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, S&P Global Market Intelligence and

Stephen Grady, Managing Director, Head of Market Structure and Strategy, Ipreo

S&P Global 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.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.