Electronic trading has caused more broker-dealers to use external liquidity to execute municipal bond transactions under $100,000.
That was the takeaway from the Municipal Securities Rulemaking Board’s Thursday report examining trends in internal and external liquidity since 2011. External liquidity is defined as “when a customer purchase or sale is filled using the offering or bid of a different and unqualified dealer than the client’s dealer,” the MSRB said.
Between the years of 2011 and 2020, the use of external liquidity for transactions under $100,000 in the municipal bond market increased to 42.4% of trades from 30.2%. For transactions of $1 million or more, the use of external liquidity decreased to 13% from 16.3%.
Customer transactions completed on any day other than the day the dealer bought or sold the position are considered to be internal liquidity, because “the dealer held a position overnight, incurring additional risk and cost to finance the position,” the MSRB said.
“I think it shows that the market is becoming more efficient and more competitive,” John Bagley, chief market structure officer for the MSRB and co-author of the report said of the findings. “There's more dealers doing a significant amount of external liquidity business. I think that they have made the market more competitive.”
Plus, “The ability to aggregate liquidity both for offerings and for responses to bids wanted, has continued to improve since 2011,” Bagley said.
The proliferation of electronic, algorithmic and proprietary trading, in addition to liquidity aggregation tools have transformed the way that dealers and individuals access and trade on the municipal bond market. But as the changes in format have caused an increase in the level of external liquidity transactions for trades under $100,000, the players have also changed.
“In 2011, the providers of external liquidity were dominated by large wealth management firms with large numbers of individual investors,” the report said. “In 2020, the providers of external liquidity were almost evenly divided between national firms and firms that have little or no individual investors and whose business model is to make markets on a wide variety of bonds on various trading platforms in order to capture order flow for customer purchases and customer sales for odd-lots and smaller block positions.”
According to Bagley, this shift was a “significant change” as these new entrants to the muni market have grown their market share significantly as the market for providing external liquidity becomes more concentrated into fewer hands. In 2011, the top three, five and 10 dealers providing external liquidity accounted for 18%, 26% and 42% of all liquidity by number of trades. By 2020, those numbers had increased to 23%, 31% and 45%, respectively.
There has also been a decrease in the number of firms providing external liquidity, as in 2011, 734 firms had completed at least one trade and in 2020, that number decreased to 518. But the number of transactions has increased slightly, as firms with 500 or more trades in a year increased from 150 in 2011 to 156 in 2020.
“This trend is consistent with previous MSRB findings showing that while the number of registered dealers declined, the vast majority of the firms exiting the market did not have a significant presence in the market,” the report said.
Those findings are also reflected in the board’s
The paper focuses mostly on smaller size trades for the years 2011, 2015, 2019 and 2020, that is, with a value of $100,000 or less. In 2011, the use of external liquidity accounted for 30.2% of the all transactions, rising to 35% in 2015 and again to 43.6% in 2019, then to drops off in 2020 to 42.4%, despite these transactions rising significantly during the first few months of COVID-19 related volatility (45.1% in April and 44.5% in July 2020).
But the report paints a different picture for transactions over $1 million as the use of external liquidity averaged 16.3% in 2011, jumping to 19% in 2015 then decreasing to 12.4% in 2019 and 13% for 2020.
“If the market disruption in 2020 impacted the use of external liquidity for larger transactions, it was less evident in March and April than the impact on smaller transactions as noted earlier, although the use of external liquidity increased to 14.7% in the last six months of the year,” the report said.
The use of external liquidity in 2020 decreased as the size of the transactions grew, as they accounted for 14.1% of trades between $1 million and $2.5 million, 9.8% for trades between $2.5 million and $5 million, 8.1% for trades between $5 million and $10 million and 3.6% for trades over $10 million.
But for smaller transactions, external liquidity was still increasing as market dislocation began.
“When the dislocation was at its peak in 2020, the use of external liquidity for smaller size transactions actually increased a good amount for customer purchases and basically stayed about the same for customer sales,” Bagley said. “That showed us that even though the market dislocated, there was still a good amount of external liquidity for helping clients either buy or sell bonds.
