Trading Activity and Transaction Costs in Structured Credit Products

Hendrik Bessembinder, William F. Maxwell and Kumar Venkataraman

Financial Analysts Journal, 2013, vol. 69, issue 6, 55-67

Abstract: After conducting the first study of secondary trading in structured credit products, the authors report that the majority of products did not trade even once during the 21-month sample. Execution costs averaged 24 bps when trades occurred and were considerably higher for products with a greater proportion of retail-size trades. The authors estimate that the introduction of public trade reporting would decrease trading costs in retail-oriented products by 5–7 bps.Structured credit products (SCPs), including asset-backed securities (ABSs) and mortgage-backed securities (MBSs), compose one of the largest (comparable in size to the US Treasury security market) but least studied segments of the financial services industry. SCPs are complex instruments that include the payment obligations of numerous borrowers, contain multiple tranches that differ in terms of payment priority in case of default, and have sizes that can change randomly as underlying loans are repaid. Uncertainty regarding SCP valuation played a role in the recent financial crisis, owing in part to the fact that secondary trades for SCPs occurred in an opaque dealer market without public quotes or trade reports.Since May 2011, FINRA has required broker/dealers to report transaction prices and quantities for SCP trades to the TRACE (Trade Reporting and Compliance Engine) system. However, FINRA does not yet disseminate data for most SCP transactions to the public. Effective 5 November 2012, the U.S. SEC approved the public dissemination of transaction prices in a subset of SCPs (specifically, in “to-be-announced” securities). FINRA has recently proposed that trade prices of SCPs, including MBSs and ABSs, be disseminated to the public.For investors as well as regulators, the key difficulty in an opaque market lies in establishing the prevailing market price. Investors cannot compare their own execution prices with those observed for other transactions. Even institutional investors have to invest significant time and effort to obtain market information, either via ‘‘indicative’’ quotes obtained through messaging systems or by telephone calls to dealers. Increased transparency has the potential to reduce dealer markups, provide information on the fair price of securities, and improve the ability to control and evaluate trade execution costs.In this study, we examined the accumulated FINRA data to provide what we believe is the first comprehensive description of this important but little-studied market. The data include all secondary market transactions for the universe of US SCPs from 16 May 2011 to 31 January 2013. We report on trading activity by subtypes of SCPs, the determinants of secondary market trading, and estimates of transaction costs in each type of SCP. Finally, focusing on segments of the corporate bond market that are comparable to segments of the SCP markets in terms of key characteristics, we present estimates of the potential effects of implementing transaction dissemination in these markets.Notably, less than 20% of the SCP universe traded at all during the 21-month sample period. One-way trade execution costs for SCPs averaged about 24 bps. However, trade execution costs varied substantially across SCP categories, from 92 bps for CBOs to just 1 bp for TBA securities. We show that trading costs depend in particular on what we term the product’s “customer profile,” which depends on issue size and the proportion of retail to institutional-size trades. Subproducts with an institutional profile tend to have lower costs. The highest average trading costs are observed for agency CMOs (74 bps) and CBOs (92 bps), each of which has a low (22% or less) proportion of large trades. The lowest average trading cost estimates are observed for TBA securities (1 bp), CMBSs (12 bps), and ABSs secured by auto loans and equipment (7 bps), each of which has a substantial (54% or greater) percentage of large trades.By matching SCP subtypes with corporate bonds that are comparable in terms of customer profile, we present rough estimates of the potential impact of introducing price transparency for the SCP markets. Our analysis indicates that price transparency is likely to be associated with substantial decreases of 5–7 bps in one-way trading costs for MBSs, agency CMOs, and CBO securities, as well as securities in the subgroups TRAN and WHLN. We anticipate smaller trading cost reductions of about 2 bps for private label CMOs. In contrast, we anticipate little or no change in trading costs for CMBSs and SBA securities, as well as ABSY issues and CDOs. Broadly speaking, this analysis indicates that trading cost reductions are most likely to be observed for SCPs with a retail clientele, whereas transaction dissemination is less likely to be relevant for those products with an institutional clientele, which already carry lower trading costs.

Date: 2013
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DOI: 10.2469/faj.v69.n6.2

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