In many asset, financial, and service markets, trade information is generally not available to interested buyers. For example, a number of securities traded in over-the-counter (OTC) markets lack transparency regarding both the frequency and price of past trades. Dealers are under no obligation to disclose this information about their products to interested buyers. The same is true in other more traditional markets for assets. In the used car industry, buyers cannot easily learn the seller’s history of past trade, nor can buyers readily observe a realtor’s history of sales in the market for residential real estate. In the market for services, a contractor is typically not obligated to disclose his past work history and the negotiated service prices. Likewise, it can be difficult for employers to discover a job applicant’s full employment history.
However, in many cases, sellers of securities, physical assets, and services, as well as aspirants for new jobs, voluntarily disclose past trade information. For example, a used car dealer can disclose the sales he has made to buyers and the prices at which the transactions took place. Likewise, the contractor can furnish the details of past agreements and their prices to newly interested buyers for the services he provides. The disclosure of such information is possible because the information is verifiable; records are produced in each transaction that allow the seller to divulge the information and credibly prove that the disclosure is true. This is due to the documents and records produced following sales, such as transfer of ownership documents, bills of sale, or signed contracts.
At the same time, regulators have become increasingly interested in boosting transparency in markets through mandatory trade disclosure. A prominent example is the implementation of the Transaction Reporting and Compliance Engine (TRACE), first implemented in 2002 requiring the public disclosure of fixed income facilities such as corporate bonds. TRACE has since been extended to include several other securities, such as asset-backed and mortgage-backed securities.
We explore this question of voluntary vs. mandatory disclosure of past trade information using a simple economic model in a recent working paper. The economic model involves a seller who can trade a single asset in each of two dates. At each time, buyers arrive for that period and make offers to the seller. The seller can either accept one offer, in which case trade takes place, or the seller can reject all offers. In the following period, new buyers arrive and similarly make offers to the seller, regardless of whether trade took place in the previous period. A critical aspect of the model is that information asymmetry exists in the market; the seller has perfect information regarding the quality of the asset, while buyers only imperfectly observe whether the asset is of high (a peach) or low (a lemon) quality.
We then consider two information structures. The first is one where the seller can voluntarily disclose if trade took place in the first period, along with the transaction price. That is, the seller has full control of the past trade information that buyers observe in the second period. The seller can only disclose trades that took place, but she cannot credibly prove that a trade did not take place. This is because sellers who traded can mimic the disclosure behavior of sellers who didn’t trade. In the second structure, the seller must publicly disclose any trade that took place in the first period, allowing buyers to observe the seller’s trade history whenever trade took place.
In solving for the equilibrium of this economic model, several interesting properties emerge. In the voluntary disclosure regime, the seller who has a low-quality asset always trades, but only discloses a trade that occurred at a high enough price. This is because sellers who have quality assets only trade at high prices and reject offers at low prices. In this way, a seller with a low-quality asset can influence buyers to believe that her asset quality is a peach rather than a lemon, thereby generating higher prices in the future. Conversely, in the mandatory disclosure regime, the seller is unable to hide trade at low prices, since all trades and their prices must be publicly disclosed. As a result, if trade occurs at a low price, future buyers will know with certainty that this seller peddles low-quality assets. Future buyers would therefore only make offers that are acceptable to sellers with low-quality assets. To avoid this outcome, the seller must sometimes forgo profitable trade in the first period (even though it is at the low price) so as not to convey that she is peddling low-quality assets. We find that this mimicry behavior can be so strong that future buyers are still less inclined to target the high-quality asset, even if trade did not occur at the low price in the first period. This is because future buyers are aware of the seller’s mimicry behavior and update their beliefs based on the fact that no buyer offered a high price in early trade.
Interestingly, in the main part of the analysis, we find that voluntary disclosure of past trade can be more efficient for market participants than mandatory disclosure. In other words, total welfare in the market is higher under voluntary disclosure than under mandatory disclosure. This occurs when market beliefs regarding the asset are initially high, which would correspond to an optimistic or “hot” market. The reason for this is that, when the market is hot, the low-quality seller’s mimicry incentive is strongest, in the sense that she always wants to hold out from trading early at a low price to attain a higher price in the future. This results in less trade in both dates in the mandatory disclosure regime. In contrast, in the voluntary regime, the seller can hide trade that has occurred at low prices, which attenuates the mimicry incentives. Since trade for the low-quality asset can still be profitable, efficiency and welfare improve with the greater trading frequency.
The results of the economic model have a number of regulatory and empirical predictions. Principally, voluntary disclosure can help to mitigate mimicry incentives that can derail trade. For example, a contractor that is not required to disclose his history of agreements should be more willing to accept work that is closer to his reservation wage and cost of labor, rather than rejecting such agreements where the negotiated price could indicate a low cost of labor and thus a lower quality of service provided. The same is true for sellers of assets or securities, whereby sellers can hold back from trade due to disclosure requirements that reveal that trade took place at low prices.
Cyrus Aghamolla is an Associate Professor of Accounting at the Jones Graduate School of Business at Rice University.
Shunsuke Matsuno is a Ph.D. candidate in Business Administration at Columbia University.
This article was adapted from their paper, “Mandatory vs. Voluntary Disclosure in the Dynamic Market for Lemons,” available on SSRN.
