(This article is part two of a four-part series called A Question of Fairness, which originally appeard on the Tabb Forum: http://tabbforum.com)

In the introduction to this series, I pointed out a fact that concerns everyone who believes in the principle of fair trading: A relatively small group of technologically sophisticated traders have learned how to build and locate computer platforms that can communicate and make buying and selling decisions faster than the vast majority of other investors.

Clearly, this split-second trading advantage plays an important role today in a number of questionable practices that have a significant impact on market gains and market volatility.

Let me explore two prominent examples.

The New Profit Potential of Classic Arbitrage Strategies

If you can move faster than the competition with ultra-low latency and high-frequency trading techniques, you can reap enormous profits on virtually every liquid security asset class by exploiting temporary deviations in price on investments offered in multiple markets.

For example, a classic arbitrage strategy like covered interest rate parity in the foreign exchange market profits from the relationship between the price of a domestic bond, the price of a bond denominated in a foreign currency, the spot price of the currency and the price of a forward contract on the currency. But that’s just one application of this approach.

With help from sophisticated algorithms and supercomputers, arbitrageurs can take advantage of increasingly complex models that utilize considerably more than four securities. And they can literally take billions of dollars out of the market that might have benefitted other investors, including institutional investors, endowments and pension funds.

The Disruptive Force of Flash Trading

Hedge funds and other high-powered traders use this controversial computerized practice to issue orders and then cancel them within the allowable timeframe before they are filled.
As a result, they are able to see orders from other market participants before the information is available to everyone. This unfair advantage gives them insights into how others are trading and helps them gauge supply and demand. The Securities and Exchange Commission proposed banning the practice in 2009.

“Concerns have been raised that the use of flash orders by exchanges and other markets may detract from the fairness and efficiency of the national market system,” Mary Schapiro, chairman of the SEC, said at the time. “Specifically, flash orders have the potential to discourage the public display of trading interest and harm quote competition among markets.

“In addition,” she continued, “flash orders may create a two-tiered market by allowing only selected participants to access information about the best available price for listed securities. Investors that have access only to information displayed as public quotes may be harmed if market participants are able to flash orders and avoid the need to make the order publicly available.”

Although some advocates believe that flash trading enhances the liquidity of markets, critics are concerned that it increases market volatility and can cause disruptive “flash crashes” like the one that occurred on May 6, 2010 when the Dow Jones Industrial Average dropped almost 1,000 points dramatically and quickly before recovering just as quickly.

Flash trading also has an unfortunate and under-recognized impact on “stop-loss orders” which are offered by brokerage houses and online trading venues to unsophisticated, casual investors and the general public.

Here’s how it works. Traders use flash trading schemes to discover the price points of stop-loss orders and automatically trigger the sale of the shares involved. Then high-speed computers quickly scoop up the shares at an artificially lowered price, which sabotages the price protection presumably offered by the stop-loss order trading option in the first place.

This questionable practice when most consumer computer trading venues still offer stop loss instructions clearly violates the principles involved in fair trading.

Emerging Opportunities for Market Manipulation

As you can see, the activities noted above can have a destabilizing impact on financial markets. But there are other threats that may prove to be even more disruptive and abusive.

• Deliberate interference with data transmission. The network topology and transmission techniques used by the financial system today are vulnerable to intentional interference. Based on an ethernet-like model, this communication system uses a corruption recognition scheme similar to the collision detection protocol that serves as an international standard for network management according to IEEE 802.3 and ISO 8802.3.

This widely used protocol helps networks ensure data integrity when interference (sometimes called “jitter”) causes packets of data to be corrupted. For example, corruption typically occurs when two devices on a network try to send data over the same channel at the same time. The packets of data collide, and that collision causes data corruption. When a corruption recognition or detection protocol is in effect, however, the network quickly recognizes the problem. And after a specified amount of time, the transmitting device is instructed to re-send the data.

Of course, in normal environments, most data collisions are not a cause for concern, since the incremental delay in transmission time has little or no effect on the parties involved. But in a high-speed trading environment, the increased latency of a corrupted communication could have a major impact on the ultimate failure or success of a trade. After all, corrupted market communications that necessitate re-transmission would operate at a decided disadvantage to uncorrupted trades with their lower latency.

Here’s something else to consider. Since it is technically possible to deliberately cause interference that will corrupt communications coming from another node on a shared network, it is only reasonable to assume that unethical traders have adopted — or will eventually adopt — this reprehensible practice as a way to gain an unfair advantage over competitors using the same wire or optical fiber communication path.

What makes the situation even more unsettling is this: It is very difficult to prove that the data collisions were deliberately caused. It will also be nearly impossible to identify the responsible party based on current IT forensic capabilities. As a result, perpetrators will run virtually no risk of detection until a solution is found.

• The potential for “cracked trades.” Even though most current Internet activity is protected by encryption, the possibility exists that trading communications could be hacked and decrypted as well as delayed through intentional data packet corruption.

Certainly, the infrastructure for cracking trades exists today with the rapid proliferation of extremely fast computers and the growing number of expert hackers with the skills and tools necessary to develop sophisticated decryption algorithms.

In addition, there are a number of related activities like industrial espionage, cyber terrorism, “hacktivism” and Internet-based crimes like “phishing,” malware insertion and “man in the middle” eavesdropping attacks that are steadily advancing the art and science of cybercrime, hacking and decryption.

In evaluating this increasing threat, it’s important to remember two additional points.

• Cyber criminals do not have to crack encryption keys in real time to discover “secrets.” If a hacker can crack the key in less time than the key is in use, he or she will have unfettered access to encrypted trade information for the length of time remaining that the “cracked” key is in use. In other words, the hacker will have an unfair trading advantage until the encryption key is changed.
• Even in cases where encryption keys cannot be cracked, the IP addresses for senders and receivers are not encrypted. As a result, this security loophole exposes some trades to potential exploitation and abuse.

The Alarming Vulnerability of Modern Trading Systems

At present, regulators may not yet have firm evidence of deliberate interference, cracked trades, snooping and other forms of Internet-based market espionage. But if you examine published data on TCP/IP connectivity and transmission technology, it’s clear that the infrastructure used to support trading and other market activities is highly vulnerable to exploitation.

It’s also important to remember that leading security vendors like Verisign and Symantec have already been hacked by Internet intruders, proving that significant vulnerabilities exist even in best-in-class systems.

In light of all of these issues and threats, the most prudent course for both regulators and self-regulating exchanges is to assume that the possibilities outlined above will eventually turn into probabilities, given the immense rewards that can be reaped by unfair and unethical trading activities.

Part Three of this series examines how technological developments have revolutionized markets and what that’s meant for regulators and self-regulatory organizations.

To read Part One, Inequality in Equity Trading: How Did We Get Here? click here.

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