Last week the CME (Chicago Mercantile Exchange) announced the forthcoming closure of most of its futures pits. Its options pits will keep trading due to the higher complexity of the trades but the “open-outcry” pit is in terminal decline.
In Europe, the last remaining example is the London Metal Exchange. Until the mid-1980s, pit trading was the norm and many people’s image of a trading floor would still be Dan Aykroyd and Eddie Murphy cornering the market for orange juice futures in the 1983 movie Trading Places. Rowdy stock trading predates the dedicated pits which appeared in the early 1800s. The embryonic London Stock Exchange was booted out of its first home for general bad behaviour. What strikes me though, is that, despite the apparent chaos, the shouting and the frenetic hand gestures, the system provides a remarkably efficient and transparent trading mechanism which explains its longevity. The robustness of this functionality was supported last Spring when a Globex outage at the CME forced pit trading to be used as a back-up. It’s not the kind of failover system I’d be recommending but it generated a respectably high trade volume from traders whose pit skills ranged from rusty to non-existent.
The Advent of New Technology
Rewind to 1995. Reuters’ nascent Globex trading system was present at 10 exchanges worldwide where it was primarily used as an after-hours back-up and only traded 6,000 contracts a day in the US. “Globex is just nickel-and-dime small investor retail business so far,” said a New York portfolio manager at the time. It’s not clear how defensive or change resistant this comment was. At that time The Internet barely existed and even Microsoft’s operating systems were only on the threshold of world domination. The electronic trading system was seen as ponderous, limiting of complex human interaction and only capable of taking “limit” orders (which execute at the point when a predefined buy price is achieved). The fear was that a large order would adversely affect market pricing due to issues of liquidity. With various issues to tackle, R&D focused initially on interface improvements before attention would turn to the need for speed and the advent of algorithmic trading.
New Technology Selection
It’s important to avoid technology investments that don’t provide a tangible benefit. I am amazed by the lack of critical thinking that leads to some of the “new for old” purchase decisions I see. When it comes to well-founded technology investments, the short-term shareholder expectations, reporting cycles and bonus structures in financial markets can make valid decisions hard to push through. In my experience, the technologists inside financial organisations grasp the benefits of new technology very quickly but they fear painful transitions, sometimes with reasonable justification, which stops them pushing harder. In the age of the beta release, buying early isn’t always the best approach but when a new product class is clearly going to dominate its market, innovative buyers can invest early in a shared development programme that saves money and creates a solution that matches their organisation’s technology and usage patterns. In the case of Globex, early adopters found a way for the system to serve them right from the start, get them acquainted with the technology and leave them well placed to gain competitive advantage. Of course, when financial organisations identify the potential for quick RoI on a technology investment it’s amazing how much money can be found. The Spread Networks fibre connection between NYC and Chicago that reduced latency to 13 milliseconds just before the financial crash was a good example as algorithmic “High Frequency Traders” [HFTs] piled in to invest $2.8B between them.
Technology’s Impact on Trading
Classical trading theory states that you can’t beat the system and that stock prices are rational. There are two distinct trading psychologies, the first, “momentum”, is a tendency to seek companies and industries which are in a growth phase. The second is the “contrarian” mind-set where value is sought in the form of under-priced stocks with strong core fundamentals. We might associate this with a slightly older trader who’s experienced at least one crash. Research suggests that bullish momentum traders believe they can beat the market whereas the contrarians are more realistic. When both trader types exist in equilibrium the market performs well but when it swings towards a majority of momentum trading then bubbles grow at which point prices cease to be rational and only the lucky ones beat the system. For the estimated 20% of trading volume that is still generated by humans, the 2 psychologies still exist but the playground atmosphere that some traders fondly describe when reminiscing about the pit is gone. If anything, the calibre of trading floor talent may now be at an all-time high and from an HR perspective, trading floor behaviour is vastly more acceptable than anything witnessed in The Wolf of Wall Street. Modern Unified Communications technology allows a high level of virtual human interaction, liquidity problems were long since overcome and trades are placed at a higher rate than before technology revolutionised the markets. Based on this evidence, new technology has brought a raft of advantages.
Of course, there are still well-publicised issues with the 80%+ (est. US) of trading volume that is performed algorithmically. On a mathematical basis, a flawed algorithm can act remarkably like a swing to momentum trading and create a short term bubble, or “Flash Crash” but this is rare and it’s their unerring success that poses problems. HFTs had become prevalent by the mid-noughties and some major players with access to super-low latency channels had created an unfair situation whereby they could “front-run”. Essentially, minuscule time advantages in inter-exchange communication gave HFTs visibility of other people’s orders before they were executed. Simply speaking this time advantage allowed them to purchase the stock before the first deal was processed and then sell it on to the original purchaser at a marginal mark-up.
“They have enjoyed a perfect view of the market; the have-nots never saw the market at all. What had once been the world’s most public, most democratic, financial market had become, in spirit, something like a private viewing of a stolen work of art.” Brad Katsuyama, IEX.
Why Technology Matters
My view is that moving away from the pits is the right thing to do because it improves working conditions, increases trading volumes and encourages talent. The problems that blight the markets are human in origin, crashes have happened before and since the technology arrived. If anything, the technology infrastructure has the potential to make things more transparent and my company, for one, is heavily engaged in the practical deployment of solutions that satisfy regulatory compliance. When investing in corporate technology it’s important to understand which aspects of legacy systems are essential, what should go and what should be improved upon. It is also important to look strategically beyond immediate requirements and short term advantages to build infrastructure that will provide a competitive edge in the medium to long-term.