Albert S. “Pete” Kyle’s “welcome to the markets” moment was a doozy.
On an October Monday in 1979, Kyle was working on a trading desk for Goodman-Manaster & Co., a futures commission merchant at the Chicago Board of Trade. The previous Saturday evening, U.S. Federal Reserve Chairman Paul Volcker convened a rare press conference to announce extreme measures: With U.S. consumer inflation soaring over 12 percent annually, the central bank was going to hike its benchmark rates substantially to prevent matters from getting worse.
The financial markets had to process this news, but there was a catch: Cash bond markets in New York were closed that Monday for the Columbus Day holiday; only futures markets in Chicago were open for trading. Markets faced uncharted waters – how would bankers, traders and everyone else in the financial system respond? What happened that Monday session remains burned into Kyle’s memory.
“It was total chaos, the most chaotic day I was ever on the floor,” said Kyle, now the Charles E. Smith Chair Professor of Finance at the University of Maryland and recently named the winner of the 2018 CME Group-MSRI Prize in Innovative Quantitative Applications.
Volcker’s announcement signaled interest rates were about to climb sharply and that great uncertainty lay ahead. On that Monday, futures prices based on 30-year Treasury bonds and other financial contracts at the CBOT, still relatively new at the time, whipped from limit-up to limit-down, eventually ending the day limit-down, Kyle recalled (bond prices move inversely to interest rates).
Liquid Markets Matter
For Kyle, that wild Monday imparted lasting lessons on the importance of liquid, efficient and well-informed markets – for both cash and futures – in an often turbulent, difficult-to-predict world.
“I learned that day that the futures market can provide liquidity when the cash market is closed,” Kyle said in a recent interview. “But the liquidity function of futures is much more efficient when the cash market is open, allowing arbitrage between the two markets and supporting price discovery.”
Kyle’s memorable Monday was just an early chapter in what became a long, productive career studying what makes markets tick. As the 13th winner of the CME Group-MSRI award, he joins an elite group featuring some of the world’s top economists (five have gone on to receive the Nobel Prize in Economic Sciences).
The CME Group-MSRI award, given in partnership with Berkeley, California-based Mathematical Sciences Research Institute, recognizes “exemplary work” in mathematical sciences, statistics and computing, and the “vital impact quantitative research and application play in shaping global financial markets”. Kyle was honored during an April 8 luncheon in Chicago.
Over the past three decades, Kyle and his colleagues researched, among other topics, “market microstructure” - broadly defined as the study of how asset prices result from interactions between traders of various types and sizes and from “institutional” factors (such as tick and minimum-lot sizes and information flow).
Information is Powerful Stuff
Information drives markets, of course – not only information itself, but also the speed at which it moves and who has it (or who’s perceived to have it). That’s a common thread throughout Kyle’s work.
In one of Kyle’s recent papers on market microstructure, he and co-author Anna A. Obizhaeva, of Moscow’s New Economic School, explored how certain principles of physics (such as “dimensional analysis”) can be applied to understand liquidity, high-frequency trading and market crashes (their related research includes the study of market crashes triggered by “big bet” trades).
Obizhaeva, who has co-authored over a dozen articles and papers with Kyle, said all markets are fundamentally “invariant,” meaning they operate according to the same set of rules, but at different speeds.
Understanding invariance can help exchanges, for example, determine margin levels and tick sizes based on trading volume. Invariance can also help regulators and others understand reasons behind, and possibly anticipate, unusual market events, such as the May 2010 “flash crash,” she said.
By studying market microstructure and invariance, “we can generate quantitative predictions… that can be practically applied,” Obizhaeva said. “We’ve just scratched the surface.”
Obizhaeva added that Kyle’s strengths include a “non-linear” way of thinking, willingness to take many different angles and embracing a “joy of research.”
“He can show the true beauty in finance and economics,” she said. “Each time I talk to him I learn something new.
Cotton Trading and The Electronic Future
Before Kyle made it to the trading floors of Chicago, he first got familiar with the cotton fields of West Texas.
Kyle’s father, Bert, was a cotton trader who worked for a cooperative in Lubbock, Texas, helping farmers market and hedge their crops through New York Cotton Exchange futures. He was also an electronic trading pioneer, establishing a screen-based spot market, originally known as TELCOT, for cotton in 1975.
“He always talked about price impact and how to control cost of trading,” Kyle said. “I heard a lot of discussion about how electronic trading was the future. It was kind of in my blood in a sense. If markets were going to become electronic, how do we build the algorithms” and other technology to power electronic systems?
In 1978, after taking a job in the CBOT’s agricultural economics department, Kyle was soon drawn to the nascent but faster-growing financial and equity-index futures markets: T-bonds and T-notes at the CBOT, as well as CME Group’s Eurodollar and S&P 500 index contracts.
After joining Goodman-Manaster, he thought about the FCM’s market-market customers who “provided liquidity for a living,” and realized he’d reached a career crossroads: futures trading, or academia.
“I decided to start studying market liquidity,” Kyle said. He’s since delved into a variety of related subjects, including high-frequency trading, market manipulation and volatility.
“Elegant and Simple”
In 1985, Kyle published a landmark study, “Continuous Auctions and Insider Trading” (which examined several questions, including how “valuable” private information is to an insider). In 1987, he was named to the Presidential Task Force on Market Mechanisms (aka, the Brady Commission), which studied that year’s “Black Monday” market crash.
Wei Xiong, a Professor of Economics at Princeton University studied with Kyle while both were at Duke University in the late 1990s, a period that had its share of market tumult, including Russia’s debt default and the collapse of hedge fund Long-Term Capital Management.
Wei, who with Kyle co-wrote a 2001 paper, “Contagion as a Wealth Effect,” said Kyle helped him grasp how seemingly small or local events can grow into “liquidity spirals” that shake markets around the world.
Without Kyle’s contributions, “we wouldn't have such an elegant and simple way of connecting information symmetry to liquidity,” Wie said. “We now have this beautiful formula that tells us how to measure liquidity, and how liquidity is determined by information ‘asymmetry.’”
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