Dynamic Coupling and Market Instability

TL;DR

This paper investigates how the dynamic interactions and feedback loops between high-frequency traders can unintentionally destabilize financial markets, leading to price spikes and crashes, regardless of the complexity of trading strategies.

Contribution

It introduces a general recurrence-based framework to model HFT interactions and demonstrates how latency and feedback can cause market instability.

Findings

Unintentional market instability can arise from HFT feedback loops.

Even stable strategies are susceptible to destabilization.

Market feedback can trigger significant price movements.

Abstract

We examine dynamic coupling and feedback effects between High Frequency Traders (HFTs) and how they can destabilize markets. We develop a general framework for modelling dynamic interaction based on recurrence relations, and use this to show how unexpected latency and feedback can trigger oscillatory instability between HFT market makers with inventory constraints. Our analysis suggests that the modelled instability is an unintentional emergent behaviour of the market that does not depend on the complexity of HFT strategies - even apparently stable strategies are vulnerable. Feedback instability can lead to substantial movements in market prices such as price spikes and crashes.