WAITING FOR THE FUTURE TO ARRIVE: ELECTRONIC TRADING HAS THE POTENTIAL TO REVOLUTIONIZE COMMODITIES TRADING. HOWEVER, A NUMBER OF FACTORS--INCLUDING THE OWNERSHIP STRUCTURE OF U.S. AGRICULTURAL EXCHANGES--WILL HAVE TO BE OVERCOME TO SPEED ADOPTION.

In the mid-1800s, as grain trading began to expand in the United States, "to arrive" contracts became popular in the newly established Chicago Board of Trade (CBOT). River merchants, who purchased grain from farmers in the late fall, had to store the grain until moisture was low enough to ship it, and rivers and canals were free of ice. These early forward contracts allowed merchants to manage the price risk of storing grain over the winter. By late 1800s, "to arrive" contracts were formalized into standardized agreements called "futures contracts," and speculators were trading them alongside merchants and processors in numerous grain exchanges.

Since these early years, futures exchanges have been critical for price discovery and risk management in agricultural commodity trading. Traders essentially made a collective forecast of the current value of grains for future delivery, facilitating price discovery. Speculators, who account for almost all grain futures transactions, aid risk management. Agribusinesses can transfer price risk to speculators by hedging against the grain they own. Since futures prices and cash prices must converge on the date of delivery, agribusinesses can "lock in" a price well in advance of delivery, effectively limiting their risk. This system not only allows the coordination of supply and demand across time, but also across space. Since any two locations tend to trade at a predictable price relationship to an exchange, information on the price of future contracts acts as a basis for trading across regions.

Today, many U.S. agricultural futures exchanges remain steeped in tradition, preserving many of their original characteristics. The emergence of the Internet and electronic trading, however, could bring about drastic change in the way these exchanges look and function.

How Technology is Changing Exchanges

To understand the impact of electronic trading, it is useful to break down exchange operations into three sequential processes: order, execution, and settlement. First, a customer's order must be communicated to the trader so it can be executed. Most exchanges and brokerages have already automated this operation. It is increasingly common for floor traders to receive orders from their brokerage house, in real time, through a palm computer.

Settlement, on the other hand, encompasses all operations after a transaction is executed, from registering to clearing the trade. This process is also largely electronic, allowing the transaction's registration and maintenance to be electronically communicated with the brokerage houses.

It is the process of execution that has proven to be the most difficult to automate. This characteristic makes it the critical element in providing a fully electronic trading system.

In traditional exchanges, execution is the physical transaction of contracts that occurs on the exchange floor. This so-called "open outcry" system involves traders signaling and shouting orders amongst, not to mention against, each other. Electronic trading removes this transaction from the pit floor and places it inside a computer network, often referred to as a "matching engine." Electronic execution allows a seller's posted "bid" to be matched with a buyer's "ask," or offer. When a match occurs, the contract is automatically formalized, processed, and sent back to the brokerage house or trader.

The computerized system automates many of the human activities needed to complete a transaction, displacing not only the floor traders, but also much of the support staff required for handling orders. Efficiencies from scale and scope economies, however, may be far more significant than efficiencies arising from decreased intermediation. While the up-front costs of developing an electronic trading platform are relatively high, the marginal costs of additional transactions on an existing electronic trading platform are often trivial. The costs of developing and launching entirely new contract offerings are also rather modest. This cost structure favors large exchanges. Hence, while scale and scope economies have always been important for agricultural exchanges, the potential for significant expansion of such economies through electronic trading paints a "winner rakes all" picture of the marker and will likely increase the pressure on exchanges to compete for a dominant position.

The Friction of Change

As with every radical technological innovation that provides an improvement, the old way must be supplanted, often causing conflicts. While electronic trading platforms have been developing rapidly around the world, the transition from open-outcry to electronic trading has been difficult for U.S. exchanges.

Perhaps the most significant barrier to electronic trading has been the ownership structure of U.S. exchanges. Historically, exchanges have been structured as non-profit organizations where members (brokers and traders) purchase "seats" on the exchange for the right to engage in trading. Within this structure, members control the assets and governance of the exchange. However, electronic trading threatens to disintermediate these member-owners and render them obsolete. Member-owners may then have an incentive to resist electronic trading, even though the long-term success of the exchange could be compromised. This conflict of interest creates a situation where it is often hard to discern what is best for the member-owners, what is best for the exchange itself, and whose interests should take precedence.

This principal-agent problem is currently being tackled by shifting the ownership structure of exchanges from mutual, or member-owned, to demutualized, or shareholder-owned.

However, the process of demutualization is nor straightforward. Members must be reimbursed for the revenue stream they expect from their "sear." Typically, reimbursement has come in the form of stock in the demutualized exchange. Member expectations about the returns from such stock allocations affect their interest in demutualization, as well as the level of intra-organizational friction.

Until recently, regulation was also a barrier to demutualization, because the long standing Commodity Exchange Act favored the not-for-profit governance structure. However, the Commodity Futures Trading Commission recently approved demutualization for the CBOT, Chicago Mercantile, and New York Mercantile exchanges. The shift in regulatory emphasis has eased the transition of incumbent exchanges to electronic trading and has invited new entrants in the industry, such as the new electronic futures exchanges Futurecom (cattle contracts) and the Merchants' Exchange of Sr. Louis (barge rate contracts).

As agricultural futures exchanges demutualize, economic viability becomes a key concern. Historically, exchanges have generated operating capital through the sale of "seats" for trading, as well as through membership dues. With members our of the equation, the individual trades become the centers of profitability. This is a difficult position to be in, because the marginal transaction costs of electronic trades are miniscule. Competition could drive trading fees close to those marginal costs, as electronic exchanges increasingly provide open access to their matching engines to compete for liquidity. This limits trading fees, which is where demutualized exchanges often expect to generate revenues.

Strategies for Change in the Exchange

To relieve some of the pressures of the transition towards electronic trading, some incumbent exchanges have opted to employ electronic and open outcry platforms simultaneously. This two-platform system allows an exchange to keep from alienating existing members while it accumulates experience in electronic trading.

Two principal models of dual trading have been tested over the last few years. Early on, electronic trading was used for after-hours transactions (e.g. CBOT's past use of Project-A). More recently, a tandem side-by-side system has been employed (e.g. CBOT's EUREX listings and the Chicago Mercantile's GLOBEX2 listings). Of course, gradual transition is not without its own costs. The two trading mechanisms often compete against each other, suffering mutual loss of liquidity -- nor to mention revenue -- from their overlapping functions. Furthermore, having two costly platforms instead of one can only be sustainable in the short term.

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