Liquidity and Toxicity Contagion

David Easley, Marcos López de Prado and Maureen O’Hara

Legislative changes in the US (Regulation National Market System (Reg NMS)) of 2005 and Europe (Markets in Financial Instruments Directive (MiFID), in force since November 2007), preceded by substantial technological advances in computation and communication, have revolutionised the financial markets. MiFID fosters greater competition among brokers, with the objective of improving liquidity, cohesion and depth in financial markets. Similarly, Reg NMS encourages competitiveness among exchanges by allowing market fragmentation. Cohesion across markets is recovered through a mechanism for the consolidation of individual orders processed in multiple venues into a single best bid or offer price for the market as a whole (the National Best Bid and Offer (NBBO)). Since the arrival of trading in multiple markets, an “arms race” has developed for the technology and quantitative methods that can squeeze out the last cent of profitability when serving the demands of market participants, hence the advent of high-frequency trading. Easley et al (2011a) have argued that these changes are related to a number of new trends in market microstructure.

One area where this competition is particularly

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