Can Too Much Transparency Harm Liquidity?

Terry Flanagan

Panelists at this week’s roundtable held by the Securities and Exchange Commission on the fixed income markets said that too much transparency could dissuade dealers and market makers from posting liquidity in large blocks.

”Liquidity and transparency are different things, which over time may move together but in short term may be inversely related, especially for large trade sizes,” said Dexter Senfft, managing director at Morgan Stanley and global head of fixed income e-commerce.

“At Morgan Stanley, we are trying to get best execution for our customers, so we will side with liquidity every time, even if that happens at the cost of reduced transparency,” he said. “It’s dangerous for regulators to be asking what they can do to improve both liquidity and transparency, because they will be hard pressed to do both.”

The SEC roundtable explored whether pre-trade transparency in the corporate and municipal bond markets can be enhanced through wider dissemination of pricing information on ATSs, whether it should apply to all ATSs or only those with significant trading volume, and whether public dissemination should provide flexibility with respect to block trades.

Currently, there is no national system for disseminating price quotes in U.S. fixed income securities, as there is for equities, although bond trading platforms such as MarketAxess, Tradeweb, and others do provide such information.

“The combination of transparency and access to electronic order flow has enabled a lot of new dealers to get into the corporate bond markets,” said Rick McVey, chairman and CEO of MarektAxess. “Previously, these were equity and alternative market makers, or regional dealers serving smaller institutional or retail clients. Today, these new dealers are responsible for 30% of our trades and 25% of our volume, so there has been an important contribution to liquidity which partially offsets the drain in liquidity from dealers who, because of increased capital requirements, are holding less inventory for market making.”

MarketAxess, which operates an electronic trading platform to trade corporate bonds and other types of fixed-income instruments, has about 1,000 active institutional investor clients (investment advisers, mutual funds, insurance companies, pension funds, bank portfolios, broker-dealers and hedge funds), and 87 broker-dealer market-maker clients.

“Among the large institutional clients we serve, the biggest concern is in block trading,” said McVey. “Block trading accounted for 55% of Trace four years ago, and is now down to 42%, despite the fact that the U.S. corporate bond market has gotten significantly larger. So institutional market makers are managing more corporate debt and block trading is getting smaller.”

The Trade Reporting and Compliance Engine (Trace) is the Finra-developed vehicle that facilitates the mandatory reporting of over the counter secondary market transactions in eligible fixed income securities.

Trace disseminates transaction level data in real-time, capping those transactions which meet Finra’s designated thresholds to ensure that liquidity for the largest traders are not reduced because of transparency (size is capped at $5 million for corporate investment grade and agency debt securities, and $1 million for high yield debt securities).

“I would worry if there are any proposed changes to the way Finra reports Trace data with respect to block trading,” McVey said. “Exposing more information with respect to exact trade size would reduce incentives for dealers to make markets in block sizes at a time when block liquidity is shrinking.”

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