Understanding flash crash contagion and systemic risk: A micro–macro agent-based approach

Abstract

The purpose of this paper is to advance the understanding of the conditions that give rise to flash crash contagion, particularly with respect to overlapping asset portfolio crowding. To this end, we designed, implemented, and assessed a hybrid micro-macro agent-based model, where price impact arises endogenously through the limit order placement activity of algorithmic traders. Our novel hybrid microscopic and macroscopic model allows us to quantify systemic risk not just in terms of system stability, but also in terms of the speed of financial distress propagation over intraday timescales. We find that systemic risk is strongly dependent on the behaviour of algorithmic traders, on leverage management practices, and on network topology. Our results demonstrate that, for high-crowding regimes, contagion speed is a non-monotone function of portfolio diversification. We also find the surprising result that, in certain circumstances, increased portfolio crowding is beneficial to systemic stability. We are not aware of previous studies that have exhibited this phenomenon, and our results establish the importance of considering non-uniform asset allocations in future studies. Finally, we characterise the time window available for regulatory interventions during the propagation of flash crash distress, with results suggesting ex ante precautions may have higher efficacy than ex post reactions.

Does Islamic Banking Promote Financial Stability? Evidence From an Agent-Based Model

“…Finally, many studies analyse financial contagion and systemic risk by performing simulations through agent-based models of interbank markets and credit interlinkages. Paulin, Calinescu, & Wooldridge (2019) characterise systemic risk in terms of both system stability and the speed of financial distress propagation over intraday timescales. Arinaminpathy, Kapadia, and May (2012) designed a model banking system which combined three channels: liquidity hoarding, asset price contagion, and the propagation of defaults via counterparty credit risk.…”

Systemic Implications of the Bail-In Design

“…In line with the contagion literature (see e.g. Gai and Kapadia (2010), Caccioli et al (2014) and Paulin et al (2018)), we average our results across realisations of the reconstructed networks to remove dependency on the probabilistic realisation. In Online Appendix B, we describe data to construct the bipartite multi-layered network of banks, non-banks and their interconnections in more detail.…”

Space‐Time Money

“…One could even imagine central banks having exchange colocations at major exchanges in order to be able to increase liquidity quickly, in the case of flash crashes, for example. Flash crashes have been considered a major challenge for modern financial markets; see Kirilenko et al (2017), Tsai (2018), and Paulin et al (2019), where the risk seems to have followed the introduction of exchange colocation. Could it be that if the loan maturities and credit markets followed the high-speed evolution that has happened in security transactions, speed could actually reduce the risk of flash crashes?…”