Machine Learning in Algorithmic Trading

Application by Dutch Proprietary Trading Firms and Possible Risks

Last updated at 28-09-2023

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Table of contents
Executive Summary 3

01 Introduction 4
Aim study 5
Approach study 5
Scope or limitations study 5
Structure of this report 5

02 Terminology matters 6
2.1. Algorithmic trading and high-frequency trading 6
2.2. Machine Learning in algorithmic trading 7
2.3. Machine learning based trading algorithm 9

03 Observations 12

04 Risks 14
4.1. Explainability 14
4.2. Market Manipulation 15

05 Discussion points 17

Annex 1 Definitions 18

Annex 2 Risks of Machine Learning in Trading 19

Annex 3 RTS 6 articles possibly affected by lack of explainability 23

2
 Executive Summary
Parallel to the success of programs such as Deep Blue and AlphaGo, developments The AFM observes that (see section 2 and 3):
in artificial intelligence and machine learning grabbed the attention of industries 1. Clear terminology is required to account for the many nuances in algorithmic
worldwide, and therefore the attention of supervisors and policy makers. Since then, trading
think-thanks, academics and supervisors have written extensively about machine 2. Machine learning is applied on a large scale in algorithmic trading
learning, and its implications for the financial markets. 3. Many machine learning models used in algorithmic trading try to predict the price
of a financial instrument
However, to the best of our knowledge, few studies have been published about the 4. Machine learning models look primarily at order book data, no fundamental
actual use of artificial intelligence or machine learning in algorithmic trading. Also, information, and use 100-1.000 features
few supervisors have shared concerns about risks relevant to conduct supervisors, as 5. Trading firms heavily rely on supervised learning, not (yet) reinforcement learning
opposed to risks for financial markets in a more general sense. 6. Trading firms find explainability of models less important than performance
7. Trading firms see risks of reinforcement learning based trading algorithms to learn
This AFM aims to do exactly that with this publication: report about the actual use unintentional and negative trading behaviour
of machine learning as reported by a subset of Dutch proprietary trading firms, and
report about the possible risks relevant to its supervision. The aim of this publication Also, the AFM observes several possible risks from the use of machine learning in
is to contribute to the public debate, inform academia and other supervisors. In algorithmic trading (see section 4). Two risks that are especially relevant to a conduct
addition, the AFM uses the findings in this study to focus its supervision on the most supervisor such as the AFM are:
relevant risks to its supervision.
1. Lack of explainability of machine learning models poses challenges for trading
Please note that observations in this study are based on surveys sent to – and firms to comply with organisational requirements regarding algorithmic trading
interviews held with – a subset of Dutch propriety trading firms. All trading firms 2. Increased risk of market manipulation. Reinforcement learning could increase
used algorithmic trading. Note that the observations in this study are not necessarily the risk of trading algorithms learning unintended, negative trading behaviour,
representative of the use of machine learning in algorithmic trading by other while the implicit use of machine learning could make trading algorithms more
segments in the financial markets (e.g., brokers executing orders for clients). Also, the susceptible to falling pretty to manipulation
findings represent a snapshot of the state of the market in the year 2022.

Executive Summary 3
 01 Introduction
It was May 11, 1997. World chess champion Garry Kasparov, to this day considered AlphaGo’s developers used so-called ‘deep neural networks’ and ‘reinforcement
one of the greatest chess players of all time, conceding the last game in a match to learning’, both types of ‘machine learning’. These models take a description of the Go
his opponent: IBM supercomputer Deep Blue. Man competed against the machine. board as an input and process it through several network layers containing millions of
The machine won. neuron-like connections. Then the developers had it play against different versions of
itself thousands of times, each time learning from its mistakes.
Deep Blue was a chess-playing ‘expert system’: a computer system emulating the
decision-making ability of a human expert. Expert systems are designed to solve Over time, AlphaGo improved, became increasingly strong and better at learning and
complex problems by reasoning through bodies of knowledge, represented mainly as decision-making.
a body of if–then rules.
Not only did AlphaGo win, but it also invented some winning moves, several of which
Deep Blue’s rules were designed by human experts in chess. In this sense, the were so surprising that they upended hundreds of years of wisdom. The reason
program acted like a human expert would. The difference between Deep Blue and AlphaGo could surprise human experts was precisely because it didn’t follow strict
a human expert, however, was that Deep Blue could evaluate many more positions human instructions, as Deep Blue did, but learned from its own experience playing
than any human ever could: 200 million positions per second. And this paid off. the game.

Almost twenty years later the computer program AlphaGo came to the stage. Parallel to the success of programs such as Deep Blue and AlphaGo, developments
AlphaGo then competed against legendary Go player Mr Lee Sedol. AlphaGo’s 4-1 in artificial intelligence (AI) and machine learning (ML) grabbed the attention of
victory in Seoul, caught headlines worldwide. industries worldwide, and therefore the attention of supervisors and policy makers.
Since then, think-thanks, academics and supervisors have written extensively about
Go is a profoundly complex game, much more complex than chess. There are an machine learning, and its implications for the financial markets. See for example
astonishing 10 to the power of 170 possible board configurations – more than the the OECD’s report on opportunities, challenges, and implications for policy makers
number of atoms in the known universe. Hence it was impossible to capture each because of the application of artificial intelligence in finance.1
board configuration in a body of if-then rules, as had been tried with Deep Blue in the
game of chess. A different approach was required.

1 See oecd.org/finance/financial-markets/Artificial-intelligence-machine-learning-big-data-in-finance.pdf

01 Machine Learning in algorithmic trading algorithms 4

Aim study Scope or limitations study

However, to the best of our knowledge, few studies have been published about the The reader should bear in mind that:
actual use of artificial intelligence or machine learning in algorithmic trading. Also, • The observations in this study are based on information provided to the AFM
few supervisors have shared concerns about risks relevant to conduct supervisors, by several large, Dutch, proprietary trading firms that use (almost exclusively)
as opposed to risks for financial markets in a more general sense. algorithmic trading.
• The observations are not necessarily representative for the algorithmic trading
The AFM aims to do exactly that with this publication: report about the actual use industry in general, especially not for algorithmic trading by firms not trading on
of machine learning as reported by a subset of Dutch proprietary traders, and report their own account (e.g., brokers that execute orders for clients).
about the possible risks relevant to its supervision. The aim of this publication is to • The observations and risks relate to the inner workings of trading algorithms,
contribute to the public debate, inform academia and other supervisors. In addition, not necessarily to the speed at which they trade.
the AFM uses the findings in this study to focus its supervision on the most relevant • The observations are based on information provided to the AFM by trading firms.
risks to its supervision. The AFM is not able to independently verify all claims.
• Technology is subject to constant development. Therefore, the observations today
(2022) might differ from observations in the future. The same applies to priorities in
Approach study risk assessment.

The AFM started this study by reading literature on the topic and coming up with
a shortlist of possible risks relevant to the supervision of a conduct supervisor Structure of this report
on the financial markets. Next, we designed a detailed survey using the input of
several trading firms. The objective of the survey was to get quantitative information Section 2 explains some concepts that are relevant to understand the application of
from some Dutch proprietary trading firms about their use of machine learning in machine learning in algorithmic trading. We pay special attention to the difference
algorithmic trading, and to report on the risks they see. between a ‘machine learning algorithm’ and a ‘trading algorithm’ and show how the
two meet in a ‘machine learning based trading algorithm’. Section 3 lists the AFM’s
The surveys were filled out by several Dutch algorithmic trading firms, and main observations about the use of machine learning in algorithmic trading. We
subsequently discussed in interviews with subject matter experts from the firms. also note trading firms’ assessment on potential risks. Section 4 focuses on possible
risks from the use machine learning in algorithmic trading, focusing on two risks
in particular. Lastly, the AFM raises a few points that it considers relevant to both
regulators and market participants, and hope they might stimulate discussion.

01 Machine Learning in algorithmic trading algorithms 5

 02 Terminology matters
In this section we explain some notions that are important to understand the When thinking and talking about algorithmic trading, terminology matters a great
application of machine learning in algorithmic trading. First, we explain algorithmic deal. There is a need to speak the same language and account for the many nuances
trading and high-frequency trading, and how the two differ. Then we give a brief in algorithmic trading, especially when it comes to analyzing the impact and risks of
overview of machine learning techniques. algorithmic trading for the financial markets.

In our discussion with supervisors and trading firms, the AFM observed that We start by defining three terms:
the terms ‘machine learning algorithm’ and ‘trading algorithm’ tend to be used Execution algorithms are algorithms that aim to execute an order. The decision to
interchangeably. Furthermore, the AFM observes that supervisors tend to think mostly invest in the financial instrument is taken elsewhere. These algorithms are often used
of ‘reinforcement learning’ when thinking about machine learning in the context of to place large orders in the market as to minimize price impact. An example would
algorithmic trading. be a Volume-Weighed Average Price (VWAP) algorithm.

In section 2.3. we aim to show how a machine learning algorithm is different from a Trading algorithms or investment decision algorithms aim to automate a strategy,
trading algorithm, but that the former can be an intrinsic part of the latter. We point and automatic execution is part of that. In contrast to execution algorithms, a trading
to the ‘implicit’ and ‘explicit’ use of machine learning in trading algorithms. Our hope algorithm does take the investment decision. The algorithm can be programmed via
is that, by pointing out the more implicit use of machine learning in algorithmic a body of if-then rules to initiate an action if certain conditions are met, but it can also
trading, the reader will see that machine learning has implications for the financial use a machine learning model to detect trading opportunities (as we will see below).
markets that go far beyond reinforcement learning only. An example would be an algorithm that seeks to optimize a portfolio’s exposure and
automatically execute the strategy.

Algorithmic trading
2.1. Algorithmic trading and high-frequency trading
Automated Execution Automated Trading
The algorithmic trading universe is vast, and algorithms come in many shapes and
Goal: execute an order (intelligently) Goal: automate a trading strategy
sizes. Trading algorithms can use different techniques ‘under the hood’, ranging from
bodies of if-then rules to advanced artificial intelligence. They are used by many Hedge funds, trading desks of
Hedge funds, pension funds,
investment banks, proprietary
different actors, ranging from pension funds to proprietary traders. Some trading investment banks, brokers
trading firms.
algorithms are very fast and need to be so, while for others speed is less important.

Investment decision Investment decision is taken

is taken elswhere by algorithm

02 Terminology matters 6
Another concept associated with algorithmic trading, and often (wrongly) used as ‘Features’ play an important role in the context of machine learning, and this term
equivalent to algorithmic trading, is high-frequency trading (HFT). With HFT, a trading will be used frequently within this study. A feature is any measurable or quantifiable
system analyses market data at a very high speed, and sends large numbers of orders characteristic that represents some relevant phenomenon in the context of the
or revises these orders within a very short time span in reaction to this analysis. modelling problem and is used as an input to a machine learning model. Think of
a feature as a numerical representation of (relevant parts of) the state of the world
HFT is not a strategy, it is a technology with which trading strategies are executed.2 which can be processed by a machine learning model. A key component of the
So some algorithmic trading firms use HFT, while others don’t. machine learning process is to determine the right set of features for the task at hand.

Example:
2.2. Machine Learning in algorithmic trading Trading firm X wants to predict the price of share XYZ 1 second from now. The firm
believes that the current volume in the order book and the price trend over the
In this section we introduce the notion of machine learning in the context of past 10 seconds contain some valuable information about where the price will be
algorithmic trading. The aim is to give the reader a sense of the different types of heading in the next second. Hence trading firm X chooses ‘volume in order book’
machine learning and how they can be used in algorithmic trading. and ‘price trend over past 10 seconds’ as features in its prediction model.

Introduction Machine Learning techniques

Broadly defined, we take machine learning to consist of sets of rules that use data to The process a machine learning algorithm uses to learn and the type of output it
automatically ‘get better’ at performing a particular task.3 obtains depend on the type of technique applied. The field of machine learning is
often divided into three types of techniques:
With ‘getting better’ in the context of algorithmic trading, one could think of getting 1. Unsupervised learning
better in predicting or estimating a share price (‘Is the share price going up in the 2. Supervised learning
next second?’, ‘What is the theoretical price of an option?’), which is the domain of 3. Reinforcement learning
supervised learning, or to make more profit or to achieve better execution, which is
the domain of reinforcement learning (more on this later).

The machine learning algorithm does so by ‘learning’. By learning in this context, the
AFM does not refer to the mental process of learning as humans do. Learning in the
context of machine learning refers purely to the process of getting better.

2 Algorithmic trading (afm.nl)

3 One could argue that this definition does not quite fit unsupervised learning. After all: while supervised
learning and reinforcement learning might get better at predicting a future price or picking the best action
in any state, unsupervised learning has a less clear benchmark to measure improvement. Hence: one
could add ‘or finds patterns in data’.

02 Terminology matters 7
 Machine learning Example:
Trading firm X wants to know which shares tend to behave similarly. That is: they
would like to divide shares into groups A, B, C, D, so that shares which belong to the
same group have similar levels of volatility, trading volume or other characteristics.
The clustering can in turn be used to assign different risk profiles to the different
groups of shares. Trading firm X uses a k-means clustering algorithm to do so.

Supervised Unsupervised Reinforcement

Supervised learning
A supervised learning algorithm learns by repeatedly adjusting the weights4 of its
Task driven Data driven Learn from features so that its output deviates less and less from the output that the algorithm
(Predict next value) (Identify clusters) Mistakes
is supposed to give. To know what output the algorithm is supposed to give (the
‘labels’), the algorithm is handed many examples. That is: the algorithm is shown
Source: 1. Machine Learning in Finance: The Landscape - Machine Learning and Data Science what the output should be for a given set of features.
Blueprints for Finance [Book] (oreilly.com)
Now, via gradually changing its weights, the supervised learning algorithm is
Based on conversations with academics and Dutch algorithmic trading firms, the supposed to learn the relationship between the features and the output, and
AFM observes that supervised learning is the current ‘go-to’ technique for machine eventually it should be able to infer the output (or predict what the output will be in
learning in the Dutch proprietary algorithmic trading industry, but that reinforcement the future) by only looking at the features. Once that point is reached, a trading firm
learning might be the ‘future’ (see section 3). can use the algorithm to improve its trading performance.

We will briefly discuss these three different types of techniques in the context of A common application of supervised learning by proprietary algorithmic trading firms
algorithmic trading. is to predict the price of a financial instrument (see section 3).

Unsupervised learning Example:

An unsupervised learning algorithm is a type of algorithm that learn patterns in data. Trading firm X wants to predict the midpoint price of share XYZ 1 second from now.
Common applications in the trading industry are clustering (‘What groups of financial The firm thinks that some features might have predictive value, e.g., the historical
instruments tend to have similar properties?’) or dimensionality reduction (‘Can we trend in the share price might tell something about where the price will be heading.
reduce 1.000 features to 100 features, while still predicting the share price reasonably They apply a linear regression model to many rows of historical data and obtain a
well?’). These techniques are mainly used in the exploration stage of new trading model which has learned the relation between trend in share price (and many other
strategies. features) and future share price. They use the predictions of this ‘trained’ model in
their trading algorithms.

4 Weight can be thought of as the mathematical equivalent to the contribution of a feature to the output of
the model.

02 Terminology matters 8
Reinforcement Learning 2.3. Machine learning based trading algorithm
In contrast to supervised learning, a reinforcement learning algorithm does not learn
from labelled data, but via trial and error. That is: one implements a reinforcement In our conversations with trading firms the AFM observed that it is very important
learning based trading algorithm in a simulation environment (or in a real market for to use the right terminology when talking about machine learning in the context of
that matter), and the algorithm is supposed to learn over time to choose the optimal algorithmic trading. For example: asking a trading firm if it uses machine learning in its
action in each state of the market. trading, the firm might say ‘No’. If we would ask the same firm if its trading algorithms
in some way use the output of a machine learning technique to determine some
The algorithm does so by measuring how much each action in each state has trading parameters such as ‘price’ or ‘volatility’ in some model (which we might
contributed to some overarching objective, e.g., profit or execution costs. If an equate to ‘using machine learning in trading algorithms’), the answer might be ‘Yes’.
action did well (i.e., cancelling an order is followed by high profits at the end of the
trading session), then the trading algorithm is more likely to pick the action the next The main point of confusion seems due to the fact that both a trading algorithm and
time it faces the same state of the market. Was the effect negative (e.g., sending in a a machine learning algorithm are instances of an ‘algorithm’, yet have very different
large market buy order is followed by high execution costs at the end of the trading functions. A machine learning algorithm doesn’t do any trading, and a trading
session), then the action will be picked less frequently in that state of the market. algorithm doesn’t do any machine learning. A trading algorithm might use the output
of a machine learning algorithm to determine one or more components in the
So, reinforcement learning is not concerned with predicting a future share price, for trading algorithm, but the trading algorithm itself does not do any learning.
example, but with choosing the actions the trading algorithm should take in order
to achieve some objective. It does not do so by comparing its action to some set of Also, the AFM observes that most supervisors, and some trading firms, tend to think
actions the algorithm is ‘supposed’ to take (such as the predictions an algorithm is solely of reinforcement learning when talking about machine learning being used in
‘supposed’ to make in the case of supervised learning), but by finding out over time trading algorithms.
and through experience what the optimal action is.
The AFM aims to show the wider implications and impact of machine learning in
The result is a model that chooses the best possible action (i.e., the action that algorithmic trading by pointing out also the more implicit use of machine learning in
historically has done best) in every state of the market. trading algorithms.

Example: We will define the term ‘machine learning based trading algorithm’ to refer to any
Trading firm X wants to optimise profits. Being a market maker, it would like to know trading algorithm that uses (the output of) a machine learning model. A machine
at what price level to send in a new buy order, given the state of the order book at learning based trading algorithm can use machine learning either implicitly or
the current point in time. It can pick actions such as: bid level 1, bid level 2, …, bid explicitly.
level 100, etc. They trained a model using reinforcement learning. Given the current
state of the order book, the model has learned that sending in a buy order at the
5th-best level in the order book has resulted in the most profitable runs in the past.
Hence, the trading algorithm will send in a buy order at the 5th price level.

02 Terminology matters 9
Implicit Furthermore, they define for each predictor certain thresholds, meaning: if the value
The trading logic of a machine learning based trading algorithm can be very similar to would go above/below a pre-determined number, then the traders think the price 1
the logic of a ‘traditional’ or non-machine learning based trading algorithm. The only second from now will be higher. For example: If the price has increased more than
difference might be that certain numbers that had been pre-defined or hard-coded in 1% over the last 10 seconds, then the traders assume the price will keep going up in
the trading algorithm (see example below), are now obtained via a machine learning the next second. They formalise this into a body of if-then rules, which basically says
model. So, a machine learning component is added to a traditional trading algorithm, that if the price went up more than 1% over the last 10 seconds, then we predict the
while not fundamentally changing the trading algorithm’s decision logic. price will go ‘Up’ in the next second:

Def price_10_second_from_now_higher(x):
In such cases, we call the trading algorithm implicitly machine learning based.
If trend_past_10_seconds > 1% or ….

We present a very simple trading algorithm that sends in a buy order if it assumes the Return “True”

price of the share 1 second from now will be higher than it is now. Note that this is a Else:
trading algorithm, not a machine learning algorithm: Return “False”

End if
If price_1_second_from_now_higher(x) then:
Prediction (obtained
Trading algorithm send_buy_order(x) via machine learning We plug this function into our trading algorithm and (assuming our traders have
or not)
End if indeed isolated good predictors) the predictions will be reasonably accurate.

At this point in time, we don’t have sufficient information to determine if this is a Option B: Machine learning based
machine learning based trading algorithm or not. In green we have the component The trading firm that uses this trading algorithm thinks that a machine learning
that could turn this trading algorithm into a machine learning based trading model might give them better price predictions, and in turn a more profitable trading
algorithm. This all depends on how the price_1_second_from_now_higher(x) algorithm.
function arrives at its prediction.
They have trained a logistic regression model that uses 1.000 features to predict if the
Option A: Expert-based price 1 second from now will be higher:
Suppose a group of experienced traders decide that the following are reasonably
Def price_1_second_from_now_higher(x):
good predictors of the share price 1 second from now:
6
• Trend over past 10 seconds If logistic_regression_model(x) == 1 then:

• Number of liquidity taking buy transactions minus liquidity taking sell transactions in Return “True”

past y seconds Else:

• Trend in related instruments Return “False”

End if

The trading firm plugs this trained model into its trading algorithm.

02 Terminology matters 10
We see that the decision logic of the trading algorithm remains the same. It still Compare the following example to the implicitly machine learning based trading
decides to send in a buy order if it predicts the price to be higher 1 second from algorithm above. In the previous example the programmer explicitly prescribed
now. The way it arrived at the prediction, however, is different: in case of Option B which action to take (‘send_buy_order’) if a condition was met. In this example, the
the output of a machine learning model determines whether to send an order or reinforcement learning algorithm decides which action to take if a condition (read: a
not, while in case of Option A the output of a non-machine learning model (read: a ‘state of the market’) is met. This is a fundamental difference: while the programmer
body of if-then rules) does. Therefore, we call the trading algorithm using option B hands the reinforcement learning algorithm a couple of actions to choose from, it
machine learning based, and option A not. does not know up front which action the model and therefore the trading algorithm
will take.
The AFM observes that proprietary trading firms in scope of our study make frequent
Optimal action
use of such implicitly machine learning based trading algorithms (see section 3). current_state = get_current_state_of_market() (obtained via
Trading algorithm
take_best_action_in_state(current_state) Reinforcement
Explicit Learning)

In the case of an implicitly machine learning based trading algorithm as defined in the
previous section, there is a relatively clear distinction between the machine learning It is the latter use of machine learning in algorithmic trading that supervisors often
algorithm and the trading algorithm. One produces an output that is used by the think of. Yet, as we will see in section 3, this is not (yet) the main application of
other. machine learning in trading algorithms.

In the case of an explicitly machine learning based trading algorithm, this distinction
is much less clear. By an explicitly machine learning based trading algorithm the AFM
refers to any trading algorithm that uses (the output of) a machine learning model,
where the latter is not restricted to a well-defined stage of its set of instructions.
One could say that the decision logic (‘What action to take in which state?’) of the
trading algorithm is (largely) determined by the machine learning model. The prime
example of an explicitly machine learning based trading algorithm is a reinforcement
learning based trading algorithm, that has learned which action to take in any state of
the market.

02 Terminology matters 11
 03 Observations
In this section we describe the AFM’s main observations about the use of machine Firms tell the AFM that machine learning is most heavily used in liquid asset classes,
learning in algorithmic trading. such as equity and futures. Machine learning is also used in other asset classes (e.g.,
options), although its application tends to be different than its application in equity
Recall that these observations are based on surveys sent to – and conversations had and futures. Where machine learning models in liquid asset classes are mostly used
with – some Dutch proprietary trading firms. Also, recall that the observations are to predict the future price of a financial instrument, machine learning in less liquid
based on information provided to the AFM by trading firms, and are not necessarily asset classes is more often used to calibrate parameters such as volatility, which are
representative of other segments of the algorithmic trading industry (e.g., brokers in turn used as parameters in pricing models of trading algorithms.
executing orders for clients). See section 1 for the scope of our study.

3. Machine learning models look primarily at order

1. Machine learning is applied on a large scale in book data, no fundamental information, and use 100-1.000
algorithmic trading features

Trading firms tell the AFM that machine learning is implicitly or explicitly used in 80%- Trading firms tell the AFM that:
100% of their trading algorithms. This percentage is higher than the AFM expected, • Their machine learning based trading algorithms look at features such as:
and shows that machine learning is no hype, but an intrinsic part of the business o Volume in order book
models of many trading firms nowadays. o Price trend
o Volatility
o Order book imbalance
2. Many machine learning models used in algorithmic • Models use many permutations of the same features (e.g., volume in order book
trading try to predict the price of a financial instrument on the first level, volume in orderbook on the second level, etc.).
• Models used in one financial instrument use features computed on other financial
Price prediction is a clear example of how machine learning can be implicitly used in instruments, asset classes and trading venues (e.g., order book data of a share on
trading algorithms – see section 2.3. CBOE is important to predict the price of the same share on Euronext).
• Models use in the range of 100-1.000 features.
• Features computed over the recent past (sub second) tend to be more predictive
than features computed over longer time horizons (e.g, minutes).
• Models do not look at fundamental information (e.g., yearly reports).

03 Observations 12
4. Trading firms heavily rely on supervised learning, So irrespective of how a trading algorithm arrives at its trading decision, most trading
not (yet) reinforcement learning firms state it might be sufficient to monitor the conduct of the trading algorithm, not
necessarily its inner workings. It is in this sense, firms claim, that machine learning
The trading firms in scope of this study tell the AFM that: based trading algorithms do not differ from non-machine learning based trading
• Most machine learning models in use are supervised learning models. algorithms.
• Unsupervised learning models are used, but mostly in the pre-trading phase (e.g.,
feature selection). See section 4 for the AFM’s views on the risks of lack of explainability of machine
• Reinforcement learning based trading algorithms are not used in practice yet. learning based trading algorithms.
However, most agree that reinforcement learning might be a promising technique
in the future. Recall that reinforcement learning allows trading algorithms to learn
through trial and error which action to take in any state of the market. 6. Trading firms see risks of reinforcement learning based
• Trading firms tend to prefer simpler supervised learning models such as linear and trading algorithms to learn unintentional and negative
logistic regression to more complex models such as artificial neural networks. trading behaviour
• The actions that a machine learning based trading algorithm can take are hard-
coded and limited, e.g., send a buy order or sell order, or cancel an existing order. The trading firms in scope of this study tell the AFM that they do see limited risks of
So, most trading algorithms are implicitly machine learning based, as defined in the a supervised learning based trading algorithm (e.g, the price prediction example in
previous section. section 2) to learn unintended and negative trading behavior, or to manipulate the
• Machine learning models are retrained periodically, ranging from weeks to months. market. However, trading firms do see risks of reinforcement learning based trading
Retraining a model could potentially change the way a trading algorithm responds algorithms to learn unintended and negative behavior. Trading firms tell the AFM that
to market conditions. this is one of the reasons they are at present hesitant to apply such techniques in
practice.

5. Trading firms find explainability of models less See section 4 for the AFM’s views on the risks on market manipulation of machine
important than performance learning based trading algorithms.

The trading firms in scope of this study tell the AFM that they are not much
concerned about a potential lack of explainability of their machine learned based
trading algorithms. Firms stress that performance or predictably of trading algorithms
is more important to them than explainability of the models. Furthermore, firms tell
the AFM that any trading algorithm, machine learning based or otherwise, should be
judged on its output (i.e., orders, transactions, deletions, etc.), not how that output
came about.

03 Observations 13
 04 Risks
In this section we describe the main risks of the use of machine learning in This added complexity has direct ramifications for trading firms – see Annex 3
algorithmic trading, from the perspective of a conduct supervisor. for a selection of relevant RTS6-requirements that might be impacted by lack
of explainability. For one, if a trading algorithm is suspected to cause disorderly
The AFM identifies several potential risks of the use of machine learning in trading conditions, the trading firm should be able to explain to the supervisor how
algorithmic trading to the fair and orderly functioning of financial markets. See Annex the algorithm’s trading decision came about. This information is important for a
2 for some more potential risks of the use of machine learning in algorithmic trading supervisor, since it allows the supervisor to assess if the resulting behavior was
to the integrity of the financial markets. Based on an analysis of our supervisory tasks intended or unintended. Note that, in a more general sense, a trading algorithm
and relevant legal articles, the AFM considers two risks especially important: lack should not act in an ‘unintended manner’ (RTS 6 Article 5(4) – see Annex 3).
of explainability of machine learning based trading algorithms, and risks of market
manipulation of machine learning based trading algorithms. Furthermore, the risk and compliance staff of a trading firm should have sufficient
knowledge of the algorithmic trading strategies of the trading firm, and sufficient
Recall that the AFM is the conduct supervisor on the Dutch financial markets. As authority to challenge trading staff. The more complex trading models become, the
such, risks relevant to its supervision might differ from risks relevant to a prudential more difficult it will be for risk and compliance staff to challenge developers on the
supervisor, such as the Dutch Central Bank. implications of using specific features or machine learning models (Annex 3 RTS 6
Article 3(4)).

4.1. Explainability Also, the more features a model uses and the more complex a model becomes, the
more difficult is for any human to deduce how the trading algorithm will behave
As pointed out in section 3, trading firms in scope of this study tell the AFM they are under any given circumstance a priori. The AFM already sees that it is difficult for
not much concerned with any lack of explainability of trading models. However, the some trading firms to be sure how their machine learning based trading algorithm
AFM does notice risks due to a lack of explainability of machine learning models used will behave before deployment in a testing or a real environment. This puts an
in algorithmic trading. increasingly large burden on trading firms to test their trading algorithms properly, in
order to be sufficiently sure the algorithm will behave as intended and not cause any
The AFM acknowledges that more complex machine learning models can disorderly trading conditions, before deployment on the real markets.
outperform simpler models (e.g., they might be better in predicting a future share
price). However, more complex models might also be less easy to interpret, explain
and control by trading firms. Similarly, adding more features to a model might
improve its performance, but might also make it more difficult to understand or to
explain the effect of a feature on the algorithm’s trading behavior.

04 Risks 14
The latter requires a testing environment that is sufficiently realistic to account for The effect any feature might have on the trading behavior of a machine learning
the interaction with other trading agents (e.g., other trading algorithms). In its 2021 based trading algorithm tends to be less transparent than in traditional trading
study ‘Algorithmic Trading – Governance and Controls’, the AFM concluded that decisions. Take a feature such as order book imbalance, which is important in the
many testing environments at present are not sufficiently realistic to account for the predictions of many trading algorithms.5 This feature can itself be multiplied with
intricate, yet important, microstructure of real trading markets. many other inputs. Consequently, the effect of a change in order book imbalance on
an algorithm’s trading behavior becomes less obvious, allowing any negative effects
Lastly on this matter, trading firms in scope of this study tell the AFM that that they (e.g., spoofing) on the trading algorithm to go unnoticed for longer. Therefore, it
have surveillance systems in place to detect market manipulation or unintended might become increasingly difficult to observe when a machine learning based
trading behavior if it were to take place. The AFM would like to stress that after-the- trading algorithm is in effect being misled or manipulated.
fact surveillance does not relieve firms from the responsibility to make sure their
trading algorithms behave in orderly manner and as intended in the first place. We have already seen that many trading firms use a similar subset of features. Also,
trading firms might use a similar dataset, hence might obtain similar information as
to which features affect predictions in what manner. Knowing the importance of
4.2. Market Manipulation features, and how they affect the predictions of other trading algorithms, could allow
a user to nudge the trading behavior of other market participants into the (for the
Supervisors’ focus, including the AFM’s, is often on detecting the agents that user) slightly more desirable direction.
manipulate the market. Yet market manipulation is a function of two components: (1)
agents manipulating, and (2) agents being manipulated. Hence, in case we would like Combining these components (more features, the effects of features on predictions
to minimize market manipulation, we should also focus on making trading algorithms being less obvious and firms sharing a similar subset of features) could increase
less receptive to manipulation. machine learning based trading algorithms’ susceptibility to market manipulation.

Supervised learning Reinforcement learning

With that in mind, the AFM at present believes that implicitly machine learning based Like some trading firms (see section 3), the AFM is concerned about the implications
trading algorithms do not necessarily pose a greater risk to manipulate the market of reinforcement learning for market manipulation. The AFM considers it likely that a
than traditional trading algorithms. reinforcement learning based trading algorithm will learn to manipulate the market, if
programmed naively.
However, supervised learning techniques might make trading algorithms more
susceptible to falling prey to manipulation. The reason for this is as follows:

We have seen that today’s supervised learning based trading algorithms can use
up to 1.000 features. Machine learning allows the user to extract valuable information
from such features, and it is not necessary anymore to understand why a feature
might have predictive value. If it does, one can add it to the model. Therefore,
machine learning based trading algorithms tend to use more features than traditional
algorithms, hence more features that affect an algorithm’s trading decisions. 5 See this study by the AFM, the Alan Turing Institute and the Oxford Man Institute of Quantitative Finance
into the predictors of the trading decisions of trading algorithms

04 Risks 15
If the objective of a machine learning based trading algorithm is to optimize some
objective (e.g., profit or price impact), then – if other trading algorithms would be
susceptible to manipulation and the reinforcement learning algorithm could profit
from doing so – there is no reason a priori to assume the trading algorithm will not
learn negative trading behavior, or even to manipulate.

The AFM notes that trading algorithms could learn to manipulate the market even if
its developers don’t want them to. Hence, good will on the side of developers is not
sufficient to prevent market manipulation.

Manipulation could be restricted to a single instrument on a single trading venue,

hence relatively easy to detect. Yet in principle such manipulation could be very
shrewd and span multiple trading venues, asset classes or instruments, which makes
it extremely difficult to detect.

The application of reinforcement learning techniques, and the implications for market
supervision, is to be monitored closely. Furthermore, further research by academia or
supervisors could be useful in determining the exact ramifications of reinforcement
learning based trading algorithms.

04 Risks 16
 05 Discussion points
The following points are related to the use of machine learning in algorithmic trading, 3. One way to deal with risks of lack of explainability and market manipulation by
and the AFM hopes they might stimulate discussion. The list is not meant to be machine learning based trading algorithms is through control frameworks (e.g.,
exhaustive. risk controls, compliance involvement, monitoring, etc.). Another might be a
larger focus on (realistic) testing environments (e.g., a focus on the output of
1. There might be substantial risks of reinforcement learning based trading models to observe how the output might differ in different circumstances).
algorithms to learn to manipulate the market. The AFM is told by trading firms
in scope of this study that they do not yet apply reinforcement learning in Lily Bailey and Gary Gensler put this as follows: ‘The supervisory focus could be
practice, but we expect that these techniques are being applied in other parts shifted from documentation of the development process and the process by
of the algorithmic trading industry. The AFM believes this development is to which the model arrives to its prediction to model behavior and outcomes, and
be monitored closely. It also begs the question whether current legislation is supervisors may wish to look into more technical ways of managing risk, such as
sufficiently equipped to mitigate any risks specific to this form of AI. adversarial model stress testing or outcome-based metrics’

2. At what point does an updated trading algorithm become a new algorithm?

What if features are added or removed? What if a model is retrained? After each
of these adjustments the algorithm might arrive at, for example, different price
predictions, and is likely to act differently from how it acted before.

This discussion is relevant for various reasons. One being that trading firms
should – as part of their transaction reporting to the financial supervisor – report
the trading algorithm used to execute a transaction. This information allows
supervisors to detect trading algorithms that might behave in a wrong fashion.
The same goes for testing of trading algorithms by trading firms: firms should test
any new trading algorithm as to make sure they comply with RTS 6.

Hence a clear definition of ‘trading algorithm’ seems appropriate.

05 Discussion points 17
 Annex 1 Definitions
Word Definition

Machine learning Generic term used to describe different types of

techniques in which machines independently learn and
aim to get better at a task or prediction. Often divided Machine learning
into unsupervised, supervised, and reinforcement learning

Implicit machine Trading algorithms that at some well-defined stage in

learning based its set of instructions makes use of predictions/outputs
trading algorithm obtained via a machine learning algorithm. The logic of
the trading algorithm might be very similar to a non-
machine learning based trading algorithm, yet certain
variables – think size and/or price or aggressiveness/ Supervised Unsupervised Reinforcement
passiveness – are obtained via applying a machine
learning model. An example would be a market making
Task driven Data driven Learn from
trading algorithm that uses (the output) of a deep neural (Predict next value) (Identify clusters) Mistakes
network to determine the price of any order to send to
the market.
Source: 1. Machine Learning in Finance: The Landscape - Machine Learning and Data Science
Explicit machine Trading algorithms that use (the output of a) machine
Blueprints for Finance [Book] (oreilly.com)
learning based learning model, where the latter is not restricted to a
trading algorithm well-defined stage of its set of instructions but is in fact
the trading algorithm. Or equivalently: the machine-
learning algorithm is not part of an overarching trading
algorithm, but acts – to a large degree – autonomously
in the market. An example of an explicit machine learning
based trading algorithm would be a reinforcement
learning based trading algorithm, that at its own
discretions decides when and how to act in any particular
state of the order book.

Feature Any measurable or quantifiable characteristic that

represents some relevant phenomenon in the context
of the modeling problem and is used as an input for a
machine learning model. E.g., order book imbalance
when modeling price movements.

Annex 1 Definitions 18
 Annex 2 Risks of Machine Learning
in Trading
There is plenty of literature on the topic of risks of machine learning (and artificial 5. Knowledge gap
intelligence) in the financial industry, both from an academic- and a regulatory Due to large investments in machine learning by especially the private sector, the
perspective. In the literature and through conversations the AFM had with experts on difference in machine learning expertise between trading firms and supervisors
the topic (both academics and market participants), the following risks recur. Please (or traders and compliance personnel) might have become so large that the latter
note this list is non-exhaustive. might be insufficiently able to challenge the former or detect potentially malign
1. Explainability or the “black-box” nature of machine learning algorithms trading behaviour.
The complexity of machine learning algorithms might make it very difficult to pin
down why a machine learning based trading algorithm takes a certain action. This
has implications for compliance with various regulatory standards.
2. Market manipulation
Machine learning based trading algorithms might be more prone to
(unintentionally) to manipulate the market (for example: spoofing) or colluding6.
Also, they might be more susceptible to being manipulated7.
3. Procyclicity
If a proportion of the machine learning based trading algorithms respond
similarly to certain market conditions, their actions might exacerbate market
dynamics (think: volatility, trend, etc.), in turn causing even more reaction by these
algorithms.
4. Concentration risk
The investments required by trading firms to benefit from machine learning (in
both human resources, data and technology) might make it economically feasible
only to a select few, hence creating a less levelled playing field.

6 See the following paper for an example of trading algorithms colluding: Cartea, Álvaro and Chang, Patrick
and Penalva, José, Algorithmic Collusion in Electronic Markets: The Impact of Tick Size (May 10, 2022).
Available at SSRN: https://ssrn.com/abstract=4105954 or http://dx.doi.org/10.2139/ssrn.4105954
7 Wang, X.; Hoang, C.; Vorobeychik, Y.; Wellman, M.P. Spoofing the Limit Order Book: A Strategic Agent-Ba-
sed Analysis. Games 2021, 12, 46. https://doi.org/10.3390/g12020046 . Note: Although this paper is not
specifically about machine learning based trading algorithms, the study shows that some trading strategies
looking at order book information might be susceptible to be manipulated.

Annex 2 Risks of Machine Learning in Trading 19

 Risks A more granular overview of risks of automated trading as we found in the literature and deemed relevant for this theme:

Trading algorithms ‘In contrast to the analog, human protagonists of traditional market manipulation, new market manipulation generally uses the electronic
programmed to communications, information systems, and algorithmic platforms of the new, high-tech financial marketplace to unfairly distort information and
manipulate prices relating to financial instruments or transactions. At its core, these distortive actions and effects tamper with the humans and computerized
information and communications systems of the marketplace. They corrupt how humans and machines communicate between and amongst
each other in the financial markets. As such, this Article has termed this new approach to market manipulation, cybernetic market manipulation.’

Pinging: ‘With pinging, a larger number of small orders for a particular financial instrument are submitted and cancelled in fractions of a second
by computerized platforms to induce others in the marketplace to react to their “pings” and disclose their trading intentions to the pinging
party. Pinging allows the initiating party to discern valuable information at little to no risk since most of the pinging orders are cancelled prior to
execution.’

Spoofing: ‘With spoofing, orders are placed by computerized platforms for a financial instrument at prices outside the current bona fide limits to
spook other market participants to react in a manner favorable to the spoofing party. Spoofing allows the initiating party to distort the ordinary
price discovery in the marketplace by placing orders with no intention of ever executing them and merely for the purpose of manipulating honest
participants in the marketplace.’

Electronic front running: ‘Electronic front running is both similar and dissimilar from its traditional counterpart. Like its traditional counterpart,
electronic front running seeks to manipulate the marketplace by executing trades ahead of a known future price change, thereby profiting once
the price moving order is executed. Unlike its traditional counterpart that front ran traders via human brokers in small batches, electronic front
running frequently leverages new, high-tech mechanisms that allow brokers to gain an unfair glimpse into order flows at one trading venue and
to jump ahead of those flows to their advantage at another trading venue.’

Mass misinformation: ‘With mass misinformation schemes, parties can manipulate the marketplace through fake regulatory filings, fictitious news
reports, erroneous data, and hacking. Because the new financial marketplace is so reliant on interconnected information and communications
systems, a distortion to one source of information can have a large, volatile cascading effect on the greater marketplace in the short run, and a
confidence-jarring effect on the greater marketplace in the long run.’

Lin, Tom C. W., The New Market Manipulation (July 3, 2017). Emory Law Journal, Vol. 66, p. 1253, 2017, Temple University Legal Studies Research
Paper No. 2017-20, Available at SSRN: https://ssrn.com/abstract=2996896

Machine learning and ‘For example, AI models can identify signals and learn the impact of herding, adjusting their behaviour and learning to front run based on the
herding earliest of signals. The scale of complexity and difficulty in explaining and reproducing the decision mechanism of AI algos and models makes it
challenging to mitigate these risks.’

OECD (2021), Artificial Intelligence, Machine Learning and Big Data in Finance: Opportunities, Challenges, and Implications for Policy Makers,
Artificial Intelligence, Machine Learning and Big Data in Finance - OECD

Annex 2 Risks of Machine Learning in Trading 20

 Risks A more granular overview of risks of automated trading as we found in the literature and deemed relevant for this theme:

Explicit machine learning ‘In this study, I constructed an artificial intelligence using a genetic algorithm that learns in an artificial market simulation, and investigated
based trading algorithm whether the artificial intelligence discovers market manipulation through learning with an artificial market simulation despite a builder of
learning to manipulate artificial intelligence has no intention of market manipulation. As a result, the artificial intelligence discovered market manipulation as an optimal
investment strategy. This result suggests necessity of regulation, such as obligating builders of artificial intelligence to prevent artificial intelligence
from performing market manipulation.’

Takanobu Mizuta, Does an artificial intelligence perform market manipulation with its own discretion? – A genetic algorithm learns in an artificial
market simulation, (21 May 2020) 2020 IEEE Symposium Series on Computational Intelligence (SSCI)

Collusion See the following paper about trading algorithms colluding:

Cartea, Álvaro and Chang, Patrick and Penalva, José, Algorithmic Collusion in Electronic Markets: The Impact of Tick Size (May 10, 2022).
Available at SSRN: https://ssrn.com/abstract=4105954 or http://dx.doi.org/10.2139/ssrn.4105954

‘In digital marketplaces, increasingly sophisticated AI pricing agents (e.g. those based on DRL8 methods) could discover, by self-learning, how to
coordinate behaviors with their rivals, without being expressly instructed by their human developers or users, while also pursuing an optimal and
rational strategy, like profit maximization. Under this novel scenario, independent AI traders employed by competing firms would be sufficiently
sophisticated to self-learn the best policy actions and experiment with different strategies to optimize their (joint) cumulative performance.
Therefore, “tacit” collusion would result from independent AI agents’ autonomous decisions, without any prior human intent to achieve such a
level of policy coordination.’

Azzutti, Alessio and Ringe, Wolf-Georg and Stiehl, H. Siegfried, Machine Learning, Market Manipulation and Collusion on Capital Markets: Why
the “Black Box” Matters (January 6, 2022). European Banking Institute Working Paper Series 2021 - no. 84, University of Pennsylvania Journal of
International Law, Vol. 43, No. 1, 2021 1, 2021, Available at SRN: https://ssrn.com/abstract=3788872 or http://dx.doi.org/10.2139/ssrn.3788872

Herding, excess ‘Similar to non-AI models and algos, the use of the same ML models by a large number of finance practitioners could potentially prompt of
volatility, illiquidity, flash herding behaviour and one-way markets, which in turn may raise risks for liquidity and stability of the system, particularly in times of stress.
crash Although AI algo trading can increase liquidity during normal times, it can also lead to convergence and by consequence to bouts of illiquidity
during times of stress and to flash crashes. Market volatility could increase through large sales or purchases executed simultaneously, giving rise
to new sources of vulnerabilities. Convergence of trading strategies creates the risk of self-reinforcing feedback loops that can, in turn, trigger
sharp price moves. Such convergence also increases the risk of cyber-attacks, as it becomes easier for cybercriminals to influence agents acting
in the same way. The abovementioned risks exist in all kinds of algorithmic trading, however, the use of AI amplifies associated risks given their
ability to learn and dynamically adjust to evolving conditions in a fully autonomous way. For example, AI models can identify signals and learn
the impact of herding, adjusting their behaviour and learning to front run based on the earliest of signals. The scale of complexity and difficulty in
explaining and reproducing the decision mechanism of AI algos and models makes it challenging to mitigate these risks.’

OECD (2021), Artificial Intelligence, Machine Learning and Big Data in Finance: Opportunities, Challenges, and Implications for Policy Makers,
Artificial Intelligence, Machine Learning and Big Data in Finance - OECD

8 Deep Reinforcement Learning

Annex 2 Risks of Machine Learning in Trading 21

 Risks A more granular overview of risks of automated trading as we found in the literature and deemed relevant for this theme:

Systematic / macro risks ‘The regulation and control of financial activity can be classified into two main categories, micro and macro. Micro control, to be executed by the
micro AI, encompasses microprudential regulations and most internal risk management in financial institutions. It is inherently concerned with
day-to-day activities of financial institutions, is hands-on and prescriptive, designed to prevent large losses or fraudulent behaviour, mandating and
restricting how institutions should operate, what they can and cannot do, codified in the rulebook. While the rulebook was once in paper form, it
is now increasingly expressed as digital logic, allowing programmatic access. Most, but not all, of the objectives a micro AI has to meet exist in the
rulebook, and it generally has an ample number of repeated similar events to train on. All of this facilitates the application of AI to micro financial
problems.

Longer term objectives, such as the solvency of key institutions, financial stability and tail risk, risks that threaten the functioning of the financial
system – systemic risk – are macro problems. Inside the regulatory space, that encompasses macro prudential regulations, and in the private
sector, the management of solvency and liquidity risks for large financial market participants such as banks, insurance companies or mutual
funds. The macro task is much harder. Macro risk is created by the strategic interactions of many players and involves aggregate phenomena
such as bank runs or fire sales (Benoit et al., 2017).’

Danielsson, Jon and Macrae, Robert and Uthemann, Andreas, Artificial Intelligence and Systemic Risk (May 28, 2021). Journal of Banking and
Finance Journal of Banking and Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3410948 or http://dx.doi.org/10.2139/
ssrn.3410948

Annex 2 Risks of Machine Learning in Trading 22

 Annex 3 RTS 6 articles possibly affected
by lack of explainability
Take the following articles in RTS 6. This list is intended to be illustrative, not
exhaustive:
• RTS 6: article 2(1) Role of the compliance function: ‘An investment firm shall
ensure that its compliance staff has at least a general understanding of how the
algorithmic trading systems and trading algorithms of the investment firm operate.
The compliance staff shall be in continuous contact with persons within the firm
who have detailed technical knowledge of the firm’s algorithmic trading systems
and algorithms’

• RTS 6: article 3(4): Staffing: ‘An investment firm shall ensure that the staff
responsible for the risk and compliance functions of algorithmic trading have:
(a) sufficient knowledge of algorithmic trading and strategies; (b) sufficient skills
to follow up on information provided by automatic alerts; (c) sufficient authority
to challenge staff responsible for algorithmic trading where such trading gives rise
to disorderly trading conditions or suspicions of market abuse.’

• RTS 6: Article 5(4): ‘The methodologies referred to in paragraph 1 shall ensure that
the algorithmic trading system, trading algorithm or algorithmic trading strategy:
(a) does not behave in an unintended manner’

• RTS 6: Article 7 (1): ‘An investment firm shall ensure that testing of compliance with
the criteria laid down in Article 5(4)(a), (b) and (d) is undertaken in an environment
that is separated from its production environment and that is used specifically
for the testing and development of algorithmic trading systems and trading
algorithms.’

• RTS 6: Article 13: Automated surveillance system to detect market manipulation

Annex 3 RTS 6 articles possibly affected by lack of explainability 23

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