Huge Derivatives Market Likely To Soon Be A Much More Efficient
Bloomberg reports this morning (in a poorly written lead) that SEC Chairwoman Mary Shapiro wants to take OTC derivative trading onto an exchange.
Which, it has been discovered, in the case of corporate bonds, drives down broker/dealer trading profits. But here’s how Bloomberg writes the first sentence.
U.S. regulators may impose the same price reporting and transparency requirements on over-the- counter derivatives that reduced bank profits by almost half in the corporate bond market when the Trace system was adopted seven years ago.
To the extent that a bank has a bond trading desk that is “making a market” (filling customer buy orders on the offered side and customer sell orders on the bid side) in corporate bonds (the vast majority do not), that is usually just a small portion of bank profits. But I digress.
What is striking is the 2006 research by Bessembinder, Maxwell and Venkataraman cited by the report,
We develop a simple model of the effect of public transaction reporting on trade execution costs and test it using a sample of institutional trades in corporate bonds, before and after initiation of the TRACE reporting system. Trade execution costs fell approximately 50% for bonds eligible for TRACE transaction reporting, and 20% for bonds not eligible for TRACE reporting, suggesting the presence of a “liquidity externality.” The key results are robust to changes in variables, such as interest rate volatility and trading activity that might also affect execution costs. Market shares and the cost advantage to large dealers decreased post-TRACE. These results indicate that market design can have first-order effects, even for sophisticated institutional customers.
Corporate debt has been traded for over a 150 years in this country and longer elsewhere. Legions of banks and investment banks from most of the states in the union have applied billions in capital underwriting and making over-the-counter markets in these securities. Multiple billions more is issued every year in corporate debt than corporate equity.
Despite this long history of diverse market makers and deep trading capital, the OTC corporate bond market proved to be a pretty inefficient market from an investor point of view. The fact that a simple approach of a real time price and volume trade reporting system, TRACE, could remove 50% of broker/dealer bond trading profits almost overnight is pretty astounding. And it makes the case that we make consistently on this blog. Market Design is the single most important factor for well efficient and well functioning markets.
