Apparently TRACE hurt bond market liquidity – but there’s a catch

A study was released today from two very smart guys at Harvard and MIT that shows prices improved and liquidity declined after TRACE was thrust upon the bond market about a decade ago. As you can see from my quote in the Bloomberg News story below, the results aren’t terribly shocking. The extra transparency brought upon by TRACE made people pay a little bit more attention to what they were trading, when they were trading and at what price they were trading, so volume declined. Prices also improved because it became much harder to charge someone a premium if they had proof a better price was had just 30 minutes prior.

That all said, the study looks at how liquidity changed 90 days after the rules went into effect. Recent experience with Dodd-Frank tells us that after only three months the market is often still adjusting to new rules and a long turn trend can not yet be observed. A great “Part 2” for this study would look at volumes/prices in the bond market years later to see when (or if) things recovered post-TRACE.

The presumed take-away here would be for regulators in the process of changing the swaps market. Unfortunately I don’t think the parallels are all that strong in this case. The study makes a point of saying that TRACE was intended to help the retail investor. The swaps market doesn’t have any of those. The swaps market does however have a trading mandate and clearing mandate that will electronify trading whether the Street wants it or not – the bond market has neither of those things.

Curious what others think. Here is my part in Matt’s story:

The findings from the latest study “aren’t terribly shocking,” said Kevin McPartland, head of market structure research at Greenwich Associates. “It’s what people have always hypothesized was the case.” He said looking past the 90-day period after the Trace phases were put in place may show whether liquidity returned.

Greenwich’s McPartland said it’s difficult to draw comparisons between the effects of increased transparency in bond and swaps markets because of their many differences, such as there being no retail investors in the swaps market, the requirement for most swaps to trade publicly and the clearing and margin requirements for swaps that don’t apply to bonds.

Read the full article on and the full research report is posted here.