Cotton Games Spur Landmark Study

Wall Street traders play for higher stakes than Monopoly rivals collecting plastic houses and fake money. But finance professor Albert “Pete” Kyle, author of landmark research on market microstructure, sees both activities as examples of games.

As a child growing up in Memphis, Tenn., Kyle enjoyed strategy games like checkers, chess, poker and bridge — especially when winning required a degree of speculation. He also enjoyed market simulations like Monopoly.

“I just loved that, and I loved mathematics,” says Kyle, the Charles E. Smith Chair Professor of Finance at the University of Maryland’s Robert H. Smith School of Business. “I wound up combining the two interests and becoming an academic who studies markets, but who studies markets as games.”

Kyle first saw the overlap between markets and games in Memphis, the center of worldwide trade for cotton. “It was a huge speculative market, as well as the bread and butter of a lot of people in the Memphis area,” Kyle says.

His father and grandfather were both cotton merchants, and Kyle observed enough to understand their influence as traders. “If you buy, you push prices up,” Kyle says. “If you sell, you push prices down.”

The rule seems simple, but economists of the day operated on a different premise. They taught that pure market forces controlled prices, superseding the influence of any individual.

“The price was just this magic thing that came out of nowhere,” Kyle says. “Everybody could trade as much as they wanted to at that magic price. I thought that was completely wrong.” 

His seminal 1985 paper, nicknamed Kyle 85 by Nobel Laureates and others, changed the thinking in academia.

“My contribution was to say the price was not magic,” Kyle says. “It was the outcome of a game — like a game of Monopoly — except it’s a game of people submitting orders and moving the price around. And we should think of it as an industrial organization problem that can be addressed using game theory.”

The cotton trade gave Kyle a second insight in his youth, shaping his work years later as a Nasdaq reformer. While working part-time in high school, Kyle saw the complexity of the cotton industry and the need to streamline operations with digital trading.

“I grew up with the idea that markets should be electronic,” Kyle says. “You don’t need all these human beings screaming and yelling at each other.”

His father saw the same thing and implemented an electronic trading platform for West Texas farmers’ cotton in the 1980s. Despite the progress, change came slowly in stocks and futures markets. Nasdaq traders were still handling orders by phone in the 1990s, making it impossible for one customer’s order to trade against another customer’s order without dealers taking a big cut for themselves.

After federal regulators got involved, they recruited Kyle as a consultant. The resulting regulatory changes forced the market to modernize its way of doing business, giving electronic access to sophisticated institutional traders and the masses.

“I’ve always been a big supporter of the idea that customers should have access to the market on a level playing field, and that access should be electronic,” Kyle says. “When that happens, the result is a more competitive price.”

After finishing high school in Greenville, S.C., Kyle headed to Davidson College in North Carolina, where he struggled to choose between a career in academia or commodity trading. “I majored in math because I didn’t know what I wanted to do,” he says. “I thought that by majoring in math I would keep every option open, which it did.”

The indecision followed Kyle to graduate school. He studied at Oxford University in the United Kingdom as a Rhodes Scholar and then finished a PhD in economics at the University of Chicago — conveniently located close to the U.S. futures markets.

Kyle worked part-time at the Chicago Board of Trade and then took a one-year leave from his PhD program to work full-time in the commodity industry. In the end he chose academia and accepted an Ivy League faculty position at Princeton University.

“It was a really, really close decision,” Kyle says.

He later taught at the University of California-Berkeley and Duke University before coming to Maryland Smith in 2006. “Both the empirical and theoretical researchers at Maryland are concerned with how real-world institutions actually work,” Kyle says. “We are very practical in the way we think about how finance operates in the real world, while at the same time bringing our research into the classroom.”

Photo caption: Albert "Pete" Kyle speaks April 21, 2016, during a symposium honoring the impact of his seminal paper, nicknamed "Kyle 85." Read more...

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