A well-functioning market entails avoiding investment fraud, guaranteeing free will, and encouraging the right investments. The information gap between investors and issuers should be minimized and information asymmetry should be eliminated for investors to make optimal investments. Today, very few investors are financially literate and make investments after extensive research. Instead, investments are typically made in light of the issuers’ perceived credibility and corporate image. Turkish laws set forth a number of measures to eliminate information asymmetry between the investor and the issuer in order to protect investors and the functioning of the markets.
The Concept of Asymmetric Information
The asymmetric information theory is a recent idea that is useful for explaining financial crises and averting future ones. This theory, as applied to capital markets, refers to the situation when the parties seeking to transact do not have the same level of information about the products and services that are the topic of the transaction. In general, the issuer is more informed than the investor about the investments to which the funds are allocated. Investors may choose not to invest if the issuer fails to inform them adequately, clearly and consistently, which might harm the functioning of the markets. The problems arising from asymmetric information are adverse selection and moral hazard.
Consequences of Asymmetric Information: Adverse Selection and Moral Hazard
Adverse selection occurs when a potential buyer, who lacks sufficient information about a product or service and, as a result, is unable to distinguish between good products and services, sets aside an average amount of money for an average product or service and purchases a product or service that is inferior to its alternatives for an average price. In this case, sellers of good products and services will be reluctant to sell their goods at an average price to a buyer who cannot tell the difference between good and bad products. As a result, sellers whose products and services are of greater quality than the market average will leave the market, which will harm market functionality. In financial markets, we witness this situation when the majority of potential stock buyers are unable to distinguish between a high-return and low-risk stock and a low-return and high-risk stock. Thus, the amount that the investor is willing to pay will be equal to the average stock price. Then, an issuer with a low-risk and high-return potential will be unwilling to sell its stocks at the average price, which could impede market functioning due to adverse selection.
Moral hazard refers to an information asymmetry problem that arises after the investor and the issuer have completed their transaction at the end of contract negotiations. An instance of this would be when the issuer performs actions that go against the investor’s wishes, resulting in circumstances that could raise the investor’s risk ratio and harm their interests. The information asymmetry theory suggests that markets can suffer when a party with incomplete information makes an adverse selection, or when a party with more information exploits this situation, leading to moral hazard. To protect investors, legislators set forth various measures and obligations aimed at eliminating information asymmetry and preserving the integrity of the markets.
Averting the Consequences of Asymmetric Information, and the Relevant Obligations
The transfer of accurate and comprehensive information in capital markets has gained increasing significance, as countries that prevent information asymmetry tend to attract more investments, thereby stimulating the growth of their economies. At this point, we should mention the public disclosure principle and the transparency principle, which are among the basic principles of capital markets. While both principles aim to prevent information asymmetry and maintain market stability, they differ fundamentally from each other. The public disclosure principle guarantees that specific information is duly provided to the public as required by law, whereas the transparency principle serves to gain insight into and grasp transactions and market participants. Another key aspect of satisfying the principles of transparency and public disclosure is the presentation of offering circulars in a way that investors can easily understand and assess. An offering circular should provide clear information on a company’s shareholding structure, financial situation, management, and taxation.
Minimizing information asymmetry and providing investors with consistent updates of precise and comprehensive information are necessary for a well-functioning market. Failure to prevent information asymmetry may lead to adverse selection and moral hazard, resulting in a decline in market functioning. To prevent such problems, offering circulars must be presented in a clear and intelligible way in line with the public disclosure principle, and issuers must continuously inform investors about their funds on their websites. Offering circulars should be reviewed in detail, and there should be additional regulations and research on this matter to protect the interests of both investors and issuers.
