Market Regulators Scrutinize
Odd Muni-Bond Trading Patterns

Unusual trading patterns in the municipal-bond market that may be resulting in differences of more than 10% between prices at which customers buy and sell the same bonds on the same day are being studied by securities regulators, according to people familiar with the probes.

The probes are being conducted by the staffs of the Securities and Exchange Commission and the National Association of Securities Dealers, based on pricing anomalies drawn to their attention in part by an industry critic who runs a bond-pricing Web site and the Municipal Securities Rulemaking Board, the people said.

The regulators are looking at whether different securities dealers have traded certain municipal bonds among themselves at successively higher or lower prices, adversely affecting the prices customers receive when they buy or sell the bonds.

The successively higher prices in the dealer-to-dealer trades could have the effect of allowing dealers to circumvent, or avoid exceeding, a 5% industry benchmark on price markups in the muni market for sales and purchases by individual investors.

Steve Luparello, executive vice-president for market regulation at the NASD, said the regulators want to learn more about "seemingly unrelated transactions resulting in customers getting substantially disparate prices" for the same bonds. The probes have been going on for more than a year, one person said. The NASD has brought enforcement actions against dealers for markups of less than 5%, some experts noted.

The MSRB, of Alexandria, Va., regulates municipal-securities dealers. It issued an advisory Monday reminding them of rules mandating that they must "exercise diligence in establishing the market value of the security and the reasonableness of the compensation received on the transaction."

The same MSRB notice cited "certain transaction patterns" that have cropped up in its electronic system for reporting municipal-bond trades, which are available the next day on a Web site, investinginbonds.com. The patterns "show abnormally large price variance in a relatively small number of issues each day." Some of the wide price variations have been spotlighted by the Web site, MunicipalBonds.com run by industry critic Kevin Olson, a former bond trader.

The MSRB warned that "a frequent scenario in large intraday price differentials occurs when a single block of securities moves through a 'chain' of transactions during the day." Typically, such chains begin with a sale of bonds by an individual investor to a dealer, "usually in a 'retail' size block of $5,000 to $100,000," the MSRB said.

The MSRB continued, "The securities are then sold through a broker's broker. Two or more inter-dealer transactions follow, with the final sale of the securities being made by a dealer to a customer. In certain cases, the difference between the price received by the selling customer and the price [paid] by the purchasing customer is abnormally large, exceeding 10% or more."

When such transaction chains are reviewed, the MSRB said, "it often appears that the two dealers" who trade with the individual investors "did not make excessive profits on their trades. Instead, the large intraday price differentials can be attributed in major part to the price increases found in the inter-dealer trading."

In an interview, Christopher Taylor, executive director of the MSRB, said some of the trading patterns that result in the variations greater than 10% in prices paid and received by investors "warrant further regulatory review." While some price variations are caused by errors in data entry, he said two to three dozen trades daily are cause for concern.

The total damage to individual investors under the scenario drawn by the MSRB may be well under $20 million annually, some industry experts noted. In that case, regulators may conclude the trading patterns may not warrant the attention of multiple agencies.

In the advisory sent out Monday, the MSRB said price discrepancies may occur because dealers don't make a thorough effort to determine the appropriate market price at times when there is "breaking news" about the issuer, such as a downgrade by a credit-rating concern. Once electronic-trade reporting moves to a real-time basis, scheduled for January 2005, such instances should become less frequent, the MSRB said.

Municipal-bond investors are more vulnerable to paying off-market prices, industry experts say, because prices of individual bonds, unlike stocks, aren't transmitted to other market participants on a minute-to-minute basis. Many investors have little way of knowing whether the interest yield on their bonds should be 4% or 6%, enough difference to produce a big variation in price.

Monday, the Bond Market Association, the largest trade group representing bond dealers, said "pricing problems are a small minority of the 10,000 municipal issues traded every day" and it supports "enforcement sanctions" for those dealers who don't obtain fair prices for customers.