Market liquidity and flow-driven risk

Using a unique dataset of trades and limit orders for S&P 500 futures, we decompose the aggregate risk into a component driven by the impact of net market orders and a component unrelated to net orders. The first component - flow-driven risk - is large, accounting for approximately 50% of market variance, and it is not transient. This risk represents the joint effect of net trade demand and the price impact of that demand - i.e., illiquidity. We find that flows are largely unpredictable, and lagged flows have no price impact. Flow-driven risk is time varying because price impact is highly variable. Illiquidity rises with market volatility, but not with flow uncertainty. Net selling increases illiquidity, which amplifies downside flow-driven risk. The findings are consistent with flow-driven shocks resulting from fluctuations in aggregate risk-bearing capacity. Under this interpretation, investors with constant risk tolerance should trade against such shocks (i.e., "supply liquidity") to achieve substantial utility gains. Quantitatively accounting for the scale of flow-driven risk poses a major challenge for asset pricing theory.