Market Transparency and
Company Disclosure
Marco Pagano
Università di Napoli Federico II,
EIEF and ECGI
ECGI Annual Lecture
27 April 2012
1
One word, different meanings
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Much talk about “transparency” in financial markets
But it is used to mean two quite different things:
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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)
2
Different tribes, different
meanings
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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
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both aspects are important
they may be related
must look at both: will
attempt to do so today
3
Plan of talk
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Transparency about the trading process
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Company disclosure
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pre-trade and post-trade transparency
effects on competition, execution risk, liquidity, price
informativeness, cost of capital
why are markets often opaque?
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
4
1. Transparency about the
trading process

Two types:
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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.
5
Many financial markets are
very opaque

… much more so than the NYSE market for IBM
shares (electronic limit-order-book market):
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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
6
Pre-trade transparency and
competition
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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:
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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
7
Evidence on quote
transparency and competition
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In the market for munis:
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opacity allows dealers to extract substantial rents (Harris
and Piwowar, 2006; Green, Hollifield and Schurhoff, 2007)
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dealer’s prices differ by more than 3% in 9% of trades
around $10,000
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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)
8
Quote transparency and
execution risk
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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
9
Order flow transparency,
liquidity and price discovery
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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,
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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
10
Post-trade transparency and
liquidity
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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:
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execution costs fell by about 50% in market for munis when
the TRACE trade reporting system was introduced in 2002
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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?
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First, we may care about trading costs borne by
uninformed traders (generally retail investors)
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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
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Amihud and Mendelson (1986)
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Brennan and Subrahmanyam (1996)
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Easley and O’Hara (2004), etc.
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Then, why are markets so
opaque?
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Market design and regulation are affected by
intermediaries who earn rents from opacity
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not just lobbying: in many cases they own the platforms
Market platforms themselves earn considerable
profits from selling data:
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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
13
Why are markets so opaque?
(2)
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Additional reason: opaque platforms are more
resilient to competition
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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
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Rationale for regulatory intervention – e.g. TRACE
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Danger of regulatory arbitrage
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But even regulation may not help if there are
competing platforms in different jurisdictions:
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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
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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
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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
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Like transparency about the trading process, also
company disclosure protects market makers from
losses with informed traders  higher market
liquidity  lower cost of capital
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Evidence:
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Lang, Lins and Maffett (2009): in cross-country data,
accounting transparency reduces the cost of capital (at
least partly) by raising stock market liquidity
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Eleswarapu and Venkataraman (2007): accounting
standards increase market liquidity, based on data for U.S.
ADRs from 44 countries
17
Liquidity when the last analyst
goes
Source: Ellul and Panaydes (2011)
18
Also direct effect on cost of
capital and access to finance
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Better disclosure can also affect the cost (or supply)
of capital directly (not via liquidity): e.g., less
adverse selection in credit market
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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
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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:
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compliance costs:
 initial cost of listing a firm’s stock: underwriting fees (34% 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
21
Tax benefits of opacity
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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
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The company held a shareholders’ meeting to decide whether
its shares should be turned from bearer to registered status
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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”
22
Tradeoff between access to
capital and tax burden
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Ellul, Jappelli, Pagano and Panunzi (2010): firms
choose transparency by trading off better access to
capital against greater tax burden
Main predictions:
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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
23
Two data sets
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Worldscope sample:
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12,783 listed firms from 37 countries in 1990-2008
accounting and financial data drawn from Worldscope
World Bank-IFC Enterprise Surveys (WBES)
sample:
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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.
25
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
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To be understood, information must be
processed by investors. This takes time and
effort, depending on
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how “financially literate” are
investors
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how “raw” is the information
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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
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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?
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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
29
Example # 1: securitization
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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
30
Example # 2: OTC markets
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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:
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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
31
Another cost of financial
transparency
32
Conclusions
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Transparency has two dimensions:
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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:
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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
33