Everyone likes a good story.  It is so ingrained in who we are.  When we talk to each other, we tend to use narratives.  And there is no place where the use of narratives can be found more than in the financial sector.

For example, look at how much effort is going into finding a story that explains last week’s 10 percent drop in the valuation of the US stock market.  Was the cause exhaustion (after all markets hadn’t dropped for several months), fundamentals (rising bond yields reduce attractiveness of investing in stocks), technical (unwinding of a trade on the volatility of stock prices) or something else?  What is important here is the search for a story to explain events.

Wall Street is fully aware of our desire to hear a good story.  Not surprisingly, its sales model is built on telling stories.

In the early 1930s, the Pecora Commission examined Wall Street.  What it found was Wall Street used a good story to hide the risk of the investments it sold.  And the investments it sold were also opaque.  In effect, Wall Street used stories to suggest how the opaque investments should be valued.

Sound familiar?

It should.  Recall how subprime mortgage-backed securities were valued.  Wall Street provided the valuation story.  Wall Street said use the ratings on these opaque securities as a substitute for your own due diligence as to how risky these investment actually are.

Given Wall Street’s storytelling prowess, the Information Matrix shows why the global financial system is designed the way it is.

Information Matrix

If you were going to design a financial system, you would want all of the transactions to occur in the Perfect Information quadrant.  Why?  There is no economic theory supporting the notion Blind Betting yields the same or better allocation of resources than can be achieved with informed decision making.

It is only in this quadrant investors know what they own.

It is only in this quadrant, Wall Street’s storytelling prowess is benign.  Investors can Trust Wall Street’s story, but they can also Verify if the story is true.

However, Wall Street prefers to sell investments which belong in the Blind Betting quadrant.  Why?  Wall Street knows it makes more money on a per transaction basis selling high margin opaque securities than low margin transparent securities.  So if Wall Street is going to spend its time telling stories, it is more profitable to tell these stories about opaque securities.

So how is the global financial system designed to maximize transactions in the Perfect Information quadrant and minimize transactions in the Blind Betting quadrant in the face of Wall Street’s ability to spin a good story?

The global financial system is based on transparency.  Government was given the responsibility for ensuring transparency.

As shown by the Great Financial Crisis, the government wasn’t able to ensure transparency.  Why did it fail?  Wall Street captured the process by which disclosure is set.  This is not surprising.  The benefits of opacity are concentrated in a few Wall Street firms while the harm from blindly betting is spread across a large body of investors.  As a result, Wall Street was willing to spend money to capture the disclosure setting process.

The Transparency Label Initiative was started to fill the void created by the government’s failure to ensure transparency.  The Initiative’s label identifies those investments that provide enough disclosure so investors can know what they own.  These investments allow the investor to Trust, but Verify Wall Street’s story and can be found in the Perfect Information quadrant.  Those investments where the investor cannot Trust, but Verify Wall Street’s story don’t qualify for a label.  They fall into the category of investments known as “Opacity as an Asset Class”.  These investments can be found in the Blind Betting quadrant.