Abstract
We test competing theories of liquidity dynamics during extreme volatility spikes (EVSs). We find that liquidity providers strategically allow for price pressures and are compensated from correcting pricing errors. As a result, liquidity provision intensifies toward the end of a typical EVS. This goes counter to a widespread concern that market-making constraints cause liquidity to deteriorate as EVSs develop. The prevailing limit order book dynamics during EVSs are in line with the socially beneficial equilibrium presented in the theoretical literature.
This paper was accepted by Agostino Capponi, finance.
Supplemental Material: The data files are available at https://doi.org/10.1287/mnsc.2022.04104 .