When Theory Meets the Market

In financial disputes, the theory matters. But ultimately, it must survive contact with the market.

For many years, I acted as a principal external expert to the UK financial regulator on market abuse and market manipulation. Much of that work meant analysing actual trading activity and asking whether the behaviour alleged could produce the market effect attributed to it. Since then, I have worked on the other side of the equation, as an independent expert in regulatory proceedings, investigations and complex financial litigation. That experience has reinforced one point: however persuasive a theory appears, it needs to be tested against the way the market actually operated.

Financial disputes inevitably generate theories. A series of trades is said to have moved a price. Transactions are characterised as artificial or commercially irrational. Losses are attributed to decisions said to have been unreasonable at the time. A complex strategy is reduced to a handful of trades which, viewed alone, look difficult to explain.

The advantage of analysing financial markets is that there is usually a great deal of contemporaneous evidence to test those theories against. We can often establish what was traded, when, at what price and in what volume. Depending on the market, we may also see prevailing prices, liquidity, volatility, what other participants were doing, and what happened immediately before and after the transactions in question.

That doesn’t make the answer straightforward. Markets are rarely that accommodating. But it does mean we can often move beyond the narrative and test it against what was actually happening at the time.

Over the coming weeks, in a new five-part series, I will look at five issues I have repeatedly encountered in financial disputes:

1. Did the trading actually move the market?
2. The danger of looking at a trade in isolation
3. Hindsight is not a market standard
4. When the numbers look more certain than they are
5. Reconstructing the trade: what the evidence really tells you

They are quite different issues, but they share a common theme: a theory is only as good as its ability to withstand testing against the market.