Last Call

By Emily Lambert –
At 7:19 A.M at the Chicago Board of Trade Harold Lavender is saying his good mornings. Each day Lavender, 57, wears the same purple jacket with red lapels to help clients pick him out of the crowd as he trades contracts for ten-year Treasury note futures. When the bell rings at 7:20, he’s ready to spring into action.
If only there were orders to fill.

This is Lavender’s 28th year in Chicago’s trading pits, which means he has been yelling and flashing signals here for one-sixth of the exchange’s colorful history. He began in 1976 as a clerk and runner making $125 a week. Now he is a floor broker, whose job is to execute trades for buyers and sellers–hedgers and speculators betting on interest rates. What kind of money can you make doing this? Until several years ago, it wasn’t unusual for a floor broker to pull in $1 million a year.
Lavender is unlikely to come close this year. In superficial ways, little has changed inside the 60,000-square-foot financial room in CBOT’s art deco building. Its five-story walls are still lined with screens blinking with market information and news. In risers surrounding the 12 mostly octagonal pits are the floor operations of Bear Stearns, Credit Suisse First Boston and their ilk. CNBC reporter Rick Santelli regularly broadcasts from the ten-year pit, and there’s still a paramedic on hand to treat overheated traders. But, as electronic trading has sapped business from the trading floor, many desks are unmanned and traders have left to conduct business “upstairs”–on a computer.
Watching his colleagues leave, Lavender has become an even louder and more passionate defender of the chaotic open outcry system that defined securities trading around the world for most of the past two centuries. Now floor trading is becoming something akin to the home delivery of milk. For the first half of the year, volume in the financial futures pits fell 11%, while that of electronic trades surged 50%, year over year. Lavender is a Luddite for all seasons. “The best computer ever made is right here,” he says, tapping his head. “I plan to be on the floor ten years from now.”
For decades the process has worked something like this: A floor manager at a booth relays an order to a floor broker. The broker yells out the order, finds a buyer or seller, makes a trade, records it on a card and hands it off to a clerk. If the market is primed, the time from call to execution can be three or four seconds, says Lavender. In some pits a broker can still earn $1 or more per contract for his services. (The going rate on the financial floor is down to 50 cents to 80 cents.)
In electronic trading there are no elbows, no yells and no brokers pacing the floor. A trader–whether a speculator or someone at a bank, insurance company or brokerage house–sits at a computer and clicks in an order, or runs an algorithm that enters orders automatically. When an electronic order has a match, the trade takes two-tenths of a second or less to complete. Instead of putting on platform shoes to gain an edge (which happens in the pits), screen traders invest in modems and T1 lines.
Lavender has been a full-time broker since 1991, and he sticks to tradition. Some brokers use electronic clerks to speed up the process. Lavender, once the head of the Board of Trade’s Technology Committee, relies on a computer only occasionally–to endorse a trade, not to make one. All around him, technology has infiltrated the floor. In the ten-year pit, with one exception, all locals–those trading for their own accounts or on behalf of an investment firm–trade using computers. They come to the pit for camaraderie, but many of their trades bypass brokers.
This digital evolution is in its twelfth year–just as the New York Stock Exchange (news – web sites) is embarking on its own massive overhaul. Brokers and traders who own the CBOT were suspicious of technology that threatened their jobs, but couldn’t stave it off. In 1998 the institution’s board voted to allow its biggest volume-getter, 30-year U.S. Treasury futures, to trade electronically alongside open outcry. They had seen electronic exchanges work havoc on floor brokers in Europe, and they didn’t want to lose the business. “We made an egregious, grievous mistake,” says Lavender, although he was part of that board approval. “We did it the way we did it out of fear.”
But many brokers adapted to that fear by following their customers off the floor. Ninety percent of U.S. Treasury futures volume is now electronic, as is 60% of the exchange’s overall volume. That has crimped brokers’ profits. In response to Eurex–the German-Swiss operation that this year set up a subsidiary a few blocks away–CBOT slashed fees, so that it charges members less to trade financial futures on the screen than on the floor. (Fees, which include exchange fees and brokerage fees, are complex, based on what commodity is traded, whether the trader is an exchange member and which brokerage house is used.) Result: Eurex was routed, but floor brokers were caught in the crossfire. “They were aiming at Eurex,” says Lavender, “but they hit the pits.”
And their cronyism. There’s a history of bringing kids, neighbors and friends into the business; Lavender was tapped by a high school and college buddy. He insists relationships don’t interfere with the market and that the pit polices itself well. “The amount of money being what it is, people watch each other,” he says. Still, there have been notorious lapses. In 1989 the FBI (news – web sites) planted moles here and at the Chicago Mercantile Exchange, nailing traders and brokers for shenanigans like prearranged trades to skim customer profits. Such scams are tougher to pull off in the electronic world, since all trades are anonymous to the parties involved.
But even electronic traders have found ways to game the system. One such character trading on the Eurex system, a trader known as the Flipper, occasionally posted an offer to sell a large position in contracts on the Schatz, the two-year EU government bond, at a low price. As sellers panicked and cut their asking prices, the Flipper sometimes pulled his sell order and bought, scoring the contracts at an advantageous price. The manipulation isn’t illegal, but it hurts the market by making traders gun-shy.
Pit bulls like Lavender have some accountability, since they still assume execution risk. A simple mistake on 500 contracts can cost $15,000. If Lavender screws up, or if the market ticks away from him on a trade, he must dig into his own pocket to compensate a customer. Moreover, the open-cry system gives brokers and traders a window on what’s going on in the market. They can gauge people’s expressions, discern the frenzy of hand signals, even overhear price gaps between, say, contracts in the 10-year and the 30-year pits–all of this drama unavailable to screen traders.
The ubiquity of electronic trading will only feed on itself. Traders can operate from anywhere in the world; without the physical constraints of the pit, they’re creating a larger, more liquid marketplace. The U.S. futures markets handled 1.2 billion contracts last year, mostly on behalf of institutions and full-time traders. They’re also moving, albeit slowly, to a broader retail audience with minicontracts. You could use those to hedge your adjustable-rate mortgage. CBOT and other exchanges will soon get a nudge from tiny HedgeStreet, which will offer “Hedgelets” of $10 and up–contracts to hedge gas prices, mortgage rates and other costs of daily living–starting in October.
For now, open outcry and electronic trading coexist. Locals can trade on the screen and in the pit at the same time. They can also act as arbitrageurs, exploiting differences between the two markets, or use the pits as a way to cancel a trade if the strategy doesn’t work. The pit still drives screen volume–20% of electronic trades in financial futures originate in the pits.
How long can the pits survive? CBOT President Bernard Dan, walking a political tightrope, talks up giving customers choice but says “it’s difficult to say forever in anything.” The electronic model is lethally effective in broadening distribution, driving up volume and eliminating labor. CBOT is trying to steal gold and silver trading from the stodgy New York Mercantile Exchange by listing those contracts electronically. This summer the exchange announced it would electronically list agricultural contracts and futures from two Midwest grain exchanges, in Kansas City, Mo. and Minneapolis–which themselves have inched in a digital direction.
And yet, within CBOT’s own pits, trading in ag futures and options still hangs on–one of two such areas–amounting to 16% of the total volume on the exchange. Then again, customers don’t have a choice: Electronic trading is limited to off-hours, and competition hasn’t forced the issue.
The other dinosaur den is financial options–the equivalent of the right, for example, to buy Treasury bond futures at a certain strike price–where traders hang over the railings, screaming and waving frantically. Software can’t yet replicate all the complex trades used in options strategies, some traders say, though there’s plenty of disagreement on this front, so for now these trades remain on the floor. Lavender says he could become an options broker if he wanted to, but that would require learning a new set of skills and strategies akin to mastering electronic trades.
This, too, is changing. CBOT this summer began pushing after-hours trading with online marketmakers. Its bigger and more progressive neighbor, the Chicago Mercantile Exchange, has released a juiced-up options product, part of its accelerated plan to digitize (see box). Lavender’s ranks are clearly thinning. The 10-year pit is down from 150 or so brokers and traders as recently as two years ago to 80 or so. Since the feds stopped issuing 30-year bonds in 2001, the 30-year pit has plunged from 600 to 50 people.
Some former pit traders are helping to throttle open outcry. An electronic trading forum held in June played to a standing-room-only crowd. The Board of Trade’s online classes draw in people from Chicago to Afghanistan (news – web sites). Harris Brumfield, who once held huge positions in the ten-year pit, left in 1997. He took over a software vendor, and now his company, Trading Technologies, handles more than half the electronic volume at the four biggest derivatives exchanges. Lavender’s first boss at CBOT, Ray Cahnman, is now a zealous, outspoken screen trader. Chairman of TransMarket Group, a trading and investment firm, Cahnman says the pits are a financial drain on the exchange. He and Lavender ran for CBOT board seats in 2003. They both lost.
A decade ago the Excelsior on the corner of Wells and Van Buren streets was packed with grain traders knocking back drinks after the markets closed. Today the bar is gone. The crowd at Alcock’s has diminished considerably. Recently the owner was on the phone trying to get a wireless connection to enable electronic traders to ply their trade by juggling laptops alongside their beers. Where do the digerati hang out? Gibraltar, jokes John Lothian, head of electronic trading at the Price Group, a brokerage that operates on an upper floor of the CBOT building. That’s because the island off the Spanish coast offers low personal income tax rates.
By 10 a.m. on this summer day, without any orders called in for his execution, Lavender passes the time with a crossword puzzle. Later, as visitors look down from the gallery, he reads the comics. He leaves the pit without making a single trade. The volume is low: 24,348 contracts traded in the pit, 442,462 traded on the screen. Lavender shakes his head and writes it off as a seasonal lull. “I’ve been the one voice willing to say we’ll be around for a long time,” he says. “And I still believe that.”
Source: Yahoo News

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