How do Extreme Price Movements End?

Abstract

We test competing theories of liquidity dynamics during extreme price movements (EPMs). 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 EPM. This goes counter to a widespread concern that market making constraints cause liquidity to deteriorate as EPMs develop. The prevailing limit order book dynamics during EPMs are in line with Weill’s (2007) socially beneficial equilibrium.

Keywords: extreme price movements, price pressures, strategic liquidity provision

JEL Classification: G10, G14