Key points raised at the FSA seminar on trading transparency in secondary bond markets

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Discussion paper 05/5: Trading transparency in the UK secondary bond markets

23 November 2005

On 14 November 2005, the FSA held a seminar on trading transparency in the secondary bond markets. This was part of its ongoing work following the publication of Discussion Paper 05/5 (DP05/5), Trading transparency in the UK secondary bond markets, in September.

The seminar brought together a range of participants from debt issuers, investment banks, fund management, data vendors, credit rating agencies, exchanges and other trading platforms, academia and a number of regulatory and legislative authorities. The FSA welcomes any comments on the points made below, which can be sent to DP05_05@fsa.gov.uk, and would encourage interested parties to submit responses to DP05/5, the closing date for which is 5 December 2005.

The following note sets out the key points raised at the seminar under the relevant agenda headings.

Market failure analysis

There was some discussion of what was meant by market failure. Put simply, the issue was whether markets worked efficiently and fairly, and whether they could work better. Some thought that failures could arise as a result of a lack of competition in the markets or from externalities (i.e. situations where the actions of one participant had a knock-on effect on another participant).
For many bonds, most of the trading during their lifetime would be concentrated in the first few weeks after issue, with liquidity drying up thereafter. This posed some difficulties for investors, both in terms of getting data for valuation and in executing their trading strategies. However, the inability to find someone to take the other side of a trade did not constitute a market failure in itself.
The lack of a central source of price information on bonds meant that market participants relied on a variety of avenues to obtain such data (brokers, dealers, trading venues). Their access to this information differed as some were more able to access information from these sources than others. The impact of this differed between different segments of the bond markets: more liquid issues (e.g. government debt) were relatively transparent, but other issues had little transparency and the process and history of price formation might be less clear. Some argued that information was expensive to access, which resulted in the need to employ a specialist trader/dealer to obtain it.
Further, some at the seminar felt that, where issues had few market makers, the lack of competition between them might give rise to wider spreads and, potentially, distorted pricing. However, it was argued also that mandating greater transparency would fail to improve price formation as it would lead to a withdrawal of liquidity provision by market makers.
It was agreed that the bond markets were not homogeneous, and that there were different conditions in different sub-markets. But, generally, it was felt that wholesale participants could usually access sufficient trading information and, as a result, there was no obvious sign of a material market failure at the wholesale end of the market. As this market was potentially internationally mobile, it was argued that, if there were serious market failures in Europe, business would have moved elsewhere.
Where retail investors found themselves holding bonds that were inappropriate for their needs and risk appetites, it probably reflected a failure of the suitability requirements placed on banks and brokers. Retail investors needed to understand that the risk associated with investing in a bond differed according to the issuer, market conditions, etc. More generally, it was thought that they would benefit from greater education on how bonds and bond markets worked. Beyond that, it was argued that the principle of caveat emptor ought to apply.
The level of direct retail investment in the bond markets differed from country to country. The UK lacked a culture of retail bond investment, whereas in other countries (e.g. Germany) retail investors had a greater interest in bonds and could easily buy selected liquid issues via bank branches. In other jurisdictions, retail investment in bonds had been encouraged through tax breaks. Some felt the fact that retail investment levels differed between jurisdictions might imply that the regulation of bond markets ought to differ from country to country too (rather than adopting a one-size-fits-all approach).

The role of transparency

The European market had evolved to provide a relatively high degree of pre-trade transparency compared with the US. Some suggested that providing greater access to this information to retail investors would not harm liquidity provision as retail investors posed no risk, in terms of holding privileged information, to market makers. However, others doubted whether retail investors would proactively use such data.
It was suggested that post-trade transparency might be of some value to retail investors, helping them to check after the event the quality of execution they had received (at least for liquid bonds). It might also aid market monitoring by regulators and portfolio valuation by fund managers, as well as help to establish the truth behind market rumours by indicating definitively at what price trades had taken place. However, an increase in post-trade transparency might also increase risk for market makers and result in a withdrawal of liquidity provision, at least for high yield bonds. Further, it was argued that, for the purpose of portfolio valuations, pre-trade data might be of greater value as it gave a clearer idea of the prices at which a fund could be liquidated. Even if post trade transparency information were of value to portfolio valuation, it did not need to be made available on an intraday basis (end-of-day probably being sufficient).
A further argument made was that post-trade transparency for a given bond would only be of value if it were possible to obtain post-trade transparency for the corresponding benchmark bond. An investor would want to know how, say, the benchmark government bond's price was moving when judging the value of a given corporate bond.
The suggestion was made that an issuer and its dealers could agree whether to make trading in a given issue post-trade transparent. Regulations could be introduced to ensure that only issues that were post-trade transparent could be marketed/sold to retail investors. But it was also argued that any change to regulations should not force change in the market's structure - for instance, by pushing trading on-exchange at the expense of the OTC markets.

Factors driving change in the structure of bond markets

The interaction between the cash and derivatives markets

The development of the credit derivatives markets had increased firms' ability to make markets: it was now easier to hedge positions and thereby manage the risks associated with market making. An increase in liquidity in the derivatives market had equivalent spill-over effects in the cash markets, benefiting all participants.
The interest rate swap curve had replaced the yield curve within the Eurozone as the benchmark against which bonds were priced. To some extent, the fragmented nature of the cash markets could be overcome through the more unified, and more transparent, credit derivative and interest rate swap markets. However, the ability to use the swap curve, and the derivatives markets more generally, to support activity in the cash bond markets differed between firms. Some were less sophisticated than others, and so would struggle to gain, or even understand, the benefits of the ongoing development of the derivatives markets. Moreover, some buyside firms had restrictions placed on their use of derivatives.
Some participants noted that the credit derivative markets were still very young. More experience was perhaps needed of how these markets performed under stress before firm conclusions could be drawn about their value to trading and transparency in the cash markets.

The growth of electronic trading

The growth of electronic trading provided an avenue for greater transparency to be provided to the markets, although the extent depended on the design of the platform and who had access to it. In general, electronic platforms helped to improve price formation for the bonds traded and to reduce transaction costs (especially for relatively small trades). It also allowed for bonds and derivatives to be provided on the same platform, which was beneficial to investors. But platforms were only really presenting commoditised products, and a large proportion of trading in bonds and derivatives continued to be done outside electronic trading venues on a request-for-quote basis.
Furthermore, it was not necessarily the case that firm quotes had to be provided via electronic trading systems or that any post-trade transparency information provided through them was necessarily real-time. The transparency information that they did offer might also be available only to direct users, and not to the broader community of bond market participants.

Developments in the investor base, including retail access

It was suggested that in some countries the retail element in the bond markets was significant and viewed as important by national authorities. On the other hand, it was noted that an increasing number of issuers were now issuing in denominations of €50,000 or more – effectively excluding retail – in order to avoid the Prospectus Directive's disclosure requirements for bonds marketed to retail investors.

The US experience: Are there lessons for Europe?

There was debate about the impact of the TRACE post-trade transparency system for US corporate bonds. Some discussed evidence (e.g. from academic studies) that TRACE had caused a narrowing of spreads and had not adversely affected liquidity provision. The scale of the benefits to different types of participant was not clear, but some felt that all participant types had gained to a greater or lesser extent. The introduction of the system had also revealed that there was a large share of retail trades (defined as those of $100,000 or less) in total turnover. Others felt that the narrowing of spreads could have been brought about by external factors other than the introduction of TRACE, although it was noted that some studies had used control groups to try to isolate the impact of transparency from other factors. In addition, some thought the increase in post-trade transparency would increase market makers' risk and reduce their liquidity provision (at least for less liquid bonds). Some participants noted that US colleagues felt transparency had had a detrimental effect on the market makers themselves and on their clients who wanted to trade in less liquid bonds or to shift relatively large block positions. But others commented that formal research had not produced quantitative evidence supporting that case.

Practical issues in changing transparency requirements

It was stated that the case for change to transparency requirements in the European bond markets had not been proved. However, if any changes were made they would have to stand up to a rigorous cost-benefit analysis.
Again, the issue arose of whether a national approach to regulation was best. While some favoured this approach, others argued that global markets such as those in European bonds should have common regulatory requirements.
If a pan-European solution were adopted, several significant challenges would have to be tackled. These included harmonising the content of reports and data formats and synchronising clocks. A reporting system would also have to be established that was flexible enough to adapt to any future market developments.

The European Commission's plans

It was noted that the European Commission's review of transparency requirements in the bond markets (and those for other asset classes) would have to involve consultation with the public and the Competent Authorities in Member States. It was understood that the Commission had a completely open mind on whether transparency requirements would have to change. The Commission would be considering whether market failures existed in the bond and other non-equity markets, as well as the costs and benefits associated with the various options open to it, ahead of the deadline for its report, currently proposed to be extended to 31 October 2007.