The endogenous dynamics of markets: price impact and feedback loops
AbstractWe review the evidence that the erratic dynamics of markets is to a large extent of endogenous origin, i.e. determined by the trading activity itself and not due to the rational processing of exogenous news. In order to understand why and how prices move, the joint fluctuations of order flow and liquidity - and the way these impact prices - become the key ingredients. Impact is necessary for private information to be reflected in prices, but by the same token, random fluctuations in order flow necessarily contribute to the volatility of markets. Our thesis is that the latter contribution is in fact dominant, resulting in a decoupling between prices and fundamental values, at least on short to medium time scales. We argue that markets operate in a regime of vanishing revealed liquidity, but large latent liquidity, which would explain their hyper-sensitivity to fluctuations. More precisely, we identify a dangerous feedback loop between bid-ask spread and volatility that may lead to micro-liquidity crises and price jumps. We discuss several other unstable feedback loops that should be relevant to account for market crises: imitation, unwarranted quantitative models, pro-cyclical regulation, etc.
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Bibliographic InfoPaper provided by arXiv.org in its series Papers with number 1009.2928.
Date of creation: Sep 2010
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Web page: http://arxiv.org/
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-09-25 (All new papers)
- NEP-CBA-2010-09-25 (Central Banking)
- NEP-MST-2010-09-25 (Market Microstructure)
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