A Call On The Snake
Exchanges in an E-Commerce World
Association of Financial Engineers
traditional futures exchanges survive in the e-commerce structure
of the twenty-first century? It is a question of some significance
to nearly everyone at this conference—or should be.
are those who will be quick to tell you, no! The role of the
traditional exchange, they will say, is finished. Kaput! The
myriad of transformations that have revolutionized the financial
services arena over the past two decades have not only terminated
the need of traditional trading floors but have even abrogated
the functional necessity of a central transaction system. No
more need to wait an hour or so for an execution report from
the soybean pit. No more need to pay exorbitant brokerage fees.
No more need to hope that the broker read your order correctly,
that he didn’t hesitate, that he didn’t lose it
in his deck, that he didn’t favor a friend before acting
for you, that the crowd didn’t front-run your order.
And no more need to hope that the trade didn’t result
in an out-trade. The celebrated role these exchanges played
in the financial landscape of the twentieth century, they say,
has no place in the twenty-first.
truth, these doomsayers make a formidable case. Some of their
arguments are right on. Surely much of the past structure is
indefensible. But I for one am not prepared to throw in the
towel just yet.
me begin by stating that the markets of futures and options
have been around for a very long time. I mean a very long time.
I don’t pretend to know what part futures played in the
Creation, but it is reasonable to assume they had some role.
Surely the Almighty or someone preparing for the big bang must
have contemplated hedging the bet. I realize, of course, that,
according to Stephen Hawking, under the conditions existing
before the big bang all the laws of science, and therefore
all ability to predict the future, break down. But when you
think about it, such chaos is a perfect setting for futures.
John Meriwether will always give you a price. I mean, what
if the first three seconds didn’t quite go the way Einstein
said they did? Wouldn’t it have been neat to have in
your back pocket an option on, say, an Alternative Universe
of options, I cannot substantiate the theory that before Eve
entered the Garden of Eden, she bought a call on the snake.
But I agree it makes sense. After all, this was before the
Kama Sutra was published, and Adam was totally without prior
experience. According to one school of thought, Eve acted on
the advice of Myron Scholes. This clearly changes the date
of the Black Scholes Model. It obviously also changes the age
of Myron Scholes. He won’t exactly admit it, but he has
intimated that it was an American-type option. This made it
much more challenging for Adam. After all, in such matters,
after the...expiration...the option is really quite worthless.
what I am quite certain, is that the first recorded futures
trade was made in biblical times by Joseph. He and his brothers
knocked it around for a while, and it was 8 to 4 in favor of
saving the Pharaoh’s administration. Joseph was chosen
to convince the Egyptian monarch about putting on some buy
hedges in grains. Some say Joseph was the last central banker
to get it right. It of course saved the Land of Egypt from
the coming seven years of lean. Centuries later, Israel called
in the debt, and it resulted in the Camp David Accord between
Anwar Sadat and Menachem Begin.
is also historically correct that ancient Phoenicians, Greeks,
and Romans extended Joseph’s idea, taking it to another
level. They began trading options against the cargoes of incoming
and outgoing ships. However, with primitive vessels and no
way to predict the weather, it was a very dicey proposition—something
like selling Treasuries to hedge junk bond exposure. Anyway,
the actual earliest source of modern futures exchanges were
the seasonal merchant fairs during the tenth and twelfth centuries
in places like Brussels and Madrid. Of course, many of the
merchants were attracted to the festivities surrounding these
events. Vast quantities of wine and spirits were consumed.
Little wonder that liquidity has been the hallmark of centralized
markets ever since.
first formalized concept of futures delivery can be traced
to these trade fairs. It took the form of an agreement between
fair merchants for the future delivery of merchandise at a
forthcoming fair. In time, the merchants developed commonsense
rules pertaining to trade which eventually transformed itself
into the Merchant’s Code and for centuries was regarded
as the official set of equitable practices of trade. The idea
of using common sense as the foundation for best practices
lasted until 1933, when the concept was summarily rejected
by the newly formed Securities and Exchange Commission.
was the first country to formalize the futures exchange. To
be exact, the house of a wealthy rice merchant named Yodoya,
in Osaka, in the year of 1650 is recorded as being the first
stationary meeting place for merchants where they would gather
to exchange and negotiate their
“rice tickets.” These were, in fact, negotiable warehouse receipts
representing either rice already grown and stored or rice to be produced for
future delivery. Rumor has it, though, that this great invention was banished
from the Rising Sun for the next 200 years because the Emperor of Japan got
caught in a short squeeze.
was not until 1826 in England, and 1867 in the United States,
that the traditional futures market was established. In the
U.S., Chicago was the natural locale as it represented the
great railroad center for products grown in the West to be
moved to the population centers in the East. It proved to be
a huge commercial success for the city. Carl Sandburg even
wrote a poem about it. Trouble was, years later, when Chicago’s
alderman Paddy Bauler proclaimed that “Chicago wasn’t
ready for reform,” the Chicago exchanges took it as gospel.
me if I dare to mention that throughout its formal history,
traditional futures were based on agricultural products. It
wasn’t until 1972 when some wild-eyed mischief maker,
without credentials, without permission from Arthur Levitt
or even one New York banker, explained to a bunch of hog traders
in Chicago that the Swiss franc was not some kind of
foreign hot dog. The shock sent the traders into turmoil and
resulted in a primordial financial soup on the floor of the
Chicago Mercantile Exchange. Years later, their cousins—euphemistically
known as financial engineers, but regarded in some circles
as financial equivalents of Osama bin Laden—fed the concoction
to their hungry computers and the rest is history. The age
of derivatives sprang to life which today boasts of $90 trillion
in outstanding contracts. Of course, somewhere along the way,
Fisher Black and Myron Scholes showed up again and spoiled
all the fun by explaining what we were doing and why. Let me
say that there are experts—knowledgeable in
the field of finance and astronomy—who believe that, as a consequence,
distant galaxies are moving more rapidly away from us.
point of this review is to show that, from their birth, the
genetic code of futures markets made them both dynamic and
resilient. While everything about them changed, while detractors
accused them of everything from the Black Plague to the 1987
stock crash, and protagonists claimed that they were instrumental
in lowering the cost of capital, raising the standard of living—and,
some even say, a sensible substitute for violent crime—one
thing remained constant: They provided liquid pools of buyers
and sellers in the management of risk. Still, any comparison
of futures exchanges in the twenty-first century with the one
in the past is like comparing the Model T Ford to the Lamborghini
Diablo. Both vehicles had four wheels, but that is about where
the comparison ends.
the confrontation between technological advancements that permeated
the marketplace and traditional open-outcry methodologies has
been brewing for over a decade, the immediate catalyst of the
war that unfolded was the 1998 SEC promulgation allowing alternative
trading systems. The ruling came in the nick of time to satisfy
the federal mandate that every agency must do something worthwhile
at least once every century. Status quo was forever
changed. It caused a swarm of electronic communications networks,
so-called ECNs, to be created. ECNs can and do encroach the
traditional turf of exchanges and represent the greatest threat
in the battle for transactional dominance.
general catch all definition is that they are transaction mechanisms
developed independently from the established marketplaces like
the NYSE, NASDAQ, Chicago Mercantile Exchange, Chicago Board
of Trade, Chicago Board Options Exchange, and so on, and designed
to match buyers and sellers on an agency basis. Some are designed
for equities, some for cash, others for futures and OTC derivatives.
They can also be grouped into market types: interest rates,
credit instruments, foreign exchange, energy, weather, metals,
chemicals, and even hedge funds to name a few.
are different types of business models among ECNs. Most of
them end up serving different client needs, but their most
significant difference is that some are destination networks,
which are principally execution systems, others are simply
routing mechanisms. In addition, there are also crossing networks;
hybrid models of electronic order routing and trade execution;
smart-order-routing facilities; and noncontinuous automated
call auction models. Each of these designs either has unique
features that serve a specific array of clients or has built-in
order flow from the systems users. There are literally hundreds,
perhaps thousands, of them, and their sheer number makes one
suspect of the genre. It is inevitable that many of them face
the same dismal fate of a multitude of B2Bs and “dot-coms”
that sprang up during the height of the Internet bubble—when
even street people had their own Web site. Still, those providing
the greatest value added will flourish.
traditional exchanges have only themselves to blame for their
vulnerable condition—this is especially true in the case
of futures exchanges. They will argue, and it is true, they
were trapped in an antiquated thicket of federal regulatory
requirements and prohibitions which had failed to keep pace
with the competitive effects of globalization and technology.
These conditions served to handcuff American exchanges and
invite entities, both foreign and domestic, not so constrained,
to create competitive transaction forums that were more efficient
and more responsive to current needs. But that excuse alone won’t
hunt. It is not the first or last
time that governmental interference or ineptitude stood in
the way of the private sector. Rather than find remedies to
overcome or ameliorate these constraints, the exchanges for
the most part were satisfied to remain in a semicomatose state.
Fat and lazy, controlled by establishment forces that, to paraphrase
historian Barbara Tuchman, “refused to alter any of their
the exchanges remained adamantly committed to a way of life that
ignored most of what happened in the last decade of the twentieth
century. Status quo at all costs was their mantra. And although
reality has now penetrated the four walls of open outcry, the
foregoing was the setting for the current battle between alternative
trading systems and the exchanges.
the core of the technological revolution lies the capacity
to collect orders, transmit them, and execute them in nanoseconds.
This capability became a natural partner to the overriding
goal of the modern trading era: investment performance. Survival
and success will go to that market structure that provides
the participant with the best chance of reaching this objective.
All else is secondary.
the past, U.S. market structures—generally composed of
exchanges and broker-dealers—have catered to the needs
of institutional and retail investors by focusing on centralization
of trading activity. In that fashion, buyer and seller interaction
is maximized. They acted as the fairs of a bygone era. However,
the explosion of ECNs has led to the potential for the undoing
of centralization. These issues have resulted in a debate whether
it is feasible or not, good or bad, and who wins or loses.
Then again, perhaps the market will evolve so that any one
ECN, or a combine of them, become the equivalent of a centralized
market. The success of traditional exchanges is materially
dependent on the outcome of this debate.
the heart of investment performance are two elements that are
in the control of the participant: (1) trading costs and (2)
the venue for
“best execution.” So the tug-of-war is whether a centralized marketplace
can do better than the ECN in achieving the best price at the lowest cost.
On one side is the contention that centralization is necessary for order-competition—in
other words, to achieve the best price. On the other side is the contention
that fragmentation maximizes venue competition—in other words, it offers
competitive efficiencies to achieve the best “all-in”
are yet two additional considerations in this contest which
are paramount: liquidity and clearing. Liquidity
as a mandatory element for success is a given. Not to put too
fine a point on it, liquidity is to markets what pitching is
to baseball. No matter what else you have, without liquidity
you don’t win the pennant. The ability to clear, process,
and settle transactions is, in my view, of similar significance.
To stay viable in an e-commerce world, a transaction system
must provide this competence or partner with someone that can.
comparing who offers the most of what, I will simply state
that with respect to liquidity, there is no contest. Traditional
futures exchanges have it. It is, as I said, their hallmark.
Can this hurdle be overcome by ECNs? Yes, it has happened—Eurex’s
wresting of the Bund contract from LIFFE is the clearest example
of such a case—but it is a rare event and doesn’t
come easy. Especially not if an exchange is alert to the threat
and takes the indicated measures. Consider, the Open Interest
in Eurodollars at the CME—a good measure of liquidity—stands
at 4,430,000 contracts, or $4.4 trillion. The Open Interest
in Eurodollar options is even bigger, and the combined average
daily volume of this futures instrument is nearly 700,000 contracts,
or $900 billion. In similar fashion, clearing and processing
on a multilateral basis has historically been the strong suit
of traditional exchanges. This is not a skill ECNs are born
with. Indeed, existing clearing organizations, sensing an opening
in the battle, are stretching their reach to provide greater
value to member firms and even extending their clearing services
beyond the traditional markets.
have characterized the battle as between ECNs and traditional
exchanges, specifically futures exchanges. However, it must
be understood that many of these platforms were created in
conjunction with traditional broker-dealers and nearly all
are owned by consortia of market participants, many of which
are broker-dealers. For instance, BrokerTec Global represents
an electronic interdealer trading platform backed by a consortium
of 14 of the most powerful institutional firms—ABN Amro,
Lehman Brothers, Merrill Lynch, Morgan Stanley, UBS Warburg,
Credit Suisse, Banco Santander, S.A.Barclays, Deutsche Bank,
Dresdner Bank, Goldman Sachs, J.P. Morgan, Salomon Smith Barney,
and Greenwich Capital. BrokerTec recently received CFTC approval
as a futures exchange. It will offer a single, fully electronic
platform that aims to trade cash and traditional futures contracts,
and claims that it will do it cheaper. One cannot dismiss this
type of competitor lightly.
I cannot yet accept the prediction for the end to traditional
futures exchanges. Perhaps the best way to explain why is to
examine what I view as a telltale test case. I am referring
to the ECN known as Blackbird Holdings, Inc.—named after
the world’s fastest aircraft developed by the U.S. Air
Force. Founded in 1996, Blackbird was the world’s first
interdealer electronic trading system for privately negotiated
over-the-counter futures, including interest rate swaps and
forward rate agreements. The ECN was no neophyte; its strategic
partners included Garban and Reuters. Following its launch
in 1999, Blackbird gained a great deal of well-deserved notoriety
since it offered an efficient screen-based alternative to the
current interdealer voice broker services. In plain language,
Blackbird epitomized the competitive threat that traditional
futures exchanges faced from sophisticated ECNs that could
replicate the trading floor.
a few years after its launch, Blackbird approached the Chicago
Mercantile Exchange to join forces. It resulted in a historic
trading initiative which linked the Merc’s Globex2 electronic
platform with Blackbird’s electronic system. The initiative
enabled Blackbird to effectively link its system with the centralized
marketplace. The dealers, Blackbird stated, will benefit by
being able to trade seamlessly through one screen. To put it
another way, Blackbird decided that rather than do battle with
the centralized market, it was a better strategy to ally with
evidence of which way the wind is blowing can be found by examining
what has happened so far in the American equities markets.
In a word, it’s a yawn. So far, the listed markets, particularly
at the NYSE and other equities exchanges, have been nearly
untouched by ECNs. On top of that, NASDAQ is launching the
so-called Super-Montage which is intended to transform NASDAQ
from a fragmented network of market makers and ECNs to a more
centralized exchange in order to gain more of the benefits
of centralized liquidity. Further, the Chicago Board Options
Exchange has maintained its dominance in equity options. And
across the street, the Chicago Mercantile Exchange is experiencing
record volume and has reached number-one status on the American
continent for the first time in its 100-year history.
are all strong signals that traditional exchanges, once energized,
can successfully compete. Because of their centralized structure,
their historically impressive liquidity pools, their time-tested
capability to clear and settle transactions, and the fact that
perhaps they woke up in time, they have, in my view, the long
end of the odds in the struggle to remain dominant.
course, the debate is far from over. Continued dominance by
exchanges or even their survival is not without a set of provisos:
Their metamorphoses must be quick and radical. They will have
to look dramatically different from even the most streamlined
entity of present day. They will have to become public companies.
They will have to be predominantly, if not exclusively, electronic.
They will have to be efficient, sophisticated, and cost conscious.
They will have to make technology a primary asset of their
infrastructure. They will have to replicate many features of
today’s ECNs, innovate with new products and product
lines, and adopt strategies to expand their distribution on
a global basis. They will have to deal in instruments encompassing
the entire gamut of business needs and provide a panoply of
services covering every facet of risk management. Their driving
mission must be the augmentation of investment performance.
In short, they must morph into an amalgamation of what they
were and what they never were expected to be.
exchanges that were not up to this task have already vanished;
others are being thrust to the sidelines. For those that survive
there is bound to be massive consolidation. Way down the road,
I would venture that there is room for two, maybe three, mega-futures-exchange
networks operating on a global basis. While there may always
be regional exchanges serving a local clientele, they will
be irrelevant unless they are tied to a global network. There
is also little doubt that the ongoing trend of blurring distinctions
between the instruments of futures and securities continues
so that in not too far a distant future, securities and futures
exchanges may also integrate. The recent joint venture in single
stock futures between the CME and CBOE is a step in that direction.
Some day there may even be only one market regulator.
all, traditional exchanges to succeed in an e-commerce world
must overpower what Milton Friedman calls “the tyranny
of status quo.” In simple terms, they must stand up to
the internal opposition of their establishment. If they resist
change, if they fear innovation, if they cling to past arrangements,
then Alderman Paddy Bauler’s admonition against reform
will be their legacy.
jury is still out. My advice is to heed Myron Scholes—buy
a call on the snake! Thank you.
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