Why do spreads blow out during a fast market?

Question

During a sudden burst of volatility (a macro shock, a flash crash, a forced-liquidation cascade), bid-ask spreads gap out dramatically and displayed depth evaporates, sometimes within seconds.

Why? Tie your explanation to the components of the spread, and explain the feedback loop.

Accepted Answer

Walk the components, then close the loop. 1. Inventory risk spikes with volatility. The risk charge in a quote scales with the short-term variance of whatever you might take on. When volatility jumps, the distribution of outcomes on any inventory widens, so makers demand a much larger cushion and quote wider, or pull back entirely. 2. Adverse selection rises with uncertainty. In a fast market nobody is confident where fair value is, and aggressive flow is more likely to be informed (or forced sellers whose selling itself predicts further drops). Quoting tight risks being run over, so makers w…

Why do spreads blow out during a fast market?

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