Three years ago, the Chicago Mercantile Exchange Inc. had an impressive business, handling an average daily volume of 2.2 million futures and options contracts, particularly complex financial instruments. Yet the exchange was in danger of becoming an anachronism. Customers were complaining that its technology was outdated and its service poor. In a world shifting to electronic trading, it appeared slow to adapt, too wedded to the open-outcry pits where exchange members traded face to face. And its grip on U.S. market share appeared suddenly vulnerable to overseas competition.
The picture looks a lot different as this year begins. Trading volume rose 23% last year, and electronic trading grew 71%, surpassing face-to-face trading to become the clear majority of the exchange's volume. Aided by technology innovation, including a systems upgrade that pared response times by two-thirds, the Chicago Mercantile Exchange's biggest challenge last year was keeping up with growth.
This transformation in how the exchange does business happened during a time of massive internal change, as it went from being an organization owned and run by trading members to a publicly traded company. It couldn't have worked without changing the IT performance and strategy, says CEO Craig Donohue. "What we're doing is practically impossible to do," Donohue says. "Technology has been actually the way we have kept the whole thing together in a way that has allowed us to compete and do it with the cooperation and involvement of our members."
Electronic trading was 69% of the exchange's total volume in January, up from 43% a year earlier. Several factors came together last year to cause volume on its electronic platform, known as Globex, to explode: the growing use of derivatives such as options and futures, greater acceptance of electronic trading as an adjunct or replacement to floor trading, and technology improvements that have made Globex faster and more reliable.
The technical improvements came just as automated trading systems, or ATS, have become one of the megatrends of Wall Street. In these systems, computers are programmed to execute trading strategies, often driving huge amounts of trading and data traffic. "Two years ago, ATS was just a name," chief technology officer Charlie Troxel says. "Now, it's changing the landscape."
Automated trading systems are changing the landscape, chief technology officer Troxel says.
Photo by Chris Lake
Something called a "butterfly trade" offers an example of how thinking at the exchange has changed. Butterfly trades are a popular way of hedging a bet. A trader buys and sells four options contracts, but the deal only makes sense if all four trades can happen at the right price. In the past, that kind of complexity could only be handled by floor traders. Last year, the exchange bought a software company called Liquidity Direct and incorporated its technology for executing butterfly trades into Globex. In the first week after the product launch in October, an average of 19,000 butterfly contracts per day changed hands on Globex.
Although the open-outcry system is unlikely to disappear for a while, its role is clearly diminishing. Electronic trading provides speed, anonymity, and reliability of execution--and increasingly electronic platforms also can handle the kind of complicated, multipart trading strategies that in the past could only be handled by the pros in the trading pits. "These are high-performance traders; milliseconds matter," says Dieter Marlovics, CIO of Gelber Group LLC, which provides technology and services to professional traders and hedge funds.
The exchange has come a long way from its roots as a Chicago emporium for trading dairy commodities. Yet in its efforts to transform itself into a modern-day financial exchange, it has had to overcome many obstacles, not the least of which was a reputation for stodginess. "Two and a half years ago, I would have rated the Chicago Mercantile Exchange as terrible in terms of customer communication and technology," Marlovics says. The exchange at times miscalculated the amount of telecommunications bandwidth needed to connect to Globex, which sometimes caused massive bottlenecks throughout the trade-execution chain. Even worse, Marlovics says, it refused to acknowledge complaints from customers "until the system was almost unusable."
This view was to a large degree shared at the Merc itself. "We knew we weren't meeting everyone's expectations and obviously needed to get better," says James Krause, a 20-year veteran of the exchange who was named CIO last year.
It did. The exchange engineered changes in a number of areas, including strategy and marketing, but none more important than technology.
Keeping speed and reliability up to par requires the attention of the Merc's top IT leaders, CIO Krause says.
Photo by Chris Lake
It was much-needed capacity: During the same period, the percentage of Eurodollar futures--which produces the largest trading volume for the exchange--traded on Globex more than doubled.
The change from a face-to-face to an electronic trading environment has not gone without resistance from traditional floor traders, who still have a powerful voice at the exchange. Many of them believe that floor trading imparts valuable information, such as the facial expressions and body language of people clustered around trading stations, that can't possibly be captured in an electronic system, says Jodi Burns, an analyst at research firm Celent Communications.
The Merc is taking steps to bridge the divide between the floor- and electronic-based trading environments. It has equipped floor traders with handheld devices and software that connect their own trading system with Globex; the devices now account for 350,000 contracts daily. Last year, it opened a Globex Learning Center, where traders take courses on electronic trading and conduct simulated trades on workstations supplied by vendors.
Yet even as the Merc was making the transition from floor-based trading to electronic, competitors were making plans to move in on its turf. Last year, the London International Financial Futures and Options Exchange began offering a competing Eurodollar futures contract to be traded on its Connect E-trading platform. The effort so far has succeeded in capturing a mere 2% of Eurodollar futures market share; the other 98% still belongs to the Merc. "LIFFE was probably surprised; it thought it could wrestle liquidity away from us," Krause says.
As it celebrates the fruits of its technology efforts, the Merc will be challenged to come up with novel ways to meet the growing demand for electronic trading. Under a deal with Reuters, for example, traders will be able to place orders for futures contracts at the Merc directly from their Reuters terminals. This is uncharted territory from a technology perspective: Although seven large financial institutions tested the setup, no one can predict what will happen once it goes live this year at 3,500 institutions around the world.
This isn't a problem for the Merc alone. Experts warn that expanding trading volumes and the increased complexity of instruments being traded will require greater expenditures of IT resources. Electronic trading is increasing trading volume, but it's also increasing the number of requests for information, and some worry the markets won't be able to keep up with the information avalanche. "All those additional orders are generating messages, whether they get filled or not," says Leslie Sutphen, president of Financial Markets Consulting, which advises futures and options exchanges on systems enhancements.
Just keeping the speed and reliability up to par in the kind of fast-growth environment the Merc is in can be difficult and demands the attention of its top IT leadership. "We do have to pay attention to it daily," Krause says.
They also need to keep an eye on the future. A lot of common but complicated trades--akin to the butterfly trade--still can't be done electronically. If the Merc doesn't figure it out, its exchange rivals surely will. Donohue says the Merc is now an "applied technology company," and this 150-year-old market needs to learn to have IT as well as financial innovation to succeed. "We're only in the early stages of technology," he says. "There's a lot more to be done."
That should keep Krause and Troxel busy.
with Chris Murphy