PrefBlog

This seems to be a hot topic, so I’ll post a reference to Transparency and the Corporate Bond Market by Hendrik Bessembinder and William Maxwell of the universities of Utah and Arizona, respectively n.b.: link updated 2011-4-30. Old link no longer works:

The introduction of TRACE to the bond
market provides a rare opportunity to assess the effects of a substantial increase in transparency.
…
While over-the-counter corporate bond trades tend to be large, they also tend to be infrequent. Edwards, Harris, and Piwowar (2007) report that individual bond issues did not trade on 48 percent of days in their 2003 sample, and that the average number of daily trades in an issue, conditional on trading, is just 2.4 Corporate bonds trade infrequently even compared to other bonds. Although Table 1 shows that they comprise about 20 percent of outstanding U.S. bonds, corporate bonds account for only about 2.5 to 3.0 percent of trading activity in U.S. bonds in recent years, as shown in Table 3.
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That execution costs for bonds decline with trade size may reflect in part that asymmetric information regarding issuing firm fundamentals is relatively unimportant for bond valuation. It could also reflect the absence of an inexpensive centralized system for processing small bond transactions. Or the higher execution costs for small bond trades could reflect the extraction of rents by better-informed bond dealers from relatively uninformed retail bond traders.
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Well-functioning security markets provide investors with liquidity. However, the term “liquidity” is a broad and somewhat elusive concept, used to describe multiple properties of trading in security markets. For example, Kyle (1985) notes that liquidity can include “tightness,” which is the cost of completing a buy and sell transaction in a short period of time, “depth,” which the size of the buy or sell order required to move market prices by a given amount, and “resiliency,” which is the speed with which prices recover from a random shock in buy or sell orders. Alternately, practitioners sometimes use the word liquidity to describe the ease of transacting.
…
Empirical evidence on the introduction of transaction reporting in corporate bonds has been the subject of countless articles in the trade press and at least three articles published in refereed academic journals: Bessembinder, Maxwell and Venkataraman (2006), Edwards, Harris, and Piwowar (2007), and Goldstein, Hotchkiss, and Sirri (2007). Although the three studies use notably different samples and research designs, all three conclude that the increased transparency associated with TRACE transaction reporting is associated with a substantial decline in investors’ trading costs.
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Bessembinder, Maxwell and Venkataraman (2006) also examine how transparency affects the competitive environment of the dealer market. They hypothesize that in an opaque market the largest dealers enjoy an informational advantage, but that this informational advantage is mitigated in a transparent market. Consistent with this reasoning, they report that in their sample the concentration ratio of trades completed by the largest 12 dealers falls from 56 percent pre-TRACE to 44 percent post-TRACE.
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Market participants with whom we spoke, including both dealers and the traders at investment firms who are their customers, were nearly unanimous in the view that trading is more difficult after the introduction of TRACE. Whereas it may have previously been possible to complete a sizeable bond purchase with a single phone call to a dealer who held sufficient quantities of the bond in inventory, the post-TRACE environment may involve communications with multiple dealers, and delays as the dealers search for counterparties. A bond trader with a major insurance company told us that there is less liquidity, in that market makers carried less “product,” and it has become more difficult to locate bonds for purchase in the post-TRACE environment. A bond trader for a major investment company responded to the publication of Bessembinder, Maxwell, and Venkataraman (2006) by sending the authors an unsolicited e-mail stating: “I want to be able to execute a trade even if a bond dealer does not have a simultaneous counterparty lined up…. [T]oo much price transparency reduces dealers’ willingness to commit capital…. [T]he focus on the bid-ask spread is too narrow, and a case of being penny-wise and pound-foolish.”
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One way to circumvent TRACE, which applies to publicly-issued bonds, is for a firm to issue privately placed bonds (sometimes referred to as Rule 144a securities, for the section of the Securities Act of 1933 that provides exemption from registration requirements). … In 2001, before TRACE, “144a for life” bonds were 7.3 percent of dollar volume and 9.6 percent of issues. The percentage of dollar volume in “144a for life” bonds jumped to 27.8 percent in 2003, the first full year after TRACE initiation, and grew to 39.8 percent in 2004, before declining to 16.9 percent in 2006.
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Also consistent with a shift towards alternative asset classes, the credit default swap market experienced phenomenal growth in recent years relative to bonds. Table 6 reports on outstanding notional principal in these credit default swaps, which grew from $919 billion in 2001 to $34.4 trillion in 2006. One dealer suggested to us that, prior to TRACE introduction, ten times as much capital was allocated to corporate bond trading than to credit default swaps, but that the ratio has now been reversed.
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To the extent that the shift to
privately placed bonds and bank loans was initiated by corporate borrowers, and in response to
TRACE, it suggests that the net costs of TRACE may exceed the benefits….Alternately, the shift to private markets could simply reflect agency issues if issuers failed to fully anticipate the potential effect of illiquidity on issue prices and underwriters and lenders persuaded corporations to issue private securities that could be traded more profitably.
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A number of industry participants told us that bond dealers have either reduced expenditures for research regarding bond valuation, or have stopped providing the research to customers, instead using it for proprietary trading. A trader for a major market-making firm noted that the easiest way to cut expenses in the wake of lower bid-ask spreads was to reduce the number of analysts on the payroll. Some bond dealers, including Citibank, no longer provide external research on the corporate bond market.
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The primary complaint against TRACE, which is heard both from dealer firms and from their customers (the bond traders at investment houses and insurance companies), is that trading is more difficult as dealers are reluctant to carry inventory and no longer share the results of their research. In essence, the cost of trading corporate bonds decreased, but so did the quality and quantity of the services formerly provided by bond dealers.

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