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Moore's Law versus Murphy's Law: Algorithmic Trading and Its Discontents

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  • Andrei A. Kirilenko
  • Andrew W. Lo

Abstract

Financial markets have undergone a remarkable transformation over the past two decades due to advances in technology. These advances include faster and cheaper computers, greater connectivity among market participants, and perhaps most important of all, more sophisticated trading algorithms. The benefits of such financial technology are evident: lower transactions costs, faster executions, and greater volume of trades. However, like any technology, trading technology has unintended consequences. In this paper, we review key innovations in trading technology starting with portfolio optimization in the 1950s and ending with high-frequency trading in the late 2000s, as well as opportunities, challenges, and economic incentives that accompanied these developments. We also discuss potential threats to financial stability created or facilitated by algorithmic trading and propose "Financial Regulation 2.0," a set of design principles for bringing the current financial regulatory framework into the Digital Age.

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/jep.27.2.51
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Bibliographic Info

Article provided by American Economic Association in its journal Journal of Economic Perspectives.

Volume (Year): 27 (2013)
Issue (Month): 2 (Spring)
Pages: 51-72

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Handle: RePEc:aea:jecper:v:27:y:2013:i:2:p:51-72

Note: DOI: 10.1257/jep.27.2.51
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  1. Gary B. Gorton & Andrew Metrick, 2009. "Securitized Banking and the Run on Repo," NBER Working Papers 15223, National Bureau of Economic Research, Inc.
  2. Hendershott, Terrence & Jones, Charles M. & Menkveld, Albert J., 2008. "Does algorithmic trading improve liquidity?," CFS Working Paper Series 2008/41, Center for Financial Studies (CFS).
  3. Rosenberg, Barr, 1974. "Extra-Market Components of Covariance in Security Returns," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 9(02), pages 263-274, March.
  4. Lo, Andrew W & MacKinlay, A Craig, 1990. "When Are Contrarian Profits Due to Stock Market Overreaction?," Review of Financial Studies, Society for Financial Studies, vol. 3(2), pages 175-205.
  5. Umlauf, Steven R., 1993. "Transaction taxes and the behavior of the Swedish stock market," Journal of Financial Economics, Elsevier, vol. 33(2), pages 227-240, April.
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Cited by:
  1. Li-Xin Wang, 2014. "Dynamical Models of Stock Prices Based on Technical Trading Rules Part II: Analysis of the Models," Papers 1401.1891, arXiv.org.
  2. Li-Xin Wang, 2014. "Dynamical Models of Stock Prices Based on Technical Trading Rules Part I: The Models," Papers 1401.1888, arXiv.org.
  3. Li-Xin Wang, 2014. "Dynamical Models of Stock Prices Based on Technical Trading Rules Part III: Application to Hong Kong Stocks," Papers 1401.1892, arXiv.org.

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