Regulating the Fixed Income Market in the United States

Felice B. Friedman

OECD-World Bank Bond Market Forum

2-3 June 2003

2

Introduction and Background

• The SEC and Debt Markets– Two Myths to Debunk

• Debt markets as unregulated

• US as case study for “Developing an Efficient Regulatory Framework for Debt Markets”

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Snapshot of US Fixed Income Market

• $20.2 trillion outstanding debt securities, year-end 2002

• $11.7 trillion in equities, slightly more than half the debt market

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$5.00

$10.00

$15.00

$20.00

$25.00

2002

DebtEquity

$ trillions

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Snapshot of US Fixed Income Market

• Treasury Securities: $3.2 trillion

• Federal Agency Debt: $2.4 trillion

• Municipal Securities: $1.8 trillion

• Corporate Debt: $4.1 trillion• Mortgage-backed: $4.7

trillion• Asset-backed: $1.5 trillion• Money Market: $2.6 trillion

Treasury DebtFed. Agency DebtMunicipal DebtCorporate DebtMtg.-BackedAsset-BackedMoney Market

Source: Bond Market Association

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Framework of US Debt Market Regulation

• Multiple Gov’t Agencies/ Regulators– US Department of the Treasury– Federal Reserve System– US Securities and Exchange Commission– Self-Regulatory Organizations

• NYSE, NASD, MSRB

– Office of Federal Housing Enterprise Oversight

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Framework of US Debt Market Regulation

• Multiple Governing Laws – Crisis-driven rather than “designed”– Securities Act of 1933 and Securities Exchange

Act of 1934. Established disclosure framework for regulation.

• All securities offered to public must be registered with the SEC, unless exempt

– Government and municipal securities exempted from registration and reporting requirements

• No exemption from antifraud provisions

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Regulation of Municipal Securities

• Securities Acts Amendments of 1975– Response to New York City financial crisis

• Regulated broker-dealers; established the MSRB

• Rule 15c2-12, adopted in 1989– Response to default of Washington Public

Power Supply System (WHOOPS) in 1983• First bond disclosure rule

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Regulation of Government Securities

• Government Securities Act of 1986– Response to failure of several key government

securities dealers• Regulated broker-dealers

• Government Securities Act Amendments of 1993 – Response to Salomon Brothers “cornering” incident

• Improvements in auction process

• Development of sales practices rules for government securities markets

• Large position record-keeping and reporting requirements

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Regulation of Corporate Securities

• Corporate Debt Securities– Sarbanes-Oxley Act of 2002

• Response to failures of Enron, WorldCom

• Focus was equity and not debt, but disclosure remedies of Sarbanes-Oxley apply equally to issuers of debt as well as to issuers of equity

– Regulatory framework for equity applied without independent consideration of debt market

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What Lessons Can We Draw?

• Hodgepodge of Regulators

• Hodgepodge of Laws and Rules

• Why does it work? What’s key?

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A Closer Look at the Municipal Securities Market

• Why the municipal securities market?– Financed the growth of the US – Has both public and private aspects– Highlights key regulatory elements – Demonstrates creativity in regulation

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Snapshot of the Municipal Securities Market

• Approx. $1.8 trillion sub-sovereign debt outstanding at year end 2002

• Approx. $430 billion in municipal debt issued in 2002, about 75% long term. About 25% due to refinancing/ refunding

• Over 50,000 issuers and 1.5 million different issues

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Overview of Municipal Securities Regulation

• Historically – Exempt from registration and reporting

requirements of Securities Act and Exchange Act

• Reasons unique to United States

• Low-risk investment

• Institutional investor base

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Overview of Municipal Securities Regulation

• What changed?– Financial crisis in major municipalities– Changes in bankruptcy law in 1979– Cutbacks on federal aid to municipalities– Proliferation of new, untested financing

techniques– Change in investor base

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Regulation of Municipal Securities

• Broker-Dealer Regulation– Securities Acts Amendments of 1975

established regulatory scheme for municipal securities broker-dealers

• Added Section 15B to Exchange Act

– Authorized SEC to set up an SRO• All MSRB rules approved by SEC• Inspection and enforcement authority with SEC,

NASD, and FRBNY

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Regulation of Municipal Securities

• Disclosure Regulation– Rule 15c2-12 -- Imposes both primary and secondary

market disclosure • Requires underwriter to obtain, file and distribute Official Statement• Underwriter must obtain from issuer a written agreement to make

financial and operating information available on ongoing basis

• Transparency Requirements– MSRB rules require transaction reporting for each security

traded at least two times the previous day

• Antifraud Regulation – and Enforcement– City of Miami, 2003

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Issues to Consider

• Who should be the regulator?– Consider US example, or non-example

• Functional regulation – How best to look after investor concerns?

– Should the safety and soundness regulator be charged with disclosure requirements for public offerings?

• Coordination among regulators – and self-regulators

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Issues to Consider

• Should there be a self-regulatory organization involved?– Sufficient government oversight

• Balance between SRO and regulator: consider powers of MSRB vs. powers of NASD

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Issues to Consider

• Should offerings of debt securities be registered?– What is being offered?

• Is it backed by full faith and credit of the government?

– Who is the investor base? • Registration and oversight more important for retail

investors and when material information is similar to that as would be required for equity offers

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Issues to Consider

• May not be necessary to have a registration scheme for offerings– Broker-dealer conduct regulation with strong

market integrity provisions may substitute– Can impose disclosure obligations on

intermediaries instead of issuers• Rule 15c2-12, as example

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Issues to Consider

• What information should be disclosed?– Material information, both financial and non-

financial• Importance of high quality accounting and auditing

principles/ standards (also to the rating agencies)

• Importance of non-financial statement disclosure– MD & A: picture of company through management’s eyes

– Role of market participants in demanding better and more timely information

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Issues to Consider

• Is enforcement regime effective? – Importance of strong, well-resourced,

independent, regulator • Complemented by individual private right of action

– Need effective judicial system with an impartial judiciary that will enforce regulatory action, where needed

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Conclusion

• Regulatory goal: Increase investor confidence and provide readily accessible source of capital– Comprehensive regulatory scheme not necessary– Key elements of regulation critical, but may vary

depending on the legal structure, the market and the investor base

• Oversight of intermediaries, including capital adequacy• Mandatory centralized disclosure and price transparency for

investors• Prohibition of fraud and effective enforcement

• Market development and regulation is evolutionary process