Information Uncertainty and Risk

Intermediaries are typically more efficient at monitoring borrowers because they can access more information and process the information more efficiently,

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and because they can reduce monitoring costs by exploiting the scale of operation. For example, to be well informed, a trader may subscribe to various newspapers, newsletters and databases. Subscription costs do not increase with the amount of funds a trader handles. Therefore, the per-transaction cost of information decreases as the scale of operation increases. Furthermore, the efficiency in processing this information may increase over time as the trader accumulates knowledge and expertise.

Even more importantly, an intermediary may spread the risk inherent in uncertain projects by diversifying its portfolio. Diamond (1984) studies such a case in which lenders contract with a risk-neutral intermediary. The fundamental reason for increased efficiency through an intermediary in this case is the law of large numbers. As the number of uncertain investment projects, that is, borrowers, increases, a form of portfolio diversification occurs. In contrast, individual investors risk a total loss when a one-project portfolio folds. Similarly, in Boyd and Prescott (1986) and Williamson (1987), financial intermediaries arise to economize the costs of acquiring information through an intermediary.

This situation is completely reversed in open electronic markets. In automated trading systems, traders bypass risk-sharing intermediaries. Thus, instead of relying on the law of large numbers, traders must resolve the uncertainty by acquiring more and better information. For this reason, you can anticipate seeing more active participation from specialized information sellers in electronic commerce.

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