Professor Who Helped Pop Junk Bubble Says Trace Slows Trade
The decade-old system of publicly reporting U.S. corporate bond transactions reduced trading while cutting price volatility in the $4.2 trillion-a-year market, according to the Massachusetts Institute of Technology and Harvard University.
High-yield bonds were affected the most, according to the study using data from the Financial Industry Regulatory Authority’s Trace bond-reporting system, which was introduced in four stages beginning in 2002. In the 90 days after the final three phases started, trading fell 15.2 percent and price dispersion shrank 8.5 percent, the study dated Sept. 4 found.
The findings from the MIT and Harvard researchers -- including Paul Asquith, whose 1989 paper on junk bonds helped burst a bubble in that market -- coincide with a government-mandated shift toward public reporting of swaps transactions. In corporate bonds, new regulations are prompting firms to pare holdings traditionally used to facilitate trading, driving volume to the lowest ever as a proportion of outstanding debt, Finra data show.
“Mandated post-trade transparency in the corporate-bond market leads to an overall reduction in trading activity,” according to the paper by MIT’s Asquith and Parag Pathak and Harvard’s Thomas Covert. “Transparency also causes a significant reduction in price dispersion.”
Trading of junk bonds declined the most in the 90 days after the change, falling 41.3 percent, according to the report. The daily standard deviation of prices shrank 24.7 percent for high-yield securities, or debt rated below Baa3 by Moody’s Investors Service and less than BBB- at Standard & Poor’s.
Lower price volatility “is also evident using other measures of price dispersion such as the difference between the maximum and minimum price on a given day and price standard deviation measures computed over longer time windows,” the authors wrote.
Asquith’s 1989 study showed the default rate for junk bonds was higher than generally accepted, the New York Times said in 1992. Investors in high-yield securities lost 4.4 percent in 1990 after gaining 16 percent the previous two years, according to data compiled by Bank of America Corp.
The effects of less liquidity were seen almost five years ago when the collapse of Lehman Brothers Holdings Inc. froze markets from overnight lending to swaps, sparking the worst financial crisis since the Great Depression.
The findings from the latest study “aren’t terribly shocking,” said Kevin McPartland, head of market structure research at Greenwich Associates. “It’s what people have always hypothesized was the case.” He said looking past the 90-day period after the Trace phases were put in place may show whether liquidity returned.
Dealers have scaled back principal trading amid pressure to increase capital to meet international standards and as transparency created by Trace lowers profits, consulting firm Tabb Group LLC said in an April report.
The 21 primary dealers authorized to trade with the Federal Reserve have cut corporate-debt holdings by 39 percent, to $11.4 billion on Aug. 28 from $18.7 billion on April 3. That follows a 76 percent reduction in inventories from the peak in 2007 through March, when the Fed changed the way it reported the data.
The study from MIT and Harvard shows that government attempts to improve the quality of markets may have multiple consequences, especially when they affect incentives for middlemen such as market makers or banks. While the system for reporting trades in real time provided a stronger anchor for prices, firms traded less as a result, the study found.
Parallels may exist in equities a decade ago when the U.S. ruled that stocks should trade in increments of pennies instead of fractions of a dollar. As spreads narrowed, profits dropped for market makers. The number of firms that facilitate trading on the floor of the New York Stock Exchange has declined to six designated market makers, as the firms are now known, from dozens of so-called specialists in prior decades.
The authors said investors may benefit from tighter bond pricing because of Trace, though the effect on transaction costs may not be in their favor.
“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,” according to the report. “The reduction of price dispersion likely benefits customers and possibly, but not necessarily, dealers.”
The report also contended that less trading may hurt investors if, instead of reducing “noise” from the market, the reduction slows how quickly new information alters prices.
Also, “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,” they said. “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.”
Applying the same transparency standards to different parts of the same market isn’t always good for investors, the authors wrote.
“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,” they said. “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.”
That may be because different segments of the same market react differently by public price reporting, they said. “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.”
Greenwich’s McPartland said it’s difficult to draw comparisons between the effects of increased transparency in bond and swaps markets because of their many differences, such as there being no retail investors in the swaps market, the requirement for most swaps to trade publicly and the clearing and margin requirements for swaps that don’t apply to bonds.
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