The Microstructure of the ‘Flash Crash’: Flow Toxicity, Liquidity Crashes and the Probability of Informed Trading
Cornell University - Department of Economics
Marcos Lopez de Prado
Guggenheim Partners, LLC; Lawrence Berkeley National Laboratory; Harvard University - RCC
Cornell University - Samuel Curtis Johnson Graduate School of Management
November 19, 2010
The Journal of Portfolio Management, Vol. 37, No. 2, pp. 118-128, Winter 2011
The ‘flash crash’ of May 6th 2010 was the second largest point swing (1,010.14 points) and the biggest one-day point decline (998.5 points) in the history of the Dow Jones Industrial Average. For a few minutes, $1 trillion in market value vanished. In this paper, we argue that the ‘flash crash’ is the result of the new dynamics at play in the current market structure. We highlight the role played by order toxicity in affecting liquidity provision, and we show that a measure of this toxicity, the Volume-Synchronized Probability of Informed Trading (VPIN)*, captures the increasing toxicity of the order flow in the hours and days prior to collapse. Since the ‘flash crash’ might have been avoided had liquidity providers remained in the marketplace, a solution is proposed in the form of a ‘VPIN contract’ which would allow them to dynamically monitor and manage their risks.
Number of Pages in PDF File: 15
Keywords: Flash crash, liquidity, flow toxicity, market microstructure, VPIN
JEL Classification: C02, D52, D53, G14
Date posted: October 22, 2010 ; Last revised: January 31, 2011
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