While many muni market participants are ready for the expansion of electronic trading, progress has been slow. Despite this, many in the market see near-term room for growth due to the greater need for efficiency and liquidity, along with the emergence of artificial intelligence.
Unlike the corporate bond market, which saw electronic trading significantly increase in 2022, the implementation of electronic trading has remained relatively stagnant in the muni market.
Around 14% of muni bonds traded electronically in the fourth quarter of 2022, up three percentage points from the second quarter of the same year, according to estimates from Coalition Greenwich.
While these figures show "that e-trading kept up with, and in some cases surpassed, the market's volume surge … the market overall continues to buck the electronic trading trend that has for the last decade taken over government and corporate bond markets," wrote Kevin McPartland, head of market structure and technology research at Coalition Greenwich, in a March 2023 report.
Various factors continue to impede the widespread adoption of electronic trading in the muni market, according to market participants.
"If you look at the Treasury market or the corporate market, where there are much fewer CUSIPs, many more markets with multiple players on both sides on the bid and offer side, those lend themselves to a quicker adoption of electronic trading," said John Bagley, the Municipal Securities Rulemaking Board chief market structure officer.
But unlike the Treasury and corporate markets, McPartland said, one million CUSIPs and very regional demand for munis "certainly complicate the move to the screen."
While the muni market has embraced electronic execution over the last several years, the same cannot be said for truly automated trading, said William Roach, a senior trader at Macquarie Asset Management.
This is due, in part, to the stratification of the market, as market structures and the number of securities make it more difficult to get reliable data, he said.
Since most bonds trade infrequently, he said, the reliability of pricing can be a challenge at times.
Some worry that the implementation will result in the reduction or elimination of jobs.
"It's human nature to fear that automation will make roles vulnerable," said Peter Borstelmann, president of ICE bonds.
"But that's a misconception, as the introduction of automation can make those individuals that much more efficient and gives them capacity and scale to focus their attention on higher-yielding trading opportunities," he said. "And if you can improve the liquidity and depth of the market, as well as who you can trade and interact with, it can create even more opportunities within the municipal space."
Over the past decade, the muni market has "experienced significant changes in market structure and how participants access the market," according to a November 2021 MSRB report by Bagley and Marcelo Vieira.
This includes "the development and proliferation of electronic trading and algorithmic and proprietary trading [and] liquidity aggregation tools," they said.
Together, they said, these changes led to an "increased use of external liquidity for transactions of $100,000 or less."
For smaller transactions, Bagley and Vieira said, "electronic trading created liquidity for most customer buys and sells together, predominantly through bid-wanteds or request for quotes."
For customer purchases, they said, "electronic trading efficiently aggregates tens of thousands of offerings and provides tools to help financial professionals and individual investors efficiently sort offerings to identify potential purchases."
"Given the focus on market spreads and the desire to do more with less, electronic trading is helping [portfolio managers] and traders meet the demands of an ever-changing market," said Daniel Kelly, head of municipal bonds at MarketAxess.
In other asset classes, there has been more transparency, activity and efficiency due to electronic trading, he said.
The muni market has been behind in realizing how beneficial electronic trading can be, Kelly said.
"We are seeing people take learnings from their experience in electronifying the Treasury and corporate space over to munis, where they can introduce efficiency and scale," Borstelmann said.
"As things start to electrify, it becomes very difficult to compete without running your business much more cost effectively, and a way you could do that is through automation and electronic trading," said Marty Mannion, former co-CEO of Headlands Tech Global Markets and current managing director and co-head at TD Securities Automated Trading.
Therefore, firms, in order "to keep up with all these offerings that are out there and readily available and changing in the marketplace" have to get more efficient, Bagley noted.
AllianceBernstein, for instance, launched an in-house liquidity aggregator ALFA in 2016, which was a way to scan the market. In 2019, the firm launched its order and execution management system AbbieX with multiple connections, said Susan Joyce, head of municipal trading and fixed-income market structure at the firm.
"We already had this data layer and so we saw that there is a real opportunity here in the municipal market to engage electronically," she said.
"We scan the entire market," she said. "Everything that is a potential opportunity, so whether items are out for the bid or being offered, and then we consume that information, we match it up against our [approximately] 24,000 accounts and we will build orders based on those opportunities as well as the trades we try to do if those trades meet a certain threshold," she said.
The firm chose to expand its capabilities to include electronic trading after seeing a gap in the market.
"When you have one million CUSIPs, 50,000 issuers and the average [separately managed account] can take upward of 50 to 60 days to build a portfolio, we thought we could do it better," said Daryl Clements, a municipal portfolio manager at AllianceBernstein. "We thought there was a way that we could provide a better outcome for our clients and we've been able to do that through better execution and through investing portfolios."
Like AllianceBernstein, other firms, especially through the start of the pandemic, have started working toward electronifying their workflows, including smaller trades, like round lots and even some block trades, Borstelmann said.
While it's still taking some time, ICE has seen a "sharp rise" in algorithmic trading for munis, especially from providers.
Investment into algorithms also continues to grow from both traditional banks and non-traditional liquidity providers, he said.
Some firms that have been strong in the corporate space are taking that expertise and transferring it to munis, working to ensure that their capabilities are providing perspective and their algorithms are robust.
More than half of ICE's top 10 liquidity providers from a municipal perspective come from "algorithmic shops who are putting a lot of focus into the technology and the data necessary to have a reliable algorithm on a day-in, day-out basis," Borstelmann said.
AI and munis
Algorithmic trading, which falls under the broad term of AI, has had a positive impact on electronic trading.
Algorithmic trading "allows both buy-side and dealers to provide a quicker price, and their processes learn from that price, they learn from execution," said Steve Winterstein, managing partner at SP Winterstein & Associates.
"It's a virtuous cycle of liquidity," he said. "The more algorithmic traders you have, the more liquidity providers you have, [and] the more liquidity providers you have, the more fluid the market becomes."
However, market participants agree it's too early to tell how AI — which includes natural language processing and machine learning, along with algorithmic trading — will specifically impact electronic trading.
That being said, John Cahalane, managing director and head of Tradeweb Direct, said, "the buzz around machine learning and AI certainly has muni market participants looking for new applications, and one of the areas we view as being ripe for disruption in muni bond trading is pricing."
In a marketplace as segmented as munis, "machine learning can assist participants in the creation of real-time quotations that will allow market participants to price more securities in a more accurate and timely manner," he said.
Tradeweb, for example, provides clients with a tool called Ai-Price for munis, which gives "enhanced price discovery and reliable pricing levels regardless of how often muni bonds trade," according to Cahalane.
Dealers have invested in this technology for several years and "now, as in other markets, those individuals who created some of these early models are moving to buy-side firms to help those firms go from being liquidity takers to having a more holistic ability to make and take liquidity," he said.
Overall, Winterstein said, he expects AI to take hold in the marketplace in three to five years.
It will be an evolutionary process where there will be specific applications in certain areas of the market, and "once that has a chance to blossom and become useful, it will work its way into other areas of the market," he said.
Despite the slow implementation of electronic trading, progress is being made.
"All of the electronic venues are having success in varying degrees, but they're all growing market share," Winterstein said. "The pie is so big, and penetration of electronic trading is so low, that there's going to be a lot of room for growth."
In the past two years, Kelly said, "the volume across trading platforms has grown so much," and he expects these trading patterns are here to stay.
"A topic that comes up in almost every conversation with clients, with asset managers is, 'What are other people doing? What are ways in which we can improve the execution workflow? Are there ways to connect to you electronically?'" Mannion said.
"When things start to automate, it only goes in one direction," he said. "We're not going to end up with a world like equities where the majority of the market trades mostly electronically, but it's somewhat inevitable that you'll see greater adoption."
