Streetwise Professor

May 23, 2024

A Fascinating Flashback to the Halcyon Days of Floor Trading In Chicago

Filed under: Commodities,Derivatives,Exchanges,Regulation — cpirrong @ 11:47 am

This Brokers, Bagmen, and Moles podcast really took me back. It tells the complex and convoluted tale of the FBI sting operation on the floors of the CBOT and CME, and the trials that followed in the 1987-1990 period.

I worked for an FCM (located in the CME building at 30 S. Wacker) during one year that the sting occurred. Leo Melamed appears prominently in the podcast (and not in a good way, I might add): I frequently saw him in the elevator there. I had just started teaching at Michigan in January 1989 when the Chicago Tribune (to the fury of the FBI and DOJ) broke the story of the investigation. In something of a Walter Block moment, I wrote a paper (not published, nor even submitted) explaining, and to some extent justifying, the conduct that put some traders in jail (though not the right ones, from the perspective of podcast producer Anjay Nagpal).

I hadn’t thought about that paper in a long time, but the podcast resurrected it from the recesses of my memory. In a nutshell, as described in the podcast, a major aspect of the allegedly fraudulent conduct engaged in by floor brokers and locals revolved around the issue of “out trades.”

Out trades were an inherent feature of floor trading. Out trades were mistakes. Two traders could trade, and agree that they traded with one another, but disagree on the price. Those were relatively easy to resolve. Bigger problems occurred when, say, ABC said he sold to XYZ and XYZ said he didn’t buy from ABC. Or when ABC said he sold to XYZ and XYZ said he sold ABC.

These types of errors were endemic in the bustle and commotion of the pits. And they were often material. In essence, if an out trade occurred when a broker traded for a customer, and the error was detrimental to the customer, the broker had to make up the loss. In the case of ABC being a broker, and the price moved down subsequent to the time the trade should have occurred, and the broker corrected the error by selling for the customer at the lower price, ABC had to pay the customer the difference. If the error worked in the customer’s favor, he got to keep the benefit.

Especially in volatile markets and for big orders, six figure errors were not unheard of, and five figure errors were pretty common.

In essence, brokers were short a random number of options (the randomness being due to the unpredictable nature of out trades). This was a cost of doing brokerage business, and could be an appreciable cost.

And this was the hook for my paper. The bulk of the allegations against the traders was that in the aftermath of an out trade, a broker would make a trade with a local (i.e., an independent floor trader) that was profitable to the broker, but unprofitable to the local. This local was called the “bagman,” hence the middle word in the title of the podcast (and a book). The broker would later pay back the local by making off-market trades that cost customers money but were profitable for the local. For example, selling to the local at a price below the best bid in the pit.

When I first read the allegations, this struck me as an insurance arrangement, and hence the paper was titled (if I recall correctly–I’m looking for an old copy) “Broker Fraud as Out Trade Insurance.” In essence, the losses from out trades were spread out among all (or least many) of the broker’s customers. The bagmen were like insurance companies: eating a loss was a claim. The profits from off-market trades were the premiums. The customers paid the premiums in the form of unfavorable trading prices. (I also argued that broker associations, also controversial, were in large part an insurance arrangement).

My argument was that this was plausibly an efficient arrangement, as it led to a more efficient sharing of out trade risk, where out trade risk is inherent to open outrcry trading, just as fire risk is inherent to owning a house or accident risk is inherent to driving.

So were customers hurt? Well, if these practices were indeed insurance, customers actually benefited. A more efficient sharing of out trade risk reduced the cost of supplying brokerage services. With a highly competitive market for brokerage services, this lower cost would be passed on in the form of lower commissions, or better service, or more perks (like picking up bar tabs or losing more to the customer on the links).

Of course, it was almost certain that some of this type of trading was not undertaken to insure out trade risk. Some brokers no doubt took advantage of the widespread nature of the practice (where its ubiquity was driven by its putative efficiency) to rip off customers on some trades. However, as I argued in the paper, the ultimate effect of that kind of behavior on customers was mitigated by competition among brokers. The ability to harvest those kinds of illicit profits reduced the reservation commission that brokers charged.

(In making this argument, I riffed on an example from (then) Donald McCloskey’s price theory/micro text. He argued that the practice whereby shipyard labor cutting wood on sailing ships pocketed and sold shavings from the wood they cut had little impact on the cost of building or repairing ships, because labor market competition reduced wages by an amount commensurate with the value of the wood thus taken. McCloskey used this to illustrate the idea–originating with Adam Smith–of compensating wage differentials).

So the argument was basically not only was this not worth a federal case (or what was at the time the most expensive FBI investigation in history), it was arguably efficient, or at most a victimless crime (in equilibrium, anyways).

Other allegations included things like trading after the close. Again, in many cases this could be viewed as efficient, and beneficial to customers: trading at the close was often insanely chaotic, making it impossible to execute all orders before the bell rang.

Labor unions know that one of the most effective ways of disrupting a production process is to “work to rule”, i.e., adhere strictly to every agreed upon rule. In any tightly coupled system (e.g., an assembly line, an airline operating on a schedule, or a trading floor), allowing for some play in the joints–some departures from strict adherence to the rules–can allow it to operate more efficiently. Strict adherence to the rules would likely have interfered substantially with the efficiency of the floor trading process.

Or think of the mess that an NBA game would be if refs called every foul. “No harm no foul” is a reasonable way to call a game.

To the outrage of other defendants–who claimed that nothing untoward happened on the floor–the lawyer for two defendants (a guy named David Durkin, interviewed in the last episode of the podcast) argued that yeah, this stuff happened all the time, and it wasn’t fraud. He didn’t make exactly the same argument as I did, but his argument rhymed with mine. That is, the intent of these violations of the rules was not to defraud, which would be necessary to achieve a criminal conviction. (The argument was not tested at trial. For perfectly understandable reasons, guys facing RICO charges and 20 years in Club Fed took a deal and pled out for terms of 8-10 months. One could argue that the relatively big delta between the deal and the penalty if they had lost reflected the government’s assessment that the argument could have indeed been persuasive to a jury.).

Take it as you will. All I can say is that nothing in the podcast made me change my mind from what I came to believe 35 years ago. (Time flies!)

The podcast delves deeply into the genesis of the investigation. This material was pretty new to me. I had heard nothing previously to challenge the public explanation that ADM’s Dwayne Andreas was ticked off (no pun intended) at being ripped off by the floor, and sicced the FBI on the exchanges. But after listening to the podcast, like Nagpal I find it unpersuasive. Would that really be sufficient motivation for the DOJ and FBI to launch such an ambitious investigation? (Perhaps they didn’t realize how hard it would be, and doubled down once they got in–the sunk cost fallacy at work.). Was it really aimed at the exchanges themselves, or the bigwigs there? Was it really launched to investigate mob money laundering? After all these years, these remain open questions, despite Nagpal’s dogged efforts to answer them.

The podcast also featured extensive interviews with various traders–some convicted, some not, and some not even charged. Those brought back memories of the floor in all its glory, color, character, and characters. And the accents! Having been away for years, the distinctive Chicago accents were truly noticeable and entertaining: at the time, as a fish in those waters, they would have seemed to be normal.

My only criticism of the podcast is in its attempt to draw Big Lessons. Nagpal’s big lessons were: (a) this conduct was rife; (b) it was fraudulent and harmed customers; (c) it was so rife that bigwigs–notably Leo Melamed–participated in it; (d) the fact that the bigwigs skated was a travesty of justice; and (e) the episode demonstrates the fundamental flaws in exchange self-regulation.

Here Nagpal gets preachy. Though in the last episode (in which Durkin plays a prominent role) he does start to wonder whether the bad stuff really wasn’t so bad after all, and that some of the bad guys really weren’t that bad.

As someone who wrote a lot about self-regulation in the 90s in particular (in large part due to the experience of dealing with it in the aftermath of the Ferruzzi episode), I am surely not in the self-regulation hallelujah chorus. However, I vigorously disagree with Nagpal’s contention that putting the futures exchanges under the aegis of the SEC would represent an improvement (not least because stock exchanges regulated by the SEC are also self-regulatory organizations). In the case of the investigation of the floor, the assumption that self-regulation failed presumes that the conduct was truly predominately fraudulent: as argued above, that’s debatable.

And yes, exchange governance is political–as discussed in detail in my 1995 and 2000 JLE articles. But government regulation is politicized too.

Overall, though, those are quibbles. In laying out in detail the complex facts, and letting the principals speak at length, Brokers, Bagmen, and Moles sheds considerable light on a long forgotten but epochal moment in the history of Chicago’s exchanges. It’s a kind of unvarnished history and I hope that others make similar contributions before the old floor traders, like old soldiers, just fade away like the sound in the pit after the closing bell.

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10 Comments »

  1. Ha.I was at the AFBD in London then where by trawling through broker accounts we turned up quite a few floor traders with 100% success rates at client expense.

    It was so rife (nobody even thought it was wrong and management saw it as a perk) that the powers that be put a lid on it but penalised the worst offenders by setting the taxman on them.

    As a result, one of the first things I did at IPE when I joined as Director of Compliance & Market Supervision in 1990 was to tape all the broker phones (which some were doing anyway),and videotape the trading pits.

    Massive resistance initially but within a week brokers were almost all completely in favour of being able to resolve out trades in the video room. A few scumbags had to call it a day, and the ritual stuffing of newbies with bum trades ended.

    Basically, compliance as quality control, which is how I always saw it. Keep on rocking, Prof.

    Comment by Chris Cook — May 23, 2024 @ 4:04 pm

  2. Apologize for the long comment. I am an old floor trader. I was on the CME Board that revolutionized the industry…..I have listened to his podcast and like you, brought back so many memories. I don’t think Nagpal was a “real trader”. I think he was on the periphery. I knew, and know the Borselino’s. They were tough guys, and tremendous floor traders. They grew up in my neighborhood and Joey went to high school with me. I knew many of the people in the podcast. Many were from the currencies. The currencies are where the FBI did most of its damage. They found minuscule things. Leo was never in on the bagman game. Jack Sandner wasn’t either, although he was a principle of the largest broker group with the Kaulentis brothers-and they weren’t exactly clean. They didn’t call him “Bracket L Jack” for kicks. Political factions developed over the course of the 1990s at CME, there was the Leo faction and the Jack faction. I was part of the Leo faction. We wanted to go public and become a corporation. Jack’s faction wanted to fill their last order and then let the doors close. Leo gets credit because he’s Leo (and aggressively takes credit) but it was Bill Sheperd who led the charge for change. Ironically, Terry Duffy was politically smart, and was able to thread the needle between both factions and is now still chairman. M. Scott Gordon and Jimmy Oliff led the exchange through the transition, but couldn’t stay after McNulty since they backed Jim, and Leo/Jack/Sheperd wanted McNulty gone.

    I traded hogs with Terry. He was always honorable. One time, I made a market in a spread during the Goldman roll and he said, “You really don’t want these.”. I think I sold him 10 and then he had thousands to buy.

    The floor was full of some of the smartest people you’d ever want to meet. There are too many to name but no one has heard of Bruce Johnson and he is probably the best meat trader in the world and has been since the 1970s. Bill Sheperd never went to college but was the largest British Pound futures trader in the world. Don Wilson started in the Eurodollar options as a one and two lot trader. He was so young they called him “Doogie”. He is a multi-billionaire now. Irv Kessler at the CBOT and Ray Cahnman….so many…

    There are quite a few of my old friends passing away. I get the notes quarterly. On a sadder note, when the floor closed I know at least 25 that have taken their own life. The amount of divorces when the money ran out is incredible. I know a lot of people that went broke after the floor closed. I myself was unable to make the transition from floor trading to electronic. I lost a lot of money from 2009-2012 when the meats went fully electronic. It’s super depressing, and you are unemployable. I was unemployable even though I was one of the leaders of the exchange transformation, had an MBA from Chicago Booth blah blah blah.

    For sure, there were bagmen on the floor. We all knew who they were, and often we detested them. Their broker protected them for the reasons you highlight above. Large brokers had more than one bagman because they were so big. A couple of guys I knew in the Eurodollars had a covey of them. They were filling 25k-50k contracts per day. Let’s say I had 1000 to sell, and 800 to buy. I might look at my bagman and execute the trade: Sell you 1000 at 1, buy 800 at 2. Let the bagman worry about being short 200. OR, I have 1000 to sell at various prices; 500 at 10, 100 at 15, 300 at 20, 400 at 25. The market quickly moves from 5 bid at 10 to 50 bid at 55. I tell the bagman he’s long 1000 at 25. Bagman goes into the market to cover the trade as fast as he can. Next day, maybe he has outtrades with the broker and adjusts his price from 25 down to the other prices. Customers are filled at the price they wanted, and the broker is able to pay the bagman back. No one really gets hurt technically except in theory, the broker should have filled them in the open market, starting to sell at 50. BUT, if everyone sees him selling they might move against him and sell hurting the probability that he could get them all filled at the prices the customer wanted-incurring a loss for himself.

    It’s hard to understand unless you were there. Trading in a pit was sometimes like a huge poker game.

    To give people the feeling of the money at stake, in 1990, brokers were paid $1 per contract to fill. In the currencies, a one tick move was $12.50. In the Eurodollars, it was $25.00. In the Hogs/Cattle, $4. In the S+P, $5, but it always moved in $25 increments. HOWEVER, contracts could move a hundred or more ticks per day and sometimes in an instant, except in the case of the Eurodollars which moved 1-10 ticks per day. The difference in the Eurodollars was the size. 100 lot orders were common, and the contract was a behemoth trading hundreds of thousand of contracts per day.

    FWIW, in the Eurodollars during the week before and after Black Monday in 1987, the market was quoted for bid/ask in 10-20 tick increments ($250/$500 per contract; remember you are trading 100 lots). That is the single craziest day I have ever seen. 2008 comes sort of close buy happened over weeks not a day. Plus, I had a gigantic position in 2008 so I had trouble sleeping.

    Screw up an order, and you eat it. One screw up could totally ruin your month, and possibly an order fillers career. Big order fillers had high overhead costs. They likely had 5-6 clerks paid up to $80k-100k, sometimes $150k a year to watch customer desks. They’d have one or two trade checkers paid about $200-$500/week to walk around and re-check trades with other traders to make sure there were no errors. They would have an outtrade clerk who came in early every morning to settle up trades and that person probably got $1000 per week if it was a huge order filler. I paid my out-trade clerk $400/month, and my trade checker around $125 week but I was a medium size local.

    When I clerked, I worked 12 hours a day, five days a week no vacation. I made $400 a week at the top and clerked for the largest options trader in the Eurodollars at the time. My hope was he would back me to trade, and after working for him for one year he did. It took that long to earn his trust, and I gave 50% of my profits after costs to him. I traded for him from 1988-1992 and then went on my own. I bought my first membership for $570k, putting half down in cash with a 9% loan over five years on the balance. Outside of that, I had $100k in the bank.

    One day, I was trading S+P 500 spreads during the rollover. I thought I had traded an 80 lot spread with a broker. I checked it, we all nodded. A few hours later, a trade checker came to recheck the trade with me. My 80 lot spread was really an 80 lot outright trade which I had gotten out of, meaning, I was long 160 S+P contracts. Sure, S+Ps tick size was $5, but it moved in $10-$25 tick increments and it moved hundreds of points at a time. The risk was huge. In this case, the market was significantly higher and I had a “winning outtrade”. I covered my 160 and don’t recall how much I made but I recall the market being 500 to 600 points higher. Think I made $150k or something. Lucky. I have had losing outtrades too and they aren’t really fun. But, you could see how that could bankrupt you.

    I think it’s also important to note that most of the people on the floor were trading their own money. It is not like NYC where you trade other people’s money. When you made 10g, you made 10g. In the parlance of floor trading, make $5k per day and you pull down $1M per year….Seems easy to do until you try it.

    I recall one time, I was short 500 Eurodollars ($12,500 per tick). The market was 10 ticks against me, and there was a 9am CT economic report due out. Do I cover them and take the loss ahead of the number, or let them ride and see what happens? I was pissed. I let them ride knowing full well the market could move another ten ticks against me in all probability. Number comes out. Market breaks. A local about five feet from me yells, “500 at Even”. Before you could blink your eye I yelled, “Buy em”. Scratch for me (meaning I only paid commission on the trade which would have worked out to about $100). As soon as we carded them up the market moved higher.

    You had to be incredibly quick on your feet as a floor trader. Remember, you are trading your own money and at the same time the job was physically demanding. I am 6’5″. I was closer to people than I am when I am sleeping with my wife and it doesn’t smell as nice. Sweat is flying along with spit. People are screaming in your ear. You are constantly being jostled like you are fighting for position for a rebound under the hoop.

    There were lots of people like me on the floor. We had ex NFL, lots of college basketball, tennis, football players and even ex pro hockey and even 1 1980 Olympic hockey player on the floor. It was 5000 people who were unemployable in the corporate world. The guy in the story above was 6’9″. For what it’s worth, we are still friends to this day. That is another thing people don’t understand about the floor. It was hypercompetitive. Sometimes, you joined up and tried to move the market or take on Goldman/Morgan/JPMorgan/BankersTrust etc and sometimes you were enemies and fighting each other. You competed for order flow. But, at the closing bell often you’d go to a watering hole and have a good time with the people you just competed with.

    There are a gazillion stories from the floor. Most of the time, people think about hookers and blow. Sure, there was some of that. But, there were incredible stories that probably could only happen there. There were tremendous acts of kindness, and millions raised for charity. I will try and write about them and publish them.

    Comment by Jeff Carter (@pointsnfigures1) — May 23, 2024 @ 4:38 pm

  3. @Jeff: Really interesting, thanks for sharing!

    @Anybody: Would I be correct in understanding that the Prof’s argument is that these practices were essentially a decentralised clearing service, doing a similar function to the centralised clearing mandated by Dodd-Frank? If that’s the case, and if the Prof is correct that this could be considered a sort of insurance, I wonder why the authorities didn’t just mandate that customers be informed about the insurance premium they were paying, and then just leave the market to sort itself out.

    Comment by HibernoFrog — May 24, 2024 @ 2:21 am

  4. Jeff is right to a great degree. Nothing he said is wrong and I’d be the last one to question him. He was, from all reports, a terrific floor trader. I, on the other hand, was a TERRIBLE floor trader. The only thing I did right was not sell my membership at the CBOT. Jeff was at the CME and the exchanges were rivals until guys like him saw the future and dragged the exchanges kicking and screaming into it. (Thank you Jeff. I profitted handsomely from your efforts). The value to having a membership was being close to information. Information is money (that hasn’t changed) and being the first to hear it and see it was valuable and that was on the floor of an exchange.
    I think Jeff is also correct in his assertion in one of his earlier posts that 20% of the people who tried floor trading were successful, the other 80% busted out. I make this point as part of a larger point regarding “bagmen”. Brokers (customer order fillers) were paid as he said, $1/contract. If you executed 500 contracts that wasn’t a bad day. If you did 1,000 or 10,000 which wasn’t at all uncommon you were in “hog heaven”. If you did that day in and day out you were near the top in income from an exchange membership. You had clerks to pay, certainly, but it still left you with a bundle.
    Being an order filler was a sought after position. Being a bagman for a broker was generally also a good deal, helping a broker off his mistakes generally put you in a position to be filled first by the broker on a trade you were bid/offering. Here is where I expand on the bagman theme. Bagmen also helped brokers “front run” orders they had to fill. Not every order and not even most orders. You only had to front run an order that was going to move the market. Of course, not every broker was quite that discerning. There were also brokers who did not trade for their own account to obviate that claim from customers.
    FCM’s and big trading houses, Golden Slacks, Solly, other big banks knew the deal and put up with it for years. Finally, they were allowed to buy memberships, which they did with abandon, and put salaried people on the floor to execute their orders. No more $1/contract and the firms also ate the mistakes. They had better be few and far between or you would be looking for work elsewhere. Broker rings were partly an effort to keep brokers fees as high as possible. To keep FCM’s from shopping their “decks” or forcing lower fees.
    As an example of how fast things changed, I started in the industry (1974) when currencies were still chalk-board traded. I recall when the only trading and volume on the limited number of currenies were done by guys with “names on the door” who were engaging in, for a lack of a better term, tax avoidance until the IRS sniffed that out and put an end to it. Then things, led by currencies and financial products literally exploded. Then finally, technology caught up with the industry and the trading floor was no longer the place where information was first heard and a value placed on it. A hell of a ride while it lasted.

    Comment by Donald Wolfe — May 24, 2024 @ 12:19 pm

  5. @Jeff–No need at all for apologies. Long comment appreciated. Would love to hear more. Thanks!

    Comment by cpirrong — May 25, 2024 @ 4:12 pm

  6. @Hibernofrog. Clearing mutualizes (insures) counterparty risk. My argument is that these floor practices mutualized out trade risk.

    Comment by cpirrong — May 25, 2024 @ 4:14 pm

  7. @Jeff-Terrific anecdotes that brought back a lot of memories! I was in the Eurodollar options pit just before you started market-making in 1988. Was the guy who backed you named Carlson?

    I can’t remember the name of the futures broker I delta hedged with but he was a 6’11” white guy who had played center for DePaul. He was both a nice guy and a good broker.

    Might you recall his name?

    And yes, all sorts of innocent mistakes could prove fatal for market-makers or brokers.

    In 1985, a CBOT Treasury futures floor broker who never intentionally took any positions for himself mistook a thousand lot customer buy order on the close for only a hundred lot (he was getting a hand signal from his phone clerk outside the pit). He was held by his customer thereby leaving him short 900 contracts overnight. It must have been a sleepless night whereby he pondered all the risks he was taking as a broker.

    Fortunately for him, T-bonds opened down a full point on the following opening. He covered immediately, netting $900,000.

    He then walked out of the bond pit, went upstairs, sold his seat immediately and retired from the business.

    Comment by JOHN L MCCORMACK — May 25, 2024 @ 7:21 pm

  8. @Prof: Thanks, I understand that a lot better now.

    Comment by HibernoFrog — May 27, 2024 @ 2:12 am

  9. My tenure was a little earlier than most of the above. I became a member of the CME in 1977, floor traded financial stuff there until ’87 when I moved back upstairs. Many people hoped to trade on the floor well enough to be able to trade well off the floor as being on the floor daily takes its toll. My course was atypical in that I started trading off floor 09/74, trading forex for Cook Industries, basically Ned Cook. Wonderful guy, very smart not just about markets but about people. I met his personal stock broker at the time, a guy at Kidder Peabody named Julian Robertson.

    After trading successfully on the floor for about five years, I ran for the board of the CME and got elected. At the time, one of my best friends was Bill Shepard, mentioned above. Bill was a great trader, opinionated about most everything and almost always right. And stone cold honest, a real rarity. Very smart guy. He was part of a group of five friends who went to Lou Mitchells on Jackson every morning for breakfast, usually before Fed time. For a year or so, one of the members of our group was Guy Martinolle, a eurodollar trader from Paris who wanted to see more about how we did what we did. We loved him.

    At the time I joined the board, there was no intra-day clearing, trading was still on cards, and out-trades were settled early every morning. When I was a Director, each Board member had different responsibilities. Mine initially were for interest rate products and clearing. Options trading hadn’t begun yet. I had traded CBOE options in ’75-76 for Cook before moving to Chicago. Cook sent me to see Eddie and Billy O’Connor who had pretty much started the CBOE. When I met them, I was largely ignorant of Black-Scholes even though it had been published in ’73 and instead created my own pricing model derived from a Ph.D. dissertation on warrant pricing written by a guy named Kasouff at Columbia, a student of Arthur Burns. The O’Connors quickly put me on the right path.

    The Chairman of the CME at that time was Brian Monieson, a very smart guy and good friend. And of course, Leo, who basically ran everything regardless of who was Chairman. But he and Brian were a great combination. Brian understood clearing and risk management. And Leo had a vision of the future that no one else did. Unmatched.

    One of the main topics of conversation was whether electronic trading could ever replace floor trading. Brian thought not, Leo was open to the idea, and I was convinced that the answer was yes. As luck would have it, I knew someone who traded Japanese Government Bonds (JGBs) actively. He told me they were traded actively from the floor of the Tokyo Stock Exchange, so I went to Tokyo to see for myself. Getting access, especially to the floor, wasn’t easy, but a bank through whom I had traded forex helped me. What I saw amazed me. All trading was electronic through terminals on the floor. Even better, the terminal showed the bids and offers on either side of the current market. And they were trading huge volume. So I flew back to Chicago, told Brian and Leo and thus began Globex. Initially, to soothe floor traders objections, trading was only outside of floor trading hours. The CME at the time had made mutual offset clearing arrangements with the Simex in Singapore and MATIF in Paris, so that helped ease the way.

    At just about this time, I told Brian and Leo that I was strongly in favor of our offering options trading on futures. Brian’s immediate reaction was to ask how would anyone price them, that it was too complicated. My answer was just use Black Scholes and make the underlying a futures contract rather than a stock or bond. I glided over a few of the math issues with that, knowing that CME research, headed by Rick Kilcollin at the time, would figure it out. Rick was one of the most valuable assets that the Merc ever had, a brilliant and creative guy very good at solving problems and imagining solutions. When we wanted to trade eurodollar futures, for example, the CFTC objected that there would be no delivery mechanism at expiration since they were case settled. We explained how cash settlement would work and that it was actually less risky since corners and squeezes such as had happened in ag futures would be impossible. To their credit, the CFTC said yes. Without that, no S&P futures trading.

    So we began to offer options on currency futures. Before we started, I visited various banks in NY where most of our current futures volume originated to see their degree of interest. They loved the idea and even seem to love it that there might be some disagreement as to how to price them.

    Brian then said to me that since it was my idea and since I had traded options that I should add them to my responsibilities of clearing and interest rate products. So we began having weekly meetings with floor traders who had made the move from futures to options. Their immediate complaint was that they couldn’t trade options like futures since if they bought a put or call they could not expect to immediately do the reverse for a profit, that instead they had to do some other put or call to hedge. At the end of the day, they ended up with positions they had not planned to have. Worse was that they didn’t know how to evaluate the risk of their new position. Our solution was to make discs containing Black-Scholes which Rick and his assistant Galen Burkhardt had tweaked for futures and give them to any floor trader who wanted one. We also offered free help in learning how to use it. To our surprise, they immediately adapted and began trading options actively.

    Almost immediately, we realized that our clearing members did not know how to margin these traders’ positions and manage their risk. In conversations with Rick and Galen, we realized that we had naively adopted CBOE margining. I had always thought that the CBOE system, which treated stock options like securities, made no sense. Options aren’t securities. The CBOE could get away with it since their traders often had securities against their option positions. So pretty quickly we derived a system which we named Dollars at Risk since that is really what it measured. We got input and help from Barry Lind, owner of Lind Waldock, very smart guy. I knew him from the Clearing House Committee which I co-chaired. Barry knew more about clearing house risk, margining, etc., than anyone I ever met. The includes so-called Risk Managers from major investment banks. And he was good friends with both Brian and Leo, a strong endorsement. The Dollars At Risk name lasted maybe a week as the MATIF let us know that they did not margin in dollars. So VAR, Value At Risk, it became.

    One irony in the above is that the CBOT, when they began trading options on their futures, adopted the CBOE margining system. For subtle, not immediately apparent reasons, this resulted in margins for floor traders being generally too low, shifting risk onto clearing member firms. That might be OK if such firms knew it and could manage it, but they didn’t. I was CEO of a CBOT clearing firm briefly in the late ’80’s, clearing about 450 floor traders on both exchanges, and went to the exchange clearing house and explained to them the risk. They didn’t want to hear it. I was too much of a CME guy and they trusted the CBOT. Unfortunately, this risk existed during the crash in ’87. That’s the event that seemed to open their eyes.

    Leading up to the ’87 crash, the CME Board was visited by a Kidder Peabody guy named Steven Wunsch, an advocate of having everyone who traded reveal not just their current bids and offers but everything above and below that current price. His belief was that this would attract more liquidity and make the markets deeper and safer. It was called Sunshine Trading or something like that. I remember looking at Leo and seeing him covering his mouth with his hand as he listened, trying to hide his amusement and incredulity. He was thinking what we all were, that this proposal meant revealing all the stops above and below the market, virtually guaranteeing that locals would trigger them. Within a week, a rumor began to spread that their were massive sell stops under the market in S&P futures, stops that increased in size the further down one went, exactly what one would expect to hedge massive gamma risk. And then it happened. It was way worse than anything we had imagined. Thanks LOR.

    The FCM I was running was owned by Rick Barnes, a hugely successful trader who loved big bets and feared no risk. I’d guess he was worth about $300 million at the time. He was short 450 futures the Friday before the crash and his close friend RD had the same. These were the original size contracts, 5X the stuff we currently trade. Rick covered a third on the Friday close, the rest mid-day the next Tuesday. All he could talk about was what he had lost by covering, not what he made on the rest. I asked him if the had heard the rumor about the stops under the market and he said no but his expression said yes.

    During all this drama, I was running over to the Merc for hourly Executive Committee meetings with clearing house staff, running back to the CBOT to see if any of our locals were dead or dying, and talking to a trader from Guangzhou whom I did not know who wanted opinion about his S&P position, short thankfully. I also had a bond position, my only comfort that day.

    It was then that I decided a change was in order. I did not run for relection to the Board of the CME, gave up all the committee stuff, and never traded on the floor again.

    This July I celebrate my 80th birthday. And in September will celebrate the 50th anniversary of when I started traded professionally in 1974. Today I trade Nasdaq futures, pretty much nothing else. I’m very much influenced in that from having observed Larry Shepard in the S&P’s years ago, a master scalper/day trader. He is Bill Shepard’s cousin and I believe the reason Bill got involved. So Thank You Bill and Larry.

    All the above aside, my best memories are from the people I knew along the way. The Delta has had many hugely successful traders, Eli Tullis, Martin Hilby, Carter Stoval, Billy Dunavant, all people I’m glad to have known and would not have met anywhere else. Lots of people abroad, some still with us. I’m still friends with friends from the exchanges, all of whom are still with us so I will not name. But it’s a great life if you can survive it.

    Comment by Bob Zellner — May 28, 2024 @ 10:00 am

  10. Jeff, did you clear Packer’s? Bruce’s shop? I ran paper for them briefly in ’91 before going the the Eurodollar pit to work for JFN and PRK. Love this quote: “It was 5000 people who were unemployable in the corporate world.” I remember often hearing the euro pit that if we were not there we’d be pumping gas or slicing meat a the Jewel. A plethora of millionaires who couldn’t tell you the name of our Vice President but could recite the starting lineup of the starting lineup of the ’59 White Sox.

    Comment by Patrick — May 29, 2024 @ 4:28 pm

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