The authors develop a model of market making with an endogenous choice of trade protocols and demonstrate that with a high inventory cost dealers engage in both principal and agency trading. Transparency shifts more transactions into the (uncertain) agency protocol and increases the bid-offer of principal trades with a sufficiently low probability of agency execution.
The authors test these predictions with a novel database of European corporate bond transactions, exploiting two sources of exogenous variation in transparency.
Transparency increases transaction costs for large trades and trades in older bonds, which are more difficult to “match”, and vice-versa.