Too Much Transparency Can Hurt Financial Markets

Excessive public information on bond trading and short-term lending can trigger risky investments

Based on the research of Michael Sockin

These days, transparency is a financial buzzword. Opening the curtains on the operations of financial markets is supposed to help investors and regulators make better decisions.

But sometimes, transparency can backfire, according to new research from Michael Sockin, an associate professor of finance at Texas McCombs. Sockin modeled two kinds of financial markets — for corporate bonds and short-term lending — and found that less transparency can lead to better economic outcomes.

Too much public information about those markets can lead companies to undertake riskier investments, he says, which can trigger repercussions such as in the 2008 global financial crisis.

“Having this extra data is not necessarily a good thing,” he says. “The spillover effects can include more corporate defaults and more losses for investors. In turn, that creates problems for insurance companies or pension funds.”

At the heart of Sockin’s study are markets for repurchase agreements — known as repo markets — which function as pawnshops for securities. Institutional investors such as insurance companies and pension funds raise short-term cash by selling securities to repo lenders. After a short period — from overnight to 28 days — they buy back the securities at a higher price, letting the lender pocket the profit as a lending fee.

Repo markets are the “plumbing of the financial system,” helping institutional investors buy and hold corporate bonds, Sockin says. In turn, that helps corporations raise capital for new projects. Though largely invisible to the public, they average over $12 trillion in loan exposure every day.

More Information, Less Discipline

During the past two decades, regulators have created systems to make bond markets and repo markets more transparent.

• The Trade Reporting and Compliance Engine (TRACE) reports most bond transactions nationwide within 15 minutes.
• The federal Short-term Funding Monitor publishes daily statistics about repo markets.

Using mathematical models, Sockin investigated the interactions between the two kinds of markets and the effects of transparency.

He found that when players have more detailed information about volumes and values in each market, they tend to loosen up credit. More buyers enter the markets, and companies can issue more bonds. The downside is that lenders issue too much credit when there are higher chances of default.

On the other hand, when players have less detail, they tend to be more cautious. Repo lenders get pickier about what securities they’ll accept as collateral and how much they’ll lend against them. In turn, that makes institutions more selective about the bonds they buy.

“These market participants impose discipline on each other,” Sockin says. “The quality of investments goes up.”

Transparency Feeds Credit Crises

His model helps shed new light on what happened before and during the 2008 crisis. After TRACE launched in 2002, Sockin says, “people were less concerned about having insufficient information when trading. The number of bond market participants went up dramatically, and more firms were able to issue bonds.”

The bill for that looser credit came due in 2008. Risky securities — such as those backed by subprime mortgage loans — lost much of their value, and repo lenders became reluctant to take them as collateral. The financial system froze, as they lent less money to institutional investors, who then bought fewer corporate bonds.

The result was that companies found it harder to raise money when they desperately needed it, Sockin says. “Companies that had to roll over their debt around the fall of 2008 were unable to do it without reducing how much they issued and getting worse prices.”

The bottom line, he says, is that bond and repo markets may take less risk and be better off if they become more selective because they know fewer specifics. They rely more on broad signals of company health such as bond prices.

How much transparency is enough? Sockin suggests regulators require an intermediate amount: general information on bond prices but less detail on trades.

“When details of every individual transaction are fully revealed to all participants, it starts eating into financial market discipline,” he says.

“To avoid crises, you want to be mindful that going too far with transparency comes with its own costs.”

“Informational Frictions in Funding and Credit Markets” is published in the Journal of Economic Theory.

Story by Steve Brooks