Independent TRACE Studies
Scholars have published several papers that evaluate TRACE’s impact on liquidity, valuation and other aspects of the U.S. Corporate Bond market. Abstracts and links to the studies are listed below.
(a) Corporate Bond Market Transparency and Transaction Costs by Edwards, Amy K., Harris, Lawrence and Piwowar, Michael S; September 21, 2004
Using TRACE data—a complete record of all US OTC secondary trades in corporate bonds—we estimate average transaction cost as a function of trade size for each bond that traded more than nine times in 2003. We find that transaction costs are higher than in equities and decrease significantly with trade size. Highly rated bonds, recently issued bonds, and bonds that will soon mature have lower transaction costs than do other bonds. Costs are lower for bonds with publicly disseminated trade prices, and they drop when the TRACE system starts to publicly disseminate their prices. The results suggest that public traders would significantly benefit if bond prices were made more transparent.
(b) Transparency and Liquidity: A Controlled Experiment on Corporate Bonds by Goldstein, Michael A., Hotchkiss, Edith S. and Sirri, Erik R; March 20, 2006 (first draft November 1, 2004)
This article reports the results of an experiment designed to assess the impact of last-sale trade reporting on the liquidity of BBB corporate bonds. Overall, adding transparency has either a neutral or a positive effect on liquidity. Increased transparency is not associated with greater trading volume. Except for very large trades, spreads on newly transparent bonds decline relative to bonds that experience no transparency change. However, we find no effect on spreads for very infrequently traded bonds. The observed decrease in transactions costs is consistent with investors' ability to negotiate better terms of trade once they have access to broader bond-pricing data.
(c) Market Transparency, Liquidity Externalities, and Institutional Trading Costs in Corporate Bonds by Bessembinder, Hendrik (Hank), Maxwell, William F. and Venkataraman, Kumar; November, 2005
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.
(d) Missing the Marks: Dispersion in Corporate Bond Valuations Across Mutual Funds by Cici, Gjergji , Gibson, Scott and Merrick, John J..; first draft November 2007, second draft May 2008
We study the dispersion of month-end valuations placed on identical corporate bonds by different mutual funds. Our dispersion measures offer insights into corporate bond valuation problems at the individual security level. Results show that pricing dispersion is related to bond-specific characteristics typically associated with market liquidity and market-wide volatility. We show that the rollout of FINRA's transparency-enhancing TRACE system has increased the precision of corporate bond valuation, benefiting investors. We also find that the volatile marking patterns of some funds are associated with return smoothing behavior. However, return smoothing behavior is not prevalent across our sample of bond mutual funds.
(e) Liquidity of Corporate Bonds by Bao, Jack, Pan, Jun and Wang, Jiang, July 9, 2008
This paper examines the liquidity of corporate bonds and its asset-pricing implications using a novel measure of illiquidity based on the magnitude of transitory price movements. Using transaction-level data for a broad cross-section of corporate bonds from 2003 through 2007, we find the illiquidity in corporate bonds to be significant, substantially greater than what can be explained by bid-ask bounce, and closely linked to liquidity-related bond characteristics. More importantly, we find a strong commonality in the time variation of bond illiquidity, which rises sharply during market crises and reaches an all-time high during the recent sub-prime mortgage crisis. Monthly changes in this aggregate bond illiquidity are strongly related to changes in the CBOE VIX Index and lagged stock market returns. Examining its relation with bond pricing, we find that our measure of illiquidity explains the cross-sectional variation in average bond yield spreads with large economic significance.
(f) Price Dispersion in OTC Markets: A New Measure of Liquidity byJankowitsch, Rainer, Nashikkar, Amrut J. and Subrahmanyam, Marti G., April 2008
In this paper, we model price dispersion effects in over-the-counter (OTC) markets to show that in the presence of inventory risk for dealers and search costs for investors, traded prices may deviate from the expected market valuation of an asset. We interpret this deviation as a liquidity effect and develop a new liquidity measure quantifying the price dispersion in the context of the US corporate bond market. This market offers a unique opportunity to study liquidity effects since, from October 2004 onwards, all OTC transactions in this market have to be reported to a common database known as the Trade Reporting and Compliance Engine (TRACE). Furthermore, market-wide average price quotes are available from Markit Group Limited, a financial information provider. Thus, it is possible, for the first time, to directly observe deviations between transaction prices and the expected market valuation of securities. We quantify and analyze our new liquidity measure for this market and find significant price dispersion effects that cannot be simply captured by bid-ask spreads. We show that our new measure is indeed related to liquidity by regressing it on commonly-used liquidity proxies and find a strong relation between our proposed liquidity measure and bond characteristics, as well as trading activity variables. Furthermore, we evaluate the reliability of end-of-day marks that traders use to value their positions. Our evidence suggests that the price deviations are significantly larger and more volatile than previously assumed. Overall, the results presented here improve our understanding of the drivers of liquidity and are important for many applications in OTC markets, in general.
(g) Transparency and the Corporate Bond Market by Maxwell, William F. and Bessembinder, Hendrik (Hank), January 10, 2008
The U.S. corporate bond market underwent a fundamental change with the introduction of TRACE in 2002. Beginning on that date, bond dealers were required to report all trades in publicly-issued corporate bonds to the National Association of Security Dealers, which in turn made transaction data available to the public. In this paper, we assess the impact of the increase in transparency on the corporate bond market. Investors have benefited from the increased transparency, through substantial reductions in the bid-ask spreads that they pay to bond dealers to complete trades. Conversely, bond dealers have experienced reductions in employment and compensation, and dealers' trading activities have moved toward alternate securities, including syndicated bank loans and credit default swaps. The primary complaint against TRACE is that trading is more difficult as dealers are reluctant to carry inventory and no longer share the results of their research. In essence, the cost of trading corporate bonds decreased, but so did the quality and quantity of the services formerly provided by bond dealers. The debate regarding optimal transparency of the corporate bond markets continues, and the question of what degree of transparency in security markets is desirable will remain the subject of study and debate for the foreseeable future.