Does commodities floor trading have a future?

Once the beating heart of global energy markets, the Nymex trading floor now seems to be in its death throes. Alexander Osipovich asks how much longer open outcry has to live – and whether we should be sorry to see it go

It was only a few years ago that hundreds of traders were shouting, shoving and jockeying for position in the trading pits of the New York Mercantile Exchange, or Nymex, the world’s top marketplace for energy derivatives. But ever since Nymex introduced round-the-clock electronic trading in 2006 – a move bitterly resisted by floor traders – volumes have ebbed away from the pits to the screen. That has led pundits and market participants to repeatedly proclaim the death of the Nymex floor, whose history dates back to 1872, when the exchange was established for butter and cheese trading.

Now, the end of open-outcry trading at Nymex seems to be coming into focus. The proportion of futures trades executed in the pit, compared to those executed electronically, is minuscule: just 0.5% so far this year, according to CME Group, the Chicago-based exchange operator that took over Nymex in 2008. Beyond this year, the floor’s future is uncertain. When CME Group acquired Nymex, it pledged to keep the floor open until December 31, 2012. “Thereafter, Nymex will maintain a trading floor in the New York City metropolitan area as long as profitability and revenue thresholds are met,” CME Group said in a document sent to market participants at the time.

When asked what will happen to the Nymex floor after New Year’s Day, CME Group says it has no plans to shut down the pits. “We will continue to provide our customers with both electronic and open-outcry trading venues,” CME Group said in a statement sent to Energy Risk. “We remain committed to our floor-based membership and open-outcry trading services, which continue to be a profitable part of our business and serve our customers well.”

Still, market participants broadly agree that the Nymex markets are inexorably moving from the floor to the screen. “I’d like to see the floor back, but it’s not happening,” says Stephen Ardizzone, a longtime Nymex floor trader who is now senior managing member of Two Rivers Trading Group, a trading firm based in the Nymex building. “I certainly believe that it’s all going to go to the screen. I don’t see anything slowing it down.”

There is one thing clearly keeping Nymex floor trading alive: options. Although increasing volumes of options trades are being executed through Globex, CME Group’s electronic trading platform, open outcry is still preferred by many options market participants, especially for more complex trading strategies that are difficult to execute on the screen. So far this year the proportion of pit volume in Nymex options has been about 53%, according to data from CME Group. That’s down from 95% in 2008 (see figure 1) but still respectable.

In the old days, you couldn’t move in the trading room. Now you can roll a bowling ball in there and not hit anybody

Indeed, during a recent visit by Energy Risk to the Nymex trading floor in lower Manhattan, the only pit in the cavernous room where traders were still standing shoulder-to-shoulder, yelling bids and offers like in the old days, was the options pit. Nearby, the crude oil futures pit was practically empty, though admittedly this visit was during the slow month of August.

Thus, the future of the Nymex floor depends on the options pit, according to market participants and outside experts. “The floor for futures is hanging on by a thread,” says Craig Pirrong, a finance professor at the University of Houston’s Bauer College of Business. As for options, “it’s in a situation where it could tip,” he says. “It will just depend on the cost of keeping the floor open. If volume continues to bleed from open outcry to Globex, they’ll make the decision to terminate floor trading.”

A recent decision by CME Group’s arch rival Ice highlights how options trading in other markets is moving towards electronic execution. In July, the Atlanta-based exchange operator said it would phase out open-outcry trading for options on sugar, cotton, coffee, cocoa and frozen concentrated orange juice futures – contracts it inherited when it completed its acquisition of the New York Board of Trade in 2007. Open-outcry trading in these contracts will cease by October, the exchange said, ending the last vestiges of open outcry on Ice’s exchanges.

Ice’s decision to end open outcry came after market participants made it clear that they preferred electronic trading, says Ben Jackson, president and chief operating officer of Ice Futures US. After Ice rolled out new options-trading technology in those markets in 2011, the shift to electronic execution was swift. “Once the technology caught up and gave people the ability to execute option trades and rapidly interact in an electronic format, then customer preference for electronic execution took over, and that’s what moved the market from 10% electronic last year to around 90%, where it is today,” Jackson says.

Compared to futures, options have been slow to transition to screen trading because they are inherently more complex. Not only do they come in a range of strike prices and expiration dates, but their prices depend on the volatility of the underlying futures contract, which can fluctuate sharply on a moment’s notice. On top of that, traders have a huge variety of strategies involving different combinations of puts and calls. In energy markets, it is often easier to execute such strategies through humans on the Nymex floor rather than through Globex, which is best used for plain-vanilla options with nearby expiration dates, according to market participants.

“Globex volume is really concentrated in the first two or three months, and it’s pretty much exclusively live calls and puts¹,” says Charles Reyl, president of Parity Energy, a New York-based firm that runs an execution facility for over-the-counter energy options. “But as soon as you start talking about strategies – call spreads, put spreads, hedged options, straddles, etc – and when you talk about calls and puts beyond the first two or three months, where liquidity is a lot more spotty, you will have a much harder time finding market-makers who can give you quotes on Globex. Then you will see these transactions remain on the floor or OTC.”

That could keep the options pit humming for a while. “I get the sense that CME Group wants to keep the floor open, because the options are creating a lot of business,” says George Gero, chairman of the Commodity Floor Brokers and Traders Association (CFBTA) and a longtime Nymex member.

From humans to algos

Some market participants think CME Group will be more hesitant to kill the floor and go fully electronic as a result of recent, highly publicised incidents that have highlighted the risks of algorithmic and high-frequency trading (HFT). Notably, on August 1, a rogue algorithm deployed by Knight Capital Group, an electronic market-maker, roiled US stocks and cost the company $440 million in a matter of minutes.

“I’m sure CME Group would like nothing better than to be able to put the options market completely online, but they are going to need a very robust system for that,” says David Greenberg, a former Nymex board member and president of Greenberg Capital, a New York-based trading firm. “And especially after what just happened with Knight, they will need to be totally, 100% sure that the system can work, otherwise they’re not going to do it. The exchanges are under a microscope, and any major incident will bring unwelcome extra regulations on them.”

The Knight incident drew comparisons to the infamous ‘flash crash’ of May 6, 2010, when the Dow Jones Industrial Average plunged around 1,000 points in a matter of minutes, then regained much of its value just as quickly. High-frequency traders did not actually trigger the flash crash, but once it got under way, they contributed to the free fall by swiftly and simultaneously pulling back their market-making activities, which dried up liquidity, according to a joint investigation by the US’s Securities and Exchange Commission and Commodity Futures Trading Commission.

Some fear the same thing could happen in energy markets. Greenberg says human market-makers in the pits were a more reliable source of liquidity than HFT firms. “When you have a pit environment, you have 200 people with 200 different opinions,” he says. “If there was a big price move, someone would step up and make a market. With high-frequency trading now, all these firms are operating the same way. So you have these flash crashes, where all the orders get pulled in a nanosecond.”

CME Group says it has safeguards to ensure that HFT does not introduce systemic risk into the energy markets. “Liquidity is the best defence against disruptive markets, and algorithmic and high-frequency traders provide liquidity,” it says. “CME Group employs effective risk-, volatility- and error-mitigation functionality to support high-frequency trading activity in a way that benefits all market participants.”

Others say the key advantage of taking a market electronic – the growth in the number of market participants – outweighs the risk of rogue algos or HFT-related disruptions. “If you move to electronic market-makers, yeah, you potentially increase the systemic risk of the market,” says a former Nymex executive. “However, the flip side is that you potentially dramatically increase the size of the market. And so on a net-net basis, it’s about the same.”

Glitches and snafus

In the past, when open outcry has been run in parallel with electronic trading, it has sometimes served as a backup in the event of technical glitches. Greenberg recalls that when Nymex first went electronic, orders were routed to the floor on occasions when the system stopped working.

Although such system failures are now rare, one such incident did happen earlier this year. Shortly after 2:00pm on Monday, February 13, a technical issue halted trading on Globex and the system stayed down for just over an hour. Electronic traders based in the Nymex building, and floor traders from the nearby options pit, rushed over to the crude futures pit to trade before the daily settlement at 2:30pm. Afterwards, some observers argued that the incident underscored the need for Nymex to retain human traders on the floor.

The problem with that argument is that few people still know the ways of the floor traders, so next time there might not be anyone around who can fulfil that role, says Greenberg. “Even since February, the attrition rate in the building has just been remarkable,” he says. “There are just not a lot of people left. In the old days, you couldn’t move in the trading room. Now you can roll a bowling ball in there and not hit anybody.”

Ardizzone agrees. “The problem is just that you’re losing more and more guys, especially the guys that were in the business for a long time,” he says. “If you’re not getting the youth that are coming out of school to trade in those particular markets, and you start losing the older guys, who are just retiring or who feel like it’s not in them to continue… once the generation has turned over, it’s just going to end.”

Still, others still believe there should be a role for both humans and machines. “Let’s face it, we’re in the 21st century and open outcry is being replaced by more machines,” says Gero. “If you’re just trying to do volume, if you’re just trying to do speed, of course the machine is the preferred venue. Nobody will argue that. I think there’s a place for both in some way, because sooner or later people will want to have more personal attention than a machine can provide. I mean, have you seen all the snafus that the machines have created? We’ve never had that kind of stuff in open outcry.”

Criminals in the pits?

Not everyone is nostalgic for the days when open outcry reigned supreme. In fact, many veterans of the energy markets argue that electronic trading is vastly fairer than the old system, when pit traders made fortunes by quickly jumping on market movements, or through more nefarious means.

“The informational advantage that they had for so many years was borderline criminal,” says the former Nymex executive, who spoke on condition of anonymity because his new employer has not authorised him to speak to journalists. “In general, many market participants hate the floor. I think more market participants hate the floor than like the floor, because they have this visceral feeling of getting robbed.”

Ice, which pioneered electronic trading in energy markets, also views the screen as a much fairer way to trade. “Customers see that the move toward the electronic market in futures led to a market that was more efficient and effective,” says Jackson. “It opened the market to global participants as opposed to an exclusive club that only has access to trade information on a particular trading floor. This additional transparency that electronic markets provide is proven to increase market participation, deepen liquidity, tighten bid-ask spreads and increase the efficiency of the overall market.”

Even former floor traders admit that open outcry has its weaknesses. “The fairest system in my opinion is electronic trading because it eliminates intermediaries,” says Ryan Carlson, a one-time pit trader at the Chicago Mercantile Exchange who has created TradingPitHistory.com, a website that is seeking to document the cultures and hand signals of various trading floors. “No market structure is perfect, but electronic trading is far more competitive than trading via open outcry, and the result is a more efficient market.”

Carlson pushes back against the notion that floor trading was crooked. “Although I’ve honestly never seen anything illegal happen in the pits, I’ve seen some trades made at bad prices because the broker executing the customer order was busy, confused, not paying attention, etc,” he says. “But that’s just part of the inefficiency of open outcry.”

The CFBTA’s Gero defends the honour of pit traders. In his view, electronic trading is actually more susceptible to manipulation than floor trading – it’s just harder to detect such activity on the screen. “I think compliance is a lot better on the floors than it is with the black box,” says Gero, a longtime metals trader who has been a Nymex member since 1966. “With the black box itself, of course, you have audit trails… But you don’t know what entity is placing that order, ultimately, until it’s too late. The floors are policed continually. You can’t tell in the black box if something looks peculiar.”

Fight the future

As exchanges around the world have gone electronic and shut down their trading pits, floor traders have occasionally fought back. So far, none of these rebellions has been successful.

In 1998, locals at the Marché à Terme International de France (Matif) in Paris went on strike to protest the exchange’s introduction of electronic trading. Their walk-out only accelerated the adoption of electronic trading by market participants. In 2005, on the last day of open-outcry trading at the International Petroleum Exchange in London, furious oil traders smashed equipment in a final frenzy of rage against Ice, which had acquired the exchange four years earlier. “I was actually in one of the pubs across the street, and they were walking into it with time clocks and filing cabinets,” recalls Ardizzone. “They absolutely trashed the floor.”

Today, CME Group is being challenged by a group of pit traders in its hometown of Chicago, who have set up a website called SaveTheFloor.com and filed a lawsuit against the exchange operator. The traders, who work in the pits at the Chicago Board of Trade (CBOT), one of CME Group’s exchanges, accuse the exchange operator of seeking to undermine floor trading by changing the way it calculates settlement prices for certain agricultural commodities. They contend that CME Group is biased against floor trading in favour of HFT and algorithmic traders.

Heather Koch, one of the plaintiffs in the lawsuit, believes the roots of the problem date back to the early 2000s, when Chicago’s futures exchanges turned into for-profit companies. That has made them hungry from the fees generated by massive volumes of trades executed by HFT firms, she says.

“CME Group favours generating revenue at the least cost possible,” says Koch, a soybean pit trader and principal at Icarus Trading, a small Chicago trading firm. “Where these earnings come from or how it impacts the marketplace is inconsequential in their business model. When exchanges were nonprofit, it was not a club of boys laughing at the consumer. The nonprofit exchange model actually worked because of the equal presence and weight from all market participants. So the membership nonprofit model gave commercials, small farmers and large traders a voice, and these debates and decisions were good for the integrity of the contracts. The shift to for-profit exchange models has forced the leadership to make decisions on generating revenue and the contracts don’t really matter. Hours, co-location, elimination of human participants, all increase revenue and, lo and behold, helps the most important customer, high-frequency traders.”

When asked about the CBOT traders’ lawsuit, CME Group said simply, “We remain committed to our floor-based membership and open-outcry trading services.”

Not everyone believes that CME Group is hellbent on closing down the pits. In fact, some members of the floor-trading community characterise the exchange operator as an essentially pit-friendly company, especially in contrast to Ice, with its relentless march towards all-electronic exchanges. “CME [Group] has been wonderful in taking care of the guys as long as they have the pit,” Ardizzone says. “If the business doesn’t dictate to get rid of them, then they won’t. They’ll keep them around as long as they can. They’re not looking to push them out.”

Ultimately, it will be the preferences of market participants that decide the fate of the Nymex floor and the other remaining outposts of open-outcry trading elsewhere in the world. Considering the huge shift towards electronic trading over the past decade or so, it is difficult to imagine that the pits will last much longer.

For some, that is a victory for market efficiency, but for others, it is a reason to be wistful. “The floors are a tangible connection to the past,” says Pirrong, of the University of Houston. “In many respects they’re not that different in 2012 than they were in 1912, or even in 1870. And so it is somewhat sad to see them fade away.”

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¹ In order to gain exposure to the volatility component only of an option, market participants will often trade an option along with the underlying swap or futures as a hedge to the underlying’s price risk. To buy a ‘live call’ or a ‘live put’ means to buy the option unhedged, without the underlying contract