- 1998: Volume 7, No. 4 The Internet: The Ultimate Solution?

Editor's Note: This article originally appeared in the April/May 1998 issue of Futures Industry magazine and is reprinted here with permission. For information on receiving a free subscription to Futures Industry, visit the Futures Industry Association online at www.fiafii.org.

During the 1980s the U.S. futures industry underwent a revolution as non-U.S. futures markets were successfully created throughout the world. FCMs, money managers, and regulators were faced with new issues and concerns-non-dollar contract settlement, around-the-clock trading and staffing, exchange linkages, global staffing and coordination, and, of course, competition. Ultimately, the industry adapted to and benefited from the foreign invasion, but the transition required some substantial re-engineering of well-established business models and practices.

The internet is spawning a new foreign invasion, but its emergence may be subtler. At the June 1996 International Derivatives Conference in London, I mentioned in passing that by the year 2001 an internet-based market "would appear from outside the futures industry to compete effectively with existing exchanges." At the time, the comment barely raised an eyebrow because it seemed so implausible that useful commercial activity could exist on the internet.

Two years later, commerce on the internet is exploding and online auction markets are leading the way. Estimates vary, but in an April 2 article The New York Times said there are more than 1,000 internet sites dedicated to auctions. In my panel session on the internet at the FIA International Futures Industry Conference in Boca Raton this year, Dr. Peter Kollock discussed the two-year-old internet-based auction market "Onsale." Focused on computer equipment and consumer electronics this "exchange" had 1,000 daily auctions, 20,000 bids submitted by their 100,000 "traders," 1997 revenue of million and 1998 first quarter revenue of .2 million. Roughly speaking, measured by revenue, this marketplace ranks in line with the fifth largest global futures market.

All that success is derived from a largely retail audience and without any requirement for Commodity Futures Trading Commission approval. Of course, none of these auction markets trade futures contracts-yet. This shouldn't be surprising when one considers the unregulated success these markets have experienced. To date, only one enterprise-Futurecom-has applied to the CFTC for designation as an internet-based futures exchange. But Futurecom asked to be designated, trading a look-alike contract to the existing live cattle futures contract traded at the Chicago Mercantile Exchange. History shows that "taking" liquidity from an existing market is very difficult indeed. It is much more likely that the internet invasion of the futures markets will feature contracts that are derivatives of the successful markets these enterprises have already created.

It is certainly reasonable to assume that viable futures markets will be derived from at least a few of these very successful "cash" auction markets. While our industry has historically been successful at "bulk" commodity contracts, electronic trading in general and the internet in particular, permit a much finer granularity of trading. The auction markets mentioned above as well as the CME's E-mini contract evidence this. There appears to be little barrier to Onsale and Priceline "bulking up" their markets to create markets that very closely resemble today's futures contracts.

David Graves, director, New York Mercantile Exchange, identifies four major functions provided by an exchange. The matching service provides a place where buyer and seller can meet; the liquidity service provides market makers so buyer and seller can arrive at different times; the clearing service eliminates counterparty risk; and the information service provides price transparency and a centralized information repository. It's interesting to explore how well the first three of these services are currently being provided by today's internet auction marketplace. The last service-information-is already the subject of many other internet articles.

Matching

This service is the one most easily built into internet auction markets. As indicated by the numbers above, buyer and seller are finding each other all the time on the internet.

It is significant that the internet auction markets and their electronic matching systems are truly being created by "futures market foreigners" with little or no knowledge of our open outcry system. Their expertise is exclusively electronic commerce and markets. As a result, the auction methods being employed are varied and tested directly in the marketplace. Examples of call and continuous markets, Yankee auctions and Dutch auctions are all currently being employed with success.

It's not clear that any one form of market matching will dominate internet auction markets. But it is reasonable to expect that those who employ the most research to develop electronic trading systems will develop the most successful of them. In fact, a case can be made that our industry does not really have a competitive advantage over any number of software companies in designing trading system technology. And since internet auction markets dedicate their full resources, which are significant, to researching and developing online markets, it's reasonable to predict that a very competitive electronic futures trading system will emerge from the internet.

Of course, futures industry electronic trading systems are being deployed globally with amazing speed. The Sydney Futures Exchange will be fully electronic. MATIF has moved to electronic after briefly listing its products on both the floor and the computer screen, while LIFFE has announced parallel electronic and open outcry trading of its products. The New York Cotton Exchange and Chicago Board of Trade separately announced electronic trading joint ventures. And the CME earns special mention for embracing both electronic trading and the internet with its E-mini S&P contract. These announcements are evidence that the direction of the industry moves inexorably towards electronic trading.

But these systems were developed almost exclusively in the historical context of our industry, which is open outcry. And from the moment two competing-and proprietary-electronic trading systems appeared in the industry, brokerage firms have complained that trading desk real estate is scarce and poorly utilized by current trading systems. The cost and efficiency of having as many trading terminals as there are exchanges, is a nightmare. Since the internet can act as a common message switch at reasonable cost, only time will tell how effectively they will compete with the new systems being spawned on the internet.

Liquidity

Currently, there is little to suggest that "internet locals" exist in the online auction markets mentioned above. This is mostly because today's internet auction markets only provide for a single seller of goods. However, in the U.S., there are an estimated 62 million people over the age of 16 online, each a potential trader, and as online auction markets become more sophisticated, nothing inherently constrains such behavior. Even if "locals" never emerge on the internet, these auction markets will likely be a source of significant data for understanding online and electronic liquidity.

In particular, Onsale's demographics point to the broad participation in internet auction markets. At the close of the first quarter, Onsale had 535,000 registered customers, up 28 percent from the previous quarter. During the quarter, those customers placed 1.4 million bids (vs. 1.0 million bids in the previous quarter), resulting in 310,000 orders (vs. 232,000 orders in the previous quarter). Repeat customers accounted for 74 percent of the orders (vs. 73 percent in the previous quarter). According to a recent survey of ONSALE customers, 47 percent reported buying for business purposes and 16 percent for resale.

The futures industry has not yet begun the real debate of electronic trading. Today's systems are really just a beginning. With 100 years of futures trading history, we have well-researched and tested theories of the factors that contribute to and detract from open outcry liquidity, but only recently have enough data existed to extend this research into electronic systems.

In the last six months, several articles have been published suggesting improvements that might increase liquidity on today's "bulletin board" electronic trading systems. This doesn't mean that today's futures industry electronic trading systems are unsuccessful. It is recognition that electronic trading-like automobiles or aviation-will undergo an evolutionary, and occasionally revolutionary, development process before reaching maturity. Within the next year or two, we will all be opining on why some electronic trading systems are more successful than others.

Consider this: many firms involved in internet commerce are spending significant resources to improve the "human interaction and interpretation" characteristics of their on-line software. This includes employing artists and designers specializing in graphical user interfaces to make their "transaction" pages more likely to generate a transaction. Others are investigating the benefits of voice recognition, 3D graphics, and other "new" technologies on commercial internet applications. And a few are hiring social scientists to analyze those factors that contribute to participation-and therefore liquidity-in online commerce and transaction systems.

Ironically, this is where the electronic trading debate may wrap around to the arguments presented by proponents of open outcry. Informationally rich trading systems, which include open outcry, have been documented to foster liquidity better than bulletin board price posting systems. Market "bits" such as depth, identity, flow, and mood all impact the open outcry trading floor. Technology is being developed that will permit this information to be captured and presented. One can only wonder whether the first to deploy it in an electronic trading application will be an internet auction market.

Clearing

No auction market on the internet has developed a "clearing" mechanism with the same degree of financial integrity that the futures industry offers. Unlike trade matching, clearing may present a significant competitive advantage for existing futures institutions. Nonetheless, auction markets like Fastparts have developed sophisticated clearing structures that manage to clear large dollar transactions.

One alternative clearing mechanism that has appeared is escrow service. TradeSafe, i-Escrow, and Trade-direct all provide escrow services to secure net transactions with fees varying from two to seven percent-extremely high by futures industry standards.

Although internet auction markets do not act as counterparties to every transaction, they have developed some interesting alternatives to improve market integrity. In particular, less formal internet auction sites have developed extensive reputation-based databases that include individual performance and default histories. In this way, traders can assess the reputations of their largely unknown counterparties effectively and factor that information into their dealings.

For example, on the E-Bay site, traders with good track records for completing deals earn coveted colored "stars." With this system in place, E-Bay reports that less than one percent of its 500,000 weekly Beanie Baby transactions results in defaults.

Final Thoughts

The internet is a marketplace that supports many forms of exchange-and many new enterprises engaged in providing markets. These enterprises have evolved from different underlying research, trading and clearing perspectives than the traditional futures industry. Furthermore the ownership, governance, and membership models of these exchanges differ from those traditionally found in the futures markets.

Until recently, any discussion of improvements to an electronic trading system were largely moot because the underlying transaction networks were developed and controlled exclusively by a few exchanges. Now the general trend toward open architecture in trading systems makes the discussion meaningful. But more significantly, the internet now enables competing systems to be developed quickly and placed into the market at relatively low cost. While it is reasonable to expect that many of today's futures exchanges will develop extensive internet-based markets, the opportunity for others to provide trading systems is now open, cost effective, and competitive.

Dr. Peter Kollock who continues to monitor the activities of many on-line auction sites and provided many of the insights for this article, is currently undertaking a large research effort to catalog existing internet trading systems. The effort is first aimed at cataloging these systems, but eventually will lead to a comprehensive study of electronic auction markets-both in and out of the traditional futures markets.

Richard Jaycobs is vice president, Computer Trading Corporation and president of the FIA Information Technology Division. He can be reached at rxj@nantucket.net