Speed Limits for Financial Markets? Not So Fast

IMF Blog, June 1, 2017

Source details

Event focus: On the afternoon of May 6, 2010, the "flash crash" produced a 998-point plunge in the Dow Jones Industrial Average that erased $1 trillion in market value in 36 minutes.
Research question: Do advances in information and communication technology amplify or dampen market volatility?
Study and authors: Barry Eichengreen, Arnaud Mehl, and Romain Lafarguette present evidence in an IMF working paper titled “Thick vs. Thin-Skinned: Technology, News and Financial Market Reaction.”

Thin-skinned hypothesis:
- Advances in information technology cause prices to react more violently to news by enabling strategies associated with volatility, such as algorithmic trading and stop-loss orders.
- High-frequency traders (popularized by Michael Lewis’s 2014 book, Flash Boys) are implicated in amplifying volatility.
Thick-skinned hypothesis:
- Advances in technology suppress volatility because faster information reduces the information disadvantages of uninformed investors.
- When information asymmetries fall, uninformed investors are less likely to engage in trend following or herd behavior.

Laboratory: The foreign exchange market, with average daily volumes exceeding $4 trillion (more than the combined GDP of Italy and Brazil).
Data and scope:
- 240,430 observations for 56 bilateral exchange rates against the dollar.
- Sample period: between January 1, 1997, and November 30, 2015.
Identification strategy:
- Markets divided into two groups: those with direct fiber-optic connections to major financial centers (Tokyo, London, New York) that receive news faster, and those without direct connections that receive news more slowly.
- Measured currency reactions to major US economic news such as changes in gross domestic product, consumer prices, and monetary policy.

Currencies traded in places with direct fiber-optic connections react less to major US economic news than currencies in places that receive news more slowly.
The reaction in markets with direct connections is 50 percent to 80 percent smaller.
Interpretation offered by the authors: faster transmission of market-moving news reduces volatility by leveling the informational playing field and reducing trend-following behavior among less informed investors.

The study’s evidence supports the thick-skinned hypothesis: broader and faster transmission of information can reduce market volatility.
The authors decline to take a position on policy proposals that would slow the velocity of data flows (for example, electronic “speed bumps” intended to damp asset-price volatility).
Policy takeaway: measures that increase information access and reduce informational asymmetries may help suppress volatility; slowing information flows is not clearly justified by these findings.

Source: Speed Limits for Financial Markets? Not So Fast — The Editors, June 1, 2017 (IMF).