With the need for greater efficiency and liquidity in the municipal market, participants say the time is ripe for the expansion and adaptation of electronic trading platforms in the space.
While it’s hard to quantify how much of the market is electronic, John Bagley, the MSRB chief market structure officer, said anecdotally there has been an increase in electronic trading, more prevalent in smaller-sized, odd-lot trading than in big blocks.
While only 12% to 15% of municipal bond trading volume is performed electronically, the largest institutional asset managers trade quite a bit more electronically, at a little over 30%, said Kevin McPartland, head of market structure and technology research at Greenwich Associates.
Sixty-seven percent of buy-side firms traded at least some munis electronically in 2021, up from 51% five years prior, McPartland said.
“There’s a lot of forces taking place on both the client- and dealer-side, which are driving this adoption,” said Marty Mannion, former co-CEO of Headlands Tech Global Markets and current managing director and co-head at TD Securities Automated Trading.
Additionally, 94% of market participants surveyed in Bond Buyer/Arizent Research survey last year believe electronic trading and artificial intelligence/machine learning will have a larger role in the muni market in the next five-plus years.
And with technological advancements, Bagley said electronic trading has momentum in the muni space, including firms with a more traditional platform looking to incorporate alternative trading models.
“I don’t see something that’s going to derail it,” he said. “I think everybody’s trying to make an investment in technology.”
Electronic trading has made strides
Electronic trading has been gaining steam for nearly two decades. People have been asked to do more with less, and volume and volatility make it difficult to “simply get to the activity in the market if your manual,” Mannion said.
“What we’ve seen over time is markets tend toward efficiency,” he said. “What used to be a floor-based kind of manual execution process become much more automated and then over time, it became fully automated.”
Automating that process allows market participants to provide meaningful liquidity to their clients instantaneously and scale efficiently with any growth in market volumes.
And large market makers, such as Citadel, can replicate many of the things traders do in a more automated workflow, which supports the growth of the business, better management of risk and the increase in volume and volatility over time, Mannion said.
“You’ve seen that same story play out in virtually every asset class,” he said. “It’s happened everywhere else; there’s no reason it can’t be applied to the municipal market.”
John Cahalane, managing director and head of Tradeweb Direct, said the first leg of electronification stemmed from a need for easier execution and trade processing, as well as price transparency and the sharing of liquidity across the sell- and buy-side.
For instance, many tickets are done electronically because they’re traditional muni wealth management buyers coming in, either self-directed through the E*Trades, Charles Schwabs, TD Ameritrades of the world, or represented by wealth management individuals and financial advisors, buying and selling muni bonds.
“From the ticket side, electronification was key; it was necessary,” he said.
Tradeweb Direct’s average retail trade size is about 40 muni bonds and the company executes 6,000 to 7,0000 trades daily.
“If you didn’t have an electronic trading platform and the efficiency that brought, we’d never be able to process all of those trades if folks are still writing short of paper tickets or typing transactions into the back-office systems,” Cahalane said.
Efficiency is a big driver
For market participants, considerable constraints today include the ability to do credit analysis quickly and get liquidity in smaller pieces, Mannion said.
For firms focused on clients with small-sized portfolios, the liquidity they need is tailored, which can only be achieved with electronic trading tools and partners that deliver the type of liquidity they need quickly in a price-effective way, according to Mannion.
Moreover, he said, through electronic trading larger shops, unconstrained with analysts having to do a credit write-up, may be able to bid on smaller micro-lots, creating more turnover in the market.
More turnover will improve liquidity, noted Steve Winterstein, head of municipal fixed income at MarketAxess.
“There’s been tremendous acceptance and adoption” of electronic trading, Mannion said.
Cahalane, though, credits the recent escalation in electronic trading in part due to the buy-side intensifying its investment in electronic trading and electronification.
“It’s for the same reason we electronified years ago,” he said. “It’s about efficiency.”
As of late, Cahalane said, the buy-side asset management space has become more competitive on fees. When fees go down, asset managers need to find a way to spend less money to keep their profitability up. Thus, the buy-side has become focused on making their trading desks more efficient.
“And then they make that investment and start to realize, ‘Hey, not only is the marketplace in need of becoming more efficient but to try and get better returns for our clients, maybe we shouldn’t just be a baker; maybe we should start being a price maker,’” Cahalane said.
The pandemic was another factor. At its start, Calahane said, there were six to eight weeks in March and April 2020 of heightened volatility, where no one was sure what would happen next. Some of the more prominent traditional liquidity providers stepped back, allowing electronic trading platforms to provide liquidity for these accounts. For asset managers connected to electronic platforms, though, they found an “incredible source” in new liquidity.
From there, Cahalane said, the level of interest in electronic trading platforms took off, where more and more of those tier-one asset managers came deep into the space for the first time.
“Ultimately, that’s the goal: to facilitate the free flow of capital and increase demand for liquidity in our marketplace,” Winterstein said.
Concerns still linger
But while the technology is highly efficient, Winterstein said, it’s a matter of getting people to understand how it works and be willing to embrace new ways of doing things.
Concerns over electronic trading from the sell-side stem from worries about being dis-intermediated from their clients and the loss of interpersonal relationships.
“It’s a business of trust; it’s a business of collegiality,” Winterstein said. “And when we move to electronic trading, the perception is that it’s much more sterile and impersonal.”
However, he sees the premise as false, saying electronic trading — like any other technological tool we use in our daily life — doesn’t necessarily displace personal relationships. Instead, it allows investors to spend the time, effort and intellectual capital on other priorities.
Electronic trading, Winterstein said, is like a calculator: The same way a mathematician can rely on a calculator to crunch thousands of numbers without error and relatively quick, thus allowing a person to focus on other areas of research, is similar to how electronic trading can be advantageous.
Additionally, some may have reservations about e-trading because of cybersecurity threats, Mannion said. After all, financial institutions are common targets for cyberattacks, and securities firms can face cyber risks because of their close ties to trading infrastructure and online trading platforms and the volume of transactions handled via their trading platforms.
But, Mannion said, if firms conduct electronic trading the right way, the risks are minimal. Moreover, for munis, he said, the lack of centralized fully automated order book trading reduces the risk of system-related issues.
“Anytime you’re building businesses like these, you put a lot of thought and effort into how you build the code, how you release the code. You don’t necessarily just let the an automated model or machine run unsupervised,” he said.
Firms have risk traders and operation staff monitoring the activity closely and ensuring things are working correctly.
Mannion said the benefits of electronic trading — efficiencies, savings for customers, ability to scale and provide liquidity — outweigh any risk for customers.
There’s also some pushback from banks and broker-dealers over electronic trading, Cahalane said. The boosted transparency from electronic trading platforms — which allows traders to communicate with hundreds of peers simultaneously and see bids and offers as they happen using a variety of protocols — can cut into banks’ and broker-dealers’ ability to turn a profit in this increasingly open market.
New strategies arise
These changes necessitate a new competitive strategy for traders, banks and asset managers.
“As electronification continues to grow in fixed income markets, firms that can quickly utilize data and sophisticated analytics to identify trading opportunities are likely to benefit,” said Amanda Hindlian, president of Fixed Income and Data Services at ICE. “We’re even seeing this dynamic unfold at the hiring level, where candidates with coding experience are being targeted by firms that want staff who can dynamically analyze big data sets and apply that analysis to their trading strategies.”
Along with hiring more non-traditional workers, some firms have made significant moves as of late and acquired technology-driven fixed-income market makers primarily focused on trading on electronic platforms.
For example, Morgan Stanley completed its $13 billion acquisition of E*Trade in October 2020. Toronto-Dominion Bank completed its acquisition of Headlands in July 2021, and Raymond James Financial reached an agreement to acquire SumRidge Partners, which specializes in investment-grade and high-yield municipal and corporate bonds, in March.
“In the fixed-income world, it’s hard to build those types of businesses from scratch and the nature of these products tend to be very capital intensive,” Mannion said.
That’s not to say it can’t be done, he said, but it’s sometimes easier to acquire a company that has already built one. He believes TD acquired Headlands because the company could take what Headlands had done, scale it out and leverage the technology into other areas of fixed-income rather than embarking on a multi-year project to build its own business.
“It was easier to do it buying or acquiring us than perhaps trying to build out exclusively in-house,” he said.
When TD Bank finalized the deal, it said in a statement that “the transaction adds capabilities to TD’s existing infrastructure as Headlands has developed proprietary software to deliver fully automated electronic market-making in municipal and investment-grade corporate bonds.”
Since the deal closed, Mannion said Headlands, now referred to as TD Securities Automated Trading, has taken a fully electronic and automated approach to trade munis.
“Fixed-income markets are undergoing a radical transformation, where automated trading capabilities are becoming much more important,” Mannion said.
“We’re seeing that adoption; I don’t think we’re ever going to go back,” Winterstein added.