Information regulation in financial markets

The mere absence of perfect information cannot justify government intervention. Given that the provision of information is costly, achieving a perfect information market condition might not be

105 The JOBS Act in the U.S. removes this barrier. This Act will be discussed in the fourth chapter.

106 A literature review of the empirical studies on the data about the hedge fund industry requires some caveats to be taken into account. These data have limitations in capturing the reality of hedge fund leverage, risks, and returns.

The voluntary disclosure system in the hedge fund industry affects the reliability of the available data about hedge funds. Since data originating from the recent regulatory changes and the disclosure requirements thereof are not available as of this writing, the recourse of this study is to the available data which belong to the pre-crisis era. The problem of data inaccuracy in the hedge fund industry originate from the shortcomings of the voluntary disclosure mechanisms in place prior to the new regulations on both sides of the Atlantic. This problem is deeply affected by the biases in the data disclosed by hedge funds partly stemming from voluntary disclosure system prior to the regulatory overhaul after the financial crisis. Given the voluntary nature of data disclosure by hedge fund managers, the data is not representative of the entire industry’s performance, risk, or leverage. Some of these biases are hedge fund specific and others are commonplace in the financial markets. Hedge funds data usually suffers from the following shortcomings: survivorship bias, stale price bias, instant history bias (backfill bias), self-selection bias, and multi-period sampling bias. For a detailed discussion of these biases and their causes in the hedge fund industry, See Vikas Agarwal and Narayan Y. Naik, "Hedge Funds," Foundations and Trends in Finance now Publishing INC, Hanover, MA (2005), pp. 55-56.

possible as well as optimal. Therefore, the aim of regulation is not to create a market with

‘perfect information’, but to provide ‘optimal amount of information’ related to the particular decision-making area. Optimal information in this sense means that the marginal costs of provision of information equals its marginal benefit. Although the precise estimation of ‘optimal’

information is unattainable, it is possible to identify situations in the markets in which the amount of information disclosed voluntarily is sub-optimal which will pave the way for possible interventionist measures.¹⁰⁷

On the other hand, the impure public goods nature of information in financial markets and the role of financial intermediaries and rating agencies in the provision of information suggest that the role of government intervention to provide information is of a complementary nature. In other words, problems associated with information in the marketplace can partly be alleviated by the private provision of information. For example, the role of credit rating agencies in monitoring and rating issuers of bonds can mitigate the severity of this problem. By the same token, banks can partly mitigate the free rider problem and profit from the production of information by screening and monitoring the borrowers and by making private loans which are not tradable in the secondary markets.¹⁰⁸

From among a variety of mechanisms to address the opportunistic behavior stemming from information problems in financial markets, the disclosure requirement as a remedy for market failures is the one which attracted more attention. For example, it is suggested that corporate disclosure can mitigate the adverse selection problem and increase market liquidity by leveling the playing field among investors.¹⁰⁹ It is further argued that mandatory disclosure can benefit the markets in which the product information is relatively difficult to understand.¹¹⁰ The underlying argument for mandatory disclosure requirements is based on the adverse selection which is a type of opportunistic behavior arising from information asymmetry between insiders of the firm and its investors, and among investors in the secondary market. Absent mandatory

107 Ogus, Regulation: Legal Form and Economic Theory, pp. 38-39.

108 Frederic S. Mishkin, The Economics of Money Banking and Financial Markets, 9th ed. (Boston: Pearson, Addison-Wesley, 2010).

109 Robert E. Verrecchia, "Essays on Disclosure," Journal of Accounting and Economics 32, no. 1-3 (2001), p. 132.

110 Michael J. Fishman and Kathleen M. Hagerty, "Mandatory Versus Voluntary Disclosure in Markets with Informed and Uninformed Customers," Journal of Law, Economics, & Organization 19, no. 1 (2003), 45-63.

disclosure, the uninformed investors would have legitimate concerns in trading with better informed investors or insiders.

In the absence of reliable information, uninformed investors cannot tell the ‘lemons’ from the

‘peaches’. Therefore, to hedge against the potential losses from trading with informed investors, the uninformed or poorly-informed investors will discount the buying price of the securities or increase their selling price. The discount rate by the investors will reflect the probability of trading with informed investors multiplied by the potential information surplus of the counterparty. This price protection will result in a higher bid-ask spread in the market.¹¹¹ The higher bid-ask spread reduces the volume of trade and decreases the liquidity of the assets being traded, and in the extreme cases brings the financial markets to a standstill. In short, adverse selection problem prevents the desirable transactions and results in market failure. As a result, it leads to smaller size of the market or in some cases it totally brings about its collapse.¹¹²

Empirical studies on the market incentives of the firms to disclose are usually divided into two broad categories; firm specific benefits, and market benefits of disclosure. Market benefits arising from the information disclosure include enhanced liquidity, lower cost of capital, and better firm valuation. Given the benefits of the disclosure requirements, in the chapters discussing the regulation of hedge funds in the EU and the U.S., a detailed account of mandatory disclosure mechanisms imposed on hedge funds will be offered and their effectiveness in the assessment of systemic risk originating from the hedge fund industry will be discussed.

However, there is a particular concern about imposing mandatory disclosure requirements on hedge funds which concerns their proprietary information. Proprietary information is referred to as any information which includes sensitive, non-public information regarding the investment or trading strategies of investment advisers, analytical or research methodologies, trading data, and computer hardware or software containing intellectual property.¹¹³ Imposing mandatory disclosure requirements on the proprietary information can have negative consequences and

111 Leuz and Wysocki, Economic Consequences of Financial Reporting and Disclosure Regulation: A Review and Suggestions for Future Research.

112 Adverse selection is rampant in the insurance industry where the insurers know less about the to-be-insured. In this case, insurance companies have to charge higher insurance premiums or stop insuring altogether. Furthermore, information asymmetry about the features of a product can create almost the same problems created by the information asymmetry about the knowledge of the contracting parties.

113 15 U.S.C. § 80b-4(b)(10)(B)

particularly can deprive financial markets from the benefits of hedge funds. Therefore, disclosure of such information receives special regulatory treatment such as requirement to maintain its confidentiality by regulators to whom such disclosure is made, and the exemption from the Freedom of Information Act (FOIA).¹¹⁴ Therefore, the regulatory dilemma is that the imposition of sweeping information disclosure on hedge funds undermines their benefits - such as diversification, liquidity, facilitation of price discovery mechanism, and their contrarian position taking function - to the financial system. Such benefits partially rest upon their ability to generate profits from proprietary information and special legal protections offered to such information in terms of its confidentiality.

In the aftermath of the recent financial crisis the opaqueness in the hedge fund industry came under fierce criticism due to their perceived contribution to financial instability. Proposals are put in place such as delayed disclosure system¹¹⁵ and the use of secure multi-party computation mechanisms¹¹⁶ for disclosure of hedge funds information to address their potential systemic risk.

However, the effectiveness of both mechanisms is questioned. The thesis suggests that indirect information regulation of hedge funds through their counterparties, creditors, and investors aimed at harnessing market discipline is the second-best solution to address the under-provision of information by hedge funds.

The next section of this chapter will review the problems associated with imperfect competition in financial markets and will study its effects on hedge funds and other financial institutions. It is argued that competitive pressures coupled with differential regulatory treatment of identical financial instruments and institutions can give rise to regulatory arbitrage which in the long run can render regulations designed to address systemic risk toothless.

114 This is mostly due to the fact that such information is of critical importance for some market participants such as hedge funds most of whose profits originate from their investment in proprietary information and exploitation of market inefficiencies.

115 It is argued that such a delay can reduce the competitive cost of disclosure. See Zingales, The Future of Securities Regulation, p. 393.

116 For a detailed discussion of the methods that can be employed to disclose data while preserving the privacy involved therein, See Emmanuel A. Abbe, Amir E. Khandani and Andrew W. Lo, "Privacy-Preserving Methods for Sharing Financial Risk Exposures," American Economic Review 102, no. 3 (2012), 65-70.