Corporations issue equity, which is a right to the dividend of the company. But sometimes firms will finance their investments in real capital by issuing a specific amount of debt known as a corporate bond.
Unlike stocks, corporate bonds are mostly traded on an over-the-counter (OTC) market, a network of dealers where investment banks intermediate trade transactions between buyer and seller.
Corporate bonds are also several times more expensive to trade than stocks are, at least in the U.S. Given the differences in how they are traded and in price, there has been a significant amount of debate in the literature about the efficiency of this setup. Is the current decentralized process optimal? Is there a reason, something specific to corporate bonds, that makes this OTC structure necessary?
Despite the ongoing debate, no one to my knowledge has addressed this question empirically. I wanted to know: What might happen if we were to migrate corporate bonds from their current OTC structure to one of public exchange? I estimated that transaction costs for the bonds would go down if they were moved to an exchange market.
A market structure comparison
To explore what moving from a decentralized to a centralized market might look like in the U.S., I juxtaposed two financial environments: one in early 20th century America and the other in modern-day Israel. I use the empirical evidence from these two markets to explain what might happen if corporate bonds were traded on exchange in the U.S.
For the American market, I analyzed a historical data set of U.S. securities from 1917 to 1921. During this period, bonds were traded on exchange and were actually less expensive to trade and more liquid than stocks—the complete reverse of how it is today. I hand-collected data—a sample of 76 stocks and 188 bonds—from New York Stock Exchange-listed securities in the Commercial and Financial Chronicle, a national business weekly of the era.
I also looked at an example from modern-day Israel for the period of 2013 to 2015, using data from the Tel-Aviv Stock Exchange (TASE), where both stocks and bonds were traded within the same exchange. The Israeli sample included 51 firms with 139 outstanding bonds and a bond sample of four million transactions and 321 million intraday quotes.
Decreased costs, future implications
My study found that centralizing corporate bonds helps decrease costs. Using the two-market comparison, bond transaction costs were reduced approximately 70 percent when bond trading migrated from an OTC market to a public exchange—decentralized to centralized.
Another outcome from the study is that the framework I’ve developed here is adaptable and transferable; it can be used to evaluate other OTC markets.
But perhaps most importantly, the findings matter because they hold policy implications about the social optimality of markets. A socially optimal market impacts everyone, and it benefits all of us to have a market that works as efficiently as possible. As a society, that’s something we should be aiming for.
Read the working paper “Should Corporate Bond Trading Be Centralized?”
Sébastien Plante is an assistant professor in the Department of Finance, Investment, and Banking at the Wisconsin School of Business.