- 1999: Volume 8, No. 3 Understanding Electronic Trading

Over six million U.S. households made their first purchase on the Internet in 1998, a 40 percent increase over the previous year. With this growth in Internet usage for the purchase of goods and services, it seemed only a matter time before Futures Commission Merchants, institutional traders, and the general public would expect the same keyboard access enabling them to execute futures and options trades.

The major exchanges recognized at least 15 years ago the need to institute new forms of technology to reduce costs, improve reliability, meet regulatory requirements, and continue to attract and hold business.

Electronic order entry attracted the initial attention of exchanges and brokerage offices. The objectives were to speed the flow of orders to the floor and send price information back, improve the accuracy of orders, and provide an improved audit trail.

Today the mantra of users of the derivatives and futures markets appears to be "Electronic Trading." This catchall phrase has gained currency among the Internet-savvy public, exchange members, institutional customers, FCMs, and the media.

In reality, the term "electronic trading" describes a variety of situations. To some it means totally electronic trading of futures and options, without human interaction. It is straight through processing of orders from an individual's PC via a user-friendly screen for order entry, matching, reporting and clearance, and settlement. To others, it means electronic transmission of orders to a firm's booth or into the pits, where they are executed by traditional methods. And of course, many participants believe that the transmission to a broker from their PC's via the Internet or dedicated line constitutes electronic trading.

Concept

Today futures and derivatives trading is clearly a global enterprise. Wheat, metals, energy and financials are now traded around the world and in many different contracts. In addition, exchanges have developed mutual offset that allows for continuous trading and settlement across many time zones.

Global electronic entry systems such as the original Globex and the new Globex2, Project A©, and others allow traders the opportunity to deal in contracts after the close of open outcry sessions. In fact, they can speculate or hedge positions virtually 24 hours a day. In addition, automated trading platforms have been developed that match bid and offer orders automatically and report information directly to clearinghouses.

Without question, the concept of electronic trading is gaining ground and is perceived by many as the method of the future. Even those who embrace open outcry believe that eventually electronic trading will be the dominant system for many contracts. The biggest unknown is the timing of the movement.

Many traders and customers alike fully believe that open outcry is the best trading system available. The ability of floor traders standing face-to-face to quickly execute orders and provide the fills that customers need can be persuasively argued. In addition, this environment creates the deep and very liquid markets preferred by users.

But even the most ardent proponents of open outcry fully accept the electronic enhancements that speed orders to and from of the floor, automatically time stamp them, and help eliminate the cumbersome writing of order tickets. In one form or another, a variety of these systems are now in place at all major exchanges.

FCMs have been at the forefront in promoting electronic order entry systems. They not only desire the fasterorder flow but also the automatic transmission of trade information for exchange reporting and clearinghouse matching. This contemporaneous status of all trades within minutes of execution creates faster and more accurate backroom processing.

In a short time, many traders have found order entry via the Internet to be a new and user-friendly way of participating in the futures market. Whether initiated to e-commerce through the purchase of books, airline tickets, CDs, or a host of other products, retail customers have discovered that the move to Internet trading can be the equivalent of a small leap.

Most retail online trading simply replaces the telephone call to the broker with an online order. To these traders, online order entry is less intimidating than a phone call. Instead of struggling with a harried, impatient order taker, the customer simply fills out an online form and then clicks "okay." Depending on the broker, the exchange, and the contract, in most cases the order is transmitted to the floor electronically, then into the pit via floor runners, or by flash signals.

Electronic Exchange Tools Order Routing Systems

One system that is used by all major U.S. exchanges is the Trade Order Processing System (TOPS) route. An electronic link between broker firms and the floor booths, TOPS was developed jointly by the Chicago Board of Trade and the Chicago Mercantile Exchange. It is the standard electronic order entry and fill reporting system. TOPS sends information directly from the FCM to the floor, where all of the relevant information required to maintain an order book, advise the clearing house, and confirm execution customer orders is maintained. This entire process can be accomplished within just a few minutes-or less.

Firms also have additional means of shortening the trading process. An Internet interface with a database incorporating customer information, such as credit worthiness and margin available, can be connected directly to the TOPS route, without the need for intervention by anyone in the broker's office.

Depending on the contract and timing, the order can be transmitted directly to the exchange order matching system (CUBS/GLOBEX2 at the CME, or Project A at the CBOT). As of this writing, the CME's Mini S&P 500 ("e-mini") is the only contract in the United States that is being traded wholly electronically. The CME membership recently voted to allow Eurodollar futures to be traded side by side with the traditional open outcry system as of June 1999. The CBOT offers side-by-side trading (along with open outcry) on 30-year Treasury Bonds, and ten-year, five-year and two-year Treasury Notes. Additionally, most CBOT and CME contracts are traded electronically after regular trading hours.

Consolidation and Alliances

The momentum toward electronic trading was initiated by European exchanges that have enhanced electronic trading platforms. Ironically, the Globex model that was available to European traders during their work hours helped inspire the shift to an electronic trading platform. MATIF, the French futures exchange, was one of the early adopters of Globex and its members constituted a large portion of trading volume. After the MATIF was purchased by Societe des Bourse Francaises, there was a strong motivation to improve technological capabilities.

Recently the SBF (including its two subsidiaries MATIF SA and MONEP SA) announced the first global alliance with the CME and the Singapore International Monetary Exchange. In addition to having a common trading engine that is accessible from a single terminal, the alliance provides for a Mutual Offset System (MOS), which allows members to establish positions on one exchange and offset them with subsequent trades on another.

The February 1999 agreement between the CME, SBF, and the SIMEX established a common trading platform for futures and options that is open almost continuously over the Asian, European, and U.S. trading periods.

Clearing Considerations

All futures and options exchanges have clearinghouses that are critical to their operation. Most notably, a futures clearinghouse facilitates trades among strangers by eliminating counterparty risk and guaranteeing the integrity of trades. Historically, each exchange has had its own clearing operation. Recently, however, exchanges have explored common forms of clearing. In December 1998, the Chicago Board of Trade Clearing Corporation and the CME clearing operation agreed to work towards common banking and cross-margining.

When trade data can be transmitted electronically, concurrent with the execution, it speeds up the trade matching process and allows the status of the trades to be transmitted to the member firms for print-out or online viewing.

Because of the rapidly changing nature of the futures and options business, including new products, systems, and strategic alliances, clearinghouse technology must be extremely adaptable, scalable, and open.

Regulatory Environment

The regulatory agencies have been cooperative in allowing the introduction of new technologies. In December 1998 the U.S. Securities and Exchange Commission approved new rules that will allow electronic trading systems to register as full-fledged exchanges.

The SEC also adopted new guidelines that subject electronic systems to more stringent fair access and security requirements.

"Technology is fundamentally changing our marketplace," said SEC Chairman Arthur Levitt. "It has caused us, as regulators, to rethink the way we do our jobs."

The Commodity Futures Trading Commission has not formally issued broad sweeping rules. They have approved many specific requests involving electronic trading systems including the request, in August 1998, by the Board of Trade of the City of New York, Inc. to begin trading on its affiliate, the Cantor Financial Futures Exchange. They have also looked favorably on many other electronically enhanced systems and have informally given encouragement to several planned systems.

Security Considerations

After some initial trepidation, the question of security with Internet transactions has been addressed. Technically, the Secure Sockets Layer (SSL) protocol, which was created by Netscape and also implemented by Microsoft, addresses all of the necessary security issues. SSL authenticates the server so customers know they are dealing with the intended Web commerce site. It encrypts sensitive information before sending it across the wire, and provides a way to verify that the transmission has not been altered en route. Optionally, it can even authenticate the client to the server, a feature important to banks, e-commerce sites, and other institutional customers.

The Arguments

Advocates of the time tested open outcry system of trading believe that no electronic system is as efficient as that which currently exists at the CBOT or CME. They argue that while there is a lot of conversation regarding electronic trading, most major customers are only concerned with their fill. One plausible argument in their favor is that large customers (institutions, banks, large commercial traders, etc.) maintain open telephone lines to the order desks on the floors where the most important contracts are traded. his direct link allows the trader to immediately convey his or her orders to the desk. Then, in a single movement, the order is flashed to the pit where it can be confirmed in seconds. The trader of stock indexes, interest rate, and foreign exchange contracts can readily take advantage of these deep, highly efficient markets in this manner. However, even some traders concede that electronic trading may work better in those contracts with lower volume.

Since futures markets are known to be highly volatile there is concern about whether the electronic systems described here can handle massive surges in volume. The experience of the online Internet securities brokers in January 1999 when day traders on the NASDAQ choked the existing networks is pointed to as a reason for maintaining a system that is not so susceptible to computer breakdowns. Today, many online futures brokers that have the capability to interface directly with exchange order-entry systems maintain a backup staff to step in when the computer "hiccups" or goes down.

Proponents of electronic trading in the futures markets claim that the existing electronic order routing and trading systems were built specifically to supplement, rather than replace, the traditional open outcry systems. They claim that the new technology being developed for that purpose has the capabilities and reliability required by the FCMs. Many members of domestic exchanges, particularly in Chicago, are concerned that the switch to electronic trading by European and Asian exchanges will cut deeply into their volume. Growth of the Internet and e-commerce across the board will make it easier for traders to shift to electronic systems.

Conclusion

Clearly, there is a movement towards increased use of electronic technology. This technology, which will improve efficiency, reduce errors, and add to profits is an inevitable result of unstoppable pressures. Just as the telegraph made it possible to communicate market prices great distances from the trading floors, and the telephone enabled customers to deal with brokers in a timely manner, electronic trading is destined to change the markets. The only questions are how and when.

Joseph H. Zoller is president of The Zoller Organization, a marketing/communications firm specializing in marketing, creative, and communications services for the futures and financial services industry since 1981. Mr. Zoller's clients have included major futures and options exchanges, as well as leading FCMs, IBs, and CTAs. The Zoller Organization offers clients a broad range of communication services, including sales materials, advertising, trade show management, and editorial assistance. Additionally, Zoller consults with management of various firms regarding marketing and communications situations. Mr. Zoller can be contacted at The Zoller Organization, 1861 Old Briar Road, Highland Park, Illinois 60035, 847-831-4788, (FAX, 847-831-9082), or at zollernet@compuserve.com.