How market ecology explains market malfunction

Standard approaches to the theory of financial markets are based on equilibrium and efficiency. Here we develop an alternative based on concepts and methods developed by biologists, in which the wealth invested in a financial strategy is like the abundance of a species. We study a toy model of a market consisting of value investors, trend followers, and noise traders. We show that the average returns of strategies are strongly density dependent; that is, they depend on the wealth invested in each strategy at any given time. In the absence of noise, the market would slowly evolve toward an efficient equilibrium, but the statistical uncertainty in profitability (which is calibrated to match real markets) makes this noisy and uncertain. Even in the long term, the market spends extended periods of time away from perfect efficiency. We show how core concepts from ecology, such as the community matrix and food webs, give insight into market behavior. For example, at the efficient equilibrium, all three strategies have a mutualistic relationship, meaning that an increase in the wealth of one increases the returns of the others. The wealth dynamics of the market ecosystem explain how market inefficiencies spontaneously occur and gives insight into the origins of excess price volatility and deviations of prices from fundamental values.

Why do markets malfunction? According to the theory of market efficiency, markets always function perfectly. Prices always reflect fundamental values and change only when new information affects fundamental values. Thus, by definition, any problems with price setting are caused by factors outside the market. Empirical evidence suggests otherwise. Large price movements occur even when there is very little new information (1), and prices often deviate substantially from fundamental values (2). This means that we need to go beyond the theory of market efficiency to understand how and why markets malfunction.Here we build on earlier work (3–7)^* and develop the theory of market ecology, which provides the necessary alternative. This approach borrows concepts and methods from biology and applies them to financial markets. Financial trading strategies are analogous to biological species. Plants and animals are specialists that evolve to fill niches that provide food; similarly, financial trading strategies are specialists that evolve to exploit market inefficiencies. Trading strategies can be classified into distinct categories, such as technical trading, value investing, market making, statistical arbitrage, and many others. The capital invested in a strategy is like the population of a species. Trading strategies interact with one another via price setting, and the market evolves as the wealth invested in each strategy changes through time, as regulations change, and as old strategies fail and new strategies appear.The theory of market ecology emerges from the inherent contradictions in the theory of market efficiency. A standard argument used to justify market efficiency is that competition for profits by arbitrageurs should cause markets to rapidly evolve to an equilibrium where it is not possible to make excess profits based on publicly available information. But, if there are no profits to be made, there are no incentives for arbitrageurs, so there is no mechanism to make markets efficient. This paradox suggests that, while markets may be efficient in some approximate sense, they cannot be perfectly efficient (8). In contrast, under the theory of market ecology, trading strategies exploit market inefficiencies, but, as new strategies appear and as the wealth invested in each strategy changes, the inefficiencies change as well. To understand how the market functions, it is necessary to understand how each strategy affects the market and how the interactions between strategies cause market inefficiencies to change with time. The theory of market ecology naturally addresses a different set of problems than the theory of market efficiency and can be viewed as a complement rather than a substitute.Our study here builds on a large body of work on agent-based models of financial markets (e.g. refs. 9–12). The theory of market ecology provides a conceptual framework for understanding such models. Our goal is not to construct a better model of financial markets, but rather to show how ideas from ecology can be used to interpret market phenomena and predict market behavior.Here we study a stylized toy market model with three trading strategies. We approach the problem in the same way that an ecologist would study three interacting species. We study how the average returns of the strategies depend on the wealth invested in each strategy, how their wealth evolves through time under reinvestment, and how their endogenous time evolution causes the market to malfunction.We show that, with realistic parameters, evolution toward market efficiency is very slow. The expected deviations from efficiency are, in some sense, small, but they persist even in the long term, and cause extended deviations from fundamental values and excess volatility (which, in extreme cases, becomes market instability). Our study provides a simple example of how analyzing markets in these terms and tracking market ecosystems through time could give regulators and practitioners better insight into market behavior.