Market Transparency, Liquidity Externalities, and Institutional Trading Costs in Corporate Bonds
University of Utah - Department of Finance
William F. Maxwell
SMU - Cox School
Southern Methodist University (SMU) - Edwin L. Cox School of Business
Journal of Financial Economics, Forthcoming
We develop a simple model of the effect of transaction reporting on trade execution costs and test it using a sample of institutional trades in corporate bonds, before and after the initiation of public transaction reporting through the TRACE system. The results indicate a reduction of approximately 50% in trade execution costs for bonds eligible for TRACE transaction reporting, and consistent with the model's implications, also indicate the presence of a "liquidity externality" that results in a 20% reduction in execution costs for bonds not eligible for TRACE reporting. The key results are robust to allowances for changes in variables, such as interest rate volatility and trading activity, which might also affect execution costs. We also document decreased market shares for large dealers and a smaller cost advantage to large dealers post-TRACE, suggesting that the corporate bond market has become more competitive after TRACE implementation. These results reinforce that market design can have first-order effects, even for sophisticated institutional customers.
Keywords: Bonds, microstructure, transparency, liquidity externalities
JEL Classification: G10, G14, G13Accepted Paper Series
Date posted: November 2, 2005
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