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Security Prices and Market Transparency (Revised: 1-92)



This paper analyzes a market where investors observe the intermediate stages of price formation and can revise their orders as prices are determined. A trading mechanism that exhibits this property is said to be transparent. The issue of market transparency arises in many current policy issues such as the timing and quality of trade reporting, sunshine trading, and the effectiveness of publicizing order imbalances to reduce price volatility. We first examine a non-transparent where traders submit written orders before market clearing. We then contrast this system with a transparent market mechanism where traders can revise their orders during the price formation process. This system is shown to have the same equilibrium as a system where information on shocks to order flow is directly disclosed to market participants. Throughout, trading is modeled as a game between strategic traders with rational expectations. Contrary to popular intuition, transparency can increase price variability and lower liquidity.

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