Systemic Liquidity Risk and Bipolar Markets: Wealth Management in Today's Macro Risk On/Risk Off Financial Environment

5

Detecting Mini Bubbles with the VPIN Metric

The key elements of the Flash Crash have been described in the previous chapter and an outline of the framework within which electronic market making takes place has been provided. Apart from its value in providing a possibility for a forensic analysis of this bout of systemic illiquidity there is an opportunity to build on the foundation stones provided by this type of micro-structural analysis to gain useful insights about macro-financial phenomena such as a full blown crisis.

The micro framework provides the opportunity for scaling purposes to enable us to gain much greater insight into the developments of imbalances which self-organize themselves into critical states and following which a tipping point is reached – a Minsky moment – and markets suddenly display dangerous non-linear dynamics (recall the sand-piles from Chapter 1). A big part of the difficulty in improving our theoretical assumptions in macro finance and economics can ultimately be traced back to erroneous views – allegedly from common sense – about the nature of causation and the need to find large causes for large effects. Understanding the logic of bubbles and the dynamics which allow them to become unsustainably large is vital to a new framework in finance and economics. This will be taken up as a challenge in the latter part of this book but it will be helpful at this stage to look at some groundbreaking work which fits the test for a new paradigm in macro finance. ...