The benefits of greater competitor and reduced spreads that have accompanied regulatory changes in the U.S. equity markets have not yet translated to the municipal bond markets.

Since passage of the SEC’s Order Handling Rules in 1996, which allowed investors to transact directly with each other without a dealer in the middle of the trade, spreads between buyers and sellers have sharply tightened.

“Unfortunately, no such mechanisms exists for the municipal securities markets,” said Jason Lehman, founder and co-CEO of Headlands Technologies, a quantitative proprietary trading firm, at the SEC’s fixed income roundtable earlier this month.

Prior to founding Headlands, Lehman worked in several fixed-income businesses at Citadel, and has been an active investor in the municipal securities markets for over a decade.

“I have devoted substantial time to understanding the intricacies of municipal security prospectuses, financial data, brokerage platforms, and trading environments,” he said. “My experiences both as an active investor and financial professional have shown me that there is significant room for improvement in the structure of the municipal securities markets.”

The problem in the municipal fixed income markets comes down to size. There are simply too many names.

“There are over a million outstanding CUSIPs,” said Marshall Nicholson, president at Knight BondPoint. “If you combine all the ATSs, they are offering about 60,000 CUSIPs, or about 6-7% of the marketplace.”

Still, this is a step in the right direction. Knight BondPoint has made arrangements to make its bond trading data available to retail investors via financial portals.

Knight BondPoint is an ECN and applications provider to the retail bond market. Its electronic trading platform links more than 300 broker dealers to 100,000 live and executable bids and offers.

“We provide the bond offerings off of BondPoint to those platforms,” Nicholson said. “One of them is recording over 20,000 searches per month, so there is value in that data.”

Lehman said there are three potential areas for improvement. First, transparency in the marketplace should be enhanced. Second, a reasonable best execution standard should be introduced. Third, customer limit order display and protection should be mandated.

The default goal for any marketplace should be full transparency. Limitations on full and equal access to pre- and post-trade information should be reserved for cases where there are overwhelming compelling mitigating factors.
“I see no reason not to make all pre-trade information available to all participants,” Lehman said.

Specifically, this includes all firm bids and offers, indications of interest, and RFQs, from every market participant. This information could be provided through an ATS, or alternately, it could be distributed centrally.

Additionally, ATSs should be required to provide fair and equal access to their marketplaces. Brokers should be required to offer customers the option of displaying their orders on these platforms in order to promote fairness in the marketplace.

“The benefits of transparency include increased investor confidence, tighter spreads, and reduced transactions costs for the public,” said Lehman.

Municipal bond brokers should be required to abide by reasonable “best execution” standards.

“Best execution standards require brokers to seek to obtain the most favorable terms for their customer,” said Lehman. “These standards need not mandate a specific venue or even price for execution; the goal simply is to ensure that adequate due diligence is exercised when executing a customer order.”

There is a critical need for a mechanism whereby a retail investor can place a limit order that is displayed to the entire marketplace. “Currently, the only outlet available to a retail investor looking to sell a bond is a principal bid from a dealer,” Lehman said. “A customer limit order could be displayed to the market through an existing ATS. Brokers and dealers must then be required to avoid trading through a customer limit order.”