The “Equitization” of The Corporate Bond Market
The WSJ’s Jason Zweig ran a piece this weekend titled “Huh? It Costs How Much To Trade a Bond?” . We are a big fan of Jason’s as he always writes some thoughtful, well-researched pieces which often try to educate retail investors about the secret costs of trading. Jason points out that transaction costs (including mark-ups and commissions) for corporate bonds are much higher than stocks. To support his point, Jason quotes from a paper published last month titled “Transaction Costs, Trade Throughs, and Riskless Principal Trading in Corporate Bond Markets” written by Professor Larry Harris. Jason says:
“Professor Harris estimates that individual investors are paying bond dealers and other middlemen an average of $7.72 per $1,000 of principal value to buy corporate bonds. If you paid that much to buy stocks, 200 shares of a $50 stock would run you at least $77.20 in trading costs—instead of the roughly $10 that you would pay at most online brokerage firms.”
At first glance, some investors may get outraged about these higher fees, but we think you have to be careful before jumping to conclusions. And we also think you have to be careful before attempting to change the way corporate bonds are traded. Our fears about poorly conceived regulatory changes comes from the developments over the past 20 years in the equity market. As we outlined in our book “Broken Markets”, the changes in the equity market started after Professor’s Christie and Schultz published their study “Why Do Market Makers Avoid Odd Eight Quotes?”. While Christie and Schultz did a great job by uncovering collusion in the equity market, the reaction by regulators created a host of unforeseen and unintended problems which have resulted in today’s fragmented, latency sensitive stock market. Regulators thought they were introducing competition into the market, but they ended up driving out traditional liquidity providers who had obligations and replaced them with proprietary traders who can walk away from the market at any time they please.
We’re afraid that some regulators may look at Professor Harris’ research and begin to make the same mistakes they made after Christie/Schultz was published. Professor Harris was formerly the SEC’s Chief Economist and has written many market structure papers including the Knight Capital funded paper titled “Equity Trading in the 21st Century”. He is no newcomer to the industry so when he writes a paper about corporate bond costs being too high, then he is likely to attract a lot of regulatory attention. What worries us most about Professor Harris’ paper is not his findings but some of his recommendations which include creating a NBBO (National Best Bid Offer) for corporate bonds and enacting a trade through rule similar to the one in the equity market that was established by Reg NMS. And even more troubling is what Professor Harris doesn’t recommend: dealer obligations. The corporate bond market is much different than the equity market but we’re afraid that Professor Harris is prescribing solutions which will “equitize” the corporate bond market. If this happens, you will soon see colocation, rebates, private data feeds and special order types coming to the corporate bond market.
Professor Harris will probably claim that his suggestions will aid in corporate bond liquidity and lower transaction costs. But ask yourself, when was the last time you heard that claim and how did that work out?