WASHINGTON - The advent of electronic trading platforms and the increased transparency brought about by regulation are the likely drivers behind an average 51% decline in spreads for dealer-to-customer municipal securities trades since 2005, according to a paper released by the Municipal Securities Rulemaking Board.

The paper was authored by MSRB Chief Economist Simon Wu and was released by the board Wednesday.

The paper says spread "is a common measure of transaction costs paid by investors to execute their trades and is one barometer of financial market liquidity for economists."

"In the context of this analysis, the effective spread is calculated as the difference between the price a selling investor receives for a security and the price a purchasing investor pays, with dealers acting as intermediaries assisting the purchasing and selling," Wu wrote. "The spread therefore also represents the gross compensation received by dealers — known as a mark-up/mark-down in the securities industry — for providing liquidity."

"In the municipal bond market, actual transaction costs incurred by investors can also include brokers’ commissions for a small percentage of agency-based trades," he added.

While the trend of declining spreads has made the muni business less profitable for broker-dealers, Wu said that the average spread’s drop to 73 basis points in April of this year from 153 basis points in 2005 signals a more efficient market.

“Our analysis shows that effective spreads have fallen substantially since 2005 for customer trades of less than $1 million par,” said Wu. “We found that while bond characteristics, such as percentage of insured bonds, average yield and average trade size, had an impact on the declining spreads, it was likely MSRB regulatory activities, transparency initiatives and advancements in trading technology that drove more than half of these changes.”

Wu’s data did not include variable rate bonds, and he performed a regression analysis to control for differing characteristics of the pool of munis outstanding over the more than 13-year period of the study: from 2005 through April 2018.

The paper analyzed shrinking spreads by trade size. Wu’s analysis showed that the decline in effective spread has been largest for trades of $10,000 par value or less, while the $10,001 to $25,000 group also showed a “dramatic decline.” These size trades approached a 60% spread decline over the period of the study. The spread for trades sized between $25,001 and $100,000 decreased by 46%. For trades between $100,001 and $1,000,000 the spread fell 34%.


Trades over $1 million, by contrast, have had a relatively stable effective spread over the years.

The paper posits 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 benefited retail investors more than institutional investors because institutional investors tend to be more well-informed to begin with. The data showed that the effective spread for trades $100,000 and below fell 53.7% from 2005 to 2017 for dealer to customer trades, but only 43.8% for interdealer trades of the same size.

“This is not to say that the recent transparency initiatives have not benefited dealers themselves, but likely at a much lower degree than retail investors,” Wu wrote in the paper.

Electronic trading and alternative trading systems (ATSs) changed the market landscape, according to the study. Rather than rely on a brokers’ broker doing business by telephone, market participants can now use an ATS to search for counterparty liquidity. Nearly 60% on interdealer trades in the municipal market are done via an ATS, according to the paper.

“The ATS and other technological advancements have greatly improved the efficiency of trading and likely reduced the counterparty search costs, potentially passing the savings onto investors,” Wu concluded.

The paper contained suggestions for further study. Wu noted that MSRB requirements for dealers to disclose their markups in certain transactions went into effect on May 14, and suggested a future analysis of spreads in light of that significant development.

“Furthermore, as a potential separate study in the future, it might be useful to conduct a cross-sectional analysis examining the effective spread differential across municipal securities (CUSIP numbers) based on a variety of bond characteristics, such as new issue securities, trading volume, issue size, issue structure, types of securities, maturity, etc.,” Wu wrote in the paper.

He added that the more efficient market may lead to reduced borrowing costs for municipalities, “since investors’ required rates of return will reflect the lower costs of transacting in the municipal bond market.”

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