Transparency is essential if markets are to function properly, Bank of Canada governor David Dodge told the Canada-U.K. Chamber of Commerce in London. He chided a number of market players for their role in the recent market disruptions.

The problem, as Dodge explained, is that the increasing complexity of structured products made them very difficult for investors to understand. “In this complex process, transparency about the underlying credit was often lost. Because the originators of the loans intended to securitize them rather than leaving them on their balance sheets, they lacked the incentives to carefully assess the creditworthiness of the borrower. And investors often lacked the ability, or did not make the effort, to see through the complexity of the instrument,” Dodge said.

The result is that investors were unaware of the creditworthiness of the root asset and the potential difficulties with the structured product’s liquidity. “Compounding the problems was the fact that the models upon which these structured products were valued assumed that they could be readily traded in a liquid market,” he said.

Dodge allowed that the creation of these products did allow for better risk management, but he also noted that central bankers had been concerned for some time that credit spreads were not appropriately reflecting risk. Policymakers have welcomed the re-pricing of risk, Dodge said, until that process hit a rough patch in August, highlighting many structured products’ complexity, opacity and illiquidity.

“The re-pricing of credit risk is an ongoing process. Unfortunately, it may take somewhat longer than in previous periods, because of the opacity and legal complexity of so many of these structured products,” Dodge said.

He admitted that it’s still too early to draw many conclusions about the responsibility for, and responses to, the market dislocation. However, he stressed the need for improved transparency.

“Vendors of financial instruments need to structure these investments in such a way that market players can clearly see what they are buying. Credit-rating agencies need to clearly indicate that their ratings for highly structured products should not be used with the same degree of certainty as their ratings for conventional, single-name issuers. At the same time, investors will have to take on more responsibility for diligent research, so that they can better understand the nature of their investments and demand greater transparency where it is now lacking. Investors should not rely simply on the pronouncements of rating agencies to deliver their seal of approval!” he said “Instead, they must do their own homework and make a concerted effort to understand what they are buying. However, this process can be successful only if they have access to all the information they need.”

Dodge added that the importance of transparency should not be limited to money markets and debt instruments. “In my view, there is a clear case for transparency more generally in the operation of all financial markets,” he said, noting that he sees a clear case for increased transparency for hedge funds, at least with respect to their objectives, operating procedures, and governance. He also called for more transparency in valuation models, sovereign wealth funds, and international financial institutions such as the International Monetary Fund.

Finally, Dodge also said a few words about the economy, noting that generally strong economic conditions have been tempered by the financial market worries, which led the Bank to leave rates unchanged at its last meeting. He noted there are significant upside and downside risks to the outlook for inflation, and uncertainty about the extent and duration of the tightening of credit conditions in Canada. Beyond that, he didn’t give any clues as to the Bank’s likely next rate move.