Transparency: does it work?

The Economist in this week’s (21/02/09) Economics Focus looks at whether transparency in financial markets is really beneficial. Transparency is currently one of regulator’s and governments’ most popular words, everyone seems to be demanding more of it.

In the recent past many in the financial services industry were calling for opacity, arguing that not having full-transparency allowed them to fully exploit the potential of secret trading strategies and that with full disclosure they would have little incentive to correct market inefficiencies through arbitrage. No one seemed to mind in the good years when everyone seemed to be benefiting.

So you can understand the attraction that greater transparency has in the current economic and social climate.

The Economist article says:

Yet transparency is amorphous; it can, frustratingly, be anything but transparent and, implemented wrongly, may harm the very interests it is supposed to serve.

When we think of financial markets and transparency we probably think of annual reports, interim trading statements etc. (in other words information disclosure). But the desire to provide full disclosure often results in “incomplete, irrelevant or outright incomprehensible” information for the user to understand. I can’t imagine Joe Bloggs on the street without training being able to understand it and make an informed decision based upon it. Maybe even most institutional investors don’t know what it all means with their poor record of investing other people’s money!

Does transparency improve liquidity?

Transparency of information and liquidity in markets are closely linked, markets are effectively based on an investor’s belief that they have better knowledge than everyone else, thus when investors start thinking that other people are privileged to lots more relevant information and that they have an unfair disadvantage they are likely to resist activity in the market.

So “[s]ymetry, not the amount of information, matters” (Economist, Feb 2009).

What does Richard think about this?

Calling for transparency through full-disclosure of information is all very well and it sounds right at first glance, but I believe that this full-disclosure can result in less transparency than you had to begin with, if the users of information are overwhelmed by the sheer volume of it, and its complexity, then you actually have a retrograde step. I would argue that regulators must instead focus on ensuring that when information is disclosed it is reliable, accurate, and relevant to its purpose. Anyone can pump out tons of information, but unless it is accurate and relevant then it is a pointless exercise.

Only time will tell what the world’s financial regulators will do…

Update: some links from the Economist.com article page.

Bengt Holmstrom, an economics professor at the Massachusetts Institute of Technology, has published a paper examining transparency. Another article on the subject is by by Marco Pagano, an economics professor at the University of Naples Federico II, and Paolo Volpin, a finance professor at London Business School. America’s government publishes the Sarbanes-Oxley Act of 2002. George Akerlof discusses writing “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism”.