MECHANICS OF A COMMODITY FUTURES EXCHANGE:
A CRITIQUE OF AUTOMATION OF THE
Published by Hofstra Law Review
Vol. 6: 149 (1977)
18 of the Commodity Futures Trading Commission Act of 19742 requires
that the Commodity Futures Trading Commission (CFTC) determine,
among other things, the "feasibility of trading by computer."3 This
seemingly innocuous section is one of the most significant within
the Act and carries with it ominous and revolutionary implications
for futures markets.
the many public misconceptions about futures, none is more prevalent
than the belief that futures markets operate in an antiquated
fashion and that they have ignored the advances in technology
of the last fifty years. Thus, it is generally concluded that
the futures market system of trade execution by open "outcry" is
nothing more than a throwback to ancient times and a capricious
gambit of the Establishment to maintain a system which benefits
visit to the Chicago Board of Trade (CBOT), the Chicago Mercantile
Exchange (CME), or the new Commodity Exchange Center in New York
should dispel such erroneous beliefs. A visitor exposed to the
tumult of these floors for the first time is usually so overtaken
by the noise, color, and movement of people that he fails to
notice the abundance of sophisticated electronic equipment which
forms an integral part of the transaction process.
does not take many visits to realize that futures markets utilize
every available form of modern technology, and that they have
done so at great expense and much more quickly than their counterparts
in the securities field. From the time a futures order is placed
with an account executive or registered representative anywhere
in the world to the time its execution is reported back, the
transaction passes through many sophisticated electronic systems.
Highly advanced technology is utilized to process the order,
quotation, transaction, confirmation, and to complete the back-office
requirements of the brokerage firm.4
at the CBOT and CME, where approximately 70% to 75% of this nation's
futures transactions occur, there are ongoing studies of newer
uses of technology with which to enhance the process of futures
transactions. Thus, the futures industry is not bound to the
status quo, but rather has quickly adapted itself to the world
of modern electronics and computers.
is one exception to this broad adaptation: The actual execution
of the futures transaction is still carried out by "open outcry" in
a pit, and in the same competitive auction fashion that dates
back to the beginning of organized futures markets 125 years
ago. The bidders shout out their bids and motion with their hands
to indicate their needs to the sellers, and the sellers do likewise
to the buyers. A transaction is consummated when a buyer and
seller have, by outcry, bought from or sold to each other.
this era of advanced automation, it appears anachronistic to
execute a futures transaction by shouting in the fashion of the
old marketplace, and to transmit a futures order by a "runner" from
the broker's station to the broker in the pit and back again.
Why incur the obvious cost, delay, and danger of human error
apparent alternative is to automate the execution process with
a computer-based trading system by installing input terminals
in brokerage offices or other suitable locations throughout the
country and the world. Trained operators would act as "brokers." Bids
and offers would be recorded on the basis of time received and
displayed for all to see on a CRT5 screen.
Execution would be electronically automatic and efficient. Section
18 (a)6 addresses this alternative.
issue was recently analyzed, under the auspices of the CFTC,
at a special conference on automation in the futures industry.7 At
this conference, a host of economists, professors of finance,
and technological experts in the field of computers and markets
submitted papers.8 Their viewpoints
were based primarily on theoretical comparisons of manual and
automated systems. With the single exception of Robert Burmeister,
Executive Vice President of the CBOT, the prevalent view contained
in the papers was that, generally, the benefits of an automated
system outweigh the costs, and that there is no substantive reason
the transaction process of futures markets cannot and should
not be automated. This general view, however, was strongly criticized
during the discussion following the presentation of the written
the proponents of automation were those who, albeit experts in
their own field, had never or for any extended time "lived" or "traded" on
the floor of an exchange. On the other hand, the proponents of
the present auction system were generally experts who have spent
a substantial part of their business lives on or connected with
an exchange floor. The proponents of automation argued that the
difference of opinion was based on the Establishment's usual
reluctance to change.10
may be some truth to this contention, since the heaviest casualties
of automation would be the floor brokers. Naturally, they would
oppose a change which would replace them with a computer. On
the other hand, one cannot lightly dismiss the arguments made
by antagonists to automation, who explained at length that a
mere theoretical analysis of this subject is insufficient, and
that no valid conclusion can be reached by anyone not intimately
acquainted with the auction system based on personal experience
on the floor. The floor, they argued, as well as the floor broker,
is such an important element of a viable futures market system
that its replacement would destroy the system.11
spent over twenty years on the floor of an exchange, and having
developed an intimate knowledge of what makes a futures market
successful, the author must agree with the latter view. It is
necessary to take part in the futures system and either to trade
on the floor or to be in direct contact with it to comprehend
fully its function, its value, and its irreplaceability.
are five major characteristics of futures exchanges which render
substitution by an automated system impractical: (1) the special
function of the floor; (2) liquidity and locals; (3) spreaders
and scalpers; (4) unique characteristics of futures; (5) orders.
Special Function of the Floor
purpose of an exchange "is to provide and maintain an optimal,
controlled, reliable environment which will insure to the users
of its facilities the attainment of two primary objectives; namely,
price discovery and a capacity to shift price risk on the underlying
commodities represented."12 The exchange
floor houses the central ingredients and mechanisms which promote
these objectives. Many of these ingredients can be replaced by
automation without damaging the central purpose of the exchange
floor.13 There is, however, one important
function fulfilled by the floor that cannot be replaced by any
form of computer automation: The exchange floor acts as a primary
stimulus for opinions and ideas.
special function was barely considered by the authors of the
conference papers.14 One commentator
casually dismissed the "crowd" function of the floor: "How important
is the cacophony of a crowded trading floor, the smells and sights
of a frenzied mob to the trading of intangibles? If you are not
adaptable, they are probably essential--if you are, to be done
with them will be a relief."15 In other
words, it is contended that elimination of the "crowd" is insignificant,
and will, in fact, improve the system.
this view were taken to its logical conclusion, then a host of "crowd" functions
that are still considered important could soon be eliminated.
Certainly any form of town meeting or political convention could
be made obsolete by automation. Delegates could easily signal
their political preferences through some computerized mechanism.
The votes would certainly be tallied faster. For that matter,
Congress itself could be eliminated. After all, Congress is nothing
but a "crowd" of delegates representing its constituents.
Congressmen could remain in their respective districts, where
they are close to their constituencies, voting on issues by computer.
is an appropriate analogy to an exchange floor. An exchange floor
is similar to a daily convention. The traders and brokers act
largely as delegates for their constituent customers. The price
discovery process is much like an updating vote total. Until
computers assume all "crowd" functions, the exchange floor, like
Congress, has a special purpose which cannot easily be replaced.
hundred people (at some exchanges over 1000) gather daily in
a large room where they have easy access to each other. During
the course of the business session, the room is inundated with
statistics, news, and information. Price movements are highly
visible and command attention. Each broker is expert about one
or more of the markets traded at his exchange. Each participates
in the markets by either acting as a customer representative,
acting as an order filler, or trading for his own account. Each
is on the floor to buy or sell, or both to buy and sell the futures
contracts open for trading. Thus, it is incumbent on each to
read, see, listen to, and discuss every conceivable factor which
affects price movement of futures contracts.
natural result of such a setting is easily understood. The exchange
floor acts as a crucible of ideas, discussions, and arguments
about futures and prices from which develop opinion resulting
in bids, offers, and transactions. Moreover, the opinions generated
on the floor further stimulate other opinions as they are transmitted
through the communication networks and as they are intermingled
with ideas originating off the floor. It is axiomatic that opinions
create speculation and, that without speculation, there cannot
be a viable futures market.
are other special effects of an exchange floor which stimulate
trading and which are nearly impossible to re-create within a
computerized terminal system. A seasoned trader was once asked
how he decided which market to trade on a given day. His answer,
according to commodities folklore, was that he traded at the
pit from which the noise came. This is a rather crude but common
way to decide where to stake a great deal of money. Local traders
are attracted to the "noise" or activity in a given market.
Their attention is drawn by noise as much as by price movement.
One cannot hear price movement or activity on a CRT. It is a
normal human response stimulated by the exchange floor; to a
degree, the floor depends upon it. Noise, body movement, highly
visible quotations, and price changes all act as stimuli for
liquidity by the locals.
some degree, each physical stimulus, as well as the crowd aspects
which form the opinion stimuli of a floor, can be reproduced
in the sterile atmosphere of a brokerage office. However, it
is naive to believe that the total result of a well-organized
floor can be equaled by a computer network however extensive
or sophisticated. Not only are such offices necessarily limited
in space, but their purpose is different. To duplicate the climate
of the exchange floor in a brokerage office would require hundreds
of smaller "floors" in each of which hundreds of CRT operators
would congregate, discussing the futures markets. It is theoretically
possible, but dubiously practical.
if each of the foregoing stimuli can be adequately reproduced
in an automated system, there remains the question of participation.
For the stimuli to be effective, a bid and offer must result.
In other words, the person must somehow have access to the market
to put his new opinion into action. On the floor of an exchange,
the member does this by going to the pit and bidding or offering.
He can do this within seconds of the time the idea is born. To
place an immediate bid or offer in a brokerage office, every
potential trader would need his own computer terminal. For obvious
reasons, a trader cannot wait his turn on the computer. The liquidity
to be generated by his new idea requires immediate action. If
he must wait for another operator to step aside before he can
activate his own idea, then the moment of opportunity may have
passed. Consider what happens when it is his turn and he does
not have an idea at that moment. Thirty seconds later, he may
want to buy or sell, but it is not his turn. Furthermore, imagine
a dozen potential traders (not to speak of fifty or one hundred)
standing by a computer terminal. Does each take a turn at the
unit in an organized manner, or do they simultaneously compete
for access to the computer to activate their ideas? Or do the
advocates of automation envision that every potential market
maker will have a terminal in his own office, irrespective of
its location? The complexity and cost of such a network is overwhelming.
value of a large, central hall which permits potential market
makers to congregate, which is organized to stimulate discussion
and opinions, and which offers immediate and easy access to market
action is so basic that its value is inestimable. Much will be
lost if such a setting is decentralized.
opinions, however, are insufficient to maintain a viable market.
The key ingredient to market viability is liquidity: the quantity
of bids and offers coming to the market. The more bids and offers
there are, the narrower the spread between them, and the more
successful the market. Liquidity, therefore, determines the ultimate
success of any futures market. Thus, it is important to analyze
the sources of bids and offers. These sources can be categorized
into two groups: bids and offers originating "off" the floor,
and those originating "on" the floor.
made both at the CME and CBOT indicate that between 40% and 50%
of daily transactions originate on the floor.16 Since
transactions are the ultimate result of bids and offers, that
is, liquidity, at least 40% of the daily market liquidity at
the CBOT and CME is generated by members on the floor of the
exchange. Thus, it is important to understand why this is so
and whether this substantial portion of liquidity can be replaced
by an automated system which would, by definition, eliminate
the exchange floor, the floor broker, and the pit trader.
people really understand the components of a successful futures
market. On paper it all looks rather simple: (1) a commodity
whose cash price movement is such that commercial producers and
users are in need of price insurance; (2) contract specifications
compatible with the trade and fair to buyer and seller; and (3)
speculators willing to assume the price risk shift from the commercials.
Although these are the three main ingredients of any futures
market, they alone cannot create a successful market. There are
dozens of contracts listed on exchanges which have these elements
but which have not become successful futures markets. There are
many more which have been tried unsuccessfully and were delisted
long ago. There are many more which theoretically have the necessary
ingredients, yet no futures exchange has attempted to open a
market for them.
is the most important factor in market success. The constancy
and number of bids and offers coming to a given futures contract
is the fundamental difference between a viable market and one
that will never be more than merely listed. What causes one market
to have such constant liquidity and another to remain dormant
is a mystery to even the most expert futures market observer.
is fundamental to futures, as well as any other market, that
the more bids and offers competing, the closer will be the spread
between them. In other words, in a very liquid market, the spread
between the offer and the bid is often the smallest increment
allowed by the contract specifications. It is also fairly certain
that a narrow spread means a "thick market."17 Accordingly,
a market whose spread between bid and offer is narrow will attract
both speculator18 and hedger.19 Only
in such a market can they be certain that their prospective order
will be "filled" near the last sales price. It is equally
important that only in such a market can hedgers and speculators
assume that the going price is "fair."20
is also fundamental that the more liquid a market, the less impact
a large selling or buying order will have on price. In other
words, a commercial hedger cannot be certain of the prospective
basis for his hedge unless he can be certain of the price range
within which he can sell or buy a large quantity of the futures
product. If his large order has a material impact on the futures
price, he cannot, with any certainty, know that he will be able
to establish his hedge at the desired price structure. Similarly,
a speculator must know that he can buy or sell a quantity of
a futures contract without adversely affecting the price, lest
he injure his own position. Market liquidity, therefore, is the
most important element in establishing and maintaining an active
and viable market. While we cannot be certain whether liquidity
will develop within a given market, we are certain of those qualities
which create such liquidity.
members, or "locals" as they are known in the trade, are the
equivalent to market makers or specialists in the securities
markets. They are the most important factor in creating inception-liquidity.
They act as catalysts to create interest in a certain market
and to insure that some bids and offers are made. They help to
execute the first important "outside" orders which come to the
market floor. They help to build an opening commitment in the
contract, and they help to inform other traders. They help to
keep the distant contract months, which usually remain totally
inactive for long periods, "in line" with current price movement
of the "nearby" contract months. Without question, time, money,
and energy spent by locals on a new contract is fundamental to
as "local" liquidity is important to get a new contract going,
so is it significant to an established market. The continual
flow of bids and offers coming to a given market depends heavily
on local traders and brokers.21 The
factors which give rise to the liquidity generated by local traders
are tied to the exchange floor. The floor produces the climate,
method, and incentive which prompt locals to act. Removing or
replacing the floor and its pit system would unquestionably endanger
the causes of local liquidity. These factors cannot readily be
duplicated. The important factors can be divided into the following:
(1) the floor as an ideal mechanism to stimulate opinions; (2)
the floor as a provider of easy access and incentive to put ideas
into action; (3) the floor as a stimulator of competitive responses;
(4) the exchange as a membership organization which can induce
a "patriotic" response; (5) the pits as an impetus to psychological
reactions; and (6) the locals' trading techniques.
the last-named component is the most important in creating local
liquidity, it is reserved for a separate section. This article
has illustrated the function of components (1), (2), and (3),
and will continue throughout this discussion to refer to their
importance. Therefore, it is necessary at this point to explain
the reference to "patriotism" and "psychology."
futures exchanges compete with each other is an established fact
in the futures industry. All exchanges compete for the business
of speculators, who are attracted to the most active markets.
Thus, if the soybean market becomes very active, it is likely
to draw business from another market. Similarly, when the meat
complex or metal complex has a special reason for price movement,
the speculators concentrate more on those markets and less on
others. Naturally, as futures market participation grows, such
effects will diminish in importance. However, currently and for
the foreseeable future, all exchanges compete for participation
from a limited segment of the population.
different futures exchanges institute the same or similar futures
contracts. Sometimes the specifications of the contract vary
considerably, while at other times, they are nearly identical.
In all such cases, however, the commodity is always the same.
Sometimes, as recently occurred with gold, four or five exchanges
may simultaneously attempt to institute trading in the same commodity;
sometimes, as with silver or cattle, one exchange will attempt
to institute trading in a commodity which has long been traded
at another exchange. In all these situations, exchanges are in
competition with each other. Each exchange spends large sums
of money for advertising, public relations, special seminars,
educational programs, and literature. The goal of each exchange
in such competitive actions is to establish itself as one of
the primary markets for the commodity in question.
many ways, local brokers and traders of each exchange are drawn
into this competition. They are on the committees which create
the specifications, advertising, and public relations. They take
part in seminars and special educational efforts. They draw on
their contracts and customers to bring business to their exchange.
Above all, they are relied upon to make a market. They, as no
one else, can insure that there will be someone in the pit to
make a bid and an offer following the opening of the contract
motivation -- the expenditure of time, energy, and money toward
a new contract -- can only be characterized as "patriotism." That
they belong to the same institution, and that they "battle" for
business with other exchanges, all motivate members to act on
behalf of their exchange. Exchanges rely heavily on this form
of "patriotism," first in the creation of new markets, and
later in the maintenance of the markets' viability. Since automation
will, by definition, eliminate the pit broker and trader on the
floor of the exchange, it will preclude the need for exchanges
in their present form. Thus, the effect of patriotism by members
of a given institution will also disappear, and with it, the
liquidity which such "patriotic" responses presently generate.
is yet another type of liquidity which is exclusively a product
of the floor, or rather of the pits. Although it is minimally
significant to market liquidity, it is important to understand.
This liquidity is the product of pit psychology. For example,
pit trader A, a large trader who trades solely for his own account,
is about to enter the pit. Pit trader A is known to have "bought
the market"22 earlier that day or the
previous day. The market has fallen during the last thirty minutes.
As pit trader A enters the pit, but before he has indicated any
bid or offer, he is seen by pit traders B, C, D, and E who also
trade for their own accounts.
trader B, a fairly large local trader, is short the market.23 His
split second reaction is that A will no doubt continue buying
the market and perhaps cause a rally. Thus, he immediately buys
to offset some of his shorts in an attempt to secure some of
trader C, a fairly large local trader, who is long the market24 and
is presently with losses and nervous about his position, reacts
entirely differently. He feels that trader A is about to sell
and liquidate his entire long position causing the market to
fall further. Thus C, to minimize his losses, immediately begins
to sell the available market bids.
trader D, a small local "scalper,"25 believes
that A will not sell out his position, but rather that he will
buy more. Therefore, D tries to buy one or two contracts for
his own account, so that he can "scalp" them a few seconds
later at a higher price he expects will soon develop.
trader E, a "spreader"26 between two
or more different contract months, has just taken a short position
in the contract month where A is about to enter the pit. E had
intended to stay in an "unhooked" position for thirty seconds
or so before completing his spread by buying the other contract
month. Upon seeing A, however, he decides quickly to "hook up" his
spreads in the other contract month so that he does not unnecessarily
expose himself, since he is unsure of what A will do.
it may turn out that A entered the pit, looked around, and left
without trading; or he may have done what some of the traders
expected. However, it really does not matter what A did. All
the bids, offers, and transactions in reaction to A's entering
the pit accounted for additional market liquidity. In fact, they
created new market positions which, in turn, would have to be
offset, probably that day, thereby creating further market liquidity.
reasons for the trades are unimportant to this discussion. It
is important that there was a visual and psychological interaction
which cannot be duplicated by computer. Without the pit psychology,
this form of liquidity is lost.
far, this article has discussed liquidity and its importance
to futures markets, indicating that the floor acts as a special
stimulus for market opinions and action. But important as such
stimuli, they are merely the climate and setting for effective
floor liquidity. The principal cause of floor liquidity is the
locals' trading methods -- in other words, the methods utilized
by local "spreaders" and "scalpers."27
spreader's method of trading is to play the differential28 between
two or more contract months in a given commodity. In other words,
he buys October hogs and sells December hogs, or vice versa.
He does not concern himself with whether the price of hogs goes
up or down. Any profit he makes will be based on the narrowing
or widening of the differential between the two contract months.
the floor" traders also "spread." But they are distantly related
to the spreader who stands continuously in a pit and buys and
sells between different contract months. The professional local
spreader is an artist. His aptitude, agility, and ability to
detect the slightest market shift is extraordinary. He performs
his transactions in a constant fashion, going from buyer of one
month to seller of another, and immediately back again. In fact,
many spreaders perform this activity between three or four contract
months. The object is always to pick up even the smallest increment
of profit in the shift of the differential. The spreader is alert
to a new offer or bid in one given month which could be spread
profitably into another month. He is quick to react to any sudden
downdraft or updraft in the market so that he can "unwind" one
side of his spread for that small moment of market movement and "hook
it up" again as soon as the price movement has stopped.
value of such spreaders to the market is inestimable. They are
not only a primary source of bids and offers in nearby contract
months, but they are primary creators of liquidity in forward
contract months. A hedger who wants to sell a large quantity
in a contract month six or nine months forward, where the trading
is still fairly sparse, could not possibly do so in the absence
of the spreader without materially affecting the price. In fact,
he probably could not carry out his transaction at all without
the spreader. In the inactive contract months, the spreader bids
to the hedger because he will be able to spread into an active
month at what he believes to be a profitable differential. The
spreader is thus most important in insuring that the differential
stays "in line" between various contract months. Every viable
futures market depends heavily on its spreaders.
is unlikely that such spreading can be done on a computer.29 Professional
local spreaders rely on their ability to bid quickly to any new
offer and to offer quickly to any new bidder. They depend on
hearing the existing or new bid or offer in the next contract
month. Their method relies on physical agility and aptness of
mind and voice to buy and sell at the right price. They remove
their bid or offer as soon as they lose contact with a counterpart
bid or offer in the other contract month. They depend on their
ability to "scratch"30 or liquidate
at a small loss one side of their spread when they cannot successfully
hook up the other side. They could not possibly function as they
do by placing a bid or offer into a "book"31 on
a computer terminal. They would thereby assume greater risk than
their method permits. If their bid was hit on the computer in
the October option, they could not know with sufficient certainty
that they could successfully sell the bid in the December option
to establish a profitable differential or to have a sufficient
chance to "scratch" the October transaction. If they had to rely
on a computer unit where they could not know with sufficient
certainty that an offer or bid would be available when needed,
they could not do business, nor could they continuously go back
and forth as they do. On the computer, they would be "scalping" or
speculating and would need a much greater degree of profit to
justify the risk on each transaction than is offered by "spreading" in
the classical sense described. In other words, the local professional
spreader would be forced to change his method and adopt the spreading
technique presently used by those who spread from "off" the floor.
Their significant contribution to liquidity would be greatly
The "scalper" is
as important as the spreader. Unlike market makers in securities
markets, scalpers are under no obligation to make a market in
futures; yet that is exactly what they do. Their motivation is
profit. The classic definition of a scalper is a trader who always
bids the market and simultaneously offers. He operates like a
spreader, but only in one contract month at a time. His method
of trading is an attempt to make a small increment of profit
on each transaction by buying and selling continuously. He attempts
always to limit his risk, since his profit is based on volume,
rather than on large profits per trade.
are many types of scalpers. Some operate along classical lines
by buying and selling between the smallest increment the contract
market provides. Others attempt to profit by buying and selling
between large daily market gyrations. Most scalpers fall somewhere
between these two methods or combine the two. In every case,
however, the scalper attempts to flow with the immediate market
movement: selling first as the market is falling, buying first
when the market is rising. Also in every case, the scalper liquidates
his position as soon as the minor market movement has ended,
or as soon as he finds that his purchase or sale is in danger
of turning into a loss. Thus, a scalper will institute and liquidate
a small position many times during one day. Scalpers seldom leave
the pit during trading.
is unlikely that scalpers could function similarly with a computer.
Like the spreader, the scalper depends on his own agility to
be one of the first bidders or offerers when a new order enters
the pit. He attempts to initiate his purchase while there are
still other bidders at the same price. Thus, he can immediately
become an offerer, so that if he is unsuccessful in his attempt
to sell at a profit, he still has a chance to sell to the remaining
bidders and wind up this particular round turn without a loss.
In a selling situation, the reverse would be true. But a scalper
could hardly function in this manner on a computer, for it places
a bid or offer in order of receipt.32
would be of little value to a scalper to place his bid in rotation
with other bidders, for once his bid was sold, he would be among
the last to place his offer. To illustrate this point, assume
that the price of December gold at a given moment is $147.10.
The smallest increment allowed is $.10 per contract. Thus, our
scalper bids $147.10 while he offers at $147.20. If he successfully
purchases first, he remains an offerer at $147.20 while other
bidders are still bidding $147.10. If he is successful in selling
at $147.20, he starts the operation again. Similarly, if he originally
sold at $147.20, he would remain a bidder at $147.10 while others
were still offering at $147.20. In either case, he was protected
because he had a chance of "scratching" the transaction if
difficulty arose. But such a method is a creature of the auction
process in which bidders and offerers compete for attention.
It depends on agility, voice, and presence of mind. The method
cannot be utilized on a computer.
spreaders and scalpers are the backbone of futures market liquidity.
Without their contribution, a futures market would lose a large
portion of its bids and offers. If the futures trade execution
process were automated, this loss would certainly occur. Protagonists
of automation have scoffed at such dire predictions. They have
insisted that the "new" world will see the coming of a generation
of computer "whiz kids" who will have their own new method of
trading which will more than compensate for the loss of liquidity
by the old methods.
evidence runs quite to the contrary. Today, there are thousands
of account executives and traders who sit in offices by a keyboard,
CRT, or quote board and watch the changing futures quotations.
Their trading techniques are similar to the type of trading expected
from operators within an automated CRT system in the "new" world.
This similarity enables us to assess whether liquidity generated
by such trading could ever adequately replace the form and measure
of liquidity generated by "locals." Experiences teaches that
it does not and could not.
the floor" bids and offers arise from reasons, techniques, and
trading philosophies which differ dramatically from the trading
plans or patterns of spreaders and scalpers on the floor. Because
the methods and stimuli differ, the type of trading and market
approach also differs. Thus, each method produces a substantially
different set of bids, offers, and transactions. In other words,
each provides a different form and measure of liquidity. Examination
of new or dormant contracts further substantiates this view.
Regardless of the "off the floor" orders which often come to
these markets, the markets remain relatively inactive unless
and until locals also participate. Only after there is a healthy
mix of "on" and "off" the floor orders do the price gaps between
sales diminish and does market thickness develop. Unquestionably,
for markets to flourish, they need a large measure of transactions
generated by participants "off the floor". However, they equally
need the continuous flow of bids and offers that are created
by locals. Neither type of liquidity replaces the other, nor
can a futures market stay viable without both.
Characteristics of Futures
advocates of an automated system have applied to futures their
experiences in and studies of securities markets. They have assumed
that the essential characteristics of these markets are identical
and that, therefore, the same type of transaction process is
applicable to both.33 There are as
many similarities between the New York Stock Exchange and the
CBOT as there are between the actual transaction processes of
each market. But there are important differences. These differences
cast doubt on whether an automated execution system, which may
work in the stock market, can work in the futures market as well.
such difference is market breadth. In 1976, not a robust year
for the stock market, the combined total of all stocks traded
was 7,035,661,000 shares, not including warrants and options;
an average of 27,919,290 shares per day. However, 1976 was a
record year for futures volume: 36,876,787 contracts were traded;
a daily average of 146,336 contracts.34 Irrespective
of the formula used to compare these statistics, the breadth
of futures markets is significantly smaller than that of the
contracts have limited life, while stocks last indefinitely.
A futures buyer must liquidate his position in a relatively short
time.35 If he does not, he does not
merely receive some shares of stock which he can keep or dispose
of at will; rather, he receives a physical product which often
must be disposed of quickly, since it might be perishable, and
which is difficult and expensive to own due to storage and interest
charges. A short seller of stock can maintain his position as
long as his money lasts. A short seller in futures ought to offset
his position prior to contract maturity; otherwise, he must deliver
the physical contract. Thus, deliveries are usually left to the
commercial producers and users, and form only a small part of
the total futures volume. Most contracts are offset prior to
of stock in a corporation maintain an unchanging and generally
known supply level. Futures markets involve commodities which
are of limited, and often uncertain, levels of supply. Thus,
futures are subject to special regulations to prevent unwarranted
control by one or more individuals. In fact, it is a violation
of federal law to own or control more than the available supply
of a given product or to hold positions in excess of prescribed
limits in a given commodity.36 No such limitation
applies to securities.
futures, there is a "short"37 for every "long."38 Thus
an "open commitment"39 in a futures
contract of 20,000 means that there are 20,000 open "short" positions
and 20,000 open "long" positions. This is so regardless of
the number of "hedge" positions in the market. In securities,
the number of "short" positions generally form a very small part
of total outstanding shares. Obviously, the "short" position
is used to a much greater extent in futures than in stocks. Consequently,
on any day when a certain stock goes up in price, the majority
of the "position" investors are "winners." Theoretically,
if there were no shorts, they could all be "winners." In contrast,
on a day in which a futures contract goes up in price, 50% of
the positions are "losers." Thus, for every "winner" there is
a result of innumerable factors, the price of a commodity is
subject to rapid and dramatic change. A commodity at a high price
and in short supply in one season can be overabundant and at
a low price the very next season. Dramatic shifts in production,
imports, exports, or consumption, are very common in commodities
and will occur in relatively short periods. Thus, futures price
trends are often brief, and large price gyrations are the rule
rather than the exception. It is quite the contrary in stock
markets. General business trends are of long duration and a majority
of stocks will usually follow such trends. A bull or bear market
in stocks may very well last several years. During such definitive
trends, stocks may sometimes move against the trend, but not
comparably to the contratrend price swings which normally occur
in futures markets.41
are highly leveraged, stocks are not. The "margin"42 for
a position in a futures contract is usually 1% to 3% of the value
of the contract. In stocks, the margin is generally between 80%
and 90% of actual cost. This dramatic difference has many significant
implications. First, stocks are actually or virtually paid for
on purchase. When futures are bought or sold, the customer does
not generally intend to become the owner or seller of the actual
product and thus only advances a sum of money as security in
the event that the next immediate price swing in the commodity
is adverse to his position. Consequently, all futures markets
in the United States have daily price limits. Such limits allow
the member firm time to call for additional "margin" from customers
as necessary. The stock market has no such price limits.43
a direct consequence of the high leverage feature of futures,
exchanges use a "mark to the market" money settlement unique
to futures. In futures, every open position must pay for any
loss in cash on the basis of the "settlement"44 price
of that contract. Similarly, all open positions which have increased
in value at the "settlement" are paid their profit. Thus, all
positions are paid for in cash "to the market" at the opening
of the next business day.45 In other
words, futures markets operate on a no debt basis which, in this
day and age, is unique in the business world.
historical reasons, trading procedures on the floor of securities
markets rely on specialists or market makers who are obligated
to maintain an orderly and liquid market on a "specialist book."46 Futures
transactions do not follow the same procedure. Each of the forty
or fifty individuals in a pit trading a given commodity, both
buys and sells with any of the other individuals. Thus, a "book" system,
which parallels the procedures in securities markets, would impose
a radically different method of trading on futures markets.47
and other characteristics of futures markets distinguish these
markets substantially from the stock market. These characteristics
give rise to many problems for futures which require different
solutions. Such differences as overall breadth, limited life,
limited and unknown levels of supply, equal numbers of "shorts" and "longs," dramatic
and sudden shifts in value, high leverage, "no debt" settlement
structure, and a "non-specialist" system result in significant
differences in the method and type of transactions. The false
assumption by advocates of automation that the two markets are
substantially similar has led to the erroneous conclusion that
the same transaction system can apply to both. Thus, they have
proposed the identical automated transaction system for futures
as is presently proposed for the securities industry.
types of orders prevail in commodities markets because of these
markets' unique characteristics. Such orders as "market," "discretionary," "stop," and "MIT"48 are
tailored to the immediate action and reaction nature of commodity
markets. As a group, these orders can be classified as "nonresting." They
are, in effect, orders which will be executed at the market price,
rather than at a specified price. In contrast, a "price limit"49 order
is a "resting" type which can be executed only at a given price
when and if the market reaches that price.
The "stop" order
is almost exclusively used in futures. It was not invented by
the "crowd" on the exchange. It was probably invented by a brokerage
firm to enable a customer to limit his loss. Thus, "stop" orders
are especially necessary in futures markets. Not only are the
markets volatile, but the "margin" on deposit with the member
firm is the limit of the customer's security deposit. The "stop" order
attempts to protect the customer from a greater loss than that
which he is prepared to take or that which his security deposit
can command. Although such orders do not always fulfill their
function, they are the best available tool.50
many futures market users have adopted the discretionary order
as a market tool. The customer thereby gives the broker some
discretion so that (1) the broker need not show his full hand,
lest the market be taken from him; (2) the broker can stagger
his executions so that the impact of the whole order does not
unduly affect market price; (3) the broker can use his judgment
and experience in best executing the order.
are mandatory tools for customers in futures and are probably
used as often as "price limit" orders. Nonresting orders depend
measurably on the thickness of the market for their execution.
In other words, good execution of a nonresting order depends
on the number of resting orders in the market and the continuing
inflow of new orders to the market. If, for instance, the number
of resting orders in a given market is small, or has diminished,
then the effective execution of a nonresting order becomes difficult.
In such markets, customers are reluctant to place their customary "market" or "stop" orders,
since they cannot with sufficient certainty know the price range
in which such orders will be executed. As a result, markets with
insufficient resting orders lose their viability and are shunned
by futures traders. It is fair to assume that irrespective of
the transaction process employed, futures markets today demand
the use of nonresting orders by customers. Consequently, it is
essential to determine whether the use of nonresting orders will
be materially jeopardized in an automated system. This article
concludes that they will be jeopardized.
large market user, whether a hedger, a speculator, or a firm
acting on behalf of many accounts, knows that even in the most
liquid market, he must place his orders so that his full intentions,
or the full scope of his intended market position, do not become
universally known. If they do, it is fairly certain that the
market will be "taken away" from him and he will be unable to
fill his order or assume or offset a large position at the desired
price level. The present system recognizes this problem and is,
therefore, geared to accommodate the necessity for nondisclosure.
Presently, a large user may place a multitude of price limit
orders with his broker at different price levels with no one
else aware of the full extent of his intentions. These resting
orders await the market, and each will be disclosed separately
when the broker bids or offers the individual order at the designated
would be foolish to assume that the large hedger or speculator
would be willing to place large resting price limit orders on
the "open book" in an automated system.51 In
other words, to believe that a large user will place orders of
significant size at different levels of the market, thereby advising
everyone of his full intentions, is to ignore the inherent characteristics
of futures markets. Because of the limited levels of supply,
the limited life of futures, and the limited breadth of participation,
an order of any special magnitude becomes immediately visible
and suspect as a possibly significant market factor. Frequently,
such disclosure would have an immediate and volatile impact on
the market. The market would consequently become distorted. It
would then be unlikely that the user would achieve execution
at his intended prices, if at all. In fact, it is possible that
such an "open book" system could become subject to fictitious
bids or offers, above or below the market, for the purpose of
adversely affecting the market.
commercials or speculators would decide that it is imprudent
to show their hand on the "open book." Small speculators and
small commercial users would not place their bids and offers
when they know that the professionals and large commercials will
not. The number of resting orders would therefore diminish substantially.
Consequently, the proposed automated "open book" execution
system for futures would not work as supposed. Futures customers
would hole back their orders rather than divulge them on the "book." The
system would become an "empty book."52 The
ultimate result could be disastrous for these markets: Execution
of nonresting orders would become increasingly difficult and
unmanageable; large price gaps might develop; larger and more
erratic price swings might occur; liquidity would diminish; and
the market would become thinner. Thus, the whole system might
be severely damaged.
many unanswered technical questions remain. Who is ready to undertake
the enormous cost expenditure necessary to implement the system?
At the CME alone, there are approximately 20,000 registered representatives.
If each is to receive a computer terminal at a cost of approximately
$3,000 per unit, it would cost $60 million for terminals alone,
not to mention the cost of the other hardware and software necessary
for a full computer-based system. "Computer burglary" is another
concern. There are hundreds of unscrupulous ways to use a computer
system in futures. Can the system be safeguarded?53 Unintentional
errors are still another concern. In the pit, if someone is offering
50 units, there is no way accidentally to purchase 100 from him.54 But
this could occur on a computer terminal if one were accidentally
to press an extra digit on a purchase or sell order. The transaction
may be consummated within a split second. But, who owns the extra
purchases or sales? Who pays for them? In short, the protagonists
of automation have failed to consider all the complex problems
involved in automating the transaction process.
markets have willingly incorporated modern computer technology
to the extent feasible. They will continue to adopt new technology
as it becomes available whenever it enhances the market system.
Futures markets, however, possess characteristics which distinguish
them from securities markets. The special nature of futures does
not lend itself to an "open book" execution process. Special
orders and specialists are required to execute transactions.
Liquidity is of primary importance to commodity futures. The
sources of liquidity in futures depend heavily on the exchange
floor, its traders, and brokers. Thus, an automated transaction
system would be detrimental to futures markets.
Special Counsel to the Board of Governors, Chicago Mercantile
Exchange. B.A., 1952, University of Illinois; J.D., 1955, John
Marshall Law School. Mr. Melamed served as Chairman of the Board
of the Chicago Mercantile Exchange from 1969 to 1972, and during
1976. He also served as Chairman of the International Monetary
Market from its inception until its merger with the Chicago Mercantile
Exchange in 1976.
7 U.S.C. & 22 (Supp. V 1975).
Id. & 22 (a)(1).
For a complete description of computer utilization by the Chicago
Board of Trade, which is very similar to the systems utilized
by the Chicago Mercantile Exchange, see R. Burmeister, Current
Status of Automation in Futures Markets (paper submitted at Conference
on Automation in the Futures Industry, June 15, 1977, Washington,
D.C.) (on file at the offices of the Commodity Futures Trading
Commission (CFTC), Washington, D.C.).
A CRT, Cathode Ray Tube, is a display device, similar to a television
tube, which, when equipped with a keyboard, can transmit and
receive information over a computer system information channel.
Commodity Exchange Act & 18 (a), 7 U.S.C. & 22(a)(1)
(Supp. V 1975).
Conference on Automation in the Futures Industry, June 15, 1977,
The following papers were submitted at the Conference on Automation
in the Futures Industry, June 15, 1977, Washington, D.C.: R.
Burmeister, Current Status of Automation in Futures Markets [hereinafter
cited as R. Burmeister]; R. Heifner, How Well Do Present Futures
Markets Perform?; International Commodities Clearing House Ltd.,
The Use of an On-Line Clearing System for Futures Markets; S.
Levenson, Automation -- the User Calls the Shots; M. Mendelson,
Current Status and Future Prospect for Automation in the Trading
Process in Securities Industry [hereinafter cited as M. Mendelson];
J. Peake, The Last Fifteen Meters [hereinafter cited as J. Peake];
M. Powers, Computerized Trading -- A Framework for Analysis [hereinafter
cited as M. Powers]. The foregoing material is on file at the
offices of the CFTC, Washington, D.C.
See Transcript of Proceedings, Conference on Automation in the
Futures Industry, June 15, 1977, Washington, D.C. (on file at
the offices of the CFTC, Washington, D.C.). The principal participants
who ere critical of the submitted papers were Willard sparks,
Former Senior Executive Vice President, Cook Industries; John
T. Geldermann, Vice President, Geldermann & Co.; Stephen
Greenberg, Senior Vice President, Bache Halsey Stuart, Inc.;
Nathan Most, Director, Commodity Options Development, American
Stock Exchange, Inc.; Lee H. Berendt, President, Commodity Exchange,
Inc.; Donald E. Weeden, Chairman of the Board, Weeden Holding
Company; and the author.
See, e.g., J. Peake, supra note 7.
See generally Transcript of Proceedings, Conference on Automation
in the Futures Industry, June 15, 1977, Washington, D.C. (on
file at the offices of the CFTC, Washington, D.C.).
R. Burmeister, supra note 7, at 2.
See M. Powers, supra note 7, at 10.
See papers cited note 7 supra.
J. Peake, supra note 7, at 8.
Unpublished analyses prepared by the staffs of the Chicago Mercantile
Exchange Clearing House and the Chicago Board of Trade Clearing
Corporation (based on daily compilations by the CME and the CBOT).
A "thick market" is one in which sufficient numbers of buyers
and sellers are available to take the opposite side of a large
order without materially changing the price.
A "speculator" takes the risk of making futures transactions
in the hope of making a profit, rather than as an adjunct to
another business operation. See generally Comm. Fut. L. Rep.
(CCH) 311 (1974).
A "hedger" completes transactions in the futures markets to reduce
risks which he incurs in the normal operation of another business,
generally as a producer, processor, or merchandiser of a physical
commodity. See generally id. 312.
If the spread between offer and bid is wide, it is logical but
erroneous to assume that either the bidder or the offerer is
trying to take unfair advantage and is "out of line." Most prudent
futures market participants will avoid such markets.
Brokers often act in a dual capacity as brokers and traders.
Thus, reference to locals includes the role played by brokers
when they trade for their account.
One who has "bought the market" generally has an established
long position in the contract. That is, he has bought one or
more futures contracts, thus establishing a market position,
and has not yet liquidated the position through an offsetting
One who is "short the market" has sold one or more futures contracts
and has not yet liquidated the position through an offsetting
purchase. See generally J. Baer & O. Saxon, Commodity Exchanges
and Futures Trading 77-85 (1949).
One who is "long the market" has bought one or more futures contracts
and has not yet liquidated the position through an offsetting
sale. See generally id. at 205.
See text at pp. 162-164 infra.
See text at pp. 161-162 infra.
Most local traders can be divided into three categories: "position
players," "spreaders," and "scalpers." Since position players
theoretically take a position in the market (often in different
markets simultaneously) and intend to stay with it for several
days or weeks, they are very similar to the majority of "off
the floor" traders. Thus, it matters little whether they make
their transaction "on" or "off" the floor. An automated system
would not appreciably change their method. On the other hand,
the method of the "spreader" or "scalper" is strictly limited
to the floor. But see M. Mendelson, supra note 7, at 11: "To
the degree that speculators' [i.e., local traders'] gains are
fair, there is nothing about computer assisted trading that will
diminish them and discourage the speculator."
The differential is the difference between the price of one contract
month of a commodity and the price of a different contract month
of the same commodity.
One commentator has argued that spreading by computer is feasible:
some critics are questioning the speed of trading with a computer,
especially when one is trying to develop a spread. Let me remind
you that currently firms try to position options and the underlying
stock simultaneously but on two different markets. The difficulties
have not stopped them. Computerizing trading cannot help but
speed up this dual positioning. M. Mendelson, supra note 7, at
To "scratch" is to offset the transaction in the same contract
month at the same price as instituted.
See text accompanying note 45 infra.
Any conceivable computer system would operate on an "open
book" basis, in which offers to buy or sell would be sequenced
in chronological order of their entry into the system. Orders
to buy or sell at a given price would be placed in a queue, formed
for that price, in the order received by the computer system.
When the market reached that price, orders would be executed
on a first come-first serve basis as long as there were buyers
for all the sell orders or sellers for all the buy orders.
One commentator has stated: "Perhaps there is a difference [between
the securities business and] the futures business which is substantive.
I must state to you that I doubt it." J. Peake, supra note 7,
Annual analyses prepared by the New York Stock Exchange Public
Relations Department and Futures Industry Association Statistical
Most futures contracts expire within 18 months of their inception;
however, the heaviest volume occurs in contracts with only two
or three months of life remaining.
Commodity Exchange Act 4a, 7 U.S.C. 6a (Supp. V 1975).
A "short" has sold a futures contract and has not yet liquidated
the position through an offsetting purchase. See S. Rep. No.
1131, 93d Cong., 2d Sess. app. IX, reprinted in  U.S. Code
Cong. & Ad. News 5843, 5894.
A "long" has bought a futures contract and has not yet liquidated
the position through an offsetting sale. See id., reprinted in
 U.S. Code Cong. & Ad. News, 5843, 5893.
interest or commitment" is the accumulated total of all outstanding
long or short contracts that have not been liquidated by an offsetting
Those short positions in the contract which are "hedges" will
not be "losers" in that it does not matter to them whether the
price rises or falls. When the "hedges" are removed and their
products sold into the cash market, their profit will be about
the same as when they first instituted their futures "hedge" position.
However, during the course of their short "hedge" position, they
lose on their futures position, whenever the market goes up.
Moreover, "blue chips," as well as other well-known stocks, will
maintain a given trend for many years; it is unusual for these
stocks to encounter so dramatic a change in their earnings as
to cause their trend to reverse rapidly.
(42) "Margin" is
a misnomer in commodities. "Margin" in futures is a security
deposit designed to protect against adverse price movement. The
amount of futures "margin" is not based on the value of the contract,
but rather on the amount which can be lost in a day or two by
the customer, in the event he is immediately faced with severe
adverse price movement.
A price limit is established by the contract specifications or
by order of the Board of Directors. It determines how far above
or below the previous day's "settlement" the price of a given
futures contract may rise or fall during the next business session
(except sometimes during the expiring month of a futures contract
or on the last day of trading). If a contract price reaches this
limit, the price is said to be "limit bid" or "limit offered."
The "settlement" price of a futures contract is the price, or
average of prices, of the transactions which occurred in the
last few seconds of trading on each business day.
The clearinghouse of the exchange acts as the mechanism for receipt
and payment of funds each business day. See generally J. Baer & O.
Saxon, Commodity Exchanges and Futures Trading 33 (1949).
A "specialist book" is a record of buy and sell orders kept by
the specialist and sequenced according to price and time of receipt.
The Chairman of the New York Stock Exchange has indicated that
his exchange seeks major changes in the performance of its specialists
by stimulating competition and by establishing a new category
of competitive traders. Address by William M. Batten, Chairman,
New York Stock Exchange, before the American Bar Association
(Aug. 9, 1977).
A "market order" is an order to buy or sell at the best available
price. A "stop order" becomes a market order if and when the
price reaches a prescribed point. An "MIT order," like a stop
order, becomes a market order if and when the price reaches a
prescribed point; it differs from a stop order in that a "buy-MIT" is
placed above the current price level and a "sell-MIT" is placed
below the current price level; the reserve is true of a stop
order. A "discretionary order" gives the broker a specified latitude
in execution. Such discretion is of various kinds. It may range
from five or ten point on a price limit order to unlimited discretion
in purchasing or selling a large quantity within a given price
range or during a given day.
A "price limit order" is an order to buy or sell at a specific
Today, "stop" orders are also popular as a tool with which to
institute new positions.
An "open book" system would show on the CRT, in the aggregate,
the quantity of bids and offers in a given futures contract available
above and below the market.
See M. Mendelson, supra note 7, at 8.
The field of "computer crime" is relatively new but has awesome
implications. For example, the General Accounting Office (GAO),
the investigating arm of Congress, is investigating the possibility
of widespread computer crime in the Social Security Administration.
This GAO probe was initiated after an internal audit within HEW
disclosed that the computer system's security procedures and
controls were inadequate to prevent fraud and abuse. See U.S.
General Accounting Office, Computer Related Crimes in the Federal
Transaction errors, of course, occur in the present system, but
they are not of this type; it is reasonable to assume that human
errors will occur in any system, but those are quite different
from the mechanical errors possible on a CRT.
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