Do broker dealers put customer interests first? Don’t count on it if you are buying or selling municipal bonds.
In 2019 the Securities and Exchange Commission (SEC) adopted Regulation Best Interest, to reflect its stated goal of pursuing retail customers’ best interests. But Reg BI has faced severe criticism. Indeed, not all pricing and fees are transparent, and financial services firms face a conflict of interest because a commitment to best pricing and low fees can come at the expense of firm profits and employee bonuses.
John Griffin, Nicholas Hirschey and Samuel Kruger, authors of the study, “Do Municipal Bond Dealers Give their Customers ‘Fair and Reasonable’ Pricing?” published in the April 2023 issue of The Journal of Finance, analyzed the pricing practices of financial firms in the municipal bond market, which has more than $3.9 trillion in outstanding debt and over $1.4 trillion of secondary market trading per year.
Trading in the muni market is decentralized among dealer networks with electronic trading platforms only in the interdealer market. In contrast to other over-the-counter securities, municipal bonds are frequently sold directly to retail investors – while households own only 6% of outstanding corporate bonds, they own 51% of municipal bonds. Regulations and oversight are provided by the Municipal Securities Rulemaking Board (MSRB), which has the explicit goal of ensuring fair and efficient pricing.
Griffin, Hirschey and Kruger used MSRB’s proprietary dataset with dealer IDs for municipal bond trades from July 2011 through December 2017. To put markups in a longer-term perspective, they also calculated markups from January 2005 to December 2019. Here is a summary of their key findings:
- Municipal bond markups to retail customers had remained high and variable throughout the preceding 15 years despite significant regulatory efforts to enhance transparency and improve execution quality.
- For small trades, the median markup was just below 1% in 2005, rising to around 2% in the early 2010s, and then falling again to just below 1% in 2019. Median new issue markups for medium and large trades were 0% throughout 2005 to 2019.
- While median markups in the seasoned issue market had slowly decreased over time, the seasoned issue market still exhibited considerable extreme markups of 3% percent or more.
- There was no evidence that median or extreme markups decreased following MSRB rule changes requiring best execution in March 2016, even for high-cost dealers.
- While some dealers consistently charged close to 0% markups on small trades, about half of dealers charged median markups of more than 1%.
- While MSRB rules G-18 and G-30 require that transactions traded on the same day should generally receive consistent pricing, there was substantial variation in prices and dealer markups – prices for the same bond on the same day differed by as much as 2 percentage points, even for bonds with extremely active trading, casting doubt on compliance with regulatory requirements for fair and consistent pricing.
- Even when considering the same dealer selling the same bond on the same day, purchase price differences between the 10% most expensive and 10% least expensive small trades of at least 0.5% occurred 35% of the time, and differences of at least 1% occurred 18% of the time.
- Dealers used practices that exploited investors’ limited attention and cognitive biases, such as using round prices and yields, targeting yields to stay above salient thresholds, and differentially marking up long maturity bonds, all of which were associated with higher markups.
- Firms profited by setting prices to exploit customers’ limited attention, cognitive biases or lack of financial sophistication. For example, firms frequently set prices to exploit the “left digit effect,” which causes customers to perceive numbers such as 1.01 to be significantly higher than 0.99. Consistent with this prediction, yields of 3.01% were much more common than yields of 2.99%, and those trades had higher markups than trades with yields just below exact percentage points – dealers used their price discretion to raise markups and decrease yields without crossing salient thresholds that customers would notice. That pricing practice was much more prevalent for small trades and among high-cost dealers.
- Because markups have a smaller and less noticeable effect on longer maturity bonds, long maturity bonds had markups that were 1.25 percentage points higher than their short maturity bonds counterparts – firms charged higher markups when they were less salient to customers.
- Over the 6.5-year sample, the total value of small trade markups (for purchase transactions) in excess of 2% was $479 million, with $1.83 billion of markups in excess of 1%, and $2.83 billion of markups in excess of 0.5%.
Their findings led Griffin, Hirschey, and Kruger to conclude: “Some dealers deliver low markups and consistent pricing to their customers, but many charge high and variable markups. Many dealers seem more concerned with maximizing markups through customer cognitive biases and limited attention than with providing best execution. Given the negligible economic impact of MSRB rule changes, significant municipal bond market reforms, such as proposals for customer access to electronic trading, may be needed to improve pricing. A growing literature documents conflicts of interest and misconduct among brokers and financial advisors. Consistent with this literature, our evidence suggests that customers should approach brokers with a high level of caution.”
Enforcement of MSRB regulations appears to be extremely limited. The authors noted: “Between August 2016 and August 2021, the Financial Industry Regulatory (FINRA) took only 12 disciplinary actions involving 204 transactions related to fair pricing of municipal bonds.” And these actions were typically for only the most egregious examples of unfair pricing: “Discussions within the FINRA decisions lack a clear definition of exactly what constitutes an unfair markup, but enforcement generally appears to be limited to markups above 3%.” In fact, the authors were unable to locate a case in which a court, FINRA or the SEC held that markups below 3% were in violation of MSRB Rule G-30 – the best execution rules have clearly been ineffective.
Investor takeaways
Dealer transactions with customers take place at highly variable markups. On the same day, customers frequently buy the same bond at different prices from different dealers, and prices even vary across different customers purchasing the same bond from the same dealer on the same day. While some dealers provide customers with low and consistent markups, it is not the industry norm. Investors, and advisors acting on behalf of their clients, purchasing individual municipal bonds from broker dealers should demand transparency in pricing and use competitive bidding processes to achieve fair pricing.
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners.
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Do broker dealers put customer interests first? Don’t count on it if you are buying or selling municipal bonds.
