Algorithmic Trading and the Regulation of Unintended Consequences

Abstract:

Algorithmic trading now dominates financial markets. Policy makers around the world grapple with the question of how to regulate increasingly volatile automated markets and potentially disruptive algorithmic trading strategies. Common responses include organisational requirements, record keeping and reporting obligations, and the suspension of trading if price movements exceed predetermined thresholds. These requirements impose a considerable regulatory burden on trading firms, often without being unambiguously supported by empirical evidence. This article focuses on one rationale behind regulatory intervention: the perceived need to address the risk that algorithms respond in unanticipated and disruptive ways to market events. Based on simulations of simple quote-driven and order-driven markets, the article explores how the interaction of algorithms affects price dynamics. It assesses the existing regulatory framework and proposed reforms in light of the findings and makes suggestions for tailoring regulation better to instances where interaction effects are harmful.