Electronic vs. open-outcry trading

by Emily Wilson
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It’s difficult to argue with success. And the open-outcry system of trading agricultural futures and options, a time-tested method for price discovery and the principal means by which sellers and buyers hedge risk in markets dependent on vagaries of economies and weather, has been a success by any measure, and for many decades. But times change. Technologies change. And it has become the growing consensus in grain-based foods that electronic trading will play an increasingly important role in grains and oilseeds markets. As yet uncertain, though, is exactly what or how great that role will be.

Only a few months ago, many had suggested that the grain and oilseed pits at the three principal agricultural futures exchanges — the Chicago Board of Trade, the Kansas City Board of Trade and the Minneapolis Grain Exchange — soon would be abandoned, replaced by traders ensconced behind personal computers at potentially thousands of disparate points and connected electronically to trading platforms operated by the exchanges and their technology partners. Indeed, this may be the future of agricultural futures trading. But it seems not just yet.

Over the past year, the exchanges have come to adopt gradual and deliberate approaches toward introducing electronic trading to an industry that has long trusted and relied upon the open-outcry system. Each exchange is committed to providing its members and customers the best possible markets in which to trade, whether that is through open-outcry, electronic trading, or a combination of the two methods.

The Chicago Board of Trade has been the trailblazer for electronic trading of agricultural futures and options, providing after-hours electronic trading of its agricultural contracts on its a/c/e (Alliance/C.B.O.T/Eurex) platform. The Minneapolis Grain Exchange plans to launch electronic trading of certain contracts sometime this fall or winter. And the Kansas City Board of Trade is evaluating what options with regard to electronic trading would make the most sense for its members. Despite their interest in exploring electronic trading, none of the exchanges expects the open-outcry system for agricultural futures and options to be mothballed any time soon, if at all.


Early entry into e-trading. The C.B.O.T. was among the first of the world’s major commodity futures exchanges to offer electronic trading, said Maria Gemskie, spokeswoman for the exchange. In October 1992, the exchange launched its Project A system for daytime transactions in new and low-volume contracts. That trading system was expanded in 1994 with the listing of the C.B.O.T.’s premier financial products during non-pit trading hours. In November 1995, the C.B.O.T. extended Project A access to locations outside the exchange building, with terminals in London, Paris and Tokyo.

On March 1, 1996, agricultural futures were traded for this first time on Project A during non-pit hours, opening participation in these markets to traders in Europe and Asia and creating spread opportunities between foreign and domestic markets. This provided traders a chance to react to market-moving news whenever it occurred, even during non-traditional hours, Gemskie pointed out.

On Aug. 27, 2000, the C.B.O.T. moved its financial and agricultural products from Project A to the a/c/e electronic trading platform, which it had jointly developed with Eurex, the German and Swiss electronic exchange.

"In terms of volume, trade on Project A (financial and agricultural) stood at 6,892,263 contracts in 2000 through Aug. 27 of that year," Gemskie said. "Volume was 11,160,033 contracts in 1999; 12,339,328 in 1998; 5,929,134 in 1997; 2,438,712 in 1996, and 531,928 in 1995.

C.B.O.T. contract volume (financial and agricultural) on the a/c/e from its inception in August 2000 through the end of that year was 8,630,085 contracts. And thus far in 2001 (through Aug. 15), C.B.O.T. contract volume on the a/c/e platform was 27,473,070.

But nearly all of this explosive growth in electronic trading was accounted for by the exchange’s financial futures. In January-July 2000, electronic trading on the a/c/e platform represented 28.7% of all volume in the exchange’s financial contracts, including 34.6% of trading in U.S. treasury bonds and 30.6% of volume in 10-year treasury notes.

In contrast, electronic trading accounted for only 1% of volume in the exchange’s agricultural futures contracts (0.6% of volume of agricultural futures and options combined) in the same seven-month period. In the case of wheat futures, 0.9% of overall January-July 2001 volume was generated by electronic trading; in the case of corn, 1.5%. Total wheat contracts traded electronically in the seven-month span was 38,232, versus pit volume of 4,178,494.

In fact, electronic trading volume in C.B.O.T. agricultural futures and options in January-July 2001 (on a/c/e) was down 25% from January-July 2000 (on Project A).

It should be pointed out, though, that
a/c/e trading in the exchange’s financial contracts takes place not only overnight but also side-by-side with pit trading, whereas trading in the agricultural contracts takes place only when the pits aren’t operating (the agricultural contracts are traded electronically from 8:30 p.m. to 6:00 a.m., Chicago time, Sunday through Friday). Still, after a year of
a/c/e operation, and before that, in four years of Project A, electronic trading remains only a minor factor in the trading of agricultural futures and options.

"At this time, electronic trading does not appear to be a significant driver for the agricultural markets, and the C.B.O.T. focus continues to be electronic access (to the open-outcry pits)," Gemskie said.

"While the volume in agricultural contracts on a/c/e remains steady, explosive growth is occurring in agricultural market orders being routed electronically to the trading floor," she explained. "This enables electronic order routing for C.B.O.T. customers to move their orders via the Internet directly to the trader in the pit. This, in turn, is creating greater efficiency with faster trade confirmations for the markets’ end-users, while eliminating errors and unnecessary paper on the trading floor — enhancing the already deep liquidity of the agricultural markets on the floor."

Gemskie said the C.B.O.T. will continue to provide both pit and electronic trading of agricultural futures and options. "Basically, we are letting the customers decide how the C.B.O.T. should proceed in the expansion of electronic trading," she said. "The exchange has stated that an open-outcry pit would continue to be supported as long as it made a liquid market. That means essentially that a pit has to maintain at least 30% of the volume in its product to continue to trade on the floor."


Calculation supplants adulation. Robert R. Petersen, president of the Kansas City Board of Trade, said, "What a difference a year makes. When I came to work at the K.C.B.T. on Aug. 1, 2000, the agenda was three things: electronic commerce, electronic commerce and electronic commerce.

"I don’t know that I’ve seen anything like the e-commerce wave that rolled over business a year and two years ago. It seemed that if you didn’t have an e-commerce strategy in place, you were looked upon as some kind of dinosaur. The environment has changed tremendously over the past year."

Petersen pointed to the failure of so many "dot-coms" in recent months as good reason for the industry to be more deliberate in its approach to electronic trading.

"I like to say that we at the K.C.B.T. are on an e-commerce journey," he explained. "And that journey has taken some interesting twists and turns in the past 12 months. We’re trying to make the best decision based on the best knowledge we have about what is the right fit for our members. So, we have been careful and cautious. And right now, we feel pretty good about that approach. We haven’t jumped. We are trying to evaluate what makes sense, and find out what our needs really are, and what the capabilities of our potential partners really are.

"We are intent on providing an electronic trading solution for our members and customers in the future. But we feel we have a bit of breathing space, given the environment."

Petersen said that a balanced approach to electronic trading was called for in part because the K.C.B.T. already has a very strong business, with a wheat pit that has done a good job for the exchange’s members and customers. He pointed out that the exchange has had seven back-to-back record volume years.

He said that at some points during the past year, the exchange had been close to finding an e-commerce solution, but for various reasons, the approaches did not come to fruition. "We feel we’re getting closer to finding that e-commerce solution, and maybe we could have something in place in six months or a year," Petersen said.

He said the K.C.B.T. had three goals in developing an e-commerce capability.

First is the need to remain competitive, Petersen said. "We’re a smaller exchange. We have one primary product, wheat, that accounts for 90% of our business. We want to keep that contract competitive. And we as an exchange want to remain competitive. That means moving into the electronic world to the extent necessary."

Petersen pointed out that under the old Commodity Futures Trading Commission regulations, the exchanges, including the K.C.B.T., more or less had franchises for trading in their principal products. "That’s changing," he said. "It’s going to be a lot easier for people to offer competitive products. We have to be very alert to that, to what the competition is doing and to what the marketplace needs."

The second goal would be to provide a platform for trading the exchange’s struggling minor contracts. "Those contracts probably would go on 24 hours a day trading, five days a
week, or whatever the right combination would prove to be," Petersen said.

The third and perhaps most important goal would be to provide a platform for the trading of new products, Petersen said.

"It’s very difficult in an open-outcry environment for a small exchange, perhaps for any exchange, to be successful in launching new products," he pointed out. "We have only a limited number of capitalized speculators, and we do a good job trading wheat. But it’s tough to sustain and nourish new products over time. We are hopeful that once we have a new electronic trading system in place, it will prove to be a good venue for offering new products, both in the agricultural and non-agricultural sectors, for our customers, members and the trading public."

The K.C.B.T. may look into after-hours electronic trading of its wheat contract. But Petersen said that decision was "a ways down the road." And he said he certainly didn’t foresee side-by-side open-outcry and electronic trading of the Kansas City wheat contract anytime soon.

Petersen praised the C.B.O.T.’s work in introducing electronic trading of futures, including its agricultural contracts. At the same time, he noted that wheat contracts traded electronically on a/c/e have totaled only about 200 a day, and corn and soybean contracts have been trading at about 1,000 contracts a day.

"Our wheat pit is about a third the size of that in Chicago, so being realistic, we can’t afford to go out and spend multiple millions of dollars on an electronic trading system and then only trade a couple hundred of contracts a night," he explained. "That wouldn’t be a good business decision. And we really haven’t had customers knocking on our doors telling us they want to be able to trade wheat electronically."

Petersen said that there is an argument that grain and other agricultural futures are different from financial contracts.

"In the financials, you have wonderful, deep, liquid and vast markets," he noted. "Grains are a little bit different. You have a finite supply. And you have a system that typically is tied to a cash market. Those things make the grain markets a bit different. The jury is still out whether grains will necessarily move to electronic trading."


New platform for new products. The Minneapolis Grain Exchange intends to launch an electronic trading platform in the next few months, said Kent Horsager, president. "Initially, our intent is to offer futures and options on two new cash-settled agriculture futures contracts," he said. "These contracts will trade during normal business hours of 8:30 a.m. to 1:45 p.m."

The new contracts, created by the M.G.E and DTN (Data Transmission Network), are the National Corn Index and the National Soybean Index. "These indices are based on an average of the U.S. elevator bids for the respective commodity," Horsager said. "The new futures contracts will be cash-settled to these indices monthly."

Establishing and maintaining an electronic trading platform should facilitate the creation of additional new products, Horsager said. "Clearly, the technology available today offers some very interesting concepts and additions to typical trading algorithms," he said. "In addition, the marginal cost of product introduction should decrease, supporting the notion of product innovation."

Some of the exchange’s current minor, low-volume contracts would be listed on the platform as well. But Horsager said the exchange’s primary contracts — wheat futures and options — would not initially be involved.

"We have no plans to close our 100-year-old trading floor," he said. "Our electronic trading plans are a completely separate initiative that is concerned with providing additional value to our membership and constituents."

Under the exchange’s plans, a customer will connect to a central electronic market server that is considered a trading engine, Horsager explained. "They may connect using a standard screen and via a direct line or using third-party software," he explained. "Most customers will have a choice of the types of connection such as direct, Internet, etc., and a choice of trading screens offering different functionality. All of these connections require F.C.M. (Futures Commission Merchants) approval and authorization. Once that is complete, the customer will have access to view and trade the markets. They will see depth of market, last trades and other pertinent trade information."

The M.G.E. considered several models and choices with regard to electronic trading, Horsager said. "Our driving factors are that a solution be secure, reliable, and contain certain trading and administrative functionality," he said. "From a business standpoint though, we really considered issues that would help us achieve our core mission of providing price discovery and risk transfer to our constituents."

Horsager said he was confident in the future of electronic trading generally and on the Minneapolis Grain Exchange in particular. "An electronic platform allows an exchange to deliver the trading pit, with all the appropriate market information, right to each trader’s desk, wherever they may be," he pointed out.


Users ponder directions. Market users were generally supportive of exchanges’ efforts to explore electronic trading but at the same time seemed to be pleased with current methods of trading agricultural futures and options.

"I think by and large most commercials are satisfied with open outcry," said Scott Cordes, president, Country Hedging, Inc., St. Paul, Minnesota, U.S., a subsidiary of Cenex Harvest States Cooperatives. "I think most feel they are getting a competitive price and order fill. We currently do some trading on the C.B.O.T. a/c/e system. The experience has been good yet limited in the number of trades. Volume has not been very heavy."

With regard to electronic versus open-outcry trading of agricultural contracts in the future, Cordes said, "At this point, I am not sure we have a preference. We want to go in the direction that is the most efficient in terms of cost and liquidity on getting good trades and fills on orders. One of the problems with doing both open-outcry and electronic trading at an exchange is that your costs go up, not down, because you have to build and staff accounting and operating systems to handle both."

Cordes suggested that over time, electronic trading could be as good a tool for price discovery as open-outcry, perhaps better. "But this might be a perception from where you are starting today," he added. "Some people might feel they have an advantage over their competition in open-outcry, while others see a greater advantage in electronic trading. One would think that electronic trading should level the playing field for everyone."

One major baker said that he had traded on the a/c/e or Project A only a few times in the past couple of years. He said that electronic trading was not a tool his company was extremely interested in using.

The baker said he appreciated and enjoyed pit trading of futures and options because in the course of a day it was useful to interpret positions of traders and market direction based on who or which commission house was moving into or out of the market at any one particular time.

While pit trading was providing adequate service, the baker said he would be open to consider any new trading tool, including electronic trading, that could make the market performance even more efficient.