Hostname: page-component-78c5997874-94fs2 Total loading time: 0 Render date: 2024-11-03T01:29:51.934Z Has data issue: false hasContentIssue false
  • English
  • Français

Signaling in OTC Markets: Benefits and Costs of Transparency

Published online by Cambridge University Press:  16 October 2018

Kerry Back Open the ORCID record for Kerry Back [Opens in a new window] ,
Ruomeng Liu  and
Alberto Teguia
Get access Rights & Permissions [Opens in a new window]

Abstract

We provide a theoretical rationale for dealer objections to ex post transparency in over-the-counter markets. Disclosure of the terms of a transaction conveys information possessed by the dealer about the asset quality and reduces the dealer’s rents when she disposes of the inventory in a second transaction. We show that costly signaling in a transparent market benefits investors through lower spreads and higher volume. Dealers may also gain from transparency despite lower spreads when potential gains from trade are small or adverse selection is high, because in those circumstances higher volume offsets smaller spreads for dealer profits.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 55 , Issue 1 , February 2020 , pp. 47 - 75
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2018 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Footnotes

1

This research was conducted while Liu and Teguia were students at Rice University and while Teguia was a post-doc at École Polytechnique Federale de Lausanne. We thank Shmuel Baruch, Alan Crane, Kevin Crotty, Semyon Malamud, and S. “Vish” Viswanathan (the referee) for very helpful comments.

References

Asquith, P.; Covert, T.; and Pathak, P.. “The Effects of Mandatory Transparency in Financial Market Design: Evidence from the Corporate Bond Market.” Working Paper, National Bureau of Economic Research (2013).Google Scholar
Asriyan, V.; Fuchs, W.; and Green, B.. “Information Spillovers in Asset Markets with Correlated Values.” American Economic Review, 107 (2017), 2007–2040.Google Scholar
Bagnoli, M., and Bergstrom, T.. “Log-Concave Probability and Its Applications.” Economic Theory, 26 (2005), 445–469.Google Scholar
Bessembinder, H.; Jacobsen, S.; Maxwell, W.; and Venkataraman, K.. “Capital Commitment and Illiquidity in Corporate Bonds.” Journal of Finance, 73 (2018), 1615–1661.Google Scholar
Bessembinder, H., and Maxwell, W.. “Markets: Transparency and the Corporate Bond Market.” Journal of Economic Perspectives, 22 (2008), 217–234.Google Scholar
Bessembinder, H.; Maxwell, W.; and Venkataraman, K.. “Optimal Market Transparency: Evidence from the Initiation of Trade Reporting in Corporate Bonds.” Journal of Financial Economics, 82 (2006), 251–288.Google Scholar
Bhattacharya, A.“Can Transparency Hurt Investors in Over-the-Counter Markets?” Working Paper, Baruch College (2016).Google Scholar
Bravo, R. A.“Corporate-Bond Pricing System May Be Too Open, Critics Say.” The Wall Street Journal (Apr. 14, 2003).Google Scholar
Burne, K.“Derivative Rules Seen Lifting Cost of Swaps.” The Wall Street Journal (Nov. 22, 2010).Google Scholar
Cujean, J., and Praz, R.. “Asymmetric Information and Inventory Concerns in Over-the-Counter Markets.” Working Paper, available at https://ssrn.com/abstract=2464399 (2015).Google Scholar
Daley, B., and Green, B.. “Waiting for News in the Market for Lemons.” Econometrica, 80 (2012), 1433–1504.Google Scholar
Diamond, P. A.“A Model of Price Adjustment.” Journal of Economic Theory, 3 (1971), 156–168.Google Scholar
Dolmetsch, C.“Jesse Litvak, David Demos Deliver Blows to U.S. Bond-Fraud Probes.” Bloomberg (May 3, 2018).Google Scholar
Duffie, D. Dark Markets: Asset Pricing and Information Transmission in Over-the-Counter Markets. Princeton, NJ: Princeton University Press (2012).Google Scholar
Duffie, D.; Dworczak, P.; and Zhu, H.. “Benchmarks in Search Markets.” Journal of Finance, 72 (2017), 1983–2044.Google Scholar
Duffie, D.; Gârleanu, N.; and Pedersen, L. H.. “Over-the-Counter Markets.” Econometrica, 73 (2005), 1815–1847.Google Scholar
Edwards, A. K.; Harris, L. E.; and Piwowar, M. S.. “Corporate Bond Market Transaction Costs and Transparency.” Journal of Finance, 62 (2007), 1421–1451.Google Scholar
Faux, Z., and Dolmetsch, C.. “Ex-Jefferies Arrest Shows Market Lacking Transparency: Mortgages.” Bloomberg (Jan. 31, 2013).Google Scholar
Fuchs, W.; Öry, A.; and Skrzypacz, A.. “Transparency and Distressed Sales under Asymmetric Information.” Theoretical Economics, 11 (2016), 1103–1144.Google Scholar
Fuchs, W., and Skrzypacz, A.. “Costs and Benefits of Dynamic Trading in a Lemons Market.” Working Paper, available at https://ssrn.com/abstract=2320179 (2013).Google Scholar
Glode, V., and Opp, C. C.. “Adverse Selection and Intermediation Chains.” American Economic Review, 106 (2016), 2699–2721.Google Scholar
Glosten, L. R., and Milgrom, P. R.. “Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders.” Journal of Financial Economics, 14 (1985), 71–100.Google Scholar
Goldstein, M. A.; Hotchkiss, E. S.; and Sirri, E. R.. “Transparency and Liquidity: A Controlled Experiment on Corporate Bonds.” Review of Financial Studies, 20 (2007), 235–273.Google Scholar
Grossman, S. J.“The Informational Role of Warranties and Private Disclosure about Product Quality.” Journal of Law and Economics, 24 (1981), 461–483.Google Scholar
Guerrieri, V., and Shimer, R.. “Dynamic Adverse Selection: A Theory of Illiquidity, Fire Sales, and Flight to Quality.” American Economic Review, 104 (2014), 1875–1908.Google Scholar
Kihlstrom, R. E., and Riordan, M. H.. “Advertising as a Signal.” Journal of Political Economy, 92 (1984), 427–450.Google Scholar
Kremer, I., and Skrzypacz, A.. “Dynamic Signaling and Market Breakdown.” Journal of Economic Theory, 133 (2007), 58–82.Google Scholar
Kurlat, P.“Lemons Markets and the Transmission of Aggregate Shocks.” American Economic Review, 103 (2013), 1463–1489.Google Scholar
Kyle, A. S.“Continuous Auctions and Insider Trading.” Econometrica, 53 (1985), 1315–1335.Google Scholar
Laughlin, K.“Three Years On, the TRACE Impact for Bond Traders, Technology Can Now Trump Analysis.” Investment Dealers’ Digest (July 4, 2005).Google Scholar
Levine, M.“Deutsche Bank Did Some Bond Lying.” Bloomberg (Feb. 13, 2018).Google Scholar
Mailath, G. J.“Incentive Compatibility in Signaling Games with a Continuum of Types.” Econometrica, 55 (1987), 1349–1365.Google Scholar
Mailath, G. J., and von Thadden, E.-L.. “Incentive Compatibility and Differentiability: New Results and Classic Applications.” Journal of Economic Theory, 148 (2013), 1841–1861.Google Scholar
Milgrom, P. R.“Good News and Bad News: Representation Theorems and Applications.” Bell Journal of Economics, 12 (1981), 380–391.Google Scholar
Milgrom, P., and Roberts, J.. “Price and Advertising Signals of Product Quality.” Journal of Political Economy, 94 (1986), 796–821.Google Scholar
Naik, N. Y.; Neuberger, A.; and Viswanathan, S.. “Trade Disclosure Regulation in Markets with Negotiated Trades.” Review of Financial Studies, 12 (1999), 873–900.Google Scholar
Patterson, S., and Zeng, M.. “Derivatives Overhaul Gets Boost – Drive for Greater Transparency Helped by Goldman Case.” The Wall Street Journal (Apr. 20, 2010).Google Scholar
Ramey, G.“D1 Signaling Equilibria with Multiple Signals and a Continuum of Types.” Journal of Economic Theory, 69 (1996), 508–531.Google Scholar
Rothwell, S.“New Rules Not Needed, Bond Traders Tell EU.” International Herald Tribune (Nov. 14, 2006).Google Scholar
Rubinstein, A., and Wolinsky, A.. “Middlemen.” Quarterly Journal of Economics, 102 (1987), 581–594.Google Scholar
U.S. v. Shapiro and Gramins, U.S. District Court, District of Connecticut, Case No. 3:15-cr-00155 (2018).Google Scholar
Wigglesworth, R.“US Banks Push for Delay in Reporting Corporate Bond Trades.” Financial Times (Apr. 26, 2015).Google Scholar
Zhu, H.“Finding a Good Price in Opaque Over-the-Counter Markets.” Review of Financial Studies, 25 (2012), 1255–1285.Google Scholar