The Effects of Transparency on OTC Market-Making

Abstract

We examine the effects of post-trade transparency on intermediation in the over-the-counter corporate bond market using the staggered introduction of TRACE as a natural experiment. Post-trade transparency leads to increased trading volume and more connected dealer networks. Transparency reduces dealers' profitability but also their portfolio risk and adverse selection costs. In contrast to prior research suggesting that TRACE benefits customers at the expense of dealers, we show that the net effect on dealer welfare is ambiguous. Bond spreads are less predictive of default in a transparent market, consistent with reduced profitability of informed trade weakening incentives to produce information.