Embracing the Future, the Municipal Bond Market Moves to Best Execution

Embracing the Future, the Municipal Bond Market Moves to Best Execution

By Carl Tugberk, Municipal Securities Rulemaking Board
Originally published on the TabbFORUM

The rise in electronic trading is changing the way customer orders for municipal bonds are executed. The MSRB remains mindful of the introduction of new technologies and changes in market structure that may affect the quality of executions. A flexible best-execution standard that accommodates both old and new execution methods is an important new protection for retail investors.

Financial markets are dynamic, constantly changing with the evolution of market practices and the advent of new technology. These business-driven changes often coincide with shifts in the regulatory landscape. For the $3.8 trillion municipal bond market, the implementation in 2016 of an explicit best-execution rule for transactions in municipal securities is representative of significant changes occurring in this market. The rise in electronic trading is changing the way customer orders for municipal bonds are executed. A flexible best-execution standard that accommodates both old and new execution methods is an important new protection for retail investors, who hold approximately 42 percent of municipal bonds outstanding, according to June 2017 Federal Reserve data.

The Municipal Securities Rulemaking Board, the market’s self-regulatory organization, adopted the best-execution rule to protect retail investors, promote fair competition and improve market efficiency. The rule is tailored to the specific characteristics of the municipal market but generally harmonized with the Financial Industry Regulatory Authority’s corresponding rule for best execution in the equities and corporate debt markets to create regulatory efficiency.

Due in part to the large number of issuers (approximately 50,000) and the correspondingly large number of outstanding securities with unique characteristics (about 1 million), the municipal bond market is an over-the-counter market that is complex and fragmented. It has substantially less trading activity than the equities and corporate debt markets. Daily trading volume in municipal bonds averages $11.1 billion, compared to an average $273 billion in the equities market and an average $30 billion in the corporate bond market (Trading activity during 2016. Sources: MSRB and SIFMA).

The best-execution rule takes the municipal market’s characteristics into account, requiring dealers to use reasonable diligence to ascertain the best market for a security when trading on behalf of or with a customer, and to buy or sell the security in that market so that the resulting price to the customer is as favorable as possible under prevailing market conditions. The rule provides a non-exhaustive list of factors (e.g., the character of the market for the security, including, for example, price, volatility, and relative liquidity; and the number of markets checked) that dealers must consider when exercising this diligence. Transactions for or with institutional investors, who qualify and choose to be treated as “Sophisticated Municipal Market Professionals” under MSRB rules, are exempt from the rule. In general, a dealer can comply with the reasonable diligence standard by developing, following and maintaining reasonably designed policies and procedures for the handling of customer orders.

The MSRB designed the best-execution rule as a principles-based rule to provide flexibility to allow dealers to satisfy their obligations in different ways, and to allow for changes in market structure and the evolution of applied technology. Because of its specialized nature, the municipal market has not adopted electronic trading as quickly as the corporate bond market. However, there are now several electronic trading platforms or alternative trading systems (ATSs), which are widely used throughout the industry. The MSRB collects data on the penetration of ATSs in the municipal market, reporting that 60 percent of inter-dealer trades and 30 percent of inter-dealer par amount traded occurred on ATSs during the 12 months ended September 30, 2017. In the same time period, 7 percent of inter-dealer trades and 20 percent of inter-dealer par amount occurred through broker’s brokers. Moreover, about 90 percent of trades were transactions below $100,000 – a strong indication that these platforms are serving retail investors.

By aggregating liquidity from many sources and offering tools to efficiently sort and find municipal bond bids and offers, ATSs and other electronic trading platforms provide dealers additional options to comply with the best-execution rule, which may create efficiencies and improve the quality of executions for retail investors. As the availability of electronic systems that facilitate trading in municipal securities increases, dealers need to determine whether these systems might provide benefits to their customer order flow, particularly retail order flow. Yet the MSRB recognizes the continued use of voice brokering in the municipal market and broadly defines the term “market” in the best-execution rule to encompass a variety of different venues – ATSs and other electronic trading platforms, broker’s brokers, other counterparties and a dealer itself as principal. The flexibility in the rule helps promote fair competition among dealers, ATSs and other venues that may emerge.

The flexibility in the rule is not limited to accommodating the diversity of trading practices and venues that exist in today’s municipal market, but is also forward-looking. The requirement that dealers conduct at least annual reviews of their best-execution policies and procedures not only supports ongoing compliance with the rule but also ensures that the rule can evolve with future innovations in the market. For example, a dealer’s policies and procedures might currently require the use of real-time trade prices and other information available on the MSRB’s Electronic Municipal Market Access (EMMA®) website to determine the character of the market for a security, and the checking of a particular ATS and/or broker’s broker prior to executing a customer order or handling a customer inquiry. However, when assessing whether those policies and procedures are reasonably designed, dealers must consider, among other things, changes in market structure, new entrants, the availability of additional pre- and post-trade data, and the availability of new technologies. As an aspect of this review, dealers should review the execution quality provided by the various markets they choose to use (including the internalization of order flow), and, to the extent information is reasonably available, assess the execution quality of other markets to determine whether to use them.

The MSRB recognizes that the municipal bond market continues to evolve and that regulations should be elastic enough to adapt without the need for constant rewriting. The broad definition of “market” in the MSRB’s rule keeps the requirement business-model neutral and accounts for the projected growth of electronic trading in the municipal market as dealers look for additional efficiencies to comply with the rule. Like investors and other market participants, the MSRB remains mindful of the introduction of new technologies and changes in market structure that may affect order-handling practices and the quality of executions for retail customer transactions.

Carl Tugberk is Assistant General Counsel at the Municipal Securities Rulemaking Board, the self-regulatory organization for the municipal securities market.

Originally published on the TabbFORUM

This column does not necessarily reflect the views or opinions of FinReg Alert or Tradeweb Markets LLC.