OPEN OUTCRY AND ELECTRONIC FINANCIAL TRADING SYSTEMS (A Comparison Study)

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1 OPEN OUTCRY AND ELECTRONIC FINANCIAL TRADING SYSTEMS (A Comparison Study) Wheny Khristianto Dosen Jurusan Administrasi Bisnis-FISIP, Universitas Lampung Abstract The impact of the Internet in the financial and accounting fields has created vast electronic marketplaces for the purchase and sale of stock, bonds, and other financial products. With rapid technological advantages, growing trading volume, and an increased demand for a more efficient trading environment, the majority of futures exchanges have introduced various forms of electronic trading. Despite this directive, a few futures exchanges still use open outcry trading. On the other sides, The impact of electronic trading in the future exchange is very significant. This article compares open outcry and electronic trading in the ability to create liquidity, the ability to reduce direct cost, and the ability to make global links. Key words: Internet, open outcry trading, electronic financial trading Introduction In the globalization era, information technology has a very important role in the trading and business activities. It provides tools for controlling the global corporation-communicating with distributors and suppliers, operating 24 hours a day trading and business activities, coordinating work teams in the global scale, and giving service about reporting needs. Intensive use of information technology in business has caused a new phenomenon in industrial society-the fully digital firm. A digital firm is one where nearly all the organization s significant business relationship with customers, suppliers, and employees are digitally enabled and mediated [Laudon and Laudon, 2004]. Thus, using Internet in the digital firm can link one organization with other organizations into a single network easily. Beside that, it can also create the foundation for a vast digital marketplace, where an information system links together many buyers and sellers to exchange information, products, services, and payments. The impact of the Internet in the financial and accounting fields has created vast electronic marketplaces for the purchase and sale of stock, bonds, and other financial products. Moreover, not only online trading and management of investment accounts for many kinds of products are available, but also financial systems are developed today on high-speed computer networks. With rapid technological advantages, growing trading volume, and an increased demand for a more efficient trading environment, the majority of futures exchanges have introduced various forms of electronic trading. The trend towards electronic trading dates back to the Commodity Exchange Act of 1974, which govern the U.S futures markets. Despite this directive, a few futures exchanges still use open outcry trading [Bank of Canada Review, 1999]. Under open outcry 65

2 trading process, investors have only limited access, because their orders can not be processed directly. They are must be processed and forwarded to the exchange through a broker first. Moreover, inefficiency is found in the order matching and execution procedures, because the original order from the investor needs to go through a broker and also the staff in the trading room before it actually enters the exchange. This article compares open outcry and electronic trading in the ability to create liquidity, the ability to reduce direct cost, and the ability to make global links. The mechanics of the two systems are described and than compared. a price by shouting out their order to other floor traders standing in a central location, which is called a trading pit. Verbal confirmation is done by buyer and seller if they agree with the price or arrive at a mutually acceptance price. Here the order is recorded manually by both parties to a trade. At the end of each day, the clearinghouse makes sure that there are no mistakes in the matches-trade information. Figure 1 bellow describes how open outcry trading is made. 1. Open Outcry Trading There are many of the largest organized future exchanges, which use the open outcry trading, such as the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME), and London s LIFFE. According to Financial Glossary, definition of open outcry trading is a system of face to face trading where brokers shout their bids and offers out loud. To place an order under this method, the customer calls a broker, who is responsible to time stamp the order. A broker must prepare an office order ticket also. The broker then sends the order to a booth on the exchange floor. There, a floor order ticket is prepared, and the order is delivered by a clerk hand to the floor trader execution. In some cases, we can find that the floor clerk may use hand signals to convey order to floor traders. For large orders, they can directly order to the broker s floor both. Then the floor trader negotiates 66

3 Buyer Seller Member Firm Member Firm Order Order Floor Broker PIT BID/ASK Trade Executed Floor Broker Pit Reporter Quotation Boards Ticker Network Clearing House Source: A Web-Based Financial Trading System (Ming, Stallaert, Whinston, 1999) Figure 1. Open Outcry Trading Process 67

4 2. Electronic Financial Trading The number of exchanges worldwide that use electronic systems in varying degrees to trade futures and options increased from 8% in 1990 to about 40% in 1997 [Baptise, Kang, Rosenfeld, 1993]. The majority of these exchanges are not located in the United States, but these are located outside the United States. Examples are DTB (Deutsche Termin Börse), MIF (Mercato Italiano Futures), and SWX (Swiss Exchange). Whereas, CBOT, CME, LIFFE are still only partially automated. The impact of electronic trading in the future exchange is very significant. Indeed, from 1989 to 1996, the volume on electronic trading systems used by futures exchanges more than doubled, from 7% to 18% of the world s trading volume [Price Waterhouse, 1997]. Based on DTB s statistic data, DTB s share of the Bond futures volume traded on DTB and LIFFE has increased from 19% in 1991 to about 42% in 1997 [Sarkar, Tozzi, 1998]. Beside that, in 1996 the number of online brokerage accounts was 1, 5 million. In the end of 1998, there was around 5, 3 million [Fan, Stallaert, Whinston, 1999]. An automated trade execution system has tree components: computer terminal, where customer orders are keyed in and trade confirmations are received, a host computer that processes trades, and a network that links the terminals to the host computer [Sarkar, Tozzi, 1998]. Under this method, customers may enter orders directly into the terminal or phone in the order to a broker. This article will describe the Financial Bundle Trading System (FBTS); a web based continuous electronic market that traders can use to execute bundle orders. With a bundle order, a trader can order a combination of stocks or assets. FBTS provides universal access to traders on the Internet, allows interactive information exchange between traders and market makers, and executes trades using the automated matching mechanism [Fan, Stallaert, Whinston, 1999]. System Architecture The FBTS consists of two primary applications: first is the Exchange and the second is the Trade Applet. Figure 2 describes the FBTS components and communication model. 68

5 Web browser Java Applet TradeApplet Remote Method Invocation (RMI) RMI callback Web Server Naming and directory service Limit order table Market administrator applet Database server Order routing and notification Automated bundle matching program Source: A Web-Based Financial Trading System (Ming, Stallaert, Whinston, 1999) Figure 2. System Architecture of Electronic Financial Trading The Exchange The function of The Exchange in the FBTS s system is the market application that manages and coordinates the trading activities across different computing platforms. It contains: Three servers: a web server, a database server, and a naming and directory server. The last provides unique object identifications throughout the entire system. A limit-order table: the function of this element is storing all open orders. Information about orders that have been filled or canceled is saved in the trade history database before it is deleted from this table. An order routing and notification system: this system monitors the limit order table and notifies traders of their activities. The automated bundle matching program: this program matches orders I real time and calculates transaction prices and trading quantities. The Trade Applet In the FBTS system, the function of The Trade Applet is the client application that is accessed via a web browser. Traders simply log in and conduct trades. FBTS contains an order error-checking functionality, based on its own trading rules, so it catches invalid orders before they reach the Exchange. The Trade Applet presents six windows. These are: Asset Status. This is the trader s current holding. Reserved lists the number 69

6 of shares for the trader s sell order that are not yet filled; Open Buy shows the number of shares in the open order; Net Open is the difference between the two. Message Board. The texts of messages sent from the Exchange are displayed here. New Order. This is where traders submit new orders. Traders are not required to submit bundle orders. To enter a bundle order, the trader enters the proportions (weights) for the bundle. If he wants to sell an asset, he checks the Sell? check box. He also enters the bundle quantity and limit price. The Pay and Receive buttons identify whether the valuation of the bundle is net cash outflow or inflow. Outstanding Order. The current open orders for the trader, including information such as date and time of the order, limit price, last traded price (it shows 0 if the order is not traded), bundle quantity, open quantity, and total transaction amount are given. Order History. The orders that have been either entered or canceled. If the trader wants to find more information about the past orders, he can select the order and click the History Details button. Price Information. Information such as the last traded price and the best bid and ask prices are presented in this window. 3. Comparing Open Outcry and Electronic Financial Trading The two most important measures of a trading system s effectiveness are its ability to create liquidity and its ability to reduce direct costs for the market participants [Sarkar, Tozzi, 1999]. Other considerations are availability of information, operating efficiency, and potential for trading abuses. Here, we describe a comparison in the ability to create liquidity, the ability to reduce direct cost, and the ability to make global links. Market Liquidity Investors in futures markets need to buy or sell futures contracts quickly and at a fair price. Their ability to do so depends on the existence of traders willing to take the other side of the trade and, in the process, supply liquidity. In open outcry trading systems, liquidity is supplied by traders who must be continually available for business even when trading activity on the floor is limited. Traders who supply liquidity in an electronic financial trading system, by contrast, can easily shift their effort to trade a different contract on the computer screen when trading activity is slow in one contract [Sarkar, Tozzi, 1999]. There are several ways that open outcry trading can contribute to market liquidity. For example, the trading floor is the primary location for price discovery, the trading pit provides easy access to the market, and the stimulating synergy on the floor triggers competitive responses [Tsang, 1999] By contrast, the evidence suggests that highly active contracts 70

7 are better traded on open outcry exchange than on electronic financial exchange. Open outcry or floor traders are skilled at executing large trades. In particular, locals (floor traders who buy and sell for their own accounts) trade frequently and are important suppliers of liquidity. Electronic trading systems are not likely to replace the ability of floor traders to execute large traders anytime soon. Although DBT has been successful in wresting market share from LIFFE in the Bund futures contract, LIFFE still dominates the market for the more complex Bond options contracts. Because the success of locals trading is largely dependent on observing other traders on the floor, locals tend to avoid screen-based systems. Nonetheless, improvements in electronic financial trading systems are increasing the system ability to handle large, complex trades. In this case, DBT has upgraded its electronic financial trading system to allow spread trades and to handle more trading activity [Sarkar, Tossi, 1999] Cost Issues On both electronic financial and open outcry exchange, member firms bear the fixed costs of operations, which are paid regardless of the volume traded. Fixed costs, determined by the number of traders employed and their salaries are higher for open outcry markets. Generally, screen-based trading requires less labor, skill, and time. According to DBT calculations, the labor costs of trading the Bond contract on LIFFE are two to three times higher than on DBT [Price Waterhouse, 1997]. The variable costs of processing customer orders are also lower for electronic financial trading. However, the initial capital to a trader of purchasing a computer workstation is larger than the cost of setting up a floor booth. Differences in overhead costs are also significant. Exchange overhead costs, which include building, staffing, and backoffice costs, tend to be higher for open outcry trading [Sarkar, Tossi, 1999]. Links to clearing houses, stock exchange, and global markets. With electronic financial trading, linkages between futures exchanges and clearing corporations can be established to facilitate the settlement process. Payment systems can be linked and margin requirements verified so that any violations can be detected as early as possible. The floor trading of a futures exchange is often located next to the stock exchange for convenience. However, limited floor area is always a problem. An automated system allows the exchange to be situated anywhere and thus relaxes this constraint. Furthermore, given the trend towards increasing international exposure, electronic financial trading can promote links between global markets and allow 24 hour trading [Tsang, 1999]. 71

8 Table 1. Comparing Open Outcry and Electronic Financial Trading Factors Open Outcry Trading Electronic Financial Trading Main suppliers Locals Large institutions; marketmaking of liquidity firms Primary costs Upkeep and staffing of trading Upgrading of software and floor; back office tasks hardware; telecommunication cost Global link Segregated exchange Possible electronic links to clearing corporation; 24 hour trading 4. Conclusion Open Outcry and Electronic Financial Trading have advantages and disadvantages. Now days, both of them are used in the futures exchanges trading. As an old system, open outcry has several ways to contribute the market liquidity. Beside that, this system has ability to execute the large trades. But, in the primary cost and global links factors, open outcry has problems. Examples, high cost for number of traders employed and their salaries, possibility to give 24 hour service and to coordinate work teams in the global scale is limited. On the other sides, electronic financial trading has ability to reduce the primary cost, because this system needs less labor, skill, and time. In the global links factor, electronic financial system provides tolls linking between futures exchange and clearing corporation, linking payment, and giving 24 hour trading. According to the phenomenon in the industrial society, where rapid advances in Information Technology and growing competition are causing fundamental changes in the world s financial services industry, electronic financial trading system should continue to grow rapidly. Because by using this system, traders can control the global corporation-communicating with distributors and suppliers, coordinate work teams in the global scale, and other possibility. Beside that, this system can improve the efficiency and cost effectiveness of trading. References Fan, Ming, J. Stallaert and A.B. Whinston. A Web-Based Financial Trading System. IEEE Journal, p , April Laudon, Kenneth C., J.P. Laudon. Management Information System: Managing The Digital Firm, Eight Edition. Pearson Education International, Price Waterhouse. The Impact of Technology on the Futures and Options Industry. Futures and Options Association, London, Sarkar, Asani, and M. Tozzi. Electronic Trading on Futures Exchanges. Federal Reserve Bank of New York, vol. 4, no. 1, Tsang, Raymond. Open Outcry and Electronic Trading in the futures exchange. Bank of Canada Review,

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