Streetwise Professor

In a semi-follow up to yesterday’s post on trading mechanisms, today I’m going to explore post-trade price transparency.

One example that has been brought up repeatedly in the context of increasing transparency in the OTC derivatives markets is the introduction of TRACE in the corporate bond market.  TRACE mandated the disclosure of all corporate bond trades, including information on price and trade size.  Currently, the information has to be reported within 15 minutes of the trade.

It has been argued that TRACE improved the efficiency of the corporate bond market, and reduced trading costs and dealer profits.  This supposedly occurred because the opacity of the market pre-TRACE gave the dealers market power that they could exploit to their benefit.

The empirical basis for these pro-TRACE claims is a couple of studies.  One compared round-trip trading costs pre- and post-TRACE, and found that post-TRACE costs were smaller.  Another exploited the fact that TRACE was phased in over time, and ran cross-sectional regressions that compared trading costs for bonds that were TRACE-eligible and those that weren’t, while controlling for other observable factors.  This study also found that TRACE lowered costs.

I am always a little leery about these kinds of studies.  They implicitly assume that the characteristics of the transactions in the TRACE and non-TRACE samples are the same, or can be controlled for based on observable variables.  I’m not quite so sure, especially given some of the other things that transpired post-TRACE–as I’ll discuss now.  (In social sciences, you always have to worry about endogeneity problems.  They’re devilishly hard to control for; natural experiments or good instrumental variables are hard to come by.)

Most notably, there is anecdotal evidence that post-TRACE, corporate bond dealers dramatically reduced the size of their trading teams, and reduced their inventory holdings.  They effectively transitioned from dealers to brokers.  The reduction in inventory means that they reduced their capital commitments to this business.

Now this is hard to square with a story that TRACE reduced dealer market power, which in turn reduced trading costs.  Typically, firms exercise market power by restricting output and capacity.  Thus, something that increases competition should lead to an expansion of output and capacity.   The opposite happened, apparently.

You can tell a kind of monopolistic competition story.  Dealers had market power due to opacity, but competed away the rents by overinvesting in capacity, or in “quality” by investing excessively in inventory that allowed them to accommodate customer needs more readily.  But even in a monopolistic competition story, increasing competition (by reducing customer search costs, for instance, through better disclosure) makes individual firm demand curves more elastic, meaning that those firms that continue to operate should increase output and operate closer to their minimum average cost point.  That’s hard to square with what happened post-TRACE.

It should also be noted that the theoretical foundation for the contention that improved disclosure reduces profitability by increasing competition is weak.  Madhavan (RFS, 1996) has a sequential trading model in which dealers can choose not to disclose trades, but are in competition with one another.  In equilibrium, dealers don’t disclose a trade that occurs today because the order flow is informative, and the information they get when they do a trade allows them to trade more profitably in the future; a dealer that trades today has a competitive advantage over other dealers in trading in the future.  But in equilibrium, dealers don’t earn any profits.  This is because they compete aggressively to attract order flow today.  Some trades are “loss leaders” that they use to attract order flow that increases the profitability of future trades.  Thus, lack of disclosure is not necessarily profitable for dealers because competition for market power dissipates rents.

There are other post-TRACE developments that are hard to square with the Gary Gensler & apple pie story.  (The details can be found in a JEP paper by Bessembinder and Maxwell.)  Notably, if you believe that trading costs really fell, this should have benefited corporate issuers.  Ultimately, investors are willing to pay less for bonds, the greater the costs of trading them later.  If trading costs fell, publicly traded bonds should have become a relatively more attractive form of finance for corporations.  But in fact, post-TRACE, firms relied much more on privately placed bonds; corporate bond issuance fell; and CLOs (collateralized loan obligations–securities backed by bank loans) grew dramatically.  So, corporations relied much less heavily on instruments that should have become relatively cheaper to issue if trading costs really fell as a result of TRACE, and relied more on stuff that couldn’t be traded at all (private placements) or traded in dealer markets (the CLOs)!  This is inconsistent with the view that transparency reduced corporate bond trading costs dramatically, and rather implies the opposite.  (Of course, a lot of other stuff was going on during this period, so it’s a stretch to lay all this on TRACE, but still, it is facially not supportive of the claim that TRACE reduced trading costs.)  (This also raises the question: if the dealer structure without disclosure was so inefficient, why didn’t issuers use their leverage to mandate disclosure, e.g., by conditioning participation in underwriting syndicates to firms that committed to disclose trade information?)

Why might trading costs have gone up?  Anecdotally, it became harder to trade in size post-TRACE as dealers weren’t willing to take on big positions once they had to disclose that they had done so.  That is, dealers were at risk of being front run once they took on big positions from a customer/counterparty.  So they offered less liquidity, making it more expensive for the insurance companies and pension funds that dominate the market to trade.  This would explain why they reduced their head counts, cut back on inventory, and essentially shifted from dealing to broking.

This all suggests that the effect of TRACE was to lower the transactions costs for some (primarily small retail traders), increase trading costs for others (mainly big investors), and change the composition of trades (in favor of trades that were easy to broker).  Put differently, TRACE made “wholesale” trades more expensive–pricing some out of the market altogether.  Not an unalloyed benefit, and arguably quite the reverse.  If the corporate bond market is primarily a wholesale market, the effects of transparency could have been detrimental on net, even if some benefitted.)

This isn’t dispositive, but it should give pause.  In particular, when evaluating the effect of a market structure change, or of a mandated change in transparency, you need to look beyond simple before and after or cross sectional price comparisons, as these may be incomplete and misleading.  Moreover, you need to look at things other than price.  If a policy change results in exit of firms and reductions in the size of firms, and substitution away from the product affected by the change, you have to seriously question whether the change increased competition.  Usually you’d expect reductions in barriers to competition to lead to entry, increased output, and substitution towards the product that became more competitive.   When the exact opposite happens, you better have a really good story–which I haven’t seen anybody advance–or you better seriously entertain the hypothesis that the supposedly pro-competitive change had the exact opposite effect.

So, rather than being the feel good story of the summer, upon closer examination TRACE appears to be an ambiguous tale at best, and more likely a highly cautionary one.  And those who constantly prattle about the wonders of transparency–and you know whom I speaking of–should be pressed to address all of the dimensions of the TRACE experience.   Because it is quite plausible that interventions into wholesale markets, including mandates to make trading more “exchange like” with more pre- and post-trade transparency, can increase the costs that customers in those markets pay.