The Microstructure of the “Flash Crash”: Flow Toxicity, Liquidity Crashes, and the Probability of Informed Trading

The “flash crash” of May 6, 2010, was the second-largest point swing (1,010.14 points) and the biggest one-day point decline (998.5 points) in the history of the Dow Jones Industrial Average. For a few minutes, $1 trillion in market value vanished. In this article, the authors argue that the flash crash was the result of the new dynamics at play in the current market structure. They highlight the role played by order toxicity in affecting liquidity provision, and they show that a measure of this toxicity, the volume synchronized probability of informed trading (VPIN), captures the increasing toxicity of the order flow in the hours and days prior to collapse. Because the flash crash might have been avoided had liquidity providers remained in the marketplace, a solution is proposed in the form of a “VPIN contract” that would allow liquidity providers to dynamically monitor and manage their risks. TOPICS: Financial crises and financial market history , exchanges/markets/clearinghouses , in markets