He Who Laughs Last
Articles about the energy futures and grain and oilseed futures markets make it abundantly clear that the ultimate dominance of electronic trading is drawing nigh. The commodity markets have been the last bastions of open outcry, but soon the largest of them–at NYMEX and the CBT–will begin side-by-side electronic and floor trading. If the experience in other markets is any guide, volume will move inexonerably to the electronic platform.
Although one can sympathize with the NYMEX floor traders quoted in one of the articles, realistically speaking they are whistling past the graveyard. Those leasing seats have no ownership in the exchange, and will thus have no vote and effectively no voice in the exchange’s future direction. They have no legal claim to any proceeds from the IPO. They are no different than renters of real estate with no control over the sale or conversion of their apartments.
And one piece of free advice–don’t strike, as the article suggests that some NYMEX traders are threatening. Learn from the French–as shocking as that sounds coming from me. The floor traders at MATIF (the French futures exchange that is now part of Euronext) tried that when that exchange introduced side-by-side trading in 1998. All this did was accelerate the movement towards electronic trading and led to the closure of the floor in weeks, rather than months. The striking traders exchanged a shrinking fraction of something for 100 percent of nothing. Not a good idea. The floor will continue for awhile even after the screens go live during regular trading hours. For most of the seat renters, it’s better to hang around and get some business than strike and get nothing. Moreover, seat lease prices will decline as the electronic system gains market share. Those that stick around will make a fair return on their capital. Those that strike won’t.
Although electronic trading currently has an aura of inevitability–and indeed obviousness–that wasn’t always the case. I’ve been around since the conventional wisdom in the futures markets–and the securities markets too–was that open outcry is inherently more efficient and liquid than electronic trading. Indeed, I played a role in challenging and changing that conventional wisdom. In so doing, I was subjected to scorn from some important people in the business, but as the the expression alluded to in the title says–he who laughs last laughs best.
I have followed developments in electronic trading since Globex’s development was first announced in 1986 (I was working at an FCM in Chicago at the time). Although Globex has become the orb-straddling collosus that its name connotes, it wasn’t always that way. I followed the system’s checkered early years, which were beset by disputes between the (then) partners in the endeavor, CME, CBT, and Reuters, and the opposition of many members of CME and CBT who viewed electronic trading as a threat. I remember when MATIF did the most business on Globex.
I wrote my first working paper on electronic trading in 1991 or 1992. The paper analyzed the potential efficiencies of electronic trading, emphasizing the ability of computerized markets to reduce the costs of access (thereby likely leading to higher volume) and to reduce error costs. The early paper also compared liquidity supply on electronic and open outcry exchanges. I didn’t reach any definitive conclusions on liquidity because there appeared to be potentially offsetting impacts. This was essentially an empirical issue.
I had the opportunity to begin an empirical examination of liquidity on electronic and open outcry exchanges in 1994. I was retained by Deutsche Terminborse to determine whether it was advisable for the exchange to create a new class of members analogous to locals on open outcry exchanges. DTB had heard ad nauseum that the open outcry LIFFE was inherently more liquid because of its individual market makers–locals. To determine whether DTB really needed electronic locals to allow it to compete more effectively with its London rival, I decided on a novel approach–to look at the data. The data showed that if anything, DTB was more liquid and deep than LIFFE.
Although DTB had originally intended to keep the report private and use it for internal decision making purposes only, upon seeing the results (subsequently published in a peer reviewed journal) the exchange released them publicly. The reaction was swift, and decidedly negative from some quarters–notably LIFFE. LIFFE’s CEO, Daniel Hodson, insinuated that a pointy headed academic shouldn’t be taken seriously–everybody KNOWS that open outcry is more liquid. (I’m looking through my clip files to get the exact quote from an old FT article–will update when I find it.) Other industry people were equally critical.
It therefore took some restraint on my part to avoid gloating when less than 4 years later DTB routed LIFFE in the Bund market, and Hodson was forced out as CEO. DTB used my study as part of its marketing blitz in 1997-1998. It’s fair to say, however, that LIFFE’s near death experience was more attributable to its own complacency than any academic study. When making its concerted attack on LIFFE, DTB cut prices aggressively and the British exchange did not respond until it was too late. In less than a year the Bund futures market–the largest in Europe and one of the largest in the world–had tipped from an open outcry exchange to an electronic one. No one would ever sneer at computerized markets again, and from early 1998 it was abundantly clear that the future was electronic and that open outcry markets were fighting a rear guard action.
Another working paper of mine presents a theoretical framework that helps illuminate why electronic trading has prevailed in the end. Open outcry advocates focused on two things that were right before their eyes–the pool of liquidity provided by locals on the floor, and the evident information advantage of those on the floor. Although these are features of open outcry (though the information advantage of floor traders may be exaggerated), in emphasizing these aspects, the floor partisans overlooked another important fact–the huge latent liquidity pool upstairs. The time and space advantages of those on the floor make it difficult for upstairs traders to supply liquidity in competition with the locals, especially in very volatile markets. The time it takes to send and revise orders from upstairs makes those trying to trade via limit order from off the floor vulnerable to being picked off. This taxes upstairs liquidity supply.
Electronic markets annihilate the floor’s time and space advantage–they eliminate the tax on supplying liquidity from upstairs. The dramatic reduction in the cost of accessing electronic markets has unleashed a flow of liquidity supply from what might term the “globals”–as opposed to the locals. The liquidity on the floor was visible–one could see the locals. In the floor era, the potential liquidity supply from off the floor was effectively invisible–since it was largely untapped, it was hard to understand how big it could become if the costs upstairs traders incurred to access the market were to fall dramatically. My 1994 DTB report hinted at the potential for alternative liquidity supplies, but in all honesty I too am surprised at the torrent of liquidity that computerized trading has loosed. In some respects, therefore, the skepticism about electronic trading that was so common in the 1990s was due to a failure of imagination–a failure to imagine how technological change would alter fundamentally the economics of liquidity supply.
In the old days, those on the floor were able to profit from their time, space and information advantage. Seat prices capitalized value of these advantages to the marginal exchange member–inframarginal members (the better traders, the more risk tolerant, and better capitalized ones) earned even more. The rents accruing to floor traders have disappeared as computerized markets take over, but the skyrocketing valuations of exchanges with publicly traded stock indicates that the pool of potential rents is even bigger in an electronic environment. Computerized trading, with its lower access costs, has driven substantial increases in volume. Seemingly small (but supercompetitive) fees on each trade generate large revenues for exchanges. Again, this was unimaginable only a few years ago, but now seems almost self-evident. It obviously wasn’t though. Even though I was an early supporter of electronic trading, I didn’t buy CME at the IPO or shortly thereafter. If I had only put my money where my mouth was;-)
