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Market Transparency and Company Disclosure

Marco PaganoUniversità di Napoli Federico II,

EIEF and ECGI

ECGI Annual Lecture27 April 2012

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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)

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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

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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

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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.

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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

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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

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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)

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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

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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

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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)

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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.

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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

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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

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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

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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

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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

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Liquidity when the last analyst goes

Source: Ellul and Panaydes (2011)

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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

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Yet, firms are often opaque…

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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

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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”

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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

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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

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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.

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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

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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

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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

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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

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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

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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

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Another cost of financial transparency

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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