Streetwise Professor

No, not Old Soldiers, but those who soldier in the pits–the futures trading pits.   In a couple of weeks, the Minneapolis Grain Exchange will close its floor.

Less than 15 years ago, electronic trading had made its first inroads into the futures business, but the conventional wisdom was that floor trading was inherently more efficient and would dominate well into the future, with computers being a mere ancillary.   I know that argument well, because I heard it a lot–usually expressed in a very dismissive, go-back-to-academia-you-egghead sort of way.

I heard such derisive remarks because in 1994 I completed a study for the Deutsche Terminborse (now Eurex) that challenged this conventional wisdom.   I documented that electronic markets could be as liquid and deep, and perhaps more liquid and deep, than floor markets.   The responsein the industry, and especially in the US, where the floor trading community was deeply entrenched in the exchange hierarchy, was basically: “Data.   We don’ need no stinkin’ data–we KNOW the floor is more efficient and will live forever.”

Well, in one case, forever lasted about 4 years.   For the industry as a whole, it lasted about 10.

My study compared the electronic DTB and the floor-based LIFFE markets.   The DTB had commissioned the study, and had originally intended to keep it private, for use in their strategic planning.   The exchange was contemplating adding a class of members analogous to locals on floor exchanges in response to the constant refrain that locals were the main source of liquidity in the market.   The results of the study were surprising to the exchange (and admittedly, to me, given my previous exposure to the conventional wisdom), so they decided to release it.

The study received some play in the press, with articles appearing in Risk and the Financial Times.   The FT article quoted LIFFE head David Hodson snorting at my study, saying (in essence) that everybody knows the floor is best so one should just ignore Yank academic scribblings.

In 1998, less than 4 years later, DTB wrested the Bund futures contract from LIFFE, and the British exchange was teetering on the edge of oblivion.   (The DTB used my study as a part of the marketing blitz that resulted in its victory.)   David Hodson was ousted as LIFFE CEO.   (I resisted the temptation to send him a copy of the FT article. )

Soon, the move to electronic trading turned into a flood.   The CME, and especially the CBT, tried to resist, but eventually competitive pressures and customer demand compelled them to adopt computerized trading.   The CBT’s members’ attempts to resist, delay, stymie, and sabotage electronic trading, and their half-hearted moves to create electronic markets, undermined the exchange’s competitive position, and ultimately doomed the exchange to become the acquired, rather than the acquirer.

Why the intellectual resistance?   Well, part of it was self-serving: the floor crowd understood that their time and space advantage would disappear in an electronic environment.   But part of it was rooted in a genuine belief that floor trading WAS better.   This belief, in turn, reflected an all-too-human response to new technology.   The strengths of an incumbent technology are well known.   The existing technology has had time to develop and achieve its potential.   The new technology is often buggy and imperfectly realized; its failings and weaknesses are usually obvious.   Moreover, pragmatic, practically-minded people born and bred in the industry tend to view a new technology through the lens of their own experience.

Viewed through this lens, it was obvious that computerized markets didn’t have many of the valuable attributes of the floor.   They did have other attributes that the floor lacked, but these were all but invisible to most of those who had spent their lives in the business.   In the end, however, these invisible attributes of the new trumped the well-known virtues of the old.

When thinking about this history, it brings to mind parallels, like the dismissive reaction of cavalarymen to the introduction of the tank.   New ideas often appear ludicrous and doomed to failure when evaluated using the old paradigm–but often, they render the old paradigm completely obsolete.   In retrospect, it is easy to see when that has occurred.   The difficult thing is to identify prospectively which innovations will overturn the old ways altogether, rather than just facilitate their evolution–if they don’t flop altogether.   Many revolutions are trumpeted, few actually succeed.   Electronic trading has revolutionized the financial markets, and stories like the above from Minneapolis are reminders of how much things have changed.

Although I was an early advocate of electronic trading, I must confess to some nostalgic regret at the passing of the floor.   There is something romantic, something intensely human, about it.   The floor is fascinating historically, economically, sociologically, and even anthropologically.   But like many romantic, historical things (e.g., dashing cavaliers), it has become obsolete in the face of advancing technology, and will soon be of merely antiquarian interest.