Undue Diligence

Modern financial markets increasingly rely on complex financial products. These products often change hands even though the buyers acquire little information about the underlying structure of the financial asset. The greater the complexity of the asset structure, the more opaque it tends to be in the sense that acquiring information about the structure is difficult and thus more costly. But are these opaque assets socially beneficial? To address this question, we construct a environment in which agents trade assets that have random returns. The buyer of the asset has the opportunity to inspect the asset, at some cost, to assess its fundamental value. In short, the buyer chooses to perform due diligence or not prior to accepting the asset. We use a mechanism design approach to determine when it is socially optimal to have opaque assets. We characterize the set of allocations that satisfy sequential participation constraints for both buyers and sellers of the assets. We show that asset trade without due diligence can generate the first-best allocation if the variance of the asset return is sufficiently low or agents are sufficiently patient. This holds even if the cost of acquiring information about the asset is costless. With sufficiently high return variance or impatience, lack of due diligence can still be the optimal outcome but the first best allocation is not implementable. For sufficiently low costs of information acquisition, due diligence is optimal if the return is sufficiently variable and agents are impatient.