Copulas, Efficient Markets, and Liquidity

Most people are familiar with the efficient markets hypothesis in general, and its strong version in particular. What's less common is the strong version of its opposite, to it's refreshing to see Robert Waldmann today:

I forget where someone asks me if I reject the "price revelation" argument in general. I do...
[Quants] assumed that market prices contained information which no one even claimed to be able to obtain any other way. So how did the information get into the prices. One hypothesis is that the Zeitgeist exists and has rational expectations. I can't think of another explanation.

He's talking about CDS prices and default probabilities, here: how can CDS prices contain information about default probabilities if that information is not available elsewhere?

The answer to that question is surely the same as the answer to the more familiar question of whether and how share prices can contain information about future earnings. The answer to both questions is nontrivial, but there does seem to be some real sense in which the wisdom of crowds exists.

In general, I think it's reasonable to say that market participants do over time change their views about such things as future earnings and default probabilities, often using often inchoate macroeconomic information, including simple anecdotal observation, rather than anything granular or specific. The change in those views is reflected in a change in market prices for stocks and bonds, and indeed the market is pretty much the only place where a large number of individual anecdotal observations can coalesce into something as quantifiable as a default probability.

But that's the "price revelation" argument which Waldmann rejects, and if you reject that argument, then I can see how you'll reject the idea that liquidity is a good thing -- indeed, you'll probably conclude, as Waldmann does, that "liquid markets are a bad thing".

And there are indeed downsides to liquid markets. If a market is liquid, I can buy a stock or bond on the hope that it will increase in value, and with the understanding that I can stop myself out with a relatively small loss in the event that it decreases in value. That encourages speculative bubbles. If there's no liquidity, investors are likely to do a lot more homework before making any decisions, and you don't get the situation we saw for most of this decade, where everybody assumed that everybody else was doing all the hard work, with the result that almost no one was doing it bar conflicted ratings agencies.

Still, count me among the people who think that net-net, liquidity is a good thing, not a bad thing. Waldmann asks how I can still believe that after writing about the role of credit default swaps in the financial meltdown -- but really they were just an input into a model, and the model was just an input into a set of trading desks, and the trading desks were just an input into a much larger risk-management function at the top of large financial institutions. And it's that risk-management function which really fell down on its job.

It's the old "guns don't kill people" debate. I've received quite a lot of emails over the past few days saying that guns (like the Gaussian copula function) don't kill a financial system, it's people who kill a financial system. Waldmann, deliciously, takes the "guns don't kill people, bullets kill people" approach. Which might be technically defensible, but does seem to rather miss the bigger picture.