It’s not just retail traders who are receiving poorer execution for US corporate bond trades; institutional traders are, too. Less active institutional traders pay, on average, 0.17% more for purchases and receive 0.36% less for sales than more active traders. Lack of transparency and the presence of dealer power only reinforce qualitative disparity.
How Is This Research Useful to Practitioners?
The enormity of the market notwithstanding, corporate bonds trade mostly in decentralized and opaque dealer markets. Many issues trade infrequently. Thus, ascertaining how well trades reflect actual prices is difficult. Dealer power and other market traits only complicate things.
Customers executing the same trade for the same issue at the same time often do not receive the same price. Qualitative issues in trade execution remain widespread. Less active investors obtain worse executions than more active traders, paying about 0.17% more for purchases and receiving 0.36% less for sales. Concentration among bond dealers is high; three make up 92% of the market. Such concentration only worsens the disparity in execution quality between trades for more and less active investors. More passive traders—for example, pension funds and insurers—are subject to greater dealer price discrimination than active traders such as mutual funds. Finally, the size of the trading network has a significant effect on the price differentials for more versus less active traders. These differences arise primarily from dealer power. The authors note that with greater awareness of the problem, institutional traders can adapt their trading networks to better counteract these anticompetitive forces.
Insurers are the largest traders of corporate bonds. Additionally, because they are institutions, insurance companies transact only with dealers. Finally, insurers’ bond trades may not be speculative, pursuant to regulation.
Practitioners on the buy side will find the authors’ conclusions informative, as will regulators seeking a better understanding of this opaque market and compliance officers charged with overseeing best practices in trade execution.
The degree of investor sophistication matters because information asymmetry can harm less sophisticated investors. Greater investor bargaining power can afford investors better execution, which suggests that concentrate trades among a smaller dealer network would be worthwhile.
How Did the Authors Conduct This Research?
The authors survey the literature on OTC market behavior to inform their study of execution differentials. The data are insurance companies’ corporate bond transactions from 2001 to 2011 from the National Association of Insurance Commissioners database. Detailed information on the trades includes identity of the issue and issuing firm, execution date, transaction price, par value traded, trade direction (the insurer buys from or sells to a dealer), and identity of the parties to the trade (i.e., insurer and dealer). Insurance company trades are institutional quality and not of a speculative nature. Insurers are classified as more or less active as a function of the degree to which the par value of their holdings is greater or lesser than the mean aggregate bond holding of all insurers in the year prior to the trade. After some winnowing for pricing errors and duplicate trades, the authors have a sample of two million trades.
They test for qualitative differences in trades between more and less active investors, comparing prices for both types of traders when they complete similarly sized trades in the same issue on the same day and adjusting for trade size differences so that they do not affect execution prices. Their findings confirm that certain traders receive worse trade prices than others.
Additionally, the authors control for dealer identity, which reveals that execution differences narrow to some extent but confirms that trading with less competitive dealers partially accounts for poorer execution quality for less active traders. The authors’ conclusions hold up to robustness tests.
The analysis importantly considers factors that worsen or improve differences in trade quality.
Abstractor’s Viewpoint
Traders’ ability to obtain fair pricing for corporate bonds continues to be a challenge in the decentralized and opaque OTC dealer marketplace. Greater transparency would help lessen dealer power, which accounts for poor execution quality. Institutional traders and regulators should be aware of the determinants of disparity in the OTC marketplace. There is evidence of some progress: The SEC approved a FINRA proposal to mandate same-day principal trade price disclosure. The TRACE (Trade Reporting and Compliance Engine) program developed by the National Association of Securities Dealers has been instituted for OTC trades in eligible fixed income securities. The European Markets in Financial Instruments Directive (MiFID II) requirements that firms establish best execution policy for all asset classes and the SEC’s attention on dealer markups in riskless principal trading are also evidence of greater compliance in this space.