The vast majority of investments in electronic markets today are deployed via computer algorithms, designed and employed by modern investment and specialist trading firms, global banks and domestic brokers.
Algorithmic trading is a software process that creates orders detecting and acting on patterns of market inefficiencies using mathematically sophisticated models of disparate market data. It also determines how orders are deployed to market venues, such as stock exchanges, via telecom lines, satellite and/or microwave links.
These algorithms reap benefits by selecting from a number of execution channels. These channels could be actual trading venues like stock exchanges or multilateral trading facilities (a ‘non-exchange’ financial trading venue, typically electronic-only, operated by an investment firm or a market operator). Or they could be trading mechanisms like ‘lit’ and ‘dark’ order books (lit order books have visible pre-trade prices, dark order books do not display prices ‘pre-trade’).
Given multiple physical venues and mechanisms with which to trade, modern software and smart order routing create a single virtual pool of liquidity where each execution channel is like an extra knob on the radio dial that helps investors get business done. Order entry and trading execution is now so fast that today’s markets have matching engines that can continuously process buy and sell transactions in less than one-millionth of a second – faster than the blink of an eye.
Volatility has reducedIn recent years, regardless of market, the trend has been a significant reduction in market volatility. Algorithmic trading actually may be contributing to this trend.
Logic suggests that because there are so many more algorithmic trading strategies in the market today trying to take advantage of market inefficiencies, the net result is in fact fewer inefficiencies as counterparties logically elect to engage in venues that minimise asymmetries between their trading strategies.
Mechanical features like static and dynamic circuit breakers – an enforced temporary halt in trading, usually triggered by a large and sudden price move – put in place on a per stock basis further protect the quality of markets in London and Europe. UK and European markets featuring these circuit breakers have avoided ‘flash crash’ events like that of 6 May 2010 in the US.
If investors decide to execute a large trade, then it is important to be able to do so without moving the market. That is more easily achieved in a market full of different strategies, both long- and short-term, which increase liquidity. The positive news is that today, large banks and brokers are using these state-of-the-art electronic trading strategies designed to optimise large orders to the benefit of their institutional clients, such as pension funds.
Some disadvantages are also being eliminated. Regulators are insisting on more robust risk management systems to protect against the dangers of algorithmic trading. And some more controversial practices, such as ‘predatory’ high- frequency trading, have become uneconomic with innovations that focus on quality of price formation rather than speed to win new business.
Algorithmic trading also helps investors to achieve ‘best execution’ – the obligation to execute orders on terms most favourable to the client – as defined by the second Markets in Financial Instruments Directive (MiFID II).
So markets are continuing to evolve towards a point where the advantages of algorithmic trading, such as lower volatility and more efficient trading execution, are being felt by investors.
Many of these improvements are a result of a very healthy debate that has taken place over the past few years, and as market structures adapt and evolve post-MiFID II, this trend continues.
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The original version of this article appears in the Q3 2018 print edition of The Review. All members, excluding student members, are eligible to receive the quarterly print edition of the magazine. Members can opt in to receive the print edition by logging in to MyCISI, clicking on My account, then clicking the Communications tab and selecting ‘Yes’.
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