The Effects of Mandatory Transparency in Financial Market Design

Many financial markets have recently become subject to new regulations requiring transparency. In our recent NBER working paper, The Effects of Mandatory Transparency in Financial Market Design: Evidence from the Corporate Bond Market, we study how mandatory transparency affects trading in the corporate bond market. In July 2002, the Trade Reporting and Compliance Engine (TRACE) program began requiring the public dissemination of post-trade price and volume information for corporate bonds. Dissemination took place in four phases over a three-and-a-half year period, with actively traded, investment grade bonds becoming transparent before thinly traded, high-yield bonds.

We find that mandated post-trade transparency in the corporate bond market leads to an overall reduction in trading activity. No sample of bonds in any phase experiences an increase in trading activity and Phase 3B bonds experience a large and significant reduction. For that group, TRACE reduces trading activity by 41.3% in the 90 days following the dissemination of price and volume information. This finding is robust across different measures of trading activity and alternative regression specifications. Event studies support a causal interpretation of our findings since the decrease occurs immediately after the start of dissemination.

Price dispersion also decreases due to TRACE. This decrease is significant across bonds that change dissemination in Phases 2, 3A, and 3B, but is largest (24.7%) for Phase 3B bonds. This finding is also robust across different measures of price dispersion and alternative regression specifications. Moreover, event studies show that the fall in price dispersion occurs immediately after the start of dissemination. It is important to note, if the transparency introduced in Phase 1 affects bonds that become transparent in subsequent Phases, our estimates are probably lower bounds on TRACE’s overall impact.

To further investigate how bond characteristics affect our results, we examine trading activity and price dispersion for samples with the same credit quality and issue size across phases. We find that the credit quality is the most consistent factor in explaining the reduction in trading activity. High-yield bonds experience a significantly greater reduction in trading activity than investment grade bonds. Our results confirm the view that transparency has a limited impact on the trading activity of the most liquid and investment grade segment of the market. Moreover, our results show that ignoring the less actively traded and high-yield bonds in Phase 3B leads to an incomplete account of TRACE’s effect on trading activity.

One possible reason TRACE has different effects on high-yield bonds is that pre-TRACE trading in high-yield bonds may be relatively more opaque than trading in investment-grade bonds. As a result, TRACE may provide more incremental information and thus cause larger change in the high-yield market. A second possible reason is that the lower trading activity in high-yield bonds post-TRACE may be the result of a supply-side response of dealers. Price dispersion falls more for high-yield bonds post-TRACE. In addition, high-yield bonds trade less frequently than investment grade bonds pre-TRACE. The fact that there is a large reduction of price dispersion for thinly traded high-yield bonds may result in lower spreads and thus cause dealers to hold less inventory. This in turn may result in a decrease in trading activity.

There are several welfare implications of increased transparency in the corporate bond market. One consequence is that it may change the relative bargaining positions of investors and dealers, allowing investors to obtain fairer prices at the expense of dealers. The reduction in price dispersion should allow investors and dealers to base their capital allocation and inventory holding decisions on more stable prices. Therefore, the reduction of price dispersion likely benefits customers and possibly, but not necessarily, dealers.

The implications of a reduction in trading activity are not as clear. Whether a reduction in trading activity is desirable depends on why market participants trade. A decrease in trading activity may be beneficial if much of the trading in a bond is unnecessary “noise” trading. On the other hand, if most trading is information-based, a decrease in trading activity may slow down how quickly prices reflect new information. In addition, if the decrease in trading activity is the result of dealers’ unwillingness to hold inventory, transparency will have caused a reduction in the range of investing opportunities. That is, even if a decline in price dispersion reflects a decrease in transaction costs, the concomitant decrease in trading activity could reflect an increased cost of transacting due to the inability to complete trades.

Our results on the corporate bond market have two major implications for the current and planned expansions of mandated market transparency. The implicit assumption underlying the proposed TRACE extensions and the use of TRACE as a template for regulations such as Dodd-Frank is that transparency is universally beneficial. First, it is not clear that transparency for all instruments is necessarily beneficial. Overall, trading in the corporate bond market is large and active, although, as seen, not comparable across all types of bonds. Many over-the-counter securities are similar to the bonds FINRA placed in Phase 3B. That is, they are infrequently traded, subject to dealer inventory availability, and trading in these securities is motivated by idiosyncratic, firm-specific information. Therefore, the expansion of TRACE-inspired regulations, such as those for 144a bonds, asset- and mortgage-backed securities, and the swap market, may have adverse consequences on trading activity and may not, on net, be beneficial.

Second, our results indicate that transparency affects different segments of the same market in different ways. As a consequence, our results provide empirical support for the view that not every segment of each security market should be subject to the same degree of mandated transparency. Both academic commentators (French et al., (2010), Acharya et al. (2009)) and leading industry associations (e.g., Financial Services Forum, et al. (2011)) have articulated this position. Despite these recommendations, the expansion of transparency by the Commodity Futures Trading Commission (CFTC) in various swap markets, i.e. interest rate, credit index, equity, foreign exchange and commodities, in December 2012 and February 2013 was immediate for all swaps in those markets. This stands in sharp contrast to FINRA’s cautious implementation of TRACE in Phases. The fact that the effect of transparency varies significantly across categories of bonds within the corporate bond market suggests that additional research is needed to evaluate the tradeoffs associated universal transparency in other over-the-counter securities.

The full paper is available for download here.