- 1999: Volume 8, No. 3 Are Futures Trading Pits History?

Will computerized systems displace open outcry "pit" trading in derivatives exchanges? The question has been debated for decades, and after several decades of accelerating computer development, open outcry is still with us. The question has taken on a more urgent tone in recent years, however, as automated systems displaced open outcry in several important European derivatives markets. Why did European markets adopt automated systems so quickly? Will they take over in the U.S.?

In thinking about the implications of the rapid adoption of electronic trading systems in Europe, it is important to try to specifically identify the contributions of trading system design, as well as other important factors. What if the European result was due to factors independent of system design? Could the fundamental driving forces still favor open outcry?

In theory, an electronic 'black box' trading system can be a beautiful thing. However, amidst seemingly overwhelming evidence that electronics are the future, the future still seems cloudy. The outcome will be determined by the interplay of markets and governments, a difficult set of forces to model and predict. As trading systems evolve, the competition between alternatives will be intense, and taxpayers will retain an interest in seeing that public resources aren't inappropriately appropriated in a search for competitive advantage.

First, a Little History - Peakes, Valleys, and Leos

Couched in open outcry language, the Commodities Exchange Act of 1974 still directed the newly created CFTC to study the feasibility of trading by computer. In 1977, as part of this initiative, the CFTC held a conference titled "Automation in the Futures Industry." The conference included Morris Mendelson and Junius Peake, whose proposal for open-book electronic trading systems was an early and thoughtful forerunner of current developments. The conference also included a presentation by Leo Melamed, one of the more effective and eloquent proponents the open outcry system has produced.

Peake and Mendelson made many of the same arguments being put forth today. Telecommunications advances have stripped away the advantage of organizing an order flow into a small geographic area, and laid the basis for the auction process to be conducted efficiently without face-to-face communication. Such a system was (and is) attacked on a number of fronts. By threatening to disintermediate market makers, the argument goes, the system would reduce the liquidity provided by important participants-those previously willing and necessary to "take the other side" of the transaction when no "public" offer was on the books. However, Mendelson argued that in a relatively illiquid market, spreads would widen to the economically efficient amount that would induce entry, by market makers or by the public, when volume dried up. The system would attract the economically efficient level of liquidity. Prices would adjust, and attract orders. If money was to be made by providing liquidity, it would be provided. Peake discussed the definition of a futures exchange, and took care to do so independent of buildings, participants, or places. Instead, Peake defined a futures exchange as a trading system that aids in price discovery and efficiently allocates the assumption of risk. Form, argued Peake, follows function, and open-book automated trading systems were the best means to the end.

In contrast, Melamed's defense of the pit centered on the value of the open-outcry process at the point of sale. Melamed took care to note the extensive (for the time) utilization of computer technology in the existing transaction process, with the important exception of the transaction on the floor. Melamed stated that with respect to the provision of liquidity, "the crowd is not replaceable, and it is indispensable." Criticizing the critics' lack of experience in the pits, Melamed cited a number of examples how relationships built on trust and experience could develop in a close arena, where participants were in daily sight contact. The argument runs that this experience provides unique information flows, from which liquidity springs.

The argument for the pits has held its own in the marketplace for many years, but when European markets adopted electronic systems in 1998, prices for seats at traditional membership exchanges in the US fell sharply. The popular mindset has caught up to this deterioration, but seat prices at the Chicago Mercantile Exchange have actually stabilized and established a modest uptrend, while seat prices at the Chicago Board of Trade have risen substantially from their 1998 lows. These exchanges have their own electronic initiatives, to be sure, but a reassessment of the inevitability of electronic systems accounts for some of the recent improvement.

Liquidity - In the Eye of the Beholder

Do I get the best possible price? How fast is my order executed? Can I get in? Can I get out, if I get in? How transparent is the system? Can I trust credit quality? Is this system reliable?

Consumers of exchange services ask fundamental questions like these every day. Consumers, not analysts, will ultimately determine the fate of open outcry. Liquidity-and how much it costs-will be the key. Like many empirical journeys, however, independent assessments of the liquidity issue have provided mixed messages.

In the last few years, trading on the long-term German government bond future migrated nearly completely out of the open-outcry LIFFE arena in London to the DTB (now Eurex), an automated trading system owned by German financial institutions. Before the transition, some studies found higher liquidity in DTB than LIFFE, other studies found higher liquidity on LIFFE than DTB, and still other studies found they couldn't reach a conclusion. Findings depend on definitions, and when it comes to economics, definitions can be difficult things to define. Just because it is difficult to measure the difference in the liquidity/quality of different trading services, however, we cannot simply throw up our hands and assume they are equal, and assume that "cost" will determine the winner. Ultimately, liquidity is in the eye of the beholder, and the right beholder is the consumer.

The liquidity and cost of competing trading systems are determined by economic factors unique to the systems themselves, but external forces also play an important role. Perhaps the most important of these is...

Regulation

Regulatory forces frame the competitive landscape in every industry, and futures trading is no exception. To understand whether electronics will supplant open outcry in the U.S., we must look beyond the fundamental design determinants of liquidity, because system design and acceptance is also influenced by the powers that be.

The issue is quite complex under the surface. Regulation can burden competitive automated trading systems as well as existing exchanges; in some ways, the trading pit may itself be a creature of regulation, and dependent on it. Regulatory authorities may restrict the availability of electronic trading services owned by overseas providers, and provide other, less explicit, means of support, that may or may not be in the best interests of overall financial market efficiency. In addition, domestic regulatory policy may itself be subject to fractious struggles between regions and/or financial institutions within an individual country. In turn, domestic regulatory policy can be influenced by international competitive considerations. In this sense, cross-border competition in exchange services may be giving rise to the types of trade debates heard in the auto and steel industries.

For many years, a London futures exchange was the primary market for the futures contract on the long-term German government bond. Some in London have argued that an especially cooperative industry/government effort effectively allowed the DTB to "buy the volume back." If a London market were to become the primary arena within which a U.S. government bond future was traded, one might anticipate a vigorous campaign to win it back to a U.S. venue, with some expenditure of government resources and/or regulatory support, to induce greater confidence in system design and more attractive pricing, at least in the short run. Team efforts like this can cloud our ability to determine that the migration of trading to an electronic arena is necessarily the result of the fact that it is an electronic arena.

Having noted these other possible reasons for the success of the DTB, however, we must also recognize that the overall efficiency gains of automated trading systems may still represent an advance from open outcry systems, even if successful automated systems have a little help along the way. Conversely, open outcry might still be the best system from the point of view of society, even if fees for trading on subsidized electronic systems are currently less than open outcry, and if over-the-counter markets benefit to a greater extent from legislative or regulatory intervention, particularly during crisis situations.

This last point shows how the regulation question is wrapped up in other important and murky issues. Banks and other financial institutions trade alternatives to exchange-traded derivatives in the "over the counter" markets. To what extent do the over-the-counter markets compete with exchanges? How does regulation frame that competition in the U.S., and how does it frame that relationship vis a vis Europe? In turn, if competition between exchanges and the over-the-counter markets is intensifying, how should public policy be framed to resist overextending the banking safety net, and protect the taxpayer, and still meet efficiency goals?

Exchange Ownership

With ownership consolidated in institutions potentially allied more closely with the immediate customer/user interests, Eurex may hold an advantage in developing more efficient, customer-friendly trading systems. The different incentive structure might also be evident in exchange mission statements. The principal objective of one US derivatives exchanges is stated along the lines of "serving the interest of our members," while the Deutsche Börse expressly states that its principal objective is "to boost the adaptability and efficiency of capital markets." An organization may declare that its goal is to promote the public good, and many do. However, saying nice things like this doesn't necessarily make it true.

The ownership structure of Eurex may help it accrue an advantage independent of fundamental liquidity determinants, and this important distinction is related to the regulation issue. If a public safety net extends more closely to the banking owners of Eurex than to the owners of the US derivatives exchanges, it might also work to reduce the relative cost of Eurex exchange capital and boost the confidence of customers in Eurex liquidity. If so, and alliances between the US and European exchanges continue to fall by the wayside, we might expect to see more initiatives in the US to gain closer access to the safety net, in order to help meet "unfair" competition from overseas producers.

Maybe It's Just the Markets

Never confuse brains with a bull market, the saying goes. Well, maybe we shouldn't confuse computer trading 'efficiency' with tranquil financial markets, either. Perhaps any liquidity advantage accruing to DTB was really just an illusion, inspired by some of the most tranquil financial market conditions in decades. Put a little more fear on the table, displace the greed, and open outcry might prove itself as the preferred arena.

This hypothesis was put to a test in the third quarter of 1998, when the Russian debt default coupled with other developments to spark a generalized run to safer investments and more liquid markets. The open outcry venues in Chicago certainly saw volume increase during this interval. Was open outcry the reason? As noted by a regular markets report by the Bank for International Settlements (interestingly, as a part of a discussion of a broader "flight to quality" during the third quarter), exchange trading generally gained market share from the OTC market during this interval. However, it is difficult to determine whether open outcry was directly responsible. Perhaps, had the open outcry exchanges been electronic, they may have experienced even higher volume, as consumers were drawn to some of the other safety and liquidity-enhancing features of exchange trading like the margin and clearing mechanisms, marking-to-market, and daily cash settlement.

Automation - The New Bureaucracy?

During the 20th century, word of mouth, semaphore signaling, and hand-carried letters have given way to wire (and increasingly, wireless) communications. Some people lost during the transition, and some people gained. The new era hasn't exhausted all the potential efficiency gains, however. New bureaucratic systems have carved out special favors, as they will always do, regardless of the current technology. Yet the new communications era, for all its imperfections, is most likely viewed as a social gain-at least by a large majority.

In what may prove to be an early stage of development, automated trading systems are exhibiting growing pains. They are imposing costly transition expenses, and seeing other unforeseen strains that may or may not be representative of their long-run cost structure. In questioning whether electronic systems are in fact the most simple, least expensive, and most productive way to conduct trading activity, the work of the famous cartoonist Rube Goldberg comes to mind. Goldberg depicted humorous renditions of machines of mind-numbing complexity performing relatively simple tasks. Complexity can inspire awe, but it can also bring unforeseen costs and the potential for breakdown. Automated trading systems may potentially be a way of turning a theoretically simple solution into a Goldberg-like maze, and it may not inspire the confidence of traders in the long run.

What's Next?

The conventional wisdom seems to have shifted in recent years, and electronic trading systems are expected to displace the pits. The conventional wisdom may yet prove wrongheaded. Hands and mouths are wonderful, physically reliable tools. Hands and mouths are free, and resistant to tyranny.

The ability of automated trading systems to prove themselves reliable, trustworthy, simple to the user, and resistant to bureaucratic entrapments will determine their rate of adoption. In theory, an electronic order-matching "black box" is a beautiful thing, and potentially represents the best, fairest and most efficient way to match orders in the marketplace. However, in practice, electronic orders placed by humans must trust complex systems constructed by profit-maximizing intermediaries. Matching systems don't have a monopoly on integrity, any more than the trading pit, or any other human institution. Integrity, and the liquidity it inspires, flows from individuals-humans in pits, humans in brokerage firms, or humans constructing electronic trading systems. (The reader is referred to Charlie D: The Story of the Legendary Bond Trader; by William Falloon for an example of integrity in the pits.) The unique information flow in the pit-where traders, cameras, and memories witness trading activity in an open environment-may yet prove itself the market's choice for discovering integrity, and prices.

The developing competition among open-outcry exchanges, over-the-counter markets, automated trading systems, and international regulators should improve the efficiency of the derivatives marketplace in several ways. The volatile environment will not be riskless, however. Its as if someone left a stew on the stove for a day, then poured in some hot sauce, gave it a big stir, and turned up the heat.

Hopefully, it won't end up splattering all over the inside of the microwave. In the 1980s, when much of the U.S. savings and loan industry was faced with extinction, a "swing for the fences" mentality developed, as industry funding was artificially bolstered by rising public guarantees. This stop-gap approach unleashed incentives that ultimately trebled our losses as taxpayers. In the derivatives arena, as risk-taking bubbles in a complex regulatory broth, we may need to take care that similar incentives don't abuse the integrity of the financial safety net, and the public welfare, in the years ahead.

Bill Bergman is a senior financial markets analyst in the Division of Financial Markets and Payments System Risk of the Federal Reserve Bank of Chicago. He can be reached at bill.bergman@chi.frb.org.