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Financial markets are fast-paced, complex and opaque. Even the US stock market is fragmented into an array of competing exchanges and a set of proprietary “dark pools” managed by financial firms. Meanwhile, high-frequency traders are buying and selling stocks at speeds that other investors cannot match.
Still, stocks are a relatively transparent investment compared to many types of bonds, derivatives and commodities. So when the financial sector collapsed in 2007-08, it led to a wave of reforms as regulators sought to streamline markets.
But every financial market, reformed or not, has its quirks, which make them all ripe for academics to examine. This is what Haoxiang Zhu does. Professor Gordon Y. Billiards of Management and Finance at the MIT Sloan School of Management is an expert on how market design and structure influence asset prices and investors. Over the past decade, his detailed theoretical and empirical studies have informed market behavior and attracted audiences – academics, traders and policy makers – interested in how markets can be structured.
“When we need to reform the markets, what should we do?” Zhu asks. “Since something isn’t done perfectly, how can we refine it? These are very concrete issues and I want my research to shed light on them directly.
An award-winning article Zhu co-authored in 2017 shows how transparent and reliable benchmarks help investors effectively identify acceptable costs and dealers in many large markets. For example, in 2012 LIBOR, the benchmark interest rate applied to hundreds of trillions of dollars of derivatives, was found to have had problems with price manipulation. Zhu’s work emphasizes the value of having robust benchmarks (as the post-2012 reforms attempted to address them) rather than removing them altogether.
Another recent article by Zhu, published last September, examines how the 2010 Dodd-Frank banking legislation changed the trading of certain credit default swaps in the United States – using centralized mechanisms to connect investors and dealers, instead of the one-on-one “over-the-counter” market. The new design works well, the paper finds, but there is still room for improvement; investors still do not have easy ways to negotiate among themselves without the brokerage of dealers. Further modifications to the market design could resolve these issues.
Many of Zhu’s findings are nuanced: A 2014 article he wrote in the stock market suggests that privately run dark pools may unexpectedly aid price discovery by siphoning off low-information traders, while better informed traders help determine prices on the biggest exchanges. And a 2017 study he co-authored on Optimal Trading Frequency for Stocks found that when it comes to setting new prices, small-cap companies should likely trade less frequently than large companies. These findings suggest subtle ways of thinking about structuring stock markets – and in fact, Zhu maintains ongoing dialogues with political experts.
“I think that kind of analysis informs policy making,” Zhu says. “It is not easy to make rules based on evidence. Finding evidence is expensive, it takes time. “
Solve one problem at a time
Zhu only fully developed his interest in finance and markets after graduating from college. As an undergraduate student at the University of Oxford, he studied Mathematics and Computer Science, graduating in 2006. Then Zhu got a one-year job with Lehman Brothers, the bank of once thriving investment. He left in 2007, a year before Lehman imploded; he had become over-indebted, borrowing heavily to finance a series of bad bets.
“Fortunately, I left early,” Zhu says. Still, his short stint in finance revealed a few important things to him. Zhu found the daily finance routine to be “very repetitive.” But he also became 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 background in the industry,” Zhu says. “I entered finance and economics by looking at it a bit from the outside. I looked at it more like an engineer would. That’s why I think MIT is a perfect fit, because of the engineering way of looking at it. We solve one problem at a time. “
This also means that Zhu’s research does not necessarily aim to produce comprehensive conclusions about the nature of all markets; it studies first and foremost the mechanisms of separate markets.
“It’s hard to go very far if you start out too wide,” says Zhu, who got a job at MIT last year. “I would say we should start with depth. Once you get to the bottom of something, you see that there are connections between many different issues. “
Zhu received his doctorate in 2012 from the Graduate School of Business at Stanford University and joined the faculty at MIT the same year. Along with his appointment to Sloan, Zhu is affiliated with the MIT Laboratory for Financial Engineering and the MIT Golub Center for Finance and Policy.
Among the honors received by Zhu, his research has won several awards. The benchmarks paper, for its part, received the first Amundi Smith Breeden award by the Finance journal; the optimal trading frequency paper won the Western Finance Association’s Kepos Capital Award for Best Investment Paper; and Zhu’s dark pool article won the Morgan Stanley Award for Financial Markets Excellence.
Like a start-up
Much of Zhu’s time and energy is also spent teaching, and he is quick to congratulate the students he works with at MIT Sloan.
“They are smart, they work hard,” Zhu says. About his doctoral students, he adds, “It is always a challenge to go from being a good student to getting good grades to producing 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. “
And while continuing to study the design of financial markets, Zhu is expanding his research portfolio. Among other projects, he is currently studying the impact of new payment systems on the traditional banking sector.
“I think this is really a fantastic area of research.” Zhu said. “Once you have a [new] payment system, people’s payments are diverted from banks. … So we’re basically looking at how fintech, in this case payment providers, is siphoning off customers and information from banks, and how banks will cope. “
At the same time, Zhu’s work on market structures continues to gain an audience in the financial industry and among its regulators, which he welcomes. Indeed, Zhu wrote several comment letters to regulators on the proposed rules that could have a significant impact on the market. For example, he opposed certain proposals that would reduce the transparency of the corporate bond market, the swap market and the portfolio holdings of investment managers. But he is in favor of the US Treasury’s innovation in issuing debt linked to the new US benchmark interest rate which should replace LIBOR.
“In market design, the message is often nuanced: there are advantages, there are disadvantages,” Zhu says. “But finding the compromise is what I find very rewarding, doing this kind of work.”
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