Most business people assume that regulation increases the cost of doing business. It usually does, but not in the case of making the bond market more transparent—with a net positive result for investors, large or small. In a new research paper forthcoming in Journal of Financial Economics, Cox Finance Professor Kumar Venkataraman and co-authors Hendrik Bessembinder and William Maxwell reveal how recent market regulation benefits investors in the bond market. The paper’s results have been widely cited across regulatory bodies and financial trade associations, and have significantly impacted the global dialogue on bond markets and greater access for investors of all persuasions.

Background
“Market Transparency, Liquidity Externalities, and Institutional Trading Costs in Corporate Bonds” is one of the first studies on bond market transparency, in this case meaning information on what the last traded prices were. Bond markets around the world have been virtually opaque, which Venkataraman considers surprising since they represent a major component of financial markets. Equity markets, by contrast, have been transparent for decades now.

In order to achieve greater transparency, the National Association of Securities Dealers (NASD) began publicly reporting transactions of approximately 500 corporate bonds through its Trade Reporting and Compliance Engine (TRACE) in 2002. After the initial subset of bonds, the trade price for a majority of corporate bonds are now reported via TRACE, providing information on approximately 22,000 transactions representing some $18 billion in volume. The initiation of TRACE transaction reporting provides a potentially powerful experiment for assessing whether transparency is important to market quality. And so, Venkataraman and his co-authors set about to determine what effect the implementation of TRACE has had on the market.

The Securities and Exchange Commission (SEC) as well as the NASD have studies that analyze these effects, but none carries the weight of independence as this study. Another distinctive feature of this research is that other studies looked at the effects of TRACE in the year after the regulation was implemented rather than around the initiation of transaction reporting; thus their results would underestimate the real impact of TRACE. In order to accomplish this mathematical feat, the authors had to re-create data using sophisticated econometric models as they lacked the detailed data the SEC had, for example. By studying the period around TRACE initiation, they were able to document a liquidity effect that could not be captured otherwise.

Findings and Implications
The study focused on institutional players—such as insurance companies with large holdings—as they constitute the majority of the market. Initially, the authors posited that since institutional players were more sophisticated investors, the results on transactions costs (one proxy of TRACE’s effectiveness) would yield minimal insights. As it turned out, transaction cost reductions were great—a 50 percent reduction, which translates into roughly over a billion dollars a year. In this equation, the bond dealers have lost, while investors have gained. There is a significant net wealth transfer from the sell-side institutions (broker-dealers) to buy-side institutions that manage money for investors.

“Ultimately, whether through one’s 401(k) or direct exposure to bond markets through retail holdings, it means roughly 50 percent (six to seven basis points) of transaction costs are now eliminated,” said Venkataraman, “perhaps even more so for retail investors who were receiving worse execution than institutions before TRACE. If you aggregate eight basis points over time with compounding, that sum becomes quite significant to the investor.” Annually, investors could achieve trading cost reductions of $372 million according to the U.K.’s Financial Services Authority calculations.

Another noteworthy effect of the regulation is the liquidity externality (knock-on effect), which results in a 20-percent reduction in trading costs for non-regulated bonds. The result of increased information about prices, or greater transparency, gives a boost to other traded bonds not required to report. “The introduction of TRACE has increased competition in dealer markets,” Venkatamaran noted. “We document that large dealers have reduced their market share and small dealers are able to compete more effectively. Previously, the smaller dealer had less information on order flow; thus the smaller dealer was more risk-adverse and quoted inferior prices because he/she didn’t know what was really going on.” Now, everybody has access to every transaction price. This has reduced the mark-ups that dealers charge and promoted greater competition. That price competition benefits the end investor—both retail and institutional. Since the implementation of TRACE, the U.S. corporate bond market is now more actively traded, which provides an indication of the increased liquidity in the market. Increased liquidity offers investors a better chance at being able to buy and sell their holdings as needed with a smaller price concession.

Impact Abroad
The findings of this study have implications beyond the U.S. bond market. Other major financial market regulators have taken note of the findings from the U.S. experiment. Both the United Kingdom*, a leading global financial center, and the European Union (EU), are in the discovery process as to what type of regulation may be needed for their bond markets of the future. The Markets in Financial Instruments Directive (MiFID) will introduce a comprehensive pan-EU transparency regime for traded shares initially, and then perhaps, after further analysis due November 2007, extend the regulation to bonds.

The U.K. and EU regulatory efforts are aimed at strengthening capital markets because of rising investment in bond funds and for pension funds with the need to moderate risk exposure due to changing demographics. These objectives also apply to the United States. EU regulators acknowledge the benefits of TRACE as providing a comprehensive picture of trading, increasing competition, and reducing trading costs. Additionally, the authors’ research has recently been cited in a series of studies about transparency in the European bond market published by the Centre for Economic Policy Research (CEPR), a cross-market group of associations.

This research has achieved powerful recognition and made a significant contribution to U.S., U.K., and EU bond markets—with great impact for the investors that are served by them. Essentially, their results confirm the color—the enhanced ability of investors to make better informed decisions—provided by transparency.

“Market Transparency, Liquidity Externalities, and Institutional Trading Costs in Corporate Bonds” by Hendrik Bessembinder, William Maxwell, and Kumar Venkataraman is forthcoming in Journal of Financial Economics.

*The authors’ research was cited and analyzed in a discussion paper by the United Kingdom’s Financial Services Authority of May 2005.

Summary by Jennifer Warren.