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Securities firms that sell bonds to customers from their own account (and buy bonds from customers from their own account) make money by charging a markup (markdown) on the price that they paid (got) for the bonds on the other side. You buy at 100, sell at 101, you make a point, etc. The metaphysics of when that markup/markdown veers into fraud are deep and wonderful. You’re not, for instance, required to disclose your markup to your customers, but if they ask and you tell them, it’s probably best if you don’t lie about it, and if you are going to lie about it, it’s best if you don’t invent whole imaginary dramas about how hard you fought to get this bond.
Similarly you’re not supposed to charge “excessive markups” but who’s to say what’s excessive? Here is FINRA’s policy on the matter, which can be summed up as:
- determining whether or not a markup is excessive is a complex question to which “No definitive answer can be given” and in answering which one should holistically take into account a variety of factors including but certainly not limited to market availability, transaction size, your reasonable expenses, disclosures to the customer, and so forth; but
- probably 5%.
Today FINRA fined StateTrust Investments, a small Miami-and-Caracas retail securities firm, something like $1.5 million for excessive markups on retail corporate bond trades. How excessive? A certain amount:
FINRA found that StateTrust charged excessive markups/markdowns to customers in a total of 563 transactions. In 227 instances, the markups or markdowns exceeded five percent. In 85 of those instances, StateTrust, acting through Turnes, charged excessive markups and markdowns, ranging from eight percent to over 23 percent away from the prevailing market price, which constituted fraudulent transactions. In each of the 85 instances, StateTrust either bought bonds from its bank or insurance affiliate and then sold the bonds to customers at a price that was eight percent or more away from the prevailing market; or bought bonds from customers at prices that were eight percent or more below the prevailing market, and then sold them to its bank or insurance affiliate at a slight markup.
So: 8%, probably a bit rich, even for retail, even for corporate bonds. And markups that “exceeded five percent,” um, exceeded five percent, which is after all the rule of thumb. The other 300 and change transactions, with sub-5% markups, were … excessive in unspecified ways?1
Obviously FINRA sometimes goes after brokers for charging excessive markups, as it did here, but equally obviously it can’t catch everyone. Also, there are those who think that it’s kind of weird for a regulator, long after the fact, to decide how much market participants can charge for their services. Shouldn’t the market do that?
That’s why FINRA invented TRACE, the Trade Reporting and Compliance Engine, which is “the FINRA developed vehicle that facilitates the mandatory reporting of over the counter secondary market transactions in eligible fixed income securities.” Under the TRACE rules every dealer needs to report every trade in certain types of bonds – in particular, corporate bonds – within 15 minutes of the trade. So if you want to see where, say, WalMart’s 6.5% of 2037 has traded most recently, you can go to the TRACE website (or Bloomberg) and just find out. I see it between 123.5ish (4.8%ish) and 125ish (4.7%ish) this week. So paying 130 for it would be right out.
This is a pretty good system for big customers, who tend to have Bloombergs and can see on a trade-by-trade basis where their bonds traded and, often, what their dealers paid for them. So markups on corporate bond trades with institutional customers tend not to get too excessive: whether or not FINRA comes after you, if you overcharge customers for bonds and they can tell, they’ll stop trading with you.2 So FINRA’s excessive markup-cases, like this one, tend to be retail. Retail customers don’t have Bloombergs, or know how to use the (somewhat annoying) TRACE website, so they need regulators to protect them.
Here though is my favorite part of this case:
Between September 2008 and March 2009, StateTrust, through its clearing firm, attempted to report 64 transactions in TRACE-eligible securities to TRACE. However, TRACE rejected the submissions because the transactions were executed at prices outside the range of prices at which other transactions in the same bonds were executed. StateTrust, however, failed to resubmit the transactions to TRACE. By failing to report the 64 transactions to TRACE, StateTrust violated NASD Rule 6230 and FINRA Rule 6730.
I mean, sure, they violated the rule by not trying again, whatever. But isn’t that sort of great? There they were, fraudulently charging excessive markups, and telling FINRA about it through TRACE, FINRA’s way of making public their markups. If the reports had gone through, their customers could in theory (though not likely in reality) have seen how much they were getting hosed. And, y’know, the SEC is making big strides in looking at data to spot insider trading and accounting fraud and hedge fund fraud and whatnot. I bet they could spare 15 minutes of a coder’s time to write an algorithm for FINRA that is like:
look at TRACE;
if ( bond trades at two prices more than 8% apart within like an hour )
maybe look into that;
Instead TRACE was like “your markup is too big, does not compute, oh well, never mind.” Maybe it should have shared that information with someone?3
In 563 corporate bond transactions executed between March 2007 and June 2010, State Trust, acting through [head trader Jose Luis] Turnes, charged unfair prices to customers. Turnes determined the prices at which StateTrust bought and sold the bonds to the customers. In 324 of the transactions, StateTrust bought the bonds from a customer at an unfair price and then sold them to either its bank or insurance affiliates or bought the bonds from one of those affiliates and then sold them to another customer at an unfair price. In most of the other 239 transactions, StateTrust bought the bonds from the street and then sold them to a customer at an unfair price or bought the bonds from a customer at an unfair price and sold them to the street. In 227 of the 563 transactions, StateTrust charged markups/markdowns of 5% or more. The excessive charges on all 563 transactions total $336,472.03.
I can see “buying bonds from your affiliates” as raising some excessive markup issues even inside of 5%. But there’s some residue of trades where State Trust bought and sold from and to unaffiliated third parties at spreads of less than 5% that FINRA nonetheless found excessive three years after the fact. Which: they probably were? (Normal markups on round lots of corporate bonds are more often an eighth of a point than four points, though you could be more forgiving on small trades like this.) But there’s zero explanation of why.
2. Jesse Litvak, the delightful Jefferies trader who made up stories about where he was getting his bonds in order to deceive his customers about the markup they were paying, had the advantage that he was trading MBS securities that weren’t TRACE eligible, so his customers didn’t catch him. If they had, though, they said themselves that they “would have temporarily stopped doing business with Jefferies had they known the truth.” That’s how the institutional market sanction works.
3. Maybe it did and this case resulted 5 years later? Meh.