SEC: Coded contracts improve understanding and transparency

The Securities and Exchange Commission posits that contracts expressed as computer code aid in deal transparency.

In a recent press statement, the proposal aims to combat complexity and ambiguity in financial offerings with new rules that would require certain deals to be written as a computer program.

For the non-bankers reading: financial instruments come with an owners manual called a Prospectus. The Prospectus describes how an investment opportunity, like a structured product or derivative instrument, behaves. As you can imagine, the more complex the instrument, the more complicated the manual, sometimes reaching over 500 pages.

For some instruments, like the ones that (arguably) brought the global economy to its knees, the Prospectus’s details that would allow an investor to understand the toxicity of the underlying assets are buried somewhere in those 500-page documents. Normally sophisticated investors have a difficult time fully understanding the deal; and, as is sometimes the case with these types of investments, the past performance figures trump any desire to fully understand the instrument’s behavior and collateral, assuming the buyer could understand things in the first place.

So, what’s the pragmatic solution to document obscurity?

When it comes to Asset-Backed Securities, the Securities and Exchanges Commission has a possible answer: let the math be math and use computer code to express the financial data, renderable on a computer.

The proposal calls for transparency in an unprecedented way, where Prospectus and deal terms can be easily subjected to objective and investor-driven analysis as sophisticated as the investments themselves. This is in contrast to the rating agency models where investors use rating agencies to guide buying decisions, where security-issuers can use rating system weaknesses to their advantage in obfuscating the real risks associated with the opportunity.

Here’s how the SEC explained it in the proposal [pdf] summary:

We also are proposing to require that, with some exceptions, prospectuses for public offerings of asset-backed securities and ongoing Exchange Act reports contain specified asset-level information about each of the assets in the pool. The asset-level information would be provided according to proposed standards and in a tagged data format using eXtensible Markup Language (XML). In addition, we are proposing to require, along with the prospectus filing, the filing of a computer program of the contractual cash flow provisions expressed as downloadable source code in Python, a commonly used open source interpretive programming language.

While a computer-parsable Prospectus will not solve all issues related to protecting investors, it’s a great first step in bringing transparency and understanding to unyielding complexity in new financial offerings and products, and may help prevent another sub-prime mortgage crisis.