Why Do Markets Crash? Bitcoin Data Offers Unprecedented Insights

TL;DR

This paper investigates the causes of market crashes, focusing on Bitcoin data, and introduces a new liquidity measure that helps understand and potentially predict market instabilities.

Contribution

It proposes a novel liquidity measure based on public information and demonstrates its role in conditioning market crashes, offering a new approach to understanding market dynamics.

Findings

Crashes are conditioned by market liquidity levels.

A new liquidity measure correlates with crash occurrences.

Potential for early warning signals of market instability.

Abstract

Crashes have fascinated and baffled many canny observers of financial markets. In the strict orthodoxy of the efficient market theory, crashes must be due to sudden changes of the fundamental valuation of assets. However, detailed empirical studies suggest that large price jumps cannot be explained by news and are the result of endogenous feedback loops. Although plausible, a clear-cut empirical evidence for such a scenario is still lacking. Here we show how crashes are conditioned by the market liquidity, for which we propose a new measure inspired by recent theories of market impact and based on readily available, public information. Our results open the possibility of a dynamical evaluation of liquidity risk and early warning signs of market instabilities, and could lead to a quantitative description of the mechanisms leading to market crashes.