As Wall Street has turned upside down, calls for more transparency, not surprisingly, have become increasingly intense. Markets thrive on information, the argument goes, and more information is better, right?

Well, up to a point. Investors in Bernard L. Madoff’s self-described “Ponzi scheme” must surely wish that they had known what he was up to. But when it comes to hedge funds and proprietary trading desks, transparency is not always a good thing. In fact, it can be dangerous.

The reason lies in the interplay between systemic risk and leverage. The meltdown of 2008 has illustrated the cascading consequences of leverage: when a market moves against a highly indebted institution, it can go under quickly, a lesson that Bear Stearns, Lehman Brothers, and American International Group (AIG) learned the hard way. Moreover, the bankruptcy of a leveraged institution—or even just a heavy trading loss—can destabilize the entire financial system.

To see why this is so, consider an example. An institution that has borrowed ten times its capital and suffers a trading loss that wipes out $1 billion in capital will need to liquidate $10 billion worth of assets to restore its original leverage ratio. Sales on that scale will drive markets down; and if other leveraged players hold the same assets, their capital will take a hit, and they too will be forced to dump holdings into a weak market. This process of contagious “deleveraging” can build in force, causing markets to swing wildly, threatening a broad swath of investors.

How does this relate to transparency? If a successful hedge fund or proprietary trading desk is known to be placing a large leveraged bet, the risks of contagion increase. Other traders will copy the successful player, creating a trend that is self-sustaining at first but ultimately unstable. Suppose a respected investor is known to be borrowing yen cheaply, then selling it and using the proceeds to buy high-yielding Brazilian real. If other investors imitate this “carry trade,” the yen will go down and the real will go up, creating profits for all who piled in early. Seeing those profits, other traders will jump in and make the trend look even stronger, further increasing the volume of trading. Eventually this trading is likely to drive the two currencies to unsustainable extremes. The initial dose of transparency has created the potential for a brutal reversal.

But that’s not all. When the trigger for the reversal arrives, the presence of large numbers of leveraged players in this crowded carry trade almost guarantees that markets will snap back viciously. As the yen rises and the real falls, investors take losses, forcing them to sell assets quickly to keep leverage levels in check. The speed of the reversal creates more distressed selling. What’s more, if it is widely known that many leveraged investors have piled into the yen–real bet, others will anticipate a sharp reversal and attempt to trade ahead of it. Again, transparency will increase volatility.

This thought experiment is not a fantasy. Starting in the late summer of 2008, huge volumes of the carry trade were indeed unwound, sparking sharp rallies in low-yielding currencies, such as the yen, and terrifying declines in high-yielding currencies, such as the real and the South Korean won. But the danger that transparency will trigger such systemic crises is not the only objection to it.

Fans of transparency should recall that there is no patent protection for trading ideas, so secrecy is essential to protecting their value. If we want to preserve incentives for innovation in portfolio management, we need to preserve the right to obstinate opacity. Right now, thanks to the crisis, these innovative investment strategies have a bad name. But the world undoubtedly benefits from sophisticated investors who move capital to the countries, firms, and individuals who seem likely to use it best.

Finally, fans of transparency should pause to ask themselves what they would do with the extra information they covet. Critics assert that forcing hedge funds or proprietary trading desks to disclose details of their portfolios will allow regulators to spot risks before they blow up. But hedge funds and other leveraged traders often pursue complex strategies that are hard for regulators to understand, and these strategies change continually. Requiring hedge funds to report quarterly on which securities they own would be meaningless for funds that change their holdings several times per day. Real-time disclosure could be required, but no regulatory agency has the personnel to monitor thousands of funds on that basis.

Of course there are nuances. Disclosing to the broader marketplace must be distinguished from narrower disclosure to regulators. Broad public disclosure destroys incentives for innovation and increases the risk of trading contagion, whereas confidential disclosure to regulators is less damaging. But the simple point is that increased transparency is not the panacea it is often said to be. When it comes to hedge funds and proprietary trading desks, transparency can be a curse and secrecy can breed stability.

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