George Akerlof’s academic study, “The Market for Lemons: Quality Uncertainty and the Market Mechanism” from 1967 on asymmetrical information in a market, and the associated market mechanics recently caught my attention.  And I am not the only one who took a while to grab the value of his conclusions.  The study was conducted in 1967, published in the Quarterly Journal of Economics in 1970, and finally won George a Nobel Prize in Economics in 2001.  (A note of thanks to Daniel H. Pink’s To Sell is Human for enlightening me on this subject).  Akerlof summarized his conclusions with a “finger exercise” of the used car market, circa 1967, to make his points.

In the 1967 used car market in America, there was a significant level of asymmetrical information.  The used car sellers had way more information about the product than the prospective buyers did.  No internet to do research, few “lemon laws”, and importantly no methods of information dissemination that could harm the sellers.  There was no e-mail to friends blasting poor service, no Twitter for venting, no Yelp!

With asymmetrical information, buyers are not willing to pay a fair market price as there is an inherent need to discount the unknown.  Many potential buyers would decide not to buy a used car at all.  Especially if the seller or the seller’s industry has a reputation for using the asymmetrical information to their favor, or being downright dishonest.  Even honest sellers are harmed because buyers will apply the same “unknown” discount to any transaction.  So even honest sellers of high quality products (used cars) have to accept a lower than fair market price when there is asymmetrical information.

Akerlof wrote, “Dishonest dealings tend to drive honest dealings out of the market.”  Further he concluded, “The presence of people who wish to pawn bad wares as good wares tends to drive out the legitimate businesses.”  When the honest dealers are pushed out, only the dishonest sellers remain.  It is possible the industry would then self-destruct, but if the product is needed, then the industry continues in a less than efficient manner.

The OTC trading industry has had it’s fair share of dishonest dealers.  Whether the retail FX world, mortgage-backed securities, treasury auctions of the early 90’s, NASDAQ in the late 90’s…..there have been many examples of the dishonest pushing out the honest.  But the OTC markets continue on as the business of risk and reward always needs new products and liquidity for those products.

In the retail FX (OTC) world, where asymmetrical information has been the norm (as has asymmetrical slippage), change is possible.  There is a clear way for the honest brokerage firms to drown out the dishonest, and to prove to clients and prospective clients the value of an honest broker’s offerings.  How?  Transaction Cost Analysis.  TCA.

Simply put, Transaction Cost Analysis is a way to analyze how well a broker execute’s client’s orders.  There are numerous, institutionally-validated price streams available in the FX marketplace.  A TCA program would see a brokerage forward information from their trading platforms to a qualified, independent, maybe even registered firm to see how close to a mid-point each firm executes it’s clients’ orders.  Is there any slippage?  If so, was the market actively moving at that time, or did the broker purposefully delay execution of the order or even execute at an off-market price?

Once this information is available, information mediums such as blogs, websites, e-mail, and social media would make it such that all but the purposefully uninformed traders would know which brokers are honest and which are less so.  There would be a rush of clients to the honest brokers at the expense of the dishonest brokers.  This would have the opposite effect of Ackerlof’s 1967 study of the used car market.  Rather than diminish the value of the industry as a whole,  the value of the marketplace as a whole would increase with economic benefits to the retail FX traders of the world, and to the brokerage firms acting as “honest sellers”.