for FINRA
              member firms, consistent with FINRA’s existing requirement for examination cycles for all
              other FINRA members. According to MSRB, broker-dealer firms that present higher risks
              would be examined on an annual basis, while other firms would be examined every 2 to 4
              years, depending on the risks they presented. Cycle examination frequencies for FINRA
              member broker-dealer firms would be reassessed at least on an annual basis.




              Page 78                                                   GAO-12-265 Municipal Securities
Appendix VI: Regulators’ Policies and
Procedures for Monitoring Compliance with
MSRB Rules G-30 and G-14




them in identifying transactions for further review. FINRA analysts follow a
series of steps to determine whether alerts generated by the surveillances
represent actual violations of Rule G-30. Specifically:

•   The analyst uses various data sources, such as Bloomberg, MSRB’s
    Electronic Municipal Market Access website, or audit trail data, to
    verify the information in the alert and confirm or establish the
    prevailing market price for the municipal security at the time of the
    trade in question.

•   If necessary, the analyst asks the firm for documentation and an
    explanation of how it determined that its price and markup or
    markdown were fair and reasonable.

•   After reviewing the firm’s documentation, the analyst prepares a
    memorandum recommending a particular disposition for review and
    approval by FINRA managers.

In their G-30 compliance reviews during broker-dealer examinations,
FINRA examiners check for price manipulation and excessive markups
and markdowns. The manipulation module of FINRA’s examination tool
kit includes several questions and warning signs that help examiners
identify whether broker-dealer firms intentionally tried to manipulate
prices. FINRA’s examination tool kit also contains a module to help
examiners identify excessive markups or markdowns. Examiners follow a
series of steps:

•   Examiners collect a variety of records from the firm, such as order
    tickets and confirmations for a given sample of transactions, as well
    as daily transaction reports.

•   Using MSRB data, they identify a comparison transaction that best
    represents the market (i.e., the prevailing market price) for each
    sample security at the time of each sample customer transaction.

•   Using the comparison transaction data and records collected from the
    firm, examiners calculate the markups and markdowns that the firm
    charged on the sample transactions.

•   For markups or markdowns outside of specific parameters, examiners
    request an explanation from the firm. Again, the parameters are
    merely guidelines to assist them in identifying transactions for further
    review.



Page 79                                          GAO-12-265 Municipal Securities
            Appendix VI: Regulators’ Policies and
            Procedures for Monitoring Compliance with
            MSRB Rules G-30 and G-14




            •   Examiners consider the facts and circumstances of each individual
                case and, when necessary, consult with FINRA fixed-income experts
                to substantiate violations.

Rule G-14   FINRA’s periodic late trade reporting surveillance identifies transactions
            reported more than 15 minutes after they occurred, with analysts
            following a similar review process as they follow for pricing and markup or
            markdown alerts. 2

            •   FINRA reviews MSRB transaction data and selects firms with higher
                levels of potential noncompliance during a given surveillance period.

            •   As with surveillances for pricing and markups, analysts use various
                data sources, such as Bloomberg, the EMMA website, or audit trail
                information to provide context for each case.

            •   If necessary, the analyst asks the firm for documentation, including an
                explanation for the late reporting and any trade memorandums in
                support of that explanation, a copy of the firm’s written supervisory
                procedures regarding municipal securities transaction reporting, and
                any evidence of the firm’s own review of the transactions in question.

            •   The analyst reviews the documentation and prepares a memorandum
                recommending a particular disposition for review and approval by
                FINRA managers.

            In their G-14 compliance reviews conducted during examinations, using a
            sample of trades from the firm’s trading blotters, FINRA examiners
            conduct a “failure to report” review to detect transactions that the firm
            effected but failed to report to MSRB. They also check whether firms have
            filed and kept current a Form RTRS with MSRB. This form contains
            information that ensures that the firm’s trade reports can be processed
            correctly. Finally, examiners look for unreported and inaccurately reported
            trades, as well as late reported trades that would not have been detected
            by FINRA’s surveillance activities. In doing so, they adhere to the
            following procedures:




            2
             FINRA also runs surveillance programs to identify other potential trade reporting issues,
            such as large (over a certain dollar amount) late reported trades, negative yields,
            excessive commissions, or unusual trade times, among other issues.




            Page 80                                                    GAO-12-265 Municipal Securities
                  Appendix VI: Regulators’ Policies and
                  Procedures for Monitoring Compliance with
                  MSRB Rules G-30 and G-14




                  •   Examiners review monthly RTRS statistics on trades that the firm
                      executed or cleared during the review period. They select a time
                      period for review and run statistical reports related to each broker-
                      dealer firm’s trade reporting for that time period. They also obtain
                      detailed trade information from MSRB.

                  •   Examiners then select a sample of trades from the time period they
                      chose for review.

                  •   For the selected sample, they request and review order tickets and
                      confirmations from the firm and compare the RTRS information to the
                      information on those documents, making note of differences between
                      the two sources. For discrepancies noted, they attempt to determine
                      the root cause of the apparent violations and, if necessary, expand
                      their sample to confirm the violation.


Federal Banking
Regulators
Rule G-30         The Office of the Comptroller of the Currency, the Federal Deposit
                  Insurance Corporation, and the Board of Governors of the Federal
                  Reserve System constitute the federal banking regulators that oversee
                  those banks that are registered as dealers of municipal securities. In
                  general, the three federal banking regulators’ examination policies and
                  procedures require bank examiners to select a sample of the bank
                  dealer’s transactions, review the relevant bank documentation and MSRB
                  data for those transactions, and analyze the data to evaluate whether any
                  prices appear to be unfair or unreasonable.

Rule G-14         Federal banking regulator officials told us that bank examiners obtain and
                  review MSRB transaction data prior to their on-site examinations. When
                  conducting on-site bank dealer examinations, federal banking examiners
                  generally select a sample of the bank dealers’ transactions for a given
                  review period. They typically request and review copies of the bank’s
                  transaction records for the review period and compare the bank’s records
                  with MSRB transaction data to ensure that the bank reported all of its
                  trades to MSRB accurately and on time.




                  Page 81                                           GAO-12-265 Municipal Securities
            Appendix VI: Regulators’ Policies and
            Procedures for Monitoring Compliance with
            MSRB Rules G-30 and G-14




OCIE
Rule G-30   In checking for G-30 compliance during broker-dealer examinations,
            OCIE examiners generally take some or all of the following steps:

            •   Examiners review MSRB data to select a sample of the firm’s
                transactions that appear to have higher markups than other reported
                transactions in a given review period.

            •   Using order tickets, confirmations, and information on
                contemporaneous costs or proceeds, they calculate the markups or
                markdowns the firm charged on the sample transactions.

            •   Examiners ask the firm to explain cases that fall outside of certain
                parameters.

Rule G-14   In checking for G-14 compliance during broker-dealer examinations,
            OCIE examiners generally do the following:

            •   Examiners select a population of municipal transactions for a given
                review period.

            •   They compare the MSRB trade information with the information on the
                firm’s purchase and sales blotter to determine whether all transactions
                were reported.

            •   They also select a sample of order tickets and confirmations for the
                trades and compare that information with the MSRB report to check
                for accuracy of reporting.




            Page 82                                          GAO-12-265 Municipal Securities
Appendix VII: Comments from the Securities
              Appendix VII: Comments from the Securities
              and Exchange Commission



and Exchange Commission




              Page 83                                      GAO-12-265 Municipal Securities
Appendix VII: Comments from the Securities
and Exchange Commission




Page 84                                      GAO-12-265 Municipal Securities
Appendix VIII: GAO Contact and Staff
                  Appendix VIII: GAO Contact and Staff
                  Acknowledgments



Acknowledgments

                  A. Nicole Clowers, (202) 512-8678 or clowersa@gao.gov
GAO Contact
                  In addition to the contact named above, Karen Tremba, Assistant
Staff             Director; Pedro Almoguera; Silvia Arbelaez-Ellis; Ben Bolitzer; Emily
Acknowledgments   Chalmers; William R. Chatlos; Rachel DeMarcus; Stefanie Jonkman;
                  Courtney LaFountain; Marc Molino; Edward Nannenhorn; Robert Pollard;
                  Lisa Reynolds; Jessica Sandler; and Ardith Spence made key
                  contributions to this report.




(250564)
                  Page 85                                      GAO-12-265 Municipal Securities
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