Too Complex to Depict? Innovation, 'Pure Information,' and the SEC Disclosure Paradigm

Abstract

Since the Depression, the SEC’s totemic philosophy has been to promote a robust informational foundation, furthering efficiency and governance. As a corollary, the SEC’s approach has been incremental, generally not venturing beyond information to substantive decision making.

The Article starts by showing that this disclosure philosophy has always been largely implemented through what can be conceptualized as an “intermediary depiction” model. An intermediary — e.g., a corporation issuing shares — stands between the investor and an objective reality. The intermediary observes that reality, crafts a depiction of the reality’s pertinent aspects, and transmits the depiction to investors.

The Article proceeds to show that the intermediary depiction model is increasingly undermined by modern financial innovation. Financial innovation is creating objective realities far more complex than in the past, often beyond the capacity of the English language, accounting, visual, risk measurement, and other tools on which depictions rely. The characteristics of some financial innovations can sometimes be so complex that even "objective reality" can be subject to multiple meanings. With such complex realities and such rudimentary tools, the depictions may offer shadowy outlines of objective reality, however that reality might be conceived. The Article illustrates, such as with asset-backed securities (ABS).

Financial innovation sometimes poses a second roadblock to depictions: even a well-intentioned intermediary either may not truly understand (i.e., suffer from what can be termed "true misunderstandings") or may not function as if he understands the reality he is charged with depicting (i.e., suffer from what can be termed "functional misunderstandings"). This second roadblock can flow both from complexities of financial innovation and organizational complexities associated with the intermediary itself.

Depictions of major banks involved in financial innovation activities can suffer from both roadblocks. An afterword (Section IV(C)(3)) on the now-unfolding JPMorgan Chase Chief Investment Office derivatives hedging situation illustrates.

Technological innovation can help. With advances in computer and Internet technologies, it is no longer essential to rely exclusively on intermediary depictions. Figuratively, the inntermediary can step out of the way. Such “disintermediation” and “pure information” have advantages — and disadvantages.

A disclosure paradigm relying on both the intermediary depiction model and the pure information model — and the full spectrum of strategies between these extremes — is necessary. The Article outlines possible strategies that, e.g., would generate “moderately pure” bank information and possible strategies for the “simplification of reality” itself. Substantive questions, including “too big to fail,” are implicated. If a bank is “too complex to depict” and pure information-type models are insufficient, should we consider if it is also “too complex to exist”?

The Article also suggests that challenges to the SEC disclosure paradigm extend to the paradigm’s philosophy, in particular, the philosophy’s incrementalist component. Departures such as the 2008 SEC short-selling ban raise SEC independence issues and the need to consider the proper relationship between the paradigm’s traditional efficiency goals and the truly rare situations in which, e.g., short-term financial stability ought also be considered. Other departures, such as responses to the 2010 “flash crash,” raise questions as to how high frequency trading and other innovations might conflict with the paradigm’s traditional goals.

A fundamental rethinking of the SEC disclosure paradigm is now essential.

Keywords: asset-backed securities, bank regulation, derivatives, disclosure, financial innovation, flash crash, governmental myopia, hedging, high frequency trading, informational asymmetry, Internet, model risk, SEC, securities regulation, short-selling, systemic risk, too big to fail, Value at Risk

JEL Classification: D82, G01, G11, G12, G14, G15, G18, G21, G28, G32, G34, G38, K22, O33