Market Watch #8

Algorithmic Trading
March 2023, edition 8

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 Table of contents
01 What is new under the sun? 3

02 Terminology 3

03 Algorithmic trading on Dutch capital markets 5

04 Benefits of algorithmic trading 5

05 Potential risks of algorithmic trading 6

AFM supervision on algorithmic trading in recent years 7

Closing remarks 8

FACTS & FIGURES - THE DUTCH SPAC MARKET: AN UPDATE 9

Table of contents 2
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01 What is new under the sun? The first objective of this Market Watch is to make the reader aware of a number
of different concepts with regards to the term ‘algorithmic trading’ - what are we
In 1982, the American Commodity Futures Trading Commission allowed a new actually talking about? Next, the AFM shares several data insights on algorithmic
financial instrument to be traded: the stock index future. That year the S&P 500 trading on Dutch trading venues - how big is algorithmic trading in the Netherlands?
futures contract was created. It quickly became, and four decades later still is, the and the subsequent sections will touch upon some of the benefits and risks of
dominant contract out there. During that same time, instead of carrying notes by trading algorithmically - what is on the mind of the supervisory authority?
hand, technology in the US allowed for trading multiple stocks simultaneously,
sending many orders ‘automatically’ to the different stock specialists in the trading Algorithmic trading is a difficult concept to pin down as algorithms come in many
pit. This was called program trading and was initially developed to support portfolio different shapes and forms and are used by many different actors for many different
trading – where a portfolio would typically consist of many different stocks. It did not (trading) purposes. Furthermore, it has been and remains a moving target as
take long before program trading was used for arbitrage between the stocks and the technology develops.
novel index futures. It really took off in the mid-80s when it also became possible for
orders to be entered automatically by computers. Considering the absolute majority of trades is done algorithmically, the AFM has
made the supervision of algorithmic trading, including gaining more knowledge
In the aftermath of the 1987 stock market crash, NYSE banned the use of the about this topic (please see our recent publication on Machine Learning in trading
Designated Order Turnaround system for arbitrage trades for several weeks and algorithms), one of its key attention areas for the coming years.
introduced ‘circuit breakers’ – a tool to automatically halt trading in times of crashing
prices. The extent to which speculation in index futures, index arbitrage, and program
trading may have triggered the 1987 stock market crash was much debated well into 02 Terminology
the 1990s. This still is an ongoing debate.
The algorithmic trading universe is vast and algorithms come in many different
Many things have changed since the 1980s, particularly due to advances in shapes and sizes. Algorithmic trading makes use of many different techniques ‘under
technology. Take the speed of execution for example: where it used to take several the hood’, ranging from (human) business logic to advanced artificial intelligence.
minutes to buy an entire S&P500 index portfolio, it now takes a fraction of a second. Furthermore, algorithms are used by many different actors, ranging from pension
Or intelligence: where the intelligence within algorithms was based on human funds to proprietary traders. Some forms of algorithmic trading are unbelievably fast
business logic and at best supported by computers, whole strategies are now and need to be so, but for others speed does not matter much.
‘thought out’ and executed by AI algorithms. It has even come to the point that
scientists are now investigating the real possibility of advanced AI algorithms working When thinking and talking about algorithmic trading, terminology matters a great
together, without needing any human instructions, to “coordinate” the prices of deal. Especially when it comes to thinking about the impact on markets, about risks,
financial instruments. about policy, there is a need to account for the many nuances that are out there.

But many things have also remained the same since the 1980s. As was the case back A first distinction can be made between execution algorithms and trading algorithms,
then, confusion existst when it comes to the terminology for automated, algorithmic, which have different aims and are used by different actors.
or ‘computerised’ trading. And the jury is still out on the effects of algorithmic trading
on markets.

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Execution algorithms aim to execute an order. The investment decision itself is The following is a simplified version of a trading algorithm used by several HFT
taken elsewhere. These algorithms are often used to place large orders (e.g. portfolio firms subject to supervision of the AFM. It (1) predicts a theoretical price of a
trades) in an intelligent manner in the market so as not to pay the highest price. An certain financial instrument (via a machine learning model) and based on that
example would be a Volume Weighed Average Price (VWAP) algo. prediction (2) takes a certain investment decision. The machine learning model
(e.g. linear regression) is optimised to predict the price of an instrument. It
Trading algorithms aim to automate a certain strategy and automatic execution is uses all sorts of properties of the order book to do so: order book imbalance,
part of the algorithm: the trading algorithm takes the investment decision itself. It volume, price trend and many permutations of these at different time horizons
can be programmed to take the decision when a certain situation arises, but it may (last millisecond, last 10 milliseconds, etc.) This data is fed into the model in
also make use of AI models to detect trading opportunities itself. An example would real-time and a theoretical price comes out (which keeps changing in real
be a quantitative hedge fund algo seeking to optimise a portfolio’s exposure and time), based on which orders are sent to the exchange(s).
automatically executing the strategy.
Please see this link for our full report on the application of machine learning in
In the earlier days of algorithmic trading, both execution and trading algorithms trading algorithms by several investment firms under our supervision.
were programmed to operate according to some business logic: a trader’s idea or
mathematical model. In the past decade, Artificial Intelligence (AI), and in particular Simplification of structure of a trading algorithm the AFM encountered
Natural Language Processing and Machine Learning, have been applied on a
large scale to algorithms. We have seen a sea-change in the last decade with the Data feed Trading algorithm
application of AI, as the logic that AI applies to arrive at a certain decision/action may Model exists
Order book data of 1000s of
now be beyond human understanding. Machine Learning based model features with
that aims to predict the next their own
Correlated products theoretical price of instrument x parameters
Then there is another concept that is related to algorithmic trading but is often
wrongly assumed to be synonymous with it: High Frequency Trading (HFT). In
Typical HFT data input:
essence, this is merely a technique that allows for extremely fast signal processing - Focus on order book
and/or order execution. In turn, the extremely fast order execution allows for activity THEO(retical price)
- Most recent micro-second
certain automated trading strategies to be successful where speed is of the utmost data most predictive power
importance. Hence, HFT is a subset of trading algorithms.
Limited
number of
But even within the world of HFT, there are many different types of actors and IF Theo > current price then buy, possible
IF Theo < … actions
strategies, and there is slower and ultra HFT. In addition, as machine learning
has been applied in HFT trading algorithms for years now to arrive at investment
decisions, the extremely fast algorithms are becoming ever more intelligent, and
consequently also more complex. Sends/amends order to exchange

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03 Algorithmic trading on Dutch capital markets

400.000.000

Data analysis by the AFM of Dutch algorithmic trading in 2021 resulted, among
350.000.000
others, in two interesting findings:

300.000.000
1. Algorithmic trading is the norm

Orders executed
250.000.000
n Algorithmic trades The pie chart shows the number of
n Manual trades
transactions per month on Dutch
26% 200.000.000
trading venues and for all asset
classes in November 2020. The dark
150.000.000
purple represents the number of
algo trades, the light purple the
74% 100.000.000
number of non-algo trades.

50.000.000

0
2. Majority of algorithmic trading on Dutch trading venues by non-Dutch firms

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The bar chart shows the number of algo- and non-algo executed transactions per

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country of origin on all Dutch venues in the period 2018-2021 in all asset classes.

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n Algo order n Manual order

The graph shows that firms located in Germany, Ireland, France, United Kingdom,
The Netherlands, and Spain play a big role on Dutch Venues, and most trades are
algorithmic in nature. Some of those firms are subsidiaries of US companies. When
looking at the type of firms that trade algorithmically, many different actors can be 04 Benefits of algorithmic trading
identified amongst the top 20 traders (by numer of transactions), such as (investment)
banks, proprietary trading firms, and brokers. Before looking more closely at the risks, the benefits algorithmic trading has brought
to the markets needs to be acknowledged. It was introduced to enable more efficient
execution to facilitate better portfolio trading. It has also enabled an increase in speed
and faster transfer of risks by HFT market makers, which, in combination with the
increased competition, has reduced the spreads of many financial instruments to
the point where they cannot get much narrower. In that sense, algorithmic trading
has improved liquidity by making it cheaper and easier for investors to buy and sell
financial instruments.

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On the trading decision side, algorithms are emotionless and do as they are In its MiFID review, ESMA proposed to amend the testing requirement to a principle-
programmed which avoids any human errors that might be caused by nerves and based testing regime where the test should demonstrate that an algorithm produces
emotion. In addition, advances in AI have enabled algorithms to incorporate more certain prescribed outcomes (e.g. not contribute to excess volatility). We believe any
information and make more accurate (price) predictions used by market makers. progress on this requirement, would be a step forward.
Such advancements increase the level of competition, which should ultimately be
reflected in lower trading costs through smaller spreads for other market participants. In general, the AFM has observed cases in which trading algorithms do not behave as
intended by the developers. An example was an HFT market maker firm that used a
trading algorithm that responded to its own orders. The algorithm observed an order
05 Potential risks of algorithmic trading being entered (its own order), and – based on that information – decided to cancel its
orders. The cancellation in turn triggered a new order by the algorithm, etc. This led
Algorithmic trading is a generic concept and the risks listed below are generic as well. to a feedback loop, with many order entries and cancellations occurring in a short
The list is non-exhaustive and emphasises risks relevant to the AFM’s capacity as a time span, creating disorderly conditions.
conduct supervisor: risks that jeopardise the robustness of the infrastructure of the
financial markets and the fair, orderly and transparent operation of these markets. The combination of speed, the amount of orders, and the complexity of the
underlying model of the algorithm in the above example shows that the exact
Control framework behaviour of an algorithm might be hard to predict under all circumstances. The AFM
An algorithm can disrupt the markets, impacting its robustness and orderly expects that firms remain in a position where they are able to explain the behaviour
operation. And this can have a huge impact, as shown by the occasional flash of their algorithms and ensure it is orderly and as intended.
crashes (where humans also play a role). The 2022 flash crash (see box on the right)
shows the importance of a sound control framework, governance, calibrated and
sensibly tailored risk controls, and a strong compliance culture. Regulations have 2022 Flash Crash
set requirements for controls and require investment firms to thoroughly assess the On May 2 2022, stock prices on several major EU trading venues started to
suitability of their algo controls on an annual basis. plummet quickly until they triggered the circuit breakers. This so-called flash
crash started when a trader executing a large portfolio order made a typing
The same goes for trading venues, which have to adhere to their own set of algo error when entering the size into the system. Due to this ‘fat finger’ error, the
controls. In addition, legislation requires trading venues to have a role in controlling portfolio order started to execute in many, many small ‘child orders’ on several
whether their members have specific algo controls in place and for members to trading venues. Before the hard-coded controls on both the firm’s side and
certify that their algorithms have been tested. The AFM expects trading venues to the trading venue side stopped the execution of the remainder of the basket,
firmly take up this role and will monitor this. many orders had already been sent to several EU exchanges to wreak havoc.
This incident illustrates the importance of sound governance and compliance
There is a specific requirement for trading firms to test their trading algorithms before culture on the ‘people’ side as well as having firm-specific hard-coded controls
they enter the market to make sure they do not behave in an unintended manner tailored to its actual business activity.
and/or cause disorderly trading conditions. At present, the testing environments used
do not necessarily enable measuring market impact and/or interaction between
trading algorithms.

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Market manipulation AFM supervision on algorithmic trading in recent years

Manipulation directly affects the fair and orderly operation of capital markets. A
trading algorithm can learn to manipulate the market. Firms and trading venues are Risk and control framework of trading firms and trading venue
required to establish and maintain effective arrangements, systems and procedures to Firms that engage in algorithmic trading must adhere to extensive legal
detect and report suspicious orders and transactions indicative of attempted or actual requirements to avoid market disruptions and market manipulation caused by
insider dealing or market manipulation and should notify the competent authority algorithms. In 2020, the AFM completed an extensive review of proprietary
without delay. trading firms’ and trading venues’ compliance with relevant regulations.
The report can be found here. We expect firms to thoroughly assess their
In addition, the AFM monitors the markets through its own set of detection compliance and suitability of their algo controls on an annual basis. They also
algorithms. Some of these are focused on algo-related variations of market need to improve compliance with testing requirements.
abuse, taking into account variables that are especially important for many trading
algorithms (mainly microstructure properties such as order book imbalance, volatility, Machine learning study
recent activity in order book, etc.). Recently, the AFM conducted an exploratory study on how machine learning
is applied in trading algorithms by several proprietary trading firms under our
Advances in machine learning technologies, particularly in the subtype supervision. The full report can be found here. In short, our study found that
Reinforcement Learning – where the model learns which actions are most rewarding these firms make extensive use of complex machine learning models. The AFM
given a certain state of affairs and is free to take many different actions – raise real also found that these models rely heavily on order book data making them
concerns that trading algorithms might learn to manipulate the market in very shrewd prone to react to any (deliberate or inadvertent) disruptions.
ways, even unintentionally (without the developers wanting the algorithm to do so). A
concern is that such trading algorithms might abuse relationships across instruments Collaboration with Alan Turing Institute
or trading venues. The AFM has large datasets at its disposal. The AFM collaborates with
researchers from the Alan Turing Institute to obtain valuable insights from this
Market quality data to improve our market surveillance and understanding.
The quality of a market can be captured by characteristics like the bid-ask spread,
depth of the book, and market efficiency. Some algorithms may impact market
quality inadvertently, some when they interact with other algorithms (herding,
exacerbating volatility, mini-flash crashes), some even by design (e.g. arguably,
latency arbitrage algorithms). These are serious concerns that deserve attention and
further scrutiny.

Besides the impact of algorithms on the market, concentration risk might have a
big impact: when barriers to entry are too high, market quality can be impacted.
Literature shows that algorithmic market making contributes to market quality
(liquidity) but only when there is enough competition.

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Closing remarks

We have seen that algorithmic trading entails many different types of algorithms and
actors, ‘that for the last decade most transactions have come from algorithms’, that
algorithmic trading is very international, and that algorithms can be very complex. We
also took a brief look at the benefits to market quality and some of the risks.

The topic algorithmic trading is diverse and has many facets. In addition, it is
developing rapidly with the advent of new technology. There still is a lot to learn and
understand about this topic on all levels: about the impact of algorithms together,
how different individual algorithms may be, on market micro structure, and about
the systemic impact of all these algorithmis interconnecting many different markets
together.

The AFM will closely monitor developments in this area and conduct exploratory
studies to better understand and assess risks in order to tailor its supervision.

In addition, the AFM works together with other supervisory authorities, actively
contributes to ESMA working groups, and is in close contact with scientists that
research aspects of algorithmic trading.

Lastly, the AFM strives to share knowledge where it can and is keen to learn from
market participants, scientists, and fellow supervisory authorities.

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FACTS & FIGURES Figure 1: Number of IPOs, SPAC IPOs and de-SPACs on Euronext Amsterdam from 2018 to
2022

18
This section of the AFM Market Watch describes a development in the Dutch 15
Financial Markets with a specific focus on facts and figures. This section 12
contains information up to 14 February 2023. 9
6
3
0
2018 2019 2020 2021 2022
The Dutch SPAC market: an update n Traditional IPO n SPAC IPO n De-SPAC

In 2021, Euronext Amsterdam experienced a record number of sixteen Initial Public Two SPACs were required to publish an approved prospectus with respect to the
Offerings (‘IPOs’) of Special Purpose Acquisition Companies (better known as business combination. As of the date of this publication, three of them are trading
‘SPACs’), raising a total of approximately €3.7 billion. A SPAC is a company without significantly below their initial issuance price of €10 per share.
business activities that raises capital with the intention to purchase all or part of a
non-listed company in the relatively near term. In January 2022, the AFM published Trading activities
an overview of the Dutch SPAC market in edition #5 of the AFM Market Watch.1 How SPAC IPOs in the Netherlands are solely targeted at professional investors. There
has the Dutch SPAC market developed since then? were low levels of trading in SPAC shares in the secondary markets and only a small
fraction was traded by retail investors.2
SPAC boom has ended
The notable boom of SPAC IPOs on Euronext Amsterdam slowed down significantly Upcoming deadlines
in 2022, as shown in Figure 1. Only two new SPACs were listed in the first half of Currently, 14 SPACs are still searching for a target company to merge with. Most
2022 and since then no new SPACs came to the market. While there were no SPACs have a term of 24 months to complete a business combination. 11 of
traditional IPOs in 2022 (compared to nine in 2021), four SPACs listed on Euronext them had the option of an extension period of (a total of) six months, subject to
Amsterdam completed a business combination with a target company (also known shareholder approval. For many SPACs the deadline is approaching fast. In most
as a ‘de-SPAC’ transaction). cases in Q2 and Q3 2023 as shown in Figure 2.3 Investors should be aware that the
sponsors of a SPAC have a commercial incentive to avoid a no-deal, which increases
De-SPACs the risk of an acquisition of a low-quality target. In general, sponsors only receive
In the case of two de-SPACs, a majority of the shareholders reclaimed their invested compensation when a business combination is completed. In the situation of a no-
funds from these SPACs by exercising their redemption rights. These SPACs deal, the sponsors may lose their total initial investment to cover the costs for the
nonetheless managed to complete the business combination by obtaining additional SPAC.
funding.

1 Please see edition #5 of the AFM Market Watch. The AFM has expressed its concerns that investing in 2 Based on reported MiFID data.
SPACs is considered highly complex and has substantial risks for investors. The AFM believes investing in 3 Based on the terms mentioned in the SPAC IPO prospectuses (and updated in accordance with recent
SPACs is only suitable for a (very) limited group of retail investors. announcements, if applicable).

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Figure 2: Upcoming deadlines per quarter of SPACs listed on Euronext Amsterdam However, investors should be aware that shareholder circulars are not approved
by the AFM. Where SPACs do not inform investors in accordance with these
10
requirements, the AFM has supervisory powers to intervene and impose sanctions.
8
6
4 For more information about the Dutch SPAC market, see also edition #5 of the AFM
2 Market Watch: AFM Market Watch | Topics AFM | AFM Professionals. More information
0 and relevant Q&As about this topic can be found on the AFM website.
Q1 2023 Q2 2023 Q3 2023 Q4 2023 Q1 2024 Q2 2024

Inside information requirements

It is expected that many SPACs will try to complete a business combination in 2023.
This will lead to situations in which the SPAC, like any other listed company, will
need to disclose (inside) information to comply with the Market Abuse Regulation.
Examples of such situations are when sponsors exclusively negotiate with a target or
seek to close a business combination deal. Inside information should be disclosed as
soon as possible. The AFM will thoroughly perform its task of real-time surveillance of
SPACs’ price movements and press releases and will intervene if necessary.

Shareholder circular
Once SPACs find a suitable target, they should provide detailed information about the
proposed business combination to their shareholders. This is usually presented in a
so-called ‘shareholder circular’. SPACs should be aware that this document should be
consistent with the information in the SPACs’ IPO prospectus and should have a level
of disclosure similar to an approved prospectus.4

4 ESMA, 15 July 2021, SPACs: prospectus disclosure and investor protection considerations.

Market Watch, edition 8 | Algorithmic Trading 10

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