The endogeneous dynamics

of financial markets
Feedback loops, instabilities
and turbulence
(A view from a physicist in financial markets)

J.P. Bouchaud, Capital Fund Management

&
Ecole Polytechnique
Why do market prices move?
• The Efficient Market answer: prices reflect faithfully the Fun-
damental Value of assets

• Prices only move because of exogeneous unpredictable news.

• Platonian markets that merely reveal fundamental values with-

out influencing them

– or is it a mere tautology??
Note 1: if we had a way to check, we would not need markets

Note 2: markets can be (nearly) unpredictable but not necessarily efficient

• Crashes can only be exogenous, not induced by markets dy-

namics itself – really??
Why do market prices move?
• My personal conviction, based on several pieces of empirical
evidence, personal observation of markets over 20 years, and
strong analogies with the physics of “complex” systems:

– The dynamics of prices is primarily the result of endoge-

neous market mechanisms

– Non-linear, positive feedback loops and multiple equilibria

are some of the mechanisms leading to turbulence and
crises: financial markets are intrinsically unstable

• Investors mostly trade on flimsy information and by doing so

randomly impact prices – on short to medium time scales,
prices are weakly anchored by fundamentals
Black’s definition of efficiency: prices are right to within a factor 2
Exogenous or endogenous dynamics?
• HF version of the seminal paper of Cutler, Poterba, Summers

• Synchronize news feeds with one minute stock price changes

• Yes, some news make prices jump, sometimes a lot, but jump
freq. is much larger than news freq.

• Only ∼ 5% of 4 − σ jumps can be attributed to news, most

jumps appear to come from nowhere

• News induced jumps and No-news jumps have markedly dif-

ferent statistics, in particular ‘aftershocks’ that follow the
analogue of the “Omori law” for earthquakes
Exogenous or endogenous dynamics?

• The distribution of price changes has the same “fat” Pareto

tails for almost anything that’s traded

→ There is a full continuum between ‘micro-crises’ and crashes

– like for earthquakes

Excess volatility, multiscale intermittency
30
10 4

5 2

20
0 0
90 95 100 95.0 95.5 96.0

10

0
0 50 100

Excess volatility, with long range memory – looks a lot like en-
dogeneous noise in complex systems
Intermittency: Barkhausen noise, Turbulence

Slow, regular and featureless exogeneous drive → intermittent

endogeneous dynamics
Exogenous or endogenous dynamics?
• The distribution of price changes has the same “fat” Pareto
tails for almost anything that’s traded

• Excess volatility, with multiscale intermittency – looks like

endogeneous intermittent noise in complex physical systems
(turbulence, Barkhausen noise, earthquakes, etc.)

• To a large extent: Universal observations in time, space &

assets

• These observations and analogies strongly suggest that en-

dogeneous dynamics is the solution to the excess volatility
puzzle – not due to fundamentals
Mechanism: Feedback loops/instabilities
• Unstable feedback loops pervade financial markets and can
and do lead to crises – to name a few:

– Model induced feedback loops: e.g. the BS feedback loop

in 1987, the CDO feedback loop in 2008,...

– Regulation induced feedback loops: mark to market, Value

at Risk...

– * 1) The volatility – liquidity feedback loop

– Pattern following: trends feed trends (learn history – it

might repeat)

– * 2) Crowd following: panic feeds panic (imitate others –

they might have some information)
1) The problem with liquidity
• Zooming in: the price dynamics results from a subtle balance
between:

– liquidity takers, who believe they have information but have

to trade incrementally (even liquid markets are not that liq-
uid), creating trends

– liquidity providers, who fear that others may have infor-

mation, and widen the spread/leave the market when risk
appears to increase, like birds on a wire

• Think of the dynamical equilibrium between the two forces

as a “tug of war”: sometimes one side yields...

Liquidity is a coward, it is never there when one needs it

1) The problem with liquidity
• An upward fluctuation in market order flow may lead to larger
local volatility, triggering more volumes, larger spreads, and
more inventory imbalance, that feedback on volatility etc.

→ micro-liquidity crises and endogeneous jumps – culminat-

ing in the flash crash of May 6th.

• Liquidity is not God given but is a self-organized, inherently

fragile process

• Can one engineer endogeneous stability, for example using

dynamic take/make fees?

• Listed, “liquid” markets are bad enough, but OTC markets are even
worse
2) Imitation and collective decisions

• Collective behaviour is often irreducible to individual dynam-

ics – common in physics (liquid-solid transition, supercon-
ductivity, etc.) – but incompatible with the “representative
agent theory”

• People do not make decision in isolation but rely on the

choice of others

• This leads strong distortion/amplification phenomena: fads

& fashion, vaccination campains, riots, birth rates, etc. and,
of course, bubbles
Starlings in Rome

Unexpected collective patterns from lousy individuals

– A. Cavagna et al.
2) Imitation induced discontinuities
1.0

0.5

J < Jc

Average opinion
0.0

−0.5

J > Jc

−1.0
−10 −5 0 5 10
Polarisation field F(t)

In the collective phase, anecdoctal fluctuations trigger crashes

Heterogeneity + interactions = Discontinuities & Breakdown

of the representative agent theory
Metaphoric models of complexity

• Generically, a system such that its individual elements are

heterogeneous and interacting (competing) has:

– Multiple equilibria – actually exponential!

– Intermittent dynamics – with long stasis in quasi-equilibrium

– Critical fragility to external perturbations

• In these systems, more efficiency lead to more vulnerability!

Conclusion
• Markets are complex systems (i.e. made of heterogeneous,
interacting elements) → rich endogenous dynamics, with in-
trinsic discontinuities and intermittency, and little anchor to
fundamentals

– Feedback loops and instabilities are numerous and are prob-

ably at the origin of excess volatility and market turbulence

• Collective effects are of paramount importance and one should

shun away from the utility maximizing, single representative
agent framework

→ Promote realistic Agent Based simulations with millions

of heterogeneous, interacting agents?

– cf. D. Farmer, D. Foley, Nature, August 2009

Conclusion

• A major scientific program, where recent ideas/methods from

statistical physics should help – i.e. inferring macro-laws
from micro-rules, or “macro behaviour from micro-motives”
(cf. Schelling)