An over-the-counter (OTC) market and an open limit order book (LOB) market are the two common mechanisms for organizing financial markets. An OTC is a decentralized market, where trades occur only through dealers. The dealers’ quotes are not fully transparent and are not binding, so customers can shop around and negotiate for the price. An open LOB is a centralized market, where traders submit anonymous orders to a central order book. The quotes are transparent and binding, traders can trade among themselves, and the transactions are transparent as well.
Corporate bonds are traded worldwide mostly in OTC markets while stocks are traded mostly in LOB markets. The corporate bond OTC market in the U.S. is considered illiquid and has higher trading costs that U.S. stock markets do. Recent studies estimate that trading costs are roughly 0.5 percent of the value of a trade for corporate bonds and even higher for retail-size trades.[1] The volume-weighted average trading costs for U.S. stocks is less than 0.02 percent.
Rick Ketchum, the former chairman of the Financial Industry Regulatory Authority (FINRA), said that “it strikes me as odd that we’ve spent enormous energy in equity markets to measure and save pennies or just basis points on execution quality, while in the fixed income market it’s more a question of nickels, quarters and dollars.” Corporate bonds should, in fact, be more liquid than stocks, because their prices are less volatile, and there is less private information about them. That prompts the question of whether corporate-bond illiquidity arises from the trading mechanism. In our recent paper, “Corporate Bond Trading on a Limit Order Book Exchange“, we investigate the trading of corporate bonds on an open LOB market, the Tel Aviv Stock Exchange (TASE), where both stocks and corporate bonds are traded by an LOB mechanism.
The Israeli corporate bond market is much smaller than its American counterpart. In December 2014, its market value was $80 billion, while the U.S. corporate debt market’s value was $7.840 billion and the U.S. municipal debt market was $3.652 billion. The Israeli market is also more isolated, with foreigners holding only about 0.9 percent of the value of traded bonds, compared with 26.7 percent in the U.S. Thus, one would expect the Israeli market to be illiquid. We found, though, that it is in fact lively, with many transactions per bond-day, very little off-exchange trading, and low trading costs of about 0.078 percent of the price. Those costs are much lower than in the U.S., especially for retail size transactions. We also compared the liquidity of stocks with that of corporate bonds issued by the same firm and found that, for a typical firm, bond spreads are smaller than stock spreads. The fact that the stocks are less liquid than bonds (and less liquid than U.S. stocks) supports the notion that the high liquidity of corporate bonds in the LOB is due to the trading mechanism and not to any particular characteristic of the Israeli market.
Our main finding is that the small TASE LOB corporate bond market is more liquid than the large U.S. OTC corporate bond market. It is consistent with the conclusion that the OTC mechanism does not encourage competition among dealers. To provide further evidence for that conclusion, we use a unique database of the TASE that includes transaction records with trader identification. We identify short-term traders, which on average flip between buying and selling within a trading day. These traders are the analog for the dealers in the OTC market, and their identity allows us to examine the level of competition in the TASE LOB corporate bond market. We find:
- Very small trading profits of short-term traders (0.013 percent vs. 1.15 percent and 0.08 percent in the U.S. market for small and large transactions, respectively).
- High competition among short-term traders. The Herfindahl-Hirschman Index (HHI) is an indicator of the amount of competition among firms within an industry. Higher value of HHI indicates a decrease in competition, and a value of one indicates a monopoly. At TASE, the short-term traders’ activity is very unconcentrated, with an average HHI per corporate bond of 0.162. In the U.S. corporate bond market, the average HHI per bond is 0.61, indicating a highly concentrated market. To get a sense of the HHI values, we use the example of the Horizontal Merger Guidelines of the U.S. Department of Justice and the Federal Trade Commission, which generally classify markets into three types: Unconcentrated Markets (an HHI below 0.15), Moderately Concentrated Markets (HHI between 0.15 and 0.25), and Highly Concentrated Markets (HHI above 0.25).
- Non-short-term traders provide much of the liquidity on TASE. LOB, as opposed to OTC, enables all traders to trade with each other and to compete on price. This finding is consistent with the findings on the NASDAQ reform of the 1990s, that enabled traders to compete with the dealers on liquidity, and resulted in a decrease of trading costs.
Finally, we identify retail investors, whose trading activity on the exchange is low. The market participants in the U.S. OTC market include mainly large investors, such as institutional investors. Retail investor participation is negligible. The LOB market is more welcoming to retail investors, because the centralized structure of the market and the transparency of the quotes and transactions make it accessible to non-professional traders. Indeed, we find that at the TASE retail investors are active in about 17 percent of the transactions (volume weighted), and we find that their participation contributes to the liquidity of the market.
Our study provides clear evidence that corporate bonds can be successfully traded by an LOB and that characteristics of the LOB contribute to market liquidity. American bond markets would benefit from adopting pre-trade transparency and some other characteristics of a centralized LOB, as several American scholars have recently suggested. Doing so could reduce trading costs and give retail investors and small institutions fairer and cheaper access to the market, while perhaps also reducing firms’ cost of capital.
ENDNOTE
[1] See Harris, L., 2015. “Transaction Costs, Trade Throughs, and Riskless Principal Trading in Corporate Bond Markets.”
This post comes to us from Professor Meni Abudy at Bar-Ilan University’s Graduate School of Business Administration and Professor Avi Wohl at Tel-Aviv University Coller School of Management. It is based on their recent paper, “Corporate Bond Trading on a Limit Order Book Exchange,” forthcoming in the Review of Finance, available here.