IFREE Financial Markets Research Leads into Zocalo

IFREE has been supporting the development of software to aid in research on a wide range of topics that arise in financial markets. Here are three examples:

• Naked short sales, price volatility, and bubbles.

A naked short sale occurs when a seller of shares neither owns shares nor borrows them from a long term holder for delivery to the buyer. Naked sales now happen routinely in the stock market. In effect, shares are created out of the (electronic) inkwell, much as money is created when a commercial bank makes a loan. Normally, or traditionally, as when a customer of a brokerage firm sells short, the brokerage firm delivers shares out of the pool of long shares that customers are holding in their account. Hence, the firm’s customers cannot sell short more shares than are actually held by customers in that firm’s “street name.” The practice of naked short selling is controversial, but the objective in this example is to explore its effect on behavior and a stock’s performance—price volatility and momentum during bubbles.

• Periodic “call” markets versus continuous trading.

Suppose stock ownership can change only occasionally in a sealed bid exchange—a call market—of shares at a single market clearing price at call time. And suppose continuous trading occurs in a futures prediction market for the call clearing price. The first market is for all those wishing to change ownership title; the second is for short term speculation based on variation in information release. call markets have low price volatility compared with continuous trading. Would maintaining two markets, as indicated, afford long term investors a less volatile means of changing title, while serving the needs of short term information and liquidity traders?

• Liquidity events and share pricing.

In finance theory, “liquidity events” have to do with large cash purchases or sales of shares. The question is how markets react—over-reaction, under-reaction, volatility—to large infusions of cash or shares, as in buyouts and new share offerings.

The software, called “Zocalo”, is being developed by Dr. David Porter at the Economic Science Institute at Chapman University, along with Chris Hibbert. This commercial grade software will be available as an open source program, at no cost to those desiring to use it in their experimental research. Zocalo uses new technology to run continuous markets on the internet with robustness to shocks (easy reentry from network or computer failures). It supports long-running prediction markets, as well as short term laboratory experiments.

According to the researchers, this software is completely "open source”, which means that anyone can help maintain and enhance it, and anyone can use it. There are downloads for several different operating systems and configurations. Any Linux box, XP or Macintosh can support the software and act as a server. Clients are connected through the web.

So far, at least five IFREE supported research papers on financial market topics have been produced, with more in the works. The more recent work has used Zocalo:

• Robin Hanson, Ryan Oprea, and David Porter. “Information Aggregation and Manipulation in an Experimental Market”. Journal of Economic Behavior & Organization, Vol. 60, pp. 449–459, 2006.
• Brice Corgnet, Praveen Kujal, and David Porter. “The Effect of Reliability, Content and Timing of Public Announcements on Asset Trading Behavior”.
• Ryan Oprea, David Porter, Chris Hibbert, Robin Hanson, and Dorina Tila. “Can Manipulators Mislead Market Observers?”
• Dorina Tila and David Porter. “Group Prediction in Information Markets With and Without Trading Information and Price Manipulation Incentives”.
• Shengle Lin. “Inertia and Underreaction in Asset Prices: An Experiment.”

Zocalo can be found at http://zocalo.sourceforge.net, or contact Jennifer Cunningham if you would like more information.