Dodd-Frank act requires a number of changes in the way that swap contracts are
cleared and traded. Among these changes is the mandatory real-time reporting
of trades. Proponents of mandatory trade reporting suggest that the increased
transparency will lower trading costs and prevent unsophisticated investors
from being exploited by better-informed dealers. Others point to possible
dangers in mandatory trade reporting. If a dealer reports a large transaction,
others will be able to infer the dealer’s position and trade ahead of him or
take advantage of his need to unwind the position in other ways. The Dodd-Frank
act is not, however, the first instance of regulators imposing mandatory
real-time trade reporting on a U.S. market. These past experiences may tell us
something about what to expect from the mandated real-time reporting of swaps
bonds, like swaps, trade over-the-counter. On July 1, 2002, at the SEC’s
direction, the National Association of Securities Dealers (NASD) began
requiring all of its members to report corporate bond trades to its TRACE
system. The public dissemination of trade information was initially limited to
investment grade bonds with issue sizes of $1 billion or more. The bonds for
which public dissemination of trade information was required expanded in 2005,
and, starting in January 2006, trades of all bonds were disseminated to the
public. Initially, dealers had 75 minutes to report trades. This declined to 45
minutes in October 2003, and 30 minutes in October 2004. Since July 2005,
dealers have been required to report trades within 15 minutes.
In the beginning, execution quality statistics were used to attract retail order flow. In the late eighties and early nineties, brokers who either sold or internalized their retail orders argued they were obtaining best execution for customer orders since they were executed at the best prevailing quote. These claims frustrated officials at the NYSE, since retail orders executed by the NYSE often received prices that were better than the best quoted prices. To reverse the loss of retail orders to markets internalizing or purchasing orders, in November of 1995 the NYSE began a pilot program named “ML/NYSE PRIME.” In this
program, the NYSE began informing Merrill Lynch’s retail investors as to the savings they received because of “price improvement”—the execution of market orders at a price better than the best current bid or offer for that stock.
number of academic studies have shown that trading costs for corporate bonds
declined with the public dissemination of trade information. Bessembinder,
Maxwell and Venkataraman (2006) estimate that TRACE led to a decline in trading
costs for institutional investors of 7.9 basis points, or 58 percent. Edwards,
Harris and Piwowar (2007) find that trading costs decline for all trade sizes
with the introduction of trade reporting and dissemination, but that the
decline in trading costs is “generally greater for smaller trades.” Goldstein,
Hotchkiss, and Sirri (2007) found that trading costs declined the most for
intermediate-sized trades of 21 to 250 bonds.
there is a strong consensus among economists that mandatory trade reporting
reduced trading costs in the corporate bond market. There are some indications
though, of unintended consequences. Bessembinder and Maxwell (2008) observe
that following mandatory trade reporting, dealers became less willing to hold
inventory and switched to being primarily brokers. There is also evidence that
the initiation of TRACE reporting was accompanied by a shift from publicly
traded to privately placed corporate bonds.
Regulators have recently imposed a
similar change in post-trade transparency in the municipal bond market.
Municipal bonds, like swaps and corporate bonds, trade over-the-counter.
Traditionally, there has been no public dissemination of trade prices in this
market. Starting in 1999, the Municipal Securities Rulemaking Board (MSRB)
began to require reporting of both dealer trades with customers and interdealer
trades. Trade information was required to be disseminated to the public the
next day for bonds that traded four or more times. In 2003, the four-trade
threshold was abandoned and all trades began to be disseminated the next day.
Starting on Jan. 31, 2005, “real-time” reporting of municipal bonds was
initiated. Trades were required to be reported within 15 minutes and trade
information (price, number of bonds, and whether the trade was an interdealer
trade, a dealer purchase, or a dealer sale) was immediately disseminated to the
Schultz (2011), I examine the impact of real-time reporting on trades of newly
offered municipal bonds. Unlike equities, new issues of municipal bonds are not
required to be sold to all investors at the same price. Underwriters are
required to sell a portion (10 percent) to the public at the stated public
offering price, but can sell the rest at whatever price the market will bear.
examine ratios of the price investors pay for bonds to the reoffering price
and the mean interdealer trade price in the 10 days following the offering. The
increase in post-trade transparency has very little impact on either of these
measures of the markups paid by investors. On the other hand, the standard
deviation of prices investors pay to purchase bonds on the same day falls
dramatically with real-time reporting. Investors are less likely to overpay for
municipals, but they are also less likely to get great deals.
like corporate and municipal bonds, trade over-the-counter. It is possible
that requiring trade reporting will have many of the same effects on the swap
market that it had on the bond markets. That is, trading costs could decline
for swaps, and that could be less variation in prices. Experiences with the
introduction of post-trade transparency in the bond markets suggest that small
investors would be the biggest beneficiaries of increased transparency. The
swap market is, however, almost entirely an institutional market. In the swap
market, as with the bond markets, there is the possibility that real-time
reporting of large trades may make it difficult for dealers to hedge or unwind
positions without being front-run.
is a critical difference between the imposition of real-time reporting in the
swaps market, and the earlier impositions of real-time reporting in the
corporate and municipal bond markets. In those cases, reporting requirements
were gradually strengthened over several years. Dodd-Frank requires creating a
new trade reporting system from scratch. It may make sense to phase it in, with
reporting requirements introduced for more swaps over time, and for allowable
reporting delays to be gradually diminished. That would make it possible to
more accurately weigh the costs and benefits of real-time reporting for swaps.
Paul Schultz is the John and Maude Clarke Professor of Finance at the
University of Notre Dame. He can be reached at firstname.lastname@example.org.
Hendrik, and William Maxwell, 2008, Markets: Transparency and the corporate
bond market, Journal of Economic Perspectives 22, 217-234.
Hendrik, William Maxwell, and Kumar Venkataraman, 2006,Market transparency,
liquidity externalities, and institutional trading costs in corporate bonds,
Journal of Financial Economics 82, 251-288.
Amy, Lawrence Harris, and Michael Piwowar, 2007, Corporate bond market transparency
and transaction costs, Journal of Finance 62, 1421-1451.
Michael, Edith Hotchkiss, and Eric Sirri, 2007, Transparency and liquidity: A
controlled experiment in corporate bonds, Review of Financial Studies 20,
Paul, 2011, The market for new issues of municipal bonds: The roles of
transparency and limited access to retail investors, Working paper, University
of Notre Dame.