Bank of England Warns of Higher Market Volatility From AI-Driven Trading

The use of artificial intelligence in algorithmic trading could exacerbate market volatility and amplify financial instability, according to a policy paper by the Bank of England released this week.

As global markets reel from President Donald Trump’s tariff policy changes, the United Kingdom’s central bank warned that the widespread use of AI for trading and investing could lead to a “herding” behavior that could raise the chance of sudden market drops, especially during times of stress because firms might sell off assets at once.

As more firms use AI for investing and trading, there’s a risk that many will end up making the same decisions at the same time, the paper said.

“Greater use of AI to inform trading and investment decisions could help increase market efficiency,” per the paper. “But it could also lead market participants inadvertently to take actions collectively in such a way that reduces stability.”

For example, the use of more advanced AI-based trading strategies could lead firms to “taking increasingly correlated positions and acting in a similar way during a stress, thereby amplifying shocks,” according to the paper.

Such market instability can affect the amount of capital available to businesses since they can’t raise as much when markets are down.

The report comes as global equity and bond markets have been on a roller coaster since the Trump administration announced a minimum of 10% tariffs on imports from all countries, with China, the European Union and a few other countries getting hit with higher rates.

The Dow Jones Industrial Average has fallen by 6.2% since Trump’s April 2 announcement, while the S&P 500 gave up 7.1% and the Nasdaq Composite fell by 6.9%. The benchmark 10-year Treasury yields rose from 4.053% to 4.509% over the same time frame as investors flocked to safety.

Federal Reserve Chair Jerome Powell said tariffs are “likely to raise inflation in coming quarters” and “it is also possible that the effects could be more persistent,” according to a transcript of his April 4 speech before the Society for Advancing Business Editing and Writing. Inflation is a key statistic influencing monetary policy such as the direction of the Fed funds rate.

Powell’s comments came five days before Trump decided to pause tariffs for 90 days for nearly 60 countries, except China.

Read also: Trump Boosts Tariffs on Low-Value Packages Again After China Retaliates

The use of AI in algorithmic trading could exacerbate these extremes because many companies rely on the same AI models or data, leading them to act similarly, according to the BoE paper.

Although AI might make markets more efficient by processing information faster than humans, it could also make them more fragile and less able to handle shocks, the paper said.

The central banker said the International Monetary Fund (IMF) identified herding and market concentration as the top risks that could come from wider adoption of generative AI in the capital markets.

The IMF’s 2024 report said the adoption of AI in trading and investing is “likely to increase significantly in the near future.” While AI may reduce some financial stability risks through improved risk management and market monitoring, at the same time “new risks may arise, including increased market speed and volatility under stress” and others.

On the positive side, AI could help financial services firms manage risk more effectively by making better use of the data they already have, the BoE paper said. With stronger risk management, firms are less likely to be caught off guard when prices suddenly drop.

That means they might not need to rush into selling off assets all at once, which is what happens during a fire sale. The resulting damage caused by market selloffs could be mitigated or even avoided.

The central banker also pointed to another potential mitigating factor. If investment managers use AI to tailor strategies specifically for each client, it could lead to more market stability since people won’t hold the same assets.

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