How Rule 144A Created a Shadow Financial Market

Image: SEC.

Over time, most financial markets have become increasingly open, shedding their history of catering to the rich and powerful and allowing ordinary investors to buy and sell stocks, funds, and other popular investments cheaply and easily. Yet behind the scenes, large institutional investors still play a key role in the financial system, and one SEC rule allows them to make big trades among themselves in investments that ordinary investors can't buy. Rule 144A has drawn attention for facilitating what some call a "shadow market," and efforts to shed light on trades conducted under the rule have found some early success. Let's take a closer look at Rule 144A and what it allows institutions to do.

What Rule 144A isRule 144A is designed to provide an exemption to the general rule that all securities must be registered with the SEC before being sold. The rule specifically addresses the resale of securities among what the rule calls qualified institutional buyers, which includes most categories of institutions that qualify as accredited investors under the securities laws. Individual investors cannot be qualified institutional buyers; only institutions qualify under Rule 144A.

The general intent of the rule is to allow institutions to engage in transactions the SEC would deem too risky for the general public. Institutions can make trades even though the underlying issuer hasn't provided the full information required for SEC registration. The assumption is that large institutions are savvy enough to do their own due diligence without the SEC backing them up, in contrast to individual investors who typically lack the resources to verify claims from issuers without the agency's help.

In addition, Rule 144A has made the markets for privately placed restricted securities more liquid than they would otherwise be. Ordinarily, a two-year holding period applies under SEC Rule 144 to institutions that buy restricted securities from issuers. By allowing trades among qualified institutions, Rule 144A allows shorter-term investment in these securities.

Why Rule 144A raised concernsOne problem with the Rule 144A regulatory setup is that even though the trades sanctioned by itbecame an important segment of trading in some issuers' securities, the reporting requirements made activity in the 144A market harder for ordinary investors to see. In the corporate bond market, the Financial Industry Regulatory Authority estimated last year that the total volume of 144A transactions was about 20% of the overall average daily volume for the entire bond market. In the high-yield debt area, that proportion was even higher at nearly 30%.

To give more information to all market participants, FINRA started reporting transaction data for Rule 144A trades in the corporate debt market in mid-2014. With its Trade Reporting and Compliance Engine, FINRA leveled the playing field for Rule 144A and non-Rule 144A trades, imposing many of the same informational requirements on both. FINRA heralded the move as "bringing transparency to a market that had previously operated in the dark." An executive at FINRA added that "the information will help professional investors and contribute to more efficient pricing of these securities, as well as inform valuation for mark-to-market purposes."

Nevertheless, even though Rule 144A is designed to allow financial institutions greater latitude in making trades, some concerns persist. Many Rule 144A transactions involve securities of foreign companies that don't want to subject themselves to SEC scrutiny, and that exposes U.S. institutions to the potential for fraudulent representations from those foreign issuers. One counterargument is that by allowing institutions to spread the risk from foreign-issued securities in private placements, Rule 144A actually reduces the overall systemic danger to the industry as a whole. Still, Rule 144A does make it easier for companies to issue private placements by essentially facilitating a secondary market among institutions for those securities. To some extent, that makes regular initial public offerings and other public issuance less attractive, leaving average investors with fewer investment options.

You won't see references to Rule 144A every day, but the SEC rule plays a key role in how large institutions trade. Thanks to efforts from FINRA and others, you can get more information on this previously hidden market and gain valuable insight from the behavior of issuers and institutions alike.

The article How Rule 144A Created a Shadow Financial Market originally appeared on Fool.com.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.