Speech by SEC Staff:
This was prepared for a Discussion on January 6, 2006 at the American Finance Association meetings in Boston, Massachusetts. The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This presentation expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
It's a pleasure to speak as part of this morning's session at the American Finance Association per Marc Lipson's invitation to introduce the two upcoming papers in the session that address bond market transparency. As an economist who happens to hold a senior position with the SEC, I want to offer a broad perspective on the economics underlying the opacity or transparency in our marketplace. However, I should emphasize at the onset of my remarks that these do not necessarily reflect the views of the Securities and Exchange (SEC) or my colleagues on the staff of the Commission.
Over the last few years the structure of the bond market has received increasing attention. Some academic work has highlighted the magnitude of the spreads and transactions costs in the marketplace. In the case of municipal bonds current and former colleagues of mine at both Carnegie Mellon and the SEC have documented in a variety of ways the surprisingly large spreads that are prevailing in the municipal bond marketplace.1 Interestingly, the spreads in these and other dealer markets typically decline with the size of trade, unlike exchange-based trading in equities, where large trades have much greater price impact than smaller trades.2 That spreads decline with size is a crucial fact that has emerged in a number of dealer markets and is suggestive that the spreads in such dealer markets are not driven by adverse selection or by competitive market forces more broadly. Instead, the evidence suggest that either the dealers have relatively large costs of processing small trades or that they are better positioned to extract rents on these trades. Anecdotal accounts suggest that these rents can be substantial.
Much of the debate concerning transparency in the bond market in recent years has focused upon post-trade transparency in reporting of transactions. The upshot of this has been to dramatically reduce the disclosure lags for many of the bonds in the marketplace. This has occurred despite the cautionary perspective of the bond dealers. For example, dealers have expressed concern that liquidity would be reduced or even dry up for difficult trades and issues, which could occur if prospective counterparties are aware of the exposure that the dealer has assumed. Yet there seems to be little evidence that liquidity does deteriorate after the market becomes transparent. The concerns that the dealers have articulated have not been accompanied by systematic evidence. The usual argument against transparency is that dealers need time to work large orders; if this argument were correct it would suggest that the spreads and price impact of large orders would be substantially greater than for small orders.
In fact, the various studies of trade reporting suggest that spreads tighten after the market becomes transparent, such as the papers by Bessembinder, Maxwell and Venkataraman (2005) and Goldstein, Hotchkiss and Sirri (2005) that are being presented in the session, as well as the paper by my current and past SEC colleagues, Edwards, Harris and Piwowar (2005). For example, focusing upon the initiation of public transaction reporting through the TRACE system, Bessembinder, Maxwell and Venkataraman for large sophisticated investors (insurance companies) find a 50% reduction in trade execution costs, though there is also a reduction of 20% for the bonds not eligible for TRACE. Given this benchmark, the interpretation is ambiguous as to the exact magnitude of reduction attributable to TRACE, but the reduction in costs, even for institutional trades is striking. At a conceptual level greater post-trade transparency isn't necessarily better, but the empirical evidence to date suggests that the impact on the marketplace has been quite beneficial. Furthermore, the conclusions seem quite consistent across studies. For example, Goldstein, Hotchkiss and Sirri (2005) find that spreads decline on BBB corporates for all but the smallest trade size groups. Similarly, Edwards, Harris and Piwowar (2005) find that costs are lower for transparent bonds than for opaque ones.
Of course, it could be that the optimal degree of transparency reflects a certain degree of opacity, but the current extent of opacity may still be such that greater transparency would be beneficial. While we lack direct evidence about the optimal transparency regime, competition and transparency have proved important in other market microstructure contexts and I anticipate that this will prove to be the case for our bond markets. As pointed out in my survey with Bruno Biais and Larry Glosten, Naik, Neuberger and Viswanathan (1999) offer an interesting argument as to why transparency in trade reporting may be optimal by enhancing risk sharing. While the conventional argument is that trade disclosure can make it harder to supply liquidity to large traders because the market maker is in a difficult position in trying unwind his inventory after a large and difficult order, Naik, Neuberger and Viswanathan (1999) argue that in a transparent system the market maker would not need to scale back the size of his trade as the informational content of the trade would already be reflected in the marketplace, thereby enhancing risk sharing. A similar effect also arises in Vayanos (1999). The empirical evidence in Gemmill (1996) for the London Stock Exchange also is consistent with the view that transparency does not reduce liquidity.
While much of the discussion about transparency in the bond market has emphasized trade reporting, I'd also to focus more attention on the absence of pre-trade transparency. It is not inherent that bond trading should necessarily be in market structures that are much less transparent than stocks. In fact, Biais and Green (2005) undertake a historical analysis of bond trading on the NYSE. There was an active NYSE market in both corporate bonds and municipals prior to World War II, but trading migrated to the OTC market as the role of institutional investors became more important. Interestingly, retail trading costs in municipal bonds were only half as large in 1926-27 as at present, presumably reflecting the difference in market structure, while equity trading costs have declined dramatically. Yet even today customers do not appear to be pushing brokers to utilize the NYSE ABS market, which has some listed issues in a structure with greater pre-trade transparency, but which offers only limited depth at present. While the bond markets are much more fragmented than the equity markets, the impediments to pre-trade transparency would appear to be greatly reduced relative to the past, given the current ability to utilize electronic and Web-based platforms and tools. Alternatively, fragmentation can be overcome by exploiting the natural substitutability within classes of instruments.3
Interesting evidence from recent years about pre-trade transparency in an equity market context is found in the paper by Boehmer, Saar and Yu (2005), who study the introduction of the NYSE's OpenBook service that provides limit order book information to investors not on the floor. Investor strategies change from the exposure of limit orders as the investors can better manage their exposures. While the specialist's participation rate declines, so does the price impact of orders and the informational efficiency of prices. In a variety of market contexts greater pre-trade disclosure of quotes or depth has facilitated competition and reduced trading costs.
I should also note that the first line of regulation with regard to the degree of transparency is the relevant Self-Regulatory Organization, which in the case of the majority of corporate bond trading is the National Association of Security Dealers (NASD) and in the case of municipal bonds is the Municipal Securities Rulemaking Board (MSRB). An interesting facet of this SRO structure is the role of the dealers as members of the committee in defining the market handling of transparency. Dealers have considerable influence and interest in the governance of the bond markets through the SRO structure. How delegation should work in defining the regulatory mechanism for bond trading does not seem completely clear and is in my judgment an important question worthy of academic study, especially in light of conflicts of interest by market participants and the centrality of the governance structure for defining the transparency regime. In fact, the governance of SROs is the subject of a recent SEC Concept Release (2004).
Bessembinder, H., W. Maxwell, and K. Venkataraman, 2005, "Market Transparency, Liquidity Externalities, and Institutional Trading Costs in Corporate Bonds," Journal of Financial Economics, forthcoming.
Biais, B. and R. Green, 2005, "The Microstructure of the Bond Market in the 20th Century," working paper, Toulouse University and Carnegie Mellon University.
Biais, B., L. Glosten and C. Spatt, 2005, "Market Microstructure: A Survey of Microfoundations, Empirical Results, and Policy Implications, Journal of Financial Markets, 8, 217-264.
Boehmer, E., G. Saar, and L. Yu, 2005, "Lifting the Veil: Analysis of Pre-trade Transparency at the NYSE," Journal of Finance 60, 783-815.
Edwards, A., L. Harris and M. Piwowar, 2005, "Corporate Bond Market Transaction Costs and Transparency," unpublished manuscript.
Gemmill, G., 1996, "Transparency and Liquidity: A Study of Block Trades on the London Stock Exchange Under Different Publication Rules," Journal of Finance 51, 1765-1790.
Goldstein, M., E. Hotchkiss, and E. Sirri, 2005, "Transparency and Liquidity: A Controlled Experiment on Corporate Bonds," unpublished manuscript.
Green, R., B. Hollifield and N. Schurhoff, 2004, "Financial Intermediation and the Costs of Trading in an Opaque Market," unpublished manuscript.
Harris, L. and M. Piwowar, 2005, "Municipal Bond Liquidity," Journal of Finance, forthcoming.
Naik, N., A. Neuberger, and S. Viswanathan, 1999, "Trade Disclosure Regulation in Markets with Negotiated Trades," Review of Financial Studies 12, 873-900.
Spatt, C., 2004, "Frictions in the Bond Market," keynote address at the Second MTS Conference on Financial Markets: "The Organization and Performance of Fixed-Income Markets," Vienna, Austria, December 16, 2004. http://www.sec.gov/news/speech/spch121604cs.htm
U.S. Securities and Exchange Commission, 2004, "Concept Release Concerning Self-Regulation," Washington, D.C.
Vayanos, D., 1999, "Strategic Trading and Welfare in a Dynamic Model," Review of Economic Studies 66, 219-254.
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