Would knowing prices on the most recently traded collateralized debt obligations (CDOs) have tempered that market in the run up to financial markets collapsing in 2008, and might some of the more spectacular deal collapses have been averted?
Looking in the rearview mirror is always problematic. Evidence suggests, however, that greater pricing transparency in the U.S. corporate bond market has caused those securities to trade within a more predictable range, and an objective view of prices in the CDO secondary market back then likely would have emitted helpful warning signals. Soon, participants in the asset-backed securities (ABS) market will be privy to that information on a timely basis and they’ll be able to determine for themselves the advantages—and perhaps disadvantages—of greater transparency.
The Financial Industry Regulatory Authority (Finra) filed a proposal Nov. 13 with the Securities and Exchange Commission to disseminate pricing data for ABS, an initiative that could result in the data becoming available within a year. Comments on proposals are typically due 21 days after publication in the Federal Register, which was expected around press time. The proposal would introduce dissemination of trade prices for securities ranging from highly liquid credit card and auto ABS to smaller and more esoteric deals in asset classes such as time shares, to commercial mortgage-backed securities (CMBS) and highly structured CDOs and collateralized loan obligations.
All Finra-regulated firms were obligated to begin reporting to Trace on most ABS and mortgage-backed securities starting in May 2011, and the following October the self-regulatory agency began releasing information on aggregate market activity, including the volumes of overall trades, institutional customer buys and sells, and inter-dealer activity. A year later, it started disseminating transaction-level pricing data for highly liquid “to be announced” (TBA) securities--a forward mortgage-backed securities (MBS) trade typically comprising pass-through securities from a government sponsored entity such as Freddie Mac. Pricing data on specified pools was launched in July.
Now, ABS is in the wings, while private-label residential mortgage-backed securities and agency real estate mortgage investment conduits remain on the backburner.
The general consensus is that increased pricing transparency benefits markets overall and especially investors. “We’ve seen the impact on the corporate-bond side, and [price-data dissemination there] has generally been viewed as positive for pricing comparability and availability,” said Ken Purnell, ABS portfolio manager at Atlanta-headquartered Invesco.
Academics have analyzed the Trace-related data that Finra has collected and generally concluded that increased transparency does stabilize prices, especially for lower rated bonds, although it can have an adverse effect on trading volume.
In a working paper published in September called “The Effects of Mandatory Transparency in Financial Market Design: Evidence from the Corporate Bond Market,” researchers from MIT Sloan School of Management and Harvard Business School found that Trace dissemination of corporate bonds’ secondary-market prices reduced “price dispersion,” in terms of daily standard deviation. The researchers found a similar reduction in the difference between high and low prices over different periods of time.
Starting in 2002, the distribution of corporate bond pricing information was rolled out in four phases over 3.5 years, with the riskiest, most volatile high-yield bond category arriving last. The researchers found that the first three categories of less risky bonds saw reductions in price dispersion between 6.5% and 8.5%, while the reduction for high-yield bonds, with the greatest price dispersion to begin with, was 24.7%.
“The reduction in price dispersion should allow investors and dealers to base their capital allocation and inventory holding decisions on more stable prices,” the paper notes. “Therefore, the reduction of price dispersion likely benefits customers and possibly, but not necessarily, dealers.”
Amy Sze, a senior analyst in securitized products at J.P. Morgan, said it’s generally assumed that dealers prefer volatility because it gives them more opportunity to profit. However she said that an objective source of pricing data would be welcomed by the sell-side. Differences between the corporate and ABS bond markets, she said, could change price dissemination’s impact on price dispersion, especially for the riskier ends of the markets.
“[Pricing transparency] could improve liquidity for plain vanilla ABS that already trade similarly to corporate bonds credit card and auto ABS have been very liquid with excellent price transparency, and this could help them trade even more like a cash surrogate,” she said. “But dealers may also be less willing to take on large positions with prices disclosed.”
Sze added that off-the-run or esoteric ABS, such as the subordinated tranches of private student loan securitizations, often don’t trade for lengthy periods of time, leading to significant price dispersions between trades. “Even now some of those bonds trade infrequently at best. So I wouldn’t say revealing the price would cause less price dispersion,” she said.
The paper also found that, while increased price transparency had little impact on trading activity of the higher-rated corporate bonds, trading activity of junk bonds dropped by a full 41.3%. ABS could be impacted similarly.
Purnell noted that some sophisticated investors scour illiquid components of the high-yield market, where pricing data is less readily available, and apply their own analytics to form valuation opinions that may differ significantly where a bond is being offered. “They find opportunities that are cheap compared to the bond’s intrinsic value. If that goes away because there’s more price transparency out there, I could see activity in those bonds diminishing,” he said.
Another factor potentially impacting trading activity is market participants’ concern that increased transparency may compromise their anonymity, enabling opportunistic players to trade against them. Another paper, “Liquidity, Transparency and Disclosure in the Securitized Product Market,” addresses this issue. Analyzing ABS pricing data between May 2011 and October 2012 provided by Finra, the paper’s authors found that indeed it does, especially in illiquid markets with a small number of participants. Information about the size of the trade and whether it was initiated by a customer or dealer can reveal who purchased the securities and provide insight into where its price is moving. This may, in turn, affect participants’ willingness to trade and so reduce market liquidity and efficiency.
“When fewer people hold a bond and you reveal key information, it’s just like a poker game, and people can guess what your cards are,” said Marti Subrahmanyam, one of the paper’s three authors and a professor at New York University’s Stern School of Business.
The paper found one could obtain adequate information about market liquidity using less detailed data without providing clues as the identity and trading positions of market participants.
The ABS proposal would exclude information about whether the counterparty is a dealer or customer. The universe of active dealers in ABS is much smaller than in the corporate bond world—there are perhaps 70 ABS dealers reporting transactions daily, compared with more than 500 for corporate bonds.
The proposal would also report any trades over $10 million as “$10 million plus,” protecting the anonymity of participants seeking larger transactions and, in the process, promoting liquidity. The cap is twice that of corporate bonds, because ABS transactions tend to be larger.
A number of vendors including Empirasign, Interactive Data Corp. and Thomson Reuters already extract pricing data from dealer bid lists and secondary-market offerings and sell that data directly to market participants a well as providers of broader financial valuation services, such Bloomberg and Moody’s Analytics. Industry convention, however, has been to provide the second-best price, known as the cover price, rather than the actual trade price.
Purnell said that Invesco scours Bloomberg messages for relevant cover prices to see where a bond of interest has traded, and that cover prices tend to track the actual price closely for highly rated ABS but less so lower rated securities. “And that’s where the need for transparency is the highest, because the bid/ask spreads are the widest, there’s less trading activity and there’s more volatility.”
Adam Murphy, founder and chief executive of New York-based Empirasign, said his firm would incorporate the Trace pricing data so that customers could see both the actual price and the cover.
“Having both pieces of information would allow our users to estimate market depth,” Murphy said, adding that in addition to ABS and MBS pricing information, his firm pre-bid list price talk, post trade data, and dealer offering prices for bonds they currently hold in inventory. Soon, he said, Empirasign’s software will parce dealer emails and Bloomberg messages to capture the bid and offer price for bonds they routinely traffic in.
Although ABS data must be reported to Finra at the end of the day, half of such trades are reported within 15 minutes. Sze said the industry’s automated systems should face little difficulty reporting trades in that timeframe. Finra will distribute the pricing data immediately, and if the ABS market follows the path of corporate bonds, participants should be prepared for rapid changes in price dispersion and trading activity.