Open Outcry Goes Dark

The CME Group announced this past February its intention to close down open outcry, or floor based trading of agricultural futures this summer beginning in early July. This is only the latest in a long evolution in the development and growth of futures offering agricultural producers as well as buyers of agricultural commodities the ability to discover price and transfer risk. Before getting into what the open outcry going dark will mean for market participants, a brief history of futures trading might be interesting and insightful.

While it is tough to determine exactly when the first future actually traded, whether it was in the mid-1600s during the tulip mania in Holland or before, it is widely accepted that futures in the United States have their origins from the Chicago Board of Trade. The CBOT was founded in 1848 with the intention to promote commerce. The idea of forward price discovery and risk transference was not a new idea in 1848 but was certainly formalized with the establishment of a specific marketplace to conduct trade. The notion of futures as we know them today was still several years off. The reality is the early days of the Chicago Board of Trade simply provided a venue for buyers and sellers to negotiate customized cash forward and spot contracts while also providing a forum to resolve disputes that arose regarding those contracts.

In 1865 the Chicago Board of Trade established new innovative rules that really paved the way for futures as we largely know them today. The idea of a standardized contract identifying terms for quantity, quality, and delivery procedures was born. At the same time payment and contract settlement terms were developed as well. More specifically a requirement for margins was also initiated. Contract standardization and margining collectively created a new frontier that brought both hedgers and speculators together in a widely dynamic marketplace. Hedgers could now use futures as a temporary substitute for their eventual physical purchases and sales.

Today this concept is applied across all facets of commerce and industry, not just agriculture. Another offshoot of these rules is the practice of modern day “mark to market” procedures. The margining process is the bedrock of the financial integrity of the entire futures market and has evolved to include daily position settlements facilitating collecting in losses and paying out gains on all positions. In fact the benefits of daily recapitalization of positions were illustrated quite transparently when many over the counter (OTC) positions across the whole financial system in 2008 were left to accumulate unsustainable levels debt before being unwound or offset causing many systemic issues.

As standardization and margining are credited as being catalysts for the early growth of the futures market due to their widespread acceptance, electronic trading could be cited as another example of market participants determining the evolution of futures. While the Chicago Board of Trade is credited with establishing the first organized futures exchange in the U.S., the Chicago Mercantile Exchange (CME) created the technology for the Globex electronic trading platform which is now the standard for price discovery and risk transfer in the futures market. Initially conceived in 1987 as a “low impact” means of providing after-hours market coverage for currency trading, it took until 1992 when the technologies could actually become operational in the context of currency products.

What really sealed the fate of open outcry trading however took almost another decade to develop. Due to the extended rally of the U.S. stock market by the late 1990s, the CME realized that the original S&P 500 futures contract had grown quite large and was becoming out of reach for many prospective traders due to its notional value. As a result, the CME developed a smaller sized E-mini S&P 500 futures contract, and deemed it would trade exclusively on CME Globex. Initially, the bulk of trade was transacted by traders equipped with CME Globex systems on the periphery of the open outcry futures pit to conduct arbitrage between the larger traditional contract and the smaller E-minis. In late 2000, the CME implemented an “open access” policy which meant that customers could trade directly on CME Globex as long as their clearing firm provided a financial guarantee for their trading activities, when it came down to customer service, CME always tries to follow up on a crm integration.

Just prior to that in 1999, the CME introduced “side-by-side” trading in the Eurodollar complex which eventually extended to other products as well in both the financial and agricultural markets. This development meant that customers had the choice between executing their contracts through either the open outcry (pit) format or electronically on Globex. The electronic market was no longer simply an overnight platform to allow access to customers outside of the U.S. to trade markets during their normal business hours, such as in Europe and Asia. The Chicago Board of Trade introduced side-by-side trading in their agricultural complex on August 1, 2006, and later that year on October 17, the Chicago Board of Trade and Chicago Mercantile Exchange merged to become the CME Group.

Almost immediately after the development of side-by-side trading in the agricultural markets, the fate of open outcry or floor trading was sealed. The obsolescence of open outcry was quickly determined by market participants choosing the electronic market over the traditional venue. Whether it was the efficiency of speed or more likely the tighter bid-ask spreads on orders there is no doubt or debate that the migration to the screen was brought on by futures customers. In fact, the CME stated in their announcement of shuttering the open outcry trading of the futures pits that floor volume had dropped to 1% of total traded volume. The CME Group however will continue to offer floor based trading for options as well as the S&P 500 Index Futures.

The CME Group has traditionally maintained a policy of “let the market decide” between routing their orders to the pit or the screen. Customers appear to have decided with regard to futures trading at least that they prefer the electronic marketplace, which has prompted the Exchange’s decision to close the futures pits. While open outcry option trading will continue to be supported by the CME Group, many feel it is only a matter of time before all trading eventually migrates to the screen.

Despite this historic development, one thing to keep in mind after the agricultural pits go dark is that the market still serves the dual purpose of price discovery and risk transfer very well on Globex. Indeed, the market is as dynamic as it has ever been, and the efficiency and speed at which orders can be transacted allows for more trading to actually occur for the benefit of all market participants. Outside of former floor traders displaced by electronic trading and affected by the loss of a bygone era, most market users will not be impacted by this development. Indeed, without recent media coverage of the event, awareness of the pit closures may have even gone unnoticed.

The darkening of the open outcry pits is by all means a historic event worthy of the fanfare it’s generating. Like the closing of the stockyards, the city of Chicago is certainly losing part of the fabric of its past identity. The reality though is the pits have largely been dark for several years now. Market participants will continue to have the ability to utilize the wonders of the forward price discovery and risk transfer functions of the CME Group, albeit an electronic version, for their margin management needs. Like many other industries, technology has fundamentally changed the way in which the futures market operates. Regardless of the format used to trade however, the main function of the market remains the same. Being able to both identify forward opportunities through price discovery and manage those opportunities through risk transfer is as alive and well today as it has ever been.