CBOT Gazes into the Pit The venerable Chicago Board of Trade is waging an uphill battle to keep its open-outcry system relevant in the Internet Age. Our writer spent a week in the pits to see how the fight is going. The conclusion: Always bring Listerine.
(FORTUNE Magazine) – Imagine a room the size of an airplane hangar, ringed with digital clocks and TV screens the size of billboards. In the middle of the room are a dozen amphitheaters six feet high and 40 to 50 feet across--and in these so-called pits are 1,337 sweating, shouting, gesticulating young traders in mesh jackets of bowling-league orange, lime green, scarlet, and purple. Around the pits skitter some 700 clerks and runners, relaying orders from trading desks and racing back moments later with handwritten confirmations. Imagine all that, and you'll have a pretty good picture of the Chicago Board of Trade's most active trading floor, where futures on Treasuries change hands. Until last year the CBOT was the world's largest derivatives exchange, and it remains indisputably a nerve center of the global financial system. From the gallery 50 or so feet above, however, it looks like nothing so much as a vast, human pinball machine.
Standing at a trading desk hard by five of the most active trading pits one recent April afternoon is Mike Daley, a trader for Paine Webber and a 16-year CBOT veteran. Less than a minute before the 2:00 p.m. close of trading, Daley gets a major order from a client, a bigtime money manager in New York. He scribbles on a well-used sheet, picks up a phone, and yells for 515 contracts to a clerk hanging over the railing of the five-year-Treasury pit across the room. He simultaneously catches the eye of a clerk in the 30-year-bond pit and signals an order to sell 1,460 contracts--palm out (for sell), a single finger over his head (for 1,000 contracts) followed by a flash of four fingers and then one finger pointed at his head like a gun (for 460). An instant later he makes similar gestures to the ten-year and two-year pits to buy 200 contracts combined. As the closing bell rings, runners are racing through the crowd with handwritten confirmations for transactions with an underlying value of $220 million.
Daley turns to a reporter. "You think a computer can do that?" he shouts. "No way. If I had to use this"--he smacks his hand against a rarely used monitor at his side--"I'd still be punching numbers and my customer would be yelling at me."
What Daley has just done is pretty dazzling, but it doesn't really answer his question. Why couldn't a computer do what he--and his traders and clerks and runners--have just done? And why couldn't the machine do it more cheaply and efficiently? It's a question that tears at the heart of the 152-year-old Board of Trade and one that its members, much as they might like to, can no longer dodge. Like the New York Stock Exchange and a handful of other "open-outcry" marketplaces--where traders do transactions in face-to-face encounters--the CBOT is under assault by technologically superior new rivals. And like the NYSE's, the CBOT's response to the competition has been hamstrung by a century or more of monopolistic complacency and by its own cumbersome governance structure, in which every major decision must be voted on by 2,171 contentious, opinionated, tradition-bound exchange members. But time is running out. Trading floors in Paris, London, and Frankfurt are in mothballs, and the price of a seat on the CBOT has plunged as much as 50% since hitting a high of $858,000 in May 1997--the same year the exchange opened its 60,000-square-foot, $182 million trading room for financial futures. The CBOT last year surrendered its title as the world's busiest futures exchange to an all-electronic Swiss-German exchange called Eurex, which didn't exist three years ago. Still harder to swallow is that in recent months the CBOT hasn't even been the largest exchange in Chicago, trailing both archrival Chicago Mercantile Exchange and the technologically savvy Chicago Board Options Exchange.
The CBOT's chairman, David Brennan, has crafted a "Hail Mary" restructuring plan of sorts. It calls for the CBOT to split into two competing for-profit companies--one that will retain the open-outcry floor and another, known as eBOT, that will trade electronically over the Eurex platform. The two will then duke it out like boxers, and may the better system win.
The plan can go nowhere, of course, without the approval of the CBOT's seat holders, who are waiting impatiently to see what they'll be paid for giving up their memberships. They should worry. If eBOT wins, members who haven't gone electronic will see a huge loss of income and thousands of jobs on the trading floor will disappear. In the process, the Chicago floor trader--arguably the noisiest, most profane, most testosterone-crazed character in American finance--will be set on the road to extinction, and that will be a shame.
With that in mind, this reporter accepted an invitation to spend a week at the CBOT, with unlimited access to the trading pits, members, executives--even washroom attendants, if I chose. As I expected, traders were defiant. Though most stood by the restructuring plan as if by rote, all insisted that open outcry cannot be duplicated on a computer screen and that it remains the most efficient way of doing business. A common theme was that electronic trading may be fine when markets are orderly, but during tough times, customers will clamor for the judgment and market sense that only experienced human traders can bring.
Maybe. I went to Chicago hoping to find that they were right. But watching traders crammed in pits shoulder to shoulder, watching them communicate with hand signals invented by their grandfathers, it was hard not to conclude that this way of life is doomed. In the Internet Age, there are simply better ways to trade.
Completing a trade at the CBOT requires information to change hands as many as a dozen times--each change an invitation to misunderstanding or error. But in an electronic trade, humans handle the order information just twice. Trading over a network is also far more discreet than open outcry, where everyone knows who's buying and selling what. Finally, electronic trading is simply cheaper: No one is paying millions of dollars to maintain a trading floor, with its armies of runners and clerks and shouting, flailing traders. In the eyes of the big institutions that are pushing the CBOT into online trading, that may be the most persuasive advantage of all. Richard "Doc" Sandor, the former CBOT vice chairman credited with developing the financial futures that now constitute 75% of the exchange's volume, acknowledges the march of technology: "The world doesn't really need guys standing in a pit flapping their hands anymore."
Even if the world doesn't need the CBOT's trading floor, it definitely needs futures exchanges. Futures provide an otherwise unobtainable kind of insurance against price volatility in commodities. Say you're a cattle rancher in Montana and each month you purchase 20,000 bushels of feed corn. A big rise in corn prices resulting from a flood in the Midwest could ruin you. To hedge against such risk, you purchase futures contracts guaranteeing you 20,000 bushels of corn at a given price when you need them at a later date. Now you know what you'll have to pay. Voila! no more uncertainty.
For every hedger, there must be a speculator--a person willing to take on the risk the hedger wants to shed. The person on the other end of your corn trade probably has no business interest in corn or cattle; he simply wants to gamble that he can later buy an offsetting corn contract at a lower price and thus make a profit on the deal.
The CBOT brings together the hedgers and speculators. The hedgers tend to be financial institutions (a money manager wanting to lay off the risk of an interest rate rise by selling Treasury futures, say), while day traders known as "locals" do the speculating. The potential for a speculator to make or lose mountains of money on the CBOT floor is tremendous. Treasury futures, for example, typically trade in 1/32 increments equal to $31.25. A trader who buys 1,000 contracts, therefore, makes or loses $31,250 with every tick. A swing of just ten ticks is $312,500. Indeed, the same day that Mike Daley made his last-minute trade, rumors swirled through that pits that one veteran local had lost his eight-figure fortune and been forced to liquidate his membership.
Yet anyone can become a local just by leasing a membership (about $10,000 a month), putting up $30,000 for margin requirements, and passing a basic quiz on rules and ethics. The only other requirements are leather lungs and a stomach for risk, although it never hurts to be tall (the better for other traders to see you) and physically imposing (for when the shoving starts). The absence of more formal educational requirements and the abundance of financial leverage makes the floor one of the few places in America where a blue-collar high school grad can earn the same money as a contemporary who took the Ivy League track--if he's lucky, that is. While the best local traders can make as much as $10 million a year, 80% of those who try fail. The more reliable career path is to land a job with a brokerage. CBOT brokers earn a commission of 85 cents per contract--whether the trade wins or loses for the customer--and can easily see an income of $500,000.
Not that there's any risk of mistaking the floor of the CBOT for a convention of trust fund babies. The stereotypical trader hails from one of Chicago's scrappier neighborhoods; he's almost always male, typically of Irish or Italian descent, frequently an ex-jock, and exceedingly fond of the "F" word in its many forms--as noun, verb, adjective, adverb, interjection, punctuation, and term of endearment. Working conditions leave something to be desired as well. The pits are deafening, frequently hostile, and always stressful. Paramedics were called onto the floor 242 times last year--that's about one emergency per trading day--and they carried 98 people off to the hospital who had suffered heart attacks, panic attacks, and accidental stabbings with the Bic ballpoints that are the floor trader's favorite tool.
You want a breath mint?" a runner standing next to me on the elevator asks. He looks to be about 18 and, like many here, is clad in an oversized mesh jacket, a solid-gold Rolex on his wrist. I took a mint. Fresh breath is an obsession in the pits. Traders annually consume 1,600 gallons of mint Listerine kept in jugs in the bathrooms and, judging from the number of wrappers on the trading floor, countless sticks of gum. In the close quarters of the floor, bad breath is a distinct competitive disadvantage.
The doors open at the fourth floor of the CBOT's building and the runner dashes out into a gallery that leads to the trading floors. It's 6:30 A.M., 50 minutes before the opening of trading in bond futures, and already the place smells as if someone had spilled Listerine in a locker room.
Out in the gallery, Bob Jakubowich is working his way through a pack of young clerks hitting wads of paper back and forth like tennis balls. Jakubowich doesn't quite fit the stereotype of a floor trader. He's of medium build, not a jock, and the son of Polish immigrants, Auschwitz survivors who settled in the Chicago suburb of Skokie. After dropping out of college, he worked in his father's deli in a rough section of Chicago called Edgewater. Then, about 20 years ago, he met someone who knew someone who'd made it big in the pits and who offered to help him do the same. (This is a familiar manner of entry for people who find careers on the exchange floor.) Newly married, Jakubowich started coming down to the CBOT, at first just to see how it worked and eventually to trade futures as a local. How does he like it? "It's better than working in a deli, " says Jakubowich, speeding off through the crowd and ascending a ladder into the 30-year bond pit.
It's now 7:10, just ten minutes until the bell. Traders are jockeying for position and psyching themselves up for the session by swapping jocular insults. Local One: "Hey, Pat, you still taking steroids?" Local Two from across the pit: "Ask your wife." It could be a busy day. The Labor Department is due to report monthly employment statistics at 7:30. Any deviation from the expected number could stampede stock investors into bond futures.
I find a spot in the pit next to Mike Ryan. Trained as a teacher at nearby Chicago State, Ryan has brokered bond transactions for Paine Webber, ABN Amro, and Bear Stearns for 20 years. Back in 1998 he was so fed up with the glacial pace of modernization on the floor that he ran for vice chairman--the same year Brennan became chairman--and won. These days he shuttles between the floor and a windowless office piled high with computers and gadgets he'd like to introduce on the floor. More than other traders, Ryan is aware of the changing times. Among his current tasks is getting as many colleagues as possible to read a self-help book called Who Moved My Cheese? in the hope that they will realize they have no choice about electronic trading.
Ryan stands between a local named Marty McGlone, who passes the minutes telling one-liners to no one in particular, and another, Bruce D'Alba, who's just dyed his hair platinum blond on a bet with his son.
Then it's 7:20. The traders don't just start buying and selling, they explode into it. The adrenaline rush is so invigorating I fold my arms to keep from becoming an accidental bidder, though several men offer assurances that the traders all recognize each other and would easily spot an intruder. As the pace of trading quickens, McGlone slams into my shoulder and bounces off without noticing. Another local smashes my head from behind with his elbow as he jockeys for position. The market is rallying ahead of the employment number. The contract is up $500.
"Dave Ryan is a buyer," someone shouts. The 38-year-old Ryan, no relation to Mike, brokers trades for Merrill Lynch, Salomon Smith Barney, Morgan Stanley, and Cantor Fitzgerald and can literally move the market. He always stands on the top tier of the pit, seemingly taller than anyone else, his Popeye-like forearms stretched above the heads of brokers brave enough to stand next to him. When a local several yards away misunderstands Ryan and questions him, Ryan, his jugular popping as if his head might explode, jumps forward and blurts out obscenities with such force you can see spit fly from his mouth and land on traders several feet away. No one complains. "This is the Wild West," Ryan says later in a weirdly calm voice for a man who has just spent the day screaming. "Every man has to stand up for himself. I have to fight all day to get my customers the best price."
At 7:30 the government reports its number: in line with expectations. You can see the traders sag with disappointment. No inflation equals no volatility. The rally fizzles. Money starts to flood out of the pit. "Dave Ryan selling! Dave Ryan selling!" Ryan hovers with his arms extended. Then the entire pit scrambles to sell. Everyone, that is, except John Sunderlin. Sunderlin is a local who is funded well enough to trade more than a million dollars a day. He looks something like the actor Alec Baldwin and, unlike most traders, calls out orders in a normal voice rather than a scream. Within a few minutes, however, he probably does want to scream as his losses pile up. His normally patient expression turns to a look of concern. The fist around his notecards tightens. Down $20,000, down $50,000, down $100,000.... He finally pulls the plug and walks away. "I should have stopped sooner," says the 34-year-old, a former restaurant major at Iowa State. Wouldn't you have been better off trading on a computer instead of getting caught up in the emotion? "If I have to trade electronically, I will. But sitting in front of a computer all day doesn't sound very exciting."
Across a hall from the Treasury-futures trading room is another cavernous trading hall--the grain room, where agricultural futures change hands daily from 9:30 A.M. to 1:15 P.M. Younger traders call the grain room Jurassic Park--in part because its 1,691 denizens tend to adapt slowly to change, and also because it's the only place at the CBOT where you see gray hair. This room is full of old-timers, guys like Whitey King, 60, who has worked the floor for 35 years and now trades in tandem with his 27-year-old daughter, Kelly. Nearby is Jay Homan, an oat broker who hasn't missed a day of work in 26 years--hasn't even taken a vacation. Lately, King and Homan have both started using an electronic routing system to receive orders from trading desks. Though neither cares much for the idea of electronic trading, both admit that more people need to use the so-called electronic clerks if they are to stay in business.
A few minutes before the opening bell in the grain room, however, the public-address system announces that the electronic router has broken down: "We have converted all of our firms to paper.... The decision has been made to delay trading until 10 A.M." A few people cheer. "Welcome to the world of electronic trading," quips Brian Scott, a trader who used to drive truckloads of slaughtered pigs from the old Chicago stockyards. He's now a major player in the agricultural pits.
Among those not amused by the router's breakdown is CBOT Chairman Brennan. Brennan is a soybean trader, as is his father, as was his father before him. Despite the family ties to the CBOT, Brennan is committed to eliminating the exchange's more backward practices, like handwriting orders on slips of paper. Substituting an electronic record can cut the number of errors, which now occur on about 3% of trades. (To be fair, the CBOT currently does about 5% of its transactions on a no-frills electronic system called Project A.)
Traders say Brennan, 43, is a tough guy. He seems it: wiry and powerful, with probing eyes and a knuckle-crunching handshake. After narrowly winning the chairmanship in 1998, he promptly tried to oust the CEO, Tom Donovan. Donovan was a backroom party boss, the former patronage chief for Mayor Richard Daley (the original one), who had been brought in to keep the CBOT in the good graces of regulators. While Donovan held on for two years, he finally resigned in mid-April of this year--the 11th senior executive to leave since Brennan won the top job--his way greased by a $10 million buyout offer.
Brennan's first big success in office was to win overwhelming approval of a joint venture with Frankurt's Eurex exchange to trade U.S. financial and agricultural futures electronically. Though he had opposed an earlier Eurex alliance, which members voted down, Brennan decided last year that the CBOT no longer had a choice. Eurex is an aggressive organization that had lured the market for German bond futures away from London's futures exchange, which used an open-outcry system like CBOT's. Brennan and everyone else knew it was only a matter of time before Eurex became a foe on U.S. soil. Not just that, but Cantor Fitzgerald--long among the most active brokers in the pits--had launched an electronic futures exchange; a consortium of brokerages called BrokerTec was threatening to do the same.
And then there were the French. The Paris futures exchange, the Matif, has become exhibit A for those who claim that open outcry cannot stand up to electronic trading. In 1998, the Matif's administrators decided to run electronic trading side by side with floor-based trading. Within weeks--literally--trading had migrated almost entirely to the electronic exchange, and the floor shut down.
"The potential electronic competition really scares everyone," says Robert Hamada, dean of the University of Chicago's business school and a CBOT director. "Everyone has to wake up to the fact that distances and national boundaries don't mean anything anymore. Somebody undercuts you by a couple pennies a trade and you're dead."
Hamada is a big supporter of the plan to split the CBOT into competing electronic and open-outcry exchanges. Both halves would hire professional managers, entice top executives with incentives like stock options, and recruit independent directors. They would then compete for the same customers. "I truly don't know who's going to win," Hamada says. "But I agree with David Brennan that competition is the only way."
As for members of the exchange, they'd get equity in both halves. To be sure, there's a very real risk that the CBOT's floor traders would suffer the same fate as those on the Matif, but owning equity in the winning electronic exchange would be some consolation. "I'd rather lose to myself than someone else," says Brennan.
After making his case, Brennan gets up and walks over to a framed magazine article hanging on the wall. Dated 1915, the article is about his grandfather and trading styles. "You see that? Trading then was basically the way it is today. That's good, because it means we stand for something. But it also means we need to move forward. The big customers no longer care if they trade on a screen or in a pit."
If Brennan is right, it's hard to see any need for a trading floor on the CBOT ten years from now--or sooner. Exchange officials continually tried to convince me of the floor's viability, with talk of gadgets that will make it work more smoothly. Handheld computers are being tested as a way to record orders; they should get wider use this year. A souped-up router would eliminate the need for runners to bring orders to the pits. Electronic links could funnel trades from Eurex to the floor. There was even talk of "virtual reality" pits in which thousands of traders stationed around the world would flash hand signals to other traders and see their responses on virtual reality headsets. (But would they smell the Listerine?) The officials also spoke optimistically of lobbying federal regulators for the right to trade futures on individual stocks, an innovation that could attract millions of new investors to the CBOT. But the harsh reality is that most of these developments are still years away--and as anyone who hedges for a living ought to be able to figure out, the CBOT just doesn't have that kind of time.
What matters most to the institutions that trade on the CBOT is liquidity, and that comes from bringing together the greatest number of buyers and sellers. Right now the CBOT alone has that power in the market for Treasury and agricultural contracts. But once an electronic alternative exists--and if the exchange doesn't create one via the Brennan plan, someone else will--the pits are through.
The prospect of becoming irrelevant after decades as the center of the financial world is understandably difficult for traders to accept. But the inevitability of change is seeping in, as I learned at dinner one night in Chicago with five CBOT traders. Over steaks the size of cows, we talked about the future. Could man best machine this time? I asked. Not a single trader argued for the computer, though each admitted that electronic trading is an essential undertaking. Even so, the floor could last for years, they said; no one really knows.
A trader sitting next to me listened to the others and shook his head. "They're wrong," he said. He admitted he loves the floor. His biggest hope is that when the CBOT launches eBOT, the world suffers a financial crisis that restores faith in the power of the floor to handle any challenge. But that will only delay the inevitable. Ultimately, it's not traditions, hard work, or sweat that matter. It's whether you can do a trade cheaper than the next guy. Staring into his second double espresso, he sighed regretfully. "The floor is toast."