Buy A Call On The Snake
Traditional Exchanges in an E-Commerce World

By Leo Melamed

International Association of Financial Engineers
Nice, France
July 2, 2001

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Can 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.

There 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.

In 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.

Let 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 Swap?

Speaking 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.

Of 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.

It 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.

The 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.

Japan 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.

It 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.

Forgive 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.

The 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.

While 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.

Their 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.

There 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.

Mostly, 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 cozy pre-arrangements,” 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.

At 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.

In 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.

At 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” cost.

There 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.

In 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.

I 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.

Still, 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.

Nevertheless, 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 it.

Similar 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.

These 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.

Of 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.

Some 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.

Above 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.

The jury is still out. My advice is to heed Myron Scholes—buy a call on the snake! Thank you.

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