In addition, as debt instruments municipal securities are generally considered less risky than equity  securities. Broker-dealers may also use broker’s brokers and electronic trading  platforms to trade in the secondary market. As we  have seen, FINRA and federal banking regulators enforce MSRB rules for  broker-dealers under their respective jurisdictions. Municipal Securities Are Priced in an Opaque Market That Favors Better- Informed Participants

Because of the heterogeneity of the issuers and the securities they issue,  the large number of securities outstanding, and the infrequency with  which these securities trade, the municipal securities market does not  maintain reliable tradable quotes on all outstanding municipal securities.Consequently, broker-dealers we spoke with said they use a variety of  information to determine the prices at which they are willing to buy and  sell securities. However, unlike post-trade information, pretrade price information  is not centralized, not publicly available, and not as available to broker- dealers (and to other market participants) as post-trade price information. Individual Investors Generally Have Less Information and Expertise to Assess Prices than Institutional Investors

Various factors could contribute to the differences in prices that individual  investors receive relative to institutional investors. SEC, MSRB, and Market Participants Are Considering Ways to Improve Pretrade Price Transparency

SEC and MSRB have ongoing studies examining the municipal security  market. It is also  intended to assist MSRB in evaluating whether pricing and liquidity in the  market could be improved with higher levels of pretrade price  transparency. SEC’s OCIE provides oversight of MSRB and FINRA’s  regulatory activities. In 2010, OCIE  began transitioning to a risk-based SRO inspection approach in  conjunction with a comprehensive assessment of OCIE’s structure and  functions. OCIE staff only  recently began a new inspection of FINRA that will encompass its fixed- income surveillance program, including the municipal trade reporting and  markup reviews. OCIE staff said that staffing constraints had prevented them from starting  another inspection sooner to review FINRA’s fixed-income surveillance  program and MSRB. Without collecting information on an ongoing  basis that provides insight into the effectiveness of SRO regulatory  programs, OCIE may not be able to identify anomalies or changes in the  operations that warrant more immediate inspections. For example, OCIE’s last inspection of FINRA’s  fixed-income surveillance program predated the recent financial crisis and  ensuing volatility in the municipal securities markets. Although OCIE  obtained some information on FINRA’s examination program through its  district office inspections and broker-dealer examinations, its lack of a  structured mechanism for monitoring the quality of FINRA’s fixed-income  surveillance during that time means that OCIE will not have a full picture of  how effective FINRA was in surveilling for and detecting violations of MSRB  rules until it finishes its 2011 inspection—more than 3 years after the  financial crisis began and more than 6 years since its last inspection. Recommendation for Executive Action

To improve SEC’s ability to monitor the operations and effectiveness of  SRO regulatory programs related to municipal securities trading between  inspections and to help identify areas of high risk, we recommend that the  Chairman of the Securities and Exchange Commission direct OCIE to  take steps to gather and analyze information on the SROs’ fixed-income  regulatory programs on an ongoing basis and use it to inform their risk- based inspection approach. SEC further noted that even if the vacant  positions were filled, OCIE’s Market Oversight group would continue to be  understaffed relative to the number and complexity of entities that it  examines and that it would need additional resources to conduct more  frequent inspections of FINRA and MSRB’s fixed-income programs or to  do interim monitoring of FINRA’s fixed income surveillance program. Pursuant to the Dodd- Frank Act, CFTC Has Issued Rules Regulating Swap Dealers’ Transactions with Municipal Issuers

Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection  Act (Dodd-Frank Act) created a comprehensive framework to provide  oversight over the previously unregulated over-the counter derivatives  market. Appendix II: Scope and Methodology

To analyze how institutional and individual investors trade municipal  securities in the secondary market and the factors affecting the prices  institutional and individual investors receive, we obtained data on all  municipal securities trades that broker-dealers reported to the Municipal  Securities Rulemaking Board’s (MSRB) Real-Time Transaction Reporting  System (RTRS) from January 1, 2005, to December 31, 2010. We reviewed studies that analyzed pricing in the municipal securities  market. In addition, we  attended or viewed the Securities and Exchange Commission’s (SEC) field  hearings on the state of the municipal securities market, reviewed industry  literature, and interviewed members of trade organizations representing  institutional investors, broker-dealers (including broker’s brokers), and  individual investors; academics; SEC Office of Municipal Securities Market  officials; MSRB officials and independent municipal market research and  advisory firms. We  also reviewed documentation describing RegWeb, the web portal MSRB  makes available to federal regulators to analyze and query RTRS data for  regulatory purposes; the Financial Industry Regulatory Authority’s  (FINRA) policies and procedures for electronically surveilling RTRS data  for potential violations of MSRB pricing and trade reporting rules; and  FINRA and federal banking regulators’ (Office of the Comptroller of the  Currency, or OCC; Federal Deposit Insurance Corporation, or FDIC; and  Board of Governors of the Federal Reserve System, or the Federal  Reserve) examination procedures for assessing broker-dealer  compliance with these rules.
Why GAO Did This Study

Municipal securities are debt instruments that state and local governments typically issue to finance diverse projects. Individual investors, through direct purchases or investment funds, own 75 percent of the estimated $3.7 trillion in municipal securities in the U.S. market. In the secondary market, where these securities are bought and sold after issuance, trading largely occurs in over-the-counter markets that are less liquid and less transparent than the exchange-traded equity securities market. The Dodd-Frank Wall Street Reform and Consumer Protection Act required GAO to review several aspects of the municipal securities market, including the mechanisms for trading, price discovery, and price transparency. This report examines (1) municipal security trading in the secondary market and the factors that affect the prices investors receive, and (2) the Securities and Exchange Commissions (SEC) and self-regulatory organizations (SRO) enforcement of rules on fair pricing and timely reporting. For this work, GAO analyzed trade data, reviewed federal regulators programs for enforcing trading rules, and interviewed market participants and federal regulators.

What GAO Found

In the secondary market for municipal securities, both institutional and individual investors trade through brokers, dealers, and banks (broker-dealers). However, GAO analysis of trade data showed that institutional investors generally trade at more favorable prices than individual investors. Broker-dealers said these differences generally reflected the higher average transaction costs associated with trading individual investors smaller blocks of securities. Market participants added that institutional investors have more resources, including networks of broker-dealers, and the expertise to independently assess prices. In recent years, the Municipal Securities Rulemaking Board (MSRB)an SRO that writes rules regulating the broker-dealers that trade municipal securitieshas required timely and public posting of trade prices in an effort to make post-trade price information more widely available. However, unlike the equities market, the relatively illiquid municipal market lacks centrally posted and continuous quotes, and other sources of pretrade price information are not centralized or publicly available to individual investors. In 2010, SEC began a review of the municipal securities market, in part to examine pretrade price information. MSRB has also begun a study that includes a review of the market structure to determine whether access to additional pretrade price information could improve pricing and liquidity. Both SEC and MSRB plan to complete these studies in 2012.
Several regulators share responsibility for overseeing the municipal securities market. The Financial Industry Regulatory Authority (FINRA)an SRO that regulates 98 percent of the broker-dealers that trade municipal securitiesand federal banking regulators enforce broker-dealer compliance with MSRB rules under their respective jurisdictions through electronic surveillances of trade data and routine examinations. SEC evaluates the quality of FINRA and MSRBs municipal regulatory programs through its SRO inspection program, which has recently evolved to a risk-based approach. SEC last inspected MSRB and FINRAs fixed-income surveillance program, which encompass municipal securities trading, in 2005. SEC staff said that staffing constraints have prevented them from conducting inspections of these SROs sooner, although they have recently begun a new inspection of FINRAs fixed-income surveillance program. SECs limited monitoring of FINRA and MSRB between inspections may not be sufficient to support its new risk-based inspection approach. For example, SECs last inspection of FINRAs fixed-income surveillance program predated the financial crisisand its ensuing volatility in the municipal marketbut SEC had collected limited information since its last inspection that would help it assess the quality of FINRAs broker-dealer oversight. SEC currently receives periodic reports from FINRA that provide statistical information on its regulatory activities related to municipal securities trading. According to SEC staff, while they might be able to use the reports to identify significant deviations in FINRAs efforts, they cannot use them solely to determine the effectiveness of FINRAs municipal securities program. Without ongoing collection and analysis of information to assess the effectiveness of SROs regulatory programs, SEC may be unable to identify and act on regulatory problems in a timely manner.

What GAO Recommends

GAO recommends that SEC collect and analyze information on SROs fixed-income regulatory programs on an ongoing basis to better inform its risk-based inspection approach. SEC agreed, but noted it would need additional resources to conduct more frequent oversight of the SROs. Such ongoing monitoring, however, could help SEC better leverage its resources for inspections.