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Electronic Trading Is a Good Thing–at First

When a century-old wheat market went electronic, it became a living laboratory for the impact of high-speed trading.

On January 14, 2008, it was freezing outside the non-descript office building that houses the Kansas City Board of Trade. Inside, traders who had spent their entire careers on an open-outcry market, where business was done face-to-face, watched as their way of life was utterly transformed.

For the first time, it was possible to trade Hard Red Winter Wheat–which, as the primary component of bread, is one of the most traded commodities in the U.S.–on an electronic exchange. Skeptics, used to the old ways, had predicted that the electronic market would be unpopular. Yet the first year it operated, it served ten times as many trades as the old open outcry market, and even though the trades were smaller on average, it still accounted for 100,000 more trades per month–nearly double the volume of the old market.

An analysis of the transition published this year by a pair of economists from Oklahoma State University captures an increasingly rare event in the developed world: the moment in time that a market moves into the information age, when anyone can trade on it regardless of their physical location, prices move in a matter of seconds and every trade is transparent.

So far, the Kansas City Board of Trade has seen only the benefits that economists previously predicted would accrue to anyone who adopts an electronic market. For example, according to the analysis by Smarth Shan and B. Wade Brorsen, moving to an electronic market meant decreased price volatility.

That’s exactly the opposite of what you’d expect if you’d read the recent coverage of last Thursday’s hiccup in prices on Wall Street. (Here’s a great example from the LA Times: “Growth of electronic trading a major cause of stock market free fall”).

Other benefits included a lower cost of liquidity–it was cheaper to move money into and out of the market–which correlated with a decrease in the size of each trade, an increase in daily volume of trades, and a decrease in the kind of round-number prices humans like to quote each other when they’re negotiating the price of something face to face.

All of this makes sense when you imagine replacing the clubby atmosphere of a trading floor packed with a few dozen guys who have known each other for decades, with a potentially infinite number of anonymous traders logging on from anywhere in the world, moving prices in tiny increments. If the point of markets is efficiency, and efficiency means volume, then it’s no wonder traders and even regulatory bodies have allowed electronic markets to flourish.

Of course, we won’t know what the long-term effects of electrification of this market are until the day traders discover the market for Hard Red Winter Wheat - which is already big enough to be included in Goldman Sachs’ S&P 500-style index of commodities futures known as the GSCI.

As the SEC seeks to regulate day traders, who may hold stock for as little as a few seconds, and therefore aren’t actual shareholders in a company by any reasonable definition, it’s markets in transition–which are, like this one, laboratories for economists studying the effect of technology on markets–that will provide data on their ultimate effects, both good and bad.

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