(This article is part three of a four-part series called A Question of Fairness: How to Level the Financial Markets Playing Field, which originally appeard on the Tabb Forum. To read Part One, Inequality in Equity Trading: How Did We Get Here?, click here. To read Part Two, On Trading Advantages and Trading Systems’ Vulnerability, click here.)

In a relatively short span of time, technological developments have revolutionized trading in the world’s financial markets. In the beginning of the 21st Century, most of the orders in the U.S. were still executed manually and by telephone. Today, only a dozen years later, almost all of the traffic is handled electronically.

Obviously, the marriage of computing technology and trading has brought many benefits to the markets, including increased speed and efficiency and substantially reduced trading costs. But the use of increasingly sophisticated technology has led to a number of new dangers and risks that regulators and self-regulating organizations have yet to control.

The Increasing Challenge for Regulators

Here’s one example of a recent development that reflects the increasing complexity of the regulatory environment. Technological advancements have supported the emergence of new trading venues that lie outside of the traditional exchange infrastructure. These venues, in turn, have given rise to arcane trading practices like “dark pools” that help market participants disguise large volume trades and maintain more favorable pricing than would exist in a truly transparent market.

In a relatively short span of time, technological developments have revolutionized trading in the world’s financial markets. In the beginning of the 21st Century, most of the orders in the U.S. were still executed manually and by telephone. Today, only a dozen years later, almost all of the traffic is handled electronically.

Obviously, the marriage of computing technology and trading has brought many benefits to the markets, including increased speed and efficiency and substantially reduced trading costs. But the use of increasingly sophisticated technology has led to a number of new dangers and risks that regulators and self-regulating organizations have yet to control.

The Increasing Challenge for Regulators

Here’s one example of a recent development that reflects the increasing complexity of the regulatory environment. Technological advancements have supported the emergence of new trading venues that lie outside of the traditional exchange infrastructure. These venues, in turn, have given rise to arcane trading practices like “dark pools” that help market participants disguise large volume trades and maintain more favorable pricing than would exist in a truly transparent market.

In addition, it is very difficult for regulators to perform the forensics necessary to detect market manipulation and identify the perpetrators in a complex, interconnected, computer-driven global trading environment.

After all, regulators—who have the primary responsibility for ensuring market transparency and fairness—often operate with IT systems that are decidedly inferior to the sophisticated, state-of-the-art platforms used by high frequency and algorithmic traders.

Of course, regulators also have to deal with a crushing volume of traditional crimes like insider trading and fraudulent investment schemes that tax their limited resources. And their efforts to keep pace with all of these market manipulators suffer from the same budgetary constraints that affect all governmental organizations.

Possible Conflicts of Interest Complicate Self-regulation

The exchanges and other self-regulatory organizations also struggle to maintain a public perception of fairness. After all, some large, powerful and very profitable customers use high-frequency trading strategies, co-located technology platforms and flash trading techniques to gain a technological advantage over the competition.

In many cases, these customers operate in gray areas of the law where there is no clear path to enforcement. But even in cases where there is a clear violation of the rules or principles of ethical conduct, the exchanges have to think twice about imposing punishment, because they run the risk of losing these highly profitable customers to other trading venues.

When you consider all of these issues and trends, it’s easy to understand why it’s so difficult for regulators, exchanges and other self-regulating organizations to maintain fairness and transparency in price discovery and trading.

But unless there is a resolution to these significant problems, the markets will eventually pay a heavy price. As more and more investors discover that they are operating at a disadvantage to the powerful few, there will be a dramatic increase in the demand for new legislation and regulation designed to ensure a level playing field.

In addition, many investors may decide to terminate their relationships with exchanges that do not enforce fair trading policies and seek out more equitable venues.

This looming “flight to fairness” could have a wide-ranging impact on markets, exchanges, regulators and the capital formation process.

The Search for a Practical Remedy

Clearly, technology has opened the door to a number of unfair and unethical trading practices that currently outpace the best efforts of regulatory organizations to control them.

The ultimate challenge, however, is not in recognizing the problems that undermine fair trading practices. The ultimate challenge is to find a practical and economical solution.

If technology can provide the means for undermining markets, it can also provide a solution.

We’ll explore one practical, cost-effective way to restore the principle of equitable trading in the last installment in this series.

Pages: 1 2