Early warnings ease market toxicity

CORNELL (US) — Stock market “flash crashes”—like the one on May 6 that briefly erased almost $1 trillion in value and left the financial world reeling—are now predictable and possibly preventable.

Despite recovering most of the losses within the hour, the crash managed to plunge the Dow Jones Industrial Average into its biggest intraday fall ever.

A new volume-synchronized probability of informed trading (VPIN) metric looks at the imbalance of trade relative to the total volume of the market and identifies flow toxicity.

“Flow toxicity refers to the risk that liquidity providers face when trading with traders who have better information than they do,” says David Easley, professor of social sciences at Cornell University, who developed the metric with Maureen O’Hara, professor of finance.

“The flow of orders is considered toxic when traders are selling when they’d rather be buying, and buying when they’d rather be selling.”

Flash “events” are short-term illiquidity crises in the market that occur when market makers suddenly stop trading in response to a high level of flow toxicity, resulting in a sudden drop in prices.

“All morning long on May 6 order flows were becoming increasingly unbalanced, and volumes were huge,” says O’Hara. “An hour or more before the flash crash our measure hit historic levels.”

The VPIN could prevent future flash crashes by giving market regulators warning of flow toxicity early enough that they could slowly adjust the market, Easley explains.

The metric could also give traders a way to hedge the risk of flash crashes, so that they don’t have to be as concerned with the value of their inventory plummeting.

“We believe that’s what caused so many of the high frequency market makers to get out of the market during the flash crash,” says Easley.

“They were taking huge losses, and they didn’t know exactly what was going on. They reached position limits so they quit. And if they could have hedged that risk, perhaps that wouldn’t have happened or the results wouldn’t have been so severe.”

“One of the problems that regulators face now is that markets are so fast that regulating after the fact is really too late,” says O’Hara. “One of the advantages of our measure is that it is forward looking, so it could be a useful tool.

“Research on these things is extremely important because when markets falter the whole economy is affected.”

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