Vol 6 (2009) - Issue 3

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Transparency and Disclosure

'If it looks too good to be true, it probably is'

A person has a choice as to how to spend his or her money. Whether consciously or subconsciously, a person makes that choice based upon a number of different factors. When spending money, a person needs be able to assess the opportunity cost of a particular decision. That requires transparency, but how do we make something ‘transparent’?

This article will provide some discussion and opinion relating to the role of transparency and disclosure in the context of the theory of choice. We want to ask at what stage a person has sufficient transparency and disclosure so that they can make a choice so that, if that choice turns out to be a ‘bad’ decision, they do not feel wronged by the result?

Put another way: what responsibility should the seller have to be ‘transparent’ and is the buyer able to protect against possible loss through ‘transparency’? Much has been said about bankers who were given incentives to structure and sell financial products into a market, but what of those who bought the products? Managing other people’s money carries responsibility and, if an investment is sufficiently transparent, then it is possible to make due inquiry – the question is then ‘when does the investment decision become a case of caveat emptor?’

Measuring relative transparency is a notoriously difficult task, but there are principles that we can apply consistently when we try to assess transparency for an investment decision. The principles need to be fitted to many different circumstances and we will discuss a few of the principal factors affecting the application of the principle of transparency.

Transparency – a slightly different perspective?

To discuss the role of transparency in a financial context, we must clarify what we mean when we use the word. Louis Brandis’ quote that ‘Sunlight is said to be the best of disinfectants’ has been used widely recently. The Economist used the quote and continued to mention that ‘transparency is amorphous; it can, frustratingly, be anything but transparent and, implemented wrongly, may harm the very interests it is supposed to serve’.

Transparency is best defined if we look not at the effect of transparency on light, but the ‘design’ of transparency itself. The concept of transparency for the purposes of financial investment decisions (or indeed, the financial markets) is not the passage of light through a transparent object. The image of continuous flow of light has incorrectly caused the use of ‘transparency’ to describe, for instance ‘the increased flow of timely and reliable economic, social and political information’.

The focus on the light’s passage causes confusion between transparency and information disclosure – while the two are inextricably linked, they are not the same. However, using transparency’s effect on light as a guiding principle will indeed be frustrating as it could be interpreted to require a continuing flow – generally of information or disclosure – which would indeed be frustrating and potentially harmful as The Economist rightly points out.

So let us turn to the ‘design’. The ‘design’ of transparency is for the object in question to allow the transmittal of light through it. As a person seeks to make an investment decision, transparency should allow them to understand the investment’s risks and its likely value (or return). To illustrate the point, there are a couple of useful analogies – both of which are helpful (if imperfect) in their illustration.