By Leo Melamed

January, 2002

Allow me to briefly examine the transformation occurring on futures exchanges and the effects of September 11, 2001. The issues center around the pace of their evolution and give 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 traditional open-outcry methodologies and technological advancements that permeated the marketplace has been brewing for over a decade. But the immediate catalyst of the war that unfolded was the 1998 SEC promulgation allowing alternative trading systems. It caused a swarm of electronic communications etworks, 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.

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, and others are simply routing mechanisms. 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 “dot-coms” that sprung up during the height of the Internet bubble. Still, those providing the greatest value added will flourish.

While to a large degree the battle is between ECNs and traditional exchanges—specifically futures 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. At 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 dominate.

That 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 futures 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.

This 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.

Finally, 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.

Long 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 11 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.

Moreover, because a 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 its choice. This gives the traditional exchanges a huge leg up.

We 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 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.

It 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 U.S. the pace toward a full electronic replacement has been much slower. But with September 11 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.

The issues are complex. American futuress 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 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. 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 11 has quickened this metamorphosis. In the meantime the CME operates in dual fashion. We maintain our trading floor and continue to expand the capabilities of Globex in order to provide the best electronic system possible.

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. It should become an “Electronic Arcade.” To understand the rationale behind this thought, one must understand that a trading floor was always more than simply the place where a transaction occurred. 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 and information as well as ideas are easily passed. 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 in the evolution toward automation.

The good news is that for futures markets, there is one unchanging constant: Uncertainty lies at their very foundation. 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, the CME continued to achieve record volumes. So much is therefore clear: The management of risk is the bedrock of futures 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 futures exchanges. The events of September 11 served to underscore this truth.

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