Risk Markets And Politics

Wednesday, August 23, 2006

Nymex: "Evolution is Inevitable"

Nymex seatholders have for some time been contemplating the value of their trading rights versus the equity value in the eventually public exchange. On September 4th, Nymex will begin offering physically settled electronic energy futures. Although it was known to be in the works, this announcement is significant and cues the end-game of futures floor trading in the US. Nymex first launched regular-hour electronic contracts in 2002, but the addition was a half-hearted gesture given the exchange's commitment to floor trading at the time. Volume on the electronic side languished until last year, when competition from the ICE motivated Nymex to back the contracts more fully. Recently, full-size electronic contracts were launched as part of April's agreement with the CME. But even though the electronic side is seeing better volume, it is missing something important: physical settlement, which can only be found on Nymex's floor. Some speculators do prefer cash settlement, but hedgers and even banks, who are among the largest exchange customers in terms of open interest, demand physical settlement. Next month they will be able to get it electronically, and transparently.

Michael Sankowski's comments on bootstrapping markets reminded me of my experience with the Nymex electronic contracts from 2002 to 2003. Essentially what we had on the oil side were 10-20 market-makers and arbitrageurs — and virtually no-one else. Active markets need a diverse set of traders with different motivations and time-frames. You can't build a market with market-makers and arbs only, even if they are well capitalized. You also need to attract long-term (fundamental) traders, short-term (technical) traders, and of course hedgers, ideally on both sides of the market. (Participants that derive entertainment from their trading can help too.) In the case of Nymex, it wasn't that they didn't "know better". They knew their business well and didn't get behind the electronic contracts until competition made it a necessity.

Leo Melamed, who pioneered financial futures, once said, "[a market] is more than a bright idea. It takes planning, calculation, arm-twisting, and tenacity to get a market up and going." Likewise, Mark Fisher advised me before I left the Nymex scene, "Jason, you don't think right because you think everything is about thinking." This was an exaggeration but he was basically right. Then, at least.

The rise of electronic trading at Nymex is a reminder of how long apparent inevitabilities, or great ideas, can take to develop. This pertains both to developments of new markets and developments within markets. CNBC loves to stress the speed and excitement of markets, but perhaps what is more impressive is how slowly - how painfully slowly - things usually play out. Stocks in the late '90s. Housing in recent years. The current account deficit and the dollar. Concerning new markets, take Robert Shiller's housing futures, which were over a dozen years in the making &mdash and three seconds months after launch many want to write them off as a failure.


  • Jason, your essays on markets are generally thoughtful and thought provoking. I do think that the backhand slap at the housing futures is unwarranted. We have an asset class (housing - $20 trillion) that has never has a derivative attached to it before, save for mortgage instruments. I think that to presume success/failure after three summer months and no multiyear listings yet is far too soon. The CME listings mark the beginning of making housing price a tradable commodity. This will take time. Many old timers remember the launches of eurodollar and oil futures, thinking they were doomed at best. Housing derivatives are only in the neo-natal ward with expectant parents looking in an devising stratgies.

    By Anonymous Fritz Siebel, TFS, at 10:25 AM  

  • Hi Fritz, That was exactly my point since I was talking about how long markets take to develop. It's surprising that anyone would interpret that remark as not being supportive contra the naysayers.

    I can see that open interest in the housing futures is steadily climbing by about $3mm/week, which is encouraging.

    By Blogger Jason Ruspini, at 11:02 AM  

  • Jason, my apologies. I misread the origination of the naysaying. I have not heard any naysaying to date, only minor pecking. I thgink when extended term get listed in Q4, I think the contract will change at a minimum in importance.

    By Anonymous fritz Siebel, TFS, at 11:51 AM  

  • "Essentially what we had on the oil side were 10-20 market-makers and arbitrageurs"

    This is a common approach to populating a new market. As far as I can tell, it doesnt work.

    Like you said a market consists of many different types of traders. The best markets have all of these traders interacting on a second by second basis. However, building a market requires something different as all of these traders will not simply show up, no matter what incentives are offered. So it is necessary to start with an idea of what traders might interact with one another, and how they might interact.

    One part of this ecosystem that has been overlooked by just about everyone trying to get a market started is trade time frame. How long do these traders stay in the market with a single trade? I know you are aware of this from your earlier comments.

    By Blogger Mickslam, at 3:35 PM  

  • In our case, traders were generally discouraged to go home with positions.. so what you had to a large extent was everyone trying to exploit the same intraday strategies such as opening range breakouts. Market-making wasn't effective either since there was no order flow and no "paper".

    Of course, having traders with different time frames is much less of a consideration with event markets.

    Victor Niederhoffer likened markets to ecosystems in another context, but the idea is similar: the various types of market participants have interdependencies.

    By Blogger Jason Ruspini, at 12:36 AM  

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