Executing into thin liquidity

Graduate · enrolled learners

This lesson opens with The sterling flash crash, 7 October 2016.

What happened

In the early hours of Asian trading, when the market for the British pound is at its thinnest, the pound fell about six percent against the US dollar in roughly two minutes, one of the sharpest moves a major currency has ever made. Analyses attributed the crash to selling, much of it automated, hitting a market with very little liquidity present at that hour, possibly set off by a news headline, so that ordinary-sized orders met an almost empty order book and pushed the price violently. The pound partially recovered soon after. Nothing was broken and no single actor was clearly at fault; the same selling that would have been absorbed with little effect during liquid London or New York hours instead moved the price six percent because there was almost nothing on the other side to absorb it. The size of the orders was not unusual; the emptiness of the market they hit was, and impact is size divided by the liquidity present, not size alone.

The decision point

The market impact of an order, how far it moves the price, depends not on its size alone but on the liquidity present to absorb it, so the same order that barely moves a deep market can move a thin one violently, and the thinness of a market varies enormously by time of day, by instrument, and by conditions. The sterling flash crash is the case: ordinary-sized selling hit the pound in the thinnest hours of Asian trading, met an almost empty book, and drove a six percent move in minutes that liquid hours would have absorbed with little trace. This is why execution must be aware of liquidity: an execution algorithm that decides how fast and how hard to trade based only on the size it wants to move, ignoring how much liquidity is actually there, will cause huge slippage and impact whenever it happens to trade into a thin market. The mental model is that impact is roughly size relative to available liquidity, so the same execution is gentle in a deep market and destructive in a thin one, and a system blind to the difference is trading with its eyes closed at exactly the moments, off-hours, stressed conditions, illiquid instruments, when the difference is largest. So the discipline is to make an execution account for the liquidity actually present: to slow down, wait, or reduce size when the book is thin and the hour is wrong, rather than working an order at a fixed pace regardless of what is there to trade against, because the sterling flash crash showed that it is not the size of an order but the emptiness of the market it meets that determines the damage.

Orientation and Year One are open: anyone can read them without an account. From Year Two onward the lessons are for enrolled learners, because progress through the later years only means anything if it is tracked against a record.

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