OTC Reform #2: End-Users Stand to Benefit from Transparency – Lessons from TRACE

Transparency is one of the objectives of the Dodd-Frank bill and the reform of OTC derivatives markets. End-users and the public at-large stand to gain the most from transparency. Dealers stand to lose as competition is intensified and profit margins are cut.

There is an important precedent for this: the recent reform of trading in the U.S. corporate bond market through the imposition of the TRACE system. A good analysis of what happened appears in a paper by Henrik Bessembinder and William Maxwell, and we rely on the information in that paper for the summary presented here.

The U.S. corporate bond market is very large. In 2006 there was $5.37 trillion outstanding, and $470 billion in new issues. But this market had traditionally been very opaque. Issuances are by different companies in different financial situations, and issuances by the same company differ by seniority, time to maturity and covenants, among other things. Many of the big buyers—insurance companies, pension funds, and so on—hold to maturity, so that there is little turnover in the market. Corporate bonds represent 20% of outstanding bonds, but less than 3% of trading activity. The market had been organized through dealers with little in the way of public price quotation and transaction price reporting. In 2002 the round-trip trading cost is estimated to have been 25 basis points.

At the start of 2001, the SEC approved creation of a new system called TRACE—the Transaction Reporting and Compliance Engine. All bond dealers were required to report to the NASD (National Association of Security Dealers) all trades in publicly issued corporate bonds. The NASD makes the transaction data publicly available through the Financial Industry Regulatory Authority website and 3rd party vendors. The system was introduced gradually between 2002 and 2006, starting with the largest bonds and ultimately covering all of them, and initially allowing a large time delay in price reporting but gradually reducing it.

As a result of the reform and improved transparency, the round-trip cost of trading these bonds have been cut in half.

The flip side of that, of course, is that dealer profits have been reduced. Competition among dealers is more intense. Each bond is offered by a larger number of dealers, and their prices are more competitive with one another. Dealers have seen their revenue drop drastically, by more than $1 billion/year. Employment in the bond trading departments has been cut back sharply.

Transparency in the OTC derivatives markets has the potential to yield similar cost benefits to end-users. These would ultimately be passed along back to consumers.

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