EXCHANGES IN A CHANGED WORLD ORDER
in the 2002 Edition of Handbook of World Stock, Derivative
and Commodity Exchanges
scholars, businessmen and government officials will agree that
what occurred on September 11, 2001 in the United States ushered
in a monumental change in civilization. The events of that day
proved that a civilized world cannot coexist with unbridled terrorism.
And since the first responsibility of government is to provide
a safe and stable environment for its citizens, the events of
that day represent a rude awakening—a watershed moment that will
be viewed by history in the manner all extraordinary events are
marked: before and after. This distinction may define
much if not most of the twenty first century.
represents a grand irony. The twenty first century had begun
on such a high note, full of hope and promise: democracy had
spread throughout the world overpowering most forms of dictatorship
and tyranny; capitalism had vanquished communism; free market
mechanisms were replacing bankrupt state-driven economic orders;
globalization had forged a global economy; the Digital Age was
born, bringing forth unprecedented changes in the lives of everyone;
new technologies were creating efficiencies and enhanced productivity
throughout every facet of industry; the Internet provided an
unequaled means for rapid and inexpensive communications and
informational flows; exploration in space had become the newest
frontier in man’s quest for knowledge about the universe; medical,
gene splicing, and cell-cloning, research promised longer life
and the eradication of the world’s worst maladies; description
of the entire human genome, its DNA and chromosomes, was completed
opening unlimited possibilities in human biochemical research;
standards of living were rising throughout the world; world stock
markets had reached record levels creating an enormous wealth
effect on the back of a so-called "new economy;" and scientific
knowledge was expanding on every front of human endeavor. Indeed,
the human race seemed on the threshold of a new golden epoch,
a new paradigm.
the events of September 11th intervened. Things changed.
By that I do not mean to imply that underlying precepts of freedom
and democracy have changed. The world’s march against dictatorship
and tyranny is the unalterable course of mankind; acts of terrorism,
no matter how dastardly, will not revise this goal. Indeed, if
anything, the war against terrorism will ultimately pave the
way to a freer and more enlightened world society. Similarly,
scientific knowledge moves forward under most circumstances.
The forces that sponsored technological advancements cannot be
diverted from their ongoing destiny. Medical science will continue
its pursuit of knowledge and its struggle against disease. Space
exploration will find the will and way to move forward.
while the fundamental direction and doctrines of mankind will
not be materially altered by terrorism, the pace of their change
will. In some instances slowed, in others accelerated. Thus,
the events of September 11th have ushered in what
I would call a Changed World Order. Unfortunately, there
isn’t time for these remarks to examine the vast array of changes
that one can foresee effecting many aspects of social existence—from
freedoms that will be relinquished, to security costs that will
be escalated, to efficiencies and productivity that will be diminished.
me here to examine but a singular line of change—the one that
will directly effect the markets of derivative exchanges. It
centers on the pace of their evolution which gives rise to several
interconnected questions. When will open-outcry be totally replaced
by electronic trade? Is there a continued necessity for a centralized
transaction system in an E-commerce world? And, is there a use
for the traditional trading floor in an age of electronic automation?
the confrontation between technological advancements that permeated
the marketplace over the last two decades 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. 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 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 non-continuous 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 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 "dotcoms" that
sprung up during the height of the Internet bubble—when even
street-people had their own website. Still, those providing the
greatest value-added, will flourish.
the past, US 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.
However, the explosion of ECNs have 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.
to a large degree the battle is between ECNs and traditional
exchanges—specifically derivatives exchanges— 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 inter-dealer
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, JP
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.
the heart of the tug-of-war are three basic issues: 1) Where
is liquidity best achieved; 2) Where can a participant receive
secure processing, clearing, and banking facilities for the transaction;
and 3) In what forum will a participant achieve the best price
at the lowest cost. The transaction system that provides the
best combination of answers to these three propositions will
liquidity is a mandatory element for success of any transaction
system is a given. Without it there is no market. One needs not
dwell on this point; examples of failed systems because of a
lack of liquidity are legion. In comparing who offers the most
of what, I will simply state that with respect to liquidity there
is no contest. It is the hallmark of traditional derivatives
exchanges. 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.
brings us to the ability to clear, process and settle transactions.
To stay viable in an E-commerce world, a transaction system must
provide this capability or partner with someone that can. Again,
clearing, processing and banking 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.
The announced intention by Deutsche Borse (the holding company
for the Frankfurt Stock Exchange and Eurex) and by Euroclear
(the clearance and settlement system for internationally traded
securities) to purchase Clearstream, the other major European
clearance and settlement system is solid evidence that the trend
toward centralized clearing continues to advance.
can a centralized marketplace 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. Again, this would point to
the centralized marketplace which maximizes order flow. 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" cost. Surely those broker-dealers
that wish to sacrifice their bottom-line by subsidizing their
clients in this respect, can beat out any other private sector
competitor. But I submit that such subsidies will not continue
to work for very long in a competitive system.
before the terrorist attacks, there was mounting acceptance by
users that centralized exchanges provide the best combination
of the necessary three requirements: liquidity, clearing, and
best execution at the lowest cost. Since September 11th this
view has been greatly enhanced by a coincidental consequence
of the attacks. More than ever, users want to take fewer chances.
There is much less tolerance for experimentation. "Carry out
my business on a forum that has withstood the test of time, that
has established expertise, and that has unquestionable financial
integrity"is the message we are getting. That message was certainly
fortified—by an order of magnitude—as a consequence of the recent
Enron experience. Indeed, EnronOnline seemed to epitomize a successful
ECN providing worldwide energy and related financial trading
facilities. Its sudden failure sent a troubling signal to the
trading community about the reliability of a private ECN, even
one as large as Enron seemed to be.
because sophisticated application programming interface (API)
serves to mask the geographical location of both the matching
engine as well as the clearing facility, the technological revolution
actually favors centralized exchanges. By virtue of an API, every
broker-dealer can plug into any sophisticated transaction system
it chooses as well as clear its trade at the clearing facility
of his choice. This gives the traditional exchanges a huge leg
are then left with the questions of electronic versus open outcry
trade and the continued necessity of the
traditional trading floor. To me it has been clear for a very
long time that with the coming of the technological revolution,
screen-based trading, or what used to be call the black box will
overtake the traditional pit-trading environment. It is axiomatic.
At the core of the technological revolution lies the capacity
to collect orders, transmit them, and execute them in nanoseconds.
Technology provides speed, efficiency and lower costs.
was that belief that led us at the Chicago Mercantile Exchange
to propose Globex way back in 1987 before any other futures exchange
in the world considered making such a revolutionary proposal.
Since then of course, the world has embraced the concept of electronic
trade. In Europe there are no open-outcry exchanges left to speak
of; in Asia this trend is recognized as well. In the US the pace
toward a full electronic replacement has been much slower. But
with September 11th and the danger of a trading disruption
that can incapacitate a trading floor—such as happened for the
first time in its history of the NYSE,—the pace toward electronic
transaction systems is bound to accelerate. This much is certain,
those exchanges that are ill-prepared or insufficiently funded
to provide an automated mechanism that can in an instant take
over from a floor trading environment are marked for failure.
What isn’t certain is the exact date when automation will completely
issues are complex. American derivatives exchanges have a long
history of successful open-outcry trading. Our floor trading
community still represents a majority of our ownership. Thus,
the livelihood of our owners is to a large degree dependent on
a floor-based system. At the CME we have spent a good deal of
time educating our members. They have learned to recognize the
facts of life and accept the reality that some day the floor
will cease to function. But we have agreed with them that the
exact date is uncertain. Instead, we have struck a bargain with
the floor members. The Merc will continue to expand the capabilities
of Globex to provide the best electronic system possible; our
management will continue to list as many products on the screen
as it deems necessary. Indeed, most of the Merc’s product line
has an electronic counterpart. Some of our most successful products
are exclusively electronic. But we will not close the floor operation
on any product so long as the product maintains its competitive
viability—based on an explicit test that includes requirements
of volume and open interest.
other words, while we have no doubt that ultimately electronics
and automation will prevail to the exclusion of the trading pit,
we will let the market itself determine the exact date for this
transformation. Without a doubt, September 11th has
quickened this metamorphosis. In the meantime the CME operates
in dual fashion. I would also argue that when open-outcry goes,
so will the purpose of the trading floor as we have come to know
it. But in my view, the trading floor can be transformed into
an important resource of a centralized exchange. While it is
far too expensive to build a new one, as long as the infrastructure
of the trading floor already exist, its function should be transformed
to fit the demands of automated transaction mechanisms. Namely,
it should become an "Electronic Arcade."
understand the rationale behind this thought, one must understand
that a trading floor was always more than simply the place where
a transaction occurred. Humans are by nature gregarious and function
best in an environment which tests our thoughts against those
of others. The trading floor acted as a crucible of ideas for
transactions. It was a gathering place for traders where new
ideas could germinate from old ones. It is precisely the reason
that giant trading floors at banks and investment houses exist.
While the trades their employees make may be executed strictly
in a technological fashion, the traders shout at each other;
information is easily passed either at the terminal or in hallways
or in nearby meeting rooms or at the water-cooler or over coffee
or at lunch. There are private electronic trading rooms springing
up throughout the marketplace. A large electronic trading arena
sponsored by a centralized exchange can be an important addition
to the successful evolution toward automation.
good news is that for derivatives markets there is one unchanging
constant: Uncertainty lies at their very foundation. In
other words, the uncertainties of a changed world order represent
a strong vote of confidence for the necessity and viability of
derivatives exchanges. Case in point, the volume statistics at
the Chicago Mercantile Exchange. Since the first of the Federal
Reserve reductions in the federal funds rates that began in January
of this year—known lovingly as the "Greenspan Effect"—the
CME continued to achieve record volumes. Clearly, a change in
federal interest rate policy was an unsettling event in the private
sector, requiring a retooling of investment policies as well
as contractual expectations and costs. The terrorist attack is
of similar consequence.
much is therefore clear: The management of risk is the bedrock
of derivatives exchanges. The prospect of any economic dislocation,
the potential for any change in value or price, the expectation
of any alteration in economic policies or behavior, whether it
be the result of international upheaval or the consequence of
domestic disruption in business flows are the natural drivers
of transaction volume on derivatives exchanges. The events of
September 11th served to underscore this truth.
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