Can a simple mathematical formula prevent another Flash Crash? A pair of Cornell professors and a hedge fund trader say they have found the key to avoiding another market plunge.
As regulators mull market-making obligations for high-frequency traders, two Cornell University professors and the head of high-frequency futures trading at hedge fund Tudor Investments claim to have developed a new metric that can pave the way for a market-based solution to liquidity shortages like the May 6, 2010, event. In a paper released this past fall, Tudor's Marcos Lopez de Prado and Cornell's David Easley and Maureen O'Hara outline a new metric -- Volume Synchronized Probability of Informed Trading, or VPIN -- that detects when orders are becoming toxic for market makers.
High order toxicity can set off a chain of events that prompts electronic market makers to stop supplying liquidity in order to stave off severe losses, which in turn can fuel a liquidity crisis and spark a crash like the one that played out so dramatically this past May. Order flow is considered toxic when it is initiated by counterparties armed with surefire information on the direction the market is heading. This can lead to a trade imbalance that can trigger significant losses for market makers if they don't unload their positions.
"In the case of May 6, the market makers were buying stocks and it became very hard for them to turn the portfolio around to sell," Lopez de Prado explains. "They accumulated losses and at some point had to shut their portfolios down and vanish from the market. The crash occurred because there was no liquidity."
Experts note that in the current marketplace such scenarios are playing out with alarming frequency, albeit on a much smaller scale. In February, for example, Apple saw its market capitalization briefly plummet about $10 billion in a matter of minutes before recovering. And this past fall, shares of Progress Energy were soaring along at $44.57 each before crashing to $4.57 in a matter of seconds. Shares of the Washington Post Co. and Citigroup also experienced similar drops in 2010.
Such plunges can be damaging for high-frequency market makers since they're operating with far less capital than traditional market makers and are saddled with more leverage. But these mini-flash crashes have become a common occurrence since market makers are forced to withdraw from the market much more often than they once did.
"In the old days on the New York Stock Exchange it was the specialists who were making the market, and they had a firm obligation to provide liquidity," says Easley, who is chairman of the economics department at Cornell and has spent the past 20 years studying how orders on exchanges affect stock prices. "It was always difficult to enforce, but it was there. Liquidity is now provided in many markets by these high-frequency guys."
According to the researchers, however, the VPIN metric can be fleshed out into a type of futures contract that can enable market makers to hedge against rising toxicity. In turn, market makers can continue supplying liquidity in a toxic market, which, in theory, should prevent a recurrence of the May 6 plunge.
"What we hope -- and we don't know yet -- is that there may be a market-based solution to this problem by simply providing a futures contract with payoffs based on VPIN," says Easley, who is married to O'Hara. "If market makers can use that as a way to lay off their risk, they don't have to withdraw [from the market]."
The theory may find a friendly ear with regulators since O'Hara, who is chairman of the board at Investment Technology Group, is also a member of the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues. Tudor's Lopez de Prado contends that regulators should consider designing a circuit breaker based on VPIN instead of price changes.
"By the time the price has dropped 10 or 20 percent, it's already too late; the damage is done," Lopez de Prado says. "But they could design circuit breakers in terms of toxicity, which is a good predictor of volatility."