Fostering innovation through academic research

6 December 2011

By Louis Lovas,
director of Solutions,

Research is the cornerstone of technological change and innovation. Research is the process by which science investigates and analyses to yield conclusions - sometimes an ascribed hypothesis of some phenomena in pursuit of the facts, or often a stated theory as the explanation of the facts. As Francis Bacon once said: "Science is but an image of the truth" (1). Research, whether in the application of practical results or pure in nature, is based on the classic scientific method of empirical evidence, a thorough study of the information, facts and data at hand.

We are all made from stardust... (2) Without the research begun centuries ago in mathematics, chemistry and astronomy, we would not enjoy the benefits of modern medicine and advanced computer technology today. Research has been the wellspring for modern society for which we simultaneously bear the burden and enjoy the benefits of what has come before.

Far too often in times of distress, whether economic or in our markets, contentious opinion tends to be the rule that holds the most influence. Fueled by emotion, a scapegoat is sought out to pin the burden of blame for whatever ails. The tumult of the recent market volatility has been blamed on numerous ‘goats’ including high frequency trading (HFT), Greek sovereign debt, the short-sale circuit breaker and basic human emotion. But hidden behind all that media cacophony is the quiet voice of reason. In universities across the US and Europe, academic researchers are immersing themselves in analysing our market structure. University faculty and graduate students within financial engineering departments are engaged in a quest to understand the multitude of factors that influence our market behaviours, both its successes and failures. They look to move beyond the anecdotal to discover hard evidence. They seek to lay bare the empirical truth of what forces, however subtle, shape the yield curve, determine the microeconomic aftermath of macroeconomic policy decisions such as quantitative easing or the Fed's Operation Twist to lower long-term rates. What factors are driving market efficiency? Is there significant influence from the exchange maker/taker rebate schedule? Richard Holowczak, professor of Computer Information Systems at Baruch College, City University of New York, looks to gain a deeper understanding of the Options Penny Pilot (3) which was begun a number of years ago but had a profound influence on the Options industry's growth.

Analytical financial research looks for the determinate forces of market microstructure. The goal of which is to rationalise the interplay of those forces, the participants influence on price formation, price discovery and transaction costs. Many research studies (5) have lasered in on HFT and its impact on volume, spreads and market quality - specifically volatility and liquidity. That is a hot research topic as HFT has matured and the industry wrestles with coming to terms with the proliferation of electronic trading across all asset classes.

What about the market impact of recent regulations? There are trade halting rules like circuit breakers and limit up/limit down rules. New pre-trade risk controls in the market access rule and greater transparency imposed by the larger trader rule. While it may be too soon to fully understand their fallout, research is underway to understand their reverberating effects not just within the fragmented equities markets, butlso across the landscape of other assets classes.

Understanding the consequences of regulatory changes is of vital importance to all participants. How else would we know conclusively of a potential Butterfly effect? Costis Maglaras, David and Lyn Silfen, professors of Business at Columbia University, discussed how the study of modern market microstructure is interdisciplinary, combining elements from economics, finance, engineering and mathematics. Faculty members and students from across the University spanning different disciplines are actively involved in the study of today's fragmented, stochastic and high-frequency markets, posing interesting questions on market analysis, market design, trade execution and policy.

University professors use research projects to challenge graduate students to understand market mechanics, explore and optimise trading behaviours, solve optimal execution problems and better understand modern portfolio theory. For this, they have created mock trading floors and big data stores to house deep equity and options data. University faculty strive to educate and groom the next generation of quantitative analysts, economists, even future regulators and prepare them for eventual leadership roles in the financial marketplace.

The quest for the truth is a noble and lofty goal. Author Sylvia Nasar says of John Maynard Keynes, a confidence in the "apparatus of the mind" is of utmost importance for wrestling with economic catastrophe (5). The recent market volatility has caused far too many to wield anecdotal opinions and too few armed with evidential facts as to why we're witnessing such distressing conditions. While it has pressed the SEC to accelerate its efforts to deploy the consolidated audit trail (CAT) and will likely cause FINRA to revise its own order-audit trail system (OATS), universities across North America and Europe have been pressing ahead to reveal the truthful image.

1. Link to Francis Bacon quote


3. Options Penny Pilot

4. The Capital Markets Cooperative Research Centre website

5. NY Times article

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