Dr. Arzé Karam - Research

Working papers:

Modern Market Microstructure: Liquidity, Volatility and Financial Stability (2025) |New Paper Version|

This review was undertaken at the request of the Financial Conduct Authority (FCA) and funded through an FCA grant.

Market microstructure studies how the design and evolution of financial markets shape price formation, liquidity, and financial stability. I review the literature on the link between market liquidity and volatility, focusing on how shifts in market participation, the growth of algorithmic and high-frequency trading, the rise of passive investing, and the increasing role of non-bank institutions have influenced modern market dynamics. I also review papers on the impact of retail trading, market fragmentation across exchanges, and the role of dark pools and systemic internalisers in European and UK markets. Additionally, I conclude with a discussion on how the rise of decentralized finance (DeFi) and private markets introduces new challenges and opportunities for liquidity provision and market stability.

Quote Volatility Pressure and Intraday Momentum, (2025), with Dimitar Bogoev |New Paper Version| |Blog|

Presented at: Central Bank of Ireland 2025, Financial Conduct Authority FSEG principals meeting 2024, QRFE one-day workshop on Market Microstructure, Fintech and AI, IFABS meetings at Oxford University, Commodity Futures Trading Commission, Paderbon University and Leicester University.

We develop a novel machine learning-based measure of illiquidity, centered on a Quote Volatility metric that captures short-term oscillations in bid-ask quotes in high-frequency markets. Trained on episodes of order book thinning and rapid quote reversals, our model incorporates nonlinear interactions between market depth, price impact, and large trading volumes. The resulting illiquidity metric effectively detects real-time liquidity stress, particularly during intraday momentum trading, where trend-following strategies amplify price dislocations during periods of deleveraging. We observe that spikes in quote volatility occur both before and during systemic liquidity crises — including the COVID-19 market selloff (March 2020), the onset of the war (early 2022), the tariffs trade war (April 2025), and the Japanese market crash (August 2024) while remaining stable in normal periods. This real-time metric provides predictive insight into market resilience, execution risk, and trading costs, offering a valuable tool for arbitrageurs, market makers, and regulators in mitigating liquidity-driven disruptions.

A discrete-time quantum walk model of extreme market events: a complexity-based approach, (2025), with Stuart Adams, Christopher McCarty and Jack Waller |Blog|

Presented at: QRFE-2nd Quantitative Finance workshop in May 2025, Commodities Futures Trading Commission March 2025, Central Bank of Ireland February 2025, Financial Conduct Authority FSEG principals meeting October 2024

Flash crashes and market collapses challenge traditional financial models, which often overlook liquidity evaporation and self-reinforcing feedback loops. This study examines extreme price events using discrete-time Quantum Walk (QW) models, parameterized by liquidity conditions or combined with machine learning techniques. Unlike classical approaches such as Geometric Brownian Motion, QW models incorporate quantum interference and superposition to capture abrupt price dislocations and liquidity shocks. Their discrete-time structure enables high-resolution modeling of microstructural dynamics, identifying nonlinear transitions and feedback loops that precede crashes. Our findings show that QW simulations detect early warning signals by linking thinning market depth to rising crash probabilities, with liquidity risk peaking before price collapses. We further demonstrate that this complexity-based framework endogenizes regime shifts, improving alignment with empirical return distributions and extending beyond reduced-form and Markov switching models. This provides a more adaptive and robust tool for modeling liquidity-driven crises in high-frequency markets.

Ethereum Urgency Score, 2025, with Dimitar Bogoev and Jiexuihui Chen |New Paper Version|

Presented at One-Day QRFE workshop on Blockchain-based markets, FinTech and Cryptocurrencies.

Blockchain technology promises decentralized transparency but remains constrained by behavioral opacity, leaving market participants and regulators with limited visibility into the informational quality of on-chain activity. This paper introduces the Urgency Score, a real-time, transaction-level metric that quantifies execution urgency in Ethereum transactions using six behavioral signals, including gas fees, timing patterns, trade size, and atypical counterparty interactions. Using reduced-form price impact models and machine learning (XGBoost), we show that high-urgency transactions contribute disproportionately to ETH/USD price discovery, especially during market stress. Component-level analysis reveals that urgency dimensions are largely independent under normal conditions but cluster episodically around major events (e.g., the Ethereum Merge, FTX collapse), generating systemic urgency waves that amplify information flow and liquidity shocks across DeFi and centralized exchanges. Urgency-based momentum strategies exploiting these signals deliver consistently positive, risk-adjusted returns, while low-urgency flows have limited or negative predictive content. These findings provide a scalable, blockchain-native framework for identifying informational asymmetries and execution strategies in real time, bridging blockchain behavior with established theories of informed trading. They also highlight the need for new theoretical models of decentralized market microstructure that endogenize urgency propagation under blockchain-specific constraints, informing both market design and supervisory oversight.

Fat Finger errors, (2025), with Olga Balakina, Claes Backman and Anastasiia Parakhoniak

Presented at finance seminars at SAFE Frankfurt University and Durham University Business School.

Using a unique identification strategy based on ticker confusion, we document the effect of short-term non-fundamental pricing errors on the market. We examine a large sample of US stocks for over two decades and identify trading in two firms that share similar tickers. We show that events that trigger trading in the first ticker trigger spillover into trading for the second ticker. Compared to a control sample, stocks prone to ticker confusion exhibit large abnormal returns and larger trading volume. This trading leads to non-fundamental pricing errors that are corrected quickly in the next few minutes following the error. This rapid correction helps in maintaining lower effective spreads, which is beneficial for market participants as it reduces trading costs and enhances liquidity. Furthermore, we sort stocks based on their algorithmic trading activity prior to the events to show that stocks prone to confusion with larger presence of algorithmic trading exhibits lower spreads following the confusion. This implies that algorithms ensure that prices reflect the value of stocks, and help maintain market stability around non-fundamental pricing errors.

Permanently Working Paper:

European Gas Markets, Trading Hubs, and Price Formation: A Network Perspective, (2019), with Tooraj Jamasb, and D. Woroniuk, Cambridge Working Paper in Economics CWPE 1964 / Electricity Policy Research Group Working Paper EPRG 1992, Faculty of Economics, University of Cambridge.

Work-in-progress:

Contagion in high-frequency (il)liquidity networks, (2024), with Kumushoy Abduraimova (Preliminary: July 2024)

Presented at: 12th Bachelier World Finance Society in Rio De Janeiro.