Pre-Trade Transparency in Over-the-Counter Markets

Abstract

To understand whether and how pre-trade transparency would affect over-the-counter markets, we construct a search model and test our model implications in corporate bond markets. Based on our search model, we argue that the increase in pre-trade information, which refines traders' information sets, enhances traders' bargaining positions relative to dealers'. Thus, traders' transaction costs measured by bid-ask spreads are reduced. Smaller bid-ask spreads induce more traders to participate, and hence, lead to an increase in market liquidity. Our model is novel in that we consider traders' lack of pre-trade information as Knightian uncertainty. In other words, the unavailability of pre-trade information impedes the formation of a unique prior for traders.Our model implications are supported through a controlled experiment on the corporate bond market. Using propensity score matching to construct groups of bonds with and without pre-trade information, we find that the average effective bid-ask spread is 11 basis points lower on pretrade transparent bonds. This means that a minimum of $930 million would be saved annually on transaction costs if pre-trade transparency had been enforced. 1

The effects of increased transparency on market liquidity : empirical evidence from Thai bond market

“…This can imply that if post-trade transparency increase, the average daily spread of overall bond in Thai bond market will decrease. This evidence supports Edwards, Harris and Piwowar (2007), Chen and Zhong (2012) who argue that traders' trading costs are decreasing in transparent market.…”

“…(Babbel, 2001) -Issue size Edwards, Harris and Piwowar (2007) provide evidence that large issues are cheaper to trade than small issues. Consistent with Chen and Zhong (2012), their results show that spreads have negative relationship with issue size.…”

“…(Pagano & Roell, 1996) Also, improved transparency can decrease market making cost. Moreover, the following study (Flood, Huisman, Koedijk, & Mahieu, 1999) argue that pre-trade transparency reduces bid-offer spread and improves market liquidity Chen and Zhong (2012) argue that traders have an information advantage over dealers. They apply the approach, used by (Hong & Warga, 2000) and (Chakravarty & Sarkar, 2003) to estimate the average effective spread of pre-trade transparent bonds.…”

“…Together with this study, they also argue that transparency can induce more traders to participate, hence enhances traders' advantage over dealer and reduce trading costs. (Chen & Zhong, 2012) Many theoretical analyses imply that spreads are declined in transparent market. (Edwards, Harris, & Piwowar, 2007) and (Goldstein, Hotchkiss, & Sirri, 2007) The results of most empirical findings conclude that the effects of increasing transparency depend on the structure of the market and its securities.…”