Online Exchanges: Munis are Net-exempt no more

The recent emergence of several alternative trading systems is causing the same sorts of tremors in munis that equities, derivatives and foreign exchange, as well as other types of fixed-income securities, have already experienced.

It took a while for the Internet to upset the status quo of municipal bond operations. But the recent emergence of several alternative trading systems is causing the same sorts of tremors in munis that equities, derivatives and foreign exchange, as well as other types of fixed-income securities, have already experienced.

By David S. Ortiz
December 2000
Institutional Investor Magazine

Suddenly, a host of Wall Street firms and technology providers are racing to update and streamline what was long regarded as a back-office backwater. In the $1.5 trillion tax-exempt segment, two groups of major institutional firms are competing to deliver centralized trading platforms. And those consortia are far from alone in a bond market modernization sweepstakes affecting everything from order placement to the backroom holy grail of straight-through processing.

Fixed-income securities, already highly standardized and electronic, are ideally suited for online trading. Munis , a market half the size of U.S. Treasuries , were the last to attract technologists, attention, but they are making up for lost time. It could even be a case of overexuberance; there may not be room for everybody.

“When we consider a $1.5 trillion market, we,re not surprised that there would be a variety of players,” says Bradley Wendt, president and chief operating officer of BondDesk.com, one of the leaders of this thundering herd.

Formed a year ago by software developer BondExchange, Goldman Sachs Group, PaineWebber Group and Spear, Leeds & Kellogg, BondDesk runs MuniGroup.com, which is seeking to control the top of the muni-clearing hierarchy.

Its chief rival is TheMuniCenter, founded by Merrill Lynch & Co., Morgan Stanley Dean Witter and Salomon Smith Barney. MuniCenter CEO Thomas Vales and Wendt both say that the competition will be beneficial, improving the muni market’s pricing mechanisms and overall efficiency. “Any attempt for greater transparency and broader distribution is a positive,” says Vales.

But on the flip side, as is evident in the proliferation of alternative trading venues for equities, is the risk of fragmentation that dilutes liquidity. Already, there is talk of a convergence mirroring the consolidation of Wall Street firms themselves. (Muni-Group supporters Goldman and Spear Leeds recently merged, and PaineWebber is combining with UBS.)

Indeed, the muni market is poised to test a pet theory of Federal Reserve Board chairman Alan Greenspan. As he said at a Federal Reserve Bank of Atlanta conference in October, “Two or more venues that are trading the same security or commodity will naturally converge toward a single market.”

Contestant No. 1, MuniGroup, came on the scene in March, when Bear, Stearns & Co., Goldman Sachs, PaineWebber and Susquehanna Partners announced this multidealer initiative to improve efficiency, liquidity and price transparency. In August MuniGroup merged with and became the municipals arm of BondDesk, a fixed-income technology company that supplied MuniGroup’s infrastructure. The BondDesk system went live in October.

MuniCenter, unveiled in May, proceeded in stages (even now bids are phoned in, offers are made electronically) while MuniGroup worked on its BondDesk merger. The race remains wide open, but clearly the big Wall Street names are convinced the stakes are worth fighting for.

MuniCenter’s Vales says Merrill, Morgan Stanley and Salomon “are among the strongest players in the industry.” They account, he notes, for 30 percent of municipal underwriting volume and can marshal a distribution force of 40,000 brokers.

Wendt counters that MuniGroup gets all the credibility and liquidity it needs through Bear Stearns, Goldman and PaineWebber. “Those three national firms account for approximately 20 to 25 percent of the long-term new issuance annually,” says Wendt, 45, a former Goldman Sachs managing director who oversaw muni capital markets. The tie-in with BondDesk expanded the venture’s participating firms to 26; 15 own equity stakes in BondDesk.

In a nod to retail investors, MuniGroup is building an educational Web site to cover the basics of municipal bonds, provide industry news and offer investment tips. But Wendt asserts that unlike brokerage sites geared to individuals , such as E*Trade, DLJdirect and MuniDirect.com , MuniGroup will remain a “100 percent B2B,” or business-to-business, platform. “The Internet allows us to create this reach all the way from the very large firms to the local broker-dealers who will be the distributors,” says Wendt.

The B2B commitment is just as strong at MuniCenter because, says Vales, “there are too many regulatory issues involved in B2C,” or business-to-consumer. More than 100 firms are actively trading on the site, and “we,re trying to establish relationships with every dealer out there, from the smallest to the largest firms.”

MuniCenter’s fourth founding equity partner, interdealer brokerage Chapdelaine & Co., is supplying crucial client support in the form of 65 telephone brokers.

“There are over 70,000 issuers of municipal bonds,” explains Vales, 36, a former Bankers Trust Corp. managing director of fixed-income arbitrage. “And these are very complex securities. A lot of the bonds have stories that need to be told , the kinds of things you need human interaction for. That should be very helpful to the traders.”

The heft of MuniGroup and MuniCenter isn,t deterring others from jockeying for position , not even those groups, principals. Placing a slightly different bet, Goldman, Merrill and Morgan Stanley in June announced BondBook, an anonymous electronic marketplace for both corporates and munis, with a projected fourth-quarter start date. Looking internationally, those institutions and others announced a Tokyo-based venture with Italian brokerage MTS for electronic trading of Japanese government bonds.

Muniversal.com of Newton, Massachusetts, has signed more than 150 institutional investors and broker-dealers to its real-time, anonymous site, which awaits regulatory approval, says CEO Elizabeth Jick. Muni bond firm M.R. Beal & Co. is trying to link with other dealers to fire up MuniBEX.com, which it hopes to launch by the first quarter of 2001. “We,re talking with major and regional dealers about joining as consortium members,” says Keith Golden, vice president of strategy and compliance at MuniBEX.

Walnut Creek, California,based eBondTrade, which started its online muni brokerage in January, is posting an average inventory of $75 million, has registered 10,500 accounts and closed bond sales totaling $2.6 billion through October, says CEO Richard Meister. Although Meister pits eBondTrade and its liquidity potential against the big investment banks, trading platforms, he also serves an online retail clientele, albeit through brokers or financial advisers.

Marilyn Cohen, president of Los Angeles,based bond investment firm Envision Capital Management and co-author of a handbook called The Bond Bible, says: “The institutions ultimately represent the individual investor, and the more that these groups get cranked up and going, the more we,ll see live offerings online. If that gets the individual better prices, bravo.”

The gathering crowd raises questions about how many networks are needed to make an efficient marketplace. The various trading platforms, overlapping ownerships or participants might naturally press for rationalization. The profitability of the municipal bond business is perennially under pressure, and many experts expect bond issuance to decline as state and local governments balance budgets and turn infrastructure projects over to the private sector.

Because B2B technology is inherently adaptable, consolidation’s effects could go beyond munis. MuniCenter, for one, plans to expand into U.S. Treasuries shortly and into agencies and corporates later. And eBondTrade has high-grade corporates and governments, among other things, on its drawing board. But Meister says, “First, we have to focus on getting the business we,re in done right.”

Munis aren,t on the front burner for two-year-old TradeWeb. With average daily volume in Treasuries of about $7 billion (of the total market’s $209 billion), the company’s expansion priorities tend toward corporates, commercial paper and, through a London subsidiary, European sovereigns.

“Two or three years from now, the majority of business will be done on two or three platforms across most fixed-income products,” predicts Jim Toffey, CEO of TradeWeb, which bills itself as “the first online bond market,” with Deutsche Bank, Goldman and Merrill among its equity owners. “What will divide the winners from the losers will be who’s got the liquidity.”

Meanwhile, Trading Edge, which began handling high-yield issues through its BondLink platform in April 1999, opened an electronic muni desk in August. “Treasuries is a well-served market. We knew the benefits of BondLink , anonymity, transparency , were better for the inefficiencies of the muni market,” says Murray Finebaum, chairman and CEO of Trading Edge, which counts among its backers and partners Brentwood Venture Capital, Capital Z Partners, Credit Suisse First Boston and MBIA Insurance Corp.

Joseph Sack, a senior vice president at the Bond Market Association, says that it is too soon to discern the outlines of any shakeout. The BMA, which counts 68 electronic trading platforms in the U.S. and five more in Europe, formed a special task force in July to study the implications of electronic munis. “Most of these systems are just now in the process of launching,” Sack says, adding that “2001 will be a telling year with regard to future development, to what share of the marketplace they will get.”

By the standards of other online markets, muni players still have much to sort out. But given the Internet’s ability to accelerate the pace of change, these efforts should start to make a lot more sense in a matter of months.

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