When AI Becomes the Market's Invisible Hand
Recently, you may have observed an increase in trading costs. Specifically, you've noted wider spreads; slightly worse fills for your order; and perhaps there seems to be less market efficiency compared to the past. While many traders accept this as a consequence of market conditions, volatility, or the inevitable broker take, what if it were something more subtle? What if it could be the machines learning to work against you without being given any explicit instructions from humans?
The advent of artificial intelligence in the foreign exchange, stock, and contracted-for-difference markets has been immense. The algorithmic trading industry has grown from a niche practice in 2015 to dominating any and all major exchanges. Here is the creepy part: according to researchers at the National Bureau of Economic Research, there exists the possibility that AI could learn to manipulate the markets by colluding (i.e., arrive at a tacit agreement to raise prices), but they could develop that collusion without any verbal or electronic communications.
How AI Trading Bots Learn to Collude Without Talking
To grasp the mechanics of AI collusion, it's important to first understand how these systems "think." AI trading bots rely upon reinforcement learning, which could be described as an advanced reward-and-punishment learning mechanism. The system will experiment with several strategies, receive either a positive or a negative feedback signal regarding profitability, and then adjust its behavior based on the feedback.
After thousands (that’s right, thousands) of scenarios, it will adapt and discover strategies that are garnering positive feedback. The brilliance and the danger in this mechanism is that the AI does not need someone to teach it collusion. It learns it automatically.
From Algorithmic Competition to Algorithmic Collusion
The nature of competition fundamentally changes when markets shift from human participants to algorithmic participants - and it will not change in your favor.
When collusion occurs, it destroys liquidity. When algorithms collude, the spreads widen, and price competition lessens. Markets that should be efficient become ever so slightly less efficient, and that extra cost is extracted from traders like yourself. You may notice it as worse fills, lower profit margins and more frequent stop-outs.
Regulators vs. Algorithms: Can Laws Catch Up?
Regulators are in a scramble, but they're in a fast-changing game of rules that cannot keep up with rapid change and the legislation in place. The SEC, CFTC, and FINRA are just now beginning to increase oversight of algorithmic trading.
The EU is moving aggressively with regulations in the AI Act which will require any trading algorithm to explain its own decision reasoning and governance. In Congress, the Preventing Algorithmic Collusion Act has been put forward to address this issue specifically. California has some draft bills that will make those who adopt an algorithm itemize their rationale and decision-making process.
Investor Strategies: How to Protect Yourself From Algorithmic Collusion
It's impossible to control changing the behavior of algorithms, but you can control the way you trade. The first strategy is to implement limit orders rather than using market orders. When you submit a market order, you are literally saying "fill me at whatever price is available now." Algorithms feast on this. They know what market orders are and will extract the maximum premium from you. Limit orders are completely different. You simply set your price and wait. Yes, you might not get filled and may miss that opportunity by the time you put the order in, but if you put in an order with more discretion you won't get hunted by algorithms.
Conclusion: Take Control of Your Trading Future
AI trading is ubiquitous. For most traders, it's less optional less optional to know how algorithms think and behave, and more essential. Your trading profits depend on it.
However, the good news is that you are not powerless. Simply by changing how you trade, diversifying how you trade, and choosing an execution platform that puts your interest above algorithmic costs, you can significantly curtail the concealed costs that AI is extracting.
For more info:-
Comments
Post a Comment