Information asymmetry explained

Tuesday, 30 October 2012

Information asymmetry explained

Information asymmetry has a fairly self-explanatory name. It is term used to describe a situation in which two counterparts have differing quantities or qualities of information. When one counterpart to a transaction has far more information about the trade or has a superior quality of information, they are at a price advantage. Understanding information asymmetry is important in understanding market manipulation.

Further explanation

Information asymmetry usually works in favour of the seller, because the seller normally has more knowledge about the product than the buyer. However it can also work in favour of the buyer. An example of buyer advantage could be a situation in which a buyer agent deliberately distorts a market on a temporary basis in order to purchase assets at a lower price, which then rises after the market manipulation exercise is terminated, creating profits for the buyer.

Information asymmetry usually works in favour of the seller, because in many circumstances the buyer can be seen as a complete novice, buying products on a Unique Single Transaction (UST) basis. UST sales account for much of the consumer market.

The purchase of a car would be a UST, because one does not often need an identical make and model of car in the short term, and the model is likely to have been superseded in the long-term, whilst buying a favoured brand of orange juice would be a Regular Transaction, where the product quality is known to be of a specific standard. An example of an Unique Single Transaction in the financial market could be the creation of a pension fund with a fund manager, (another could be the taking out of a mortgage, we'll come back to mortgages later). Once the transaction has been agreed, the average consumer rarely changes their pension provider (or their mortgage provider) and the buyer then has little incentive to do more research such as enquiring into the specific investments being made by the fund manager. The evidence shows that the majority of buyers have little inclination to ever switch their pension (or mortgage) provider. In cases where people are successfully encouraged to switch financial products, it is normally achieved with simple price enticement such as the provision of more favourable interest rates. The vast majority of pension savers (or mortgage holders) switch for price, very few people undertake a comprehensive risk analysis of their financial services provider, they simply put their in trust "the market" and the regulatory authorities.

Signaling and screening

Joseph Stiglitz and Michael Spence did pioneering work in asymmetric theory for which they were awarded the 2001 Nobel Prize in economics. They described it in terms of signalling an screening. In perfect market conditions one would expect the seller to give accurate price signals and the buyer to carry out diligent screening (risk assessment) in the investments they make. In a perfectly operating market one would also expect the seller to screen the wider market before setting a price and the seller on some occasions to signal an intention to buy so that price negotiation can happen fairly.

The problem is of course that reality has not, does not, and will never experience perfect market conditions. One cannot expect each and every seller to signal the price honestly or for each buyer to complete a comprehensive risk review before every transaction, therefore it is necessary to have regulation of the market and risk mitigation practices in order to prevent agents from corruptly taking advantage of information asymmetry.

In functional markets it is necessary to have regulatory powers to prevent agents from defrauding the market by propagating false information or by concealing valuable information. Risk mitigation practices such as regular auditing of company finances (via the big four financial audit oligopoly) , internal compliance policies (self-regulation) or investment specifications that the investment group (your pension fund, your mortgage holder) must only invest in products that have been rated "low risk" (by the Credit Ratings Agency oligopoly).

Signalling is also "outsourced" to agents, the most obvious example being the multi-trillion Dollar advertising sector, which is essentially a vast information signalling market. Other examples of outsourced information signalling include Public Relations, stories planted in the mainstream media, and political patronage.

Bounded rationality

Bounded rationality is the idea that in decision making, the rationality of the agent is limited by the quantity and quality of information that they have, their own cognitive limitations and the amount of time they have to make the decision. Information asymmetry is unavoidable in a market comprised of individuals of varying intelligence, with varying amounts and qualities of information and varying time limitations on their decisions.

Market manipulation

The idea of artificial price manipulation is as old as economics itself. Traditional false signalling methods include the creation of artificial scarcity, artificial gluts and price-fixing operations, which are all used in order to manipulate prices or to stimulate desired market activities. Some market manipulation is considered entirely acceptable, such as the advertising industry or government subsidisation of research, however there is also a great deal of corrupt market manipulation. The more complex a market becomes, and the more opportunities for market manipulation are presented and the more opportunities for asymmetric corruption are created too.

Misinformation

Market manipulation is often reliant upon the propagation of false information in order to create information asymmetry. Misinformation based asymmetry can create favourable conditions for market manipulators to generate profits by either creating false market confidence or false market pessimism.

False and misleading advertising
False advertising is probably the most familiar example of asymmetrical market manipulation, in which advertisers create a false incentive to buy via the process of spreading false claims about the value of the product. Back in the 1930s and '40s tobacco companies actually spread claims that smoking was good for the health, even though there was a growing body of scientific evidence (including the work of the Argentine scientist Ángel Roffo) that smoking causes cancer. Other more modern examples of false advertising include the trend for cosmetics and "health food" adverts to dress up additives to their products in bogus pseudo-scientific names ("Pro-retensifier smoothease" in face cream or "L. Casei Healthitas" in a yoghurt) or to conduct sham surveys in which 91% of women agreed that our product is "great" (based on a survey of just 11 women, who all received free samples of the expensive product). These kinds of misleading claim create information asymmetry, in that the buyer is led to believe that the product has better properties than the seller knows that it has in reality.

False claims
Although false advertising depends heavily upon the making of false claims, there is another component in falsely incentivising the buyer to purchase a product through the making of false claims, which is deliberate misselling. A familiar example to most British people is the Payment Protection Insurance (PPI) misselling fraud, where high street banks told customers that they could only take out loans if they also took out PPI policies on the loan. This was nothing short of fraudulent inducement to buy unwanted and unneeded products. The banks have been made to pay back customers who had been taken in by the PPI scam, however UK financial sector regulators refuse to treat the PPI scandal as the large scale fraud that it clearly was. The misselling of financial products like PPI policies relies on information asymmetry because the consumer is led to believe that they must buy the product, whilst the seller knows that the consumer doesn't actually need the product in order to take out a loan, and furthermore that it is actually illegal to make claims that they do need it.

False statements
Another way to profit from information asymmetry is through the practice of direct market manipulation through the dissemination of false information. There are many examples of how false information can be presented in order to boost short-term profits, from a multi-national oil company wilfully overestimating their oil reserves to boost their share price, to a corporation using creative accounting to hide the scale of their debts (Enron). If false financial statements are made, then information asymmetry is created because agents in the "general market" are duped into a false sense of confidence.

Rumours
Rumours are often a key component in market manipulation. False rumours can be spread by potential buyers in order to drive down an asset price, in order that the shares can be purchased at an artificially lowered price, or by a seller in order to sell at an artificially high price. The dissemination of true rumours that are not known to the wider market is known as insider trading.

Insider trading
The trading of insider-information is one of the most recognisable forms of manipulating markets with asymmetrical information. Insider trading relies upon the ability of one agent to provide specific information that exists outside the "general market", so that the recipient can make strategic investments on high probability outcomes that the "general market" are unaware of. Insider trading is heavily reliant on the circulation of rumours. Knowing and trusting the rumour source is vital, since it can be just as easy, and just as profitable to circulate false rumours as it is to share true ones.

High Frequency Trading
Since the 1980s an ever increasing proportion of stock market trades have been carried out by computer programmes rather than by human stockbrokers. Recent research has shown that 84% of stock trades by volume in the United States are done by computers rather than humans.

It is easy to imagine how High Frequency Trading can be used to create false price signals to distort the market. One example is Wash Trading where huge volumes of simultaneous buy and sell orders are created at below market value in order to drive the market price lower so that stocks can be bought at an artificially lowered price, which then generates profit for the buyer when the wash trades are terminated and the stock values return to their higher level.

Another example of how High Frequency Trading can be used to generate asymmetrical profits can be seen on the New York Stock Exchange, where from 2008 "preferred investors" were allowed to buy access to the NYSE proprietary feed of stock market information, a process that is called "frontrunning" the market. This access to restricted data gave the preferred investors up to several seconds information advantage over the general market, which is plenty of time for computer algorithms to take advantage of information asymmetry to create trades in anticipation of movements that are likely to happen once the information reached the general market. The SEC fined the NYSE just £5 million for allowing this institutionalised information asymmetry abuse.

Information asymmetry and free-market theory

Free market theories are built upon the foundation of agents who's behaviour is determined by rational self-interest. There are many problems with this foundational assumption, not least the fact that not all humans are selfish egoists. If "the invisible hand" of the free market relies upon a society composed of rational self-serving individuals, groups like socialists, environmental protesters, charities and religious organisations must essentially be eradicated, since their behaviour defies the idea that self-interest is the only true virtue and that all other so-called virtues (social concern, environmental concern, charity, patriotism, empathy, religious beliefs...) are heresy.

The idea that mankind's essentially co-operative nature must be eliminated in order to create an Utopian free-market, guided by the "invisible hand" sounds completely crazy, but this is essentially the central philosophy of free-market economics.

That there are more gaping flaws in such a barmy ideology is hardly surprising. One of the most obvious (and relevant) ones is the problem of bounded rationality. If the individual is limited by the bounds of their own rationality it is impossible for them to achieve information symmetry, therefore it is impossible for the individual to behave in their own rational self-interest, only in their subjective self-interest, which may actually be against their rational self-interest.

This problem of bounded rationality leads to the situation where signalling and screening operations are outsourced to intermediaries such as advertisers, PR firms, accountancy firms and credit rating agencies. When signalling and screening are done on an industrial scale, greater information symmetry is achieved within the market. Agents tend to rely upon things like advertised benefits of buying a particular product, the health of company accounts and the ratings given by the credit ratings agencies in order to make their investment decisions.

It is obvious that the activities of these market intermediaries should be carefully regulated. The scope for corrupt market manipulation would be enormous if advertisers were allowed to lie, accountancy firms were allowed to present false audits and credit ratings agencies were allowed to give the highest possible ratings to complete junk.

The problem is of course that since the rise of neoliberalism in the 1970s, neoliberal free-market economists have demanded ever more deregulation, which has allowed ever greater possibilities for corruption.

The simplistic "deregulation is always good" mantra, relies on neglecting the impact of anti-competitive practices such as the creation of monopolies and oligopolies as well as ignoring the negative impact of increased information asymmetry in the market.

Another aspect of human behaviour that the free-market fundamentalists deliberately neglect when calling for ever more deregulation is the very self-interest that underpins their economic ideology. If barriers to corruption are removed, regulatory authorities are castrated so badly that corrupt agents never face punishment for their market corrupting activities, and financial sector institutions are allowed to become too big to fail, creating moral hazard; it obviously becomes the rational self-interest of financial sector agents to act corruptly in order to maximise their profits.

Information asymmetry and the economic crisis

If we take a closer look at the causes of the neoliberal economic crisis it becomes obvious that information asymmetry played a huge part in creating the economic meltdown. Information asymmetry can be seen at every step of the "securitisation food chain" that caused the sub-prime crisis, the Wall Street meltdown and the "credit crunch".

At the first level, self-certification mortgages allowed people to make up lies about their income (an unemployed person with no assets claiming to earn $140,000 a year as an IT consultant for example) in order to obtain a mortgage. This deliberate failure to determine risk levels at mortgage brokers like Countrywide, Washington Mutual and New Century led to the creation of information asymmetry.

Once mortgages had been sold on to the investment banks to be packaged up into Collateralized Debt Obligations, they paid the Credit Rating Agencies oligopoly to stamp these products with the highest grade AAA ratings. When traders within a financial sector organisation are selling AAA rated financial products that they describe in internal emails as "sacks of shit" or "shitbreathers" and then the very organisations that created them take out Credit Default Swap insurance on the products they have just sold in order to cash in when the financial product fails, these are absolutely clear examples of profiting from information asymmetry.

Another layer of information asymmetry can be seen in the bankruptcy and bailout of the insurance giant AIG. Had they known that the financial products they were insuring were described as "sacks of shit" by the traders that were selling them, it is highly unlikely that they would have created a multi-billion dollar market in insuring these products.

From the self-certification mortgage applicants right up to the credit ratings oligopoly, the entire securitisation system was riddled with false price signals. It was clearly information asymmetry in the form of false price signals that caused the global economic meltdown and the credit crunch.

Trust and risk

It is absolutely clear that lack of scrutiny and excessively risky behaviour caused the neoliberal economic crisis. Investors put far too much trust in outsourced intermediaries such as the credit ratings agencies oligopoly and the big four audit firms. Had institutions conducted their own risk assessments instead of relying on the AAA ratings, they could have easily discovered that the financial products they were buying were nothing more than the highest risk mortgages packaged up into complex financial instruments.

Once it became clear that the financial sector had been flooded with toxic sub-prime junk dressed up as low risk financial products, and that many financial sector institutions had recklessly over-exposed themselves to buy up such products, there was a complete failure of trust within the market. Financial sector institutions stopped lending to each other in order to invest in safer, lower yield assets such as government bonds.

It is quite clear that allowing financial sector organisations to create information asymmetry by marketing extremely high-risk products as the safest grade of investment is what caused the economic crisis, and that the failure to punish them for this market manipulation has created an extremely risky financial sector environment, since there is little or no disincentive to stop them from doing it again.

If the regulatory authorities rufuse to punish institutions that engaged in asymmetric market manipulation, the continuation of self-interested asymmetric market manipulation practices is certain, and aversion towards investment in the financial sector obvious consequence.

Information asymmetry and technology

As I was researching this article I came across this laughable assertion about information asymmetry from Investopedia, which claims that:

"With increased advancements in technology, asymmetric information has been on the decline as a result of more and more people being able to easily access all types of information."

That such a ridiculous assertion can be found on a website like Investopedia is actually quite worrying. The statement conflates two fundamentally distinct phenomena (information quality and information volume) and neglects the obvious fact that the more information there is, the more work is needed to get a complete understanding of the product and the quality of the market conditions (the limitations of bounded rationality). These are both big flaws but the biggest gaping flaw in the assertion is that it actually makes an unsubstantiated claim that information asymmetry "has been on the decline" when I believe that I have made a strong case that the opposite is true and that information asymmetry is now more prevalent than ever and that it can be seen as the root cause of the global economic meltdown.

The rise of technology hasn't just improved the capacity of the individual to access valid information, it has also massively increased the capacity for agents to produce deliberately asymmetrical information (using high-frequency trading or other market manipulation techniques). It is this rise in asymmetrical information, created by the neoliberal deregulation mania, high frequency trading and the vested interests of market agents, that drove the global financial sector off a cliff in 2007-08.

Conclusion

Once the neoliberal economic meltdown is perceived in terms of information asymmetry, the austerity vs stimulus debate is rendered meaningless. If nothing is done to reduce information asymmetry in the market, it doesn't matter what the fiscal growth strategy may be, the market will continue to be undermined by factors that cause market instability (market manipulation, insider trading, price fixing).

Another factor is that once the majority of agents in the market understand that the lax regulation regime and the timidity of the legal authorities has created market conditions where false price signals are abundant, if not the norm, it becomes the agents' rational self-interest to either participate in the fraud or to carefully shun speculative investments. Speculative investments are the engine of technological advancement and of economic growth, if investors are incentivised to favour investment in products that are perceived to be safe (government bonds, precious metals...) due to risk aversion, economic growth is stymied.

Recklessly under-regulated markets where information asymmetry was abundant, created the economic crisis. And the failure to react with prosecutions and re-regulation has created the risk averse "credit crunch" scenario which is maintaining the economic stagnation that looks set to continue almost indefinitely unless serious market reforms are undertaken to deal with the problem of information asymmetry.