The Exchange of Flow Toxicity

Abstract

Flow toxicity can be measured in terms of the probability that a liquidity provider is adversely selected by informed traders. In previous papers the authors introduced the concept of Volume-synchronized Probability of Informed Trading (the VPIN^* metric) and provided a robust estimation procedure. In this study, they discuss the asymmetric impact that an incorrect estimation of the VPIN metric has on a market maker’s performance. This asymmetry may be part of the explanation for the evaporation of liquidity witnessed on May 6th 2010. To mitigate that undesirable behavior, they present the specifications of a VPIN contract, which could be used to hedge against the risk of higher than expected levels of toxicity, as well as to monitor such risk. Among other applications, it would also work as an execution benchmark and a price discovery mechanism, since it allows for the externalization of market participants’ views of future toxicity.