Transparency is a Failed Business Model…and Now Opacity Is Too

Credit derivatives, structured products, complex conduits, private equity, hedge funds, “black box” trading strategies, and other esoteric or “alternative” investments have exploded in decades leading up to  today.

Remember that prior to 1995, the Internet was not a household toy. Before fundamental financial data was widely available, at the blink of an eye, 24 hours a day, people used to rely on paper copies of quarterly 10K and annual 10Q reports.  If you did not work on Wall Street, or if you did not have a broker on Wall Street who would speak to you regularly, you likely missed out on a lot of information, and certainly did so without the luxury of being the first to know.  Said another way, the cost of information on fundamental corporate earnings performance was much more expensive a few decades ago than it is today where you can hop on the Internet and have access to thousands of web-based tools for screening and sifting through company financial metrics.

In addition, the movement from fractional quotes to decimal quotes a decade ago paved the way for compressed margins between bid and ask prices, removing brokers ability to levy a haircut from matching buyers and sellers, a 200 year old trade.  Furthermore, in the late 1990’s the advent of electronic trading and Internet trading brought trading margins down dramatically, and essentially eliminated profitability of the traditional brokerage model.

Wall Street has been the center of informational advantages, since its inception.  Whether through the more controversial insider trading of years ago, or through the pump and dump schemes orchestrated by stock analysts during the Internet bubble, the pursuit of ways to make money (commissions) by maintaining an informational advantage has been the bell-weather of Wall Street profits.

For each over-exploited informational advantage, however, government regulation usually catches up, after a catastrophe has struck.  Regulation on separating sell-side research departments from the investment bank or the introduction of Sarbanes Oxley are more recent examples of methods employed by regulators to squash unfair, or overly exploited informational advantages.

Now we are certain to see regulation reek havoc on the business model that got us here, unprecedented risk taking in financial instruments whose offering documentation often exceeded a hundred or more pages.

Joseph Stiglitz won the Nobel Prize in Economics in 2001 in large part to his advancements in the field of Information Asymmetry. 

In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry. Examples of this problem are adverse selection and moral hazard. Most commonly, information asymmetries are studied in the context of principal-agent problems. [Wikipedia]

Transparency is the enemy of information advantages, and opacity is the friend of high margin investment products.  In the wake of unprecedented regulation after the dot-com bubble and the Worldcom and Enron scandals, Wall Street turned transparency and disclosure on its head by layering so many documents onto each other, few people ever bothered to read them.  This obfuscation of otherwise transparent information recreated new informational asymmetries leading to new high margin businesses.  Informational advantages are what drive Wall Street profits.  

The modern process of obfuscation on Wall Street was simply to take otherwise transparent processes and convolute them to the point of obscurity.  Take a typical CDO.  A typical CDO has in theory, traceability into each of the underlying securities, which is what drove the argument that insurers and rating agencies could reasonable analyse these complex securities. [To learn more about how a CDO works, click here for a great flash-based demo.]  However, as we stand today, many of these investments were so intertwined, that trying to figure out what they are made of is simply impossible in man-hours.

Wall Street’s success, regardless of the bubble, have been the result of a lack of transparency.  Regardless of how hard regulators work to simplify and lend more transparency to the marketplace, I’ll bet that the next generation of financial engineers will find a whole new way to confuse investors.  Until then, the complex instruments that helped destabilize the financial system will likely crawl back into their shell, if only for a little while.

Information Asymmetry
Wikipedia, Accessed 10AM October 28, 2008


One Response to Transparency is a Failed Business Model…and Now Opacity Is Too

  1. […] Asymmetry – A case of what you don’t know will hurt you Jump to Comments This blog entry describes how and why opaqueness is a must on Wall Street and notes the obvious — that a drive […]

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