Historically, Trading Futures
Historically, trading futures, bonds and other financial instruments required face-to-face communication. Changing trends in technology have lead to the rise of financial technology, where financial services are further enhanced with the help of technological advances. Today, information technologies further improve economic judgement by shaping available resources.
Traditionally, daily trading practices take place in open outcry pits, which is the method of communication that involves traders shouting and using hand signals to transfer information on the trading floor. Technology has introduced new electronic information systems which is a platform in which uses computerised trading systems that have begun to replace traditional open-outcry pits (Barclay, 2003). This has become a critical component of globalisation, however there are several pros and cons to this.
This essay will evaluate the advantages and disadvantages of Electronic Communication Networks compared with traditional trading methods based on Terrence Hendershott’s Electronic Trading and Caitlin Zaloom’s field research Ambiguous Numbers. The analysis will focus on comparing whether innovations in electronic networks help traders develop more accurate interpretations of numerical information better than face to face trading practices.
In Hendershott’s reading, emphasis was placed on innovative communications which focus on removing the physical barriers as it makes global order routing and trade information across national borders possible (Hendershott, 2003). Susan Strange, a British scholar of international relations defines financial trading as a “global casino (Strange, 1986). Because of electronic communication networks, there are less barriers to communication because it reduces the need for direct physical contact on trading floors (Zaloom, 2003). On traditional trading floors, transactions are carried out in person, whereas electronic communication networks allow someone to make quick transactions from another part of the world. For example, Nasdaq’s information can be accessed from outside of New York City (Hendershott, 2003). Thus, ECN amplifies global market interconnection.
Another advantage of ECN that Hendershott mentions is that automated communication and matching systems have resulted in lower trading costs. Unlike traditional face-to-face methods, ECN’s allow traders to avoid intermediaries such as dealers and brokers, which lessens costs incurred. Research shows that dealers in the New York Stock Exchange have an operating margin of 50%. Thus, ECN gives traders the opportunity of cutting these costs which leaves them with more funds focus on having a more competitive position as a trader in the market.
According to Hendershott’s research, faster order execution is another advantage of ECN. The average execution time for an ECN is two to three seconds, compared to face to face trading, which takes more than 20 seconds to execute. (Hendershott, 2003) In Caitlin Zaloom’s reading Ambiguous Numbers, her field research whilst working for the Chicago Board of Trade shows that after a trader has made an agreement and yells “sold” or “bought”, the two write a code on a card and hands it to his clerk, who then confirms it with the counterpart (Zaloom, 2003). This traditional method is much slower than the pace of transactions that take place electronically. Quick matches are also done through the use of limit order books where the ECN attempts to find internal matches first to execute trades immediately. The designer of London Future Dealings’s (LDF) graphic user interface of their ECN opts for a Spartan approach, where “ultra fast prices” are communicated without any “analytics or fancy recommendations” so that traders can “observe the market they want to” (Zaloom, 2003). In a world where market prices constantly change, time is off the essence, which makes ECN advantageous to traders.
Another advantage of ECNs is that they provide anonymity of traders, as they only display the price and the size of the order (Hendershott, 2003). Unlike face-to-face trading, the chances of uninformed investors copying strategies and misinterpretation of data as information is transmitted through signals and bodies of traders are less. Maintaining anonymity is necessary in order to avoid strategies that traders can leverage on for their own profits, according to Zaloom’s reading (Zaloom, 2003). Therefore, when a trader carries out a transaction on an ECN, he remains secure from other traders.
According to Caitlin Zaloom’s reading, ECNs seek to “purify” the transparency of information that according to her, already exists in an open-outcry pit. The designer of the LDF’s interface says that in an electronic world, “the truth comes out” (Zaloom, 2003). For example, Nasdaq’s order execution is transparent though the use of SuperMontage, even though it does not offer post-trade transparency (Hendershott, 2003). Thus, the designs of an ECN commit to a simple numerical representation of the market which then increases transparency.
Even though there are numerous advantages to ECN, there are several disadvantages and limitations that must be considered. Caitlin Zaloom outlines the way traders choose to have some knowledge on the social contextualisation of the market. ECN’s typically do not keep traders in the loop on social context as they often “keep it down to the absolute minimum (Zaloom, 2003). ECN’s often leave traders “cloaked in the abstracted numbers of the market”. Because of this, software designers attempt to provide social information through their technologies. Thus, traders like to be socially informed and ECN’s fail to provide that as well as face-to-face trading methods do.
With regards to social context, Zaloom found that traders in an outcry pit benefit from physical signals like the tone of voice and body language of the opposite trader. Traders use these signals to form market judgements as they get a more intuitive idea of the current market condition. Traders use their colleagues body to get “contextual clues and understandings of market fluctuations”. An electronic communication network may not be appropriate if the trader would rather learn more from sensory information and “learn not to calculate”. Thus, electronic trading often removes the human aspect of interpreting market data (Zaloom, 2003).
Although transaction costs are reduced when a trader uses an ECN platform, there are fees that have to be paid. Hendershott’s reading outlines that ECN has fees that subscribers have to pay directly and that non-subscribers have to pay indirectly. Subscribers have to pay to purchase the ECN terminal which could be very costly. For example, in the case of Nasdaq, the company would need a terminal for every one of their traders. In addition to that, ECN’s charge a fee if an incoming order was executed against the limit order book. Thus, the costs incurred to obtain the ECN platform are higher than that of an outcry (Hendershott, 2003).
Another limitation to ECN is that larger, more complex transactions may be difficult to carry out electronically. According to Hendershott’s reading, electronic platforms distribute quotes and allow bids, asks and sells but the volume of the transactions are not yet substantial. For example, bonds and FX that are traded in large amounts have yet to be traded electronically in a large volume and is still largely based on telephone communication and face-to-face meetings. Only 10% of corporate bonds were traded electronically as per year 2000 (Hendershott, 2003). The reason behind this is that large transactions occur without posting limit orders, which is one of the key factors of an electronic trading system.
Electronic trading has transformed the world of financial markets. Its innovation has enhanced trading to a global scale, connecting people from across the world to make transactions that they can profit from. With reduced costs and quick execution, electronic communication networks has also offered privacy and security, compared to face-to-face trading in the pits. However, Hendershott and Zaloom’s readings places emphasis on the idea that electronic trading systems have yet to replicate human intermediaries and functions within trading. Although electronic communication has helped speed the process of trading, bonds and foreign exchange may not be suited to be traded electronically because limit orders hinder larger transactions. In conclusion, electronic communication networks is necessary to connect the world and executive quick and efficient trades. It keeps up with quick changes in the market and allows traders to profit from these changes. However, electronic trading cannot fully replace face-to-face trading because trading is not all numbers, it is also based on human beings. To conclude, ECN’s are more suited for informed traders who would benefit from anonymity and fast execution, but does not suit traders who trade in larger volumes, requiring to learn more about social context.