HKUST Business School Magazine

The Rise of AI in Algorithmic Trading By Associate Professor JI Yan Department of Finance HKUST Business School Algorithmic trading has been prevalent in financial markets worldwide for over two decades. The use of computer algorithms allows market participants to automatically execute trading decisions and efficiently manage their orders, increasing market liquidity and enhancing price informativeness. 1 Recently, breakthroughs in AI technologies, particularly reinforcement learning and deep neural networks, have captured the interest of major hedge funds and investment powerhouses. These entities are now leveraging AI to enhance their algorithmic trading, enabling algorithms to trade intelligently through self-learning in dynamic environments rather than relying on rigid, hard-coded protocols. With the U.S. Securities and Exchange Commission's (SEC) approval of Nasdaq's reinforcement learning-based, AI-driven order type, the integration of AI in trading is gaining significant momentum. 2 AI-powered trading presents new regulatory challenges and has the potential to fundamentally reshape financial markets. One of the key roles of financial markets is price discovery. By aggregating information from sophisticated market participants who trade for profit based on informative signals, market prices reflect the fundamental values of underlying assets. Over the years, this powerful source of information has become increasingly informative due to reduced information costs and transaction fees, improved data access, and a rise in institutional ownership. 3 The integration of algorithmic trading with AI could significantly enhance market efficiency, thanks to AI's ability to analyze vast amounts of data and make predictions. However, recent research indicates that AI-powered trading also carries risks. If the development and adoption of AI are dominated by a few leading entities, market prices may become less informative regarding asset fundamentals. AI Algorithms are transforming market efficiency and risk dynamics, presenting both opportunities and risks. Understanding AI collusion in financial market and its implications is essential for navigating the evolving landscape. Insight Biz@HKUST 30