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 nearly 10 percent against the US dollar within around 40 seconds, one of the sharpest moves a major currency has ever made. The BIS Markets Committee found no single cause: selling, amplified by options-related hedging and, to a lesser extent, stop-loss orders, hit a market with very little liquidity present at that hour, and as the price fell, liquidity providers, automated and human alike, widened their prices or stopped quoting, so that orders met an almost empty order book and pushed the price violently. A sterling-negative Financial Times headline about President Hollande appeared at 00:07:13 British time, after the first moves; the BIS says it carried no new information and could at most have added weight at the margins. Most of the move reversed within the ten minutes that followed. 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 nearly 10 percent because there was almost nothing on the other side to absorb it. On the BIS reading the decisive condition was not any single order but the emptiness of the market the selling hit, 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: selling hit the pound in the thinnest hours of Asian trading, met an almost empty book, and drove a move of nearly 10 percent in under a minute 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.

It is free. We do not sell the list and there is nothing to buy at the end of it.