PITS ARE NOW THE PITS: IT’S A REVOLUTION AS EXCHANGES FIGHT TO SURVIVE

The warp-speed growth of high-tech competition is forcing stock and futures exchanges around the globe to suddenly think the unthinkable: mergers with longtime rivals, initial public offerings, even the prospect of dumping their old-fashioned open-outcry systems and switching to all-electronic trading.

The changes could mean lower trading costs for retail and institutional investors. But they also could mean the eventual dislocation of thousands of clerks, traders and others at the exchanges –shaking the cities that host them and consider themselves financial services centers.

Consider these recent developments:

* The Paris-based Matif futures exchange is shuttering its traditional trading pits after a two-month trial offering simultaneous electronic and open-outcry trading. In Australia, the Sydney Futures Exchange is making a similar move to abandon pit trading and build an electronic trading system.

* The London International Financial Futures and Options Exchange — ravaged by Germany’s Deutsche Terminborse electronic exchange — last week approved a radical plan to reorganize as a for-profit corporation and offer electronic trading alongside its open-outcry pits within 12 months.

* The Chicago Board of Trade also last week acknowledged it was exploring a partial IPO of Project A, its overnight electronic futures and options trading unit. Just in time, too: A competitor’s soon-to-be-launched computerized exchange will trade the same Treasury bond futures that now generate 55% of the Chicago mart’s business. The Board of Trade move follows a similar IPO study by the Chicago Mercantile Exchange for its revitalized Globex2 computerized trading unit, which recorded its first quarterly profit in March.

* Leaders of the American Stock Exchange in New York last week agreed to acquire the Philadelphia Stock Exchange, even as the Amex prepares to merge with the National Association of Securities Dealers, parent of the electronic Nasdaq Stock Market. Meantime, the New York Cotton Exchange completed the first round of its merger with the Coffee, Sugar & Cocoa Exchange, forming the New York Board of Trade.

* Even Big Daddy — the New York Stock Exchange — won’t be immune to rethinking what it does and how it does it: Seat prices on the New York exchange have plunged 32% from a record $2 million set only in March.

What’s driving these dramatic developments?

“It’s cost, cost, cost — traders are looking for the low-cost provider,” says Joseph O’Neill, president of the New York Cotton Exchange, which, together with government securities trading giant Cantor Fitzgerald LP, will soon challenge the Chicago Board of Trade by launching the computerized Cantor Financial Futures Exchange (InvestmentNews, April 20, May 4).

Adds A. Carver Wickman, managing director and head of global futures for Goldman Sachs & Co. in New York: “This is really about the entire global capital markets. It includes the stock exchanges as well as the futures exchanges. Technology is enhancing the way that we do business, and the market is now just beginning to create ways to use it. It is manifested first and foremost in the exchange derivatives markets because it is a place where there are more efficiencies to be wrung out of the market.”

The shift is being played out in the U.S. and abroad as old-line exchanges and upstart competitors scramble for ways to harness technology to outslash each others’ costs and speed up the flow of trading information.

After a stunning showing in Europe — where the Deutsche Terminborse, or DTB, has wrested an 83% share of the 10-year German Bund futures business from the London exchange, vs. 31% just 18 months ago — the threat of electronic trading is now unfolding most dramatically in Chicago.

Here, the 150-year-old Board of Trade and the 124-year-old Chicago Mercantile Exchange — long the world’s two largest derivatives marts — continue to cling to open-outcry trading in which brokers and traders physically signal buy and sell orders across trading pits. Both exchanges are reeling from plummeting membership prices as electronic trading ventures threaten to siphon away their business.

Though the Board of Trade remains the world’s busiest exchange based on volume, it may well be eclipsed later this year by Germany’s DTB. The brash, eight-year-old electronic futures exchange has surpassed both London and the now No. 4-ranked Chicago Merc in the space of a year.

Both Chicago exchanges are trying to preserve their historic monopolies through a variety of maneuvers, ranging from pressing for government regulation of over-the-counter traded derivatives to mounting legal challenges against upstart electronic ventures. All are aimed at buying time while the marts figure out how best to compete as investors and the securities industry embrace electronic trading.

But the exit of institutional traders, such as Northern Trust Corp. and Harris Bankcorp Inc., as well as the specter of new electronic trading initiatives, have exchange leaders scurrying to prop up seat prices and calm member anxieties.

Chicago marts eye ipo

A full Board of Trade membership earlier this month sold for $495,000 — 42% off its high of just over a year ago. At the Chicago Merc, full memberships are trading at $325,000, or slightly more than one-third what they fetched at their 1994 peak of $925,000.

Last month, the Merc hired consultant McKinsey & Co. to develop a strategic plan by yearend. “We are studying how to convert to automation,” says Merc chairman emeritus Leo Melamed. “One of the issues is whether we should consider listing Globex2 as an IPO.”

In exploring public offerings, Chicago’s futures marts hope to jump-start their small but fast-growing electronic operations by tapping the capital markets. The Board of Trade seeks to connect its system into a new pan-European venture called Eurex.

According to internal Board of Trade estimates, officials believe a public offering could value the ProRevolution in the trading pits

ject A electronic trading unit at perhaps $300 million, based on the unit’s 1998 projected earnings of $12 million on $22 million in revenues and its current 100% annualized volume growth.

But some exchange estimates have valued the electronic trading unit as high as $700 million — an unlikely scenario unless the venture were to operate during traditional daytime open-outcry hours.

That’s a politically and emotionally charged minefield in Chicago — or any other people-oriented mart — since the value of exchange memberships derives from the information edge that traders enjoy by standing in the pit crowd and quickly trading as clerks funnel in orders from the sidelines.

“It seemed to be going over like a lead balloon,” Board of Trade Chairman Patrick Arbor concedes of early member reactions to his IPO proposal. “But interest is growing and people want to know more about it.”

Mr. Arbor insists Board of Trade already has sufficient financial resources to fund its strategic initiatives. But there are clear strains.

It’s servicing a $100 million debt on the construction of a new financial trading floor. And the performance of new contracts based on the Dow Jones Industrial Average has been disappointing: Trading levels are about 10,000 contracts under the estimated 25,000-a-day level the exchange needs to cover its substantial marketing and licensing costs.

seats slumping

In fact, the mart’s Index Debt and Energy Market membership — the seat most closely identified with the Dow contracts — now trades at $34,000, or one-fifth what it commanded in March 1997, when word began circulating that the Board of Trade had likely won the right to trade the stock index contract.

The Board of Trade also bled operating cash for the quarter ended in March. Net operating cash flow ran a negative $2.9 million vs. a negative $600,000 during the same period last year, and a positive $10.4 million in 1996. (Exchange officials say trading volume is up 16% this year and the mart is financially sound.)

A public offering of an exchange wouldn’t be without precedent: Sweden’s OM futures exchange is part of publicly owned OM Gruppen and currently trades at about 13 times this year’s forecast earnings.

Other exchanges may follow Sweden’s and Chicago’s lead. Industry sources say Germany’s Deutsche Borse (parent of the DTB) may seek to go public within two years. Such an offering could value the bourse at $2 billion, based on current trading multiples and the DTB’s 73% trading volume growth through the first five months of this year.

In Chicago, Mr. Arbor says a public offering may also be planned for the exchange’s Chicago Board Brokerage, an electronic cash T-bond trading venture to be launched next month: “If CBB is successful, it certainly could be another possibility for another separate IPO.”

At the same time, the Board of Trade is pursuing an alliance with Eurex, the cross-European electronic mart resulting from the pending merger of the DTB and Switzerland’s Soffex exchange.

In joining Eurex, the Board of Trade will gain access to a new generation of electronic trading under development by Chicago-based Andersen Consulting. This so-called “open system” will allow almost anyone with a personal computer to hook into the system and trade. The closed-network computer trading systems now used by most exchanges require costly custom terminals just to hook into the system.

But pressure to slice costs and compete against electronic trading will soon force other exchanges — from San Francisco’s Pacific Exchange and the Chicago Stock Exchange to the Boston Stock Exchange and even the Big Board –to reexamine how they will operate.

The one thing they all share: They must act fast. Goldman Sachs, for instance, shifted nearly its entire Bund trading business to the DTB in 12 months, after determining it could save more than 30% in trading costs.

“Electronic trading is forcing the marketplace into new efficiencies,” says Goldman’s Mr. Wickman. “It’s a wake-up call, not just to the Board of Trade, but all exchanges.”