Illustration by Jac Depczyk

ITS promises are alluring, yet elusive; everyone, from politician to pundit, calls for more. In its recent report on financial reform, the Group of Thirty, a body of financial experts, mentioned it more than 30 times. Transparency is in vogue. Yet few ask whether it actually works.

Not long ago the cheerleaders of opacity were the loudest. Without privacy, they argued, financial entrepreneurs would be unable to capture the full value of their trading strategies and other ingenious intellectual property. Forcing them to disclose information would impair their incentive to uncover and correct market inefficiencies, to the detriment of all. And for years the so-called shadow banking system thrived, away from prying eyes. Then crisis hit, lending weight to the quip “What you see is what you get; what you don't see gets you.” Few saw it coming, but if a lack of transparency was pervasive, how could they have?

As clear as mortgage-backed securities

“Sunlight is said to be the best of disinfectants,” wrote Louis Brandeis, later a Supreme Court justice, in 1913, and almost a century later his words have become a maxim. Yet transparency is amorphous; it can, frustratingly, be anything but transparent and, implemented wrongly, may harm the very interests it is supposed to serve. In financial markets, the word is nearly always equated with information disclosure. The trouble is that the information is often incomplete, irrelevant or outright incomprehensible. Subprime-mortgage-backed securities are a case in point. These instruments—whose value remains shrouded in mystery—can have prospectuses of about 500-600 pages, most of which are devoted to intricate legalese. Yet, inexplicably, they do not contain the information about individual loans that is needed to detect default risk.

Nor is transparency free. The Sarbanes-Oxley act, which partly restored confidence after the scandals of Enron, WorldCom and others, came at a cost—not only in terms of the burden of compliance it imposed on companies. In order to shield small firms, those with a stockmarket value of less than $75m were initially exempted. This created a peculiar incentive: at least one study suggests that firms just below the threshold began disbursing unusual amounts of cash to shareholders and making fewer investments. The act has also been accused of stifling risk-taking and increasing directors' pay.

At its onset, the turmoil in financial markets was described as a liquidity crisis. And transparency and liquidity are close relatives. One enemy of liquidity is “asymmetric information”. To illustrate this, look at a variation of the “Market for Lemons” identified by George Akerlof, a Nobel-prize-winning economist, in 1970. Suppose that a wine connoisseur and Joe Sixpack are haggling over the price of the 1998 Château Pétrus, which Joe recently inherited from his rich uncle. If Joe and the connoisseur only know that it is a red wine, they may strike a deal. They are equally uninformed. If vintage, region and grape are disclosed, Joe, fearing he will be taken for a ride, may refuse to sell. In financial markets, similarly, there are sophisticated and unsophisticated investors, and unless they have symmetrical information, liquidity can dry up. Unfortunately transparency may reduce liquidity. Symmetry, not the amount of information, matters.

The good news is that transparency can work. When information is relevant, standardised and public, it fosters intelligent decision-making. Lenders, for instance, are required to quote interest rates as annual percentage rates, making loans easy to compare. Some behavioural economists call this “simplified transparency”, and think similar requirements should be imposed on complex financial products. Information must also be accurate as the credit-rating debacle shows: an AAA rating is harmful rather than helpful if it describes a CCC asset.

But politics impedes the ideal of transparency for at least two reasons. First, the benefits of transparency are widely dispersed among information users, whereas the costs are borne by few information disclosers; the disclosers therefore dominate the political process. Second, disclosure requirements are often drawn up after crises. They therefore tend to be hurried and haphazard, and support for them fades with memory of the hard times.

And even well-designed disclosure requirements may not suffice. People may make ill-informed choices, simplified transparency or not. In a recent study, two groups (made up of Harvard University staff) were asked to pick mutual funds. One group was given prospectuses which neatly summarised the funds' objectives, risk profiles, costs and past performance in a few pages. The other group received the standard long-winded and hard-to-understand prospectuses. They nonetheless made nearly identical choices, opting for funds with good past performance and largely neglecting fees. Academic research suggests that people should do precisely the opposite.

Still, for all its difficulties, transparency is usually better than the alternative. The opaque innovations of the recent past, rather than eliminating market inefficiencies, unintentionally created systemic risks. The important point is that financial markets are not created equal: they may require different levels of disclosure. Liquidity in the stockmarket, for example, thrives on differences of opinion about the value of a firm; information fuels the debate. The money markets rely more on trust than transparency because transactions are so quick that there is little time to assess information. The problem with hedge funds is that a lack of information hinders outsiders' ability to measure their contribution to systemic risk. A possible solution would be to impose delayed disclosure, which would allow the funds to profit from their strategies, provide data for experts to sift through, and allay fears about the legality of their activities. Transparency, like sunlight, needs to be looked at carefully.