Here's Why It's So Hard to Fix the Corporate Bond Market

a massive, massive market is actually traded. So when people think about the corporate bond market, I think there's a tendency to think way back to sort of liars poker era corporate bond trading, like this was the big business on Wall Street. People made lots of money from it, You had certain personalities that were tied to it, and it was sort of old fashioned the way bonds were traded.

And then fast forward to you know, post financial crisis, the two thousand tens, and surprisingly, even as the stock market had largely electronified, the corporate bond market was still pretty much operating like it had in even the nine eighties.

You know, trades done by phone, some trades done by facts, kind of amazingly, and then if you fast forward to one We've spoken a lot on the show about the idea of the pandemic forcing or increasing the rate of digitalization in the broader economy, the idea of everyone ordering stuff online and more things just moving to the cloud and computerized processes. Interestingly, it seems like the pandemic has had a little bit of that effect on the corporate

bond market as well. So we've actually seen the proportion of corporate bond trades that are electronic go up. The most recent research I saw, I think it was from Greenwich Associates, had electronic trading as a proportion of overall investment grade corporate bond trading at about forty of the total UH. That is up from I think at the beginning of and up from a minuscule one tenth of

total trading in eleven. So that tells you how far we've come, But of course there is much further to go, and there have been efforts to reform corporate bond trading the way it's done for many, many years now, and one of the most interesting developments in that space has been the establishment of the Fixed Income Market Structure Advisory

Committee by the SEC. This was created back in with the intention of improving the fixed income market and encouraging its development So today I'm very pleased to say that we are going to be checking in on what's going on with the corporate bond market, whether or not Fim Sack has been able to fix it or you know, at least improve it moderately. We're gonna be doing that with the perfect person. We're going to be speaking with Larry Harris, who was on film Sack so on the

SEC committee. He's also the former chief economist at the SEC. He was there from two thousand two to two thousand four and he is currently the Fred V. Keenan Chair in Finance at the USC Marshall School of Business. So, Larry, thanks so much for coming on the show. Oh, it's a pleasure to be here. So maybe just a first question. I mean, it sounds like you have been in these sort of trading and market micro structure space for a

very long time. Is this something that you've always been following. Yes, I've been working in market microstructure pretty much from the beginning of the academic field now probably forty years. So given your expertise, I have to ask what that about corporate bonds that seems to make them a little bit more stubborn when it comes to things like electronic trading standardization,

uh other efforts to improve liquidity. It feels like the corporate bond space, despite people trying to evolve it for i mean decades now, it feels like it's definitely an uphill battle. Tracy, that's a great question. If you listen to the vested interests in the bond market, they'll tell

you that bonds are just simply different. They're different from equities, they're different from options, they're different from futures, and they say that the differences are what makes the market structure different. Of course, they don't often articulate exactly what those differences are. So often they'll tell you that they're different because there are so many bonds, but there are even more options that trade, and they trade in exchange markets and they

trade pretty well. They'll tell you that they're because they're so risky. Although equities are more risky per dollar of principle than our bonds. So it's a it's a little hard to understand this question on its face. We're gonna have to dig deeper. But as long as we're starting with some history. As you started history, um, you started around the eighties. I'd like to push it back much further. UH, to share with you and our audience some very interesting

things that many people don't know. Bonds used to trade almost exclusively in exchange markets at the New York Stock Exchange and at the American Stock Exchange. Corporate bonds stopped trading on the exchange markets in the mid forties, UH, and an interesting paper was done by two academics, Bruno Bier and Rick Green. And what they did is they looked to see how those bonds traded in the forties and in the late thirties and compared that trading to

how they presently trade now. And when I say how they trade, I'm really referring to how expensive was it to trade the bonds. And when I speak about expense, I don't call I'm not speaking about the price. I'm talking about the transaction costs of trading. So if you buy a bond that's worth a hundred but you pay a hundred one, then your cost was was one point of par value. So these bonds that traded New York Stock Exchange. I'll save the result for a moment, but

you can all anticipate what it's going to be. Let's talk about how they traded. So they traded in order books, just like the stocks trade, but because there were so many bonds, they had to put the order books in filing cabinets. And so these order books, these databases were contained in filing cabinets. If you wanted to trade a bond, you went to the bond specialist post and you mentioned, you know, he said what bond you wanted to trade,

and the clerk would go. The specialists go and look up the bond in the filing cabinet, find out who had left orders for it. And so now the punchline, of course, it is one that everybody's expecting in those non electronic but order driven markets. So order driven means exchange markets in which you have rules that match buyers to sellers. So the most aggressive buyer, the one is willing to pay the most gets matched to the most

aggressive seller, the one who's offering the lowest price. In those order driven markets, bonds traded at lower transaction costs ages ago. Then they were trading until just a few years ago. So so that leaves us with the interesting question why why did the markets move away from the stock exchange where the stock exchanges Because the AMAX bonds were also important. Why did they move away from the stock exchanges and into the investment banks and the dealers

and brokers, So somehow they captured it. And this is not really well understood. Bruno Bier and Rick Green speculate about it. It's hard to imagine that it made sense for the buy side, UH, the investors, because in the end they did worse. But um I think it's just because the investment banks probably controlled much of the supply of bonds. They were buying and selling them. They were dealers, and they preferred to trade as dealers then as some

dealers operating in exchange markets. Of course, dealers always operate in exchange markets. There's nothing new there, but they're more powerful when they trade in a dark environment where you don't see the trade prices and you don't see the quotes. Now fast forward and UH two thousand and two to

oh four or so. At the time I was chief economist, the sec FINRA started the Trace bond price reporting project, and the dealers were very opposed to having those trade prices reported, even with a fifteen minute lag, which is what was finally determined. Um I was privileged, along with some others to engage in research that showed that making those bond prices public information would lower investor transaction costs

by about a billion dollars per year. So the opposition to the dealers to making the prices public kind of withered away in the face of those empirical results. I'll tell you two fund stories. There's somewhat self serving, but does make the point about this story. Yeah. So the first one is that, um, so the SEC did indeed mandate that the bond trade prices be made public, and now trace prices are available on the Internet and everybody

can see them. So the two stories are. First, um, somebody came along, I forget the fellow's name, might have been a woman and replicated the study in which I participated and discovered that indeed investors were saving billion dollars. So my study had been based on just a trial of trace and from the bonds that were public, and we compared them to the bonds that weren't public publicly where the information wasn't publicly available to trade price information.

From doing the comparison, were able to determine what we thought the savings would be. The way we did the study, we compared how the bonds that were trading in more transparent markets, the initial trace transparent bonds. We compared how they traded to the ones that had not yet been converted, and we we found that about a billion dollars would be saved by investors. And so the first story is that, uh, indeed, somebody looked at it a few years later and determined

that our estimate was was on target. So I I say, somewhat immodestly that we did well. But the important point is that not only on a prospective basis, but on a retrospective basis, it appears that that bond price transparency substantially lower transaction costs. So that's the first story. The second story is a little bit more fun. And Nette Nazareth, who was then the director of what was then called the Division of Trading and Markets, who was a big

proponent of making the bond prices transparent. She kept asking me, Larry, how come you're not done with that study? How come night you're done done with the study? Because they needed that study to build the political wherewithal to get the capital to to get this done. And I kept telling her, listen and that I'd like to have it done yesterday, but we're going to be super careful because the dealers are going to criticize this study. So fast forward about

ten years. I'm at some conference. I'm talking to somebody, you know, an academic conference, and uh and this guy sort of drops uh. He says, um, you know you did that bond study about transaction costs to the initial trace down And I said yeah. He says, uh says, I know, I know a backstory about that. I'm going yeah, he says, he says, the dealers, Uh sent it to a colleague of mine at the university. I won't say which one, but it was a strong, reputable university, asking

is there anything wrong with the study? Uh, you know, can you find econometric problems or something like that? And Uh. The response was apparently no, you're gonna have to live with it. It was well done. So again a pat on my back. But also also there's a more important point, which is that there's a role for academic work. Rigorous work didn't have to be done by academic can be done by practitioners as well, and by the economists at the SEC. There's a role for rigorous work for trying

to understand how things could be different. I mean, that is such a fascinating um insight into the way the SEC works and also the way it's various stakeholders um sort of interact with it. There's one thing I wanted to ask you before we sort of move on to what happened next, But can we just can we focus in on on the dealers here a little bit more so? You know, you you kind of touched on this, this idea that the dealers have vested interest in the way

that the current system works. So I brought up liars Poker at the beginning. You know, this is the idea of people sitting at the big dealer banks who are taking calls from investors who want to buy or sell certain bonds. They're basically the middleman who are holding the informational power and who can say like, well, I have a quote on this one or I have a quote on that one, and no one really is quite clear what the actual price of these bonds are. They're sitting

in the middle. It's a very intransparent process. Now, in the years since then, we have had these new electronic trading venues set up, and here I have to do a massive disclosure and say that Bloomberg has one UM, so we have Bloomberg Trade Web and market Access, and my understanding of those is that basically they've made dealing with dealers potentially more efficient. So you can do a request for a quote with just you know, a click of a button and you can get one very very quickly.

But they still preserve some of the power of the dealers in that process. You can't do a deal directly with another buy side participants for instance. Is that right? Is that the right way to think about it? Yes, that's generally correct. And though they would like to create exchange type markets, uh, they know that they still need the dealers to provide the liquidity and so that the dealers call the shots. Tracy, you're, you're. You use the word um informational power. You could not be more on

target with that phrase. So, just so that everybody listening has a clear understanding of how powerful information is, let's discuss a simple example of where that everybody can relate to. Suppose you need to buy a say a used car or could be a new car, uh, and you go to the dealer and you find what you want to buy, and you you then make a bid. Okay, now, they two mistakes that you can make. You can underbid or you can overbid. Now, if you underbid, here's what happens.

So the salesman says, say, Larry, I'd really love to sell you that car at that price, but if we do that, we just can't stay in business. The price is simply too low. So, um, you don't do the deal. Now suppose that you overbid. What does the salesman say. Salesman says, hey, Larry, I'd really like to sell you that car, but if I do so at that price, we're going to go out of business. But hang on a minute, let me see what my sales manager says. And of course he comes back and sells you the

car at the price that's uh, that's too high. So what's going on here? Obviously you can make two mistakes. But because the dealer knows values better than you do, the dealer isn't gonna sell it for undervalue, but it'd be more than happy to sell it for overvalue. And so this is the story. This is why information about values is so incredibly important. Unfortunately, we only have half the story on price values. We've got now the trace data that we just talked about which tells you the

prices at which bonds traded. By and large, we don't have very much quotation data, although it's increasing substantially, we don't have much quotation data where the dealers are telling

the public the prices which they're willing to trade. So if you want to go buy a bond and you're smart, what you do is you you you go and call up a dealer and say what's your offer, and then you call another dealer and ask for what your offer, and you call another dealer and you can sort of make them all know that you're doing this, or you can do a request for quote, which is essentially the same thing, and you try to get them to compete

with each other. But it's an expensive process and um, they're only volunteering information to you, not to the public, so it's not quite as effective as the competition we see every single day for even a liquid securities at

the various stock exchange is or the options exchanges. So when pricing data became available on trades, you're getting the specific points, the specific prices at what which bonds are being traded, but you're not getting potential quotes from a bunch of dealers about like where they could buy or seldom you're getting the actual transaction data. How did that

change the market or change behavior of participants. Well sophisticated people and even some less sophisticated who know enough to look up bond prices can find out where the bonds recently traded. And if a bond recently traded, you know, just minutes ago, then you have a good point of reference to what the value that bond is, especially if it's a very large trade. The large trades tend to be more informative than the smaller trades because the smaller traders, frankly,

you know, they just don't know as much. They don't know how to they don't know how to control the information environment. They trade through brokers who aren't particularly how full, and so the smaller trade prices aren't so important. But if you want to trade a bond, say you're trying to sell a bond, is a more typical story than wanting to buy one. Uh, you want to sell a bond that you need that you need to generate some liquidity. Maybe that bond didn't trade yesterday or today, Um, that

would be ideal. Say it traded last Um, you know a month ago or perhaps a year ago. Uh, there are a lot of bonding issues out there, and some of them, they we say they trade only by appointment, which is kind of funny. Okay, so you've got a bond trade from ages ago, and now all the question is what's the thing worth? And you know there are bond pricing services that can give you some sense of

what the bond is worth. That's very important because mutual funds that hold bonds have to value their bonds and if they don't trade, well, I mean, what's the bond worth? They've got to know every day. So these pricing services what they do is they say, okay, this bond didn't trade, but it looks a lot like these other bonds, maybe bonds by the same issuer, or maybe be bonds with the same cupon rate, the same maturity, the same the

same preference in liquidation, stuff like that. And so they say, okay, we got a model that says if if these other bonds are sort of recently traded and we see their prices, we can infer what this thing is probably worth. Of course, you know, the small trader, the guy who's trading odd lots. You're on the right show. I know. That's that's why I laughed here. Uh. Yeah, they don't get that information and it's expensive. And in any event, though, um, what

the pricing services say is not necessarily true either. It's just their best estament. Real truth comes when people are ready to put their money on the on the table and trade and actually negotiate prices. So it's good to have those trace prices, but it would be even better if we had perspective prices, pre trade prices. The quotes, there are a lot of them out now out there now, and uh, entities like bond to click are starting to

aggregate them from dealers. The dealers are willing to share with bond click because they want to see what the other dealers are saying. The dealers aren't They're not They're not dummies. Uh, they're very very sharp people, of course. But the consequence, though, is that increasingly this data is becoming more public and you know, bond click is uh appears to be leading here, but I suspect I believe that there's some others as well. The dealers aren't entirely

happy about it. So it's not an easy proposition. As long as you're speaking about a little bit of history. Cannor Fitzgerald ran a open outcry sort of brokered bond market and treasuries, and through their E Trade subsidiary since spun out, they wanted to get the bonds into an electronic trading system and they had had a terribly difficult time doing that. The dealers basically boycotted the system for a while, but they persevered. They managed to get it done,

but it's not easy. The big challenge that these systems face creating an exchange like system is that when somebody needs to trade, they usually need to trade right now, and they look at a system they say, wow, that is a cracker jack system. That's beautiful. I'd love to trade there, but right now, I got to get my order done and there's nobody else there, so I'm gonna get my order done. And when when that market becomes looking, you give me a call and I'll definitely send my

orders there. So it's a chicken and egg problem here. Only the problem is it's not which came first, is that neither comes first because people need to get their business done and so that's that's the force that keeps change from happening too quickly. But On the flip side, these electronics systems have vastly decreased the cost of dealing, and now you have lots of proprietary traders who are

willing to deal bonds like they deal stocks. The deal odd lots, but they're willing to come back over and over again, and so increasingly you're gonna start seeing, and we've already seen it, are algorithms used by institutions to fill large orders in odd lots, and they'll they'll do that because there are dealers who are well dealers are proprietary traders, but let's call them proprietary traders are essentially using, you know, some crude version of the high frequency trading

methods that they use in the stock markets to deal. We should be clear about what bonds are. So here's a fun way of thinking about a bond. People tell you that bonds are something special, but from this point of view, there perhaps not so special bonds if you think about their risk. There are a package of two types of risk. There's interest rate risk and it's bundled with credit risk. So credit risk is the risk that the company that's promised to pay off its bonds goes

bankrupt and you don't get paid. An interest rate risk is the risk that, say you bought a bond and then interest rates rise in the price of your bond drops. So that's not comfortable. So think about this risk. What is there about putting both risks into a single instrument and tying them together with an invisible string. The string is actually called the bond covenant, the contract that sets

up the bond. What is there about doing that that makes the bond something different from the risk that trades elsewhere. So the interest rate risk trades in highly liquid treasury bond markets. They are also in the futures markets. They are whether they are cash or in the futures. They trade in these order driven exchange like systems, and the credit risk, as we mentioned earlier, the credit risk of bonds is even as much less than the credit risk

of the associated stocks. So the credit risk is being traded in again order driven markets, the stock exchanges and the similar systems, and they're both highly liquid markets with lots and lots of pre trade and post trade order exposure. So pre traders, the quotes and post trade or the trade prices, and those markets function really well. So what is there about that magic string that connects those two risks into a single bond that somehow makes it necessary

to trade it in the dark. And if you've got a good answer, I I'd love to hear it, because I've heard lots of people try to explain it, but nobody has convinced me. And I'll remind you again one final reminder before we turn to another topic. That explanation, the magical explanation, also has to explain why it didn't operate in the nineties when these markets were trading in ex anti and ex post transparent markets at the exchanges. So there's anybody wants to explain this one is going

to have to work really hard to be very creative. Well, I think that brings us up to modern times very very well. So you know, we have some progress when it comes to pricing transparency, notably the trace data which is now being produced based on actual bond trades but not potential quotes. You have the electronic trading venues that are mostly operating on a request for quote basis and are mostly preserving some of the informational power of the dealers.

And you have some venues that are trying to aggregate prices um and quotes for bond trades like bond click, which you mentioned, but sort of improvements on the edges, nothing massively fundamental. And yet this is something that you know, you laid it out very clearly earlier. This is something that has been of concern to the SEC for a long time now, and I personally remember speaking to think it was Dan Gallagher back in and he was saying, you know, it's time to address the liars poker dynamics

embedded in the corporate bond market system. And yet here we are years later, still talking about potential fixes or improvements that could be made. So I want to talk to you specifically about one of the big SEC projects to try to fix all of this, which is the establishment of film SACK, the Fixed Income Market Structure Advisory Committee. In this was supposed to be. My understanding is it was supposed to be the big effort by the SEC to try to come to a consensus on what needs

to be done and then actually implement it. And you are on the committee, So maybe maybe you could give us your perspective of what exactly the goals were when it was established. Well, I suppose it depends who you ask and how Canada, they will be when they respond. When I went into it, I thought this was a great opportunity to modernize the markets. Um I had been instrumental with the net Nazareth and many others. Remember every success has lots and lots of grandparents and parents and

godfathers and god mothers and so forth. We have been instrumental in moving the stock markets from open outcry floor based systems into electronic systems that are incredibly efficient now. So that was neat, and so I thought, gee, this would be a really great time to see what we can do to to solve some of these problems. They're not really problems, but just to make the markets better.

And so some things that I was hoping we'd be able to do is that we could, you know, call for the formation of a national best bitter offer, or have Finra do like NASDAC did, or have NASDAC and the nas d do this create a a nasdak. The original nasdack for bonds. The original naz Back was just a quotation system where he showed everybody's quotes, all the dealer quotes. It's called a quote tableau, so it just seeing the quotes. Ex Anti gets people to compete more

and makes the markets better. And then they ultimately evolved into the NASDAC stock market, which is a full blown exchange and and regulated as such. Now, so I thought, you know, at a minimum we could try to ask for that. There was almost no support for that. There were a few people who were in the boat, but the vast majority of the members of FIM SACH were

opposed to any change so radical. Who were the other members? Well, we'll talk about that, But so we weren't calling you know this what this proposal was not a call for, you know, a trade through rule, which would be pretty radical. We're just saying, you know, let people, let's collect all the ex anti data that the quote data. So who were the people on FIM SACK. Well, by law, these advisory committees have to be representative of sort of everybody

who has an interest in the issue. Everybody has to be the at the table. But the law doesn't tell you how the table should be weighted. You know, how many people of each type. And so you had the bond dealers, you had the bond issuers, you had a few academics, you had a few investor advocates, you had the alternative trading systems. You had some dealers, I think I mentioned them as well, issuers and large institutional investors.

So I think it pretty well covers the gamut, but it was weighted heavily towards people who were either vested in the status quo or who we're dependent on people

who are vested in the status quo. So if you're an issuer, you don't want to go out and piss off your investment bank because because you've got to do business with them, and so basically you just go along and uh, you know, I would make in passion speeches about how we should be doing what's best for the country and stuff like that, and they all, in their own way, thought that they were doing what's best for

the country. But I think that perhaps there are points of view might have been partially compromised or at least subtly influenced by their self interest. So I'm trying to be polite, but you know exactly what I've said, and it's not surprising. There's a lot of fear that if we made any changes, we'd screw things up. And so the problem to getting changed is that our bond markets are for all their awards the best bond markets in

the world. They could be a whole lot better. I know that from my experience, and uh, a lot of other people know it, but getting it there is really difficult,

and so it's very challenging and disappointing. My understanding was, I mean, this can have come as a surprise to anyone who created this committee, Like if you get a bunch of varying interests together in the room, they might not be able to agree on fixing the market or improving the market, especially given that they haven't really agreed on how to do that, you know, for many, many

years previously. And I always thought the idea of getting the SEC involved was that you would have an independent arbiter who could look at this information and try to, you know, come up with a solution that might be independent of the individual interests of people in the market currently. But that doesn't seem to have happened, judging by the lack of news that I've seen on you know, stuff being proposed or coming out of the committee. Well, there's

a lot, there's a lot in that. So I mentioned that the composition of film Sack basically established what they were going to do, and what they were not willing to do. It's instructive that the very first thing that they proposed was to the a the reporting of of super large bond trades. Right now, their prices are reported within fifteen minutes with the marker saying that the trade is if it's an investment grade bond, it's more than five million dollars, and then six months later you can

find out the full size. But who cares at that point and five million dollar trade is plenty big enough, you know, it's big. So they proposed that that we should delay reporting those trade prices and sizes for I think three days or something like that, but then we'll report the whole thing. So there was like, well, we'll give you something. But what they were taking away was really really meaningful, and this is the first thing they proposed. So that was like a shock to me. It's like

we're going backwards. Uh, it's just crazy. Okay, So the SEC appoints all these people and they according to how they do the waiting, they can determine the outcome. So let's be generous to the SEC and say that there are a couple of different ways that change can take place, and how you feel about these ways depends on how you feel about uninformed investors and how you feel about political economy or your political philosophy. So one way is

for the SEC to mandate change. So we did this when we were making changes to equity market structure to make the markets electronic. That was reag MS and it was extraordinarily successful. So the SEC has the power to regulate markets, and it gets challenged by the incumbents, but in the end, if they do their work properly, they can get what they want and done. The argument for the SEC doing this is that somebody has to represent the interests of uninformed investors who will never be able

to do this by themselves. Okay, so that's an argument. The counter argument, which is also respectful, is that listen, f the markets would be better in a changed state. There will be people who will provide those changes, and though it might be difficult, uh, it's not impossible, and in US it's impossible, we shouldn't regulate. So, for instance, there are private entities who are now aggregating best bids and offers. We talked about bond click. There are brokers

who are doing it as well. So interactive brokers will allow its clients to trade on bond markets where Interactive is collected quotes from a multitude of dealers. And more interestingly, Interactive will allow their clients to post their offers to trade, so they can post bids and offers just like you can in the stock market, and uh they post them at venues where they actually might get hit. And so instead of always buying at the ask price, you might be able to buy at the bid price if you

trade through Interactive. Now, in the interest of full disclosure, I have to tell everybody that I am a director. I'm actually the lead independent director of Interactive, and so um, you should recognize that that. Uh, I have an interest in letting people know about this. But they're innovative and

that's in things. So going back to political philosophy, clients want this, they can go trade through Interactive brokers, and if SWAB sees that they're losing clients or e Trade or you know, merrit Trader, they can start offering the same services. So the premise here, of course is that ultimately the uninformed and unknowledgeable trader will benefit because there are knowledgeable traders who put significant demands on the system and cause the system to change that may take twenty

or thirty years, or may never happen. It may only happen for the informed traders, and everybody else sort of gets left behind because people never know any better. And if that bothers you, then you're back into the first camp that says maybe the SEC should do something. So from my point of view, I think that the SEC

should exercise a little bit more power. I don't like to see them do too much regulation, but they should exercise power when you have certain problems in the market that make competitive solutions difficult, and those problems are agency problems where people are represented by people who have conflicts of interest. The people who are doing the representation, like the brokers, they don't have a strong interest in serving their clients. Well, if the client doesn't know that, they're

getting screwed. I believe that's the technical term in the market. So I hope nobody takes any offense. It wouldn't be the first time it was said on all lots. Yeah, I'll be more careful about some of the other technical

terms that are often bandied about in the markets. So when the broker has a conflict of interest and the client doesn't even recognize it, the broker is not going to be too eager to change it because the broker is going to act in their self interest, and their self interest is usually too to go along and keep things simple. And in some cases they even get paid for order flow. But I don't think that happens in the bond markets. That may be misinformed. So that's a

that's a potential problem. And then another potential problem was this um uh. Economists call it the order flow problem, but if you're just a regular person, you just know it as a notion that liquidity attracts liquidity. And we discussed it earlier when we talked about how difficult it is to start a new market. You got a new market exactly. It's a cracker jack market. But the problem is is that it never gets off the ground until

people are willing to trade there. And they're not willing to trade there because I've got to get their stuff done right away. So that's it. That's a problem that inhibits competition. We all may be better off with that cracker jack market. You know, maybe it's an order driven market with all the bells and whistles that will make trading super efficient, like we see in the equity markets, and then to a lesser extent in the options markets,

and certainly in the futures markets. We we may want that and it could be better, but we may never get there without the assistance of a regulator. So these problems, agency problems and externalities see the fan see words that economists know and use. These problems ensure that that free markets don't often don't always produce competitive markets. And so this is where political fossiphy can diverge. I am a hundred percent in favor of free market, of free markets

when free markets produce competitive markets. But if a free market is got problems like agency problems or externalities that ensure that we don't get to the competitive solution, then we need to have a very light hand that will give a nudge. I'm avoiding the word that that nasty word regulation, but to give a nudge to get us to the right equilium, to get a structure that benefits everybody. We should talk for a moment why we care about this.

Even though we have the very best markets in the world in the bonds, they could still be substantially better, and if they were better, we would all benefit. So volumes would increase substantially, which ironically would benefit the dealers.

Transaction costs would drop, and uh we would you know, people who are saving for the retirement would be able to save more efficiently, and issuers would see lower issuance costs because the cost of issuing a bond depends on how liquid the market's going to be after you've issued the bond. People don't want to pay so much for a bond that will be locked up forever if they need the money out, they don't want to lose a

lot trying to sell it. But if the bond looks like it's going to trade in a highly liquid market, they'll pay more for the bond. And when people pay more for initial public offerings to bonds, when the corporations are funding, it means they're funding costs are lower and so that's good for them as well. So there are a lot of really important and very valuable benefits that are associated with making these markets that are markets. But there are some strong vested interests. Give you a note

on a story about vested interests. So the SEC adopted trace, we talked about it at length. At the same time, the Canadian markets were faced with the same proposal and they didn't do it. They since have adopted post trade transparency, you know, to show you what the trade prices were, but it took them ten fifteen years to do it. And the reason perhaps was that the regulator there was the Bank of Canada, and the Bank of Canada has a close relationship with the large dealers and as a consequence,

they just didn't want to rock the boat. This despite the fact that there's overwhelming evidence from America that the world didn't end as some people suggested with those bond prices being made public, and likewise, the world's not going to end if bonds were traded in order driven systems, because we see order driven systems trading similar instruments all the time all throughout the world and in the United States as well. So lots of fears about the end

of the world, but I'm not there. Well, can I just ask one devil's advocate point on this idea of regulation versus natural market evolution, And it kind of relates back to something I said in the intro, which is this idea that over the past year or so you have seen something of an improvement or a migration in the amount of bond trades that are actually electronic UM

and going through some of those platforms. So I think I cited the Greenwich Associates data that had the number of i G Investment grade bond transactions UM that were electronic at UM currently versus something like less than at the beginning of So something happened in UM, you know the pandemic. You had the Federal Reserve buying corporate bond

e t s for the first time. Those two things arguably have helped shift the market more than previous regulation or some of these previous private efforts have done in the past. So is there an argument to be made that you could just let the bond market continue its natural progression and maybe eventually people will change their behavior. UM. Certainly you could make that argument. There's strong evidence that this is what's happening, and it may continue to accelerate.

The two stories that you offered may have contributed. But I think there was another story even stronger, which was that as a result of Basil three UM, the large banks came to be at a disadvantage to proprietary traders when dealing bonds. And we can talk about what that disadvantage was, but basically, when holding a bond portfolio, UH, the banks have to hold more capital against the positions

than do proprietary traders have to hold. And as a consequence, the banks could not compete as effectively as they had competed before, which meant that a lot of the personnel at those banks left and form their own proprietary trading groups or joined other proprietary trading groups. And all of a sudden, you have a core of highly skilled dealers in a proprietary environment that want to make money, and uh,

they're electronically sophisticated. And I believe that it was probably these guys who have made the electronic venues more liquid and has given us that and I expect that that will that trend will continue, and I think that's I think that's a good thing. And indeed, if you look at studies of spreads, we see that spreads have indeed dropped in the bond markets because of the more competition from these electronic entities. And there's of course two competitions

here that we want to promote both of them. There's the competition for best price, which works best when you put everybody in the same place. Best price means that buyers looking for the lowest purchase price in the sellers looking for the highest sales price. They also have the competition to be the venue that hosts that competition, whether it's an exchange or a broker, or just a dealer who says, I'll take the other side and give you

the liquidity. So we like to have both competitions, but the two competitions don't coexist particularly well with each other, and the sec and over time has leaned towards promoting one competition versus the other competition. And what's really interesting, of course, is that anybody who has a position in these markets about my position, I don't mean their bond position, but I mean they're their opinion about how they should be organized. Anybody has a such an a pain and

always cites their opinion is being pro competitive. So if they want to see more centralization, they say they want to see the competition for best price enhance. That's really good. And if they want to see more competition among exchange venues and so forth, they say, the system as it is is really competitive and that's important, and it's created the best markets that ever were now until recently, they

are now the best markets that ever were. But until recently before these electronic innovations, those markets back in UH in the nineties at the stock exchange, they were better. And how much better would they be now that we have computers that can handle those filing cabinets. You know, it's just a database problem. So it's pretty darn interesting. One other issue it love to share with you. Yes, ses regulatory framework for small retail traders in the bond

markets is dealer centric. The assumption is that dealers are doing all the trades. In contrast, in the equity mark is the regulatory framework is broker centric. It revolves around the brokers, and so the difference is that the brokers are required to get best execution. And but when the the brokers are acting as dealers to you, there's a

sort of a different relationship. But quite frequently now that the markets are electronic and where you have venues where quotes are being aggregated, or we have dealers who are sharing their quotes directly with brokers. Quite frequently a broker dealer who offers bonds to their clients takes no position whatsoever.

They do what's called a riskless principal trade, which means that they buy from a dealer and they immediately sell, usually marking it up to their client, and they'll show the client what's available because they have a list of what the dealers say is available, and the client chooses what they want and being of the trade is done okay. So there's no principal risk involved with that transaction because the intermediary, the broker, is literally acting as a broker,

but is regulated as a dealer. So there's a type mismatch here. And uh, if there's a good reason that we regulate broker dealers primarily as brokers when doing ristless principal trades, which is essentially what they do when clients buy stocks or options or futures, why don't we regulate them the same way when they're trading bonds. And the answer of courses bonds are different, so, but but I

don't think they really are so different. There's one other question that I wanted to ask you, which is about Gary Gensler, the new SEC commissioner. And you know, we've seen him come in and he's made a lot of noise about focusing on things like crypto and payment for

order flow in the equity market. Um, and you know, general retail stock trading issues um seemed to be high on his agenda, but he has also spoken quite a bit about price transparency in the bond market and maybe some other um improvements that you could make to the regulatory structure. And I'm aware that we haven't really spoken about a t S at all or alternative trading systems, But is this something that you would expect Gensler to

be looking at in the next year or so. Do you get the sense that this is high on the SEC's priority list given what happened with fim Sak, all that happened under Film SAC and most importantly, the constitution of the committee itself took place under a SEC that was dominated by more conservative political interests. So now we have an SEC that's now dominated by somewhat more liberal political interests, and as a consequence, there is a potential

for change here. My impression though, is that this is not his hot issue. There's a variety of reasons why, but the evidence that it's not a hot issue is that he still has not appointed a full time director for the Division of Trading and UH. It is now called the Division of Trading and Markets. It used to be called the division of market Regulation. I misspoke earlier when I mentioned that. So he still has an acting director who seems quite competent, but a acting director just

doesn't have the same power as a director. And then all of his regulatory people report to a person in his office who doesn't have a strong background in market structure. She's an attorney. Her last job was a deputy general counsel for a f l C. I Oh, I've never met her. I'm sure she's a wonderful woman, and I'm sure she's a very fast learner, as almost all attorneys are, and I can assue every attorney thinks they are. But

it's not the same thing. And so uh so, just from those omissions, if you will, I'd suggest that perhaps some market structure issues aren't high on his regulatory agenda. Now, all that said, there's a lot of money involved in these issues, and when there's a lot of money involved in the issues, vested interests will lobby their senators, and so they make contributions to senators, and senators look at that and say, Hey, the US bond markets are the

best markets in the world. Why would we ever want tom up with them? Because just because some you know, academic who thinks he knows something tells us that it could be better. Well, you know what, I just don't see it. And so you know, if the SEC proposes to do something, as senator writes the letters saying not an opposition, but can you kindly explain why you're doing what you're doing, And then in between the lines, which

is not written, it's uh oh. And by the way, you may recognize that I sit on the the Finance Committee and we set your budget. And from the tone of let or there's a little bit of skepticism and sort of everybody knows, what's what? Why do senators do this? Well, they do care about the markets, but it's an abstraction.

It's far away from them. They can raise capital, which is political contributions, cheaply and then spend it where it's more dear to them, on the issues that are more important to them, whether it be abortion or early childhood education or armed forces or who knows what roads doesn't matter.

And so what you see is senators on both sides have this tendency to be co opted by strong interests, and so what you need is a very very strong SEC that can make the case and explain how much better things would be if we do all this, because it's going to be painful. The SEC will end up being sued. They'll be letters from senators, and at some point the letters can be less than subtle. So you

need you need somebody who's really been empowered. We had that, uh under Harvey Pitt, who was actually too outspoken, but it continued under Donaldson, and that's when Reagan mis NMS

was adopted over the objections of the Republicans. And it was odd that Donaldson, a Republican, actually voted with the two Democrats to adopt Reagan MS, but that was perhaps because he said was at the closer to the end of his career than to the beginning of his career and may have been thinking more as a statesman then as somebody with vested interests. He also may not have cared very much and just let staff do what they

wanted to do and they got away with it. But it's it's difficult, no question about Yeah, I'm getting that sense, Larry. This has been a fascinating conversation and I feel like we could probably talk like all day potentially about SEC history and some of the political mechanations there. But thank you so much, really appreciate you coming on all thoughts, Thanks for this opportunity to share some really important insights with you and your audience. Figure So clearly I enjoyed

that conversation. It's always a joy for me to get back to talking about corporate bond market structure, And of course a couple of the things that stand out is that tension between a regulatory push towards fixing these agency problems that Larry described versus the natural development of the market.

And part of me thinks, like, yes, we've seen some improvement over the past couple of years or so, but there is still so much further to go in what is one of the most important markets in the world, and it's sort of amazing to me that there isn't

more of a spotlight shown on this particular issue. But on the other hand, I thought Larry did a very good job of explaining some of the political considerations that going into formulating the SEC's uh sort of agenda under various personnel and new commissioners, and so maybe that explains it. I can't imagine that telling people that your regulatory focus

really needs to be on fixing credit markets? Um, is that much of a sexy topic for a broader audience, Although you know, certainly, on this particular podcast, we try to make it one all right. Um. I think I'm gonna leave it there because it's weird to talk to myself without Joe. This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway. You can follow my co host Joe Wisenthal. He is at The Stalwart. You can

follow our producer Laura Carlson. She is at Laura M. Carlson. And you should follow Bloomberg Podcasts. They are at podcasts. Thanks for listening to