Staff Working Paper No. 743
By Geir-Are Kårvik, Joseph Noss, Jack Worlidge and Daniel Beale
This paper examines the role of high-frequency traders in flash episodes in electronic financial markets. To do so, we construct an agent-based model of a market for a financial asset in which trading occurs through a central limit order book. The model consists of heterogeneous agents with different trading strategies and frequencies, and is calibrated to high-frequency time series data on the sterling-US dollar exchange rate. Flash episodes occur in the model due to the procyclical behaviour of high-frequency market participants. This is aligned with some empirical evidence as to the drivers of real-world flash crashes. We find that the prevalence of flash episodes increases with the frequency with which high-frequency market participants trade compared to their low-frequency counterparts. This provides tentative theoretical evidence that the recent growth in high-frequency trading across some markets has led to flash episodes. Furthermore, we adapt the model so that large movements in price trigger temporary halts in trading (ie circuit breakers). This is found to reduce the magnitude and frequency of flash episodes.