Algo-Trading Involves Risks for Stability on Financial Markets

Algo trading, i.e. computerized trading of stocks based on clearly defined algorithms, is on the rise at the stock markets. This involves many risks for the financial markets. This is the finding of a current survey conducted by the Centre for European Economic Research (ZEW) in Mannheim. In total, 193 financial market experts were surveyed.

Slightly more than two thirds of experts participating in the survey fear that computerized trading could affect the stability on financial markets negatively or very negatively. While the regulation of derivates and the structuring of benefit schemes to improve the stability on financial markets is discussed frequently, algo trading does not play a role in public discussion. This is surprising considering the importance of this type of trade. In 2007, algo trading already accounted for 50 percent of turnovers at the German Stock Market.

Algo trading are computerized trading orders at stock markets based on clearly defined algorithms. They are usually based on quantitative models which take historic and current market data into account. As algo trading is a closed system, stock traders cannot interfere. The advantage of an automatic trading system is that it is possible to instantly react on incoming news and implement them in the trading decisions.

Another aspect of algo trading programmes, however, is problematic. If many programmes are based on similar rules, a dangerous domino effect could occur in certain market situations. For example, a flood of trading orders placed in a short time could foster or intensify a market crash. "This would really endanger the stability on financial markets. Therefore algo trading should be subject to special controls," says Michael Grünewald, ZEW researcher.

Grünewald’s opinion is shared by many experts. 66 percent of financial experts surveyed by ZEW consider a regulation of this type of stock trading necessary. According to 69 percent of experts, the current regulations of trade suspensions are not enough to step in successfully in crisis situations. However, an effective regulation of algo trading would be rather difficult. 47 percent of experts think such a regulation would be possible. 53 percent of experts on the other hand do not share this opinion. Even if a regulation was effective, the question if it might foster trade markets outside the stock market could not be answered. These dark pools would not be subject to any controls. Moreover, 69 percent of experts think there is the risk that information from dark pools could be used on the regulated markets. Traders not participating in dark pools would have disadvantages because they would not have access to this insider information.

For further information please contact

Michael Grünewald, E-mail: gruenewald@zew.de