The SFI has issued a White Paper exploring how financial markets got Brexit so wrong, and how the episode of last June demonstrates limits of "efficient market theory".

While British and European Union political leaders cross rhetorical swords over Brexit, the financial and academic community is trying to figure out whether a failure of most investors to predict last June’s momentous referendum result reveals major failings.

The Swiss Finance Institute has issued a White Paper, authored by ETH Zurich researchers, Ke Wu, Spencer Wheatley and Swiss Finance Institute Professor Didier Sornette, entitled How Brexit Refuted Market Efficiency.

“The nine-hour, district-by-district process of announcing the results of the EU Referendum that took place in the UK on 23 June 2016 provided a rare real-life experiment with which to test the efficient market hypothesis,” it said. 

The document goes on to say: “Crucially, the market - ordinarily robed in complexity - momentarily exposed itself in a simplified state, allowing an exceptionally objective analysis of responses to fundamental information. The stream of 382 local area vote count announcements provided the stimulus, and the British pound market in US dollars the response.”

The paper claims that by mapping prior polling results onto early voting announcements, the “Brexit result could have been predicted with high confidence in real time after only 20 out of 382 local voting results had been revealed, and hours before the market priced in the outcome. This failure of the market suggests a glaring contradiction to the paradigm of efficient markets, in a `semi-strong’ form”.

Last June UK voters chose, by a 52 per cent/48 per cent split, to end the UK’s 44-year membership of the European Union, arguably the greatest change in western European politics since the collapse of the Berlin Wall and reunification of Germany. The vote has been seen as a revolt by people upset about issues such as mass immigration, high contributions to the EU, bureaucracy and lack of full democratic accountability by the EU system. Critics of Brexit fear departure from the EU spells a retreat from free trade and a ratcheting up of nationalism.

The Brexit vote triggered a slide in sterling against currencies such as the dollar and euro; the UK equity market, however, rose and the UK economy has continued to grow, confounding some of the gloomier forecasts that a departure from the EU would be disastrous for the UK. 

The fact that so much investment opinion was wrong-footed by Brexit, as it was by the election of Donald Trump last November, should cause soul-searching in the financial world. The failure to anticipate such a result might suggest continued failings in understanding of voters’ intentions. With French elections imminent and German polls due later in the year, there is a clear need for investors to get a stronger handle on political developments.

Information
“Financial markets have long been regarded as efficient information aggregators, and effective predictors of the probability of future events. Belief in these properties underlies free market systems and economic liberalism. In the literature, semi-strong market efficiency has usually been tested by how quickly security prices reflect relevant information that was obviously publicly available,” the SFI’s White Paper said.

“However, there are ongoing controversies over several definitions in the abovementioned tests: the boundary of “quickly”, the level of rationality, the entanglement of different types of event impacts and reactions, the operational market efficiency, the limits to arbitrage, etc. Further, to make a test of the efficient-market hypothesis operational, one must specify additional structures like investor preferences, normal return models, etc., which create a joint hypothesis problem, and lead to the claim that it is very difficult to carry out such unambiguous tests outside of an actual laboratory experiment,” it said. 

During the nine hours of `Brexit night’, the market was in the state of a `natural experiment’, or `quasi-controlled experiment’, where near-laboratory conditions for studying markets’ response to fundamental information were present in the real world. The market was targeted on a single final event: the referendum result, with only two possible outcomes (leave or remain), whose market values were widely known to market participants before, as seen from forecast reports from major financial institutions including JP Morgan, HSBC, and Goldman Sachs (conservatively, in the range 1.4–1.5 USD/GBP for remain and 1.1–1.35 USD/GBP for leave),” it said.

“In this highly active and temporarily simplified market, not only were the typical functional shortcomings and `distractors’ that plague event studies naturally removed, the often fatal `joint hypothesis problem’ was conveniently avoided,” it said.

To see an example of other recent coverage of SFI reports, click here.