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The End Of Open Outcry?

The proliferation of screen-based trading has many pundits predicting the end of open outcry as we know it. But a number of significant obstacles remain.

For at least a decade, a number of wags in Chicago and New York have predicted that open outcry trading pits—born to serve 19th century American agricultural markets—would soon join the abacus and the slide rule in the annals of Western commercial history.

The proponents of electronic screen-based trading have been more than matched by the denizens of the pits, who have argued—with just as much conviction—that open outcry trading has significant advantages that will allow it to continue far into the foreseeable future.

Lately, however, a number of events have made the issue much more than a topic for futures exchange cocktail parties. New advances in screen-based trading have forced traders and exchanges alike to face up to a variety of rapidly evolving technological developments.

These days, the issue is not whether the open outcry system as it is presently configured will survive. Even the most rabid pit traders admit that big changes are in order if open outcry is going to prosper in the next century. The new debate centers on how the outcry system might be adapted to a world in which electronic trading plays an increasingly dominant role.

Previously stalwart open outcry supporters such as the Chicago Mercantile Exchange are beginning to soften their positions with vague pronouncements on the inevitability of electronic trading. "In the long run, we're moving toward screen-based trading,” says Merc chairman emeritus and senior policy adviser Leo Melamed. "But the long run could be 10–15 years. In the meanwhile, we will try to keep open outcry as viable as possible by bringing new technology to enhance the open outcry process. We should also prepare [by creating] an electronic trading system that is as good as any in the world, so that we are in the position of using both to the best advantage, while letting the evolution take its own course.”

Manifest destiny

The first arguments trotted out to support the inevitability of electronic trading involve mushy pronouncements about the how technology allows people to leapfrog over institutions born in the pre-electronic era. The rapid growth of the Internet, for example, has allowed consumers to deal directly with any number of vendors, and people can now bypass travel agents, computer resellers, even car dealers. It will only be a short time, they contend, before people will be asking whether they really need all the structure of the current futures markets.

While the electronic trading technologies may not be up and running yet, proponents argue, there's no doubt the technology is developing at blinding speed. Recent improvements in bandwidth technology, for example, have allowed telecommunication companies to provide wide area networks and intranets at prices previously unthinkable. All these advances, moreover, have been driven mostly by people who want to use technology to make more money. The moment several thousand derivatives traders find they can make more money on a screen, they argue, open outcry will be history.

After years of vague pronouncements, proponents can also point to a definitive success story, the Deutsche Terminborse. For years, the DTB has mounted a stiff challenge to LIFFE's leadership in German Bund futures trading, and last year, it was poised to surpass it. In 1997, the DTB's Bund futures showed 57 percent growth over the previous year. Market share has jumped from 27 percent in August 1996 to 48 percent by the end of 1997 to more than 50 percent through January of this year.

The success of the DTB highlights what proponents of electronic trading believe is a critical point: by leveling the playing field, electronic trading may soon attract hordes of participants from the fringes of the market eager to compete with the big boys. "The DTB has already proven that high-frequency, small transactions marry up very comfortably with lower-frequency, large transactions,” says Alex Lamb, director of marketing at Trading Technologies, a company that develops screen-based trading systems. "Electronic trading allows you to match small orders with large orders without either party having to feel the difficulties associated with that size disparity. A big-order buyer can trade with hundreds of small-order sellers without feeling any degradation or impact in administrative functions associated with that sort of big order–small order mismatch. There are plenty of one-lot traders in the Bund market who trade with 100- and 500-lot traders. The two trader types are fundamentally different in character, yet the same matching system serves them both well.”

"Electronic trading allows you to match small orders with large orders without either party having to feel the difficulties associated with that size disparity.”
Alex Lamb
director of marketing,
Trading Technologies

Another key argument for the inevitability of electronic trading involves predictions about a regulatory end-run by the largest institutional users. Under this scenario, it's simply a matter of time before the big brokerage houses and institutional users, emboldened by new technological advances, begin wondering why they need exchanges at all. They would face the usual regulatory hurdles, of course. But some point to a joint venture between Cantor-Fitzgerald and the New York Cotton Exchange that already seeks to provide an alternative to the big Chicago markets.

Some of the strongest evidence for the ascendance of electronic trading comes from the actions of the exchanges themselves. While talking up open outcry as hard as they can, they nevertheless have done much, as one trader says, to "let the camel's nose into the tent” and help build momentum for screen trading.

The Chicago Mercantile Exchange took the first step last September by introducing the e-mini, a miniature version of its benchmark S&P contract. The e-mini was the first screen-based contract to trade during regular trading hours on the floor of a U.S. exchange—and has traded quite nicely, thank you.

At the Chicago Board of Trade, Project A has made major inroads as well. The success of that trading medium, in fact, led exchange officials to abandon their commitment to the much-heralded open outcry linkage with LIFFE last year. More recently, it has supplanted the open outcry evening trading session.

Not so fast

Despite its recent successes, electronic trading will have to solve a number of difficult challenges before it can hope to rule the trading world. The first might be called the "information gap.” The problem is that electronic trading simply doesn't allow market participants the same amount of market color.

"All markets replicate what's been successful in the pit, and vice versa,” explains Trading Technologies' Lamb. "The pit, after all, is a great gathering place for traders. In the absence of any other common market, the pit created the matching mechanism. It became more efficient as more buyers and sellers came to the market, as more customers saw prices and tempered their orders to reflect their perception of what the current market price was. As markets have grown, however, seeing current prices has become more and more difficult.”

In screen-based trading, traders see only the bid-ask prices, but are blind to sizes. That's a critical missing component for large institutions, because a series of small bids and offers inevitably mean a big trade will move the market against them. Traders on the floor know how strong market sentiment is, and good floor brokers will be able to communicate that to their clients on the other end of the phone line. One of the great strengths of the Merc's e-mini, note some fans, is that the screen lets traders see the size of the bid and offer.

That's a particular problem for option traders, who need to see where the volatility is. If an option trader is legging into a position, he'll know the price of each leg, but he won't know which strike prices are getting action. If the action may be concentrated in at-the-money and two strikes out, he won't have a clue. "It's easy if you're in a pit, where you can know where the resting orders are,” says David Nuelle, managing partner at the Helios Group. "That becomes especially important in fast markets. Screens are less liquid then. That means that in a fast market, an option trader, with no feel for where volatility is, must navigate without a compass. That's confusing.”

The relative importance of the missing information depends on what kind of trading you do. "On parts of our business, having open outcry has an impact,” admits Rick Ballsrud, a principal at the Clifton Group. "It's important to know the mood of the floor, where the sell stops are, what people are focusing on. Other aspects of our business are more mechanical. We do lots of market orders that could trade just as well over a screen.” It is not clear how to quantify the value of sentiment and other non-numeric details. For it to disappear could be a loss.”

"People have trouble with the DTB because they don't know who's there. By contrast, LIFFE's after-hours APT screens are more pit-like. All who are plugged in have an icon, so you know who's there.”
David Nuelle
managing partner,
Helios Group

Another critical piece of missing information is the identities of the traders making the bids and offers. Knowing who is making what play allows traders to call on their experience with particular players in the past. "People have trouble with the DTB because they don't know who's there,” says Nuelle. "By contrast, LIFFE's after-hours APT screens are more pit-like. All who are plugged in have an icon, so you know who's there.”

The identity problem has even inspired former Merc chairman Jack Sandner to suggest that electronic trading systems be programmed to look something like video games that allow you to blast away at particular figures that pop up in various places on the screen.

Of course simply forcing traders on electronic screens to enter size as well as price won't necessarily solve the problem. The CBOT's Project A screen rewards traders who enter large bids and offers by giving them a proportionately larger piece of the next transaction that hits the bid or offer. That, paradoxically, may give traders a false sense of what the market will take.

"It appeared to be a good way of doing it,” says Alex Lamb, vice president of sales and marketing at Trading Technologies. "But it does lead to a little bit of disinformation, because when you look in the market and see 2,000 on the bid and 2,000 on the offer, you can't help but wonder how much of that comes from people inflating their positions in the hope that they will get a larger piece of the transaction when it comes in.”

Another limitation to screen-based trading its the difficulty it gives options traders working on particular spreads. On open outcry exchanges, traders typically phone-in requests for particular spreads to their brokers, who quote the spread price and execute both sides of the transaction simultaneously, in accordance with exchange rules governing spread trades. To trade in a screen market such as the DTB, option traders must leg into each leg separately.

"Options trading can be done, but it's a case of the exchanges knowing that they have to show not only outrights to the marketplace but strategies as well,” says Lamb. "Options traders think in two ways. They will typically make the price in outrights, but at the same time they'll make a combination price, where they start to shave the price to reflect the reduced risk of making the combinations on their books. Current electronic systems typically don't tell the market that I'm interested in doing such conditional transactions. The same thing applies to strips and spreads, although the DTB has gone some way in offering spreads. Listing strategies as actual products, such as the CBOT's yield curve spreads, represents a step in that direction too.”

The most important limitation of screen-based trading, of course, is liquidity. Market users benefit from liquidity in two primary ways—liquidity reduces transaction costs, and it facilitates trade execution. In a liquid market, users can always find buyers and sellers. There will be competition for bids and asks such that the bid-ask spread will tighten. The size of the bid-ask indicates the cost of transactions—the tighter the spread, the lower the cost.

Equally important, liquidity allows users to enter and exit the market with minimal slippage with less size constraint. Portfolio managers placing large orders may not be able to get only one price. A 5,000-contract order will have to go through several prices, but it will get off.

Screen markets, to the extent that users cannot see size and cannot sense the flow of activity in the market, tend to have trouble on both counts. In the absence of a sure sense of competition, the bid-ask may not be as tight as in an open-outcry market, and doing size may be difficult at times.

All these hurdles add up to a significant obstacle course. One vociferous proponent of electronic trading points out that although the Merc's eurodollar contract has developed good liquidity when it's traded on the electronic after-hours GLOBEX screen, liquidity drops like a stone as soon as the contract opens on the open-outcry SIMEX exchange. It seems that when given a choice, some traders would rather call halfway across the world than tap into the screens in their bedrooms.

The Common Fund's Petzel recalls how institutional users initially supported the Intex screen in the mid-1980s, which was designed as a secondary electronic market in which to trade cash equities. "Commercials always want an alternative,” he says. Yet the Intex market foundered because it lacked liquidity and so could not offer the tight bid-ask spread the market users demanded.

That seems always the crux. No matter what people say otherwise, a good bid-ask spread, symbolic of strong liquidity, gets the business.

As the new century draws near, the question of whether the futures market of tomorrow will be open outcry or screen-based remains. But maybe it will be neither. It could be that CBOT chairman Pat Arbor's vision of a paperless floor—where the open outcry traders operate amid an entirely electronic support structure—will provide the best of both worlds to result in the most efficient marketplace in terms of cost and execution speed. That, after all, is the ultimate goal, whatever the system.

The Fed Gives Open Outcry Last Rites

Lately it seems that everyone involved in the listed markets has an opinion about the future of open outcry. But in January, a previously silent and seemingly disinterested observer cleared its throat and issued a forceful statement. The Federal Reserve Bank of New York devoted its January issue of Current Issues in

Economics and Finance to the report entitled "Electronic Trading on Futures Exchanges,” by Asani Sarkar and Michael Tozzi of the New York Fed's research and market analysis group. Open outcry, it says, is on the ropes.

Open outcry remains the more effective system in trading active contracts, say Sarkar and Tozzi, but electronic trading has the potential to become much more efficient in trading smaller futures and options contracts. While open outcry is better at building and sustaining liquidity for certain contracts, it demands that many traders devote all of their attention to a single product, even when volumes and liquidity are suffering. Electronic trading, by contrast, allows traders the ability to move freely and quickly to the most liquid contracts. Still, complex trades such as stop loss orders and spread trades are best completed via open outcry, so "electronic trading systems are not likely to replace the ability of floor traders to execute large and complex trades anytime soon,” says the report.

But electronic systems provide many other benefits that could prove important in the near future. Chief among these is cost. The report asserts that "fixed costs, determined by the number of traders employed and their salaries, are higher for open outcry markets,” because "screen-based trading requires less labor, skill and time.” The variable costs of processing individual orders are also lower for screen-based systems, although not at first. And the overhead exchange costs—staffing, building and back office—are much higher for open outcry systems. All of this translates to lower costs for members of electronic exchanges. The report notes that the LIFFE charges $1.50 per contract on its German Bund contract, while the DTB charges only $.66.

The authors downplay two important distinctions between the two systems. Open outcry lets traders revise their quotes instantly in the event of negative price movements much faster than is possible in screen trading. And open outcry allows traders to observe the sounds and actions of other traders and to identify counterparties, neither of which is possible in screen trading. But the report dismisses these, saying "these disadvantages [in screen trading] are offset by the fact that electronic traders have real-time access to market analytics and breaking news, information that is not easily accessible from the trading floor.” Screen trading can also "virtually eliminate errors in recording orders and reporting trades, resulting in significant cost savings.”

Comparing Open Outcry and Electronic Trading
  Open Outcry Trading Electronic Trading
Main suppliers of liquidity Locals Large institutions; market-making firms
Primary costs Upkeep and staffing of trading floor; back-office tasks Upgrading of software and hardware; telecommunications costs
Information sources Trader's observations of market activity Order book; outside news sources
Operating efficiency Large time and labor investment; potential for errors Speed, accuracy and transparency
Possible sources of trading abuse Lack of precise trade records; lack of anonymity in trading Manipulation of orders before entry
Source: federal reserve bank of new york

The report supports its conclusions with a bevy of statistics that point to an increasing willingness on the part of traders around the world to trade electronically. For instance, from 1989 to 1996, volume of electronically traded contracts at exchanges increased from 7 percent of the world's trading volume to 18 percent; and the DTB's market share of its electronically traded German Bund contract rose from 19 percent in 1991 to 42 percent in 1997—and to more than 50 percent this year—signaling the end of the supremacy of the LIFFE's open outcry version.

The report's prediction: that a "new generation” of traders comfortable with electronic systems will build liquidity at electronic exchanges, supplanting locals as liquidity suppliers. "As technology advances,” the authors conclude, "the trading process on futures exchanges is likely to become increasingly automated and the volume of electronically traded futures and options contracts should grow rapidly.”

For a free copy of the report, call 212-720-6134.

—Robert Hunter

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