Muniland: the big picture (part 2)
Last week I wrote about the size of the municipal bond market and the kinds of investors who are involved in it. This week I thought it would be helpful to explain how municipal bonds are traded.
Most people understand that stocks are traded on exchanges but bonds aren’t. Although bonds could easily trade on an exchange (the New York Stock Exchange already has a setup to do just that), they currently trade “over-the-counter,” meaning that brokers contact each other and trade bonds between them.
This method of trading between dealers can happen on a phone call or fax, through the messaging system of a Bloomberg terminal or through an aggregator platform. These aggregator platforms are very common for fixed-income trading. The SEC publishes an updated list of trading platforms, which are known as “alternative trading systems” (ATS). The regulatory oversight of ATS is very limited when compared with exchange oversight, and they are not required to publish their rulebooks as exchanges are.
According to the Municipal Securities Rulemaking Board there was an average of 36,000 municipal bond trades a day in December 2011 (January ran about 10 percent ahead of that). Municipal bonds are not actively traded — only about 0.2 percent of outstanding bonds trade every day. The most active ATS in the municipal bond markets are:
Retail investors can access some of these platforms through online brokers such as E*Trade and TD Ameritrade. In contrast, institutional-size municipal trades ($1 million and up) would often be handled outside of an ATS by one dealer’s trader calling other traders in the market.
ATS are called aggregator platforms because all the dealers post their municipal bond inventories on them and then the bonds are aggregated into asset categories and maturities. This approach is very similar to the way eBay is structured. Many sellers post their stuff, and then the platform organizes it into searchable content. ATS have built a lot of good tools to help traders fulfill compliance requirements and other bookkeeping functionality. ATS are not “order books” in the same way that stock exchanges maintain continuous bid/offer data for each security. They are much less sophisticated than exchanges and have significantly lower volumes.
For U.S. Treasuries, Credit Suisse made an exciting announcement this week: It is launching streaming trading for institutional investors. This is much closer to an exchange model, and it will be interesting to monitor its development. It could be a big breakthrough for bond trading.
Most bond trading is now done electronically using the FIX Protocol, the same language as that used in high-frequency stock trading. It’s used globally for all major financial asset classes (except derivatives and structured products). Here is the official description:
The Financial Information eXchange (“FIX”) Protocol is a series of messaging specifications for the electronic communication of trade-related messages. It has been developed through the collaboration of banks, broker-dealers, exchanges, industry utilities and associations, institutional investors, and information technology providers from around the world. These market participants share a vision of a common, global language for the automated trading of financial instruments.
Electronic trading for fixed income has slowly been gaining ground since 2000. The ATS Tradeweb was the first to implement it for institutional trading. In 2002 I co-edited a FIX Implementation Guide, which explains the basics of moving trading to an electronic platform. Firms around the world have moved trading to electronic platforms. Maybe the next step is to move bond trading to exchanges.
In the next big picture installment I’ll address how municipal bonds are issued.