March 29, 2022 | Stamford, CT — New regulations designed to protect investors could actually remove liquidity from huge sections of the U.S. bond market.
Investors and fixed-income dealers are sounding the alarm about SEC Rule 15c2-11, which they say could reduce liquidity and increase costs for issuers and investors in high yield, emerging markets and the $2.5 trillion market for privately placed “144A” bonds.
Rule 15c2-11 would make it a violation for broker-dealers to publish a quote on a bond without first forming a “reasonable basis” that the information is materially accurate and coming from a reliable source. Meeting this new requirement could require access to publicly available data on the issuer of the bond and regularly published quotes. In fixed-income trading, many securities will not meet either criteria and only the most liquid bonds will meet the frequency requirements of one quote over a five-day period.
“Market participants are worried that 144As and other less liquid bonds could turn into useless securities through rulemaking if no one can quote them and they become completely illiquid,” says Audrey Blater, Senior Analyst for Coalition Greenwich Market Structure & Technology and author of When It’s Time to Recycle Regulations: The Impact of SEC Rule 15c2-11.
Still Time to Act
The rules at issue were originally intended to protect retail investors from fraudulent behavior in the trading of OTC stocks (i.e., the “pump and dump” schemes of the 1990s). The current firestorm erupted when the SEC decided to extend the rules to OTC fixed-income securities.
There is still time to address the industry’s concerns. Due in part to industry pushback, the SEC has shifted to a phased implementation model to take full effect on Jan 5, 2024. The SEC also issued a no-action letter keeps 144As out of the rules until January 2023.
The SEC’s ultimate ruling could have significant consequences for markets and investors. Corporate bonds—including investment grade, high yield and 144As—and EM debt have trended higher in recent years as investors look to diversify their portfolios and search for yield amid tight spreads and low rates in the market. In 2020, COVID-induced volatility caused a spike in trading, supported by broker-dealers’ ability to quote and trade these instruments.
“Without ample liquidity, it would be difficult to imagine smooth risk transfer when inflation, rates, geopolitical tensions, and other frictions influence the market,” say Audrey Blater.