Transparency and Liquidity: A Controlled Experiment on Corporate Bonds

Abstract

This article reports the results of an experiment designed to assess the impact of last-sale trade reporting on the liquidity of BBB corporate bonds. Overall, adding transparency has either a neutral or a positive effect on liquidity. Increased transparency is not associated with greater trading volume. Except for very large trades, spreads on newly transparent bonds decline relative to bonds that experience no transparency change. However, we find no effect on spreads for very infrequently traded bonds. The observed decrease in transaction costs is consistent with investors' ability to negotiate better terms of trade once they have access to broader bond-pricing data. (JEL codes: G14, G18, G23, G24, G28) Although larger than the market for US Government or municipal bonds, the corporate bond market historically has been one of the least transparent securities markets in the United States, with neither pretrade nor posttrade transparency. Corporate bonds trade primarily over-the-counter , and until recently, no centralized mechanism existed to collect and disseminate posttransaction information. This structure changed on July 1, 2002, when the National Association of Securities Dealers (NASD) began a program of increased posttrade transparency for corporate bonds, known as the Trade Reporting and Compliance Engine (TRACE) system. As part of this structural change, only a selected subset of bonds initially was subject to public dissemination of trade information. The resulting experiment enables us to observe the effects of increased posttrade transparency on market liquidity in a controlled setting.

The Same Bond at Different Prices: Identifying Search Frictions and Selling Pressures

“…Goldstein, Hotchkiss, and Sirri (2007) find that dealers do not split trades and perform a matching/brokerage function in illiquid bonds. And according to market participants, risk limits often prohibit dealers from taking bonds on the book and splitting trades when there is a liquidity shock.…”

“…The first research papers using TRACE transactions data focus on the effect of enhanced price transparency and find that dissemination of prices lowered transaction costs for investors (Edwards et al (2007), Goldstein et al (2007), and Bessembinder et al To estimate the search model outlined in the previous section an estimate of roundtrip costs in the dealer market is needed, i.e. the difference between the price at which a dealer sells a bond to a costumer and the price at which a dealer buys a bond from a customer.…”

“…The second is a regressionbased methodology where each transaction price is regressed on a benchmark price and a buy/sell indicator (Schultz (2001), Bessembinder et al (2006), Goldstein et al (2007), and Edwards et al (2007)). However, both approaches require a buy/sell indicator for each trade, which is not publicly available for most of the sample.…”

“…Retail investors have a low search intensity while institutional investors have a high search intensity. I use trade size as a proxy for investor sophistication, since small trades are mainly retail trades and large trades predominantly institutional trades (Goldstein, Hotchkiss, and Sirri (2007) and Bessembinder, Kahle, Maxwell, and Xu (2009)). Specifically, there are six investor classes, who differ in their search intensity ρ, and they trade in par values of $0 − 10, 000, $10, 000 − 50, 000, $50, 000 − 100, 000, $100, 000 − 500, 000, $500, 000 − 1, 000, 000, and more than $1, 000, 000.…”

“…The left-hand graph shows that prices paid by institutional investors are higher than those paid by retail investors in a normal market. I use trade size to distinguish between retail and institutional trades, since trades smaller than $100, 000 are predominantly retail trades and larger trades are mainly institutional trades (Goldstein, Hotchkiss, and Sirri (2007) and Bessembinder, Kahle, Maxwell, and Xu (2009)). In the middle graph institutional prices are lower than retail prices because there were more sellers than buyers in the market.…”