Electronic Trading Challenges Dominance of Open-Outcry
U.S. Futures Exchanges Follow Europe's Lead & Move To Electronic Enhancements
Copyright 2000 Barclay Trading Group, LTD.
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Technology, with its implicit promise of increased efficiency, is the siren song of the new millennium. Coupled with the ability of the Internet to distribute the fruits of technological advance in an instantaneous, cost-effective manner, the allure of this seductive refrain would captivate mighty Odysseus himself. Whether or not this temptation will lead to shipwreck is open to discussion.
Certainly, many middlemen have been rudely awakened by the fear of just such a shipwreck in their businesses as they are being forced to rethink their value-added while hordes of e-merchants chanting, "Remove the middleman" jostle for market share and visibility. No area of commerce is exempt from these wired usurpers. Even the most fundamental of free market institutions, the stock and futures exchanges, are caught up in this cyber-space turf battle.
Futures exchanges developed as meeting places where commercial participants, using open outcry for the exchange of bids and offers would engage in the process of price discovery. In the U.S. today, the overwhelming majority of these transactions take place on the floor of the exchange. In Europe, however, the major futures exchanges have gone electronic.
Certainly, electronic trading has some advantages. Clearly, it should be faster and cheaper. But open outcry has unique advantages as well, such as liquidity and the ability to continue functioning during extreme market volatility. In order to get a better understanding of the issues, we've assembled a panel of experts who've agreed to answer a few questions for us. Our panel includes:
Irwin Berger, Sjo, Inc. Mr. Berger, vice chairman of Sjo, Inc., has been with the firm since February 1988. He has spent over twelve years developing proprietary trading, risk management, and asset allocation models for the futures markets and has written a number of articles on trading and risk management which have appeared in professional and trade publications.
Heike Eckert, Deutsche Borse AG. Ms. Eckert is Head of the U.S. representative office of Deutsche Borse, also representing Eurex. Her primary responsibility is to promote the use of Eurex products and to increase Eurex membership in the U.S. Prior to that she worked in various departments at Deutsche Borse AG in Frankfurt, including business development for derivatives and cash markets.
Norman E. Mains, Ph.D., Carr Global Advisors. Mr. Mains is President of Carr Global Advisors (CGA), a subsidiary of Credit Agricole Indosuez. CGA specializes in the creation and implementation of managed futures funds and multi-manager hedge funds. CGA also provides systematic risk management systems using proprietary techniques.
James Oliff, Chicago Mercantile Exchange. Mr. Oliff is the Second Vice Chairman of the CME as well as the Chairman of the Strategic Planning Oversight Committee. Mr. Oliff, an attorney, has been in the futures industry for more than 25 years. He holds a B.A. from Brandeis University and a J.D. from Northwestern University School of Law.
Q: Although the U.S. is the world's technology leader, futures exchanges outside the U.S. have been more aggressive than their U.S. counterparts in moving toward electronic trading. Why have the U.S. exchanges seemingly resisted change at the same time that U.S. stock exchanges have embraced technological change?
Berger: The U.S. exchanges have a long history of open outcry futures trading. This goes back to the start of the U.S. futures markets that began with agricultural trading. A major portion of the liquidity in these agricultural markets was provided by locals who tried to earn short term profits by buying at the bid price and selling at the offered price. Today locals continue to play an important role in supplying the daily liquidity to the agricultural markets and other physical commodities. The start of financial futures in the late 1970's also allowed locals to play an important role in supplying the daily liquidity and keeping the bid/offer spreads narrow. Therefore, the managements at the Chicago and New York futures exchanges have been reluctant to change totally to electronic trading because they believe the liquidity may decline due to most of the locals not participating in an electronic market in the same manner as an open outcry market.
Eckert: The steps recently taken by U.S. futures exchanges to trade futures contracts on their respective electronic trading systems alongside open outcry show that the U.S. exchanges are already moving gradually toward electronic trading.
Since EUREX was founded relatively late (trading started on January 26, 1990), it has been a fully electronic exchange from the beginning. Therefore, in contrast to other European exchanges like LIFFE or MATIF, the task of managing the changeover from traditional open outcry to electronic trading did not need to be undertaken.
The introduction of the Euro has created direct competition on a product level between European exchanges which has forced the transition to electronic trading at a much faster pace.
Mains: Most of the non-U.S. futures exchanges have been operating only since the middle of the 1980s or so, while the U.S. exchanges have been operating for about 50 to 150 years. As a result, the operating and governance structures of the U.S. exchanges were established long before the "electronic technology and information economy" began to have an impact. Non-U.S. exchanges adopted electronic platforms because the technology was available and it was cheaper than starting open outcry facilities. Electronic trading platforms have been studied, ad nauseam, by the boards, members and staffs of U.S. exchanges, but their adoption during "regular trading hours" has been resisted by those exchange members whose economic livelihood is threatened by electronic trading.
Most market participants have conveniently forgotten the back office "crisis" that engulfed U.S. stock exchanges in the early 1970s. U.S. stock exchanges and their member firms adopted relatively primitive "electronic" trading mechanisms to help solve their paperwork problems. Moreover, the current paragon of technology, NASDAQ, has the "spin" of an electronic trading powerhouse, but only displayed its quotes electronically and crossed most orders with a 19th century invention, the telephone, throughout most of its existence. In short, U.S. stock exchanges are currently just as threatened by electronic trading platforms as are U.S. futures exchanges.
Oliff: I can' t speak for all U.S. futures exchanges, but I can tell you that the Chicago Mercantile Exchange (CME) has continuously been in the forefront of creating, deploying and integrating new technologies. We pioneered the concept of global, after-hour electronic futures trading as early as 1987 when we announced our GLOBEX partnership with Reuters. That vision became reality in 1992 when we became the first exchange in the world to launch a global trading network. Over the years, CME leadership has consistently addressed the need to further integrate new technologies and electronic trading into our operations. In recent years, the CME has created products that specifically utilize technology in connection with open outcry markets to derive the benefits of both platforms such as our E-mini S&P 500 contract and our new GALAX-C hand-held trading devices which allow pit-based traders to electronically access various markets.
The U.S. futures industry remains heavily pit-based due to the simple fact that the industry that developed here many years ago created large, liquid and efficient markets. These markets were based on open outcry and gave users very economical contract pricing and excellent execution abilities long before electronic trading was even conceived. Some foreign exchanges developed in recent years only after the concept of a purely electronic exchange was already a reality. Indeed, much of the liquidity provided on those European exchanges emanates from the Chicago trader community. It should also be noted that the U.S. futures industry compares favorably with U.S. securities exchanges in the level of technology in use. We trade electronically with a single matching engine, with some products listed on GLOBEX2 around the clock.
Q: As exchanges move to screen trading from open outcry, the traditional role of the "local" as a supplier of liquidity becomes greatly diminished. How will adequate liquidity be maintained on an electronic exchange if there aren't any "locals"?
Berger: I believe it is best to answer this question by analyzing the role of the local in physical commodities and financial futures markets. As I mentioned in my answer to the previous question, the local continues to play an important role in supplying daily liquidity to the physical commodity markets. A few large commercial firms that use these markets for hedging price risk dominate most physical commodity markets. Therefore, it is likely the daily liquidity will be diminished if physical commodities are traded solely on electronic exchanges. The locals will lose their edge for making profits on an electronic exchange and this will keep many locals from making the transition from open outcry to electronic trading. It will be difficult to find a replacement for the locals who scalp the market in physical commodities. The locals who scalp on a daily basis help to keep the bid/offer spreads narrow in the physical commodities. Without the participation of locals in screen trading, the bid/offer spreads are likely to be wider, as we have seen in grain trading on the CBOT's Project A and the New York Mercantile Exchange's Access. If the physical commodity markets are to make the transition to electronic trading, it is important to incorporate the features of open outcry trading that are most important to the locals.
Although the role of the local in providing liquidity to the financial futures markets is important, it is the large institutions such as commercial banks, investment banking firms, brokerage firms, and asset management firms that provide most of the liquidity. Therefore, liquidity problems are not likely to occur in most financial futures markets as long as the institutions continue to use these markets.
Eckert: The change to a screen based trading environment does not necessarily lead to the disappearance of "locals", but requires them to adapt to a different trading environment by modifying their trading style.
At EUREX, market liquidity in options products is provided by market makers. Any exchange participant can obtain this status. A market maker has to fulfill certain quote obligations with a specified maximum bid/ask spread and a minimum quantity of contracts. In return, market makers receive substantial reductions in transaction fees. In liquid futures products without market making, locals already contribute to a large extent to the high degree of liquidity at EUREX.
Mains: It may not. Locals are important price "makers" (as opposed to "takers") in the price discovery process of futures markets. This role takes on added value when market conditions are turbulent; locals bid or offer when prices gap up or down in response to new information or, sometimes even worse, the lack of new information. Studies sponsored by the U.S. regulatory commissions concluded in part, for example, that open outcry exchanges performed better than NASDAQ in the October 1987 stock price meltdown because OTC dealers simply stopped answering their phones.
It would be shortsighted, however, to limit the possibilities of electronic trading platforms to the current model of open outcry trading. Electronic Crossing Networks (ECNs) and other innovative trading schemes are challenging the traditional methods of trading stocks in the U.S. and around the globe. Therefore, it seems highly probable that new trading methods will emerge for futures markets that will bring forth the liquidity currently supplied by the local community.
Oliff: Futures trading will always rely on two basic groups of participants; hedgers and speculators. Chicago's long history in this industry has provided our markets with a strong base of speculative traders that are the envy of the rest of the world. There is no inherent reason that these locals cannot continue to participate in markets of the future regardless of what method of trading will be utilized. Our E-mini S&P 500 contract is one example where a large local population has specifically developed around a largely electronically traded contract.
At the Chicago Mercantile Exchange, we have made special efforts to help provide our locals with the skills and tools they will need to deal with tomorrow's markets through education courses and technology such as our new GALAX-C hand-held trading device. These are initial steps. In the future, other technologies will be developed that are geared specifically for the local/speculative trader.
Q: During periods of extreme price volatility, trading volume can expand dramatically. How much experience do the current electronic exchanges have with coping with the demands of extreme volatility? How rigorously have the fail-safe systems been stress tested?
Berger: Electronic exchanges have a short history in coping with the demands of extreme volatility. Electronic futures exchanges were not around for the stock market crashes in October 1987 and October 1989 and the Maastricht votes during the summer of 1992. As we have seen from the stock exchanges when there were large volatility and large trading volumes, computer systems were taxed to the limit. The NASDAQ and NYSE had to upgrade their computer systems due to the demands from large volatility leading to large trading volume. Therefore, the electronic futures exchanges need to run simulated tests of high volatility, high trading volume market conditions to make sure the computer systems do not break down.
Eckert: EUREX started as a fully electronic exchange in January 1990. Since then, the number of products as well as trading volumes has increased steadily. On June 2, 1999, a daily record volume of 2.6 million contracts was reached. This shows that the EUREX system is able to cope with the same high volumes and the high degree of liquidity common to traditional open outcry exchanges.
With the continuous upgrade of all hardware and software components since the beginning, hardly any component of the EUREX system is currently older than 18 months. In spite of increased volumes and volatility in the European markets, the overall system availability is 99.98%. At the same time, host processing times have decreased steadily. All EUREX members are connected to the host computers via a proprietary network. With total redundancy of all network and hardware components and an automated fail-over capacity, the system is failsafe on both the exchange and the member level.
Mains: It is probably accurate to say extreme volatility and massive volumes have not tested the current electronic exchanges yet. However, many of these electronic exchanges are more closely linked to their underlying spot markets than was the case in the U.S. in October 1987. It is less likely, therefore, that an increase in, say, European interest rates will cause an uncoupling between futures markets and spot markets in the future.
Whether the "fail-safe" systems have been adequately stress tested will not be answered until after a high volume "crisis" occurs. But, virtually all systems have been heavily scrutinized in anticipation of Y2K, so this shouldn't be a problem.
Oliff: All electronic trading systems will continue to grow in speed, efficiency and dependability, while they are also subject to periodical disruptions caused by hardware and software failures and human error. The Chicago Mercantile Exchange has invested significant resources in its state-of-the-art GLOBEX2 electronic trading system that is capable of expeditiously handling significant volume levels.
The overall percentage of electronically traded volume is still relatively small (approximately 7 percent so far this year), but it continues to make steady gains. Our electronic trading systems have handled significant volumes when put to the test. During the midst of last summer's dramatic stock market downturn, roughly 125,000 contracts were traded on our GLOBEX system in a single day. Since that time, we have completely upgraded our trading system with next-generation technology that we expect to greatly outperform its predecessor system during periods of major volatility. Still at the present time, the trading floor provides a more intelligent environment for and has a proven track record in responding to unusual circumstances.
Q: Do you believe that electronic trading will/should completely replace open outcry on the U.S. exchanges? If it were to replace open outcry, would that be an improvement? What is the value-added provided by open outcry?
Berger: I do not believe that electronic trading will completely replace open outcry on the U.S. futures exchanges. In my opinion, the physical commodity markets will continue to use the open outcry format, due to the importance of locals in providing daily liquidity and the sizable amount of seat ownership by locals. The CBOT and CME are allowing their customers to use either electronic trading or open outcry trading during their open outcry hours. These two exchanges are going to allow the marketplace to decide which format to use in the future. Under this type of test, locals will continue to use open outcry trading. Thus, it will not be possible to determine if locals would make the transition to electronic trading in the financial futures markets. The exchange's customers are most likely to use the format providing the greatest liquidity, and this is currently open outcry. Therefore, I do not expect electronic trading to generate any significant volume during open outcry hours. The main reason U.S. exchanges would move to electronic trading is a reduction of costs which would lead to greater profitability. If the benefits from electronic trading outweigh the costs, it is possible that the top management at the U.S. exchanges would recommend a switch to electronic trading during regular market hours and would put this issue to a vote among the exchange members.
Eckert: Whether open outcry on U.S. futures exchanges will eventually be completely replaced by electronic trading is for the market to decide. However, we see a clear trend.
For an increasing number of market participants, electronic trading offers clear advantages over open outcry. Low transaction costs, speed of execution and market transparency play an increasingly important role. The possibility to have single access to multiple markets regardless of the geographic location of the market participant attracts more and more global players outside the major financial centers.
The further expansion of electronic trading depends on the capability of electronic trading systems to successfully compete in terms of system reliability, particularly in highly volatile trading phases. For particular products, electronic exchanges have to show their capability to replicate complex combination trading strategies in a screen-based environment.
Mains: The "value-added" of open outcry is that it works. The process was transferred from relatively small commodity markets to financial markets by Chicago exchanges in the 1970s and early 1980s and revolutionized risk management and trading in global markets. Electronic trading platforms will replace open outcry trading pits completely, and this will likely occur in the next few years. This is unfortunate for those individuals that derive their economic livelihood from facilitating order matching in the pits, but it's probably good news for worldwide market participants. The possibilities for order entry, matching, settlement and new types of contracts are much greater in the electronic arena.
Oliff: How futures trading will be conducted in years to come is ultimately a decision of the marketplace. It is the expectation of the Merc's leadership that both open outcry and electronic forms of trading will be utilized for some time to come. At present, there are advantages to each method: electronic trading appears to provide greater control, anonymity and speed while open outcry continues to offer advantages in price discovery and sophistication.
What method is best depends on the nature of the contract being traded, the regulatory and business environment and the participants involved. Given the current state of technology, open outcry continues to perform better in complex markets or when complex strategies are involved.
Q: Electronic trading coupled with reduced commission rates and volatile equity prices have created a new class of retail stock day-traders. Do you see the potential for a similar phenomenon occurring in the futures markets? How would such a development impact price volatility and market liquidity?
Berger: I do not expect to see a greater amount of futures day trading by retail clients under electronic trading coupled with reduced commissions. Most futures markets do not have enough daily volatility (as measured by the price range in ticks) to successfully day trade. The exceptions to this are the stock index futures contracts. Mini versions of the large stock index contracts are vehicles that can create retail day traders. The E-mini S&P contract at the CME is largely successful due to a significant amount of day trading. The E-mini NASDAQ was just launched by the CME as another vehicle that can be used by day traders. I believe this phenomenon can occur on exchanges outside the U.S. if electronic mini versions of the Nikkei Dow, DAX, FTSE, CAC 40, IBEX, Australian Share Price Index, Hang Seng, Taiwan Index, and Toronto 35 futures were created.
Eckert: The advantages of electronic trading combined with additional technology, like order routing facilities and the availability of the Internet, clearly provide the environment to bring retail investors closer to futures and options markets. As a prerequisite, electronic exchanges have to implement standard open interfaces to allow FCMs to offer retail investors access to trade via electronic order routing systems and thereby add liquidity to the markets.
Mains: The potential for participation by individual investors in futures markets is almost as large as the current "new class" of individual traders in the stock market. Many U.S. broker/dealers, especially wirehouses, began shunning futures in the late 1980s largely due to the inexperience of their sales staffs coupled with the potential liability from unsuitable investment claims by investors that entered into trades with unrealistic reward/risk profiles. However, the availability of electronic order entry and trade matching via the Internet creates a huge opportunity for futures markets. Futures exchanges have been leaders in the globalization of financial markets, and there are a lot of individual investors around the globe that would like to directly participate in financial markets.
Most academic studies have concluded that the existence of futures markets tends to dampen price volatility rather than augment it. A greater amount of participation by worldwide individual investors would be a positive development for futures markets.
Oliff: The rapid spread of technology and the growing ranks of individual traders is already having an impact on the futures markets, as is evidenced by the success of CME products such as the E-mini S&P 500 and our new E-mini NASDAQ 100 contracts. This trend is obviously increasing liquidity in selected contracts, which consequently should reduce short-term volatility.?
Copyright 2000 Barclay Trading Group, LTD.