HOW DO FINTECHS ADDRESS THE ISSUE OF INFORMATION ASYMMETRY IN FINANCIAL MARKETS?

How Financial Markets Exhibit Asymmetric Information

In any transaction in which one of the two parties involved has more information than the other and so has the potential to make a more informed decision, financial markets display asymmetric information.

According to economists, unequal information causes market failure. That is, the rule of supply and demand, which governs how products and services are priced, is distorted.

Understanding Asymmetric Information

When either the buyer or the seller has more information about an investment’s past, present, or future performance, asymmetric information can arise in the financial markets. One party is capable of making an informed judgment, but the other is not.

It’s possible that either the buyer or the seller is aware that the asset is undervalued. In each situation, one side stands to gain financially from the deal at the expense of the other.

The Subprime Meltdown and Asymmetric Information

The subprime mortgage crisis of 2007-2008 could serve as a textbook example of the consequences of asymmetric knowledge. Mortgage-backed securities were the cause of the financial crisis. Consumers were given mortgages by banks, which were subsequently sold to third parties. These third parties bundled them together and sold them to investors in batches. The securities were evaluated as high-quality and sold accordingly.

However, many, if not all, of the individual mortgages involved in those products had been issued to borrowers purchasing homes at inflated prices that they couldn’t afford. The borrowers, as well as the secondary buyers of their mortgages, were stuck when prices halted.

The vendors have information that the end buyers did not have unless no one done their homework at any point during this lengthy process. That is, they were aware that high-risk mortgages were being misrepresented as high-quality financing. They were taking advantage of asymmetry in information.

Ignoring Risks

According to economists who research asymmetric information, such scenarios might create a moral hazard for one of the parties in a transaction. When a seller or buyer knows or reasonably guesses that the transaction involves a real but unreported risk, a moral hazard can arise.

Consider the selling of such mortgage-backed securities, for example. The vendors may have done their homework and realized they were offering sub-prime mortgages disguised as high-yielding investments. Or they may have detected early warning signs of a coming housing price crash.

Did the buyers have access to the same information as the sellers? If they did, they were most likely playing the same game of pass-the-trash and hoping to profit by reselling the securities before the finish.

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