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Pennies to billions: Doctoral thesis reveals how price rounding adds up in muni markets

Coin thumbnailFrom a single-transaction point of view, paying a few extra pennies for municipal bonds may seem like small change to investors — especially if they don’t know they’re paying it.

But when broker-dealers add pennies to create rounded prices on thousands of transactions that small change tends to add up. In fact, one Tepper School doctoral student put a price tag on the collective annual effect of price rounding: approximately $1 billion.

Dan Li, who now works as an economist for the Federal Reserve’s division of statistics and research in Washington, D.C., analyzed price-rounding practices for her doctoral thesis under the direction of Rick Green, Richard M. and Margaret S. Cyert Chair; Professor of Financial Economics; Associate Dean, Research.

What she found was that in the secondary market, more muni bond prices are rounded up to even-dollar amounts. Through this rounding, dealers can charge retail investors as much as 45 cents per $100 par bond, Li notes. Based on the estimated trade volume, percentage of whole-dollar trades, and the cost of those trades to investors, the average broker-dealer can make $471,475.72 a year from rounding, or a total of $1 billion across all registered bond dealers.

Li, whose doctoral program was in finance, was also earning a master’s in Machine Learning at Carnegie Mellon, where she spent a lot of time on data mining. She knew Green had a huge data set related to municipal bond trading, so the research seemed like a natural fit. She was also familiar with literature related to rounding price problems in the Nasdaq market. When she saw how often the bonds were trading at whole-dollar prices, the idea that they were being rounded up seemed obvious.

“I suggested that she have a look at this data, but she identified these rounding effects in the data on her own,”says Green, who continues to work with Li and fellow doctoral alumnus Norman Schuerhoff, now Assistant Professor of Finance at HEC in Lausanne, Switzerland, on research related to price discovery in the municipal markets.

“These broker-dealers are doing billions of dollars in business,” says Green. “The reason it’s interesting to financial economists has to do with the structure of the markets in which they trade.”

Bonds are traded over the counter, not as part of an exchange, so the prices lack transparency, and the buyer must beware.

“The question is: Is this a bad thing? Because you can control the transparency through regulation. You could insist that securities trade on an exchange, for example,” says Green. And while many transactions do not have to trade on an exchange, “It’s important, then, to look for evidence of opportunistic, monopoly power on the part of broker-dealers on the market. Do they appear to be taking advantage of retail investors? And this rounding is evidence that they are behaving opportunistically.”

One need not look further than the current financial crisis on Wall Street to see why opaque trading can become troublesome, Green says.

“The importance of transparency is illustrated in what’s going on now,” he says. “These credit markets where we’ve had all these difficulties are over-the-counter markets.”

Apparently, the perception of a need for greater transparency has also caught the eye of regulators, who began mandating disclosure of MSRB (Municipal Securities Rulemaking Board) data in the muni market in 2001, and TRACE (Trade Reporting and Compliance Engine) corporate bond data a year or so later. The release of that information gave researchers the first opportunity to look at bond trading on a trade-by-trade basis, and Li’s paper was part of a much broader research effort, including several papers that originated at the Tepper School.

“They have paid attention,” says Green of regulators. “The very existence of this data is the result of mandated disclosure by the regulators forcing broker-dealers to record their trades.” 

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Mark D. Burd

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