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Exchanges Empower Investors... Sometimes
by: Russell Wasendorf, Sr.
The spectacular growth of the futures industry during the past two decades is directly attributable to the world’s futures exchanges’ sensitivity to the needs for risk management and their unique ability to expertly wrap reliable financial safeguards around ground-breaking futures products. Far-sighted exchange leaders in the U.S. crafted futures trading on currencies in the early ‘70s when wide currency fluctuations were plaguing international commerce, on debt instruments in the mid-‘70s just in time to manage the risk of interest rate volatility, and in the ‘80s on broad-based stock index futures, coinciding with the beginning of the longest bull market in stock market history. The U.S. seemed to have a monopoly on the best and brightest ideas in the futures markets. It would have been difficult not to be a bit smug.
Yet though U.S. exchanges were the standard bearers for innovations that changed the landscape of risk management, particularly in the financial futures markets, they presently face some self-made challenges and are running the risk of exporting their leadership to more responsive foreign exchanges. Even if that does not come to pass, slowness to the market with cost-efficient, time-sensitive customer solutions will make them look as if they believe that the status quo is an acceptable substitute.
Case in point, the Deutsche Börse and the Swiss Exchange in 1998 joined forces to operate their respective derivatives markets, DTB and SOFFEX, as a common all-electronic market called Eurex. The strategy revolved around pooling their electronic trading and clearing functions, offering a broad number of derivatives products under one banner, and making costs lower for participants. This, of course, was not the first time that an exchange offered computerized futures order matching, but it was the first time that futures exchanges with a broad vision took the bold step of becoming totally electronic. Within two years, Eurex became the world’s largest futures exchange as measured by volume, eclipsing previous records of its U.S. futures cousins.
The early success of Eurex should have been a wake-up call for U.S. exchanges, and to some extent it was. The Chicago Mercantile Exchange (CME) answered the call by designing an API to allow intermediaries and vendors to make direct connections to the Chicago Mercantile Exchange’s Globex order-matching engine. In a much-ballyhooed press conference, Peregrine Financial Group, Inc. (PFG) demonstrated Best Direct, the first online customer connection to Globex in December 1998, close on the heels of Eurex’s bold step.
Other intermediaries and vendors followed suit, and soon online trading helped U.S. exchanges boost trading volume to ever-increasing levels that previously might have been unthinkable. Just last month, in fact, the Chicago Mercantile Exchange’s electronic trading volume for the first time exceeded floor-traded volume. Additionally, the all-electronic E-Mini S&P volume on the CME, reflecting the volatility of the ragged equities markets, registered nearly one million contracts traded in a single day. Thus, no one would argue that direct access to electronic trading engines has transformed the futures business and empowered investors with a greater control over order-entry than ever before.
Going from a Seller’s Market to a Buyer’s Market
And, thus, with innovation, comes a shift in the business itself — the futures industry is fast becoming what most would call a “buyer’s market.”
Until recently, futures trading has been a “seller’s market.” The sellers (providers) of futures trading, the exchanges and exchange members, dictated almost every aspect of trading — what kind of orders would be accepted, the hours of trading, limitations during high-volume trading (fast market conditions), when and how quickly phones would be answered, etc. - were conditions thrust upon customers. “Take it or leave it” appeared to be the general response from exchanges when customers reacted adversely to conditional participation.
But the advent and advancement of online order entry and, increasingly, the gradual disappearance of geographic trading limitations is putting customers in greater control of both order placement and market information. In essence, they are becoming the masters of their own destiny.
Initially, electronic order entry simply replaced the futures account executive by replicating, electronically, what the account executive would have done physically. Traditionally, futures orders were placed through an account executive who acted as a conduit from the customer to the trading floor. The account executive placed the order, received the fill, and notified the customer.
Because online systems enabled the customer to connect directly to the electronic trading engine, a customer could place an order, have the order transmitted directly to the trade- matching engine and, at the end of the loop, have the fill reported directly back to the customer. In many instances, this electronic communication is completed in a fraction of second. Further, as order-entry systems became more sophisticated, a broader array of order types become available to the customer, along with more detailed information. Since the order-entry system was directly connected to the electronic trading engine, a REAL “real-time” price could be transmitted back to the customer. As even greater sophistication developed for the online systems, the capability of reporting the “book” became possible. The book is the roster of resting orders above and below the market, price with the quantity for bids and offers.
Giving the customer access to the real, real-time prices, a view of the book of resting orders, and the immediate response to the order placed all have dramatically leveled the playing field between the individual trader and the member in the futures trading pit.
Additionally, improved economies for intermediaries by virtue of electronic order handling allows them to do more with less – more orders with less infrastructure. Lower transaction costs have been passed through to customers. In other words, the Internet has enabled customers to shop rates and has given them more control over the commissions they pay. Again, this is a case of futures trading truly becoming a buyer’s market.
Most “Real-Time” Futures Price Quotes Are Not Real Time
For many years, futures exchanges have charged a substantial premium for the transmission of real time price quotes, but the question remains, what is real time, as defined by the exchanges? A subscriber of a real time quote service for futures contracts traded on the floor of an exchange is really receiving a quote that has been delayed by pure logistics of the price quoting process. When a transaction occurs in a trading pit, the price of that transaction is observed by a clerk. The clerk enters the price into the price quote dissemination system.
Anyone who has spent time observing the activity of futures trading from an observation deck with an individual who understands hand signals can easily recognize that there is a delay between the time that a transaction is made and when it is actually displayed in the price quoting system. In other words, the only traders who can react to real time prices are those who are actually standing within the trading pit. When traders receive price quotes from a price quote vendor they are observing a price that has been delayed by some degree — sometimes a matter of seconds, sometimes longer.
Fast Markets Can Mean Slow Response from the Pits
When the trading activity in a trading pit becomes a fast market, by definition the prices are changing so quickly that the clerk is unable to enter all of the price changes. When fast market rules come into effect, customers may be limited to the type of conditional orders they can place, and the trading pit will not be “held” to a particular rule on order filling or price. Unquestionably, one of the worst things a broker can say to an individual trader is that the order that they’ve placed will not necessarily be handled based on the rules the futures customer understood to be true.
Empowering Investors Via Electronic Trading
Once a customer has experienced the efficiency and speed of an electronic order entry system matched with the electronic trading engine, it’s difficult for him to accept the procedures of the past. And once that same trader has experienced the ease of point-and-click order entry mechanisms - normally receiving fills in a matter of seconds even in fast markets - it’s not easy for him to understand, much less tolerate, the trading floor limitations which include being told that his order will be not held.
It’s also difficult for a trader to understand the slippage of prices for orders placed in a trading pit when he is looking at price quotes and expecting better prices. A typical comment often heard from customers demanding time-and-sales reports for orders they have placed in a pit traded environment is, “Yes, but that was not where I observed the market to be when I placed the order.”
For decades, intermediaries — FCMs and Introducing Brokers — have been forced to explain and often rationalize the limitations of the trading floor to angry customers who feel that their order may have been abused or mishandled. But what once may have been somewhat understandable, and perhaps even grudgingly accepted in a world devoid of the Internet and online matching efficiencies, today is falling on deaf customer ears.
The Intermediaries Are Caught in the Middle
The exchanges provide the trading “engine” either via a trading floor or an electronic matching engine, while intermediaries provide the conduit from the customers. For access to their order matching facility, exchanges charge an exchange fee and their clearing houses are paid a clearing charge. Intermediaries, of course, must absorb these charges and add on a value-added charge to create the commission to be paid by the customers. Growing international competition has caused customers to be very aware of competitive commission rates.
The intermediaries are caught in the middle, struggling to eke out a profit between the lowered commissions demanded by customers and the locked-in cost of the transaction. Intermediaries have responded to this problem by striving for greater efficiency.
Online order entry systems are a godsend for intermediaries because they solve a number of their critical economic problems. Not only do electronic order entry systems make possible greater cost efficiency, enabling the intermediary to do greater volume at a lower cost; they also eliminate two risks for the futures industry — the risk of order placement errors and the risk of potential misconduct by brokers. With electronic order entry systems, the risk of order entry errors are virtually eliminated since the order entry process is both initiated by the customer and completed by the customer. When an error is made, it is the customer’s error and, therefore, the customer’s financial responsibility. Occasional misconduct by brokers has been a problem when brokers take it upon themselves to churn, or enter unauthorized trades for customers in customer accounts, but this is eliminated when the trader holds his own “deck” in an electronic environment.
During the last half decade, futures trading has become ever more accessible to a greater variety of traders, and the product delivery system has played an important role in improving the efficiency of market access. As Marshall McLuhan argued during the late 1960s, “the medium is the message.” Nothing could be truer for futures today — the method of delivery may be as important as the market that’s being traded.
Clearing the Trades Is Necessary, But is it as Cost-Efficient as it Should Be?
Futures markets were a wonderful invention, providing the proven economic functions of risk management, forward pricing, and price dissemination, along with the crucial capitalization to reduce counterparty risk. From the beginning of their modern history, futures exchanges have provided a center for buyers and sellers to meet, and at the hub of that development are the members and clearing members that provide the necessary financial guarantees for all transactions. The clearing houses of the exchanges act as buyer for all sell orders and seller for all buy orders and, thus, are responsible for matching buyers and sellers. The combined financial strength of all of the clearing members of the exchange acts as a guarantee to protect against counterparty risk, and without these guarantees, futures trading would not exist.
But what about clearing? If many of the advances in the sea of the futures business are making enormous waves of progress, cannot joint, independent clearing have yet another positive effect on market efficiency and competitive pricing for futures customers? There is debate, of course, on this subject. Many will say that they have tried. The Chicago Board of Trade and the Chicago Mercantile Exchange, for example, several years back embarked on what eventually became a doomed project for common clearing. Certainly, there were purported technical and philosophical issues but, more than likely, self-interests collided somewhere along the line. Since then, there’s been little tangible progress to report on this front, though the subject of separating execution of futures trades from clearing has come front and center of late.
In a recent article written by Futures Industry Association President John Damgard, he points out that the passage of the Commodity Futures Modernization Act (CFMA) “marked a start of a new era in our industry,” and that one of the outcomes of the act was to authorize the CFTC to create a new regulatory category – derivatives clearing organizations. Additionally, Congress included into the CFMA two crucial directives that relate directly to clearing issues in that the law instructs the CFTC to prevent “any unreasonable restraint of trade” or impose “any material anti-competitive burden on the contract market.” The act also instructs the CFTC to “facilitate the linking or coordination of derivatives clearing organizations with other regulated clearance facilities for the coordinated settlement of cleared transactions.” In other words, there eventually may be some changes afoot that could alter the way futures clearing is handled today.
In fact, clearing could become one of the main drivers in determining the degree of competition in the futures industry. The challenge, of course, is in finding a way that promotes competition in a positive, best-practices manner, and that won’t be easy.
Exchanges have been and continue to change from member-driven, committee-heavy associations to for-profit organizations, and a few are on the edge of IPOs, though this may be a tough market in which to move forward. Clearing and the enormous profits that it can engender likely are the lifeblood of some exchanges’ operating budgets, so it’s understandable that exchanges would be less than amenable to a common clearing facility that could endanger the current status quo.
The Economics of Fungibility
Additionally, many believe that product fungibility and common clearing are inexorably linked. Fungibility is standard in the securities market, so a market participant can, for example, buy IBM options on one exchange, sell them on another exchange, and take advantage of the highly cost-saving benefit of cross-margining.
This is not without precedent. The Options Clearing Corporation (OCC) once was the clearing unit for the Chicago Board Options Exchange (CBOE) only. When the American Stock Exchange (AMEX) made plans to enter the world of stock options a year later, the member firms and the SEC urged the AMEX and CBOE to consider using the same clearing organization. And, so, it came to pass. Today, the OCC clears trades for five options exchanges. The fungibility afforded market participants, best execution choices, and processing cost reductions under this joint format result in lower costs for all customers.
Because there is no common clearing ground in the futures world, this same kind of efficiency is currently unavailable. Captive products cleared on captive clearing houses removes the incentive for any kind of centralized clearing between exchanges.
According to the FIA’s Damgard, the issue of competition between exchanges, as they move closer to a for-profit ownership structure, will be key. “As long as they are run as membership organizations, the exchanges are not likely to take full advantage of their market power to raise their fees to the highest possible level.” The reason, he says, is that it’s not in the exchange members’ interests. “Whatever profit the exchange might make is a secondary concern, because the members’ primary business is trading, and from their point of view the transaction fees charged by the exchange look like a tax.”
However, this will change once the exchanges go public, with corporate profits and trading profits flip-flopping in order of importance. If history repeats itself — and there is no reason why it would not — public companies with outside shareholders will be much less interested in the members making a profit and much more “invested” in the profits and dividends generated from the business itself. And unless the clearing component becomes independent of the transactional side, larger fees and customer costs could easily result.
As the landscape changes and as regulatory tides begin to turn, the efficiencies of clearing and the healthy competition it brings must increasingly change to benefit customers.
Finally...
The futures markets of yesterday are a mere shadow of today’s markets. Tremendous strides have been made in the realm of electronic trading, new products that meet the needs of a whole universe of businesses and investors, and safeguards that give those market participants assurances that the markets are not the rough-and-tumble nomads huts of yesteryear. But though much progress has been made, the exchanges must learn that progress does not end within their doors.
The brokerage firms that cater to the public are under increasing pressure to lower costs and, to do that, they must strive to influence the exchanges when it comes to the economics of business. Those exchanges that can enhance those efficiencies in all-electronic trading and clearing cooperation will, in the long run, be the winners. Whether futures leadership remains in the U.S. or flows to ECNs or to exchanges in many corners of the globe, is squarely in the hands of the U.S. exchanges, who have everything to lose and nothing to gain by fighting the winds of change.
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The Route of a Futures Order
Whether an order is placed electronically or to a trading pit it will follow a similar path. The customer will enter the order, either by making a telephone call to a broker or by placing the order directly via an online order entry system. From this point, the order enters a “black box,” within which a number of things must occur in order for the order to be executed. It first must be routed to the appropriate exchange where it’ll be handled either on a trading floor or through an electronic trading engine. During the routing process, the order will experience a confirmation process and some level of risk management. The confirmation may be as simple as the broker repeating the order back to the customer when it is placed, or the electronic order entry system will often display a confirmation dialog box for the customer to confirm the order. The level of risk management could be the broker checking to be sure that the customer has the resources to make the transaction. With electronic systems, risk management takes various forms, the best of which is a computerized system that checks the customer’s account balance before accepting the order. Once the order reaches the trading engine, whether it be the trading pit or the electronic computerized matching engine, it will be determined whether it is electable based on the current market prices or whether it will rest within the trading engine until the price is matched.
Once an order has been executed or filled, it follows the routing mechanism back to the customer via the online order entry system or to the customer’s account executive. While it is being routed back to the customer, it also will be sent to a back office system for accounting and creation of the customer’s account statement. With most electronic order entry systems, the steps from customer’s order entry to the order reporting back to the customer occurs in nanoseconds. If the order is placed through a trading floor, the human factor slows the execution.