Can Transparency Hurt Investors In OTC Markets?
Cornell University – Samuel Curtis Johnson Graduate School of Management
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March 11, 2016
This paper examines the efficacy of post-trade transparency regulations like TRACE in over-the-counter (OTC) markets. It is a widely held belief that greater transparency in the trading process benefits investors by reducing opportunities for their exploitation, but I show that this need not be the case. Using a multi-period auction based model of trading, I demonstrate that potential counterparties may delay their trades when there is transparency because they can monitor transaction prices and learn more, before participating. This leads to liquidity dry-ups and increased execution risks for investors with immediate trading needs. My model offers an alternative explanation for many of the pronounced adverse characteristics of OTC markets in recent times — like diminished liquidity — usually attributed to the exodus of dealers from the market. I also propose alternative market designs that can ameliorate some of the negative effects.
Can Transparency Hurt Investors In OTC Markets? – Introduction
In this paper I study the efficacy of post-trade transparency reforms in over-the-counter (OTC) markets. Market transparency has been a major concern for regulators all around the world, especially since the financial crisis in 2008. While there is still considerable debate as to the precise triggers for the crisis, most stakeholders now agree that opaque venues trading complex financial products were key enablers. A key focus of the regulatory agenda in the post-crisis era, therefore, has been transparency, and the template for reforms has been the Trade Reporting and Compliance Engine (TRACE) and Transaction Reporting System (TRS) regulations. These two were among the earliest rules in OTC markets to engender transparency, introduced in 2002 and 2005 respectively.
In recent years, TRACE’s regulatory reach has been expanded to include agency debentures (March 2010), mortgage-backed securities (July 2013), 144-A private placements (June 2014) and asset backed securities (June 2015). Proposals under review seek to expand its ambit further to include collateralized mortgage and debt obligations, and commercial mortgage backed securities. Moreover, researchers at the Federal Reserve have been advocating a TRACE-like reporting mechanism even for OTC derivatives, and in January 2013, such a system was rolled out for OTC swap trades. Despite the huge real world importance, academic research – especially theoretical work – on the impact of regulations like TRACE remains limited. In this paper I aim to bridge this gap in the literature by developing a tractable model of OTC trading that provides a number of insights on the effect of such transparency reforms.
A key result in the paper is that transparency need not be uniformly benign for all market participants. Specifically, it is investors with immediate liquidy needs who suffer. To see why this may be so, imagine an auction (with possible resale) for an object with a common value component. Suppose some bidders do not have precise signals about the common value. When there is transparency, such bidders may prefer to stay out of the main auction and buy later from the winner. This is because transparency allows them to monitor the auction and learn information about the common value; this enables them to negotiate a good bargain with the winner later. But since some bidders opt out, competition in the main auction comes down, and the only bidders that offer quotes are the ones with precise knowledge about common value seeking to exploit the information. Thus the seller with immediate need for liquidity earns less revenue. In effect, transparency leads to a redistribution of trading surplus, and my analysis explores which market segments benefit and which suffer.
The redistribution effect offers an alternative explanation for many of the adverse attributes of OTC markets in the post-TRACE era. For instance, shrinking liquidity, a pronounced feature of bond markets in recent times, may be at least partly attributable to counterparties voluntarily opting out of active trade in favor of monitoring for more information. Similarly, increased execution costs, reported by some OTC investors, may occur due to the preponderance of informed quote providers. The prevailing wisdom blames mostly banks that may have abdicated their conventional dealership roles due to enhanced restrictions and capital requirements after the financial crisis in 2008. But this explanation cannot resolve the apparently inconsistent findings in empirical papers like Asquith, Covert, and Pathak (2013) (fall in trading activity accompanies a fall in price dispersion after introduction of TRACE) which my model can.
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