1
Market Transparency and Company Disclosure
Marco PaganoUniversità di Napoli Federico II,
EIEF and ECGI
ECGI Annual Lecture27 April 2012
2
One word, different meanings
Much talk about “transparency” in financial markets But it is used to mean two quite different things:
Market transparency: information available in security trading what goes on (or just happened) in the relevant security
market: quotes, orders, traders’ identities, etc. Company disclosure: information available about asset
fundamentals firms’ accounting transparency disclosure of security payoff structure or risk characteristics
(e.g., IPO of equities, issuance of CDO)
3
Different tribes, different meanings
These different meanings partly arise from the academic and practical division of labor: security market professionals and market microstructure
experts tend to think of transparency in security trading auditors and accounting experts think of it as concerning
data about recent firms’ performance, their reliability, etc.
Yet both aspects are important they may be related
must look at both: will attempt to do so today
4
Plan of talk
Transparency about the trading process pre-trade and post-trade transparency effects on competition, execution risk, liquidity, price
informativeness, cost of capital why are markets often opaque?
Company disclosure here too, effect on liquidity, cost of capital, access to capital why do issuers often prefer opacity?
Links between these two forms of transparency Regulation of market transparency and disclosure
5
1. Transparency about the trading process
Two types: pre-trade transparency: what you know about current
quotes, orders, other traders’ identities,… post-trade transparency: what you know about past
trades and prices E.g., take a retail investors wanting to buy IBM
shares: he may want to get an idea of quotes he may currently get on the market: contact his
broker, and he will check with dealers, etc. recent prices: internet, Bloomberg, Openbook, etc.
6
Many financial markets are very opaque
… much more so than the NYSE market for IBM shares (electronic limit-order-book market): in over-the-counter (OTC) markets (e.g. the currency
market) brokers and dealers cannot know all the trading opportunities simultaneously available
in the U.S. market for municipal bonds (“munis”) and corporate bonds, quotes are typically available from a dealer only upon request
before the establishment of the TRACE system in 2002, in these markets it was hard to get data about past trades, even with considerable delay
7
Pre-trade transparency and competition
Most basic form: know currently available quotes Why do we care? First, it enhances competition Assume competing dealers’ quotes are not visible
and clients pay search cost c to get a dealer’s quote In equilibrium each dealer will quote monopoly price:
will sell at the highest price a buyer will offer, and buy at the lowest price a seller will accept bid-ask spread will be at its maximal level (Diamond, 1971)
moreover, dealers price-discriminate price dispersion
Instead, with transparency, bid-ask spread = 0
8
Evidence on quote transparency and competition
In the market for munis: opacity allows dealers to extract substantial rents (Harris
and Piwowar, 2006; Green, Hollifield and Schurhoff, 2007) dealer’s prices differ by more than 3% in 9% of trades
around $10,000 in 2004 NASD sanctioned dealers upon finding major price
discrepancies: a bond sold for a customer for less than 50% of its price later in the day
In the stock market, the price impact of orders (illiquidity measure) dropped after the NYSE started disseminating data on limit orders in 2002 (Boehmer, Saar and Liu, 2005)
9
Quote transparency and execution risk
Bid-ask spread has a random component (liquidity risk)
An investor who has advance information about quotes can avoid trading when the market is particularly illiquid
This is another way in which pre-trade transparency reduces trading costs and enhances volume
It also explains (at least partly) why people are willing to pay for real-time quote information
10
Order flow transparency, liquidity and price discovery
Orders carry information impounded into prices by market makers
Key issue: how complete is the picture of the order flow that market makers observe?
The more complete this picture, the more likely they are to outguess informed traders the
less exposed to adverse selection the lower the bid-ask spread they require: greater liquidity
the sharper the information on which they condition in setting quotes the faster information gets impounded in market prices: better price discovery
11
Post-trade transparency and liquidity
A dealer who does not disclose past orders can reap information rents by using them to interpret later orders these rents are at the expense of uninformed traders larger trading costs
So, just like pre-trade transparency, also post-trade transparency increases liquidity
Evidence: execution costs fell by about 50% in market for munis when
the TRACE trade reporting system was introduced in 2002 bid-ask spreads fell in the U.S. corporate bond market for
the same reason (Edwards, Harris and Piwowar, 2007)
12
Why do we care about market liquidity?
First, we may care about trading costs borne by uninformed traders (generally retail investors) investor protection is part of most regulators’ mission
Second, higher liquidity is associated with a lower required rate of return = lower cost of capital to firms Amihud and Mendelson (1986)
Brennan and Subrahmanyam (1996)
Easley and O’Hara (2004), etc.
13
Then, why are markets so opaque?
Market design and regulation are affected by intermediaries who earn rents from opacity not just lobbying: in many cases they own the platforms
Market platforms themselves earn considerable profits from selling data: in 2003 data sales generated revenues of $386 million for
U.S. equity markets, for a cost estimated at $38 million now they even sell “low-latency” (super-fast) access to data
feeds – including the right to locate their servers very close to the platform’s computer
so they are not interested in making information about the trading process available quickly and for free
14
Why are markets so opaque? (2)
Additional reason: opaque platforms are more resilient to competition
Why? In opaque trading platforms, dealers can use current order flow information to earn informational rents on future orders will also be able to undercut dealers who operate in more transparent platforms attract all trading volume
Rationale for regulatory intervention – e.g. TRACE
15
Danger of regulatory arbitrage
But even regulation may not help if there are competing platforms in different jurisdictions: migration of wholesale blue chip equities to
London in the early 1990s was partly due to the lack of trade publication requirements on London’s SEAQ International
lately, the increasing role of “dark pools” and OTC markets in the U.S. (first) and the post-MiFID Europe (today) can be explained in the same way
16
2. Company disclosure
So far, we looked at transparency only as “public information about the trading process”
But “public information about fundamentals” = company disclosure is of paramount importance. Firms/issuers can hire auditor to certify their accounts, adopt strict standards hold frequent meetings of management with analysts list on markets with strict disclosure standards release data to assess risk exposure of complex securities
Also here, bringing (otherwise private) information in the public domain reduces adverse selection
17
Here too, transparency fosters liquidity and lowers cost of capital
Like transparency about the trading process, also company disclosure protects market makers from losses with informed traders higher market liquidity lower cost of capital
Evidence: Lang, Lins and Maffett (2009): in cross-country data,
accounting transparency reduces the cost of capital (at least partly) by raising stock market liquidity
Eleswarapu and Venkataraman (2007): accounting standards increase market liquidity, based on data for U.S. ADRs from 44 countries
19
Also direct effect on cost of capital and access to finance
Better disclosure can also affect the cost (or supply) of capital directly (not via liquidity): e.g., less adverse selection in credit market Bradshaw, Bushee and Miller (2004) and Aggarwal, Klapper
and Wysocki (2005): non-U.S. firms with better voluntary disclosure attract more funds from U.S. institutional investors
Khurana, Pereira, and Martin (2005) and Francis, Khurana and Pereira (2005): more comprehensive disclosure is associated with lower cost of capital and more external financing
Daske, Hail, Leuz and Verdi (2008): firms converting to IFRS face lower cost of capital
21
Why are firms often opaque?
They may regard transparency as costly for three reasons: compliance costs:
initial cost of listing a firm’s stock: underwriting fees (3-4% in Europe, 6-7% in the US), legal and auditing fees (3-6% in the UK), listing fees
ongoing costs of reporting and disclosure requirements tax costs:
with transparent accounts, hard to evade or avoid taxes it also depends on book-tax conformity and enforcement
information processing costs: processing more information imposes costs on investors
they will require to be compensated for these costs
22
Tax benefits of opacity
At the end of 1936, the Dutch beer-producing company Amstel Bier N.V. was flush with cash, so that it had been able to pay down its bonds completely
The company held a shareholders’ meeting to decide whether its shares should be turned from bearer to registered status
When a shareholder asked the reason for this proposal, the chairman answered: “This is done to be freed from the obligation to publish the balance sheet, now that this has become possible due to the complete repayment of the company’s bonds. The Board thinks the advantages of this with regard to the government … are important”
23
Tradeoff between access to capital and tax burden
Ellul, Jappelli, Pagano and Panunzi (2010): firms choose transparency by trading off better access to capital against greater tax burden
Main predictions: investment and access to finance should be positively
correlated with accounting transparency and negatively with tax pressure
transparency should be negatively correlated with tax pressure
financial development should enhance the positive effect of transparency on investment, and encourage transparency by firms that are more dependent on external finance
24
Two data sets Worldscope sample:
12,783 listed firms from 37 countries in 1990-2008 accounting and financial data drawn from Worldscope
World Bank-IFC Enterprise Surveys (WBES) sample: 42,916 (mostly unlisted) firms from 90 countries in
2005-09 qualitative survey data on external auditors, quality
certification and access to finance information on age, size and ownership
25
Investment regressions:WBES sample
Firms that choose higher transparency have better access to finance, controlling for the direct effect of taxes as an obstacle to growth.
26
Transparency regressions: WBES Sample
Firms that perceive tax rates as a major obstacle for growth have lower transparency than those stating that taxes are not an obstacle
27
Investors’ information processing costs
To be understood, information must be processed by investors. This takes time and effort, depending on how “financially literate” are
investors how “raw” is the information how complex is the company:
Cohen and Lou (2012) show
complex companies’ prices
adjust more slowly to news
28
Investors’ information processing costs
Investors want to be compensated for information processing costs or will stay way from asset: “too much data, not enough information” (Kay Report, 2012)
This may be yet another reason why firms/issuers prefer not to disseminate “too detailed” information
John Kay: “The time has come to admit that there is such a thing as too much transparency. The imposition of quarterly reporting of listed European companies five years ago has done little but confuse and distract management and investors” (FT, 29 Feb. 2012)
This concern is even greater if investors differ in their information processing ability
29
What if investors differ in their information processing costs?
If some investors are good at information processing (“sophisticated”) but others are not, more fundamental information increases informational asymmetry exacerbates adverse selection
Contradicts the idea illustrated so far that “more public information = less adverse selection”
If the “unsophisticated” are rational, under transparency they will require a discount to buy an asset compared to opacity for the issuer, this creates a rationale for opacity
30
Example # 1: securitization
Pagano and Volpin (2010) apply this idea to the issuance of complex securities (“securitization”)
By witholding information about the composition of the underlying loan pool, issuers can reduce “winners’ curse” at the issue stage sell asset at higher price
But if the information witheld at issue stage can be obtained later by sophisticated investors, adverse selection will reappear in secondary trading illiquidity, market freeze
If secondary market illiquidity generates externalities (e.g. fire sales of other assets, defaults), this provides a rationale to mandate transparency
31
Example # 2: OTC markets
Di Maggio and Pagano (2011) apply this idea to sale of an asset via sequential bids (search market, OTC)
Again, some investors are sophisticated, others unsophisticated (but rational)
Issuers may dislike disclosure because it induces a trading externality: if sophisticated investors abstain from trading, unsophisticated
ones will imitate them depress the asset price transparency in trading reinforces this (by making trades of
sophisticated more visible) it makes issuers more hostile to company disclosure: they will want to substitute less of one form of transparency for more of the other
33
Conclusions
Transparency has two dimensions: market transparency (trading process) company disclosure (asset fundamentals)
In both forms, it tends to promote liquidity and benefits uninformed investors ultimately benefit firms via lower cost of capital and/or better access to external finance
But it may also impose some costs: some are private costs, not social ones (e.g. limit tax evasion) others are also social costs (e.g., Kay’s point) regulation should (i) distinguish between private and social costs
and (ii) consider that market transparency may amplify the effects of company disclosure
Top Related