For many people, the words stock exchange invoke images of men clad in weird jackets frantically gesturing and yelling at each other while quickly scribbling on their pads. Albeit exaggerated and over-simplified, this is how a lot of exchanges used to function, regardless of whether they're stock, options, or futures exchanges.
But the human floor trader is becoming a relic of the past as exchanges go virtual and traders handle business through impersonal computer terminals and phones. With the rise in electronic trading, there has been no major conversion from an electronic system back to the old method. So with virtually all of the momentum on the side of electronic trading, is there much of a future left for human floor traders or human interaction?
- The open outcry system was common in the early days of trading for financial instruments like stocks, bonds, options, and futures.
- Traders often sat at desks and walked over to other traders to conduct their business.
- Firms and clients began to see what technology could offer them, particularly in terms of faster execution and lower error rates.
- Electronic trading made its way into the trading world in the late 1960s and flourished, with many major exchanges making the switch to fully automated trading.
- Although open outcry is primarily a thing of the past, there are still physical trading floors at the NYSE and the London Metal Exchange.
A History of Open Outcry
Given that stock and commodity trading predates the invention of the telegraph, the telephone, or the computer by hundreds of years, it is fairly obvious that face-to-face human trading was the standard way of doing business for a long time. Some exchanges began as little more than informal gatherings of local businessmen with common interests like a grain buyer and a grain seller.
Over time, though, the functions became more regular and specialized, and the people involved came up with common rules and policies. This culminated in the creation of open outcry markets for financial instruments like stocks, bonds, options, and futures. Although the rules and procedures varied from exchange to exchange, they all had a trading floor where members conducted their business.
Trading was once a fairly sedate and orderly affair where traders would sit at desks and walk over to other traders to do business. But as business picked up, the interaction changed. The desks eventually went away. Sedate and leisurely trading was replaced by sometimes-frantic yelling and gesturing, with particular hand signals for buying, selling, and the numbers involved.
The trading floor was sometimes called a pit.
The Rise of the Machines
While a busy trading floor looked like bedlam to the uninitiated, it worked surprisingly well for the most part. But member firms and clients began to see what technology could offer them, particularly in terms of faster execution and lower error rates.
- Instinet was the first major electronic alternative, finding its way into the trading world in 1969. With Instinet, clients (institutions only) could bypass the trading floors and deal with each other on a confidential basis. Instinet was a slow grower and didn't really take off until the 1980s. But it became a significant player alongside the likes of Bloomberg and Archipelago, which was acquired by the New York Stock Exchange (NYSE) in 2006.
- Nasdaq was established in 1971 but didn't really begin as an electronic trading system. Rather, it was basically an automated quotation system that allowed broker-dealers to see the prices other firms were offering as trades were handled over the phone. It eventually added other features like automated trading systems. In the wake of the 1987 crash, when some market makers refused to pick up their phones, the Small Order Execution System launched, allowing electronic order entry.
Given the benefits of electronic systems and client preferences for them, a very large percentage of the world's exchanges converted to this method. For instance:
- The London Stock Exchange (LSE) was among the first major exchanges to switch, making the conversion in 1986
- The Borsa Italiana made the change between 1992 and 1994, followed by the Toronto Stock Exchange in 1997
- The Tokyo Stock Exchange switched to all-electronic trading in 1999
Many major futures and options exchanges also made the switch along the way.
Global firms and traders can use electronic communication networks (ECNs) to conduct trades within and outside the normal trading hours of any major exchange.
Open Outcry Today
For a long time, the United States was more or less alone in maintaining open outcry exchanges. Some of the country's major commodity and options exchanges all used open outcry as a way for traders to conduct their business. These exchanges included the:
- Chicago Mercantile Exchange (CME)
- Chicago Board of Trade (CBOT)
- Chicago Board Options Exchange
The open outcry system in each of these exchanges worked alongside electronic alternatives for traders to use. But many of the physical trading floors closed permanently, primarily because of the COVID-19 pandemic. The NYSE temporarily shut down its pit during the pandemic. It reopened and required individuals to show proof of vaccination to access the trading floor as of 2021.
The London Metal Exchange (LME) is the largest exchange outside the United States that still uses the open outcry system. The exchange calls its trading floor the Ring.
Which Is Better?
It may seem intuitive or obvious that electronic trading is superior to open outcry. Computers are certainly faster, cheaper, and more efficient. And although they're also less error-prone with routine trades, the error rate in open outcry trading is surprisingly low. What's more, computers are at least theoretically better for regulators in creating data trails that can be followed when there are suspicions of illegal activity.
Having said that, electronic trading is not perfect. This makes the unique features of the open outcry system very desirable. For instance, traders who can read people may be at an advantage when it comes to picking up non-verbal cues on the motives and intentions of counterparties. Perhaps analogous to the world of poker, there are some players who thrive as much on reading the players as playing the odds. As such, electronic trading removes those signals from the equation.
Oddly enough, human interaction is also often better for complex trades. Many of the trades that are sent to the floor at the CBOE Options Exchange and other open outcry exchanges are complex or unusually large. Skilled floor brokers can often get better execution and better pricing by working the order with other traders, which is something that electronic systems generally cannot do so well.
The Future of the Floor
Despite the potential advantages that human floor trading can offer to some clients, the march of electronic trading seems inexorable. A very large percentage of stock trades are conducted electronically today. In fact, very few people—if anyone at all—seems to want to go back to the old ways.
That said, so long as members feel that floor traders provide a useful service and the traders themselves make enough to continue showing up, there may not be much of a push to get rid of them. Put another way, they are not hurting anybody with their presence today, so why chase them out if they wish to stay?
The Bottom Line
The face-to-face human trading floor is all but dead. Electronic trading dominates the financial world as a whole. As the influence of large institutions on trading patterns seems only likely to rise further, the efficiency and speed of computer networks make them an entrenched part of the trading infrastructure.