page_title: 2010 flash crash
section_title: Academic research
hierarchical_section_title: 2010 flash crash / Explanation / Academic research
caption_attribution_description: English: Network snapshots before (left) and during (right) the simulated flash crash. The nodes represent the HFT agents and the color range represent the inventory size.
context_page_description: The May 6, 2010, flash crash, also known as the crash of 2:45 or simply the flash crash, was a United States trillion-dollar stock market crash, which started at 2:32 p.m. EDT and lasted for approximately 36 minutes.
context_section_description: As of July 2011, only one theory on the causes of the flash crash was published by a Journal Citation Reports indexed, peer-reviewed scientific journal. It was reported in 2011 that one hour before its collapse in 2010, the stock market registered the highest reading of "toxic order imbalance" in previous history. The authors of this 2011 paper apply widely accepted market microstructure models to understand the behavior of prices in the minutes and hours prior to the crash. According to this paper, "order flow toxicity" can be measured as the probability that informed traders (e.g., hedge funds) adversely select uninformed traders (e.g., market makers). For that purpose, they developed the Volume-Synchronized Probability of Informed Trading (VPIN) Flow Toxicity metric, which delivered a real-time estimate of the conditions under which liquidity is being provided. If the order imbalance becomes too toxic, market makers are forced out of the market. As they withdraw, liquidity disappears, which increases even more the concentration of toxic flow in the overall volume, which triggers a feedback mechanism that forces even more market makers out. This cascading effect has caused hundreds of liquidity-induced crashes in the past, the flash crash being one (major) example of it.
  However, independent studies published in 2013 strongly disputed the claim that one hour before its collapse in 2010, the stock market registered the highest reading of "toxic order imbalance" in previous history. In particular, in 2011 Andersen and Bondarenko conducted a comprehensive investigation of the two main versions of VPIN used by its creators, one based on the standard tick-rule (or TR-VPIN) and the other based on Bulk Volume Classification (or BVC-VPIN). They find that the value of TR-VPIN (BVC-VPIN) one hour before the crash "was surpassed on 71 (189) preceding days, constituting 11.7% (31.2%) of the pre-crash sample". Similarly, the value of TR-VPIN (BVC-VPIN) at the start of the crash was "topped on 26 (49) preceding days, or 4.3% (8.1%) of the pre-crash sample".
  Note that the source of increasing "order flow toxicity" on May 6, 2010, is not determined in Easley, Lopez de Prado, and O'Hara's 2011 publication. Whether a dominant source of toxic order flow on May 6, 2010, was from firms representing public investors or whether a dominant source was intermediary or other proprietary traders could have a significant effect on regulatory proposals put forward to prevent another flash crash. According to Bloomberg, the VPIN metric is the subject of a pending patent application filed by the paper's three authors, Maureen O'Hara and David Easley of Cornell University, and Marcos Lopez de Prado, of Tudor Investment Corporation.
  A study of VPIN by scientists from the Lawrence Berkeley National Laboratory cited the 2011 conclusions of Easley, Lopez de Prado and O'Hara for VPIN on S&P 500 futures but provided no independent confirmation for the claim that VPIN reached its historical high one hour before the crash:
  With suitable parameters, [Easley, Lopez de Prado, and O'Hara] have shown that the [CDF of] VPIN reaches 0.9 more than an hour before the Flash Crash on May 6, 2010. This is the strongest early warning signal known to us at this time.
  The Chief Economist of the Commodity Futures Trading Commission and several academic economists published a working paper containing a review and empirical analysis of trade data from the Flash Crash. The authors examined the characteristics and activities of buyers and sellers in the Flash Crash and determined that a large seller, a mutual fund firm, exhausted available fundamental buyers and then triggered a cascade of selling by intermediaries, particularly high-frequency trading firms. Like the SEC/CFTC report described earlier, the authors call this cascade of selling "hot potato trading", as high-frequency firms rapidly acquired and then liquidated positions among themselves at steadily declining prices.
  The authors conclude:
  Based on our analysis, we believe that High Frequency Traders exhibit trading p
caption: Network snapshots before (left) and during (right) the simulated flash crash. The last 400 transactions in the order-book are plotted by connecting the HFT agents who transact with each other. The node color indicates the inventory size of the HFT agent. When the market operates normally (left subplot), almost all of the HFT agents are in control of their inventory (greenish color). In crash period (right), most of the HFT agents gain large inventories (red) and the network is highly interconnected: over 85 percent of the transactions are HFT-HFT.[52]
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