Fed, WikiLeaks data underline market inefficiency
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.
One lesson from recent fat data dumps relates to fat tails. Both the Federal Reserve’s publication of data on its emergency credit facilities and the WikiLeaks releases of State Department messages could have caused market turmoil if they had been made public in real time. But some financial and political insiders were at least partly informed. It is a reminder that even supposedly efficient markets can’t reflect unknowns — and that information is always unevenly distributed.
The efficient market hypothesis and the formulae derived from it used in Wall Street’s risk management systems make the assumption that information is equally available to market participants. In the case of the Fed data, that wasn’t the case. For instance, while Morgan Stanley’s borrowing under the primary dealer credit facility totaled $61.2 billion at the peak, Citigroup’s topped out at $18.6 billion. Such information on the relative illiquidity of major market participants during the crisis was valuable, yet it was available, presumably, only to the Fed and the institution concerned.
Similarly in the WikiLeaks case, the information that Saudi Arabia’s King Abdullah wanted the United States to bomb Iran to eliminate its nuclear weapons program could have shocked markets if public. Yet it must have been known to senior officials in Saudi Arabia, some of whom may have had influence over substantial asset pools.
Complete openness is not the solution. There’s a rationale for not immediately disclosing details of emergency lending by the Fed, since doing so might create volatility in the markets it was intended to stabilize. In any event, this is an impractical goal. Market participants would find ways to avoid disclosure in sensitive cases.
Instead, market theory and risk management techniques should be adapted to reflect that not all information is public and that private information in particular is unevenly spread around. The immediate implication is that some “market” prices are false because not all relevant facts are widely known. It also implies that extreme events and market swings are far more likely than efficient market theory indicates. In the jargon, the tails of the distribution are fatter than conventional theory admits.