The Flash Crash: The Impact of High Frequency Trading on an Electronic Market
Andrei A. Kirilenko
Massachusetts Institute of Technology (MIT) Sloan School of Management
Albert S. Kyle
University of Maryland; National Bureau of Economic Research (NBER)
University of North Carolina (UNC) at Chapel Hill - Finance Area
Federal Reserve Board
May 5, 2014
This study offers an empirical analysis of the events of May 6, 2010, that became known as the Flash Crash. We show that High Frequency Traders (HFTs) did not cause the Flash Crash, but contributed to it by demanding immediacy ahead of other market participants. Immediacy absorption activity of HFTs results in price adjustments that are costly to all slower traders, including the traditional market makers. Even a small cost of maintaining continuous market presence makes market makers adjust their inventory holdings to levels that can be too low to offset temporary liquidity imbalances. A large enough sell order can lead to a liquidity-based crash accompanied by high trading volume and large price volatility - which is what occurred in the E-mini S&P 500 stock index futures contract on May 6, 2010, and then quickly spread to other markets. Based on our results, appropriate regulatory actions should aim to encourage HFTs to provide immediacy, while discouraging them from demanding it, especially at times of significant, but temporary liquidity imbalances. In fast automated markets, this can be accomplished by a more diligent use of short-lived trading pauses that temporarily halt the demand for immediacy, especially if significant order flow imbalances are detected. These short pauses followed by coordinated re-opening procedures would force market participants to coordinate their liquidity supply responses in a pre-determined manner instead of seeking to demand immediacy ahead of others.
Number of Pages in PDF File: 45
Keywords: High Frequency Trading, Algorithmic Trading, Flash Crash, Liquidity, Volatility, Price Impact, May 6
JEL Classification: G12, G13, G18, G28working papers series
Date posted: May 27, 2011 ; Last revised: May 6, 2014
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