Thursday, February 09, 2012

Asymmetric Information

One way to get advantage over someone else is to some crucial fact that your rival doesn't. You might, for example know the cards in his poker hand while he doesn't know yours. Freshwater economics is based on the idea of perfect markets, which require perfect information. Real markets with large information asymmetries allow large rents to be extracted from the economy.

This fact is the reason it's cheating to have a colleague signal you the contents of somebody else's card hand, and the reason market and company insiders are prohibited from profitting through their insider information.

Financial engineering, Wall Street style, was and is all about creating and maintaining information asymmetry, which they do by creating and trading exotic financial instruments sold over the counter with little oversight. These "dark pool" markets are ideal since only the broker/creator really knows the terms of the other paties to the deal, and because with no open market, would be sellers need to return to the broker to deal.

I was discussing this with a guy who, though quite a bit smarter than I, had not made a study of such matters. "Why," he asked, "don't they make that illegal."

The answer, I think, is that only a few people really understand this. Some of them are would be reformers. The rest are the guys making hundreds of billions from the situation. Guess who speaks with the louder voice.