“There is not a crime, there is not a dodge, there is not a trick, there is not a swindle, there is not a vice which does not live by secrecy,” Joseph Pulitzer once said. The famous publisher’s words could easily apply to the bond market.
The bond market has always been one of the murkiest corners of the financial system — a vast, dark pool prowled by predators waiting to pounce on less sophisticated investors. The corporate bond market is particularly opaque, and regulators have over the years fought hard to introduce some transparency, with some success.
But some asset managers and banks have started to argue that this has had negative unintended consequences on the market’s health, aggravating already poor trading conditions, and are quietly but forcefully lobbying for regulators to scale back some reporting requirements. This may sound self-serving, but their argument is understandable.
For much of the 20th century, investors wanting to find out the price of a corporate bond had to call one of the big investment banks that dealt in the fixed income market, and trust the information they were given was accurate and timely. That was not always the case.
But the industry underwent a revolution in 2002 when the National Association of Securities Dealers — nowadays known as the Financial Industry Regulatory Authority — ordered that all corporate bond trades should be reported in a timely fashion.
Finra’s Trade Reporting and Compliance Engine has since been expanded to encompass virtually all bonds traded in the US, most recently complex bonds backed by the revenue streams of car or student loans, which were brought under the Trace fold in July. Most transactions have to be reported within 15 minutes, when anyone in the world can see what price a bond traded at and have a rough idea of the size.
Banks have never been thrilled about Trace, arguing that the transparency hurt their ability to make markets, but for most of the noughties these misgivings could be ignored or dismissed as laughably self-serving, given how liquid bond markets were. But in the trading crunch that has followed the financial crisis, their concerns are being taken more seriously in the wider financial industry.
Before, a bank trader could comfortably take a $50m bond position from an asset manager, and if he was unable to sell it quickly at a higher price, he could stash it away on the bank’s balance sheet. The price paid would go out on Trace, but in a few days or weeks it would be stale, and the trader could offload the position in one big chunk or several slices over time, pocketing any mark-up.
These days, bank traders are loath or unable to sit on big positions due to regulatory restrictions. Even if an asset manager is willing to offload his position to a dealer at a deep discount, the price they agree will swiftly go out to the entire market through Trace, hamstringing the trader’s ability to offload it quickly.
There is therefore a mounting industry campaign to delay Trace reporting requirements when trading big blocks of bonds. Asset managers and banks argue this would ameliorate the liquidity crunch afflicting bond markets, at a paltry cost to its transparency.
There is some evidence to back them up. A 2013 paper by Paul Asquith and Parag Pathak at MIT and Thom Covert at Harvard Business School looked at the impact of Trace rollout for various segments of the bond market on trading volumes. They found that “price dispersion” fell thanks to the extra visibility, but trading activity also shrank markedly. The impact was particularly sharp for junk bonds.
For the most part this is still an acceptable trade-off. But on balance there is a strong case for easing reporting requirements for bigger bond block trades worth, say, $25m or more. Transactions would still be reported to Trace instantaneously to ensure that regulators have full and contemporaneous clarity, but public dissemination could be delayed by perhaps a day without unduly impeding fairness and transparency.
People close to the talks say Finra appears open to the idea at least. Whether a financial industry still struggling with a credibility problem will be successful in curtailing Trace remains to be seen, however.
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