Financial markets are heavily dependent on the joint forces of buyers and sellers, with prices reflecting the balance of demand and supply. To achieve a balanced and efficient functioning of the financial markets, two types of players: liquidity providers and market makers, are very important.
Traditionally, liquidity provision and market making were handled by skilled human specialists on the exchange floors. These individuals utilized their capital, knowledge, skills, and even intuition, to ensure the smooth running of the market. However, as time went by, the market became more complex and the volume of trades exploded. Consequently, human specialists began to struggle with scalability. They were also exposed for their personal bias and emotional decision-making.
As a way of advancing from the traditional way of doing things, technological advancements such as algorithmic trading and automated market makers were created to provide faster and more efficient alternatives.
The Use of Algorithms
With the use of algorithm trading supported by machine learning and artificial intelligence, the possibilities for processing information and responding to market fluctuations are endless.
Automatic Market Makers (AMMs)
AMMs are computer programs that use algorithms to automatically trade assets using existing rules. They continuously execute buy and sell orders using pre-defined rules and logic. AMMs often tap into liquidity pools to facilitate trades and ensure smooth transactions.
Artificial Intelligence (AI)
AI in machine learning algorithms analyzes historical data, identifies trading patterns, and predicts future market behavior. With the use of AI, market makers can make better-informed decisions and ensure price stability.
Some of the most obvious advantages of the use of algorithms are:
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Big data analytics: Advanced algorithms can gather and analyze huge datasets. They gather historical data, data from news, and even social media for analysis and to predict future prices. This translates to accurate and real-time adjustment of prices to reflect market changes.
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Precision and Speed: With the use of algorithms, the analysis of market data is now very accurate and precise. Further, these algorithms can fully analyze market data and execute trades precisely in milliseconds. Consequently, algorithms ensure smooth order flow and tighter bid-ask spreads.
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Advanced Risk Management: The risk management tools integrated into the algorithms are very sophisticated. They can set stop-loss orders and even adjust their positions in real time based on volatility. This ensures a stable trading environment.
Positive Impacts of the Adoption of Technology in the Financial Markets
Technological innovations have significantly helped to stabilize and make financial markets more efficient. Here are some of the top ways it does that:
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Reduced Transaction Costs: Technology has made the market-making process more efficient and that has resulted in lower transaction costs for investors
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Increased market participation: With technology, new and equipped market makers can now enter the market and ensure healthy competition with others.
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Enhanced Market Access: More investors now have access to financial markets due to technology-driven market liquidity provision.
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Improved Price Discovery: Faster, and more efficient order execution in the market ensures that prices are more accurate.
Limitations Associated with the Use of Algorithms
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Transparency: There are concerns about the transparency of the decision-making process of some algorithms. This riles up regulatory concerns on market fairness.
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Human Factor: Human judgment remains very important in trading. Human expertise helps navigate complex dynamics that algorithms may not be familiar with. They also reduce flash crashes, which happen when algorithms overreact to certain events and prices crash suddenly.
Future Expectations
Some of the future technological innovations expected from the financial market concerning liquidity provision and market making are:
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Alternative Data Sources: Market makers will be more interested in alternative data sources like social media sentiments to get a better understanding of the market.
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Regulation: Standard regulatory agencies will spring up to monitor market-making activities and ensure fair and transparent trading practices.
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More efficient and sophisticated algorithms
