The catchphrase “too much information” can be applied in many circumstances, personal and social, but not, surely, in relation to financial markets.
It has long been held that greater transparency, thus more information, can only increase the volume of trading and improve liquidity.
In conventional thinking, illiquid markets are an expression of the sort of information asymmetry that causes spreads to widen as traders seek protection against the possibility that their counter-parties know something that they do not. Transparency reduces such information asymmetry, thereby improving liquidity.
That indeed has been the accepted wisdom – until now.
Our findings suggest that there are circumstances when increased transparency, far from improving liquidity, actually reduces it. This is counterintuitive, but we demonstrate that this is the case. Underlying our proposition is the observation that information asymmetry is low either when there is a lot of information or when there is no information. When transparency increases information to a select group of individuals, then it can increase information asymmetry and hurt liquidity relative to when there is no transparency.
To investigate this proposition, we needed a set-piece example of a one-off change that increased the level of information available about a specific type of security. We then needed to examine the effect of this change on market liquidity.
Our example relates to an increase in the disclosures required of banks in relation to some of the mortgage-backed securities (MBSs) that they issue. The additional information ought to have prompted, according to conventional wisdom,an increase in liquidity, as traders gained greater comfort from the expanded quantity of data at their disposal.
In fact, far from improving liquidity in the markets for the MBSs in question, increased transparency led to a decline of 14 percent in liquidity in comparison with the position before the requirement for additional disclosures came into effect.
Why this may be the case we shall examine in a moment. But first, some background to the changed disclosure regime that provided the raw material for our research.
In 2013, the European Central Bank (ECB) introduced what was titled the loan-level disclosure (LLD) initiative, which required banks to provide regular and detailed information regarding the individual loans comprising the MBSs that they had lodged with the ECB as collateral for borrowing from the central bank. This increased considerably the information available to investors concerning the fundamental composition of the loans in question.
Here was an opportunity to study the levels of liquidity before, during, and after the imposition of the 2013 LLD requirements. Taking the period from 2011 to 2014, we scrutinized the secondary market for European residential MBSs, which comprise 95 percent of all asset-backed securities for which market data is available.
Our measure of illiquidity involved taking the number of trading days in each particular security in which no trades had taken place and dividing it by the total number of trading days in a month. As mentioned above, this showed a 14 percent decline in the liquidity of the securities in question.
To unpick the puzzle of why this should be so, we needed to work out where the incentives lie for traders in their use of available information concerning the securities in which they are involved.
Let us assume the benefits of acquiring information about a particular security far outweigh the costs for all market players. Then everyone would acquire and process this data, which levels the playing field and increases liquidity.
At the other end of the spectrum, let us say the costs of acquiring such information greatly exceed the benefits. In such a situation, no-one would go to the trouble or expense involved, there being no financial incentive to do so. The asset in question would be what is known as “information-insensitive,” and transparency would have no impact on liquidity.
Although investor behavior and the outcome for liquidity would be the exact opposite in each case, the result would be the same in terms of maintaining a level playing field.
But between these two extremes lies a landscape in which the incentives differ from one market player to another, with significant consequences for liquidity. Put another way, this landscape contains investors for whom the acquisition of available information is profitable and those for whom it is not.
Investors who are sophisticated, both in terms of human expertise and the necessary resources, can process publicly available information about a particular security in order to turn this raw material into valuable insights – “private information,” if you like – that can be employed to make profitable trades.
However, less sophisticated investors, lacking these resources, would not attempt to process this public information into private information. But nor would they be likely to remain in the market at a costly disadvantage. Rather, in response to what is a classic case of adverse selection – a situation in which one party to a potential trade has more information than the other – they might well decide to pull out of the market, and this is what seems to have happened in relation to the MBS arena post-2013.
So, who are the sophisticated players, and who are the players deterred from involvement in the market by the knowledge that the former are now armed with an information advantage? Some private equity firms are certainly processing the newly-available MBS data to their advantage, as are some complex real estate investment trusts (REITs). But it is hedge funds that dominate in this area.
As for those deterred by the shift of incentives, they include institutions such as pension funds and central banks, which, while sophisticated in comparison with retail investors, are generally thought to be at the unsophisticated end of the institutional investment spectrum. But increased transparency has changed the nature of the MBS market, making it less suitable for their purposes than had been the case.
Previously, they would use the MBS market to park money for three to six months, earning a better return than that available from U.S. Treasury securities. It was, notwithstanding the negative publicity surrounding the role of MBSs in the 2008 financial crisis, a safe market and a way to make some return on institutions’ cash. But in the wake of the LLD regime, it has been transformed into something closer to the equity market, with professional money managers, such as hedge funds, actively seeking to profit from it, hence their incentive to process and package newly-available MBS information for their own use.
The net effect of the withdrawal from the market of unsophisticated investors is, of course, to deny such investors the opportunity to deal in the MBS market. But it has adverse consequences too for the sophisticated investors, who, given the reduction in liquidity, may face difficulties in trading their MBSs.
Market efficiency would therefore have been compromised by increased transparency, because additional information can be exploited by some players but not others. Previously, less sophisticated operators were not deterred from dealing with more sophisticated ones, because everyone had access to the same scarce data. After the LLD regime, some investors were able to produce private information using a greatly increased volume of data.
Once increased transparency allowed that greater sophistication to be weaponized, the position changed markedly.
However, it is important to note that the effect of the LLD regime in this regard has not been uniform across the MBS market.
In relation to the safest MBS assets, there is no more incentive now than before for sophisticated investors to put money and effort into processing the newly available data, because the private information created will offer little benefit.
We like the example of a pawn shop, in which an item, such as a wedding ring, is worth about £170 is pledged as security for a loan of £100. It may be that the ring is not worth exactly £170, but the pawn shop owner does not need to know its precise value because of the extent of the over-collateralization of the loan. More information would be of little financial benefit to that owner.
At the other end of the risk spectrum, where the most risky MBSs are to be found, there has long been profit-seeking market behavior of the type now spreading across the spectrum in the wake of the LLD regime, in which professionals have always sought as much information as possible in order to avoid loss. Here, the availability of more information as a result of increased transparency will, we believe, lead to an increase rather than a decrease in liquidity.
To sum up, our findings can be grouped under two headings. The first is that more information in financial markets is not always beneficial. It can reduce rather than increase trading and liquidity.
The second is that one size does not fit all in terms of gauging the impact of transparency on liquidity. For the safest of the MBS securities, the impact of transparency is negligible, while for the riskiest, transparency enhances liquidity. It is in the broad middle of the risk spectrum that liquidity is negatively affected.
Our findings ought to be of interest to regulators on both sides of the Atlantic. In order to promote transparency and to bolster market discipline, supervisors have imposed various loan-level requirements in both Europe and the United States. The assumption seems to be that more transparency is always a good thing.
In such a climate, there has been insufficient investigation or understanding of the effects, including the negative effects, of such requirements on MBS market liquidity. Our work, we believe, begins to put this right.
This post come to us from professors Karthik Balakrishnan at Rice University, Aytekin Ertan at London Business School, and Yun Lee at Singapore Management University and London Business School. It is based on their recent paper, “(When) Does Transparency Reduce Liquidity?,” available here.
This cannot be the end of the story. After all, the capacity to digest newly transparent the information into a simpler ABCD rating is subject to technological improvement and, ultimately, commoditization. It would be interesting to revisit the data ten years later and see if technology once again reduced asymmetry and restored the public goods benefit of greater mandated disclosure.