Does Asymmetric Information Exist?

Asymmetric information describes situations in which a participant or participants in a trade have access to relevant information about the value of an asset being traded that others involved in the same trade do not. For some, these situations could lead to an unfair advantages for certain traders, and in more extreme cases poor pricing of assets, or even the failure of markets to operate.^[1]

Origins Of Asymmetric Information

The notion of asymmetric information in markets was first outlined by economist George Akerlof in his 1970 research paper, "The Market For Lemons: Quality Uncertainty and the Market Mechanism." He explored the impact of differing degrees of buyer and seller information on the market for used automobiles and markets for insurance and labor.

Akerlof's examination of asymmetry arose from an interest in economic growth theory and the suspicion among economists at the time that variations in the business cycle might be prompted by changes in the availability of information and education. Among other examples, he chose the used car market "to show that the informational advantage of sellers of used cars over buyers of new cars would force car buyers into the new car market and therefore exacerbate business-cycle fluctuations."^[3]

The matter of asymmetric information, which also became known as the "principal-agent problem," was later extended to other areas such as political and computer science. Within economics, it was applied to questions in various markets and extended to include several concepts. Among those are adverse selection, moral hazard and monitoring costs:

• "Adverse selection" is when buyers or sellers in markets have private (also called "hidden") information or better expertise regarding goods or services being traded.
• "Moral hazard" is when one party in a transaction is responsible for the interests of another but lacks incentive to protect those interests. This may also be associated with hidden actions on the part of participants in a transaction.^[5]
• "Monitoring costs" are when parties to a transaction may face prohibitive costs to monitor compliance with the terms of a contract.^[6]

Is Asymmetric Information An Inherent Characteristic Of Markets?

The theory of asymmetric information has been widely used to explain pricing action in markets, but some have argued the term may be a misnomer applied to describe what Austrian economist Friedrich Hayek earlier called the "division of labor." The argument is that the notions of perfect markets and perfect information are unrealistic, and if they did exist, market action itself would cease to exist. Under Hayek's vision, it's argued that the production of goods and services and their transfer in the market requires a collective effort among market participants, and their pricing is merely a reflection of the division of labor within the market.^[7]

Information Costs

Related to Hayek's theory, other theorists note that the gathering and transfer of information about goods and services itself has a cost that must necessarily be transferred to asset prices. Thus, the availability of information (or lack thereof) about the value of an asset will be directly factored in to negotiations over its price, resulting in wider or narrower premiums or discounts for buyers and sellers.^[8]

The Age Of Asymmetric Information: A Bygone Era?

Some researchers have argued that continuing improvements in the efficiency of gathering and distribution of information have reduced asymmetries of information among market participants and may eventually do away with them altogether.^[9]

According to this idea, technological developments have given access to accurate and complete information about product quality and the nature of financial transactions to everyone who seeks it. Because of this, they say that markets have been rapidly evolving to a situation where buyers and sellers may have roughly equal knowledge about the value of the assets they are trading, and the notion of asymmetric information may be rendered obsolete. While this argument has been contested by some, it could have important implications for costly economic regulations directed toward resolving information asymmetry problems that may no longer exist.^[9]

Information Asymmetry In Financial Markets: Rational Expectations

The idea of asymmetry of information has broad implications in financial markets, ranging from market liquidity, to government policy actions, to individual prices negotiated between traders.

Under the rational expectations model, which was proposed by economist John Muth, traders will use all available information at their disposal to estimate the fair value of an asset. Later, the "noisy rational expectations model," outlined by Sanford Grossman and Joseph Stiglitz, proposed that some traders may choose not to be fully informed and instead make educated guesses because of the costs or difficulties of collecting complete information. Researchers found in subsequent studies that when complete information is too costly or unavailable because of timing issues, market pricing can see jumps and erratic volatility.^[10]

As part of these models, informed traders serve a role as leaders of market pricing activity and less-informed traders serve a role of providing liquidity. While informed traders receive outside information signals about asset values, uninformed traders will make decisions based only on price. But as more traders choose to become informed, the pricing system is understood to become more informative, thus protecting both informed and uninformed participants from possible mispricing.^[10]

Another characteristic of the participation of less-informed traders tends to be the widening of bid-ask spreads. On the flip side, narrower spreads have been shown to indicate the presence of traders who feel a greater certainty about the economic fundamentals behind price levels.^[11]

Order Flow: A Source Of Private Information

One area where studies have highlighted a possible consistent source of private information is in order flow to dealers. Under this hypothesis, financial market dealers gain access to client orders to buy and sell assets before the information is publicly available to the broader market, thus giving them an inside line on supply and demand for assets before other market participants.

The Impact Of Economic News And Public Information On Markets

Depending on the market and the type of information considered, information asymmetry may not always have a large impact on prices. Studies have found that some key macroeconomic information such as employment and manufacturing data, and GDP announcements, can have consistent visible impact on asset price levels, while other data announcements have more erratic impact. Additionally, such data announcements appear to have a larger direct impact on interest rate markets, and subsequent impacts on other related markets such as currencies and equities.^[13]

Studies have also found that the time frame for use of information about public announcements by traders is very short, often less than one minute.^[14]

Trading Volume

One indicator that may reveal the visible effects of information asymmetry for traders is trading volume. Some studies show that trading volume can fall dramatically when up-to-date information about an asset is unavailable, and rise again when it becomes available.^[15]

Impact Of Large Players

In a scenario where asymmetric information is acknowledged to exist, there are documented concerns that large players in markets may have unfair access to private information and leverage that can allow them to influence prices to a greater degree than small participants.^[16]

A study conducted by economists Giancarlo Corsetti, Paolo Pesenti and Nouriel Roubini in relation to recent financial market crises gave support to such concerns. It showed that large players:

• "tend to be better informed or perceived to be better informed;
• "are able to build sizable short positions via leverage;
• "tend to move first based on an assessment of fundamental (economic) weaknesses;
• "contribute to currency pressures in the presence of weak or uncertain fundamentals;
• "are closely monitored by smaller investors prone to herd on their observed or guessed positions, even when the small traders would act as contrarians based on the private information available to them;
• "(and) may recur to aggressive trading practices."^[16]

However, the authors of the study noted that despite this apparent advantage of large participants, small players were still able to hold influence over pricing and that the complexities of the market didn't allow for an absolute advantage of large players in all situations.^[16]

Summary

The possible existence of asymmetric information has been considered a risk factor by some, and for others it's merely a necessary element of normal market operations. Recent advances in the collection and dissemination of information have caused some to question the future relevance of asymmetry for maintaining a consistent advantage in markets.

Evidence clearly shows that some market participants have continued to benefit from information asymmetry because of their size or positioning in the market. Many studies seem to support the notion that more-informed traders have an advantage in achieving profits.

However, the very structure of markets and nature of trading also appear to provide the possibility of profits for traders who may not have access to the largest financial resources or highest quality information at all times. Additionally, the potential advantages of asymmetric information may be expected to increase over time for both large and small-scale traders as advances in information dissemination proliferate.

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