The metric was developed by David Easley and Maureen O’Hara, economists at Cornell University, and Marcos López de Prado, head of high-frequency trading research at the Tudor Investment hedge fund. The trio have filed a patent, and have urged regulators to use VPIN as a watchdog. “Some traders are going to have superior information, for a variety of reasons,” says Easley. “And if you have people with good information, they tend to buy. It becomes imbalanced on the buy side. From the point of view of a market maker, that’s toxic, because the market maker’s job is to provide liquidity.” Using VPIN, Easley and his team retroactively calculated that the stock market registered some of the highest readings of toxicity in recent history an hour before the flash crash.
Not everyone agrees that VPIN will be the market’s savior. The most prominent critics are Torben Andersen, a professor at Northwestern University’s Kellogg School of Management, and Oleg Bondarenko, a professor at the University of Illinois at Chicago. In a paper published in October 2011, they argued that “our empirical investigation of VPIN documents that it is a poor predictor of short run volatility, that it did not reach an all-time high prior [to], but rather after, the flash crash, and that its predictive content is due primarily to a mechanical relation with the underlying trading intensity.”
One problem, they note, is that VPIN conflates trading volume and time: Because trades are grouped sequentially and then by regular clock time, the delineation between two days’ trading sessions is unclear. In short, they argue, VPIN is “highly dependent on when exactly you start counting trades. If you start counting one day later than someone else, your groups will contain different trades and your VPIN will be different.” Using a slightly different data set (which they argue is more accurate historically), the two researchers had to start in 10 to 15 different places before they could replicate VPIN’s results. The implicit concern is that VPIN could dupe investors and analysts into a false sense of security.
Andersen says he has no desire to get into a mudslinging match, and that his work on the subject is ongoing, but that he has “accumulated additional strong evidence that VPIN is not working as advertised.” Easley says his group’s research on VPIN also continues, and that Andersen and Bondarenko simply performed a fundamentally “different analysis—reasonable, but different.”
Meanwhile, regulators are increasingly concerned about their ability to keep up with the trend toward ultra-fast trading; in the spring of 2012, the SEC went before Congress to ask for a 2013 budget increase of $245 million, largely to protect investors and to “strengthen oversight of market stability, and expand the agency’s information technology systems.” Meanwhile, the SEC has taken note of VPIN’s possibilities. In late 2011, the agency assigned a group from the University of California at Berkeley to investigate VPIN’s promise, and in a working paper, the Berkeley group wrote that VPIN did “indeed give strong signals ahead of the Flash Crash event on May 6 2010. This is a preliminary step toward a full-fledged early-warning system for unusual market conditions.”
Regulators and industry groups are also taking steps to humanize the world of computerized trading. In June 2012, a group of 24 brokers and traders sued CME Group, which owns major commodities exchanges in New York and Chicago, in an attempt to overturn new rules that cater to high-frequency traders. And in July, the SEC approved a new rule that will require exchanges and the Financial Industry Regulatory Authority to jointly devise a plan for the development of a consolidated audit trail, which would track every order, cancellation, modification, and execution of a trade for all listed equities across all U.S. markets.