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Market Efficiency, R.I.P.; Merton vs. Merton

On Saturday I coached a junior rugby team in a tournament and I am very pleased to say we came first out of five teams, winning all four matches. The abilities across the attending clubs weren't well matched and during one game, the difference was painful.

After scoring 4 tries in de first half against nil for the opposing team, I brought the boys together during half-time for  little speech about fair play. I also ordered my two strongest try scorers to hold back and pass the ball instead of scoring.

I explained the new rules to the referee and started the second half feeling confident that the two teams would be better matched. 'Unfortunately' we played even better in the second half scoring a further 7 tries until the ref finished the game prematurely. 

My boys had truly trashed the other team, unintentionally aided by my changes to the team dynamics. Although we played well in the first half, during the second half, play was phenomenal. I had never before seen my boys play together that well as a team.

What basically happened on Saturday was that the star players were still creating opportunities, but passed the ball to the other players. In fact, the other boys, who had previously relied on a supporting role, where now more focussed than ever on their positioning in the field, making sure they were standing free and were able to receive the ball. All were looking for opportunities and calling out to receive the ball. And the result was astounding.

Afterwards I walked over to both the referee and the other team coach and explained my halftime instructions and the unintended consequences. The referee, clearly the academic type, responded with a quote which he attributed to Robert Merton. 

As an economist, the Robert Merton I am most familiar with, is the father of efficient markets movement, Robert C. Merton ("Continuous Time Finance" is my bible). However, the efficiency of markets has been in dispute recently with ever increasing volatility, lack of liquidity and heavily skewed market movements, and unprecedented and increasingly desperate actions from central banks to get markets kick-started again.

But this was not the Merton that was referred to, last Saturday morning. "Mister C's" father, Robert K. Merton, was also an academic and a sociologist, who invented the concept of "Unintended Consequences" and is considered to be one of the founders of modern-day sociology.

And this makes Robert "K." Merton not only the 'Grandfather' of the efficient markets movement, but also the answer to why it has broken down. 

I do think market efficiency has broken down; Bonds that trade in both real and nominal yields at negative rates, banks that aren't lending, brokers that are no longer making markets, and market-moves that statistically should not happen, do occur on a weekly basis.

These are all results of the overarching response globally to the financial by increasing financial regulation. Stiffer accounting rules, central clearing, solvency 2, Basel 3, trade taxes and stamp duties, and above all central banks that have disrupted ("disrupted" is the buzz word for 2015, unfortunately here it is used in it's original, negative connotation) the financial markets with unprecedented intervention.

And new regulation is continuing to impact markets: MiFid 2 will evaporate what ever intend there still was amongst banks to make markets in corporate bonds and will further increase volatility and vulnerability of markets.

The current breakdown in markets is a direct consequence of the actions governments and regulators have taken since the credit crisis. Law of unintended consequences; central bankers and politicians pushing buttons of which they do not know which lights will turn off. Unfortunately, unlike my rugby match, I don't think anybody is benefiting.