The Nature of Market Evolution – Learning From the Natural Sciences

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Both the business and popular press have spent a lot of time and ink recently covering what appears to be a never-ending set of random changes in the financial markets. 

The Nature of Market Evolution – Learning From the Natural Sciences

Actually, changes in two kinds of markets: 1) the markets for financial instruments and 2) the markets for services related to those instruments, services like market-making, clearing and settlement, and asset management. While many of these changes appear to be, and are often treated as, issues unto themselves, they are actually part of an evolutionary process. So it behooves us to look at these changes the way natural scientists look at evolution in the physical world.

 

The Scientific Approach to Natural Evolution

Scientists have been studying evolution for at least 150 years, and they have come to a consensus on several topics.

  1. There are two kinds of environmental forces at work in evolution, with two different timeframes.
    • Gradual forces, like climate change or tectonic plate movement that change the environment on a global or location specific level. These forces have massive effects and longevity, but usually allow gradual adaptation by both flora and fauna depending on the circumstances.
    • Sudden, cataclysmic events, like volcanic eruptions, meteor strikes or tsunamis. These events throw every species into uncharted waters, and often cause mass extinctions. However, in each case some species continue to survive past these events, and proliferate in the void left behind, while adapting to the new environmental pressures.

In natural evolution, these two kinds of forces interact. In some cases, the cataclysm compresses the gradual change, rendering gradual adaptation insufficient and forcing its pace. In other cases the cataclysm suddenly stops the gradual process, making it look like the species have much more time to adapt than they actually do.

  1. Underneath the observable species specific changes, there are larger scale effects at work.
    • Everything is connected to everything else. For example, changes in the troposphere affect life at the bottom of the oceans, and changes in microorganisms/autotrophs can have a major impact on heterotrophs further up the food chain, and in the entire ecological community. In ecology (and its impact on evolutionary adaptation), there is no such thing as an isolated incident. Of course, the connections can be fiendishly difficult to decipher, and scientists are still determining some of the causes, as well as searching for future effects.
    • Adaptability is everything; history is full of species that weren’t as well adapted as other species, with estimates suggesting around 5 billion species (99% of species that have existed) subsequently became extinct. However, surviving species adapted and proliferated in the changing environments. Sometimes this adaptability is accidental, as with timely random genetic mutations that provide an advantage. In other cases, it is behavioral/voluntary, like our forbearers discovering the nutritional rewards available through cooking their food and providing the ability to vastly increase their population. Not all adaptations are successful, though – some can limit a species in the face of change. The lesson, though, is that staying the same in the face of change is almost always a ticket to the fossil display at the natural history museum.

 

Evolution in the Financial Markets

So now we need to see how much of this is applicable to the financial markets we are concerned with, particularly the markets for financial services.

Our first finding is there are indeed two kinds of changes happening in these markets as well. First, there is the gradual kind of evolution found in such areas as the automation of both trading and trade reporting, or in the gradual compression of fee structures due to competition and efficiency. In the same long-term category is the compression of bid-asked spreads as many financial products mature. We also see the melding of many different financial products into an array of combinations that start out as bespoke offerings and evolve into standardized products.
Finally, we see both the emergence and stagnation of various geographies or political structures, and the inevitable globalization of all markets. All these changes have been happening day by day over many years.

While these are going on all the time, we have seen cataclysmic events shake the markets as well. The credit bubble and its bursting, that dominated most of the 21st century, is perhaps the most prominent example. While the bubble itself served to move the markets in one direction, the implosion snapped them sharply the other way. Then, the markets faced two external forces at the same time, both as a result of the credit bubble. The first was the actions of the world’s central banks, as they attempted to prop up the world’s economies through the money supply, often acting in an uncoordinated fashion. The second was a plethora of market regulations issued, again regionally, as governments tried to redress what they thought were the causes of previous market panics.

Now let’s look at the larger scale effects to ecology/evolution that we identified previously to see whether they are applicable in the markets. The first is the axiom that everything is connected to everything else. For example, do changes in the regulation of the equity markets impact business processes in the settlement of currency trades, and, if so, how? And how do the prolonged very low interest rates we currently see worldwide affect the liquidity in the financial markets? There are, of course, dozens of such questions to be asked, and, needless to say, the answers are almost as difficult to determine precisely as they are in the natural world. But their difficulty doesn’t render them unimportant. So the one thing we can be sure of is that reacting to just one change in just one aspect of the markets is very likely to miss a very important factor just out of our view, and render our efforts suspect, if not disastrous.

A much easier question is whether adaptability is as much a key to survival as it is in the natural world, which I assume we can all agree is true. Once we do agree on that, however, we have to move on to determining which adaptations have the best chance of success and which are likely to be blind alleys. That, in a nutshell, is the question of survival, both in and of the financial markets. 

A much easier question is whether...

Applying What We Have Learned

If we have arrived at the conclusion that the evolution in the natural world can, in many forms, be applied to evolution in the financial markets, how do we go about doing that? Here are some guidelines:

  • Adhere to the rigor that science requires: Scientists operate under rigorous a set of requirements, involving validity testing methodologies, peer review, and continuous critical reexamination under the influence of subsequent research. The worst thing that can happen to a scientist is to have his/her research be revealed as economically motivated and ignore contradictory evidence, or to have major validity concerns. The opportunity for these missteps is much higher in the financial markets, so everyone needs to be on the alert for subjective findings or rushes to judgment. Those in positions of thought leadership in the markets must be open about any research they do and how they reached any conclusions.
  • Make sure our research is broad enough: Scientists know that missing a single input can render their conclusions misleading or false, and the same holds true for conclusions in market evolution. Attributing a trend, for example the decline in the number of futures clearing merchants (FCMs), to a single cause, such as increased regulation, will surely invalidate any conclusions, and can lead to catastrophic results. Taking all variables into account is a tall order, but an order nonetheless.
  • Subject hypotheses to testing: This is one of the hardest rules from science to apply to market evolution. After all, we can’t take segments of the market into a lab and inject them with something, but evolutionary scientists can’t inject live individuals of an extinct species either, yet they have found ways to test their hypotheses. Fortunately, the markets are overflowing with data, making metrics research not only possible but required. We just need to be smart and creative about how we test.
  • Treat research as a cooperative effort: Scientists know that an open mind to approaching a problem, from multiple disciplines and backgrounds, are much more likely to produce useable conclusions than single views, often clouded by biases or economic motivations. Only when we all see this work as serving a common purpose, as opposed to promoting an agenda, will we step out of the fog into the sunlight.
  • Reward effective research: Market research, like scientific research, takes resources. Where that research benefits one segment, it is appropriate for that segment to fund it, but there are plenty of cases where the research benefits everyone equally. In the same way that the natural sciences solve this problem, the science of market evolution will have to.
  • Have no fear of breaking molds: The progress of the science has been a long history of the skepticism of assumed truths. In market evolution, we should also expect a variety of structures to be torn down and replaced. Sacred relationships between vendors and customers, time-honored ways of doing business, even legal structures that once served a higher purpose, must all be viewed as suitable only when they fit with the evolving market.
  • Understand the objective of it all: In some ways, this will be the hardest guideline to follow. For each individual participant in the markets, the objectives are clear – either profitability or statutory obligations to ensure market safety and fairness. But every market participant has a hidden objective, whether they know it or not – that the markets continue to function and provide a place to do business. Beyond all the individual competitions and struggles, the markets themselves are moving down a path that takes no notice of any single participant. So, while each participant may have complete understanding of its own environment, only together do we have the chance of adapting by evolution – and surviving, not to mention thriving. It really is up to us.

This article was first published in edition 8 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.Rocket 8

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