Pre-trade Transparency in Over-the-Counter Markets

To understand whether and how pre-trade transparency would affect over-the-counter markets, we construct a search model and test our model implications in corporate bond markets. Based on our search model, we argue that the increase in pre-trade information, which refines traders’ information sets, enhances traders’ bargaining positions relative to dealers’. Thus, traders’ transaction costs measured by bid-ask spreads are reduced. Smaller bid-ask spreads induce more traders to participate, and hence, lead to an increase in market liquidity. Our model is novel in that we consider traders’ lack of pre-trade information as Knightian uncertainty. In other words, the unavailability of pre-trade information impedes the formation of a unique prior for traders. Our model implications are supported through a controlled experiment on the corporate bond market. Using propensity score matching to construct groups of bonds with and without pre-trade information, we find that the average effective bid-ask spread is 11 basis points lower on pretrade transparent bonds. This means that a minimum of $930 million would be saved annually on transaction costs if pre-trade transparency had been enforced.