The Exchange of Flow Toxicity
The Journal of Trading, Vol. 6, No. 2, pp. 8-13, Spring 2011
12 Pages Posted: 27 Jan 2011 Last revised: 27 Feb 2012
Date Written: January 17, 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.
Keywords: Liquidity Provision, Flow Toxicity, Market Microstructure, VPIN
JEL Classification: C51, C53, G10, G12, G14
Suggested Citation: Suggested Citation