Can Transparency Hurt Investors in Over-The-Counter Markets?

Abstract

This paper examines the efficacy of post-trade transparency regulations like TRACE in over-the-counter (OTC) markets. It is a widely held belief that greater transparency in the trading process benefits investors by reducing opportunities for their exploitation, but I show that this need not be the case. Using a multi-period auction based model of trading, I demonstrate that potential counterparties may delay their trades when there is transparency because they can monitor transaction prices and learn more, before participating. This leads to liquidity dry-ups and increased execution risks for investors with immediate trading needs. My model offers an alternative explanation for many of the pronounced adverse characteristics of OTC markets in recent times --- like diminished liquidity --- usually attributed to the exodus of dealers from the market. I also propose alternative market designs that can ameliorate some of the negative effects.

Keywords: OTC market, transparency, financial regulation, TRACE, bonds, market microstructure, market design

JEL Classification: G14, G18, D47, D44