Economists Find ''Strong Evidence'' of Best-Execution Failures in Corporate Bond Trading
Commentary by Steven Lofchie
In a paper titled "The Best Execution of Corporate Bonds," Cornell University Finance Professor Maureen O'Hara, Fordham University Business Professor Yihui Wang and Board of Governors of the Federal Reserve System Economist Xing Zhou provide "strong evidence of best execution failures in corporate bond trading."
Using an "extensive sample" of bond trades by insurance companies, the paper found that (i) an insurance company entering a trade of similar size and on the same side for the same bond on the same day with the same dealer will receive a better price if it is more active as an investor than less active; and (ii) trading with the dominant dealer or underwriter worsens these differentials, while greater transparency and smaller trading networks lessens the effects. The paper found that "these differences are reduced by greater transparency and can be partially ameliorated by trading network structure," and that this finding supported the authors' "contention that these differences arise primarily from dealer power."
The paper recommended that, in order for them to improve best execution in fixed-income trading:
- institutional traders should adapt their trading networks "to better counteract these anti-competitive forces";
- institutional traders should improve pre- and post-trade transparency through measures such as the introduction of a "public limit order display facility" in order to help fixed-income trading move to electronic venues;
- regulators should clarify and enhance best-execution requirements in fixed income trading, exemplified by the currently proposed Markets in Financial Instruments Directive in Europe, which requires investment firms to establish the fairness of prices based on market data and comparison with similar instruments; and
- regulators should require dealers to disclose trade prices for similar-sized same-day trades on trade confirmations, which could "facilitate both transaction cost analysis and allow for the development of meaningful execution benchmark prices."
The paper highlighted the need for investment firms "to establish the fairness of prices based on market data" and to compare themselves with "similar instruments." However, it also noted that such data, which it utilized in its own research, is "not currently available to bond market investors." Additionally, the paper contained the warning that research suggests "it is not just retail traders who are paying the price in corporate bond trading."
Commentary
The major "finding" of the report is that investors who trade frequently receive better dealers' prices than investors who trade infrequently. In short, dealers tend to favor better customers. This idea is neither wrong nor unexpected. What business doesn't favor its larger and more loyal customers?
The most interesting finding of the report is that smaller customers can receive better prices by trading with fewer dealers; i.e., smaller customers do better when they become the reliable clients of the few rather than the insignificant clients of the many. ("We find that small networks actually reduce the price disparities between active and less active traders, and can completely remove it for buy trades" (at page 5).)
This paper offers less surprising information than its title suggests. The use of the term "best execution" in the title is somewhat misleading. "Best execution" largely is an "agency" concept that is irrelevant to a dealer market. Investors in bonds can engage a firm to act as "an agent" in bond trades - in which case the agent would have a "best-execution" obligation. But the article is not about agency executions. Dealers acting as principals do not have an obligation to provide "best execution," nor do they have an obligation to provide the same price to every customer. Further, certain of the suggestions in the report are wholly impractical. As the study notes, many bonds trade very infrequently, if at all. Thus, establishing exchange mechanisms to trade such bonds is clearly a nonstarter.