Why exchanges shift from open outcry to electronic trading

An article in the NYT on the shift away from open outcry today, which gets it right and gets it wrong. The right part is that the shift and merger of the CME and CBOT onto a single floor located at the CBOT spells the end for open outcry. It’s a natural transition point, and the break will break what’s left of pit trading. There will likely continue to be a floor for the largest volume contracts, but even those won’t likely survive for long. I’ve long been agnostic over whether or not the floors will die (historically, there were dire warnings about the death of open outcry about every 20 years since the 1950s). But this may well be it.

What I think the article gets wrong is the why. The imagery is one of the futility of human labor against the labor of a machine. As one trader notes, “Sometimes it feels like we’re John Henry going up against the steam hammer.” Kate Zaloom is quoted as noting that in electronic trading is “the idea of having a more pure market, one that doesn’t have the complications of flesh and blood.”

This idea, that technology displaces humans, is way too undifferentiated to be a useful explanation. Stuart Elliot’s research for the National Research Council, in part estimating the occupational displacements due to technology by 2030 (I include the key table at the end, just to demonstrate how scary-screwed many workers might be), show pretty wide heterogeneity across occupations. So one question unanswered by the John Henry argument is, why trading? Lawyers don’t seem to be going anyplace, and I’m not convinced that the technical requirements of work are great explanations.

The second problem is this idea of a ‘more pure market.’ It’s kind of BS. I did a literature review on what financial economists themselves suggested were the differences/comparisons/reviews of open outcry and electronic trading, and the results are decidedly mixed.
Comparison of Open outcry and Automated Trading
In the table, the research is placed on the side that is ‘better’ in the estimation of the author, using the measures they use – liquidity, transaction costs, obtaining adverse (that is, private) information. So a study on the open outcry side suggests that it’s better than electronic trading. My favorite finding is that when comparing the actual prices with the theoretical prices you should get if markets were perfectly efficient (or, more precisely, if markets followed the formulae exactly), both open outcry and electronic trading kind of suck.

So the question remains, why did electronic trading displace open outcry? I think the answer is pretty simple:
1) The clients changed. The modal trader in the 1970s was a high-income individual who was looking to increase returns to his (yes, his) investments via a riskier kind of financial investing. Commission costs, transactions costs, these are important, but the form of trading mattered little. At the end of the 1990s, it was estimated that something like 97% of the trading in financial futures came from institutions. Electronic trading is great for these clients. They bought their own seats, demanded a voice in decision-making. Their interests are different from both floor traders and from wealthy individual clients. It cannot be stressed enough that electronic trading is best for institutions who are able to capitalize on the kinds of things that electronic markets are good at – speed, cross exchange trades, digitized, already-model-manipulable data.

2) Electronic trading changed the products of the CME and CBOT. The exchanges’ products are contracts, liquidity, and prices. Electronic trading changed what counts as a price, so that while the two products look the same, they are not the same. The information that is captured in an electronic price is qualitatively different from the information that is captured in an open outcry price. They overlap, but they are distinct constellations of information. Here I agree most with Daniel Beunza and Yuval Millo, that electronic trading is losing information that might be useful in the change-over. But if that information is not useful to someone who could actually, you know, use it, it doesn’t really matter. In any case, the idea that electronic markets win out because they’re more ‘pure’ is just not correct.

I think there’s something sad about the passing of open outcry. I’ll miss the guy from the meats who sold beef jerky out of a duffel bag. And the quick wit and black humor. I also am not terribly sad. The guy who got women to give him blowjobs behind the desk, the references to Lind-Waldock as Lind-Welfare because they actually hired Black people, the eye-candy summer interns, all that is part of the open outcry world too.

Jobs expected to be displaced by technology
[Source: Stuart W. Elliott, “Projecting the Impact of Computers on Work in 2030,” p. 37, available online [PDF].] (thanks, Alex)

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