Strategic Liquidity Provision and Extreme Volatility Spikes
Management Science, Forthcoming
93 Pages Posted: 14 Nov 2020 Last revised: 24 Dec 2022
Date Written: September 26, 2020
Abstract
We test competing theories of liquidity dynamics during extreme volatility spikes (EVSs). We find that liquidity providers strategically allow for price pressures and are compensated from correcting pricing errors. As a result, liquidity provision intensifies towards the end of a typical EVS. This goes counter to a widespread concern that market making constraints cause liquidity to deteriorate as EVSs develop. The prevailing limit order book dynamics during EVSs are in line with Weill’s (2007) socially beneficial equilibrium.
Keywords: extreme price movements, price pressures, strategic liquidity provision, extreme volatility spikes
JEL Classification: G10, G14
Suggested Citation: Suggested Citation