What purpose does minimum denomination serve in municipal bonds today?

Denomination — the face or “par” value of a financial instrument— is an artifact of finance’s paper-based origins.

Example: Overpriced Coffee

Denomination remains a vital concept in transactions involving physical currency. It’s easy to understand the fundamental role denomination plays in an example activity most of us do almost every day in downtown San Francisco: buy a $4.50 cup of coffee. At checkout, we can either:

  1. Pay with cash. In this method, denomination is essential. We could break a $10 bill. We could pay with four $1 bills & two quarters. We could pay with 450 pennies to ruffle some feathers, or we could pull out a couple of $2’s & a half dollar piece to really blow some minds. Point is, if we choose the cash method, we rely on denomination.
  2. Pay with card, most likely via Square. What’s the denomination in the electronic method? If there even is one, it’s $0.01, but even that’s flexible if you’ve ever seen Office Space. A better question: how often do we wonder whether Square took one $5 bill or five $1 bills from our digital “wallet”? Probably never, since Square’s software does all the work for us. In this digital method, the concept of denomination seems…irrelevant.

What About Bonds?

Denomination played a vital role in the evolution of the municipal bond market. For the better part of two centuries, borrowing communities issued municipal bonds using certificates — pieces of paper that stood for the value of the investment. Physical bonds were most commonly denominated at $1,000, though thousands of communities throughout the US issued bonds in other denominations, such as this $500 San Francisco bond.

500 San Francisco Bond

But not long ago, just about every borrowing community in the $1 billion per day primary market converged on $5,000 as the standard denomination of bonds. Though some market professionals still use $1,000 (or Bond with a capital “B”) as substitute terms to talk about orders, even if the specific deal in question is technically denominated at $5,000.

In 2016, nearly 100% of all municipal securities are sold, bought, and traded electronically, through a system known as book-entry. In our coffee analogy, the municipal bond market operates as if no one uses cash to pay.

So what purpose does minimum denomination serve in municipal bonds?

Protection…

As a matter of practicality, denomination used to enable transactions. Now it remains as a regulatory device with the ostensible purpose of protecting low net worth investors from risky investments. Preventing many, or in some cases most, buyers from buying bonds directly.

Yet the efficacy and real intention of minimum denomination has long been questioned, even when denomination was necessary to transact. Louis Brandeis argued against high denomination more than a century ago:

Other People's MoneyCh 6. Other People’s Money (Brandeis) 1914

Who decides?

In a new bond issuance, the borrowing community gets to decide what denomination should be, by defining it in the bond document. But most just stick with the current default of $5,000. In the present market, most borrowing communities work with public finance professionals to borrow money, who have not much incentive to explain that denomination can be whatever the community wants. As a result, very few new issuances come to market in something other than $5,000 denominations.

Two notable recent exceptions:

$1000 Bond

Vermont’s $1,000 Citizen Bonds help the State find local buy & hold investors

Denver Mini-Bond

Denver’s $500 “mini-bonds” were a crowd favorite

How many more investors could buy a $500 bond than could buy a $5,000 bond? What if that $500 bond was tradable, and technology made that trade so efficient that the cost to trade makes economic sense? It’s not so far-fetched when you look at the stock market, where apps like Robinhood bring $0, nearly instant stock trades to your phone.

Why Not?

We asked various market participants why it would not make sense to issue bonds at denominations lower than $5,000. Answers fell into four basic categories:

  1. Administrative burden — too much hassle managing high volume of small orders
  2. Bad unit economics — clearing costs and associated fees to process orders mean small orders are break even, or money losers
  3. Not worth the effort — increased demand and liquidity would not be significant relative to deal size
  4. Lack of suitability — anything lower than $5,000 invites investors who might not be suitable purchasers based on income or other factors

Technology solves points #1, #2, and #3:

  • Thanks to software, administrative work for 10,000 orders @ $100 each = 10 orders @ $100,000 each.
  • Clearing costs & fees associated with buying / selling / trading municipal securities continue to fall, and will collapse in the next few years. The same collapse of equivalent costs in equity securities (now fractions of a penny, milliseconds) will occur for fixed income securities like munis (currently > $10, days).
  • The global bullhorn of the internet serves as a force multiplier for reaching far larger audiences than the tombstone ads of yesterday.

And point #4 should be challenged. Please consider that the average American has less than $1,000 in savings. With it, he can:

  • go to almost any gas station and unload his entire fortune on lottery tickets. This is legal, even somewhat socially accepted, since a portion of the proceeds will maybe fund a public school somewhere in his state.
  • Now that the JOBS Act Title III is in full effect, he can invest as little as $100 in a startup business that, despite best efforts and intentions, is statistically more likely to fail than to succeed.

Yet, because of the unnecessary barrier of minimum denomination, he cannot invest in the school down the street from his house, even though it has a more direct impact on his life, and a far higher probability of realizing direct financial returns on his investment.

Why not a maximum denomination instead? We believe there are many reasons to let people invest:

  • The ability to directly invest in one’s own community, even if not wealthy, is a big part of what made this nation great. That kind of direct financial connection to place makes a difference in countless ways.
  • More participants = better pricing & greater liquidity for all.
  • Communities need a diverse investor base moving forward.
  • Low denomination opens the chance to finance smaller projects using as much local capital as possible.
  • People want this, as proven by the successful “mini-bond” offerings from cities like Denver in recent years. We believe that demand for such direct local investment opportunities will continue to increase as JOBS Act Title III reshapes our thinking about how we allocate savings.

Worth Thinking About

A quote from Rear Admiral Grace Hopper on the wall of @iconews #DPD2014 pic.twitter.com/3jwxmOH4Ft

— ICO (@ICOnews) January 28, 2014

Grace’s quote reminds us to think critically about why we do things the way we do, an important exercise as our society undergoes the greatest economic, social and technological transformation in its history. But it’s not entirely fitting in this case, since the municipal bond market grew up on denominations far smaller than today’s de facto $5,000 minimum denomination. Worth thinking about as we advance into a new chapter of our society.