Biais, Bruno and Green, Richard (2007) The Microstructure of the Bond Market in the 20th Century. IDEI Working Paper, n. 482, Toulouse

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Abstract

Bonds are traded in over-the-counter markets, where opacity and fragmentation imply large
transaction costs for retail investors. Is there something special about bonds, in contrast to stocks,
precluding transparent limit-order markets? Historical experience suggests this is not the case.
Before WWII, there was an active market in corporate and municipal bonds on the NYSE. Activity
dropped dramatically, in the late 1920s for municipals and in the mid 1940s for corporate, as
trading migrated to the over-the-counter market. The erosion of liquidity on the exchange occurred
simultaneously with increases in the relative importance of institutional investors, who fare better
in OTC market. Based on current and historical high frequency data, we find that average trading
costs in municipal bonds on the NYSE were half as large in 1926-1927 as they are today over the
counter. Trading costs in corporate bonds for small investors in the 1940s were as low or lower in the
1940s than they are now. The difference in transactions costs are likely to reflect the differences in
market structures, since the underlying technological changes have likely reduced costs of matching
buyers and sellers.