With the era of steady annual double-digit rates of growth for derivatives industry now probably over, the question becomes how the shares are likely to be divided between its two main claimants, the futures exchanges and the over-the-counter swaps dealers.
For the next 10 to 15 years, the exchanges, for reasons discussed further below, can probably achieve a rate of average annual productivity growth sufficient to stay even with, or at least not fall too far behind, their major over-the-counter competitors. For the longer term, however, the picture is murky, given the enormous and far-reaching technological development through which we are living and which threaten the current structure not just of the exchanges but of financial trading generally.
These changes almost certainly will lead to the eventual disappearance of the trading floor.
Thanks to the Internet and related developments, buyers and sellers are increasingly able to find each other directly without the services of intermediaries, and certainly without trading floors. Trading floors and trading screens, after all, serve mainly to permit traders and other financial intermediaries to bring buyers and sellers together and to overcome the problems posed by the lack of perfect synchronization of their demands.
The eventual disappearance of the trading floor, however, need not mean the disappearance of the futures exchanges themselves. Their main function will simply change from one of offering primarily transaction services, to one of offering primarily the services of clearing and settlement, functions in which the exchanges already have enormous expertise and may well have a real comparative advantage over many of their OTC rivals. That may seem an improbable outcome perhaps from today's vantage point, but technology often has a strange way of reshuffling otherwise familiar decks.
The futures exchanges with their centralized trading floors, clearinghouses and daily settlement rules rank with the telegraph, the telephone, the railroad and electricity generation as among the major technological inventions of the 19th century. Ingenious as the innovation of the futures exchange was, however, and as valuable to society as were its byproducts of price discovery and price transparency, other competing technologies were and still are available.
Swaps are the breakthrough of the 20th century. Each technological mode has its natural customer base, and the boundaries are not rigid. The bigger a firm or bank you are and the higher your credit rating, the more choices you have. Which route you take depends mostly on cost and convenience. It follows then that if the cost of using a sector falls relative to those of its rivals, that sector is likely to expand. And if its costs of doing business rise relative to its rivals, it will almost certainly have to contract.
The likely future division of the derivatives pie between the exchanges and the OTC sector thus comes down to a matter of the rate of change of relative costs.
Can the exchanges reasonably hope to produce productivity gains by reducing the costs of trading in their own current open-outcry environment? Adding capacity to the trading pits substitutes fixed capital costs for the high variable costs occasioned by demand surges. But will the long-run average cost over normal volumes be put on the kind of steadily declining path necessary to keep the exchange/OTC intermodal boundary from shifting against the exchanges? Given the structure of the trading floors, the question comes down to the likely path of average costs for the individual traders.
One obvious area of potential cost savings is in something as elemental as trade recording. Under present technology, trades are recorded by writing five of six characters on trading cards, which are later collected and subsequently entered into one or more computer data-processing systems. The procedure is not only slow and labor-intensive but prone to substantial error which shows up in "outtrades" that must be settled in early morning, face-to-face negotiations the next day before the parties can resume trading. Additional costs are incurred in reconstructing the so-called audit trails (essentially the precise timing of transactions) needed for assuring compliance with the exchange's trading rules.
One natural solution to these problems of trade recording and timing would be some sort of hand-held, wireless, electronic instrument that could record the trades as they occur and transmit the information instantly to the appropriate computers. Outtrades could then be reconciled right on the spot while memories are still fresh and the reconstruction of the trading sequence would be automatic. Costs to clearing members of monitoring their floor traders would also fall because credit limits could easily be programmed in. Both exchanges, to their great credit, have in fact cooperated to develop just such hand-held terminal technology, so far, alas, without success, despite the investment of as much as $20 million to date in the project.
Much of the blame for this conspicuous waste of resources on implementing the hand-held technology rests with the Commodities Futures Trading Commission and its congressional agricultural committee overseers who were pressing the industry severely on the audit-trail issue - an issue that is trivial for society but crucial to the public relations image of the regulators, particularly after the famous FBI sting operation of 1989.
Threats of sanctions and retaliation from those regulators led the exchanges to gamble on a crash program for a near-perfect audit trail well before the technology was there to support it. Nor is the end of these unnecessary regulatory burdens in sight. The dead weight costs piled on exchange trading by an archaic and uneconomic regulatory structure has been likened to forcing the exchanges to run their competitive race against the far less minutely regulated OTC market with a 50-pound bag of bricks tied to their backs.
Additional costs of using the futures route are incurred, of course, in the so-called "back office" operations of both the exchanges themselves and the futures commission merchants who serve as intermediaries between the exchanges and the customers. The futures exchanges, for a variety of reasons, have lagged far behind other industries in adopting uniform industry technical standards. In after-hours electronic trading systems, for example, the FCMs currently confront no less than three totally incompatible systems - the Chicago Mercantile Exchange's Globex, the Chicago Board of Trade's Project A and the New York Mercantile Exchange's Access - with more to come.
Each exchange, moreover, maintains its own unique order-entry and position-reporting systems, a lack of compatibility that not only adds to FCM costs, but leads to wasteful duplication of computing facilities.
The CME and the CBOT, for example, maintain between them no less than five separate mainframe computers, each costing them more than a million dollars a year, when with a relatively simple accommodation, the exchanges could make do with at most two mainframes, and possibly only one if they could arrange for a suitable, offsite backup for any emergencies.
The recognition, however belated, that the exchanges and their customers can, and for their own survival, must achieve substantial cost reductions by consolidating their essentially similar operations and by adopting uniform standards for entering and confirming trades was the motivating impulse behind the recent formation by the CME and the CBOT of Joint Strategic Initiatives Committee, on which I am serving as executive director.
Achieving these urgently needed consolidations is difficult because the futures exchanges in the United States, at least, are organized not as investor-owned corporations, like the Swedish OM derivatives exchange, based in London, but essentially as "trader cooperatives." Only a very limited class of operating decisions is delegated to professional managers; all key decisions, of the kind facing the Joint Strategic Initiatives Committee, must be voted on first by the 30 or so members (plus some "disinterested" outsiders) serving on the board of directors; and then, in any matter of major importance, by several hundred trader-members in what amounts to a plebiscite. Recognizing this need, the two exchanges have nominated parallel lists of 20 or more "influential" members to the JSIC. Such broad-based participation will surely help in the long run, but in the short run the sheer size of the group makes it extremely difficult even to arrange committee and subcommittee meetings.
Still, I remain confident that these institutional obstacles will ultimately be overcome. As an economist, I believe that if the efficiency gains are large enough - and I am convinced they are - private negotiation and contracting between the individuals affected will achieve them. Admittedly, the opportunity for compensatory side payments in cash or stock, of the kind routine in ordinary corporate negotiations, would vastly simplify matters and hasten agreement, but in its absence, the mounting competitive pressure on the exchanges from their OTC and foreign rivals can serve as at least a partial substitute. In the famous words of Dr. Samuel Johnson, nothing seems to concentrate the mind better than the prospect of being hanged.12
Merton H. Miller, a 1990 Nobel laureate in economics, is Robert R. McCormick Distinguished Service Professor at the Graduate School of Business, University of Chicago. His commentary is excerpted from a more extensive keynote speech delivered at a conference in Taipei, Taiwan, sponsored by the Asia Pacific Finance Association and the Pacific Basin Capital Markets Research Center of the University of Rhode Island. The full text of his speech will appear in a forthcoming Pacific Basin Finance Journal.
