A deep look at the design of the financial markets

Financial markets are fast moving, complex and opaque. Even the US stock market is fragmented into a number of competing exchanges and a number of proprietary “dark pools” operated by financial companies. Meanwhile, high-frequency traders zoom to buy and sell stocks at a rate that other investors cannot match.

However, stocks are a relatively transparent investment compared to many types of bonds, derivatives and commodities. When the financial sector collapsed in 2007-08, it sparked a wave of reforms as regulators tried to streamline markets.

But every financial market, reformed or not, has its quirks that make it all ripe for scientists to question. Haoxiang Zhu does that. The Gordon Y. Billiards Professor of Management and Finance at the MIT Sloan School of Management is an expert on how market design and structure affect the prices of assets and investors. Over the past decade, his detailed theoretical and empirical studies have shed light on market behavior and gained audiences – academics, traders, and policy makers – interested in how markets can be structured.

“What do we have to do when we have to reform the markets?” Asks Zhu. “To the extent that something is not done perfectly, how can we refine it? These are very specific issues, and I want my research to shed light on them directly. ”

An award-winning paper that Zhu co-wrote in 2017 shows how transparent and reliable reference prices help investors efficiently identify acceptable costs and traders in many large markets. In 2012, for example, it was shown that LIBOR, the interest rate measure for derivatives valued at hundreds of trillion dollars, had problems with price manipulation. Zhu’s work emphasizes the value of robust benchmarks (as post-2012 reforms attempted to address) rather than deleting them altogether.

Another Zhu paper, published recently last September, looks at how the 2010 Dodd-Frank banking legislation changed the way some credit default swaps are traded in the US – by using centralized mechanisms to help investors and traders instead of joining the one. On-one-over-the-counter market. The new design worked well, the paper notes, but there is still room for improvement. Investors still do not have easy ways to trade among themselves without the intermediary of traders. Additional changes in the market design could solve these problems.

Many of Zhu’s findings are nuanced: a paper he wrote on the stock market in 2014 suggests that privately owned dark pools can unexpectedly contribute to pricing by siphoning off traders with less information, while better informed traders help lower prices at the to determine larger exchanges. A 2017 study he co-authored of the optimal trading frequency of stocks found that companies with smaller market capitalizations should probably trade less frequently than larger companies when setting new prices. Such results suggest subtle ways of thinking about structuring stock markets – and indeed, Zhu is in constant dialogue with policy experts.

“I think this type of analysis influences policy making,” says Zhu. “It’s not easy to create evidence-based rules. It is expensive to find evidence, it takes time. ”

Solve one problem at a time

Zhu didn’t develop an interest in finance and markets until after college. As a student at Oxford University, he studied mathematics and computer science and graduated in 2006. Then Zhu got a job at Lehman Brothers, the once thriving investment bank, for a year. He left in 2007, a year before Lehman imploded; It was over-funded and had massively borrowed to fund a number of bad bets.

“Fortunately, I left early,” says Zhu. Still, his brief time in finance revealed some important things to him. Zhu found the daily routine of finances “very repetitive”. But he was also convinced that there were compelling problems to be solved in the area of ​​market structures.

“I think part of my interest in the details of market design has to do with my industry experience,” says Zhu. “I got into finance and economics and looked at it from the outside. I looked at it more like an engineer would. This is why I think MIT is a perfect fit because of the technical way things are going. We each solve a problem. ”

This also means that Zhu’s research is not necessarily intended to draw overarching conclusions about the nature of all markets; He primarily examines the mechanisms of separate markets.

“It’s hard to get very deep when you start too broadly,” says Zhu, who earned a tenure at MIT last year. “I would argue that we should start with the depth. When you get to the bottom of something, you can see that there are connections between many different topics. ”

Zhu received his PhD from Stanford University’s Graduate School of Business in 2012 and joined the MIT faculty that same year. In addition to his appointment in Sloan, Zhu is a faculty member at the MIT Laboratory for Financial Engineering and the MIT Golub Center for Finance and Policy.

Among the awards that Zhu has received, his research work has received several awards. On the one hand, the paper was awarded the Amundi Smith Breeden First Prize by the Journal of Finance on benchmarks. The paper on the optimal trading frequency was recognized by the Western Finance Association with the Kepos Capital Award as the best paper on investments. and Zhu’s Dark Pools paper won the Morgan Stanley Prize for Excellence in Financial Markets.

Like a start-up

Much of Zhu’s time and energy is also devoted to teaching, and he is quick to praise the students he works with at MIT Sloan.

“They are smart, they are hardworking,” says Zhu. He adds of his PhD students: “It is always a challenge to go from a good student with good grades to a research. Producing research is almost like starting a business. It is not easy. We do our best to help them and I enjoy interacting with them. ”

While continuing to study financial market design, Zhu is expanding his research portfolio. Among other things, he is currently investigating the effects of new payment systems on the traditional banking industry.

“I think this is really a fantastic area for research,” says Zhu. “As soon as you have one [new] Payment system, people’s payments are diverted away from the banks. … So we’re essentially looking at how financial technology, in this case the payment providers, is pulling customers and information away from the banks and how the banks will deal with it. ”

At the same time, Zhu’s work on market structures continues to have audiences in the financial industry and among their regulators, which he both welcomes. Indeed, Zhu has made several comments to regulators about proposed rules that could have a material impact on the market. For example, he has opposed certain proposals that would reduce the transparency of the corporate bond market, the swap market, and investment manager portfolio holdings. He does, however, advocate the US Treasury Department’s innovation in debt issuance related to the new US benchmark rate, which is intended to replace LIBOR.

“In store design, the message is often nuanced: there are advantages, there are disadvantages,” says Zhu. “But figuring out the compromise is very rewarding when doing this type of work.”