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Market Transparency, Liquidity Externalities, And Institutional Trading Costs in Corporate Bonds

Security markets vary greatly in their transparency, i.e. in the amount of information regarding market conditions made public on a timely basis. Equity markets generally disseminate continuous pre-trade information, such as best quotations and, in some cases, information about unexecuted limit orders, and also report immediately prices and sizes of completed trades.

Most futures markets report trades, but do not disseminate pre-trade information. Foreign exchange markets disseminate only non-binding “indicative” quotations to the public, and do not report transactions at all. Corporate bond markets were traditionally similarly opaque, with quotations available only to a few market professionals, and no public transaction reporting.

Market transparency has been the subject of a handful of studies, but neither the theoretical predictions nor the empirical evidence is conclusive as to whether market quality is enhanced by increased transparency. In this paper, we develop a simple model of how more precise estimation of values occasioned by increased transparency can affect trade execution costs, and test its implications by estimating institutional trading costs in corporate bonds when the National Association of Securities Dealers (NASD) began to publicly report transactions in approximately 500 corporate bond issues through its Trade Reporting and Compliance Engine (TRACE) on July 1, 2002.

The initiation of TRACE transaction reporting provides a potentially powerful experiment for assessing whether transparency is important to market quality, because the corporate bond markets were quite opaque prior to TRACE. In contrast, the previous empirical work on transparency studied relatively small changes in the already quite transparent equity markets.

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Market Transparency, Liquidity Externalities, And Institutional Trading Costs in Corporate Bonds