Bond dealers have problems with MSRB spreads study
WASHINGTON — The Municipal Securities Rulemaking Board's July analysis of declining spreads for muni trades missed the mark, the Bond Dealers of America said in a letter to the board.
BDA Chief Executive Officer Mike Nicholas communicated that sentiment in a letter dated Nov.7. The MSRB produced a study in July concluding that the advent of electronic trading platforms and the increased transparency brought about by regulation have been the driving forces behind an average 51% decline in spreads for dealer-to-customer trades since 2005. The study overestimated the impact of those things and failed to adequately account for wider market factors and dealer intermediaries, Nicholas told the board.
“The BDA believes that a contributing factor to the lower spreads was an overall low interest rate environment, which resulted in lower volatility for market-making firms,” Nicholas wrote. “Equating lower spreads with good execution is an incorrect premise in many instances.”
The MSRB paper, produced by its Chief Economist Simon Wu, posited that increased transparency measures enacted since 2005 such as the launch of EMMA in 2008 and the effectiveness of the best execution rule in 2016 may have especially benefited retail investors. The data showed that the effective spread for trades of $100,000 and less fell 53.7% from 2005 to 2017 for dealer to customer trades, but only 43.8% for interdealer trades of the same size. The spread for trades of more than $1 million was relatively stable, Wu found.
The BDA argued that the historically low interest rates and resulting reduced yields during the MSRB’s sample left less flexibility for higher markups.
“As interest rates moved lower and volatility decreased, this also added to the perceived reduced risk of holding inventory,” wrote Nicholas. “The lower the perceived risk of holding inventory, the lower the need for a higher markup, which equates to lower spreads. If interest rates continue to move higher, as we are currently experiencing, the BDA believes that the average effective spread may stabilize or even increase.”
Nicholas also told the board that dealer intermediaries also probably played a role in the reduction of spreads, because trades running through intermediaries can often show a lower spread but also result in a lower yield for the investor. The report exaggerated the impact of ATSs, though BDA agreed with MSRB that they have brought some additional transparency and efficiency to the market.
In a larger sense, the BDA said, the report failed to evaluate whether spreads have been reduced for the actual individual investor.
“The BDA believes that the report evaluated data based primarily on trades from dealers to investors and has not taken into consideration structured products by investment advisors and others who will purchase municipal securities from a dealer at thin margins and then re-package those municipal securities into structured products. This results in much higher spreads to the end retail investor, which does not take into consideration the ongoing ‘management’ expense related to maintaining the investment for the client,” Nicholas wrote.
The letter, which the BDA said was written after an “extended period of time” working with its membership, concludes by urging the MSRB not to use the study as a basis for rulemaking.
“In conclusion, the BDA cautions the MSRB from using this report as the benchmark for future research and encourages the MSRB to use extreme caution prior to relying on any findings in this report prior to making any final recommendation for future rulemaking,” wrote Nicholas.