Abstract
Crashes have fascinated and baffled many canny observers of financial markets. In the strict orthodoxy of the efficient market theory, crashes must be due to sudden changes of the fundamental valuation of assets. However, detailed empirical studies suggest that large price jumps cannot be explained by news and are the result of endogenous feedback loops. Although plausible, a clear-cut empirical evidence for such a scenario is still lacking. Here we show how crashes are conditioned by the market liquidity, for which we propose a new measure inspired by recent theories of market impact and based on readily available, public information. Our results open the possibility of a dynamical evaluation of liquidity risk and early warning signs of market instabilities, and could lead to a quantitative description of the mechanisms leading to market crashes.
Highlights
Accepted: September 11, 2015Published: October 8, 2015
The main driver of market crashes is the mismatch between the aggregate market order flow imbalance (O, defined below) that becomes strongly negative and the prevailing liquidity on the buy side, i.e. the density of potential buyers below the current price
Whereas the former quantity can be reconstructed from the series of trades, the notion of “prevailing liquidity” is only at best ambiguous. It is only when the price starts heading down, that one expects most of the interested buyers to declare themselves and post orders in the order book
Summary
Accepted: September 11, 2015Published: October 8, 2015. The main driver of market crashes is the mismatch between the aggregate market order flow imbalance (O, defined below) that becomes strongly negative and the prevailing liquidity on the buy side, i.e. the density of potential buyers below the current price.
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