by Dismal-Jellyfish

Fixed Income and Options: The Other Market Structures Remarks at the Fixed Income Forum Spring Roundtable: www.sec.gov/news/speech/crenshaw-remarks-fixed-income-forum-spring-roundtable-033023

This speech is long but worth the read. I am going to attempt to chop up the two main topics–Fixed Income Markets and Options.

Fixed Income Markets

Comprise around half of the capital markets the SEC oversees
$24 trillion Treasury market
$10 trillion corporate bond market
$12 trillion mortgage-backed securities market
$4 trillion municipal bond markets
Beginning in 2017, broker-dealers were required to report post-trade transaction data in Treasuries
In 2022, the Federal Reserve began requiring many non-FINRA member banks to report information on their transactions as well.
Starting in May, FINRA will require a portfolio trade indicator for corporate securities, which should improve the usefulness of TRACE by making it clear when a particular price was agreed to as part of a portfolio, and may therefore not be reflective of the independent market.
FINRA also has proposed shortening the fifteen minute reporting timeframe for non-treasury TRACE-eligible securities to one minute.

The proposed Regulation Best Execution, that apply to trading in fixed income securities, as well.

The fixed income markets are still considerably less transparent and can be much more costly for investors than, for example, national market system (NMS) stocks.
Fear the story can be a tale of two markets, with increased transparency and oversight in the Treasury and agency securities markets, but without corresponding changes to the corporate bond and municipal securities markets.
The corporate bond and municipal securities markets are relied upon by both retail and institutional investors, including Americans who are approaching retirement or are already there
In the corporate bond market, trades under $100,000 account for between 60% and 70% of reported customer transactions.
In the municipal securities market, transactions of less than $25,000 account for more than half of the trades, and those less than $100,000 account for 87% of trades, reflecting that individual investors hold the majority of outstanding municipal bonds.
Investors in these markets are incurring trading costs that far outstrip the costs of transacting in the equity markets. While estimates of trading costs can be a challenge in part due to the relative lack of transparency, academics have estimated corporate bond trading costs at around 84 basis points and municipal bond trading costs as high as 90 basis points for retail-size trades.
Unsurprisingly, smaller bond transactions, which are more likely to originate from retail investors, are more expensive to complete than larger transactions – the opposite of the pattern typically observed in equity markets.
Research on municipal bond markets from the SEC’s Division of Economic and Risk Analysis showed that the majority of customer trades execute at worse prices than best available dealer quotes.

“The theme is the same – SEC requirements intended to protect investors are leaving behind investors in the corporate bond and municipal securities markets”

The lack of meaningful and consistent pre-trade price transparency hinders competition, increases costs, and makes it difficult for investors to assess their execution quality.
The SEC’s Fixed Income Market Structure Advisory Committee (FIMSAC) found that investors in municipal bonds often receive information that’s over 500 days old – and may be relying on bond ratings that are imperfect at best.
Market intermediaries and platforms trading corporate and municipal bonds have been largely left out of these initiatives. For example, while the SEC has proposed extending the requirements of Regulation SCI to certain platforms that trade Treasuries and government securities, to date, has not proposed applying that rule to any trading platforms that exclusively trade corporate debt or municipal securities.
Similarly, the most recent proposal would apply Regulation SCI to certain large broker-dealers, in particular, those that exceed a total assets threshold or a transaction activity threshold in NMS stocks, exchange-listed options contracts, Treasury securities, or agency securities. However, broker-dealer or ATS activity in corporate bond and municipal securities markets at any level would not trigger the application of Regulation SCI.

Options Markets

Today, there are sixteen options exchanges, with another proposed to come online this summer
While options serve an important hedging function in many institutional portfolios, the last several years have also seen an increase in retail participation.
Total options volume was $3.4 billion in 2022, an all-time high and the third consecutive record-breaking year, and volumes have continued to increase in 2023.
As compared to traditional equity markets, options markets are generally less liquid, can have wider spreads and higher fees, and feature pervasive conflicts of interest.

The options market already includes so-called price improvement auctions; however, they operate without some of the features and protections of the proposed auctions for equity securities. All this adds up to auctions that are less competitive than they may appear to be, and certainly not as competitive as they should be:

Rule 605, requires market centers, such as exchanges, ATSs, and broker-dealer internalizers, to make monthly disclosures of standardized information concerning execution quality for orders in NMS stocks–there is no similar requirement in the options market for entities to publish information about execution quality.

TLDRS:

Fixed Income Markets: “The theme is the same – SEC requirements intended to protect investors are leaving behind investors in the corporate bond and municipal securities markets”

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For options: the features of retail trading on the equity markets that have led to concerns about the lack of competition – specifically, the dominance of a handful of large market-makers internalizing orders, and conflicts of interest between market intermediaries and their customers – are even more pronounced in the options markets.

Not surprisingly, options markets account for by far the largest share of payment for order flow, making up about 65% of payments.

One potential way to improve investor outcomes in the options market would be to apply some of the features of the proposed Order Competition Rule to these existing price improvement auctions.