Financial Innovation I, Two Problems and TRACE

Remember all the discussion about financial innovation, including this Planet Money podcast? Let’s dig that back up. I want to talk a little bit about problems discussing financial innovation, point out some financial innovations that are pretty great, and then discuss a new paper by Bob Litan about financial innovation over the next day.

Two Problems

To start, there are two major problems when it comes to the popular discussion of financial innovation:

1) You think financial innovation is about making more money quicker. Admit it. You think financial innovation means that you become rich quicker. This is one reason why scammers target Americans so often, because to an American the idea that royalty in a faraway country would give him or her lots of money for helping them wire money makes perfect sense on some level. You’ve seen a lot of innovation in your lifetime, and for finance to become more like how you think finance is means you get a giant bag of money for doing little.

2) You have a cynical relationship with marketing. Every day you see lots of advertisements telling you that eating a candy bar will make you into a better person, clicking on an online ad will introduce you to attractive women, and purchasing a Dodge Charger will make up for men’s 30 years of stagnant wages and record high unemployment. You don’t think these things are true like physical laws are true. But you don’t think they have absolutely no impact on your life, as they construct a relationship between yourself and the things you buy. Your relationship with the advertising industry is complicated, and outside the bounds of this post, except for one particular – you don’t think that a better product is predicated on higher risk.

Picture you going to buy laundry detergent, and you see your favorite brand, and then next to it you see the same brand, same price, but with a “Now With UltraClean Technology – Making Clothes 10% Brighter!” sticker. You may think that UltraClean Technology is real, or you may think it is a gimmick. But what you don’t think is that it makes your clothes 10% brighter because there’s an even chance it could make your clothes 10% less bright, or there’s a small 5% chance it will melt your clothes.

There are some places where you understand this tradeoff. If one lottery ticket pays off $5, and another costs the same but pays off $100, you know it’s less likely you’ll win on the second ticket. Same with roulette wheels. But when the same dynamic is folded under the rubric of “innovation”, it’s very difficult to tell the signal from the noise.

The ways these two issues blur together is how a lot of financial innovation gets sold. You can pack in a little extra risk through derivatives or leverage, to get a little bit higher payoff. People think that this is innovative, or they think this is a cynical marketing ploy, but they don’t necessarily think what they are getting is risk. This was the whole debate over reverse convertible bonds, where someone “innovated” putting a naked put into a cash position and calling it a bond, giving it a higher payout through more risk. Retail investors are prone to think this was made by the best and the brightest so it must be an innovation over a regular bond, so it must mean more money. At worst they think this is advertising as “cheap talk”, the same talk that convinces them to buy all kinds of things that they’ll never use. What they miss is the danger and risks that have been unloaded onto them by the financial system.

TRACE

But here’s what a real innovation looks like.

Although larger than the market for U.S. Government or municipal bonds, the corporate bond market historically has been one of the least transparent securities markets in the U.S, with neither pre-trade nor post-trade transparency. Corporate bonds trade primarily over-the-counter…This structure changed on July 1, 2002, when the National Association of Securities Dealers (NASD) began a program of increased post-trade transparency for corporate bonds, known as the Trade Reporting and Compliance Engine (TRACE) system…

With the July 2002 introduction of TRACE, all NASD members were required for the first time to report prices, quantities, and other information for all secondary market transactions in corporate bonds. Some market participants and regulators initially were concerned that public dissemination of this data for smaller and lower grade bonds might have an adverse impact on liquidity. Therefore, as of July 2002, the trade information collected by the NASD was publicly disseminated only for investment grade issues (bonds rated BBB and above) with issue sizes greater than $1 billion.

That’s from Transparency and Liquidity: A Controlled Experiment on Corporate Bonds, by Goldstein, Hotchkiss, and Sirri. Corporate Bonds are traded over-the-counter, and the transparency of the market is terrible. (Someone told me, in response to me pushing for exchanges for derivatives to get price transparency, that I should go after the corporate bond market first cause it is worse. Fair! But corporate bonds didn’t almost destroy the world economy.)

So in July of 2002 NASD members were required to report prices, quantities and other information for corporate bonds in the over-the-counter market. Everyone was freaked out about liquidity concerns, so they only make public the information for the subset of investment grade issues.

You know what that sounds like: natural experiment! Let’s go to the abstract (my bold):

This paper reports the results of a unique experiment designed to assess the impact of last-sale trade reporting on the liquidity of BBB corporate bonds. We find that increased transparency has either a neutral or positive effect on market liquidity depending on trade size. Measures of trading activity such as daily trading volume and number of transactions per day suggest that increased transparency does not lead to greater trading interest. Except for very large trades, spreads on bonds whose prices become more transparent decline relative to bonds that experience no transparency change. However, we find no effects of transparency for very infrequently traded bonds. The observed decrease in transactions costs is consistent with investors’ ability to negotiate better terms of trade with dealers once the investors have access to broader bond pricing data.

This is what financial innovation looks like. Doesn’t this make your heart leap out of your chest a little bit with joy? Spreads decrease with transparency, with no negative impact on liquidity. Everything runs a little bit smoother, middle-men and the biggest players squeeze smaller players less because the little guy gets a little bit more bargaining power, and information is allowed to do its job for the greater market. And there’s more! From this study, Corporate Bond Market Transaction Costs and Transparency: “Costs are lower for bonds with transparent trade prices, and they drop when the TRACE system starts to publicly disseminate their prices.”

Some of you out there may catch a parallel to another over-the-counter market in the financial reform debate: derivatives. If you are thinking stripping the party information for over-the-counter derivatives that can’t be standardized enough to trade on an exchange, and just reporting the volume and price to a well-accessed database might be a good solution, like this TRACE deal for the bond market, I would think you are on to something.

Note a few problems selling it as innovation: It’s boring. Nobody got rich. Powerful players pushing spreads on poor transparency lose a medium amount, and everyone gains just a little bit. (Or maybe lose a huge amount – JP Morgan would lose $3 billion a year in revenue if exchanges brought price transparency to the derivatives markets by some estimates.) But boring might be a pretty good future for the financial industry.