(This article is the conclusion 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. And to read Part Three: Inequality in Equity Trading: Regulatory Challenges, click here.)

Two basic problems undermine the principle of fairness in many of today’s financial markets.

1. Some participants use their technological superiority to make trades at a faster pace than other investors.
2. Some traders use technological trickery to gain unfair advantages in terms of market manipulation and price discovery.

In theory, the solution to these inter-related problems is readily apparent. Equalize the latency of trades and ensure that buyers and sellers meet in an open marketplace ruled by a transparent price discovery process.

At first glance, those goals seem beyond our reach in today’s overtaxed regulatory environment. But fortunately there is a practical technological solution available that will address the problems noted above and level the playing field for all investors regardless of the scale and scope of their financial resources.

This solution — based on a proven, Internet-based technology platform — is an exchange gateway device.

A Modest Proposal to Level the Playing Field

In essence, an exchange gateway device (EGD) is a software-and-hardware system designed to connect the Local Area Network (LAN) of a trading exchange to a Wide Area Network (WAN) or the Internet. (In fact, the Internet is the world’s largest WAN.)

Based on the technological concept of an Internet gateway device, the EGD —which is currently under development by Fair Trading Devices LLC — is designed to process all of the electronic messages that come from traders operating outside the exchange’s LAN.

In other words, the EGD is a digital conduit through which all trade requests must pass. But it will be controlled by a flexible “fairness algorithm” that determines the speed and order in which trades are processed. As a result, the EGD provides a new capability for administrative control — a capability that will help exchanges equalize the latency of all trading activity.

The EGD will also serve as an effective countermeasure against snooping and activities like the intentional corruption of packets of data that comprise digital trading messages. Since market participants can’t gain a latency advantage, they will have no incentive to engage in these unethical practices.

In addition, the EGD will improve transparency and regulatory oversight by compiling a comprehensive audit trail of all transactions. This audit trail can then be analyzed to ensure equitable trading and identify any anomalous activities.

Two other points deserve mention here. To ensure equitable trading, the controlling fairness algorithm should be made available to regulators and the public at all times to ensure transparency.

Independent auditors and regulators can also use the audit trail mentioned above to make sure that the published fairness algorithm is, in fact, the one in use.

A Quick Overview of the EGD in Operation

In terms of implementation, the EGD will be integrated into the LAN of an exchange inside the exchange’s security firewall. By design, it will be able to use the exchange’s encryption keys to decrypt incoming traffic from the WAN. As a result, it will be able to break down the contents of incoming messages and identify the trading symbol, price, type of trade request and other pertinent information.

Once this step is completed, the EGD will store each trading message in an electronic message queue. After a defined queue interval timeframe, these stored trade requests will be transferred to a release batch in which individual trades will be sorted in an order determined by the fairness algorithm. Trades will then be released to the exchange’s trading computers for final fulfillment.

In the traditional approach, trading messages received by an exchange are forwarded to trading computers for fulfillment in the order in which they are received. But this process ensures that traders who successfully exploit latency gain an unfair advantage.

The EGD, on the other hand, provides the capability to negate the effect of the latency of trades and establish an equitable queue order determined by the controlling fairness algorithm — a flexible algorithm that can be configured in a number of ways.

One Example of a Practical Configuration

To ensure trading fairness and efficiency, an exchange could configure the fairness algorithm to set the queue interval at approximately one second. The decision could also be made to establish a sort sequence in which “buys” in the release batch would be processed first followed by the “sells.”

In each buy or sell sub-group, trades would be arranged in the appropriate “limit order” price sequence and processed in descending order according to price.

This approach would ensure that buys with the highest price get matched with the highest priced sells. In addition, market orders would be ranked at the top of the group in the sort sequence.

Practical experience and an analysis of trading activity will provide the insights needed to fine-tune both the fairness algorithm and the queue interval to achieve the optimal level of performance and fairness for all of the stakeholders involved: exchanges, investors and regulatory organizations.

A Flexible Solution for Today and Tomorrow

Since it is based on proven technology, the EGD will easily interface with existing communication and trading platforms without requiring major changes or re-engineering. In fact, the entire implementation would be efficient and economical.

Thanks to its inherent flexibility, the fairness algorithm will also be easy to adjust to maintain efficiency during changing market conditions. As a result, the EGD will be able to adapt to peaks and valleys in trading volume, different times of day, and other factors that affect exchange operations.

In addition to meeting the operational requirements of today’s volatile markets, the technological flexibility and adaptability of the EGD will ensure its long-term relevance, since trading on the financial markets will continue to be affected by new IT developments and innovations.

Living Up to the Principle of Equitable Trading

The world’s leading exchanges and other high-volume trading venues will reap a number of benefits from the implementation of the EGD and its fairness algorithm.

They will be able to prove their commitment to equitable trading practices. They will significantly improve the transparency of buying, selling and price discovery. They will also help minimize the disruptive volatility that can generate windfall profits for market manipulators.

Over time, as investors’ perception of unfair trading heightens, these “fair trading” exchanges may also be able to gain a powerful competitive advantage by winning the public trust, earning the approval of regulators and attracting the vast majority of people who want to participate in a free market on a level playing field.

The Exchange Gateway Device is not the complete solution to the problem of abusive trading practices. But it is a significant step forward in the right direction.

For more information, see www.fairtradingdevices.com.

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