Learning about Toxicity: Why Order Imbalance Can Destabilize Markets

54 Pages Posted: 13 Dec 2018

See all articles by Nihad Aliyev

Nihad Aliyev

University of Technology Sydney (UTS) - School of Finance and Economics

Xuezhong He

University of Technology Sydney (UTS) - Finance Discipline Group, Business School; Financial Research Network (FIRN)

Tālis J. Putniņš

University of Technology Sydney (UTS); Stockholm School of Economics, Riga

Date Written: November 19, 2018

Abstract

How does a market digest order imbalance? We show that when market participants learn about the level of adverse selection (the risk of trading against better-informed counterparties) from order flow, a large order imbalance can be destabilizing, causing sharp price movements and evaporation of liquidity, as it signals high toxicity. While such effect is consistent with the practitioner view that order flow is informative about toxicity, it contrasts with standard microstructure models in which the level of adverse selection is assumed to be known and thus order imbalance improves liquidity by revealing private information. Our model helps to understand when markets are most susceptible to imbalance-induced instability and the dynamic process of how markets digest order imbalance.

Keywords: Flow toxicity, market instability, order imbalance, multidimensional uncertainty

JEL Classification: G14, D81, D83

Suggested Citation

Aliyev, Nihad and He, Xue-Zhong 'Tony' and Putnins, Talis J., Learning about Toxicity: Why Order Imbalance Can Destabilize Markets (November 19, 2018). Available at SSRN: https://ssrn.com/abstract=3286933 or http://dx.doi.org/10.2139/ssrn.3286933

Nihad Aliyev (Contact Author)

University of Technology Sydney (UTS) - School of Finance and Economics ( email )

Haymarket
Sydney, NSW 2007
Australia

Xue-Zhong 'Tony' He

University of Technology Sydney (UTS) - Finance Discipline Group, Business School ( email )

Haymarket
Sydney, NSW 2007
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Talis J. Putnins

University of Technology Sydney (UTS) ( email )

PO Box 123
Broadway
Sydney
Australia
+61 2 9514 3088 (Phone)

Stockholm School of Economics, Riga ( email )

Strelnieku iela 4a
Riga, LV 1010
Latvia
+371 67015841 (Phone)

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