Chicago faces bleak future as online trading deposes open outcry system

Global Finance, Feb 2002 by Platt, Gordon

EXCHANGE TRADING OUT OF OPTIONS?

RUNNING OUT OF OPTIONS?

Chicago's exchanges face up to the threat from new technology - By Gordon Platt

Chicago has long carried a chip on its shoulder as America's "second city" east of the Rocky Mountains. Now its well-established futures exchanges, the Chicago Board of Trade and the Chicago Mercantile Exchange, are facing stiff competition-and not only from New York.

The exchanges have long preached "open outcry" as the gospel of trading in the pits, where contracts for corn, soybeans, and wheat, as well as livestock, trade alongside financial instruments, metals, and energy. Chicago's location as a transportation hub of the Midwest, with its railroads and canals that link the Great Lakes with the Mississippi River, made it a natural spot for trading agricultural products.

The rough-and-tumble culture of trading in the pits is rapidly giving way to a less-frenetic form of trading via computer, a method that depends less on location-or having the loudest voice-than on technology."I wouldn't be surprised if pit trading didn't exist in a few years," says Joseph Shatz, government/financial futures and options strategist at Merrill Lynch in New York.

Electronic trading is clearly replacing open outcry as the dominant method of trading, Shatz says. "We expect this trend to continue in 2002, as more competing electronic exchanges, such as BrokerTec, enter the financial futures market," he adds. According to Shatz, competition is rearing its head in many forms, including entirely electronic exchanges and exchange-traded funds, such as the fixed-income ETFs, or iShares, launched last month by Barclays Global Investors Services.

Chill Winds of Change

The events of September 11 underlined the risks of concentrating trading in a single physical location. Longer-term changes are buffeting the Chicago exchanges, too. The suspension of the 30-year US Treasury bond places the future of the T-bond futures contract in jeopardy. Meanwhile, the US Federal Reserve is expected to be less active than in 2001, when it slashed interest rates 11 times. This could reduce liquidity in the eurodollar and federal funds futures contracts.

But by far the greatest threat to the Chicago futures exchanges is likely to come from entirely electronic exchanges with lower overheads, analysts say. BrokerTec, based in Jersey City, New Jersey, was formed in 1999 by a consortium of financial services companies. It began trading cash US Treasury and agency securities and European sovereign debt in June 2000 and traded more than $7 trillion in fixed-income products globally in its first year.

BrokerTec launched BrokerTec Futures Exchange (BTEX) and its affiliated clearinghouse, BrokerTec Clearing Company (BCC), on November 30 2001. Many of the major "bulge bracket" firms already are committed as market makers."We saw the need for a truly liquid and cost-effective electronic market for US financial futures; says Hank Mlynarski, president of BTEX and BCC.

Previously, financial institutions rarely used futures to hedge because it was too difficult to get certainty of outcome and single-price execution for large transactions, he says.The ability to create multi-leg trades is an important benefit to market users, Mlynarski says."The costs of the technology are down, and the reliability is up," he says. "We don't have bricks and granite buildings and large staffs. Costs are important, but if you don't have the liquidity, you can give it away for free and no one will come; he adds.

Trading Without Moving the Market Mlynarski, a former senior vice president of strategic planning for the Chicago Board of Trade, says the advantages of the product offerings will determine whether electronic trading will overtake the "open outcry" system. "I don't see anyone starting `open outcry' systems nowadays," he remarks.

BTEX members include such well-known firms as Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, J.P Morgan Chase, Lehman Brothers, Merrill Lynch, and Morgan Stanley. BTEX will have a block trading facility that will allow single price execution through off-exchange trades of large lot orders with delayed reporting requirements."The delayed reporting is a huge advantage to market makers and their large institutional clients, but disadvantageous to locals because it prevents front-running," says Shatz of Merrill Lynch. Front-running, which is illegal in the United States, is the practice of trading on the basis of material nonpublic information about an impending order or trade. According to Shatz, the ability to execute a trade without substantially moving the market will allow market makers such as Merrill to offer better prices to their customers on large transactions.

For more than 145 years, the primary method of trading at the CBOT had been "open outcry."Then, in August 2000, the CBOT entered into a partnership with Eurex, a completely electronic exchange based in Germany, and formed A/C/E, or Alliance/CBOT/Eurex, an electronic trading platform.