Expansion of TRACE in the U.S. Fixed-Income OTC Market
Trade reporting and market transparency in the U.S. fixed income OTC market will expand substantially this year as trade reporting encompasses entire new classes of debt. Two initiatives by the Financial Industry Regulatory Authority (FINRA) would more than double the percentage of the U.S. debt market subject to FINRA data collection.
First, effective March 1, 2010, FINRA will begin collecting and disseminating trade data on debt issued by federal government agencies, government corporations and government sponsored enterprises (GSEs), as well as primary market transactions in new issues. Prior to this change, FINRA’s Trade Reporting and Compliance Engine (TRACE) reported real time pricing and trade volume information only on corporate bonds trading in the secondary market.
The second change, pending approval by the U.S. Securities and Exchange Commission, will pave the way for collection of trade data on securitized products, including asset-backed securities (ABS) and mortgage-backed securities (MBS). As with the original implementation of TRACE in 2002, FINRA would initially only collect transaction data and after detailed analysis determine whether dissemination of some or all ABS and MBS data is appropriate. TRACE reporting of ABS and MBS transactions would provide to FINRA trade prices, volume and other information.
Collecting transaction data on these additional markets will enhance FINRA's ability to better detect fraud, manipulation, unfair pricing and other misconduct that violates federal securities laws and FINRA rules. From a regulatory perspective, these changes to widen the reportable-bond universe would increase to 70 percent from 28 percent the proportion of the U.S. debt market under FINRA market surveillance. This includes market surveillance FINRA conducts on municipal debt securities on behalf of the Municipal Securities Rulemaking Board. Firms would report post-trade data for all publicly traded debt securities except money market instruments and U.S. Treasury securities.
FINRA's proposal to collect ABS and MBS data, if approved, also would advance disclosure as an effective means of creating more stable capital markets, as emphasized by U.S. President Barack Obama's administration in the U.S. Treasury Department's "Financial Regulatory Reform: A New Foundation".
TRACE has played a large role in creating a structure for OTC market transparency. Recently, the Federal Reserve Bank of New York’s study of the OTC derivatives market published last month (Federal Reserve Bank of New York Staff Report No. 424 – Policy Perspectives on OTC Derivative Markets Infrastructure http://www.newyorkfed.org/research/staff_reports/sr424.pdf) identifies improvement of “trade level price reporting” as an effective step to improve the OTC derivatives market. FINRA’s TRACE is cited in the report:
“For example, TRACE, a system for disseminating essentially all transactions prices in the over-the-counter markets for corporate and municipal bonds, was established in 2002. TRACE reports transactions prices after a brief delay, providing investors some insight into the range of prices at which they are likely to be able to execute their next trades. This can improve the ability of investors, particularly those who are not dealers, to “shop around,” that is, to determine more easily whether to accept the bids and offers quoted to them, and also allows them to better monitor the quality of price execution that they have received on their past trades.”
TRACE: Perspectives on Transparency in the Corporate Bond Market
The U.S. corporate bond market is a vital financial sector with outstanding issuance exceeding $6 trillion. TRACE currently captures and disseminates secondary market transaction information in over 30,000 eligible securities from 2,000 FINRA-regulated firms registered to trade corporate bonds.
TRACE was established in July 2002 to bring transparency to the corporate bond market. It was fully phased in by January 2006, offering real-time, public dissemination of transaction and price data for all publicly traded corporate bonds – including intra-day transaction data and aggregate end-of-day statistics (most active bonds, total volume, advances and declines and new highs and lows). This data is available through all major market data vendors and on certain public websites. Over 40,000 professionals currently use the data, and free access is available to retail investors through FINRA’s website.
The Impact of Transparency – Independent Academic Studies
A number of independent academic studies have been undertaken to explore the effects of TRACE on the market place. Among their findings:
- TRACE has effectively narrowed bid-ask spreads, widely agreed to be a hallmark of efficient markets.
- TRACE has reduced investor cost significantly. Independent studies indicate estimated annual trading cost reductions of nearly $1 billion for the full corporate bond market.
- TRACE has contributed to improved valuation precision, reducing the dispersion in valuation between different mutual funds holding the same security.
- There has been no observed loss of liquidity since the launch of TRACE. During the roll-out of TRACE, one study indicated that the increased post-trade transparency had a neutral or positive effect on liquidity for BBB-rated corporate bonds.
Two studies explored the trade execution cost in light of TRACE and reached similar conclusions. In a 2004 study, Edward, Harris, and Piwowar concluded that “[Transaction] Costs are lower for bonds with publicly disseminated trade prices, and they drop when the TRACE system starts to publicly disseminate their prices. The results suggest that public traders would significantly benefit if bond prices were made more transparent.”
Similarly, a 2005 study authored by Bessembinder, Maxwell, and Venekataraman found that “The results indicate a reduction of approximately 50% in trade execution costs for bonds eligible for TRACE transaction reporting …We also document decreased market shares for large dealers and a smaller cost advantage to large dealers post-TRACE, suggesting that the corporate bond market has become more competitive after TRACE implementation.”
In a 2004 study, Goldstein, Hotchkiss and Sirri explored the effects of TRACE on liquidity: “Overall, adding transparency has either a neutral or a positive effect on liquidity. Increased transparency is not associated with greater trading volume. Except for very large trades, spreads on newly transparent bonds decline relative to bonds that experience no transparency change. However, we find no effect on spreads for very infrequently traded bonds.”
Regarding valuation precision, a 2008 study authored by Cici, Gibson, and Merrick measured the dispersion of month-end valuations placed on identical corporate bonds held by different mutual funds: “Results show that pricing dispersion is related to bond-specific characteristics typically associated with market liquidity and market-wide volatility. We show that the rollout of FINRA's transparency-enhancing TRACE system has increased the precision of corporate bond valuation, benefiting investors.”
In its almost eight years of existence, TRACE has provided the market place and regulators with invaluable insight to the Corporate Bond market. Many of the pre-TRACE notions of the market proved inaccurate or incomplete: dealer participation is less concentrated than was anticipated; retail investors are much more active than was commonly thought; a broader range of securities trade more actively than most industry participant predicted; among others. FINRA makes aggregate market information available in the FINRA TRACE Fact Book published annually (as of 2009, the Fact Book includes quarterly updates).
Market Activity Levels & Market Breadth
The corporate bond market is more actively traded than previously perceived. Over the time period TRACE has been in effect, trading has averaged $19.8 billion in par value and approximately 26,000 trades on a typical day. There was a reduction in volume during the credit crisis with average daily total par value traded hitting a low of $13.9 billion in Q3 2008. While average volume in publicly traded debt fell 18% from Q3 2007 to Q3 2008, average daily volume in non-disseminated 144A issues fell by 44%.
Since the fourth quarter of 2008 however, TRACE average daily volumes have increased sharply: record levels both in number of transactions reported and par value traded were recorded in Q2 2009, with an average daily par value traded of $23.9 billion and over 46,000 average daily trades. By Q4 2009, market activity had leveled off slightly from the highs in Q2, but was still showing historically high volumes, with average daily par value traded of 20.9 billion and approximately 39,000 average daily trades. The volume of trading is also evident in the breadth of securities trading: approximately 20% of the 30,000 TRACE-eligible bonds trade at least once each day, and almost 50% trade a least once a month.
Dealer Participation and Concentration
In 2009, 1,668 dealers reported trades to TRACE. The number of reporting dealers has been relatively stable since TRACE inception, with a high of 1,687 in 2005 and a low of 1,607 in 2007. In terms of active dealers, on average approximately 500 dealers report a trade each day. This number has also been consistent, with a high of 585 in 2009 and a low of 439 in 2007.
TRACE data suggest that the corporate bond market is less concentrated than originally thought. In 2009, the top 10 TRACE broker-dealers accounted for 39% of trades and 52% of par value traded. To contrast, in 2007 the top ten NASDAQ market-makers represented 73% of shares traded.
TRACE data show strong retail participation in all credit qualities. For the past seven years, approximately 68% of overall customer transactions are below $100,000 in par value, the size widely used by the industry to distinguish between retail and institutional trades. While retail-sized transactions represent a large part of reported trades, they account for approximately 1.8% of par value traded. Retail-sized transactions, especially those in Investment Grade securities, have significantly contributed to the recent increases in the number of trades: TRACE now records twice as many retail sized transactions as it did in October 2008.
The TRACE Experience
TRACE has provided investors and regulators with invaluable insight into the corporate bond market. It has provided investors with crucial price information: real-time data is available to over 40,000 market professionals, and few in the market place would act before consulting the transaction information available from TRACE.
Retail investors are more active than originally thought, and their activity levels have grown significantly as equity markets have been volatile and other investment alternatives such as Treasury bonds have returned low yields. Regulators have crucial information for oversight and surveillance, and can more effectively ensure the market integrity necessary for investor protection.
FINRA’s expansion of regulatory-mandated transaction reporting and dissemination will further enhance market transparency, as well as improve FINRA’s oversight and surveillance programs to ensure market integrity and investor protection.
 Corporate Bond Market Transparency and Transaction Costs by Edwards, Amy K., Harris, Lawrence and Piwowar, Michael S; September 21, 2004
 Market Transparency, Liquidity Externalities, and Institutional Trading Costs in Corporate Bonds by Bessembinder, Hendrik (Hank), Maxwell, William F. and Venkataraman, Kumar; November, 2005
 Transparency and Liquidity: A Controlled Experiment on Corporate Bonds by Goldstein, Michael A., Hotchkiss, Edith S. and Sirri, Erik R; March 20, 2006 (first draft November 1, 2004)
 Missing the Marks: Dispersion in Corporate Bond Valuations Across Mutual Funds by Cici, Gjergji , Gibson, Scott and Merrick, John J..; first draft November 2007, second draft May 2008
TRACE is owned and operated by FINRA, the Financial Industry Regulatory Authority, which is the largest non-governmental regulator for all securities firms doing business with the U.S. public. FINRA is dedicated to investor protection and market integrity through effective and efficient regulation and complementary compliance and technology-based services.
About N. Ola Persson
Mr. N. Ola Persson is Director of TRACE and Fixed Income Strategy with FINRA’s Transparency Services division. In this role, Mr. Persson manages the TRACE program and is overseeing the expansion of TRACE to include Agency Debt Securities and Securitized Products. Mr. Persson joined FINRA in 2004. Prior to joining FINRA, Mr. Persson worked for ten years at Thomson Reuters where he held a number of positions in the Fixed Income division.