Transparency, Market

The word transparency can mean different things to different people. In the corporate finance world, people use the term to refer to the degree to which a firm's accounting choices help investors understand the valuation of items on the firm's balance sheet. In the banking world, transparency often refers to the banker's knowledge of credit characteristics associated with a loan customer or a trade counterparty. In the world of futures and securities markets, the word transparency refers to the degree to which financial exchanges publicly disseminate real-time information on transaction prices, quotations, order flow, and other market variables. It is this case that is addressed here.

A completely transparent market would be one where all relevant market information is instantly and freely available to all potential investors. Some observers distinguish between pretrade transparency, that is, information disseminated ahead of a trade, and posttrade transparency, that is, information disseminated after a trade.

In the United States, the United Kingdom, and other domains, the level of government-mandated market transparency has become a source of contentious public debate. A central element of this debate is the extent to which market forces can be relied on to supply the level of transparency demanded by the public. The debate has intensified due to recent innovations in trading technology that allow for the capture and dissemination of vast amounts of market information at low cost. Government-mandated transparency requirements are often based on the premise that complete transparency is a desirable goal.

Economists have been more circumspect in opining on the desirability of complete transparency. Some observers have argued that complete transparency may actually result in investors having access to less information. This is because mandated transparency sets up a paradox: As securities prices become perfectly known, there is less individual return to discovering new information. Requiring complete transparency can reduce the incentives of individual investors or analysts to gather fundamental information and incorporate it into market prices. If the incentives for gathering information are reduced, prices will be less informative.

The provision of transparency involves both social benefits and social costs. Therefore, identifying the socially optimal level of transparency, that is, the level of transparency that balances social benefits and social costs, is an important consideration in the public policy debate on the subject. Optimal transparency may not be consistent with complete transparency, a concept that implicitly assumes that transparency provides benefits at no cost. The public policy debate on transparency hinges on the question of whether financial exchanges, such as the New York Stock Exchange, possess sufficient private incentives to provide the socially optimal level of transparency.

The provision of transparency is costly because for financial exchanges to disseminate market information, this information must first be produced. Producing market information, what economists refer to as “price discovery,” is a costly activity requiring considerable investment by a financial exchange. Restrictions on the use of market information can be viewed as a means of protecting the exchange's investment in producing accurate prices. Under this view, exchanges hold property rights to the information they produce, analogous to a trade secret. Exchange-imposed restrictions on the dissemination of information can reduce the externality problems associated with information production; that is, exchange-imposed restrictions serve to limit the use of information by off-exchange traders who do not contribute to the price discovery process at the exchange. Government-mandated transparency reduces the exchange's return on its investment in information production (because information is given away for free to rivals who have not paid the costs of its production). The result can be less accurate prices, higher costs of trading, or both.

...