Summary
The first-of-its-kind research investigates the impact of algorithmic trading
It has significant implications for securities market as computer programs trade faster than human traders
Researchers at the Indian Institute of Technology (IIT) Madras are studying the impact of Algorithmic Traders (ATs) on the stock market. The research is unique as it investigates the impact of Proprietary Algorithmic Traders (PATs) and Buy-side Algorithmic Traders (BATs) trading on market quality and vice versa.
Algorithmic Trading has significant welfare implications for the securities market as computer programs trade faster than human traders. The research is focused on processes that happen when computer programmes predict market order flow and take over the trading process.
The research was led by P. Krishna Prasanna, professor in the Department of Management Studies, IIT Madras; and Devika Arumugam, Fulbright fellow and a PhD scholar, Department of Management Studies, IIT Madras. The syudy examined the impact of ATs on the National Stock Exchange (NSE).
Elaborating on the importance of this research, P. Krishna Prasanna said, “Existing studies consider ATs as a homogenous group, which is far from reality. ATs use different algorithms based on their source of funds. So, they are classified into two categories – Proprietary Algorithmic Traders (PATs) and Buy-side Algorithmic Traders (BATs).”
The research on algorithmic traders has just begun to emerge. Some of the literature that favours ATs suggests that they offer better prices through lower-order placement costs and update quotes faster. However, other studies suggest that algorithmic traders create a ‘barrier to entry’ situation for human traders, which deteriorates the market quality significantly.
“The crucial difference between the two is Proprietary Algorithmic Traders or PATs trade with their own funds and their algorithms are arbitrage seeking, while Buy-side Algorithmic Traders or BATs trade with their clients’ funds and their algorithms are predominantly cost reduction seeking,” P. Krishna Prasanna said.
The key learnings and findings from the research include PATs and BATs trade differently and have a differential impact on the market quality. Also, the cancellation of PATs increases the quoted spread, while BATs order placement reduces the same. It was also revealed that the BATs crowd out PATs orders, but not vice versa.
“These new findings have substantial financial and regulatory implications. Traders and regulators stand to gain from the market quality enhancing capabilities of BATs,” said Devika Arumugam, PhD scholar and Fulbright fellow, Department of Management Studies, IIT Madras.
Last updated on 10 Jan 2022
