Formula May Pave Way to Stopping Flash Crashes By Justin Grant (mailto:firstname.lastname@example.org) March 07, 2011 URL: (http://advancedtrading.com/infrastructure/229300493) Marcos Lopez de Prado, head of high-frequency futures trading at Tudor Investments, explains why a metric he developed with Cornell University professors Maureen O'Hara and David Easley (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1695041) may hold the key to stopping a repeat of the market events of May 6, 2010. In an interview with Advanced Trading, Lopez de Prado sheds light on how Volume Synchronized Probability of Informed Trading, or VPIN, can enable high frequency market makers to continue supplying liquidity in times of stress, stopping sudden market plunges in their tracks. How can VPIN keep high-frequency market makers supplying liquidity despite toxic order flow? Marcos Lopez de Prado: This model identifies when order flow toxicity is negatively impacting the performance of market makers, either because volume is imbalanced, there is an increase in the rate of trading, or a combination of both. If this information could be made available in the form of a contract, market makers could hedge against losses they would incur if toxicity keeps increasing. So you could see it in a similar way that the VIX -- the Chicago Board Options Exchange Volatility Index -- is used to hedge against increases in volatility. VPIN could be used to hedge against increases in order flow toxicity. What makes order flow toxic to market makers? Lopez de Prado: An order flow is considered toxic when market makers provide liquidity at their own expense. Market makers are constantly in the market providing bids and offers, or providing a trading range around the bid and offer. But if toxicity increases, they start to accumulate inventory on a particular side and this inventory begins to lose money. In many cases they shut the portfolio down and call it a day or they have to widen the spread they're providing liquidity at. So order flow becomes toxic when it selects market makers adversely. Why is it important for high-frequency market makers to be able to detect order toxicity? Lopez de Prado: Because of what happened during the Flash Crash. On May 6, the order flow was the most toxic it's been in recent history. That day illustrates what happens to market makers when they operate under extreme toxicity. In this case they were selected to buy stocks and it became very hard for them to turn their portfolios around to sell. And the market kept going down. They accumulated losses. At some point they had to shut down their portfolios and vanish from the market. The crash occurred because there was no liquidity to support their loss-taking. The little liquidity that existed was drained by market makers who were leaving the market they were supposed to make. So once they note high toxicity, what can be done to keep the market makers involved? How can they do this within the context of VPIN? Lopez de Prado: There are many ways this model can be used. One way would be for regulators to design their circuit breakers based on VPIN instead of price changes. Because by the time the price has dropped 10 or 20 percent, it's already too late. The damage is already done. What they could do is to design circuit breakers in terms of toxicity which is a good predictor of illiquidity-induced volatility and that's one of the conclusions that we reached. Secondly, this model could be the basis for a futures contract that market makers could buy and sell in order to hedge against rises in toxicity. So that enables them to protect themselves and they can continue supplying liquidity in times of stress like during the Flash Crash? Lopez de Prado: Market makers do not have any way to hedge against the probability of adverse selection. They are always providing bids and offers, which exposes them to adverse selection. That people only trade with them if they have information could generate persistent losses for the market makers. Some days they could lose many times what they could make in a good day. What a contract on VPIN could do is provide a hedge against those extremely negative days. How necessary is such a contract in an environment where mini flash crashes seem to be occurring regularly? Lopez de Prado: Flash crashes are happening all the time. It's just that they don't reach the magnitude of May 6. But sudden drops of one or two percent are becoming more common and they are very damaging for market makers. High frequency market makers in particular run with very limited capital. They're not like the traditional market maker that would operate with large capital and little leverage and they could just withstand a position for several days. Once they face a loss of one or two percent, they have to liquidate and protect their firm. In these circumstances we're seeing many more mini flash crashes. Editor's Note: A more complete version of this interview will appear in the March digital issue of Advanced Trading.