The same tools and techniques used in algorithmic trading can be used in risk management and regulatory oversight.

Risk Management

Real-time pre-trade risk firewall. As high frequency- and algorithmic trading are replacing manual processes the need for automated control systems to reduce risk is increasing. Human errors, fat fingers and miscalculated algorithms can cost businesses millions of dollars and cause severe damages. Controls can be applied against trading activity via pre-defined limits implemented on a pre-trade basis.

Back testing and market simulation. Algorithms can be tested using historical data before they are put to work in production.

Regulatory Oversight

Surveillance algorithms can be used to spot potential market abuse and compliance breaches. The goal of real time monitoring is to detect potential patterns while they are happening. Such patterns include insider trading, front running orders, painting the tape, fictitious orders, wash trading, and trade collusion.

Practice Question 1

A broker receives an order from a client to buy 1,000,000 shares of Company X. He holds it until he executes the purchase of a smaller order of the same stock in his own account. He then executes the client's larger order, which drives up the share price. He then sells his shares. This practice is known as ______.

A. front running orders
B. quote stuffing
C. wash trading

Correct Answer: A

Front running orders is the practice of a broker executing orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers. It is not only unethical, but also illegal. It is also known as tailgating.

Practice Question 2

Continuous data analysis and pattern recognition techniques used in high-frequency trading can be used to detect ______.

I. trading errors such as fat finger trades
II. market risks such as interest rate patterns
III. market abuse such as trader collusion

Correct Answer: I and II

Practice Question 3

Let's say trader A and B want more people to buy the stock of Company X. They decide to buy big blocks of Company X shares from each other so that the ticker shows a huge jump in trading volume for the stock. The idea is that unsuspecting investors will see the spike in activity, think something is brewing, and buy the stock. This in turn drives up the price of Company X shares, which is what trader A and B want. They sell their shares for a profit. This practice is known as ______.

A. fictitious orders
B. painting the tape
C. insider trading

Correct Answer: B

The practice is illegal as it creates an artificial price for a security.

Practice Question 4

A trader may offer to sell a large number of shares in stock X at a price that's a little away from the current price. When other sellers jump in on the action and the price goes lower, the trader quickly cancels his sell orders in X and buys the stock instead. Then the trader puts in a large number of buy orders to drive up the price of X. And after this occurs, the trader sells his holdings of X, pocketing a tidy profit, and cancels the spurious buy orders. This practice is referred to as ______.

A. order stuffing
B. layering
C. spoofing

Correct Answer: C

A spoofer places limit orders that are not intended to be executed.