Should Corporate Bond Trading Be Centralized?

Abstract

This paper shows that centralizing the US corporate bond market would yield large gains in efficiency. By studying two markets where corporate bonds are successfully traded on central limit order books, I estimate that the transaction costs of US corporate bonds would decrease by 70% on average if trading migrated from over-the-counter markets to limit order markets. To study the social value of reforming the corporate bond market, I build a parsimonious model of centralized and decentralized trading. The model implies that the optimal market structure can be determined by appropriately scaling the transaction costs associated with each market structure. Estimating the scaling factors reveals that a centralized market structure would be optimal for 91% of the bonds studied. For the average bond, moving to limit order markets would generate a social surplus equal to 1.28% of total par value. Large bond issues with low credit ratings and long time to maturity would benefit the most.