Academics studying the May 2010 crash, which saw stock prices plummet and recover in the space of minutes, have called for the introduction of liquidity safety valves to go alongside standard price-based circuit breakers.
The findings come from a new paper Illiquidity Contagion and Liquidity Crashes by Dr Giovanni Cespa of Cass Business School, part of City University London, and Thierry Foucault from HEC School of Management in Paris.
They argue that the advent of high frequency trading has led to markets becoming progressively intertwined. This means that liquidity suppliers in one asset class increasingly rely on the prices of other asset classes to set their quotes.
According to the authors, such cross-asset learning generates a self-reinforcing positive relationship between price informativeness (the amount of information about an asset fundamental value that is provided by its price) and liquidity. As a result different market “regimes” characterized either by high illiquidity and low price informativeness or low illiquidity and high price informativeness can arise.
“Markets can therefore hover in different liquidity states for the same set of underlying fundamentals. This means that for a given underlying, the market can be in a high or a low illiquidity regime,” said Dr Cespa.
“In the former state, aggregate order realizations due to temporary price pressures trigger huge price adjustments. In the latter, the same realisations command milder price movements. Thus, the price impact of orders of a certain size is not univocally determined. Within this framework, a switch from the low to the high illiquidity equilibrium is what causes a flash crash.”
Stock market rout
Dr Cespa said the findings indicate that the ‘limit-up/limit-down’ circuit breaker system coming into force in the US next year may fail to prevent another stock market rout.
'This liquidity evaporation may materialise in one market first, triggering a spiral that drags all assets into the illiquid regime', said Dr Cespa.
'Price based circuit breakers do not necessarily offer a good protection against such illiquidity spirals because the latter may happen without trades and therefore without changes in prices'.
To counter the risk of illiquidity spirals, the authors argue new 'illiquidity-based circuit breakers' should be introduced in tandem with price-based circuit breakers. They say trading could be stopped when market wide depth falls below a specified threshold.
'It could be an effective way to block an illiquidity spiral at its inception and thereby help traders to re-coordinate on a regime with higher liquidity', added Dr Cespa.
In the study, the researchers also provide an explanation for the dismal performance of ETFs during the 'flash crash'. Indeed, all the transactions that occurred with a price drop in excess of 60% during the crash were successively broken by exchanges. Interestingly, ETFs account for nearly 70% of the securities involved in those transactions.
Dr Cespa explained: “The fact that the market can hover into two liquidity states has implications for the ability of cross-market arbitrageurs to provide liquidity.
'Indeed, cross-market arbitrageurs diversify the risk associated with their position in one asset by taking an offsetting position in another (correlated) asset. As specialized dealers are the counterparties to this offsetting trade, liquidity provision by cross-market arbitrageurs rests on liquidity provision by specialized dealers.
'As a liquidity crash is characterized by a drastic reduction in specialized dealers’ liquidity supply, it leads cross-market arbitrageurs to curtail their liquidity provision as well. This can explain the severe price disruption in the ETF’s market, as well as the why the dispersion of price differentials between assets can increase considerably during a liquidity crash, leading to the perception of major price dislocations'.
‘Illiquidity contagion and liquidity crashes’ by Giovanni Cespa of Cass Business School and Thierry Foucault of HEC School of Management, Paris