Remarks to the SEC Fixed Income Market Structure Advisory Committee

Thank you, Michael [Heaney].  Good morning everyone.  Thank you all for being here and for traveling to our offices in New York.[1]  Today’s agenda is full and important. You have assembled expert panels on (1) structured disclosures by municipal issuers, (2) rating agency compensation models, (3) index construction, (4) government securities trading platforms, and (5) the LIBOR transition.  We also have updates from our Technology and Electronic Trading Subcommittee and the Corporate Bond Transparency Subcommittee.

I could not be more pleased with the work of the Committee over the last two years.  You have brought a diversity of expertise and perspective that has enhanced our understanding of the fixed income markets and informed policy decisions.  Since the FIMSAC’s last meeting, the Commission has appointed Giedre Ball and Lee Olesky to fill the vacancies left by Carole Brown and Amar Kuchinad.  I would like to extend a warm welcome to Geidre Ball, the Debt Program Manager at the Metropolitan Washington Airports Authority, and Lee Olesky, the CEO of Tradeweb.  Geidre and Lee, thank you for participating on this Committee and sharing your expertise. 

I want to make a broad comment that again demonstrates the importance of your work and comment briefly on three of the agenda items.  The fixed income capital markets are playing an increasingly important role in our economy, on an absolute and a relative basis.  This should not surprise us.  This increase is the logical and predictable result of monetary, fiscal and regulatory policy, domestically and globally. 

Just a few metrics that illustrate the importance of our fixed income capital markets:  In the United States, outstanding nonfinancial corporate debt stands at almost $10 trillion.[2]  Municipal debt is almost $4 trillion.[3]  Together, these markets are equivalent to roughly 45 percent of the market capitalization of U.S. public companies.[4]  Recent growth in these markets has been significant and reflects a shift in our credit markets from debt held by banks to debt held outside of banks, including in funds.  Nonfinancial corporate debt is at its highest level in history—approximately 47 percent of U.S. GDP, up from about 40 percent in 2010.[5]  Municipal debt issuance had record years in 2016 and 2017.[6]  In short, our fixed income capital markets have at least as prominent a place as they have ever had in our markets and our domestic economy and our global economy.

Now, three items on my mind that I hope you will consider today:

First, index construction:  Do investors and those who advise investors understand how indices are constructed from (1) a technical perspective (e.g., weightings, adjustments and the like), (2) from a market exposure perspective (e.g., opportunities and risks the index incorporates), and (3) as a subset of those opportunities and risks, any key value judgments the index provider has made (e.g., to include or exclude certain types of companies)?  I have some concerns in this regard as I have had many discussions with investors where they express concern about particular risks and choices yet it appears these concerns are not reflected to the same extent when they index invest.  As one question, should we encourage or require more disclosure?

Second, rating agency compensation models:  This is not a new issue, but it is an important issue and, as always, the landscape is changing.  We need to continually review whether market participants who substantially influence or are relied upon by investors are appropriately disclosing, monitoring and managing their conflicts.  While they play different roles, have different compensation models, and have different regulatory obligations, we need to continually monitor the activities of rating agencies, securities analysts, investment advisers, proxy advisory businesses, brokers, particularly retail brokers, and accountants.  None of their interests are fully aligned with investors and our regulation and oversight need to recognize that reality.  With regard to credit rating agencies, a broad, and I recognize not new, question is:  Are there alternative payment models that would better align the interests of rating agencies with investors?

Third, LIBOR:  As I have noted for some time now, the pending transition presents risks that market participants, working with central banks and regulatory authorities, need to address.  I applaud the work to date, including identifying SOFR as a potential replacement for LIBOR as well as efforts to include transition language in loans, bonds and products that use LIBOR as a benchmark.  That said, much, much more work needs to be done for the transition to avoid substantial frictions, including frictions that will harm investors directly, through higher costs, and as a result of uncertainty more generally.  With this context, I ask today’s panel to comment on a broad issue. I will speak very generally (recognizing the issue, in practice, is more complex):

• LIBOR-based securities and products generally reflect three components: (1) a risk free rate, (2) a bank funding/base lending spread over this risk free rate, and (3) an additional fixed spread to/from the lender/borrower or customer.
• The current LIBOR benchmark incorporates both (1) and (2), the risk free rate and the bank funding spread over the risk free rate.  Although each of these components fluctuates with market conditions (e.g., changes in treasury yields and changes in the cost of funding for banks), and do so not uniformly, they are expressed to the market as a single number.  For example, “three month LIBOR.”
• The SOFR benchmark, on the other hand, incorporates just the first component, the fluctuating risk free rate, but not the second component, the fluctuating bank funding spread over the risk free rate.
• As a result, a loan, bond or product that is comprised of (1) the SOFR rate and (2) an additional fixed spread, would not be expected to fully incorporate the floating bank funding spread.
• This difference in approach appears to me to make a like-for-like mapping of a LIBOR product to a SOFR product challenging.

I ask today’s panel, and the members of the FIMSAC more generally, to comment on whether they see this as a challenge and, if so, how we can best address that challenge.

Thank you very much.