The Microstructure of the Bond Market in the 20th Century

Bonds are traded in OTC markets, where opacity and fragmentation imply large transaction costs for retail investors. Is there something special about bonds, in contrast to stocks, that precludes trading in transparent, limit-order markets? Historical experience suggests this is not the case. Before WWII, there was an active market in corporate and municipal bonds on the NYSE. Activity dropped dramatically, in the late 1920s for municipals and in the mid 1940s for corporate, as trading migrated to the OTC market. This migration occurred simultaneously with an increase in the role of institutional investors, which fare better than retail investors in OTC market. Based on current and historical high frequency data, we find that, for retail investors, trading costs in municipal bonds were half as large in 1926-1927 as they are now. The difference in transactions costs is likely to reflect the difference in market structures.

Financial Intermediation and the Role of Price Discrimination in a Two-Tier Market

Though unambiguously outperforming all other financial markets in terms of liquidity, foreign exchange trading is still performed in opaque and decentralized markets. In particular, the two-tier market structure consisting of a customer segment and an interdealer segment to which only market makers have access gives rise to the possibility of price discrimination. We provide a theoretical foreign exchange pricing model that accounts for market power considerations and analyze a database of the trades of a German market maker and his cross section of end-user customers. We find that the market maker generally exerts low bargaining power vis-á-vis his customers. The dealer earns lower average spreads on trades with financial customers than commercial customers, even though the former are perceived to convey exchange-rate-relevant information. From this perspective, it appears that market makers provide interdealer market liquidity to end-user customers with cross-sectionally differing spreads.foreign exchange; market microstructure; pricing behavior

Impact of Electronic Trading Platforms on the Brokered Interdealer Market for Government of Canada Benchmark Bonds

This study examines the impact of increased transparency, brought about by the introduction of three electronic trading systems, on the brokered interdealer market for Government of Canada benchmark securities. Using the CanPX dataset for the 2-, 5-, 10-, and 30-year benchmarks, the paper finds some evidence of decreased bid-ask spreads for the 30-year benchmark in the months following the introduction of the electronic platforms. Bid-ask spreads are not significantly different in the pre- and post-transparency periods for the 2-, 5- or 10-year benchmarks. The price-impact coefficient, calculated using dollar value as a measure of order flow, also decreased in the post-event period for the 30-year benchmark but is not statistically different for any of the other benchmarks. Overall, there is little evidence that liquidity improved or was lowered by the introduction of the electronic systems.Financial markets; Market structure and pricing

Financial intermediation and the role of price discrimination in a two-tier market

Though unambiguously outperforming all other financial markets in terms of liquidity, foreign exchange trading is still performed in opaque and decentralized markets. In particular, the two-tier market structure consisting of a customer segment and an interdealer segment to which only market makers have access gives rise to the possibility of price discrimination. We provide a theoretical foreign exchange pricing model that accounts for market power considerations and analyze a database of the trades of a German market maker and his cross section of end-user customers. We find that the market maker generally exerts low bargaining power vis-á-vis his customers. The dealer earns lower average spreads on trades with financial customers than commercial customers, even though the former are perceived to convey exchange-rate-relevant information. From this perspective, it appears that market makers provide interdealer market liquidity to end-user customers with cross-sectionally differing spreads. --foreign exchange,market microstructure,pricing behavior

Price Discovery in Currency Markets

This paper examines the price discovery process in currency markets, basing its analysis on the pivotal distinction between the customer (end-user) market and the interdealer market. It first provides evidence that the price discovery process cannot be based on adverse selection between dealers and end users, as postulated in standard equity-market models, because the spreads dealers quote to their customers are not positively related to a trade’s likely information content. The paper then highlights three hypotheses from the literature – fixed operating costs, market power, and strategic dealing – that may explain the cross-sectional variation in customers spreads. The paper finishes by proposing a price discovery process relevant to liquid two-tier markets and providing preliminary evidence that this process applies to currencies.Bid-ask spreads, foreign exchange, asymmetric information, microstructure, price discovery, interdealer, inventory, market order, limit order

Beyond Bond Markets 2000: The Electronic Frontier and Regulation of the Capital Markets for Debt Securities

On Oct 18-19, 1999, more than fifty securities lawyers, representatives of ratings agencies, regulators and academics gathered in Washington DC for a conference on the regulation of capital markets for debt securities. Some of the recurrent themes and conclusions arising from deliberations by conference participants are discussed

Comparing possible proxies of corporate bond liquidity

We consider eight different proxies (issued amount, coupon, listed, age, missing prices, yield volatility, number of contributors and yield dispersion) to measure corporate bond liquidity and use a five-variable model to control for interest rate risk, credit risk, maturity, rating and currency differences between bonds. The null hypothesis that liquidity risk is not priced in our data set of euro corporate bonds is rejected for seven out of eight liquidity proxies. We find significant liquidity premia, ranging from 9 to 24 basis points. A comparison test between liquidity proxies shows limited differences between the proxies.euro market;corporate bonds;liquidity;Fama-French model

SIZE AND HETEROGENEITY MATTER. A MICROSTRUCTURE-BASED ANALYSIS OF REGULATION OF SECONDARY MARKETS FOR GOVERNMENT BONDS.

This paper deals with the economics of secondary markets for government bonds. Ultimately, the analysis is shaped by a public policy goal: assessing the elements of a regulatory framework for these markets. In that regard, the decisive role of market structure leads to a critical review of microstructure conclusions relevant specifically for government debt markets. It is argued that the nature of information asymmetries and matching costs in government debt markets determines a bias towards a fragmented microstructure at odds both with exchange-like arrangements and with ordinary regulatory approaches. Hence, a generic conclusion highlights the risks of blindly transposing regulatory principles from the equity markets area without due regard to the specifics of the bond market. As a specific application of this idea, the paper critically reviews electronic trading platforms that emulate exchange-like order execution solutions. More specifically, the paper opposes the hybrid microstructure (pure limit order book plus affirmative quoting obligation) faced by European primary dealers and the arbitrage-based approach to market-making found in US inter-dealer markets. The Citigroup disruptive trade in August 2004 is analyzed from this perspective. Government bond regulation is argued to necessarily depart from ordinary approaches also because it captures the diverse interests of various governmental agencies. As an application of this principle, the paper discusses repo and short-selling regulation in government bond markets. The atypical market structure and the multi- agency endeavour around government bond markets raise the chances of regulatory failures. Nevertheless, it is argued that a reliance on competition, integrative infrastructure and basic systemic protections as over-arching principles for regulation is consistent with recommendations from relevant economic theory. Finally, political economy issues arising in implementation of transparency, disclosure or retail investor protection will be addressed in the context of selected country cases.government bonds, microstructure, regulation

E-Finance: An Introduction

" Franklin Allen, James McAndrews and Philip Strahan, October 2001 Abstract: E-finance is defined as "The provision of financial services and markets using electronic communication and computation". In this paper we outline research issues related to e-finance that we believe set the stage for further work in this field. Three areas are focused on. These are the use of electronic payments sys tems, the operations of financial services firms and the operation of financial markets. A number of research issues are raised. For example, is the widespread use of paper-based checks efficient? Will the financial services industry be fundamentally changed by the advent of the internet? Why have there been such large differences in changes to market microstructure across different financial markets?