Not long ago anyone who wanted to trade futures either worked in the pits or knew someone who did. Harris Brumfield understood this as well as anybody. Two decades ago he arrived in Chicago from rural Mississippi still shaking Delta dust from his cuffs and quickly transformed himself into a pit bulldog at the Chicago Board of Trade with a voracious appetite for Treasury futures.
Then one day in 1997 he got a peek at something remarkable: a laptop computer running a program enabling the user to trade on Eurex, Europe’s electronic derivatives exchange. It was fast. It was simple. It was anonymous. Brumfield immediately realized he was staring into the future of futures.
“Electronic trading let the whole world come to the exchange at the same rate of speed,” says Brumfield in his distinctive Southern drawl. “Competition just exploded, and the whole world became the pit.”
These days you won’t find the 42-year-old Brumfield in the pits. He works out of an 11th-floor office on the edge of the Chicago River, spreading the gospel of electronic trading as the CEO of Trading Technologies International -- whose headquarters happens to look out over the Chicago Board of Trade and the Chicago Mercantile Exchange. TT’s widely used platform has helped spur an electronic revolution in futures, opening the market to a flood of new traders. In 2006 a total of 805 million futures contracts were traded on the CBOT, where roughly 72 percent of trades were done electronically. And the pace doesn’t seem to be slowing. In February the CBOT set a one-month record of 67 million contracts traded, 79 percent of which were electronic.
Hedge funds have been driving the growth, thanks to advances in electronic futures trading and to a 2003 rule change eliminating registration requirements. The timing couldn’t be better for hedge funds, which are looking for ways to hedge other than by using the traditional technique of shorting -- selling borrowed securities in hopes of buying them back later at a lower price to return to the lender. Advances in electronic futures trading have also made the market more attractive to algorithmic traders, who rely on computerized trading programs based on mathematical algorithms to carry out strategies in stocks and bonds.
“We now have demand for $700 billion of short stock from hedge funds -- an amount that cannot be satisfied by the stock and bond loan departments on Wall Street,” says Charles Gradante, managing principal of New Yorkbased hedge fund consulting firm Hennessee Group. “Consequently, hedge funds are moving into futures; they are being used in place of stock to hedge.” Gradante believes the number of hedge funds trading futures has doubled over the past four years.
Hoping to cash in on the estimated $1.4 trillion in assets that hedge funds now control, the futures exchanges and technology vendors have been actively courting hedge fund managers. In July 2006 the CME created a special team -- the Hedge Fund and Brokerage Services group -- to serve its existing hedge fund customers and attract new ones. “We set up this group because we recognize hedge funds are large liquidity providers to any market,” says Tina Lemieux, head of global hedge fund and retail sales for the CME, which along with its rivals has begun offering special membership deals and discounted trading prices to hedge funds. At the same time, technology companies like TT that specialize in futures trading software have stepped up sales efforts aimed directly at hedge funds.
“Everybody is after hedge funds,” says Travis Schwab, TT’s managing director of global buy-side sales.
Futures trading is hardly a new concept for the hedge fund set. Such managers as Louis Bacon, Bruce Kovner and George Soros have long used futures to place their macro bets. Yet as recently as a decade ago, the barriers to entry into futures trading kept most hedge funds on the sidelines.
“Before electronic trading, trades were in the hands of floor brokers,” says Joseph Riggio, a principal who heads up execution and client education for New Yorkbased commodities and futures broker Saratoga Futures, which caters to hedge funds. “If you were a hedge fund and you wanted to buy winter wheat, it was possible a broker would get wind of it and buy first, selling it to you [at a markup].”
Technological advancements have since made futures trading faster, cheaper and more transparent. Electronic systems now aggregate and display up-to-the-minute market information, allow for simultaneous order entry and enable users to concurrently access multiple exchanges around the globe. “There is nothing between you and the information,” says Riggio.
Notes one hedge fund trader who deals in futures and asked to remain anonymous, “With electronic trading there is less information slippage of the sort you get with pit traders, runners and brokers who relay information by telephone.”
But one of the biggest catalysts for the mass movement of hedge funds into futures was a rule change by the Commodity Futures Trading Commission in August 2003 eliminating a requirement that hedge funds and other pooled asset funds that trade futures register with the regulator as commodity pool operators.
"[The change] was obviously a positive influence on futures trading,” says John Gaine, president of the Managed Funds Association, a Washington, D.C.based hedge fund industry group.
Before the rule change, it was primarily former pit traders who embraced electronic futures trading. They simply put out a shingle and began trading for their own accounts. That’s how Brumfield, the son of a cotton and soybean farmer who grew up in Inverness, Mississippi -- population 1,061 -- stumbled upon TT. Following his 1997 departure from the CBOT, Brumfield found himself shopping for a trading software provider. He chose TT, which had recently relocated from Frankfurt, Germany, to Evanston, Illinois. He says the more he used TT’s software, the more he liked it. Brumfield started investing some of his trading profits in the private company, continuing to do so until he became the majority shareholder and, ultimately, its CEO.
“I liked the system, and I thought it had a lot of value,” says Brumfield, a graduate of Mississippi State University. “We were bringing together exchanges around the world.” He also got involved with TT engineers’ efforts to enhance and modify the company’s trading programs, helping to create screens that would mimic the actions of pit traders.
What TT came up with is a screen format the company refers to as “the ladder” -- its X_Trader software -- which has become traders’ preferred way of electronically displaying and entering futures orders and market movements. Because futures contracts tend to trade in a narrow range, TT’s ladder provides traders with a list of possible prices for a specific contract on an exchange. On a static, vertical, ladderlike grid, prices are displayed in boxes in descending order, with adjacent ladders on each side flashing bids and asks for the corresponding prices. As traders spot movements, they can enter buy and sell orders with a single mouse click.
The ladder launched TT on a pattern of rapid growth. The company had 25 employees in 1998 but now has more than 500 housed in ten offices around the world and estimates that there are as many as 10,000 of its screens in use. Users pay $14,000 to $15,000 per year. But expanding proved easier than generating profits. Although revenues have grown at an annual rate of 40 percent, Brumfield says the company is still just at the break-even point and is fighting for market share with a handful of other software providers that offer similar ladderlike products.
Paris-based GL Trade Group is one such competitor. Formed in 1987, GL Trade has been offering electronic trading systems since the early 1990s and developed a system that allows trade execution with a single mouse click. The company, which created its own ladder screen, has roughly 1,200 employees and boasts about 30,000 screens in use. Banks, brokerages and several independent software developers have also created programs -- all of them incorporating ladder-based display screens.
Brumfield believes competitors with ladder-based offerings have violated TT patents, and in 2004 the company filed lawsuits against GL Trade and a host of competitors. TT began settling the lawsuits in 2005, but a handful remain ongoing -- including the one against GL Trade. “We believe we were first with the ladder,” says Hugues Deroubaix, who heads GL Trade’s buy-side trading solutions. He insists that GL Trade developed its ladder trading program independently and says the company will continue to fight the suit. Brumfield declined to comment on the issue.
Competition for proprietary traders was at the heart of the ladder disputes. Since then, however, electronic trading providers across the board have turned their attention to hedge funds. “In my group our entire focus is on hedge funds right now,” says TT’s Schwab.
A similar move has taken place at GL Trade, which started out marketing its system primarily to sell-side clients and last year created a separate division to serve the buy-side market -- including hedge funds. Deroubaix says the buy side is where the growth and activity are these days.
To accommodate hedge funds’ unique needs, the new generation of trading software incorporates more extensive tracking of, and accounting for, futures transactions, based upon the way funds allocate those transactions to investors within their funds. Unlike proprietary traders, who continuously buy and sell futures contracts throughout the day -- looking to make money one tick at a time -- hedge fund managers often use futures as hedges and hold on to them for longer periods. In particular, S&P 500 futures contracts have become a popular device for hedging against equity positions. Some fund managers also use futures contracts on specific sector indexes and occasionally even on individual stocks. Trading platforms have also had to adapt to the sophisticated automated algorithms many hedge funds use to trade futures, allowing for so-called “black box” trading.
Algorithmic trading systems, which require electronic access to exchanges, work best when there is high volume. The rapid expansion of electronic futures trading has therefore made futures more attractive to algorithmic traders. TT and other software venders say they see increasing demand from hedge funds for ways to use algorithmic trading on futures exchanges.
The exchanges, for their part, are enjoying the benefits of electronic trading in the form of strong volume growth -- owing largely to hedge funds. Although the continuing evolution and expansion of electronic futures trading could soon mean the end for floor-based trading in the fabled pits of Chicago, both the CME and the CBOT insist that there will always be a need for direct, person-to-person trading of certain commodities.
Don’t tell that to futures software companies like TT and GL Trade, which insist that the writing is on the wall. “In a few years there will not be any more pits,” says GL Trade’s Deroubaix. “Everything will be done with electronics.”
