The Impact of Greater Transparency in Financial Markets

[M]andated post-trade transparency was associated with an overall reduction in trading activity.

Corporate bonds are traded in one of the world's largest over-the-counter markets. In July 2002, this market underwent a significant change when the Financial Industry Regulatory Authority (FINRA), then the National Association of Securities Dealers (NASD) required timely public disclosure of information on the prices and volume of completed transactions. This reform was implemented through the Trade Reporting and Compliance Engine (TRACE) program. Bond trade dissemination was phased in on four separate dates, denoted Phase 1, 2, 3A, and 3B, over a three-and-a-half year period. The increase in the amount of information available to market participants as a result of these reforms was so significant that it has been compared to the introduction of stock market tickers in the early twentieth century and to the adoption later on of electronic screens for Treasuries.

In The Effects of Mandatory Transparency in Financial Market Design: Evidence from the Corporate Bond Market (NBER Working Paper No. 19417), authors Paul Asquith, Thom Covert, and Parag Pathak study the impact of this increase in transparency. They find that mandated post-trade transparency was associated with an overall reduction in trading activity. While they do not find any statistically significant negative effects in Phases 1, 2, and 3A, in Phase 3B they find that trading activity in the affected bonds fell by 41.3 percent in the 90 days following the dissemination of price and volume information. The drop in trading activity coincided with the start of dissemination.

The implementation of TRACE is also associated with lower price dispersion. This decrease is significant and robust across bonds that change dissemination in Phases 2, 3A, and 3B, but is largest, 24.7 percent, for Phase 3B bonds. The authors note that if the transparency introduced in each phase affects not only the specific bonds covered by that phase but also all bonds that become transparent in subsequent phases, then their estimates of the impact of the later phases may understate TRACE's overall impact.

The authors also find that high-yield bonds experience a significantly greater reduction in trading activity than investment-grade bonds. They infer from this that requiring transparency has a limited impact on the most liquid segment of the market.

The authors point out that increased transparency may change the relative bargaining positions of investors and dealers, allowing investors to obtain fairer prices at the expense of dealers. In addition, lower price dispersion should allow investors and dealers to base their capital allocation and inventory holding decisions on more stable prices.

Many over-the-counter securities are similar to the bonds that FINRA placed in Phase 3B: they are infrequently traded, subject to dealer inventory availability, and their trading is often motivated by idiosyncratic, firm-specific information. This raises the possibility that expansion of TRACE-inspired regulations to the markets for other securities may affect trading activity and price dispersion in those markets.

--Les Picker