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On June 1, 2020, the Securities and Exchange Commission
("SEC")'s Fixed Income Market Structure Advisory Committee
("FIMSAC")'s Technology and Electronic Trading
Subcommittee ("Subcommittee") recommended, among other things,
revising the Commission's approach to pricing "cross-trades."
Cross-trades occur when an investment adviser causes the purchase
and sale between two accounts under its management. Because of the
risk of self-dealing the SEC under its rule 17a-7(b) (in effect since 1981), the SEC has
imposed a number of restrictions on cross-trades. Most notably,
from the Subcommittee's perspective, is the limitation on the price
at which these cross-trades can be executed, i.e. the "current
market price" which is further restricted for bonds to the "the
average of the highest current independent bid and lowest current
independent offer determined on the basis of reasonable inquiry,"
i.e. the rule 17a-7 "price restriction."
This pricing restriction has proven difficult to meet and, is in
fact, a more difficult standard to meet than the rule 17a-7 pricing
for trades involving institutional clients where the price must be
"the most favorable under the circumstances." The result is that
rule 17a-7 has discouraged cross-trades for bonds leading
investment advisers to execute such transactions competitively and
therefore imposing related transaction costs.
The Subcommittee has therefore recommended that the SEC "allow
other methods of ensuring that a fair price is obtained in cross
trades involving fixed income securities (beyond obtaining multiple
bids and offers)." Specifically, the Subcommittee suggested the SEC
eliminate the price restriction while preserving the limitation
that cross-trades be executed at the "current market price" which
would include instances where the investment adviser uses either
"an independent pricing source" provides a fair value or "an
electronic trading platform that has functionality designed to
achieve fair pricing of cross trades."
Consequences if subcommittee recommendations are
implemented
The consequences of the SEC implementing the Subcommittee
recommendation will extend beyond US retail bond investors, beyond
also Employee Retirement Income Security Act of 1974 ("ERISA") fund
managers (subject to ERISA
rule 408b-19 which cross-references rule 17a-7's pricing
restriction for cross-trades involving ERISA accounts). In many
cases, where a US (or other regulators') regulations are the
binding constraint, they affect global firms. We can therefore
expect that the SEC implementing the Subcommittee recommendation to
have a global impact, particularly large global fund complexes
whose internal controls and compliance practices are based on the
most restrictive regulations the fund is subject to across
different regulatory regimes.
Buyside trading teams uniquely positioned to determine
fair price and its application - independence
As members of the Subcommittee noted, there would need to be a
system of checks and balances in place to ensure appropriate due
diligence to ensure compliance with the Subcommittee's
recommendation when/if it is implemented by the SEC. Buyside
trading teams, particularly with their well-established
capabilities and focus on best-execution are well positioned to act
as neutral arbiters of price between internally managed funds
(whether by a single or multiple portfolio managers). Moreover,
they are well versed in treating separate internal investment
teams/individuals in a verifiably and visibly even-handed
manner.
They have access to at least some of the tools and platforms
that can assist in this regard. Focus will quickly shift to
reviewing and potentially adding to these toolsets should the SEC
act on the Subcommittee recommendation (which recent history has
shown that they are likely to do, at least in the case of the
FIMSAC recommendations).
IHS Markit role
IHS Markit's Ed Chidsey
represented the "independent pricing source" perspective at the
FIMSAC's June 1 meeting and we intend to continue to deliver
insights and solutions as the FIMSAC recommendation takes shape
through SEC regulatory action (as is expected). IHS Markit supplies
datasets and analytical tools to support the process of identifying
and delivering independently verifiable neutral process for
determining fair valuations for a range of the assets that would be
considered as captured by this regulation. As such we will be
watching developments closely and are able to assist customers
adjust to this new paradigm should the SEC implement it.
Posted 12 August 2020 by Salman Banaei, Americas Head of Regulatory Affairs and Executive Director and Global Head of Clearance & Settlement, IHS Markit and
Stephen Grady, Managing Director, Head of Market Structure and Strategy, Ipreo
IHS Markit provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.
