November 13, 2008

Recent market events have shocked the country and brought the subject of derivatives trading into the mainstream, and the current credit crunch and recent company consolidations have had an adverse effect on the trading volume of interest rate futures globally. Countering this development is the explosion of volume in equity and currency futures that occurred in September 2008. Since then, the value of global stock markets has dropped and volatility is at an all-time high.

The U.S. dollar has also reversed its long-term downtrend due to the weakening of the European economies, a weakness that will lead to interest rate reductions in the European Union. Off-balance sheet activity in the over-the-counter markets will never be the same, as the risks inherited with derivatives were not managed properly by the major broker-dealers and their customers. The listed derivatives markets will benefit due to the push toward a more regulated marketplace, while the OTC derivatives business will not. The vendors that support futures and options on futures trading will continue to evolve to meet these demands.

The Evolution of Electronic Trading in Futures

Electronic trading of futures contracts started in the early 1990s when Eurex (then DTB) introduced the 10-year German interest rate contract commonly known as the "Bund." The idea of launching a fully electronic exchange was radical at the time, never before having been implemented in an established marketplace. Switzerland's SOFFEX and Sweden's Options Market were the only electronic exchanges operating without an open-outcry trading floor, while the Chicago Mercantile Exchange's Globex platform was only used when the trading floors were closed.

DTB licensed SOFFEX's proprietary system and adapted it for the German market. In 1997 the exchange captured more than 50 percent of the market in Bund futures. By the end of the decade, however, Eurex had captured all of the liquidity in the German interest rate sector. The LIFFE exchange, which had previously owned market share in the German debt futures, was able to keep control of the short-term interest future known as the "Euribor." That exchange ultimately became completely electronic, eventually closing its floor operation altogether.

As efficient as pit trading was, there was always frustration among players that traded futures off the floor that the pit would misrepresent how many contracts were available on the bid/offer. With the adoption of electronic trading, the actual bid/offer size of the contract could be seen on the screen, and the days of asking how much was bid/offered and trying to hit/lift the amount and missing the majority were history.

The evolution of e-trading in the United States took place at a much slower rate than it did in Europe. The idea was not originally well received, as industry players preferred the tradition, and in some cases the advantages, of open-outcry trading. Certain exchanges wanted to go fully electronic but had a hard time convincing their membership, while end users wanted electronic trading for its lower fees and increased efficiency.

Outside competition (i.e., Brokertec Futures Exchange) eventually forced the hands of the Chicago exchanges to adapt in the early part of this decade, and trading futures electronically became the norm. Liquidity was now evident on screens, and trading software companies started to develop futures front ends and build infrastructures to connect to the exchanges. Today these vendors see themselves not only as software providers but as providers of front-to-back solutions and greatly enhanced front-end capabilities.