As Wall Street has turned upside down, calls for more transparency, not surprisingly, have become increasingly intense. Markets thrive on information, the argument goes, and more information is better, right?
Well, up to a point. Investors in Bernard L. Madoff's self-described "Ponzi scheme" must surely wish that they had known what he was up to. But when it comes to hedge funds and proprietary trading desks, transparency is not always a good thing. In fact, it can be dangerous.
The reason lies in the interplay between systemic risk and leverage. The meltdown of 2008 has illustrated the cascading consequences of leverage: when a market moves against a highly indebted institution, it can go under quickly, a lesson that Bear Stearns, Lehman Brothers, and American International Group (AIG) learned the hard way. Moreover, the bankruptcy of a leveraged institution-or even just a heavy trading loss-can destabilize the entire financial system.
To see why this is so, consider an example. An institution that has borrowed ten times its capital and suffers a trading loss that wipes out $1 billion in capital will need to liquidate $10 billion worth of assets to restore its original leverage ratio. Sales on that scale will drive markets down; and if other leveraged players hold the same assets, their capital will take a hit, and they too will be forced to dump holdings into a weak market. This process of contagious "deleveraging" can build in force, causing markets to swing wildly, threatening a broad swath of investors.