Overreacting Algorithms in Financial Markets

One rationale for the regulation of algorithmic and high-frequency trading is the perception that algorithms are prone to overreacting to market events, for example by producing unanticipated interaction effects that exacerbate volatility and disrupt efficient price formation. This articles explores how algorithms interact and affect price formation in quote-driven and order-driven markets. It observes that existing regulation and proposed reforms are generally not based on a consideration of, and are thus not responsive to, the precise causes of inefficiencies in the process of price formation. The article argues that it is not helpful to ascribe inefficiencies to the “overreaction” of algorithms and suggests that regulation should focus on the supply of liquidity through an appropriate design of the microstructure of markets, rather than holding algorithmic trading firms responsible for disorderly trading conditions