Sell Side

Platforms Stand to Gain From Market Change

Capital constraints caused by the credit crunch are leading many investment and commercial banks to make tough choices about where they want to put risk capital to work. That's evident in the municipal market, where some firms are pricing bonds to sell in the primary and keeping fewer securities on their own books. As a result, they are turning to the electronic trading platforms to provide inventory.

"The street is clearly taking on less inventory," said Tom Vales, chief executive officer of MuniCenter LLC, an online trading platform. "The [trading platforms] are providing surrogate inventory for the street."

In the first quarter of last year, MuniCenter averaged about 28,000 municipal items listed each day, but in the first quarter of this year, the platform is only averaging 18,000 items. In that time the "turn ratio" the number of items a day versus the number of sales a month has doubled, meaning that fewer bonds are being offered but sold more frequently.

"A lot of the firms are taking less risk and turning their inventory over a lot more," Vales said.

Brokerage firms like Chapdelaine & Co. and J.J. Kenny Drake are also poised to take advantage of the current market.

"The type of liquidity that a brokerage shop like ours supplies would be in more demand," said Hans Hanf, a senior vice president at Chapdelaine. "Especially with the way that the UBS firm is doing business because the focus is not on risk trading."

UBS AG announced last month that it would exit the origination business, limiting the risk of using the bank's balance sheet on relatively smaller margins in U.S. public finance. Its reluctance to put capital at risk is also being exhibited at many of the market's largest banks.

These banks' concerns can be seen most recently in Lehman Brothers, which reported a first-quarter loss of $2.8 billion on Monday. In comments surrounding the release, executives said the bank was selling assets in a move to deleverage its balance sheet, adjust its risk profile, and improve its financial position.

While Lehman executives have not singled out the municipal business, some calculations show how badly some firms could have suffered in the recent credit crisis. A firm carrying about $2 billion in municipal inventory before the credit crisis could have had as much as half of it insured by the now beleaguered bond insurers. As the insurers got downgraded, the values on those bonds fell and if they fell by 30%, that would mean a loss of $300 million.

"Everything involves risk and the balance sheet," said Rob Larkins, a managing director at Wedbush Morgan Securities Inc. who left Lehman earlier this year. "Anybody who carried a large inventory last summer lost big."

And in this environment, sources say the electronic trading platforms are poised to play a larger role. Vales said MuniCenter volume is up more than 40% over last year, while BondDesk LLC, another one of the leading electronic trading platforms, has also seen volume increase. Peter Adams, director of TradeWeb retail, said in recent months his firm has seen a "marked" increase in interest from banks looking to use the platform.

External inventory could become even more important if firms cut back on traditional underwriting. In addition to UBS, market sources have suggested that Citi may make further cuts in its municipal business as well.

UBS' departure calls into question the theory that banks must do origination and underwriting in order to feed their traders and wealth management clients with product. When the move was announced, UBS said it would transfer a portion of the municipal securities unit back to the wealth management business to make it easier for traders to buy and sell munis for clients.

"Municipal securities are an important part of many of our clients' portfolios," said Jim Hausmann, head of transaction products for UBS Wealth Management Americas, in a statement at the time. "Through an open architecture platform, our clients will have access to a broad of supply of both new issues and secondary securities."

As one of the first owners of BondDesk, UBS has long supported electronic trading platforms and the increased inventory that they provide. However, it remains to be seen how the firm will provide new issue supply to its traders.

Using an electronic platform would make sense for a competitive sale in the primary market, but Myles Harrington, president of the Grant Street Group, owners of online auction platform, MuniAuction, said he does not foresee more competitive deals moving online.

"Frankly, I have seen little of a long term shift in the disposition of market participants toward electronic auctions," Harrington said.

UBS management declined to provide further details about its so-called "syndicate open architecture" plans, which would relate to primary market sales.

If other firms pull back from underwriting, the inventory could be provided by regional firms who are already looking to pick up the slack as the large firms stay on the sidelines. Regional firms have already started hiring displaced bankers from those larger firms.

"Twenty-five years ago the muni business was regional and I think we will go through a devolution back to the regionals," Larkins said. "Insurance homogenized the market and facilitated concentration of capital flows through remotely-located dealers who traded on the basis of the triple-A wrap. Fundamentally, ours is a very fragmented, local market, with something like 75,000 separate underlying credits. I think the regional firms will thrive because they understand the local economies, local politics and individual legal environments that define the credits."

And electronic trading platforms are ready to post their inventory for all to see.

"If I was a small regional dealer, I might have my own muni underwriting desk for local issues but I'm not sure I would have a lot of money invested in risk taking or risk capital," said Tony Miscimarra, president of BondDesk Trading. "I would prefer to level the playing field [by using an online trading platform] as a means to access the same inventory as much larger firms without risking capital."


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