Insight - For crying out loud

The recently rumoured (though strongly denied) merger between theatened by on-screen alternatives. Yet Liffe plans to spend at least #200m on a new trading floor. Why? London Stock Exchange’s screen-based equity market and Liffe – the London International Financial Futures Exchange – has added to speculation that the days of screaming kids in stripey jackets and trading pits may soon be over.

So, too, has the increasingly high profile of German, French and Swiss futures markets, which expect to gain more euro-business at London’s expense if Britain stays out of the first wave of single currency countries.

London’s open-outcry futures market appears to be underseige from the onslaught of on-screen alternatives.

Yet the futures markets in London, Chicago and New York do not see it that way. Indeed, in October a poll of Liffe members revealed that a substantial majority are still in favour of retaining the present system.

But in mainland Europe exactly the opposite view prevails. There, screen-based trading is spreading fast in all fields. As the battle lines form, many finance directors of British companies will have ringside seats for the coming contest and are already making judgements on which system suits them best.

Liffe has itself gone some distance down the electronic road, but mainly for after-hours trading. It also relies on its screen-based system APT (Automated Pit Trading) to handle all of its JGB (Japanese Government Bond) business and will move euroyen trading onto APT in the near future.

Liffe is likely to move all trading in these contracts onto APT since it believes that splitting the market reduces liquidity. Market officials say Paris’s MATIF market – which, like London, operates two systems – also avoids having the two types of trading running parallel in the same product and in the same time frames, presumably for the same reason.

And yet, Liffe is making a #100m-plus investment to develop a new electronic trading platform for equity options, targeted to launch in autumn 1998.

A factor driving this type of option business forward will be the trend of large institutional investors to look to deal on what is called “natural” business – where another big investor wants to be the counterparty rather than relying on brokers to use their capital to facilitate the business.

This is all part of the trend towards order-driven, screen-based markets as distinct from the UK quote-driven model which thrives on floor trading.

Some finance directors may shrug their shoulders at news of these developments and wonder whether any of this matters to them, so long as the business gets done.

They are missing a couple of points. One is that open-outcry pit trading is fertile ground for innovation. The other is that it is likely to prove the only soil in which “local traders” – the self-employed punters who have their own seats on the exchange and who provide both innovation and liquidity – can flourish.

Simple trades may be cheaper using screen-based trading, but this advantage is offset by the need to talk to a person, not a screen, when complex trades are needed such as short-term interest rate cover (“Buy June, Sell September, Buy December!”). In dynamic situations, where complex products and shifting strategies need to be combined to best advantage, people-power wins.

Put another way, an entirely screen-based system seems unlikely to give FDs the tailored service they need, when they need it most. Even in calmer times open-outcry is the simplest way to launch new developments such as the use of “strips” and new products such as the “Bobl” (a five-year German government bond futures and option contract introduced in September).

But Liffe accepts that electronic screen trading is going to grow fast.

In fact, Liffe chief executive Daniel Hodson goes as far as to say: “Long term, we want to see it all over the world, accessible via terminals on office desks, and not just through local trading centres.”

So is the “war” a phoney one with no major battle taking place? Don’t you believe it. If Liffe had a lawn it could be said that the Germans now have their tanks on it in the shape of Eurex, set up in Frankfurt by the Deutsche Borse as a three-nation, screen-based derivatives system.

Swiss Soffex joins next summer. France’s MATIF – mainland Europe’s second-largest market – will join as soon as it has a fully-compatible electronic system.

By 1999, members of any one of these European markets will be dealing on all three markets from a single screen. Frankfurt’s conviction is that screen-based trading is much cheaper. And they will have a single currency in which to do it.

Before long, this alliance will be extended to share dealing. That creates a powerful continental European impetus for a general switch to electronic trading. It requires heavy investment, but with 13 different currencies about to disappear and 22 futures exchanges calling out for rationalisation now is the time to do it.

Werner Siefert, chief executive of Deutsche Borse, says this development will reduce the cost-base so that everybody wins. Sardonically he says: “The fun thing about Liffe is that they still think the future lies in competition.” In the last few weeks he has even suggested a merger with Liffe.

But Clifford Dammers, secretary-general of the International Primary Markets Association, believes local traders will be all but wiped out, unable to afford the capital cost of a fully electronic trading system.

The painful result for users of the exchange would be much reduced market liquidity on Liffe, especially at times of crisis.

It is by no means certain that London’s strong position as the second largest derivatives market – having recently overtaken the Chicago Mercantile Exchange – will be undermined if the UK stays out of Emu. It was just as possible that it could be mainland Europe that finds itself sidelined.

There is no guarantee yet that everyone will be enthusiastic about holding euros, a currency that has yet to be tried and tested over time and which is backed by an industrial base with high wages and appalling pension problems.

One strength is Liffe’s own international – rather than little Englander – membership: 70% of its 223 member firms are foreign-owned. Hence, Liffe believes it can afford to hasten slowly towards the concept of an all-electronic 24-hour global trading system.

Moreover, claims from Frankfurt that a combined Eurex will have volume as big as Liffe by 1999 are on shaky ground based on current figures.

Whereas Liffe has been growing at 45% a year since 1982, the German market has grown at just 17% a year while the Swiss figure is actually down 18%.

Meanwhile, Liffe already has possession of the high ground. It has 54% of all 10-year German government bond trading and 97% of short-term German interest rate products.

Liffe is currently planning to build a new trading floor or two in London’s Spitalfields. The plans allow for one trading floor of 60,000 sq ft and potentially a second floor of 40,000 sq ft. Liffe currently squeezes its traders into a 38,000 sq ft site above Cannon Street station, but will be spilling over into 20,000 sq ft of space on the former London Stock Exchange floor in May. However, that space will be predominantly taken up by the coffee/cocoa/sugar London Commodity Exchange, which merged with Liffe last year and operates out of St Katharine’s Dock.

With Liffe about to spend some #200m-#300m of its members’ money on the new exchange site, it clearly believes that open-outcry has a future.

by John Heffernan.