Prices Vibrate Before They Crash

When an earthquake strikes, its relatively mild P-waves travel through the earth faster than the powerful S-waves that cause the severe shaking. Taking advantage of this speed difference, usually just a few seconds, earthquake early warnings systems have alerted people so that they could take shelter.

Can investors be alerted of destructive "earthquakes" in financial markets? Menkveld and Yueshen (2019) find that there seem to have been early signals---like P-waves---preceding the major price crash in one of the most notorious recent earthquakes in financial markets, the Flash Crash on May 10, 2010.                                                                                                                                      

Prices vibrated heavily across venues, seconds before they plummeted. More precisely, price dispersion across venues became unusually large, bids did not equilibrate across markets, nor did asks. This is observed for S&P 500 trading through E-mini and SPY, ground zero of the Flash Crash. But it is also shown for the 31 most heavily crashed constituent stocks.

The graph below illustrates it for one of these stocks: 3M. The top panel shows how the midquote in BATS, one of the many venues, starts to deviate substantially from the midquotes in other venues right before the edge of the steep cliff. The horizontal lines in the bottom panel indicate when cross-venue price dispersion becomes abnormally large, judged by a standard statistical tool adopted by the researchers. These statistical alerts merely formalize what can be seen with the naked eye in the top panel, but they could also be used to track many securities in many markets instantaneously, thus creating signals for increased risk of imminent destructive S-waves.

3M stocks

The authors further show that such cross-venue price fluctuations indicate impaired cross-market arbitrage, a form of liquidity provision, which would in normal times tightly link prices across venues and keep them integrated. When such arbitrage weakens or breaks, a liquidity demander in a single market effectively only leans on local liquidity suppliers. For example, when a large seller only meets local buyers, her trades, however small, could easily push the price down, deviating from the prices in other venues. Price dispersion thus arises.

Early detection of such price dispersion is important, not only for regulators but also for market participants. As a case in point, the authors show that a large seller, a mutual fund complex, in the E-mini market suffered substantial price impact when executing her position in the period of the Flash Crash. They show that this price impact is about one-fifth the size of the seller's total assets.

Securities markets have become increasingly fragmented. For example, for U.S. equities, there are a dozen stock exchanges, numerous crossing networks, dark pools, over-the-counter trading options, etc. The 2010 Flash Crash could be read as a cautionary tale about such fragmentation. Investors could pay a high price for demanding liquidity when cross-market arbitrage weakens. They might want to follow the miners and buy a canary.

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Menkveld AJ, Yueshen BZ (2018). The Flash Crash: A Cautionary Tale About Highly Fragmented Markets. Management Science 65(10):4470-4488.