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Electronic Trading vs Open Outcry. Will the "pits" Last?

September 27, 2004

 

"The pits will be gone within a year" is a saying which has been heard in the streets of Chicago for over 5 years now. But somehow the pits remain, with thousands of Chicagoans filing into the venerable trading floors of the Chicago Board of Trade and Chicago Mercantile Exchange each day to yell, scream, and shout at one another in one of the purest forms of capitalism you will ever see.

For those of you who have never been on the trading floors, the best way to describe the action may be "organized chaos". To the uninitiated, it is almost disturbing how billions of dollars in trades are executed through funny looking hand signals, the yelling of orders across a room, and unintelligible scribblings on a trading card. The trading floors are littered with half finished crossword puzzles, Chicago Tribune sports pages, and dead order tickets while middle-aged, usually oversized men in brightly colored and decorated coats pack tightly into a circle to trade futures on everything from the stock market to Soybeans. Most people say to themselves, "surely there is a better way".

Well, there technically is a better way to facilitate these transactions, and that is electronic exchanges. Electronic exchanges automatically match the highest bid with the lowest offer to complete a trade, and can do millions of such transactions in the time it takes a human to do just a handful.

So why do the trading floors and open outcry markets still exist? The United States is the only country with substantial open outcry futures markets. The rest of the world, from Hong Kong to Germany, has gone completely electronic, and many futures professionals believe the same will happen in Chicago's famed "pits" sooner rather than later.

The only thing standing in the way of these markets going completely electronic is the incredibly powerful locals who make their livings trading off the inefficiencies of the open outcry method. The Chicago Exchanges are still run by these locals for the most part, and until it is worth their while to embrace an all electronic market, the pits will remain. By creating the "market", through their being willing to buy at a certain price and sell at a certain price, locals are entitled to buy the bid and sell the offer from time to time in what is knows as scalping.

If it is a foregone conclusion that electronic markets will take over, what is the real time frame until we see 100% electronic futures markets in the USA?

For Attain's two cents, we believe we are at least five years away from seeing the two most active open outcry pits, Euro Dollar and S&P futures at the Chicago Mercantile Exchange, make the switch. For other markets such as the CBOT's treasury bond and note contracts, and the CME's foreign currency contracts - the switch may come as soon as the end of next year.

The reason we believe the bonds and currencies may be moving sooner rather than later lies in a communication from Man Financial last week. Man is one of the largest Futures Clearing Merchants, and came out with the following statement:

"We at MAN have observed that the liquidity in electronically matched Treasury futures and Currency futures traded at the e-CBOT and GLOBEX respectively has continued to increase dramatically. In side-by-side volume, i.e., where fungible contracts trade electronically and in open outcry simultaneously, electronic volume has reached 82% of the total for some Treasury futures contracts and over 62% for currency futures contracts year to date, and this trend shows no signs of abating. Because of these increasing disparities in liquidity, we believe that our customers will be better served in these electronic markets. Please be advised that beginning Thursday, September 16, all CBOT/CME orders will be screen traded unless otherwise discussed."

This communication effectively ended all of Man's retail operations in the bond and currency pits, meaning all of their small client orders in those markets will be traded electronically. Man's retail base is not as large as Refco's is, for example, but this letter certainly put the handwriting on the wall that the pit traded bonds and currencies days are numbered.

So what does all of this mean for the trading system investor? The easy answer is nothing. A system doesn't care what market its executing in, and there could be some benefits to the better efficiency and lower cost structure of electronic markets.

But, the answer is not all that simple. For one, systematic traders who rely on historical market data to base their buy and sell decisions must wrestle with the fact that the electronic bonds and currencies only have 5 years worth of data - as compared to close to twenty years of pit traded data. "Can't you test on the pit traded and execute on the electronic" I hear some of you asking. Of course you can, but while the results may be close to those you tested - they are guaranteed to be different. This small discrepancy can be worrisome for systematic traders who prefer to leave nothing to chance.

Beyond the length of data available, there is also the logistical problem that the electronic markets have different hours (8 PM through 4 PM the next day versus 7:20 AM – 2:00 PM). The lack of a standard beginning and end to the day will require some systems to be re-coded to fit the new schedule and possibly change the market dynamics around the normal market hours.

Lastly, many proponents of open outcry argue that the human element is essential in keeping orderly markets, and that without "locals" in the pit willing to buy into sell offs and sell into rallies, extremely volatile market action could ensue. There is a reason the NYSE curbs program trading once the market is down a certain percent. A human trader may say, "I don't care how much the market is down today, I haven't seen any big banks selling, so I think S&Ps are a buy these levels" In letting that emotional decision into her trading, she has a stabilizing effect on the market. Without that "pit sense", traders watching the screen may base their decisions on the numbers only.

In conclusion, while 100% electronic futures exchanges are likely to be a reality within the next 5 years, the complete transition to those markets is not here yet. Even the pit traded bond and currency markets - which have seen a dramatic move towards the "screen" (as those in the business call electronic trading) - are still among the most liquid contracts available for trading.

The dangers to system traders revolve around how a change in market hours and removal of local "safeguards" will affect individual market dynamics. The change to any one market could be severe and cause a situation where the system backtesting is invalid.

Please feel free to call for an evaluation of how a switch to 100% electronic markets would affect your trading system.