Financial Disclosure and Market Transparency with Costly Information Processing

Marco Di Maggio

Columbia Business School – Finance and Economics

Marco Pagano

University of Naples Federico II – Department of Economics and Statistics; Centre for Studies in Economics and Finance (CSEF); Einaudi Institute for Economics and Finance (EIEF); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Abstract:

We study a model where some investors (“hedgers”) are bad at information processing, while others (“speculators”) have superior information-processing ability and trade purely to exploit it. The disclosure of financial information induces a trade externality: if speculators refrain from trading, hedgers do the same, depressing the asset price. Market transparency reinforces this mechanism, by making speculators’ trades more visible to hedgers. As a consequence, issuers will oppose both the disclosure of fundamentals and trading transparency. Issuers may either under- or over-provide information compared to the socially efficient level if speculators have more bargaining power than hedgers, while they never under-provide it otherwise. When hedgers have low financial literacy, forbidding their access to the market may be socially efficient.

Financial Disclosure and Market Transparency with Costly Information Processing – Introduction

Can the disclosure of financial information and the transparency of security markets be detrimental to issuers? One’s immediate answer would clearly to be in the negative; financial disclosure should reduce adverse selection between asset issuers and investors. The same should apply to security market transparency: the more that is known about trades and quotes, the easier it is to detect the presence and gauge the strategies of informed traders, again reducing adverse selection. So both forms of transparency should raise issue prices and thus benefit issuers. If so, issuers should spontaneously commit to high disclosure and list their securities in transparent markets. This is hard to reconcile with the need for regulation aimed at augmenting issuers’ disclosure and improving transparency in o¤-exchange markets. Yet, this is the purpose of much financial regulation – such as the 1964 Securities Acts Amendments, the 2002 Sarbanes- Oxley Act and the 2010 Dodd-Frank Act.1

In this paper we propose one solution to the puzzle: issuers do not necessarily gain from financial disclosure and market transparency if (i) it is costly to process financial information and (ii) not everyone is equally good at it. Under these assumptions, disclosing financial information may not be beneficial, because giving traders more information increases their information processing costs and thus accentuates the informational asymmetry between more sophisticated and less sophisticated investors, thus exacerbating adverse selection.

Specifically, we set out a simple model where the issuer of an asset places it with one of many competing dealers, who sells it to investors through a search market that randomly matches him with buyers. The price at which the issuer can initially place the asset with the dealer depends on the expected price on this search market. The sale of an asset-backed security (ABS) is one example: the ABS is placed by its originator (e.g. a bank wishing to o­ff load a loan pool from its balance sheet) with an underwriter who searches for buyers via an Over-The-Counter (OTC) market. Another example is that of a company that hires a broker to sell its shares via a private placement or a Direct Public Offering (DPO) to investors, who an trade them on the Pink Sheet market or the OTC Bulletin Board.2

Before the asset is initially placed with investors, the issuer can disclose fundamental information about the asset, e.g. data about the loan pool underlying the ABS. If information is disclosed, investors must decide what weight to assign to it in judging its price implications, balancing the benefit to trading decisions against the cost of paying more attention. We show that when investors differ in processing ability, disclosure generates adverse selection: investors with limited processing ability will worry that if the asset has not already been bought by others, it could be because more sophisticated investors, who are better at understanding the price implications of new information, concluded that the asset is not worth buying. This depresses the price that unsophisticated investors are willing to pay; in turn the sophisticated investors, anticipating that the seller will have a hard time finding buyers among the unsophisticated, will o¤er a price below the no-disclosure level.

Hence, issuers may have good reason to reject disclosure, but they must weigh this concern against an opposite one: divulging information also helps investors avoid costly trading mistakes, and in this respect it stimulates their demand for the asset. Hence, issuers face a trade-o¤: on the one hand, disclosure attracts speculators to the market, since it enables them to exploit their superior information-processing ability and so triggers the pricing externality just described, to the detriment of issuers; on the other hand, it encourages demand from hedgers, because it protects them from massive errors in trading.

Financial Disclosure

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