The Transparency Task Force asked why does greater transparency restores trust and confidence in the financial system.  The short answer:  we “Trust” the investment stories we have been told and this trust turns to “Confidence” when we have access to the disclosure we need to independently “Verify” the investment stories are true.

I like to demonstrate this using a physical model of two securities.  The two securities only differ in their transparency.

The physical model of a transparent security is a plastic bag.  Since you can see exactly what is in the bag, you can Trust the story you are told about the value of its contents and Verify if the story is true or not.

As shown by this security, financial transparency has two components.

The first component is “what is disclosed”.  What needs to be disclosed is all the useful, relevant information.

The second component is “when is this information disclosed”.  To be useful, disclosure must be made far enough in advance of the investment decision that the investor can use the information disclosed in assessing both the risk of and return on the investment.

The plastic bag security model highlights several other important feature of our global financial system.

First, you aren’t forced to use any or all of the information disclosed in making your investment decision.  You instinctively do so.  Why?  Curiosity, but also you know you are responsible for losses on your investments.  Therefore, you have an incentive to use at least some of the disclosed information prior to deciding to invest.

Second, you are not required to assess the disclosed information yourself.  You could get help from an expert.  Experts are never stumped by too much transparency.  They know what information to look for and what, if any, to ignore.

Third, you could have a trusted third party make the investment decision for you.  Part of the reason for trusting this party, like a mutual fund, is you think they can assess or will hire an expert who can assess the disclosed information.

Fourth, you don’t have to invest.  You have the option to engage in the Wall Street Walk.  You could walk on by and not invest for many reasons including how complicated it is to assess the security or the results of the assessment.

Fifth, “Confidence” in the financial system comes from transparency.   It allows investors to do their own due diligence.  Investors “Trust” their own risk/return assessment.  When the investors’ assessment can Verify the valuation story they have been told, their Confidence increases.

Sixth, financial transparency is necessary for maintaining market liquidity under adverse circumstances.  Market liquidity is talked about in terms of buyers.  It falls on a spectrum from very liquid when there are a lot of buyers to very illiquid when there are few, if any, buyers.  With the plastic bag level of transparency, it is easy to see we maintain a very liquid market even in the face of a negative story.

The physical model of an opaque security is a paper bag.  An investment is opaque when it either doesn’t disclose all the useful relevant information or it doesn’t make this disclosure in a timely manner.  For an opaque investment, you can Trust the valuation story you are told, but you cannot Verify if it is true.

Unlike the plastic bag security, nobody knows what is in the paper bag right now.  All you have are guesses as to the value of the contents of the paper bag based on a story you are told.  And when the story is called into doubt, so too the guessed at value.

Financial crises and their associated “runs” occur when market participants come to doubt the story and their guess as to the value of opaque securities they own.  In the absence of facts, when doubt sets in there is no logical stopping point in the downward valuation of the opaque securities other than zero.  Investors know this.  Hence, when doubt sets in, they “run” to try to get their money back.

The Information Matrix provides a map of what we have just discussed.

Information Matrix

	Does Seller Know What They Are Selling?
Does Buyer Know What They are Buying?		Yes	No
	Yes	Perfect Information	Antique Dealer Problem
	No	Lemon Problem	Blind Betting Problem

In the upper left corner of the Information Matrix, we find “Perfect Information”.  Both buyer and seller have the visibility of the plastic bag and with it the Trust and Confidence this visibility makes possible.  This corner also happens to be the foundation on which most of economics and all of finance is built.  It is only when transactions take place in this quadrant their theories hold.

In the upper right and lower left corners, we have “Information Asymmetry”.  One party to the transaction has the visibility of the plastic bag and the other party is betting on the unknown contents of the paper bag.  The problems associated with information asymmetry are readily apparent when you realize one party is blindly betting.

Finally, in the lower right corner, both buyer and seller are blindly betting on the unknown contents of the paper bag security.  The existence of over $3 trillion of opaque bonds shows this quadrant is very active for financial securities.  This isn’t surprising.  One reason Wall Street loves opacity is it allows Wall Street to phish for fools based solely on a story about what the value of the opaque securities might be.

If you were going to build a financial system from scratch, in which quadrant of the Information Matrix would you like 100% of the activity to occur?

If you work on Wall Street, you would like all the activity to occur where buyers and sellers are blindly betting.  While this is good for Wall Street, there is no reason to think this is very good for anyone else.

The Information Asymmetry quadrants are similarly flawed.

This leaves only one remaining quadrant and I think we can all agree we want 100% of the activity to occur in the Perfect Information quadrant.

Policymakers in the 1930s agreed with us.  The SEC and its sister regulators in other countries were given the responsibility for preventing Wall Street selling opaque products.  In theory, regulators do this by setting disclosure requirements.

In reality, across much of the global financial system there is a gap between what is disclosed and what investors need disclosed in order to know what they own.

Why does this gap exist?  Wall Street has the financial incentive and is willing to use its resources to capture the process by which disclosure requirements are set.  By capturing the process, Wall Street is free to sell high margin, opaque financial products like the subprime mortgage-backed securities at the center of the Great Financial Crisis.

At the same time, professional asset managers market their expertise to investors by citing their investment track record.  They don’t disclose they can’t do a fundamental risk/return assessment on each investment product/security because many they invest in are opaque.  They rationalize away this omission with “investors want these exposures as part of the investors’ asset allocation strategy”.

Of course, if the professional asset managers aren’t going to say the investment product/securities are opaque and buying them is blindly betting, who exactly is going to tell the investors?  To date, it certainly hasn’t been the firms that employ these asset managers or the consultants advising investors.

So how can investors limit their exposure to blind bets on opaque products/securities to what they are comfortable with?

This is where the Transparency Label Initiative comes in.  The Initiative uses a label to divide the global financial system between transparent and opaque.  The label is solely to help investors and other market participants distinguish between rigged and unrigged markets and where there is adequate disclosure so they can make a fully informed decision and where they are blindly gambling.

Where there is a label, investors know there is adequate disclosure to know what they own.

Where there is no label, investors know there is inadequate disclosure regardless of what the existing disclosure requirements might be, what financial regulators might claim or what a security’s rating might be.

The Initiative makes the investors’ view, rather than the captured financial regulators’ disclosure requirements, the global standard for adequate disclosure.  Fortunately for us, there are no legal barriers preventing raising the disclosure bar to where investors can truly know what they own.  The Initiative’s label raises the disclosure bar to this level.

Every investor has a use for the Initiative’s label.

Individual investors can use the label to choose exactly how much exposure, if any, they want to opaque securities.

Endowments, foundations, pension funds and sovereign wealth funds can build the label into their investment criteria.  There is no legitimate reason these entities should have any exposure to and blindly gamble on opaque securities.

Financial regulators can build the label into regulations to limit the exposure of regulated firms like banks and insurance companies to blind bets.

Central banks can limit the securities they buy or accept as collateral to only those that carry a label.  After all, central banks should not blindly gamble taxpayer money on opaque securities.

By using the Initiative’s label, we can move the financial system to where there is much more Trust and Confidence.