This research was commissioned to answer a range of questions relevant to a comprehensive regulatory review of market transparency, liquidity and efficiency in the European government bond markets, including:

• Do government bond markets in the European Union (EU) deliver efficient market outcomes?
• To the extent that outcomes are not efficient, could improved pre- and/or posttrade transparency improve bond market efficiency?
• To what extent will increased transparency occur as part of the natural evolution of bond markets?
• To what extent can market participants be encouraged to develop their own solutions and what can only be achieved by direct regulatory intervention?

We cannot claim to have answered these questions fully, but we do believe we have brought new evidence to bear upon them. We have carried out the research in close consultation with the commissioning organisations, who have given us invaluable access to market participants and help in obtaining data. In strict accordance with the policies of the Centre for Economic Policy Research, however, our work has been totally independent, and our arguments and conclusions are solely our own.

We have indeed departed significantly from the initial intention, insofar as we have not focused explicitly on the ‘market failure burden of proof’ for regulatory intervention. That, for example, is the approach of the FSA (2005). This is one way of structuring an analysis from first principles, and it certainly informs our research. But this approach has already been developed extensively, and we judged it unlikely that we could contribute much by pushing it further. Instead, we have sought to go more deeply than previous work into the meaning of transparency for securities markets. Seeking to exhibit the implications of transparency is at the centre of our theoretical and empirical research here, both of which we believe to be novel in their approach and results. This then leads to relatively straightforward, though not detailed policy implications.

Section 2 sets out the issues and goes into the key differences between electronic and voice markets, with their implications for transparency and for market outcomes. Markets are not merely theoretical constructs, nor do they typically function according to simple textbook rules. They are complex institutions that have histories and that evolve over time, partly under the influence of external forces like regulation and partly endogenously. We observe this process and its current outcomes in the European government bond markets. We stress the problems posed by the winner’s curse for dealers and the position risks they take on. Transparency may reduce liquidity, so there may be a tradeoff between the benefits of transparency and those of opacity. The discussion here suggests how difficult it will be to identify what level of transparency is optimal.

Section 3 reviews major contributions to an extensive existing literature on securities market transparency, liquidity and efficiency. There is theoretical modelling, empirical work, and experimental research. But some of the theoretical propositions are conflicting, and some of the evidence in the empirical work is contradictory. Very little of the latter deals with government bond markets. The evidence does suggest, however, that infrequently traded stocks benefit from some degree of opacity, and that a very transparent B2B limit-order book does not have benign effects on execution quality.

In Section 4, we take a game-theoretic approach to modelling the interaction between issuers, dealers, and customers. The framework has an incentive structure that represents, we believe, the institutional structure of the auction and syndicate issuance systems used for European government bonds and the interplay between them. We find that the introduction of full transparency in this context can drain liquidity from the government bond market abruptly and completely.

Section 5 discusses the structure and operations of the EU public debt markets. We point out how countries differ in their issuance techniques and the obligations they impose on primary dealers. This, we suggest, will have direct implications for the degree of transparency in the secondary market. The heterogeneity is not just the result of historical accident, and imposing uniform transparency requirements could have widely different consequences across countries. We also compare the EU government bond markets with the US Treasuries market, and we find very different roles of cash and derivatives markets in price discovery on the two sides of the Atlantic. Greater transparency in the EU cash markets might affect that balance, if it were to drive activity and liquidity from the over-the-counter (OTC) markets to the electronic markets. The discussion in this section also suggests some hypotheses for our empirical work. ...

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Peter Dunne, Queen's University of Belfast
Michael Moore, Queen's University of Belfast
Richard Portes, London Business School and CEPR

City of London
PO Box 270, Guildhall
London
EC2P 2EJ
www.cityoflondon.gov.uk/economicresearch

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