Tuesday, May 18, 2010

The false God of transparency

Are we seeking wisdom, a voyeuristic look at secrets, or dirty laundry?

Transparency is one of those things that seems to be inherently good. But, that’s really a superficial attitude that is, fortunately, tempered by the application of common sense. It ignores a prime question: What should be shown? I certainly don’t want to see many of my friends nude, for example. It also ignores both privacy and intellectual property issues. That’s an acknowledgement from this blogger who is usually interested in what others are thinking. However, an even more interesting issue is: What will result from transparency? It’s a fascinating issue because people often don’t seem to have thought about it.

Let’s look at privacy first. We’ll use a headline issue: the GS and Paulson’s trade discussed in the two postings on how “Sometimes Wall Street provides more entertainment than Hollywood.” It is unfortunate that this example is so convenient because people get quite irrational when GS’s name comes up. But, forging ahead, we’ll set the topic with a quote from a NY Times piece entitled "From Buffett, Thought-Out Support for Goldman.” (full story at: http://www.nytimes.com/2010/05/04/business/04sorkin.html?scp=1&sq=from%20Buffet,%20thought-out%20support%20for%20goldman&st=cse )

“One Berkshire shareholder who has been a regular in Omaha is Bill Ackman, an outspoken hedge fund manager who has made a career of railing against bad corporate practices. … In recent days, he has gone even further than Mr. Buffett in his defense of Goldman, suggesting it would have been unethical for the firm to disclose Mr. Paulson’s position in the Abacus deal. He says that Goldman, as the market maker, had a duty to protect the identity of both sides of the transaction.”

Think about it this way: If it was ethical for GS to disclose Paulson's position, then it should be OK for your broker to disclose your positions to potential counterparties. Similarly, should GS have disclosed to Paulson who was taking the long position? Very analogous reasoning would argue that brokers should be allowed to disclose to potential counterparties that a mutual fund or pension fund plans to take a position in a stock; after all, Paulson had not, and could not have, taken his position until someone took the counterparty position. People have gone to jail for doing that sort of disclosure. It allows front running.

My only disclosure is that I have accounts with multiple brokers so that no single broker or dealer can disclose all my positions or even my net positions. It’s a by-product of differences in what each offers in tools and investments. But, many financial institutions use multiple dealers specifically to avoid having their positions disclosed by any one dealer. Your pension fund or mutual funds probably do exactly that.

If one tries to set parameters for when privacy should be sacrificed, it gets hairy real quick. Think about exchanges. Exchanges suppress all information about counterparties. Theoretically, one’s counterparty is the exchange. Should exchanges have to disclose their net positions? Could they even do it given the volume and speed of trading?

Many market observers hold the position that derivatives should be brought onto exchanges; I’m among them. If one shares that opinion about exchanges, but simultaneously say that GS should have disclosed that Paulson was shorting the bonds GS was selling, the observer isn’t being consistent. The observer is advocating suppressing the very information they’re saying should be disclosed. On an exchange that individual counterparty information is suppressed.

The same logical inconsistency exists whenever a person trades on an exchange (where they don’t have counterparty information) while simultaneously maintaining the counterparty should be disclosed. Do you know who your last few trades were with? Probably not.

Transparency is desirable if it involves the right information. Otherwise it is distracting and can have major negative consequences. To illustrate, both postings on how Wall Street can be more entertaining than Hollywood point out that neither the winners nor the losers felt that the motives of their counterparties were important. But, it is relevant, and perhaps not stressed enough, that most people involved either didn’t want their net positions disclosed or were worried by how much was publicly known about their net positions. In fact, some of the people who were net short mortgage bonds abandoned the trade because they feared a short squeeze. The issue of short squeezes is a point often overlooked in the discussions of transparency.

However, the really dangerous oversight from the perspective of financial stability is the failure to address what should be transparent. The motive of the counterparty is not really relevant. If it were, exchanges would be irrelevant. What matters are: (1) Is the counterparty solvent (i.e., can the counterparty make good on the trade)? and (2) Is the trade at a legitimate market price?

Why is this dangerous from a systemic risk perspective? Exchanges face conflicting objectives. They were mention in a previous posting on this blog. They are sufficiently central to this point that the discussion is quoted below:

“The issue surfaced in an exchange between Duncan Niederauer, CEO NYSE Euronext, and Bob Greifeld, CEO Nasdaq OMX Group Inc. Greifeld’s contention is that the overall volatility in the stock was increased by the Nasdaq’s inability to provide enough liquidity to accommodate an orderly handling of the volatility. He doesn’t say it that way since blaming it on the NYSE is so much more consistent with his interests. But, that’s the bottom line of his position. That seems reasonable. When all the volatility risk is shifted to one market, that market will be stressed.

Niederauer’s counter that the purpose of the NYSE is to provide an orderly market. Can’t argue with that. But, under the circumstances he seems to be overly professional in not pointing out that Nasdaq didn’t deliver an orderly market.

Here’s where the verbal exchange gets interesting, and it betrays each man’s philosophy and the market they serve. Another function of an exchange is to provide liquidity. Clearly, when the NYSE moved to slow mode it traded off providing instant liquidity for orderly market. Who is served by each? People don’t even sense instant liquidity. The slower mode and even a pause for a few minutes would hardly be noticed. By contrast, computers assume instantaneous, continuous liquidity. Put bluntly, Nasdaq would accommodate computers at the expense of people while NYSE leaned the other direction.

Next step in the analysis involves the exchange’s role as a method of price discovery. Clearly, that is a key function of an exchange. Again, Nasdaq was willing to “execute” any trade without regard to whether the price discovery was being compromised in order to accommodate continuous trading. NYSE wasn’t. If one needs proof, it will come when trades are unwound as is being discussed.

Finally, an exchange acts as a clearing house becoming the counterparty. NYSE slowed trading to ensure it could fill that counterparty role. We will see whether Nasdaq honors all trades. This last issue goes to the heart of the issue of whether an exchange walked away from the market. Slowing trading isn’t walking away from the market; it’s slowing it. By contrast executing erroneous trades and then not honoring them is walking away from at least two important responsibilities of an exchange.”

The exchanges are clearly trading off providing liquidity, providing an orderly market, supporting price discovery, and acting as counterparty. Now, ask yourself which is important from the perspective of investors. My vote goes to supporting price discovery. If the price quoted on the exchange is not a market price available to every potential trader, risk takes on an additional dimension. What good are all the other disclosures if one doesn’t really know what the price is?

The argument that acting as counterparty is most important can’t be dismissed. After all, a rapid, radical shift in assessments of counterparty risk was a prime cause of the 2007-2009 financial crisis. Also, acting as counterparty eliminates any real liquidity issue if there is honest price discovery. The flash crash resulted from a fictitious liquidity created by the development of trading systems without real counterparties. So, the clearinghouse function is right up there, especially as it relates to systemic risk.

The problem is that exchanges are compromising the most important forms of transparency: price. Flash trading involves not just allowing trades at prices other than quoted prices, but is close to offering different prices on a selective basis. If selected traders are allowed access to inside information about market internals, they have an opportunity, and some would say are encouraged, to trade at other than quoted prices. This subverts basic transparency.

Similarly, dark pools, where stocks trade off of the markets, raise the same issue. If the price in the market isn’t the price at which the stock is being traded, transparency is a fiction. Again, who cares why the stock changes hands when the price at which it trades isn’t really the price?

So, it seems discussions of transparency should always be prefaced by the question: What is going to be made apparent? It also seems that the SEC and the investing public need to think about what transparency is important.


One could argue that liquidity is a necessary condition for price discovery. The trader would ask: What relevancy is a price quote if nothing can be traded at that price? The fund manager would say: The price isn’t valid for the volumes the fund trades. The Doc would add: There is no market without liquidity. But, that seems to be basic economics. Supply curves and demand curves have slopes. Given prices in digits and fractional shares, how much of the demand curve and the supply curve could be disclosed?

It seems with volumes and prices a lot about liquidity is already known. Bid ask spreads and/or price fluctuations over whatever time frame is assumed in one's definition of liquid, are known. Thus, historical liquidity is disclosed. Future liquidity and instantaneous liquidity are nice concepts, but not a reality. However, if blocks are traded without disclosure (i.e., in dark pools), then neither liquidity nor price are being disclosed.

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