The endogenous dynamics of markets: price impact and feedback loops

We review the evidence that the erratic dynamics of markets is to a
large extent of endogenous origin, i.e. determined by the trading
activity itself and not due to the rational processing of exogenous
news. In order to understand why and how prices move, the joint
fluctuations of order flow and liquidity – and the way these impact
prices – become the key ingredients. Impact is necessary for private
information to be reflected in prices, but by the same token, random
fluctuations in order flow necessarily contribute to the volatility of
markets. Our thesis is that the latter contribution is in fact dominant,
resulting in a decoupling between prices and fundamental
values, at least on short to medium time scales. We argue that markets
operate in a regime of vanishing revealed liquidity, but large
latent liquidity, which would explain their hyper-sensitivity to fluctuations.
More precisely, we identify a dangerous feedback loop
between bid-ask spread and volatility that may lead to microliquidity
crises and price jumps. We discuss several other unstable feedback
loops that should be relevant to account for market crises: imitation,
unwarranted quantitative models, pro-cyclical regulation, etc.