Automated programs for the bidding process haven't transformed trading in the municipal bond market as they have in equities. But they've been making noticeable inroads in the past few years.
Broker-dealers have developed ever more advanced electronic programs to help them sort through thousands of bid-wanteds they see daily in an automated way, which is driving efficiency, to a degree, in the marketplace.
But the muni market has a long way to go, industry watchers say, before electronic trading evolves to the point where technology leads to a centralized market that ensures transparency and trades that
And electronic trading technology is spreading and becoming more mainstream as technology vendors and firms that run inventory management systems develop applications for more muni participants, Vales said. It should continue to spread, too, he added, as the cost of technology falls, the models gain greater acceptance and the mandate at firms to do more with fewer bodies pushes demand for technologies that automate any of the processes that move munis.
"It's more an aid in helping a dealer discern bids on bonds when they've got to respond to many thousands of bid-wanted requests in a day," added Michael Decker, managing director and co-head of the municipal securities division at the Securities Industry and Financial Markets Association. "Model-based pricing is most prevalent in circumstances where the dealer is responding to bid-wanted requests. That's a typical way for generating liquidity for odd-lot or retail-size transactions."
In a typical scenario, a broker-dealer will put out a request for bids to the market for a particular Cusip and size on behalf of a customer, acting through a broker's broker or through an electronic trading platform — institutional customers also put bonds out for the bid directly, without using a broker-dealer or broker's broker. Other dealers will respond with bids, letting the customer decide whether they want to execute.
Thousands of those bid-wanted requests a day are issued through the platform into the systems of broker's brokers. And it's often most efficient for firms who want to be active in that sector of the market to generate their bids electronically, based on algorithms or models.
Electronic trading technology used to be reserved for the larger firms, because they had the resources and capital to build it, Vales said. That has changed. Today, the technology has become much more commonplace, he added, as small and mid-sized brokerages have adopted it.
On the buy side, most of the hedge funds are using these tools already, Vales said. Large institutions are using it for trading strategies.
"So they're either using it to filter out inventory, like bad prices, or to help clients make decisions through modeling what a price might be," Vales said.
The industry's largest dealers declined to comment for the story, save Wells Fargo Securities. Marty Bingham, who heads municipal sales and trading there, said the largest dealers all have their own internalized electronic trading systems.
A few years ago, Wells Fargo created its own automated system to organize bid-wanteds. It helps the firm quickly aggregate, sort and provide indicative bid levels for bid-wanteds from institutional customers, retail and other dealers, Bingham said.
"What we've tried to do is in real time to sort out the thousands of bid-wanteds you see on a given day," he said, "and come up with the best bid model, where we can control what we're buying, and then the distribution."
Much trading of equities, for example, is done through automated programs called algorithms, which pre-set stock names, trade sizes, trade times and desired prices electronically. Algorithms are also used to price U.S. Treasuries, as they involve real-time feeds of real-time markets for the world's most liquid security.
Munis, though, trade infrequently, and involve more than 80,000 individual issuers and more than one million different securities. So when it comes to trading them, "there's a bit more of an art that has to go along with the science," Vales said.
Munis also lack a centralized market, such as the New York Stock Exchange, Nasdaq or the many crossing networks or "dark pools," that stock traders can access. Instead, dealers and institutional investors buy and sell munis on electronic marketplaces called alternative trading systems, or ATS.
Four firms operate an ATS: Knight BondPoint, TMC Bonds LLC, Tradeweb Markets LLC and BondDesk Group LLC. According to a recent estimate, the Securities and Exchange Commission noted that ATS handle between 30% and 50% of the number of trades; retail orders comprise many of them.
When a retail investor sends a bid-wanted into the market, it sorts its way to all the dealers, Bingham said. And the dealers find a way to put up the best bid, so that the retail investor is trading at the best possible price.
Presently, Wells Fargo trades an estimated 35% of its tickets in this manner. But from a par perspective, the amount is much smaller, Bingham said; it doesn't execute its institutional blocks this way.
For connections, Wells Fargo links its system to those of ATS such as BondDesk and TMC Bonds, among others. But each market participant's electronic system functions separately, Bingham added, and does not connect to a central market center.
"Currently, a lot of retail systems bid them internally, own them and sell them back out to the Street," he said. "It's not done in a very efficient way where everyone's involved, like equities."
TMC Bonds sees thousands of bid-wanteds a day, Vales said. It routes them directly to its clients, who then can enter them into their electronic trading systems and generate bids on them automatically, without requiring a trader go in and inspect each one.
"In a lot of instances, you might have the more generic liquid bonds be automatically bid," Vales said. And you might have the bonds that don't perfectly fit with a model get kicked out to a trader, where maybe the model generated an indicative price and gave him parameters, but expects him to set the value."
In fact, the turnover on a single muni security is still low enough today that electronic order flow in the bids-wanted model challenges broker-dealers, said Mike Wood, global head of Bloomberg's Trade Order Management Solutions. They must aggregate and normalize multiple bid-wanteds that established ATS, single-dealer platforms, retail networks, other brokers and the broker's own internal sales channels and messaging platforms generate.
Brokers who elect to work with a technology provider can face issues with integrating their system, Wood said. What's more, he added, brokers must hurdle potential obstacles that can arise with physically integrating their system with different markets, as well as other system and business processes.
Where is the technology in the muni market headed? The technology to aggregate current bid-wanted order flow, as well price aggregation, has developed recently, Wood said. But the next generation of trading solutions will likely focus on automating the pricing and quoting process.
