Matt Levine writes:
Prices very quickly reflect information, specifically the information that there are big informed buyers in the market.
That’s good! That’s good. It’s good for markets to be efficient. It’s good for prices to reflect information.
Let’s take this argument to the limit. Every order contains some small amount of information. Therefore every order should move the market (as they do in building block models of market microstructure)– and of course big orders should move the market even more than small orders. Matt Levine is claiming that this is the definition of efficiency.
But wait: What is the purpose of markets? Do we want them to be informationally efficient about the fundamental value of the assets, or do we want them to be informationally efficient about who needs/wants to buy and sell in the market? These are conflicting goals. When a hedge fund is forced to liquidate by margin calls, those sales contain no information about the fundamental value of the asset. Should prices reflect the market phenomena or should they reflect fundamental value? According to Matt Levine they should reflect the market not the fundamentals.
Matt Levine supports his view by referencing an academic paper that assumes on p. 3 that all orders contain some information about fundamental value — and thus assumes away the problem that some market information has nothing to do with fundamental value. With only a few exceptions the theory supporting the view that trade makes markets informationally efficient in the academic literature assumes (i) that informed traders trade on the basis of fundamental information about the value of the asset and (ii) that the informed traders have no opportunity to use their information strategically by delaying its deployment. Almost nobody models the issue of intermediaries trading on the basis of market information. And the whole literature by definition has nothing to say about efficiency in the sense of welfare (i.e. the Pareto criterion) because it assumes that liquidity traders are made strictly worse off by participating in markets.
It has long been recognized that liquidity is one of, if not, the most important service provided by secondary markets. Liquidity is the ability to buy or sell an asset in sizable amounts with little or no effect on the price.
Matt Levine’s version of informational efficiency presumes that there is no value to liquidity in markets. Every single order should move the market because there is some probability that it contains information.
I thought the reason that financial markets attract vast amounts of money from the uninformed was because they were carefully structured to provide liquidity and to ensure that the uninformed could get a fair price. Now it’s true that U.S. markets were never designed to be fair — and were undoubtedly described in extremely deprecating terms by London brokers and dealers for decades — at least prior to 1986. But there’s a big difference between arguing that markets don’t provide liquidity as well as they should, and arguing, as Matt Levine does, that the provision of liquidity should be sacrificed at the altar of some poorly defined concept of informational efficiency.
If Matt Levine is expressing the views of a large chunk of the financial world, then I guess we were all wrong about the purpose of financial markets: as far as the intermediaries are concerned the purpose of financial markets is to improve the welfare of the intermediaries because they’re the ones with access to information about the market. Good luck with that over the long run.