The Exchange of Flow Toxicity
Cornell University - Department of Economics
Marcos Lopez de Prado
Hess Energy Trading Company; Lawrence Berkeley National Laboratory; RCC at Harvard University
Cornell University - Samuel Curtis Johnson Graduate School of Management
January 17, 2011
The Journal of Trading, Vol. 6, No. 2, pp. 8-13, Spring 2011
Johnson School Research Paper Series No. 10-2011
Flow toxicity can be measured in terms of the probability that a liquidity provider is adversely selected by informed traders. In previous papers we introduced the concept of Volume-synchronized Probability of Informed Trading (the VPIN* metric), and provided a robust estimation procedure. In this study, we discuss the asymmetric impact that an incorrect estimation of the VPIN metric has on a market maker’s performance. This asymmetry may be part of the explanation for the evaporation of liquidity witnessed on May 6th 2010. To mitigate that undesirable behavior, we present the specifications of a VPIN contract, which could be used to hedge against the risk of higher than expected levels of toxicity, as well as to monitor such risk. Among other applications, it would also work as an execution benchmark, and a price discovery mechanism, since it allows for the externalization of market participants’ views of future toxicity.
Number of Pages in PDF File: 12
Keywords: Liquidity Provision, Flow Toxicity, Market Microstructure, VPIN
JEL Classification: C51, C53, G10, G12, G14Accepted Paper Series
Date posted: January 27, 2011 ; Last revised: February 27, 2012
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