Not a TRACE of Transparency for Troubled Assets

POGO sent a letter to Securities and Exchange Commission (SEC) Chairman Mary Schapiro on Friday raising concerns that a proposed rule for increasing price transparency in the market for troubled assets has been undermined by significant loopholes.

POGO’s letter describes how the proposed rule, which was issued in October by the Financial Industry Regulatory Association (FINRA), contains provisions that will indefinitely delay transparency in these markets, and will prevent the dissemination of key information to the public. POGO believes that the inclusion of these loopholes reflects the pervasive influence of the securities industry, and exemplifies the kind of watered down rulemaking we’ve come to expect from FINRA and other industry-friendly self-regulatory organizations (SROs).

FINRA’s proposed rule would require its members to submit information on transactions in certain types of troubled assets—such as mortgage- and asset-backed securities—to a centralized reporting system known as the Trade Reporting and Compliance Engine (TRACE). But if the SEC accepts the rule as it’s currently written, this information won’t have to be reported until the end of the day—as opposed to the usual 15-minute timeframe—and won’t have to be disseminated to the public. These restrictions could potentially have far-reaching consequences: according to one recent estimate, the total outstanding debt in mortgage-related and asset-backed securities is worth over $11 trillion—nearly one-third of all outstanding debt in the U.S. bond market.

As highlighted in an August report by the Congressional Oversight Panel, when the original credit risk assumptions for these assets came into question due to the rise in residential mortgage defaults, it led to a dramatic freeze in the markets for mortgage- and asset-backed securities, and as a result, the usual price-discovery mechanisms for these securities became frozen as well. Since the financial meltdown last fall, many of the government’s bailout programs have been aimed at strengthening the price-discovery mechanisms for troubled assets.

The TRACE system could potentially have a huge impact on price transparency for mortgage- and asset-backed securities if the loopholes in FINRA’s proposed rule are removed. In fact, the TRACE reporting system has been improving transparency in other types of assets for nearly a decade.

In 1998, under pressure from Congress and buy-side traders to improve price transparency, the SEC asked FINRA’s predecessor—the National Association of Securities Dealers (NASD)—to create a database for the reporting of transactions in the corporate bond market. In response to this mandate, NASD proposed a rule that led to the creation of TRACE, but the rule only required reporting on transactions in corporate bonds. The following types of securities were exempt from the reporting requirement: “debt issued by government-sponsored entities, mortgage- or asset-backed securities, collateralized mortgage obligations, and money market instruments.”

In the aftermath of the financial crisis last fall, many experts highlighted the need for more transparency and price disclosure for the types of securities that were originally exempt from TRACE reporting. In its white paper on financial regulatory reform, the Treasury Department wrote that “the SEC and the Financial Industry Regulatory Authority (FINRA) should expand the Trade Reporting and Compliance Engine (TRACE), the standard electronic trade reporting database for corporate bonds, to include asset-backed securities.”

But when it came time to write the rule, FINRA added loopholes that will undermine price transparency and prevent the public dissemination of key information about these securities. Under the current TRACE rules, FINRA members are required to report transactions to TRACE within 15 minutes of the transaction, and transaction information for most TRACE-eligible securities is immediately disseminated to the public. While FINRA’s proposed rule would bring mortgage- and asset-backed securities under the TRACE reporting system, it wouldn’t require reporting until the end of the day, and information on these transactions would not be disseminated to the public. Future dissemination would only be possible in limited circumstances pending an indefinite review by FINRA.

Participants and institutional investors have told POGO that FINRA’s restrictions would completely undermine the purported intent of this rule, which is to increase price transparency for the troubled assets that fueled the financial meltdown. The restrictions are being supported by securities industry lobbying organizations like the Securities Industry and Financial Markets Association (SIFMA), which has been described by the Center for Responsive Politics as “one of the industry’s most vocal trade groups.” The securities industry wants to stop these transparency reforms since it makes money from the “bid-ask spread”—the difference in price between what the buyer and seller are offering. Less transparency means a higher bid-ask spread, which means more profit for the securities industry.

In addition, SIFMA has enjoyed a particularly cozy relationship with FINRA. As Chairman Schapiro described it when she was CEO of FINRA, a white paper written by SIFMA’s predecessor “was one of the sparks that helped light the fuse” that ultimately led to FINRA’s creation. And one of FINRA’s Board members, Richard Brueckner, also serves on SIFMA’s Board.

SIFMA argues that requirements for 15-minute reporting and public dissemination will “act to hamper a return to normal market conditions, thus acting counter to government's efforts to safeguard financial stability and restore the provision of credit and lending to the economy.” But at a 2007 conference, when a SIFMA executive was asked if he had any data to support this argument, he could only point to a survey which showed that 15 other institutional investors shared his view. On the other hand, a study conducted by Professor Kumar Venkataraman found that the effects of TRACE on the corporate bond market led to a dramatic decrease in trading costs. Professor Venkataraman also explained to the conference attendees that increased transparency gives investors a better tool for valuing securities, improves investor confidence, and can help give regulators early indications of fundamental credit problems.

POGO is urging the SEC to amend FINRA’s rule so that transactions in asset- and mortgage-backed securities are reported to TRACE within the standard 15-minute timeframe, and information on these transactions is immediately disseminated to the public. There’s simply no reason to delay any longer in bringing these much-needed transparency reforms to the troubled assets market.